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This Quant Giant Wants to Use Vanguard’s Tax-Busting Fund Structure

Dimensional Fund Advisors wants to create ETFs as a share class of its mutual funds.

(Bloomberg) -- Pioneering quant investor Dimensional Fund Advisors has applied for a new fund structure that would give it a powerful tax advantage enjoyed exclusively by Vanguard Group for more than 20 years.

The David Booth-founded firm wants to create ETFs as a share class of its mutual funds, according to a Thursday filing with the Securities and Exchange Commission. That model would essentially mean the money manager can port the tax efficiency of the ETF wrapper into many of its established products.

The structure was pioneered by Vanguard in 2001. Cannily, the Jack Bogle-founded giant quickly established a patent, meaning rivals would have to agree a license with the firm to follow suit. That patent expired in May.

A mood change at the SEC in subsequent years threw up another, more formidable barrier. The regulator must grant exemptive relief from existing rules before the structure can be applied, but it has become concerned that the model sees ETF holders subsidizing mutual-fund holders. 

VanEck applied to offer ETF share classes through 2012 and 2015, but was never successful. Dimensional is at least the second firm to apply for relief this year, and there’s no deadline for Wall Street’s watchdog to respond. 

“The timeline is a little bit uncertain and will be driven by what the SEC is prioritizing,” Gerard O’Reilly, Dimesional’s co-CEO and chief investment officer, said in a phone interview. “We’re hopeful that as we raise our voice, others in the industry will raise their voice and that will hopefully raise up the priority list for the SEC to look at ETF share classes.”

Dimensional, which controls over $600 billion, started discussing ETF share classes of its mutual funds with SEC staff in 2019, O’Reilly said. Its use of the structure would differ to that of Vanguard, which only deploys the model in passive vehicles. While rules-based, most of Dimensional’s products are active.

The firm was a late entrant to the ETF market with its first products launching in 2020, but it rapidly ramped up its presence using aggressive pricing and by converting nearly $40 billion of mutual-fund assets into the newer wrapper. The Austin, Texas-based asset manager is now the largest issuer of actively managed ETFs, with roughly $95 billion across its lineup, according to data compiled by Bloomberg. 

The application lands as the rift between mutual fund outflows and ETF inflows continue to widen. Mutual funds are on track to bleed roughly $243 billion this year while ETFs have absorbed more than $200 billion, Investment Company Institute data compiled by Bloomberg show. That follows last year’s record $1.5 trillion gap. 

As well as porting the ETF tax advantage to its mutual funds, the move would also deliver economies of scale and cost savings to Dimensional’s clients, O’Reilly said. But it all hinges on the SEC.

“Step one has always been seeking exemptive relief,” he said. 

--With assistance from Emily Graffeo.

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