Equity Investing with Dimensional in Mutual Funds vs. ETFs

Dimensional has announced the launch of UCITS exchange-traded funds (ETFs) for European investors. These solutions will complement our existing suite of mutual funds and separate accounts in Europe, offering investors access to Dimensional’s active equity solutions in an ETF wrapper.

Unlike index ETFs (or index mutual funds), active ETFs do not passively track an index. Instead, they seek to achieve a specified investment objective using an active investment strategy. This provides flexibility to adjust a portfolio’s holdings each day and implement a daily investment process as Dimensional has done for more than 40 years. The introduction of Dimensional UCITS ETFs offers European investors greater choice in accessing Dimensional’s time-tested, systematic investment approach.

ETFs are often compared and contrasted with mutual funds. Our approach to managing ETFs offers the same components of value-add and cost-effective implementation as our approach to managing mutual funds.

In this article, we highlight key areas of that approach and describe the nuances of applying it to an ETF structure versus a mutual fund. We also touch on some considerations that may be important to investors evaluating which vehicle to choose, such as implications for tax efficiency, the differences in how mutual funds and ETFs are bought and sold and the types of costs encountered when investing in the two vehicles.

It’s important to distinguish investment strategy from investment vehicle. Dimensional has a consistent investment philosophy and approach that provides the underpinnings of how we manage portfolios, regardless of the investment vehicle.

We have a long track record of designing investment solutions that offer consistent, diversified exposure to the market or market segment in which they invest, while adding value through implementation. We seek to add value at each step of our investment process, which includes research, portfolio design, daily portfolio management and trading.

Our Research team, working in close collaboration with leading academics, continually deepens our understanding of expected returns through robust theoretical and empirical research. We translate these results into portfolios that are designed to systematically and efficiently pursue higher expected returns, while managing risk and controlling costs.

In our daily implementation, Portfolio Managers consider numerous inputs that inform how we pursue higher expected returns across multiple premiums while giving our Traders flexibility when participating in available market liquidity. This flexibility allows them to reduce trading costs. We also aim to enhance the value of our holdings through our integrated approach to corporate actions, securities lending and investment stewardship practices.

We have more than four decades of experience, developed through investments in our people, our processes and the systems that support Dimensional’s approach to managing portfolios. We expect to bring all aspects of our investment process to the management of Dimensional ETFs. Exhibit 1 lists components of our value-added process that we can employ across both our mutual funds and ETFs.

While Dimensional has one investment philosophy and we apply the same investment process across our solutions, there are important differences in how an ETF operates that can provide additional tools for implementing daily rebalancing.

ETF Portfolio Managers can rebalance their underlying portfolios using the same trading tools as mutual fund managers. An additional tool for rebalancing an ETF is the ETF share creation and redemption process, which is facilitated through an authorised participant (AP).

For example, when new ETF shares are created, the ETF issues creation units, which are blocks of a specified number of ETF shares, to the AP in exchange for cash. Similarly, the ETF can redeem creation units in exchange for cash. This creation and redemption process generally leads to the purchase or sale of a diversified “basket” of securities in the ETF. The composition of this basket is defined by the ETF issuer before equity markets open.

ETFs have the flexibility to provide “custom baskets” to APs, or baskets that do not mirror the exact underlying holdings of the ETF portfolio. These baskets can take into consideration the same daily inputs that factor into our mutual funds’ buy and sell lists. By using baskets to increase and decrease certain portfolio holdings, we can use the creation/redemption process as one more way to rebalance the ETF portfolio, similar to the way we use client cash flows to rebalance our mutual funds.

The decision to invest in our mutual funds versus our ETFs depends in part on an investor’s preference for one vehicle type over the other. Mutual funds and ETFs have similarities and differences. For example, both our Irish fund range and our new ETFs are investment funds registered with the Central Bank of Ireland, and UCITS rules apply to both. Differences between ETFs and mutual funds may include tax efficiency features, how investors buy and sell them, how prices are set and the types of costs investors should consider.

Tax Efficiency

Irish-domiciled ETFs generally have an advantage over many other European domiciles when it comes to the taxation of dividends from US equities. For example, while Irish-domiciled mutual funds and Luxembourg-domiciled ETFs or mutual funds generally pay a withholding tax of 30% on such dividends, ETFs domiciled in Ireland generally pay a withholding tax of 15%. This advantage does not hold against UK-domiciled mutual funds, which are generally subject to the same preferential tax treatment of US dividends as Irish-domiciled ETFs.

Access and Price

Mutual funds usually offer share classes in multiple currencies, which are bought and sold directly with the fund manager at the end of each business day. Investors in mutual funds subscribe and redeem only at the net asset value (NAV) of a share class. Unlike mutual funds, ETFs usually only offer share classes in their base currency.³ Each share class, however, is generally tradable on multiple stock exchanges in the relevant local currency. Through these listings, share classes can be bought and sold during the day and at market prices that may be at a premium (above the NAV) or discount (below the NAV).⁴ Additionally, platforms may offer the option to trade ETFs outside an exchange at the NAV.

Cost Structure

In assessing the costs of investing in ETFs versus mutual funds, it’s useful to consider the types of direct costs investors face and when they are paid. For example, both vehicles incur ongoing charges, which include the management fee and other administrative costs. These expenses are costs investors incur throughout the holding period, and we anticipate will generally be similar across Dimensional’s mutual funds and ETFs for like-to-like strategies.

Investors also face potential entry and exit costs when transacting in the vehicle. For example, investors typically pay a platform transaction fee when buying or selling mutual funds. In contrast, many platforms now charge low or sometimes no commissions to buy or sell ETFs on an exchange, or offer ways of trading ETFs outside an exchange via dedicated APs. However, as with trading any stock, there are other trading costs to consider when trading an ETF, such as bid-ask spreads and market impact. For example, our analysis of the microstructure of the European ETF market shows that the spread is widest near market open but drops significantly and becomes relatively stable 30 minutes after the open.

In addition to the direct, or explicit, costs an investor incurs for each vehicle, investors should consider the cost effectiveness of the underlying portfolio. High transaction costs in the underlying portfolio generally lead to lower returns for investors, all else equal. In both a mutual fund and an ETF, Dimensional considers costs at every step of the process, from broadly diversified and low turnover portfolio design to flexible portfolio management and trading that take into consideration information in markets daily and use cash flows from client activity and other sources to help rebalance portfolios.

Settlement Period

European mutual funds commonly settle investor subscriptions and redemptions three days after trade execution, whereas ETFs generally follow the standard two-day settlement cycle of stocks. While this makes a reallocation from single stocks to an ETF more seamless, investors should plan for settlement and timing differences when trading between mutual funds and ETFs.

Holdings Disclosure

An active ETF usually discloses portfolio holdings daily on a public website, compared with monthly for most mutual funds.

Dimensional invests with a consistent investment philosophy and approach to pursuing higher expected returns for investors in either an ETF or mutual fund. Offering both vehicle structures allows investors to choose the vehicle most suitable for their unique circumstances and preferences.