United States: Dimensional Fund Advisors Files For Exemptive Relief For An ETF Share Class

Dimensional Fund Advisors became the second asset manager this year to file an application ("Application") with the SEC to permit its mutual funds to offer an ETF share class. Dimensional's filing, which seeks to build upon ETF share class relief obtained by Vanguard nearly 20 years ago, as well as the February 2023 SEC filing by Perpetual US Services, LLC,¹ would permit certain actively-managed Dimensional mutual funds to offer a class of shares operating as an ETF.

Dimensional requires the requested exemptive relief because Rule 6c-11 under the 1940 Act does not provide relief from Sections 18(f)(1) or 18(i) of the 1940 Act, nor does Rule 6c-11 expand the scope of Rule 18f-3's multi-class relief to permit an ETF class of a mutual fund to operate. In the 2019 release adopting Rule 6c-11,² the SEC expressed concern that a mutual fund with an ETF share class that transacts in-kind with authorized participants may give rise to differing transaction costs to shareholders of the different classes. Absent a mechanism for allocating transaction costs solely to the appropriate class(es), all shareholders would generally bear these costs. Similarly, an ETF share class of a mutual fund, through its in-kind creation and redemption process, would provide tax benefits that would accrue to all shareholders, including mutual fund shareholders who acquire shares directly from the fund in exchange for cash. Recognizing the significant differences between traditional ETFs and mutual funds with an ETF share class, the SEC excluded share class ETFs from the scope of Rule 6c-11.

While the ETF-as-a-share-class structure raises certain issues, including potential cross-subsidization among the share classes, particularly with respect to transaction costs and tax efficiency, Dimensional argues that the ability to manage a single vehicle that offers both mutual fund and ETF share classes would be beneficial to all shareholders. The multi-class structure will allow each investor to choose the manner in which they wish to invest in a fund based on the share class characteristics that are most important to them, while enjoying the benefits of efficiency and scale in a combined vehicle.

Dimensional's proposal would rely on a fund's board of directors to assess, both initially and periodically, whether the multi-class structure is in the best interests of each mutual fund class and ETF class individually and of the fund as a whole, as well as whether the multi-class structure is operating effectively. To inform these assessments, the board would review data regarding brokerage and other costs associated with portfolio transactions, cash levels, and tax consequences for the fund and each share class, and evaluate potential conflicts between the classes. The board also would receive reports on the unique operations of the ETF share class, including information on trading spreads, premiums or discounts to net asset value ("NAV"), and authorized participant activity. Further, the fund's registration statement also would clearly describe the multi-class structure, including any associated risks, such as the potential for cross-subsidization of portfolio transaction costs and tax consequences.

Observations. Dimensional's Application presents the staff of the SEC (the "Staff") with clear arguments regarding the potential merits of the ETF-as-a-share-class structure, including the proposed structure's ability to offer greater benefits to all investors. In addition, the Application contemplates a robust board oversight structure that may address the concerns about cross-subsidization articulated by the SEC in the Rule 6c-11 adopting release. However, the Application does not address how swing pricing, if required, would apply to an ETF share class of a mutual fund. We expect that applicants will need to engage with the Staff to work through the issues raised by the proposed structure.

We believe that having the ability to offer investors an ETF share class within an existing mutual fund vehicle would be beneficial not only for ETF class shareholders, but also to shareholders of traditional mutual fund classes, and we look forward to helping clients work through the issues potentially raised by ETF share class structures. Asset managers may wish to file their own form of application for relief to ensure that the Staff hears their views on these issues and to preserve a place in line should the SEC grant some version of the relief.

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