The Latest Innovation in ETFs and Mutual Funds: Share Class Exemptive Relief, Explained — with Marlena Lee (EP.232)

0:28We all need to make smart decisions with our money. I asked Marlena to come on the show to discuss something that is very exciting in the world of mutual funds and ETFs, but maybe you haven't heard of yet. And we do get into some of the technical weeds here, but Marlena is so good at simplifying these complex topics. And so I'm not going to spoil exactly what it all is because I want her to have the opportunity to explain it before I do myself. If you want to keep on top of these exciting developments and be the first to hear about all the things that I'm looking into. You can sign up for my newsletter, which comes to your inbox every other Wednesday.

1:03There is a link at the top of the episode description to sign up. And when you reply to that email, I respond to every email I get. So I love hearing from listeners. Go ahead, sign up for that newsletter at the top of the episode description. And now here's my conversation with Marlena Lee.

1:21Welcome back to the Long-Term Investor. I'm so excited to have a returning guest Marlena Lee, Global Head of Investor Solutions for Dimensional Fund Advisors. Marlena, thanks so much for joining me. Always good to see you, Peter. As a reminder, if you're watching on YouTube or on Cheddar News, you can go to thelongterminvestor.com where you can find links, resources that are mentioned throughout the show. And I think that's going to be important today because Marlena Lee is just a wealth of information. And whenever I have her on the show, I have a hard time choosing what to talk about. And today, Marlena, there's a news item that Dimensional has put out there to all the advisors, to their clients that I want to touch on.

2:01And it's the share class exemption. Let's start at the highest level, because I get the sense that most individual investors probably aren't aware that this is something you were working on or that this was even a thing for anybody in the past. Yeah. So share class exemptive relief. Very exciting. More exciting than it sounds when you say it like that, for the record. Like a super legal term. But yes, all right, carry on. I just felt like everyone shouldn't tune out already once they heard the phrasing. We are super excited. Investors should be excited too. I mean, we've been working on it for over two years.

2:36We actually filed for exemptive relief in July of 2023. So, okay, what is it? Everyone knows what a mutual fund is. Everyone hopefully knows what an ETF is. and outside of one company, typically those two things, like if you invest in ETF or if you invest in a mutual fund, they are separate portfolios. So we also kind of know what a share class is, hopefully. They've been around for forever. They are a way for there to be multiple access points into the same portfolio. So what does ETF share class do? It basically allows investors to either pick whether they want to access that portfolio through a mutual fund structure or an ETF structure.

3:21This is something that we have seen out there, but again, only from Vanguard. There's lots of other managers that would like access to this structure. And in order to do that, many people thought it was because Vanguard had a patent on it and the patent expired. But actually, that was not the major constraint. The major constraint is the SEC needs to give you approval to have the structure. So we applied for approval. We've been waiting. And just at the end of September, the SEC published a notice that it intends to grant dimensional approval to launch ETF share classes. So it's exciting. It is very exciting.

4:00And I think maybe for listeners and viewers to appreciate how they're going to be impacted, maybe you could share a little bit on how a mutual fund works in like the nuts and bolts and how that can impact the end investor, both in their returns or their tax consequences. And then maybe also go through like an ETF and just kind of get through how there are differences in those structures in the first place. Then I'll circle back to some of this other stuff. So there are some key differences between mutual funds and ETFs. So the way a mutual fund rebalances, or for that matter how investors access a mutual fund, is typically you invest cash with the mutual fund.

4:39You get to buy it at end of day NAV. And then within the mutual fund, it buys securities to put that cash to work. Or on the flip side of it, if you are selling shares of the ETF, we need to sell the securities so that we can deliver the investor cash. So that's typically how money flows in and out of a mutual fund. It's a little bit different in an ETF. So actually when you buy and sell an ETF, that happens on something called the secondary market. It trades on an exchange, just like a stock. But if there's net inflows or net outflows, then what happens is there's an entity called an AP, authorized participant.

