ETFs and mutual funds: What dual share classes could mean for investors

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Funmi Osiyale: The ETF market continues to grow at an incredible pace. Global AUM is now roughly, is now roughly $20 trillion and the industry shore about 2.2 trillion of inflows last year, marking the 15th consecutive year of net inflows. Welcome to J.P. Morgan's Making Sense. I'm Funmi Osiyale from the ETF sales team with our market sales and trading business. And for today's episode, we're diving in to one of the most talked about topics in the ETF industry right now, dual share classes. Joining me are Joel Schneider and Lauren Olson from Dimensional Fund Advisors, who have been at the forefront of this evolution. Most recently, the launch of the first active exchange traded share class tied to an existing mutual fund. Lauren, Joel, welcome and thanks for joining us.

Joel Schneider: Thank you for having us.

Lauren Olson: Yeah, really happy to be here. Thank you.

Funmi Osiyale: Thanks so much. To start off, Joel, can you help describe your role at Dimensional and how you're involved in getting the jewel share classes across the line?

Joel Schneider: I co-lead our equity portfolio management team, and our team manages all of our equity portfolios. So that includes ETFs, mutual funds, institutional separate accounts, and many other types of vehicles. And when we entered the active ETF space about five years ago, we brought a lot of expertise from managing tax-aware strategies, as well as sub-advising on ETFs. So, when we went to bring active ETFs to market, our portfolio managers have been involved on multiple fronts. One is with clients, talking with them to really understand what their long-term needs are and what solutions they need. The second is building out all of our technology that allows us to offer active ETFs and share classes of them. And the third is adapting our investments to the new tools that active ETFs and share classes give us. Now there's more ways to manage and rebalance portfolio, whether that be through in-kinds or on-market trading. And then the last way I would say that we were involved is by standing up a capital markets team. And Lauren is the head of that, and so it's great to have her here.

Funmi Osiyale: Thanks so much for that, Joel. So that ties us perfectly into Lauren. Now, turning to you, can you please describe your role and how that work connects with the ETF share class?

Lauren Olson: Thanks, Funmi. So, as head of the ETF capital markets team, our team is responsible for the efficient trading of the ETFs, which includes oversight for primary and secondary market activity. We also work with the authorized participant and market maker community, as well as we work with the broader industry around industry engagement or any regulatory changes and how they may impact ETFs. Case in point is ETF (laughs) dual share class. And finally, we also work with our clients on understanding ETF mechanics and around ETF trade execution. So as you can imagine, many of the areas that we cover also would touch an ETF share class, and so we were heavily involved in kind of how an ETF share class would impact or fold into the various parts of what we cover as part of our role. And in terms of the ETF share class specifically, it was really awesome to see all of the community engagement around the ETF share class.

Funmi Osiyale: From your seats, you guys have really been at the forefront of the implementation of this dual-share class. For those curious listeners who are newer to the concept, can you help explain what the share class means and how they've been used historically and what's different about their use today?

Joel Schneider: Yeah. So whenever you hear people talk about share classes, think of it as there being one portfolio that holds all of the stocks or bonds or other investments, and then there's two access points to get into that portfolio. So you could either buy it on an exchange, like you buy an ETF, or you could buy it directly from the issuer at NAV, like a mutual fund. So it's two access points to one portfolio, and being one portfolio brings with it a lot of advantages, which I imagine we will get into in our discussion today. But thinking about the history of having an ETF and a mutual fund share class of the same portfolio, I would say that really goes back to around 2000. Issuers couldn't offer them unless the SEC gave exemptive relief from the '40 Act that allowed you to offer that. And the SEC gave that exemptive relief to Vanguard back in 2000, and those were for indexed ETFs. And then after that, other managers did not receive exemptive relief until just recently when we did, and then a lot of others in the industry submitted applications as well, sort of following our approach. And so, active ETFs allow us to do is something better than what index ETFs did. And after we launched a number of standalone ETFs and we converted a number of our mutual funds, we got to a point in the last couple of years where we felt like it was really time for us to go kind of lead the charge to ask the SEC to grant more exemptive relief in the industry. And so that's where we are today.

