The ETF vs. Mutual Fund Debate: Investment Strategy Matters

Investors may wonder which investment vehicle is better—a mutual fund or an exchange-traded fund (ETF). As ETF assets grow, industry participants continue to debate the merits of one vehicle over the other. While the ETF versus mutual fund debate has many angles, one stands out: should investors consider a manager’s underlying investment strategy when comparing ETFs versus mutual funds in areas such as how investor activity is managed, how frequently holdings disclosures are required, and tax efficiency? In Dimensional’s case, we believe our systematic approach can add value and control costs, whether in a mutual fund or an active transparent ETF wrapper.

Proponents of ETFs argue that they are more efficient than mutual funds because ETF investors generally bear their own trading costs. In a mutual fund, investors typically invest and redeem with cash, and any costs of trading due to cash flows are shared by all investors in the mutual fund. In an ETF, by contrast, most trading related to investor activity happens outside the fund. Investors may buy and sell shares of the ETF on the secondary market, with shares being created and redeemed in exchange for baskets of securities. This in-kind creation/redemption process allows for trading costs to be externalized such that investors bear their own trading costs through the bid-ask spread and premiums and discounts.

But is there more to the story? Whether these mechanisms give ETFs an advantage over mutual funds depends in part on how the manager deals with daily investor trading activity. For example, if the fund is designed to track a static index, investor activity is generally managed by buying or selling a pro-rata slice of the index holdings based on the last index reconstitution. This type of pro-rata approach to managing investor flows potentially incurs trading costs but does not use current information from market prices, company financials, and corporate actions to efficiently rebalance the portfolio. For pro-rata approaches, the externalization of trading costs that happens in an ETF can be viewed as a benefit for ETF investors, as those trading costs are not offset by expected improvements in the funds through rebalancing. It is often the case that index funds don’t aim for such improvements.

In fact, until the September 2019 adoption of the new ETF rule (SEC rule 6c-11), most ETFs were required by regulation to follow a pro-rata approach for the in-kind baskets used in the creation/redemption process. Perhaps not surprisingly, as shown in Exhibit 1, most ETFs followed indexing strategies until recently, and fund flow data from Morningstar show that cash flows into indexed equity ETFs over the past 10 years were more than double those of indexed equity mutual funds.¹

In contrast to the pro-rata approach to portfolio management, Dimensional manages our portfolios using a flexible daily implementation process, centered on taking into consideration information in current market prices to help keep our portfolios positioned according to their intended characteristics. In our mutual funds, we can use cash flow from investors for rebalancing, which has historically helped reduce turnover. For example, net positive investor cash flows on a given day can be used to increase the weight of securities with higher expected returns or purchase securities to improve diversification. Absent that cash flow, investing in those securities would require selling other securities in the portfolio, incurring additional costs and potentially taxes. Similarly, in the case of net redemptions, we can sell securities or trim positions to help rebalance the portfolios in a way that maintains the desired portfolio characteristics. This flexible approach to daily management also allows us to consider short-term drivers of expected returns, such as security price momentum, in our process and better manage liquidity and trading costs, thereby seeking to improve the underlying portfolio. The 2019 ETF rule allows for use of custom baskets, meaning baskets that may represent a subset of underlying holdings or different baskets that trade on the same day. Using custom baskets in the creation/redemption process allows greater flexibility for non-pro-rata approaches and will be an important tool for Dimensional in allowing us to make similar determinations in the daily management of ETFs and mutual funds.

ETFs and mutual funds also differ in how frequently holdings are required to be publicly disclosed. Most ETFs are fully transparent, meaning they disclose their holdings on a daily basis with a one-day lag. By comparison, most mutual funds are generally required to publish holdings with a 30-day lag. Publishing holdings daily should not present a limitation for indexing strategies, as they are designed to track a published index, and index holdings generally do not change between rebalancing periods. However, do frequent disclosures of holdings limit the ability of an active manager to add value? Again, the answer depends on the approach. For example, publishing holdings on a daily basis may be viewed as an impediment by an active manager seeking to uncover mispriced securities or forecast market trends ahead of other market participants. As shown in Exhibit 1, until recently, virtually all actively managed funds were structured as mutual funds. While there are many possible reasons, requirements for frequent holdings disclosures may factor in.

In our view, publishing holdings daily with a one-day lag is not an impediment for our approach to adding value. By design, our portfolios have relatively low turnover and are broadly diversified across stocks, with a high degree of overlap in holdings from one day to the next. Our investment proposition is based on using information in markets to systematically and efficiently pursue higher expected returns while seeking to manage risk and controlling costs, not on trying to outguess the market through traditional forecasting or by uncovering stocks that are believed to be mispriced.

Finally, do ETFs have advantages over mutual funds with regard to tax management? The creation/redemption process provides an important mechanism for ETFs to control capital gains distributions. In a redemption situation, an ETF can redeem securities in-kind to an authorized participant² in exchange for creation units, allowing the fund to reduce its holdings of these securities without triggering a capital gains distribution. In-kind redemptions can reduce or eliminate the need to sell an appreciated security. As a result, ETFs are largely able to limit capital gains distributions to zero or close to zero. While in-kind redemptions are available to both mutual funds and ETFs, they have been used by ETFs with much greater frequency.

However, a manager’s investment strategy and approach also matter when it comes to tax efficiency. For example, limiting a portfolio’s turnover level and maintaining flexibility in managing distributions for income and both short- and long-term capital gains can contribute to tax efficiency. With regard to Dimensional’s approach, we believe we can deliver tax-efficient solutions by keeping turnover low and considering income and potential capital gains in our daily process, whether in a mutual fund or an ETF. An ETF offers an additional tool for managing capital gains distributions.

Debates about the pros and cons of investment vehicle types are important. Vehicle type can have an impact on cost, tax efficiency, and transparency—considerations that may be meaningful to many investors. We believe these arguments should be carefully considered in the context of the manager’s approach. In Dimensional’s case, we can offer a similar investment approach in a mutual fund or an ETF, providing our clients a choice in how they can access our investment offering.