5:26And it's only APs that are allowed to transact with the ETF issuer directly. So let's just say you have a lot of clients, Peter, they want to buy an ETF and there's just not enough shares of the ETF. So what would happen is an AP would gather up a basket of securities and they would deliver those securities to the ETF issuer. And then the ETF issuer issues new ETF shares. That's a very, very like there's a lot there. But basically the major difference there is within the ETF, rather than getting cash and trading within the ETF like we do in mutual fund, we get baskets of securities in and out.

6:07So there is a lot less trading that needs to happen within the ETF. Those are all of the nuts and bolts. But what's important to investors probably is that the redemption in kind procedure. So let's just say there's an AP comes and they say, hey, we would like to sell a bunch of ETF shares. And what we would do is we would give them a basket of securities. We get to pick which securities we want to put in that. So we could put in securities that are highly appreciated. In other words, have a lot of embedded capital gains in them and give those to the AP. And that process is kind of how you have control over the capital gains within ETF structure, rather than if I were to sell that security within the mutual fund, that would trigger some capital gains.

7:01So that's the major difference is generally most people know that ETFs, you don't tend to see a lot of capital gains from ETFs, and therefore it's perceived to be much more tax efficient as a vehicle. It turns out, by the way, that you could do that in mutual funds too. It's just much, much less common to see that in-kind redemption procedure within a mutual fund. That's how you get the differences. That's how you get tax efficiency within the ETF structure. So let me replay back some of this to you and make sure that I have all of my logic in place before I keep moving down the pathway. So if like you and I are invested in a mutual fund together and I decide that I need to sell some of my shares of the mutual fund, whether it's to rebalance or pay tuition or who knows, the mutual fund manager is going to have to actually sell securities in their portfolio in order to deliver me my cash.

7:50whereas if an ETF and this is maybe where you could correct me like if there is more demand or less demand for shares in the sense that more sellers out there today where the manager is going to have to have less outstanding shares of this security they're going to transfer those baskets of individual securities they're going to pick the ones with the biggest gains so that if I'm liquidating you're not stuck with my tax bill like you are in the mutual fund I realize I'm a little rougher on the edges than you are. But am I generally on the right track using slightly different words? Absolutely, Peter.

8:23That's exactly it. Okay. Well, so then here is where I think I'm excited for our clients and investors as a whole is that in the past, we've watched, as you mentioned, one competitor, I was trying not to say any names here, but one competitor use the different share classes because it seems as if if a mutual fund has an ETF share class, they can funnel some of those higher capital gain positions through the ETF to create some tax efficiency, both for the mutual fund shareholders and for the ETF share class. Is that all fair? And if so, can you go into a little of how that works? Yeah. So that's why it's exciting is because once you have the same portfolio with both a mutual fund and an ETF share class, there are potential benefits to both share classes.

9:13The mutual fund investors stand to benefit as well as new investors in the ETF share class. And when you think about just how a portfolio needs to meet redemptions or, you know, apply cash flows or how it needs to rebalance, having more tools at your disposal is always good. So what the ETF share class does or having these dual access points, it allows the portfolio to rebalance with cash flows. So both actual cash, if it's cash flows from the mutual fund side, or with custom baskets. So I didn't really get into that. Actually, how Dimensional uses these baskets of securities on the ETF side is we don't need to have those baskets look exactly like the portfolio.

10:02So the baskets, when we're receiving stocks into the portfolio, those are called creation baskets. We want those baskets to look like stocks that we want to buy, higher expected return stocks. And then the redemption baskets, the stocks that we want to sell or reduce weight in the portfolio, either because of tax reasons or just to rebalance, we can do that on the ETF share class side. So overall, we think that there's benefits. So for the mutual fund holders, if you see dimensional launches and ETF share class, what that means for you is that we have one more tool to make the portfolios even more tax efficient.

10:44And the portfolios are already really tax efficient. So we just released our distribution estimates. And just like last year, they look really good. So on the mutual fund side, the vast majority of the funds do not expect to pay either short term or long term capital gains. And a big part of that has to do with just how we manage the portfolios. Well, diversified, low turnover, our investment philosophy enables us to be very tax efficient. But even though they are tax efficient, this is one more way that we can make them even more tax efficient. So even if you're a long term mutual fund investor, you have no desire to exchange them into ETF shares, it still is good news for you because it's just one more way to get tax efficiency.

