Quant firm Dimensional Fund Advisors has received formal approval to adopt a fund structure that for two decades has been used exclusively by Vanguard Group to save investors billions of dollars in taxes.
Dimensional, founded by David Booth, said on Monday that regulators had granted it so-called exemptive relief to offer dual share class funds. Dimensional had applied to add exchange-traded fund share classes to 13 of its US equity funds, and said in a press release that it will continue to evaluate “subsequent candidates.” The US Securities and Exchange Commission in September had indicated that the approval was coming.
The decision to grant the form to Dimensional represents a watershed moment for the $13 trillion U.S. ETF industry and U.S. money managers, many of whom have seen billions of dollars flow out of their mutual funds, often in favor of the more tax-efficient ETF vehicle.
The fund design, where one share class of a mutual fund is exchange-traded, was invented by Vanguard more than two decades ago. Since the firm’s patent expired in 2023, nearly every major money manager — including BlackRock Inc. and State Street Corp. — has asked the SEC for permission to use the dual share class model. The official green light sets the stage for a wave of future approvals, since more than 75 other firms are in the queue for potential permission, according to Morningstar.
“The joining of mutual funds and ETFs through share classes represents a significant enhancement in how millions of Americans can access financial markets in the future,” Gerard O’Reilly, Dimensional co-CEO and co-CIO, said in the release. “Share classes allow investors to choose the investment strategy that best suits their needs as a first-order consideration, and then select their ideal wrapper to access that strategy, while broadening benefits of increased tax efficiency and reduced costs from scale.”
Vanguard’s patent expiration proved to be the first obstacle for its rivals to clear. The bigger hurdle was waiting for the SEC to grant exemptive relief from current ETF rules to use the structure. Vanguard itself is part of the most recent round of applicants, as it has so far only received permission to use the structure in passive funds.
Some analysts anticipate a wave of new ETFs should other asset managers also get the regulatory nod. In the long run, that could potentially rewrite the tax consequences and performance of countless mutual funds, and may even erode the barriers that have largely locked ETFs out of the American retirement system.
Investors in the mutual-fund share class could be the biggest benefactors, according to Daniel Sotiroff and Bryan Armour at Morningstar. Funds that add an ETF share class are expected to offer what’s called “exchange privilege,” meaning that an investor wouldn’t have to sell mutual-fund shares to purchase the equivalent ETF share class, a move that could trigger capital-gains distributions and taxes, the pair wrote in a note. Instead, investors would get the tax advantage of an ETF’s redemption mechanism that can reduce or altogether eliminate capital-gains distributions.
“After the SEC’s groundbreaking green light, ETF share classes are poised to give investors new options and, in some cases, better capabilities,” they wrote.
