Dimensional's Tax-Managed Funds Conversion to ETFs: What You Should Know

Dimensional Fund Advisors announced late last year plans to convert six tax-managed mutual funds into ETFs. Now, the fund company says four of these conversions are expected to take place on June 11.  

No action is required of IFA's clients who hold these funds. The conversions will be organized as a tax-free event for U.S. tax purposes. So, we anticipate no taxes related to the conversion of full shares.

There may be some cases where fractional shares are held in the mutual fund and at the current time, ETF shares are not issued in fractional shares. In this case, fractional mutual fund shares will be redeemed and paid out which may result in a very small taxable event. For example, if a fractional share of $25 was held and redeemed, the relevant tax rate would be applied to the capital gain portion of this single fractional share resulting in total taxes paid of less than $25.

A copy of the Dimensional filing (Form N-14) to the Securities and Exchange Commission regarding these conversions will be sent from custodians (or providers such as Broadridge on behalf of custodians) to investors in the U.S. tax-managed mutual funds. This communication will either be through traditional mail or delivered electronically, depending on the election selected by shareholders, and will likely be sent in the next few weeks.

Below is a table showing the funds by current name, what they'll be called in the future and annual fees charged by DFA. In each case, this conversion will result in a reduction of expense ratios, which express dollar amounts as a percentage of assets held. It includes two other international tax-managed mutual funds also slated to covert to ETF shares. Those are:

  • Dimensional Tax-Managed International Value. It's set to be listed as the Dimensional International Value ETF. 
  • TA World ex-US Core Equity Portfolio. In ETF form, this fund's name will change to the Dimensional World ex-US Core Equity 2 ETF.  

The exact timing, which is dependent on SEC approvals, is still unclear. But early indications suggest ETF conversions of these two international funds could take place before year's end, according to DFA officials. 

Source: Dimensional Fund Advisors, LLC. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available at Dimensional Fund Advisors. 

Following the conversion, DFA's management fees of the six funds are expected to be reduced by 27%, on average, from current levels on an asset-weighted basis. "We're pleased to broaden our ETF platform in a way that can help investors manage taxes even more efficiently," Dimensional Co-CEO and Chief Investment Officer Gerard O'Reilly related in a statement about the conversion. 

Unlike with index mutual funds, an index-based ETF manager works with so-called authorized participants to create and redeem shares. These APs are usually a large brokerage, institution or other market maker who is given details about securities held by an ETF.  When new shares are needed — either to launch an ETF or simply to meet demand — the AP will buy the stocks and bonds making up that ETF's portfolio. Then, these "baskets" are exchanged to the ETF company for "creation units," or a specified number of new ETF shares. 

In general, such "baskets" turned over by APs are designed to reflect an index ETF's overall make-up. For example, if an ETF composed of the 500 largest U.S. companies needs to create new units, the AP might collect those same 500 stocks and do an in-kind exchange for a certain amount of creation units.

Interestingly, Dimensional's managers are taking advantage of recent regulatory changes allowing a bit more flexibility. They are prepared to accept what are referred to as "customized baskets."

In these cases, APs don't necessarily have to mirror the fund's underlying holdings in exact numbers and composition. Cash can also be used in some creation/redemption instances. Such flexibility is aimed at keeping execution costs low, according to Dimensional, but won't be allowed to sacrifice accuracy in terms of reflecting an ETF's portfolio. Similarly, the AP can redeem creation units in exchange for a basket of securities and cash. 

In essence, Dimensional's managers say they can use the ETF's unique in-kind creation/redemption process as an additional way to rebalance a basket of securities. By contrast, mutual fund shares are issued or redeemed directly through the fund company itself. When large inflows or outflows take place, mutual fund managers must issue new shares or sell securities in their funds to directly meet such demand.

Managing investment flows are much trickier for funds that trade a lot. Along these lines, it's probably worth pointing out that Dimensional funds selected by IFA to be included in each client's portfolio have historically featured low turnover rates. In our view, such a lack of portfolio churn is largely due to this fund family's adherence to a disciplined approach — one that centers on providing investors with consistent exposure to factors identified by leading academics as driving long-term returns. These relate to stocks that are more value-oriented, smaller-cap in size and show higher levels of profitability. 

So, let's put this conversion into perspective. IFA Index Portfolios are already designed around a globally diversified and passively managed mix of funds featuring strategies our Investment Committee finds enhance modern indexing's fundamental characteristics. As a result, whether it's a mutual fund or ETF, our portfolio construction strategy inherently lends itself to building portfolios in taxable accounts with a higher degree of tax efficiency relative to less diversified strategies with higher turnover.

Dimensional's methodology in running both its mutual funds and ETFs also supports IFA's efforts to maximize tax efficiencies for our clients in other ways. In particular, these include: 

  • Along with excluding real estate investment trusts (REITs) from their non-REIT focused funds, the firm's managers have also historically held a relatively higher portion of their portfolios in qualified dividend income, or QDI. 

QDI is taxed at a lower rate than nonqualified dividend income. We've found over the years that such a practice has contributed positively to tax efficiency for our client portfolios holding Dimensional funds. This same QDI awareness will continue with ETFs, according to DFA. 

  • Given its broadly diversified and low-turnover approach, Dimensional points to a long-term track record of generating lower levels of long-term capital gains distributions, on average, compared to mutual fund managers who trade more frequently.

Additionally, it's worth mentioning that IFA's asset allocation strategy includes assessing how each fund fits into a broader mix in terms of maximizing an overall portfolio's tax efficiencies. Besides applying such an "asset location" analysis for each IFA Index Portfolio, our investment managers regularly monitor for opportunities to tax-loss harvest in taxable accounts.

This is a complimentary service available to our clients. In practice, IFA's tax-loss harvesting process involves examining the total portfolio and looking for opportunities to generate capital losses that can be used to offset capital gains. (For more information, please read the article, "Tax-Loss Harvesting: Taking Advantage of Opportunities.") 

IFA's wealth managers welcome questions from investors interested in finding out more about how their fund assets can be managed in a more tax-savvy fashion. Initial consultations are free-of-charge for those who aren't currently working with an IFA advisor.

We urge those who've already built existing relationships with us to take advantage of our complimentary offer to create an individually tailored financial plan. Such a holistic planning approach aims to take a comprehensive view of a client's investments and financial situations. As part of this process, our wealth managers can look into a range of financial issues, from household budgeting and retirement planning to educational savings and health care spending needs.

This article originally appeared on IFA.


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