11:31Now, if you are interested in ETF and you have mutual fund shares, then at some point, it won't be ready yet. The industry needs to get ready for it. You could do a tax-free exchange. So make your mutual fund shares into ETF shares and have that not be a taxable event. So we know that some investors who prefer an ETF structure are certainly looking forward to having that exchange functionality supported. Now, if you just care about ETFs, then it's also good. And a part of that has to do with first, having the mutual fund side and being able to overbalance with cash, generally helpful because again, it's one more tool.

12:17We'll only apply the tool if it's a benefit to both share classes. but then also just immediate benefits of scale. So you're not starting an ETF from scratch with a low AUM. You can invest in an ETF that already has all of the scale of the mutual fund. And that means just better ability to get really broad diversification. Scale always reduces other expenses because to the extent that some costs of managing a portfolio are fixed, having a broader are based to spread around those fixed costs are good, generally increased securities lending revenue. So on both sides, we think there's benefits, regardless of which vehicle you like.

12:56I wrote down so many things as you were speaking, and then I started reorganizing them. That's one of my favorite things about speaking with you, Marlena. And for the listeners, one of my roles as chief investment officer at PlanCorp, when I'm performing due diligence, both on providers that we're currently using or prospectively using, I'll do site visits, I'll spend time on the trading floor. I'll spend time with the PMs, with the investment committee members, the thinkers. And one of the things that always strikes me when I come to Dimensional is how innovative they are in the trading front.

13:25And you just like so casually mentioned, oh, well, even mutual funds can do this great thing that ETFs can do. And you say that so not flippantly, it's just I don't think that even if I'm here oozing over it, I don't think even the listeners are going to really appreciate how much effort goes into being an innovator. So I just wanted to call that out before I go through some of these comments. You just so casually mentioned something that's really impressive that your firm does. But one of the things you mentioned is, okay, if you want to exchange a mutual fund for an ETF, it's not that uncommon for people to switch mutual fund share classes.

13:57And so again, if you're watching or listening to us, oftentimes as you get to a certain asset size, you'll qualify for a cheaper mutual fund share class. And that's one common instance where you'll make a change. Another more legacy reason, at least I hope it's legacy, is sometimes you would get sold mutual fund share classes that had high fees to enter like a five or six or seven percent fee just to invest your money. Or sometimes it's on the back end and you could transfer out of those share classes depending on who you're working with. But here, all we're talking about is if you're holding a mutual fund and you want to enter an ETF, it's not a taxable event.

14:32And to Marlena's point, I'm not sure the infrastructure is really there with the custodians. So when you hear this news, you just call your custodian and tell them that you want to be able to do this. That'll help Marlena and my teams out immensely. But let me ask you this. Aside from people who are holding a mutual fund where you launch an ETF share class and they might say, oh, I want an ETF now. Let me ask you a slightly different question. Whereas if you're a new investor and you have these funds that have both an ETF and a mutual fund share class, how would you go about thinking which share class is right for you, the investor?

15:08I would ask your advisor, Peter. I do have a response, but you're the star today. So you get to answer. One of the important things I think is what we've seen over like just recent years is there does seem to be a preference for ETF over mutual funds. So if you just look at flows, ETFs are garnering more flows than mutual funds. And I think a large part of that flow trend we've been seeing does have to do with it's more like a flow to low fees because historically we've seen ETFs, they tended to be predominantly index funds and therefore lower fee. Now, one of the things as Dimensional has gone and launched ETFs is we have felt it's very important to take fees off the table in the decision between mutual funds and ETFs.

16:02So we charge very similar fees for a similar strategy, regardless of whether it's a mutual fund or an ETF. We've been working really hard to remove tax efficiency as a consideration. To your point, Peter, we've been doing a lot of work in the mutual funds to make them very tax efficient. And what we see across our mutual funds is they're just about as tax efficient as some of the peer ETFs out there. So if you can remove tax efficiency and the share class does that, the share class, remember, you're getting the same tax efficiency because it's the same portfolio, regardless of whether it's a mutual fund or an ETF.