Funmi Osiyale: Thanks, Joel. That's a super clear way of explaining what the ETF share class structure means. Now, what are the implications of the share class for the average investor, and can you explain the benefit from the wider adoption of this structure across the broader industry?

Joel Schneider: Yeah, I think there should be four benefits to the end investors. One is lower expenses. A second is enhanced tax efficiency. A third is greater choice. And the fourth, I'm hopeful that there will be greater simplicity at the end of the day. So how are those four benefits actually achieved? So let's go back to the lower expenses. That's achieved through economies of scale. When you have one portfolio that holds all the securities, and there's two access points into that one portfolio, you're now getting greater economies of scale than if you had to have two separate portfolios. So hopefully those greater economies of scale will bring down expenses, which will have a positive impact in terms of lowering expense ratios for investors. I'm hopeful we'll see that play out over time. The second is enhanced tax efficiency, and that works primarily through the use of in-kind transactions that ETFs can do. So whether that's through daily create and redeem activity or through periodic rebalancing, you're able to do tax management with another tool. You now have a new tool in your tool belt to tax manage the portfolio. Greater choice is the third benefit, and that comes about simply because managers are now able to bring existing strategies that they may have in mutual fund format into the ETF wrapper. And that's what we just did with our U.S. Micro Cap strategy, DFMC. So by bringing some of the great strategies out there in the industry over to ETFs, now investors can benefit from the choice. And the fourth benefit, which I'm hopeful that we will see, is right now, there's a lot of different types of share classes of mutual funds, and some of them come with different expense ratios. And so it can be hard for investors to navigate what's often an alphabet soup of different mutual fund share classes. I think what you may see is that as more and, issuers offer ETF share classes, they may rationalize that lineup and get to a point where, frankly, Dimensional already is, where we offer similar strategies in both wrappers for a similar price. At the end of the day, I think hopefully that will be better for investors overall and bring some simplicity where they can just choose what investment strategy do they want, and then know that they can get it in either wrapper at a similar price.

Funmi Osiyale: So economies of scale, choice. And also the ability to kind of carry on the track record that you've had from the mutual fund is also great for the fund as well. So speaking of choice, what made you choose to prioritize the U.S. Microcap portfolio as the first ETF share class? What led you to choosing this particular fund?

Joel Schneider: Let's start with just a definition. What are Microcaps? They're really a subset of the Small Cap asset class. And so for us, we define Small Cap to be the smallest 10% of companies in terms of their market capitalization, and Microcap is the bottom 5%. So basically it's the smallest half of the Small Cap universe. And you might say, "Well, why is that interesting now?" And I would say that the origin story of this strategy is hyper relevant at this moment. This strategy was designed 45 years ago for institutional clients. Back then, those institutions had most of their allocation to U.S. Equities in Large Caps, and they needed diversification. They needed to access a lot of the rest of the market and be able to diversify some of their concentrated exposure to U.S. Large Caps. Now, for anyone listening, that may sound very similar to today, where everyone's concerned about the Mag Seven and the level of concentration in the U.S. equity market. So in many ways, history repeats itself. The same challenge that institutions were having 45 years ago, investors of all stripes are having today. And so over those 45 years, this Microcap strategy has undergone many enhancements, and it's performed in a way that has been excellent for investors. So we think that for investors looking to diversify away from the Mega Cap stocks in the U.S., not only do you not have to give up good performance to get that diversification, but in this case, we think DFMC, which is the ticker, could be a more effective diversifier. And the reason why I say that is because if you look at some of the other Small Cap index funds out there, they actually have a lot of holdings that overlap with some of the Large Cap indexes. So we think this is a better diversifier for people who are looking to have different exposures in their U.S. equity allocations than they could get from a lot of other Small Cap ETFs.

