ETFs or Mutual Funds? How to Target Benefits of Both Worlds.

Same concept of single fund, multiple access points of share class. Is it same concept of what DK outlined of ETF share class of the same fund conceptually? Absolutely! Okay. I like to use the metaphor 'cause we're talking about a pool of assets of a swimming pool summer in Texas. I think we're all spending time at the pool. That's right. Do you wanna go in, do you wanna take the slide in? Do you wanna take the ladder and you wanna cannon ball in? You're getting in the same pool- Same pool. Either way. And that has a really important connotation too, for tax efficiency, which we haven't touched on yet. Okay. Which is, if we go back to that debate, is a mutual fund more tax efficient than an ETF? Yep. Where I say, you know, that debate, you really gotta look beneath the surface. Everyone's in the same pool when it comes to a multi-class fund. Welcome to "The Informed Investor," where we break down the latest financial headlines, bringing in research and insights to help you separate the news from the noise. Welcome everybody to "The Informed Investor," a podcast brought to you by Dimensional Fund Advisors, a firm that is bringing financial science to investing with over $1 trillion of assets under management. I am Jake DeKinder, I am not Mark Gochnour, he is actually out today. So we don't really know what's gonna happen on this podcast here, but incredibly excited. We're gonna be talking a little bit about ETF share classes. You might been hearing some stuff out there, articles that are being written. We want to dive into the details of that and kind of unpack what is an ETF share class and what does that mean for you as an investor. Incredibly pleased to be joined by Isabelle Williams, Deputy Head of Investment Solutions, and Dave Kavanaugh, global head of investment operations. Guys, great to have you here. [Isabelle And Dave] Great to be here! Now I'd like to define one term upfront. I'm gonna call you DK. That's okay, I can live with that. We have worked together for way too long, well over a decade. And I literally can't call you anything but DK. That works for me, Jake. I mean, it was kind of weird calling you Dave Kavanaugh, just to be clear. Guys, I got a couple headlines here. We always start with a couple headlines, so I'm gonna read a couple here and you can comment on those initially and then we'll get into some of the details of what I talked about. So one here "Opening the Door, Not the Floodgates: The Real Impact of ETF Share Classes." And then another one here, "ETF Share Classes Off to the Races, but Operational Reality Will Slow Progress." So I don't know if any of those kind of spark a thought right off the bat. I mean, I know we're gonna get into some of those issues, but when you hear that, what do you think DK? Yeah, I think that there's been a lot of headlines on ETF share class and what that means. So I think part of this podcast will be, you know, really trying to describe, you know, in some detail what we're really talking about when we're talking about ETF share classes. But I would agree with the sentiment, and I know we'll get into some of the operational details of it, is that it's great that these can be available, but I would agree there's not gonna be a flood of products immediately. I think most issuers are gonna kind of inch their way into it. But I think in, you know, 5, 10 years time, there will be a lot of ETF share class products out there in the market. Okay. What do you think when you hear some of those headlines? I think they had captured the sentiment pretty well, which is we're right at the cusp of what I think of as a real revolution in the asset management industry and how funds will be delivered to investors. But it's also going to be something that I don't think your average investor really recognizes is happening around them, because it's gonna happen behind the scenes. It's gonna happen with operational builds and complexity from service providers, asset managers, and the end investor is just gonna get to enjoy the types of solutions that they have been enjoying, but a little bit more efficient, a little bit more cost effective, which in my view is kind of the best possible type of revolution in the asset management industry. Completely, and we'll talk a little bit about those benefits, but let's just start off initially, what is an ETF share? Well, let's even start off, I mean, what choices broadly sort of do you have available as an investor when you think about public markets and how you access that in the form of a fund? Yeah, totally. So as an investor, people are probably familiar with mutual funds and ETFs as the most common types of funds available to you. And an ETF share class combines features of those two realities. And we'll talk about that a little bit more. But essentially when you're an investor, you have the option of going out and buying stocks, bonds directly. But that has a lot of potential risks and costs associated with it. What mutual funds and ETFs allow you to do as an investor is have a professional investment manager, an asset manager, manage a portfolio of stocks, bonds, what have you, for you. You get operational technicalities taken care of by the asset manager. You get lower cost, because you're pooling all of your assets with other investors and