16:37So that's no longer relevant. Really, the big difference now is do you have a preference for how they trade? Because a mutual fund, you get the comfort of going in and out at end of day NAV. You don't have to worry about best trading practices, things like that. But in an ETF, some people do value that intraday trading. You can trade it at any time of the day, but you do need to focus on some best trading practices to make sure that you're minimizing your trading costs as you trade those things. So we talked to a lot of clients that just prefer, for example, if they have a model portfolio, they want to all the ETFs just because that's easier to rebalance across the different funds that they hold or all mutual funds.

17:20And then of course, some investors have to hold mutual funds, not all accounts can hold ETFs in it. So there's a few just differences and people may have a preference based on how they trade. But really, I think the share class ETF really eliminates a lot of what was driving the trend towards ETFs. And then now it becomes a matter of really just trading preferences. And that to me is actually the most interesting piece of this all. And I think it'll take some education, not just with individual investors, but with advisors. A big draw of the ETF was the tax efficiency piece. And then even today, I see a lot of people almost mistakenly assume that because there's no commissions on ETF trading, that they aren't garnering any sort of implicit cost.

18:08And so you make a really good point. If you're an individual, and I'll feel much more strongly about this once this all takes place, there's a really good case for the ease of mutual funds because you know how you're executing trades. And while there will be a commission, there are so many hidden costs that you don't really see in the ETF trade itself, whether that is the bid ask spread, whether that is how the underlying securities in the basket are getting valued. And so I do appreciate you calling that out. And so I guess you maybe already said this. So if you're repeating yourself, my apologies, but do you feel like a couple of years into this all happening, it really will just be a matter of trading preference as opposed to cost and tax efficiency trade-offs?

18:50Yeah, I do think that tax efficiency is going to be kind of removed from the evaluation. And your point, Peter, is exactly dead on. So some mutual funds trade with commissions, but there is a bid-ass spread. It's not quite as in your face as trading commissions on mutual funds. So I think that that is part of what drives a lot of folks' preference. But you know, spreads on ETFs, they can vary, right? So when we hit volatile times in markets, all spreads tend to widen, whether we're talking about stocks or we're talking about ETFs. So I do think that if there are investors who can just walk away and say, hey, I'm not going to trade because the markets are really volatile, spreads are wider, the cost of me trading an ETF is going to be bigger.

19:37If you can just walk away and say, I'm going to wait until markets calm down, That's one great approach. But if you have to trade and can't really step away, then maybe the comfort of not having to worry about those trading costs. And instead, to your point, we have some great traders at CFA. And if you just say, hey, I just want end of day NAV. I don't have to worry about the spread and let our traders take care of that trading for you. I think that that's going to be a really attractive option to a lot of investors. Yeah, especially investors without an advisor. There's so much nuance to ETF trading.

20:14And because I go through a different platform than the average retail investor, I get nervous just about people entering a trade correctly, the right time of day, thinking of all these things. And when something's free, you have to remember, listener and viewer, you are the product. So there really isn't anything that's free. It's just like how transparent are the costs or risks that you're assuming? Now, I do want to ask a question, and you're probably not quite this far down the public disclosure path, but maybe you can give us a little insight for Dimensional has this exemptive relief. Almost.

20:48Well, excuse me. Yes, it's coming. But my point is that I think other managers will get this as well. Lots have applied. If I'm an investor and I'm looking at a manager who has existing mutual funds and adds an ETF share class. Whether I hold the mutual fund or I'm now thinking of investing in one of those share classes, what is it that goes into the process of making those choices and how should an end investor view those choices from their own perspective? Fabulous question, mostly because I've been talking about this through the lens of dimensional and how we manage portfolios. But you're right that not all mutual funds are going to be really great candidates for this.

21:27I was actually in New York on a panel and another manager on the panel was making this exact point that as they're looking at it, there's lots of mutual funds they manage that they're not going to consider because there are certain disclosures or certain characteristics that you need in order to ensure that both share classes have benefits to their investors. So if you have a certain investment style, where maybe the mutual fund investor imposes additional costs on the ETF share class, that that's not going to be a good type of investment portfolio or investment strategy for this dual structure.