Funmi Osiyale: Wow, that's really great to get some insight into how you really thought through this methodically onto which fund you chose to start with for launch of this dual share class. You touched on this slightly already, but could you walk us through in more detail what Dimensional's path to share class approval was and why it was priority for the firm?

Joel Schneider: Yeah, it was a priority for the firm because it was better for our investors. So we talked earlier about those different benefits that they get, right? So it's more cost-effective due to economies of scale, it can enhance tax efficiency, it gives them more choice. And a lot of our clients, and you know, think about Dimensional more as a B2B company, not B2C. So our clients are other investment professionals, institutions, financial advisors, insurance companies, so on and so forth. And when we go out and talk with them, a lot of them wanted to be able to access these strategies in both the ETF and the mutual fund format. And so it really became our mission to allow this to happen in the industry. And so in 2019, when the SEC passed what's become known as the ETF rule, it's rule 6C11, that allowed for truly active ETFs to come to market. And we launched a number of those. They've been very successful. We also converted some tax managed mutual funds into ETFs, that was very successful, but then at some point, we had strategies that had both, taxable clients, non-taxable clients, people that held their holdings at- in brokerage accounts, Summit custody accounts, where for those types of clients, those types of portfolios, instead of doing a conversion, it just made more sense to have one portfolio with two share classes as access points to it. So, in 2023, we filed for exemptive relief with the SEC and asked to be able to have ETF share classes of our active mutual funds. And what we saw was many others in the industry. I think there was over 80 other managers that also filed for exemptive relief. And many of them followed our application using it as a template. So, we had very constructive dialogue with the SEC. They pointed out some of the criteria and the considerations that they had. And after a number of years, actually earlier this year, we ended up getting all the approvals that we needed. And so we were first to launch an active ETF that's also a share class of a mutual fund. And I think you're going to see many others start to do something similar because there are a lot of benefits for investors. But I do think there's a lot of considerations that you have to think through because it may not be a pain I see for everybody.

Funmi Osiyale: Congratulations. It's been really an amazing to hear about the effort, and it's been great to see Dimensional leading the charge here, and we look forward to the other firms who will follow on in their launches of other dual classes. Turning to you, Lauren, the dual share class opens up additional options for traditional mutual fund investors. Now the fund is an exchange traded product. What are some of the day-to-day dynamics between issuers, authorized participants, market makers, and investors to consider?

Lauren Olson: Yeah, happy to. Great question. It's a question that we received a lot as we were planning out and thinking through how we would bring these solutions to market. And I've sort of approached this question two different ways. There's sort of the industry-wide mechanics question, and the good news there is not a lot changed in terms of day-to-day functionality, and I'll talk about what that means, but also there are some manager-specific considerations, and I can talk about what that looked like for us, and then, of course, that's going to be different for, for each manager. To the point that Joel just made, you know, ETF share classes maybe not necessarily, uh, a panacea or every single mutual fund needs to have an ETF share class, for example. So, zooming out to the sort of the mechanics, the industry-wide, day-to-day, when... I think it can be helpful to think through this from how an investor accesses each structure. So, for a mutual fund, we will continue to have investors typically transacting directly with the mutual fund issuer at end of day nav and in cash. That's how the end investor will interact with a mutual fund. The ETF, of course, is different. It's exchange traded. The investor is transacting on the secondary market, and then should there be a need to create or redeem additional shares, that still occurs just as it does in as it would in a standalone ETF where an authorized participant can transact directly with the ETF issuer in the primary market, and that will be a mix of in kind or cash as well. So those two paths, investment paths for the investors in the primary and secondary market stay the same. Where I think the question becomes a little bit more manager-specific is, and some of the thinking through when we were bringing the issuer to market is for us, a lot of the work that we did to support our existing active ETFs will carry over to the ETF share class as well. And some of that includes just publishing daily holdings, for example, and we interact with market makers the same way through the day, and they interact with our ETFs the same way through the day with- that they currently do. And it's the same with other industry participants. So, the access point answers a lot of the questions around the mechanics, and the access points and the mechanics around those access points are staying the same. I think the other neat part about the access points is now you have two different types of investments into the portfolio, and this is a benefit for the portfolio management team, or the investment team, or the implementation of the strategy itself. You're receiving cash through the mutual fund that portfolio managers can trade on market, invest on market, and we're also receiving securities in kind through the baskets that are being created and redeemed by authorized participants.

