Vanguard’s patent that allowed it to bolt an ETF share class to existing mutual funds expired in May. ETF market watchers and participants have been speculating which firms would take advantage of the development. Dimensional Fund Advisors recently filed its plans to add an ETF share class to some of its mutual funds with the SEC. In the document, the issuer explained how adding an ETF share class could benefit investors in traditional mutual fund shares and in ETF shares.
VettaFi spoke with Joe Hohn, a Dimensional senior portfolio manager and vice president, about how the firm decided to take this step and what the move could offer investors.
A 3-Pronged Plan
VettaFi: What was Dimensional’s rationale for implementing the Vanguard model for ETF shares of mutual funds for its products?
Joe Hohn: We’re hoping to get the approval of the exemptive relief, and we’re optimistic there. And then our mutual fund board [needs to determine which funds the structure makes sense for]. Our thinking has always been that everything is client-driven, and we had clients asking for this.
Five years ago, clients asked a lot for us to get ETFs, period. So when SEC Rule 6c-11 came out, we developed a three-pronged attack for this. We said, “Hey, we know there are some standalone ETFs we want to launch.” That was prong number one.
Prong number two was, “There are some mutual funds that we have that would probably be really good candidates for a full conversion.” Those are the tax-managed or tax-aware funds [which converted into ETFs in 2021 and 2022].
With prong three, some clients asked about a partial conversion or a share class kind of structure [so they could keep some assets in mutual funds and some in an ETF structure].
We developed that three-pronged plan and executed on the first two because we could control the timing of those a lot more. It is unknown how long [the current]discussion will take with the SEC. They — understandably so — have some questions and concerns. I actually really appreciate the concerns they have — they are looking out for the best interests of investors, and that’s great.
Answering SEC Concerns
That’s great for us, too, because we can look at the concerns that they have, and we can tell them how we think it would work if we were able to get a share class going forward. We’ve got 40 years of mutual fund operations. We believe our trading costs are really low, our implementation costs are low, and our tax efficiencies rival those of ETFs.
Over the last three years, we’ve been managing ETFs. I think we are the most advanced and most innovative active ETF manager out there in the space.
VettaFi: Are there any potential drawbacks to adding an ETF share class to an existing mutual fund?
Joe Hohn: We’re just going to have two ways of managing a fund. We have mutual fund [creations]and redemptions, which happen via cash in our strategy. Our portfolio managers will still be managing these funds, just like they do now. Then on the ETF side, we’ve got this process of building out creation and redemption baskets on a day-by-day basis that are active [and]rebalancing the portfolio. They’re increasing expected returns. We just turn that on so we can see the flow from both ways, [with]both ways helping out the funds.
In fact, with our standalone ETFs right now, yes, the majority of the flow, like the change to holdings of the securities in the fund, happens via basket activity. But the portfolio managers are still there managing those funds on a day-by-day basis and doing basis point level turnover each day. It’s not that dissimilar to what we’re already doing in our funds.
A Question of Active Management
VettaFi: Is the fact that Dimensional funds are actively managed a barrier to approval by the SEC, in your opinion?
Joe Hohn: It’s tough to say because there are different flavors of active management. There also are some potential concerns that the SEC could have regarding index funds because they aren’t opportunistically using flow on either side to rebalance the portfolios. They’re just looking to track an index.
That being said, there are some very different active managers out there with high turnover or stock-picker kinds of active managers. We believe we have the best of both worlds — we are low cost and low turnover. The SEC’s concerns are reasonable, and we think we can mitigate them. Given our investment strategy, we believe we can answer their questions and concerns.
VettaFi: It’s unclear if you can close an ETF to a new investment like a mutual fund can. Is that a concern at all for Dimensional?
Joe Hohn: We think about it in terms of the size of the room and the size of the door. The size of the room is, “How big is my fund relative to the asset class that I’m trying to capture?” And our funds are pretty big, but there are a bunch of index funds that are way bigger than us [that are]trading in what I would consider to be much less efficient ways. And they still aren’t taking up too much of the asset class. I think we’re a long way away from having problems concerning the size of the room.
The size of the door speaks to, “Are we seeing flows that are so big that we can’t put the cash to work?” And we aren’t seeing any of those issues. Massive diversification helps there as well.
More the Merrier
VettaFi: Do you think other mutual fund issuers will follow suit en masse?
Joe Hohn: We’ve had discussions with SEC staff since 2019. We’ve been trying to understand their concerns, their considerations, and give them data to address their concerns. It’s good that the SEC has those concerns and considerations. But if other issuers come and start asking for the same kind of thing, we will have to address those concerns and considerations individually with the SEC staff. But if more and more of us are asking for it, I think that helps to just drive the discussion.
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