22:12There are a lot of things that we've put into our application for exemptive relief that requires us to report certain things to the board, because in the end, the board is the one who needs to make sure that this is going to be beneficial to both share classes. And this is one of the benefits of being first in line is we got to write the application where we knew for our portfolios that we could qualify or satisfy this requirement. Some of those things, for example, are, you know, at Dimensional, just the way we manage portfolios, we have really deep capacity. We generally have very low cash exposure.

22:54And that's something that you may not see typically across mutual funds. So other mutual fund managers tend to have a lot higher levels of cash. And that's because again, mutual funds, you have to rebalance within the portfolio. And some, if you are more of a stock picker, or you're trying to work and buy securities, not across a broad basket, but instead like over a few handful of names, then you may have to hold back some cash and buy whatever you want slowly over time. So that's something that you tend not to see as much of in the ETF industry, just because those trades are happening in kind in those creation redemption baskets.

23:41Typically, something like cash exposure, that's something that we will be reporting out to the board, tax efficiency is an important one. For us, we expect tax efficiency on both the mutual fund and the ETF side of things. Now, we see a lot of portfolios out there that do not have as good of tax efficiency in their mutual funds, whereas the ETF, typically people just assume that they're going to be tax efficient. Now, because when you add on an ETF share class, it inherits the tax efficiency of the mutual fund, especially at first. And that would make it so that if the mutual fund was not tax efficient and you have a manager adding on an ETF share class, you may have a tax inefficient ETF share class because the mutual fund was also tax inefficient.

24:36So there's a few different things like that, that I think people really have to consider, it's not the case that you can assume just because it's an ETF that it's going to be really tax efficient. So it kind of makes the investor's job a little bit more difficult or your job, Peter, because I think that there's more due diligence that's going to be required as we see, I assume it will be a wave of ETF share classes out there. Because to your point, And at last count, there was 70 other managers that have applied after us. So I think it really does make the difference in the vehicle, mutual funds versus ETFs.

25:16I think it becomes irrelevant. And I think what becomes a lot more relevant is you have to evaluate the underlying investments. Yeah, I think that last point is what strikes true for me. And again, if you're an individual investor, that last point is really important as you look at the two structures. if you can roughly assume that fees and tax efficiency are the same. It comes down to a trading preference. The other thing I would point out is Marlena jokes about my job security and or the more work for me gives me more opportunity to perform due diligence. But I think this also calls out for working with an advisor that really has the capacity to do this sort of work.

25:53And so it's a little bit of a commercial for Plaincorp where we have a deep team where our advisors are just focused on our clients. Our investment team every single day is getting into the weeds on this stuff. And so it's really difficult as someone who used to be a lead advisor myself. It's really impossible for one person to be everything and anything to everyone. Let me ask you one more quick question, at least on this topic. You know, if you're looking, it used to be in the due diligence side. If a new ETF is coming to market, internally, we have a soft rule that I won't say that explicitly, but basically you would wait for a couple years of the ETF to be in existence and to reach a certain asset level because most ETFs that fail, fail in the first two to three years.

26:39And what that means is when an ETF fails, for those of you listening who've never had an ETF fail, it can mean a couple of things. It means that it could merge into another fund that isn't what you really wanted to buy in the first place, or, and this is probably the worst scenario, they return your cash to you and any related taxes. So that's not like the best, but here I'm curious, because you could launch an ETF share class that has the benefit of the mutual fund scale, there's a little bit lesser risk of going into a brand new ETF that is attached, for lack of a better word, to all the assets in a pre-existing mutual fund.

27:13Is that a fair statement? I do think that that's fair. what we see as we look at the ETF landscape, as well as the mutual fund landscape, that survival rates are important to consider. And they're actually similar though. So that would be my caveat is that that's important regardless of whether you're evaluating a mutual fund or an ETF. The things that you mentioned happen in both. And they happen with pretty frequent regularity. So one of the benefits of the ETF share class, to your point, is if it attaches to a mutual fund that already has significant assets, the chances of that are lower. So the size of the fund does tend to be a pretty good correlate with how likely it is to close down or merge with another fund.