those are being spread out across a wider asset base. So there's a lot of inherent benefits that both mutual funds and ETFs have, but they have different features as well. And I think investors know some of that, but maybe don't actually know in great detail always what the difference is between a mutual fund and ETF. Yeah, completely. I think one thing to highlight too is that you can manage strategies as an asset manager in a very similar way, whether it be an ETF or a share class. So because of the ability to do that, as Isabelle mentioned, I think over time it just makes sense to have, you know, a single product where you have a mutual fund access point and an ETF access point. And that's where we're at today. So if you go back in time, I mean mutual funds have been around longer than ETFs, but ETFs been around for a number of decades. Yeah. I mean DK, walk us through just kind of high level the history sort of of where we've gotten to. Yeah, so in terms of mutual funds, you're right, mutual funds have been around for decades and they have really been a great investment solution for millions and millions of investors. ETFs, to your point, they came to market I believe, in the early nineties and they just operate a little bit differently and we can get into that. So mutual funds, going back to mutual funds, so one important difference is that the way they trade. So when you are buying a mutual fund, you're actually interacting directly with the fund company in a purchase. And then when you're redeeming, you're actually redeeming, and then again, working directly with the fund company on that or transacting directly with the fund company on that. ETFs are different. And so ETFs actually trade in the market, just like any other security. They trade on an exchange. They trade on an exchange. Okay. And in a market. And then when there is a demand for more ETFs to be traded, that's when there will be a creation transaction with the fund company. Okay, I'll say pros, cons, gimme characteristics of mutual funds versus characteristics of ETFs. You wanna jump into that? Sure, I think characteristics and especially contrasting characteristics of ETFs and mutual funds tend to come down to how you are transacting as an investor. Okay. With that fund. So as DK described, because with a mutual fund, you're transacting basically directly with the fund in effect as an investor, that comes with certain features. The main one that I think is helpful to understand is that when you transact with a mutual fund, you are getting to buy or sell that mutual fund at what we call NAV, which is Net Asset Value. And it's basically the assessed value of all the underlying securities in that mutual fund. And the asset manager who runs that fund sets that value, that NAV, once a day at market close. So if I place a trade in a mutual fund mid-afternoon, what I actually end up paying for that or receiving for that is that net asset value. And I don't know that price until the end of the day. Gotcha. That has some benefits for an investor. It means that you don't have to stress about that, how you're placing that trade, you're going to get that NAV value either way that can be great, but it also means you only have that one chance on a day to basically buy or sell. An ETF, you're trading like, a stock, you're trading it on an exchange like we mentioned before. And that means that you're getting it at market price. You've gotta be thoughtful about how you place that trade. There are trading best practices to keep in mind. But that also means you can buy yourself throughout the day. You don't have to wait for the NAV value to be struck after hours. That has some potential benefits as well. It really comes down to what you prefer and how you want to transact with a fund. Yeah, and I think to your point there that you made earlier, which is sort of when you think about an investment process or a way to manage money, you really can do it similarly in a mutual fund or an ETF. And one of the comment I just want to get in is, is that I think there has been a narrative and maybe rightly so about this idea of tax efficiency of ETFs. And I do think there has been some truth to that and we don't have to get into the details, but you actually can make or do similar things in a mutual fund as well. Is that correct? Yeah, so I think you're right that there's this perception that ETFs are more tax efficient than mutual funds. And where that is coming from is the fact that a lot of the tax efficiency claims that ETFs make come from the fact that they are able to do their rebalancing through what we call in kind transactions. And we don't have to get into all the mechanics of that, but it's essentially an intrinsic mechanism that ETFs have that allows the portfolio manager to buy or sell underlined stocks or bonds without having to sell those in a way that realizes capital gains. And that gets passed along to the investor by basically giving the investor a little bit more control over when they want to realize gains from their own transactions. And the, when they realize I think is important, 'cause on previous episodes we have defined, you know, people would say sort of like, "Well, you're not paying the tax on it." You'd be like, "No, it's actually more of a tax deferral barring a step up in basis." So again, we don't have to go into