Equity Investing with Dimensional in Mutual Funds, ETFs, and ETF Share Classes

ETFs are often compared and contrasted with mutual funds. Some funds offer ETF share classes, which provide investors an additional access point to the underlying portfolio. While there is no one-size-fits-all solution, Dimensional’s approach to managing portfolios offers the same components of value-added and cost-effective implementation across vehicle structures.

In this article, we highlight key areas of that approach and describe the nuances of applying it to an ETF or an ETF share class structure versus a mutual fund. We also touch on some considerations that may be important to investors evaluating which vehicle to choose, such as 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 flexible 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. Exhibit 1 lists components of our value-added process that we can employ across our funds.

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

ETFs can rebalance their underlying portfolios using the same trading tools as mutual funds. An additional tool for rebalancing in an ETF or ETF share class is through the in-kind creation and redemption process facilitated through an authorized participant (AP). In an ETF share class, both mutual fund and ETF class shareholders can benefit from this additional rebalancing mechanism. 

When new ETF or ETF class shares are created, the ETF issues creation units, which are blocks of a specified number of ETF shares, to the AP in exchange for a “basket” of securities and cash. Similarly, the ETF can redeem creation units in exchange for a basket of securities and cash.

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

Tax efficiency is an important consideration for many investors. The tax efficiency of any portfolio is strongly related to the investment approach. Dimensional’s strategies are designed to be broadly diversified and have lower turnover. That design inherently lends itself to a higher degree of tax efficiency relative to less diversified strategies with higher turnover. We believe that we can deliver tax-efficient solutions through a low turnover approach and considering income and potential capital gains in our daily process, regardless of vehicle structure.  To better understand what drives the tax efficiency of Dimensional strategies, it’s useful to break down tax efficiency into the management of 1) dividend income and 2) short-term and long-term capital gains.

Dividend Income

Income distributions are an important component of tax costs and, for portfolios with low turnover, may be at times a larger component of total distributions than capital gains distributions. By considering dividend income when we buy or sell securities and by excluding real estate investment trusts (REITs) from our equity portfolios, dividend distributions from many of our funds have historically had a higher portion in qualified dividend income (QDI). QDI is taxed at a lower rate than nonqualified dividend income (NQDI). This has often contributed positively to tax efficiency for Dimensional’s equity funds.

Capital Gains

Selling securities to rebalance the portfolio or meet redemptions has the potential to result in distributable capital gains in both mutual funds and ETFs. However, in-kind redemptions can reduce or eliminate the need to sell an appreciated security. While in-kind redemptions are available to both mutual funds and ETFs, they have been used with much greater frequency by ETFs. In an ETF, when an AP redeems creation units in exchange for a basket of securities, those securities are redeemed in-kind out of the ETF, which means the ETF can reduce its holdings of these securities without triggering a capital gains distribution. As a result, investors in funds using in-kind redemptions have greater control over the timing of capital gains, although the value of this flexibility depends on the particular investor's circumstances.

Because tax efficiency is related to the entire fund, we expect tax efficiency for a fund with an ETF share class will generally be the same across the mutual fund and the ETF class. Funds with an ETF share class could benefit from enhanced tax efficiency relative to a standalone mutual fund due to the additional rebalancing mechanism available via in-kind redemptions.

The decision to invest in a mutual fund versus an ETF depends in part on an investor’s preference for one vehicle type over the other. Mutual funds and ETFs have similarities and differences. Both are investment funds that are registered with the SEC under the Investment Company Act of 1940 (40 Act), and the majority of the rules under the 40 Act apply to both of them. Differences between ETFs and mutual funds include how investors buy and sell them, how prices are set, and the types of costs investors should consider.

Access and Price

Mutual funds are bought and sold directly with the fund manager at the end of each business day. Investors in mutual funds invest and redeem only at the fund’s net asset value (NAV). Unlike mutual funds, ETF shares are traded on a national stock exchange and can be bought and sold throughout the day and at market prices that may be at a premium (above the NAV) or discount (below the NAV).

Cost Structure

In assessing costs of investing in ETFs versus mutual funds, it’s useful to consider the types of direct costs investors face and the timing of when they are incurred. For example, both vehicles charge an expense ratio, which accounts for the management fee and other administrative costs. Expense ratios are costs investors incur throughout the holding period.

Investors also face potential costs when transacting in the vehicle, on entry and exit. For example, investors typically pay a brokerage platform transaction fee when buying or selling mutual funds. In contrast, many brokerage platforms now charge low or sometimes no commissions to buy or sell ETFs or ETF share classes. However, as with trading any stock, there are other trading costs to consider, such as bid/ask spreads and market impact.

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 mutual funds and ETFs, 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.

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