Funmi Osiyale: So more access is key here. And then when dealing with an exchange-traded product, liquidity is always a huge topic there. What liquidity concerns come up with the broader adoption of dual share classes? Which are well-founded and which would you say are misunderstandings?

Lauren Olson: When we're thinking about bringing any investment solution to market, regardless of if it's a share class or a standalone, we're really thinking about what investor need we are trying to meet. And how that relates to liquidity is not just what is the investment need or the investor need that we're meeting, but then how are we going to implement in a way where the end investor is going to have a good experience when they're transacting with the particular vehicle? And for ETF share class, what that means is we want to be thoughtful about the liquidity because that is where the end investor is ultimately meeting the ETF on the secondary market. So, liquidity is part of the broader approach that we are thinking about when we're launching a solution. The good news here is Dimensional has a long track record of thinking about the long-term need that is being met by one of our solutions. And again, part of that, and to be specific to the ETFs, what that looks like is ensuring that we have the appropriate relationships in place and the appropriate liquidity profile for the ETF, such that that investor is going to have a positive experience. And that is something that we have been working on since the first ETF that we've ever launched. What that looks like in the longer term for the dimensional suite is when you think about our funds that we've brought to market, 100% of our funds that were available 20 years ago are still available today. So, again, I think that really speaks to meeting that, that client need. And then bringing that to maybe more of a near-term consideration, looking at just the ETFs, which have been live for the past five and a half years or so, looking at the flows, again, I think is the- a good proxy for thinking about meeting that client need. And we have had positive net flows in all 42 of our ETFs in every year of their existence. And 16 ETFs have had over a billion dollars in net new assets in 2024 and 2025. Having that cash flow profile in mind and having that client need in mind is going to support the liquidity that you're probably ultimately looking for when you are issuing an ETF. So the liquidity question is not necessarily a share class challenge or an ETF challenge. I think about it more as one of many considerations that issuers will want to keep in mind as they're thinking about bringing ETFs to market, regardless of wrapper and in an increasingly competitive environment, you know, Funmi, to some of the stats that you read off at the beginning of the ETF, just seeing this is all kind of in consideration of the tremendous growth in the ETF space and the active ETF space in particular.

Funmi Osiyale: Thanks, Lauren. It's great to hear all the considerations that Dimensional has for not only their end investors, but also how everything will work in practice with other market participants for these share classes to work. So Lauren, can you take us through how the movements between share classes will actually work in practice?

Lauren Olson: Sure. So one of the key features of having an ETF share class attached to a mutual fund is the ability for the investors to move between classes. We've spent a lot of time talking about what that exchange will look like and what that experience will be for the investors. And at the end of the day, again, going back to that empowering investor choice, for the investors that would like to stay in the mutual fund, they are free to do so. For the investors that want to invest for the first time maybe into the ETF share class, that's also fine. There's a path to do so. And then now we have this third option where there's this ability to move in between classes. There is currently a manual process in place, and we are confident in our abilities to execute on that process, and we've worked very closely with our service providers to be able to facilitate that exchange on behalf of investors. However, we do understand the benefits could be more broadly felt and more easily felt once there is a more automated solution in place, something that looks like investors logging into their brokerage account, or their investment account and clicking exchange this mutual fund share for this ETF share. We're optimistic for a more industry-wide and automated solution being put in place. And again, we know that work is happening on that front, and we're optimistic for that solution to be in place in the near future.