the details, but important for investors to understand that's the way an ETF works. Well, yes, exactly. And I think ETFs sometimes get a little bit of a free pass in the tax efficiency discussion. People say, "It's an ETF, it's gotta be tax efficient," "It's a mutual fund, maybe it's less." And at the end of the day, what drives any fund's tax efficiency is gonna be far more based on its underlying investment strategy. How much turnover is the portfolio manager having to do? Are they forced to do that turnover at opportune times or not? Those are gonna have real implications for tax efficiency regardless of vehicle types. So you shouldn't just assume any ETF is more efficient than any mutual fund. You've really gotta look at the actual fund manager, their track record and assess vehicle agnostic. And there are lots of things that managers can do to make mutual funds highly tax efficient as well. So while it is important to be aware of this benefit that ETFs have and how they can kind of naturally do in kind rebalancing, it's, you gotta look beneath the surface- You do. To actually know what's gonna be the most tax efficient experience. Completely. Yeah. Jake, one more thing feature I wanted to mention is about availability. So mutual funds are generally made available through retirement plans as well as you know, on other platforms of course. But historically ETFs have not been as widely available in the retirement plan space. So as we get into the benefit of an ETF mutual fund share class, the great thing is you can have a single product that you can hold in your non-taxable accounts as well as your taxable accounts. Okay, good. So, good definitions. Clarification there. What's an ETF? What's a mutual fund? Little bit of history, I appreciate that. The point of the episode is ETF share class. What the heck is an ETF share class? Yeah, so I'd say broadly speaking from an operational perspective, you have a single pool of assets. So a single fund pool of assets and what could those assets be? You know, securities, you know, stocks, bonds, you know, that fit the investment strategy. The great thing about a mutual fund ETF share class is you have an access point that is an ETF. And so trades like an ETF, it is an ETF, and then access point that is a mutual fund. And so again, single pool of securities, just different access points for that particular product. Okay. What do I need to know as an investor? So let's, I'm just gonna use a hypothetical here. I own a mutual fund and now I have an option for an ETF share class. Like, what does that mean to me? Yeah, well I mean one thing is that if you really like that strategy but you know, prefer to hold it in a mutual, in an ETF wrapper, then you get the same track record, you get the same benefits that you were getting in that investment strategy, but you're just able to purchase it in ETF. So that's one example of a benefit. So what does that mean to me from a tax standpoint? Like, if I owned a mutual fund and there was a company who now had an ETF share class of that mutual fund and I like the ETF share class. Yep. What does that mean from a tax standpoint? Well I think you're getting into convertibility. I think which is a really important feature of a mutual fund and ETF share class. So what you can do within the structure is if you are holding a mutual fund, then you do have the ability to convert that mutual fund into the ETF class in a non-taxable transaction. Slight caveat, if there are fractional shares, there could be a small portion of that that is taxable. But again, the important thing is you can move from that mutual fund to the ETF in a non-taxable transaction. Okay. That's good. So some of the articles that I read here, or headlines that I read here are sort of this idea of ETF share classes coming onto the market. There's a lot of interest in it right now. I guess the question is, is that like why now, and what do you have to actually do to have an ETF share class? What do you have to accomplish? Sure, so, ETF share classes, historically it hasn't been possible for most asset managers to offer them. In order to be able to offer an ETF share class, you have to get something called exemptive relief from the SEC. There's a whole process involved with that. Dimensional actually undertook that process, applied for exemptive relief to be able to offer ETF share classes. And we were granted exemptive relief to be able to do so in 2025. Now... So you basically gotta get permission. You gotta get permission. You gotta get permission from SEC. Exactly, you gotta get permission, which is different than if you just wanna launch an ETF or you wanna launch a mutual fund. So there's- It's a little different process. A different process, a bit more of a hurdle. Now, lots of other asset managers are also applying for- Hence all the articles we read. Hence all the articles. So I think this is the kind of inflection point in the industry that we're talking about. Now when it comes to, once you have that exemptive relief, how do you launch an ETF share class? It works pretty similarly to how you launch other types of share classes for a fund. We haven't talked about this a ton, but multi-class funds, multi-class mutual funds are actually a very common occurrence in the industry. It's very common that a mutual fund might have a class for retirement plans, a class for individual investors, and maybe a class for financial professionals. Something like that, very common. Again, allows different types of investors to use the same fund, which has great economies of scale. Okay, I'm gonna let you continue, but I just wanna come back. So same concept of single fund, multiple access points of share class. Is it same concept of what DK outlined of ETF share class of the same fund conceptually? Absolutely. Okay. I like to use the metaphor 'cause we're talking about a pool of assets of a swimming pool, summer in Texas, I think we're all spending time at the pool. That's right! Do you wanna go in, do you wanna take the slide in? Do you wanna take the ladder and you wanna cannon ball in? You're getting in the same pool- Same pool, yeah. Either way. And that has a really important connotation too for tax efficiency, which we haven't touched on yet. Which is, if we go back to that debate, is a mutual fund more tax efficient than an ETF? Where I say, you know that debate, you really gotta look beneath the surface. Everyone's in the same pool when it comes to a multi-class fund. Let's say it adds an ETF share class. You add that optionality for investors, they can decide now to, they can decide now to take that slide in to the pool, the tax efficiency for all the investors in that pool, regardless of if they are coming in via the ETF share class, they came in via the mutual fund share class and they're converting over to the ETF share class, the tax efficiency experience is shared across all investors. Because you've added the ETF share class, the portfolio managers can now take advantage of those in kind rebalancing techniques that are intrinsic to ETFs and the potential benefits of that can be spread across all the investors. So can I just think of it as if I've got these multiple share classes, these multiple access points, me as a portfolio manager, I got more options and options have a non-negative value. I mean, not to be too technical, But like- Absolutely! Yeah. If I ask a portfolio manager anywhere, "Do you want options?" They're they're gonna- They're gonna say "Yeah!" They're gonna say "Yes!" Completely. They're gonna say "Yes!" Completely. Okay, one other quick question then I wanna come to you on operations. I was in Atlanta a couple of weeks ago. Some financial professionals were asking questions and one thing that came up was track record. So the mutual fund's been around, the ETF share class is new. How does that work with the track record of the fund? Because for a lot of people and definitely maybe more in the professional area, track record is important. Yeah, absolutely. Track records help you evaluate an investment. They help you understand how it's performed historically. Assess what types of clients or allocations it may be most appropriate for. This is a great feature in my view of ETF share classes. You can have a fund that has existed for decades and decades. It could predate the existence of ETFs at all. And when you add an ETF share class to that mutual fund, it shares the historical track record. Okay, so it carries over. Because it's that same underlying pool. Exactly! Okay. Carries that same historical track record, it shares that and then going forward, you also have a very similar performance experience between share classes because the only difference you would expect between those share classes performance is gonna come down to differences in operating expenses for different share classes, which tend to be fairly small, though it can vary by fund manager. Okay, that's good. All right, so one of the headlines I read here was, "ETF share Classes Off to the Races, but Operational Reality Will Slow Progress." I mean, talk to me about maybe where we are at in the industry and why that headline there could have some truth to it. Yeah, so going back to your question though, Jake, about what does it take to kind of stand up an ETF share class. There are some, I am an operation so I do have to comment. I know you are, DK! There are. There is a fair amount of work that that it takes to actually, you know, kind of onboard an ETF structure into a mutual fund. So take the example of you got a standalone mutual fund today, you wanna create an ETF share class of that. You know, Isabelle obviously walked through a lot of the benefits of that. But you do have to retain service providers to perform those ETF operational services, transfer agency services and importantly, you know, you have to have the capital markets capabilities, you know, which a lot of firms have been building up over the last few years with respect to standalone ETFs. But the same would hold true for an ETF share class of a mutual fund. So capital markets teams are those that actually, you know, interact with the market participants out there, pay attention to trading quality. There is a little bit more work in terms of, you know, standing up an ETF share class, you know, after you get through the SEC exemptive relief process. DK, one thing that I've learned of working with you for a decade is, there's always a lot more work behind the scenes. Well, you know... Sort of us sales guys are like, "Ah, it's so easy, no problem! Make it happen." And you're like, "No, we actually have to do a lot of work." Yeah, yeah. But I think, you know, the question you're