Funmi Osiyale: So, historically, Dimensional broadened your investment solutions you offered your investors by converting mutual funds to ETS back in 2021 and 2022. Can you explain the benefits of the share class solution versus conversions that which you've done in the past?

Lauren Olson: Yes. Joel already touched on the broader benefits, and just to hit some of those, again, there is the economies of scale, there is investor choice, and there's greater tax efficiency as part of adding an active ETF share class to a mutual fund. So again, one of the benefits here is by adding an ETF share class, you retain the mutual fund. That wasn't the case with the conversions, and we had a very specific reason for why we did those conversions. In the conversion, you replace the mutual fund with the ETF, and you want to be really thoughtful about the investor base if you are going to make a switch like that as an issuer. In our case, the mutual funds that we converted to ETFs were all tax managed mutual funds. The investors in those funds were typically tax sensitive, and they were typically holding those mutual funds in brokerage accounts. By converting to the ETF, we were able to offer the same or similar investment solution that was being implemented in the mutual fund, now in an ETF wrapper, and with that greater tax efficiency. That might not be the case for the funds that we're looking at to add a share class to, where we do want to retain that investor base, and we’re leaving it up to the investor to determine which wrapper is ultimately best for them.

Funmi Osiyale: Thanks, Lauren. That's really helpful in kind of helping our listeners understand diversity of wrappers and packages out there, and also the different use cases, which make them applicable to them. Needless to say, share classes have been a huge focus for Dimensional, the ETF industry, and beyond. Joel, turning back over to you. To wrap up today's episode, looking ahead, what's next for Dimensional's ETF business?

Joel Schneider: So, what's next for Dimensional? We have filed for 13 different U.S. equity strategies to have ETF share classes of our mutual funds. One of those has launched already. Some of those are upcoming. Given that we're in the quiet period for some of them, there's a limit to how much I can say about them, but I think you will continue to see us bring more of our equity mutual fund strategies to also have ETF share classes of them. Where else might we be headed? Back in 2020, when we entered the active ETF space, we entered with strategies that we call our market series, and these were designed to be index replacement strategies. So they're active, but they're broadly diversified, they're low fee, they're low turnover, they're tax efficient. So, for clients who wanted low tracking error and broad diversification, we launched these strategies, their tickers are DFUS, DFAU, DFAI, DFAE, and they have been incredibly popular across all sorts of different channels, from institutional clients to advisors. And now we have some of those clients asking us to launch mutual fund share classes of those ETFs. So, I think that we may be headed in that direction as well, so that's great. We can go both directions, right? We can go from mutual fund to ETF, we can also go from ETF to mutual fund. And so I think you'll see some of that, and then also I think you may see us bring some new strategies to market that may be offered in both. And so, we are very optimistic that there is going to be a lot of growth, both for us and the industry, we want to do that in a way that serves our clients well. And Lauren mentioned some stats earlier. Now, with Dimensional, for our funds that were launched 20 years ago, 100% survived and 83% outperformed. And so I'm telling you those stats not just to get in a good word for us, but to say that I think it's really important that managers think about not just what can I sell tomorrow in the short term, but what would serve investors' interest well in the long-term. And so I do think that there's going to be a lot of growth in this area. We're going to be very diligent and thoughtful about it. But I think investors would be well served to, you know, apply the same level of scrutiny. Don't get caught up in all the excitement with ETF share classes. There's a good chance that a lot of managers launch a bunch of stuff and then close a bunch of stuff. That's been the track record in the industry, and that's a thing that you need to be cautious of.

Funmi Osiyale: Thanks, Joel. Those sets are super enlightening. And also it's a great reminder that the share cost does go the other way as well. There are people actually launching mutual fund versions of their existing ETFs. I think that's a great place to wrap up today's conversation. Joel, Lauren, thank you so much for joining me today and for sharing your insights.

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