really getting at before though, or around, what do we mean in these headlines by these operational challenges? So I think what that's really getting into is the challenges around conversions from a mutual fund to an ETF. And the way I described it before sounds very simple, but the reality is, is that the trading systems and operational infrastructure that were built for ETFs are very different than what was built for mutual funds. So what does that mean? It means that these two systems, and this is an industry-wide, you know, issue, they don't talk to each other. All right. So they've historically not talked to each other. So when you talk about converting a mutual fund to an ETF, you know, you've gotta have the ability for the client's custodian to, you know, send an order in to the mutual fund transfer agent that then communicates with the ETF transfer agent and then which issues the shares and then those shares go back to the end client's custodian for delivery to that client. You know, that- Has not been set up. That has not been set up. The depository trust clearing corporation is really an industry utility. They do a lot of great things for the industry, but one of the things that they have done and released last month was protocols around what that messaging looks like. So the intermediary can transmit that information to the mutual fund transfer agent, to the ETF transfer agent, and then back the shared delivery back to the client's custodian. So that's where we're at today. But here's the reality though, is all of the service providers, you know, within the industry then have to build technology and operational systems that can leverage those capabilities that I described. And they have to test to that. And so the industry has been working extremely hard, you know, at this for quite some time. The reality is though is that they'll probably have some of the service providers will have that functionality available later this year, but we're looking probably 2027, 2028 before it's broadly available. It just takes a lot of work to get those systems talking to one another. Correct. Correct. And I think it's worth underscoring all that complexity, the mechanisms DK is talking about are really specific to that conversion mechanism. That ability for an investor who holds a mutual fund share and then their mutual fund adds an ETF share to convert their mutual fund shares into ETF shares and have it be not a taxable event generally speaking. Of course today, if you're in a mutual fund and you wanna buy an ETF, you could sell that mutual fund, buy that ETF, but that's gonna be a taxable event. There's transaction costs. There's all sorts of frictions that conversion does away with and that's what's really elegant about the conversion solution as an investor. For DK, I don't know if elegance is the word he's gonna use to describe all the work he and his team and the service providers have to do, but as an investor, all that work is gonna solve this friction that people have been dealing with anytime they wanna move between a mutual fund and an ETF share. Okay. When we get down the road and we've got some more of those pipes talking to one another, DK, are we gonna have a beer together? We may, we may do. You feel really good. You're buying, You're buying. I'm buying! That's a total deal. Okay listen, kind of walk me through what are the main takeaways from this discussion here? I'm an investor, what do I need to know? So I think the main takeaways I would have as an investor is that there is something very exciting happening behind the scenes in the asset management industry right now. Largely thanks to work from DK and other operations professionals around the industry, which is that you are going to have the opportunity in a much more widespread way than has been the case in the past to have this vehicle structure, this multi-class structure, that gives you choice of access points. Do you wanna trade a mutual fund or an ETF? It lets you put that choice, as a secondary matter so that you can focus first and foremost, "What fund do I wanna be in?" "What investment strategy do I like?" And then you can walk up to that fund and decide which pathway you want to trade in and out of it through. You'll have that choice. That means that the fund you're getting has increased efficiencies of scale. It has that long-term track record, it has this conversion feature and it has this potentially enhanced tax efficiency. So you're getting a better fund potentially, you're getting more ways in and outta that fund and you're getting this conversion mechanism that is only available in this sort of multi-class ETF share class structure. So you're getting a lot of additional features and potential benefits while in effect, it's the same funds you've always known and loved. So that's what I mean about, I think you're getting a quite revolutionized experience as an investor, but there's no work that you have to do. You can kind of just sit back and see the expanded choices in front of you. It's exciting. Guys, Isabelle, DK, thanks for coming on the broadcast. Great discussion there I think, and more to come. So we'll see how everything continues to evolve. All right everybody, thanks for tuning into "The Informed Investor." A couple of things to note here. 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