When a mutual fund company that’s been critical of exchange-traded funds opts to reverse course, advisors and clients should take notice.
Dimensional Fund Advisors, which has about $660 billion under management, recently converted four mutual funds to ETFs and plans to convert two more in September. The company launched three ETFs in November and December 2020.
As a firm, DFA spoke out against ETFs for years. But the fund landscape is changing.
The Shift Away From Mutual Funds Toward ETFs
According to research from Morningstar, ETFs enjoyed net inflows of $502 billion last year, while mutual funds had net outflows of $289 billion. The trend of ETF flows outpacing those of mutual funds has been underway for the past decade, but 2020 saw the widest divergence yet.
William Stack, advisor at Stack Financial Services in Salem, Missouri, sees a few reasons for the accelerating transition away from mutual funds.
“ETFs offer slightly more control over the buying and selling process,” he says. “Moving in and out of positions can be done with stop-loss and limit orders throughout the trading day.”
Mutual funds are only priced once a day after markets close. That means buyers are placing orders at an unknown price during market hours. That’s not usually a big problem for retirement savers. But in some cases, it could make a difference, especially in taxable accounts or when making a trade in large accounts.
For DFA, there’s a significant distinction between launching new ETFs and converting some of its existing funds. That’s because the track record of the predecessor mutual fund is assigned to the ETF. For example, one of the new products, the Dimensional U.S. Core Equity Market ETF (ticker: DFAU) is too young for even a one-year performance record.
To use one of the converted funds as an example, the Dimensional U.S. Equity ETF (DFUS), which listed on June 14, carries over the performance record of the prior mutual fund, the Tax-Managed U.S. Equity Portfolio.
Advisors have traditionally favored mutual funds, even as more ETFs came onto the market, but advisor usage of ETFs has been increasing.
According to a 2020 survey of more than 500 advisors released by Broadridge Financial Solutions, a growing number of advisors have been shifting away from actively managed mutual funds. Those advisors expect to continue investing client assets in ETFs.
Broadridge also found that younger advisors are more likely to move away from mutual funds to ETFs, with 64% of advisors under age 40 planning to make that move.
Yet the gravitation to ETFs won’t cause mutual funds to disappear, at least not in the foreseeable future.
Why Mutual Funds Won’t Disappear
Chad Carlson, president and co-chief investment officer at BDF Private Wealth in Chicago, says there are reasons mutual funds make sense in some cases.
“I could argue mutual funds have a better structure for some fixed-income instruments,” he says.
Actively managed fixed-income mutual funds have more latitude to beat their benchmark by making trades, whereas an index fund simply tracks its benchmark. As part of that active management, fund companies employ credit analysts who can determine the likelihood of default. Actively managed funds can also selectively invest in bonds that aren’t widely traded, something an index fund can’t do.
Carlson notes that investors with a significant capital gain in a mutual fund shouldn’t feel the need to sell out and pay the taxes just to make a swap for an ETF.
“A lot of this debate has been set up as mutual funds versus ETFs. However, I believe this is more about costs and taxes,” he says.
Actively managed mutual funds generally have higher expense ratios than index-based ETFs. Many mutual funds also still operate under a system of paying out commissions, commonly known as a load or sales charge, to nonfiduciary advisors.
Dimensional Fund Advisors didn’t pay commissions to advisors or charge a sales fee, which makes its ETF transition smoother for advisors already working with the company.
When it comes to taxes, capital gains are not an issue in qualified accounts, such as a 401(k) or individual retirement account. That means there’s no reason to switch to an ETF because of capital gains taxes, but there’s also no tax consequence for those who do.
However, ETFs do have another advantage over mutual funds in taxable accounts.
Mutual funds pass along distributions to shareholders, normally at the end of the year. Investors must report mutual fund transactions on their tax returns and pay any taxes on income in taxable accounts. That’s true even if the distributions are reinvested in mutual fund shares.
“If taxes are a nonissue, and you don’t worry about trading intraday, assuming costs are equal, there’s really no push to ETFs,” Carlson says.
Meeting Advisor and Client Demand for ETFs
Part of DFA’s move was motivated by demand from advisors and clients, says Dave Alison, founder and CEO of Alison Wealth Management in Palo Alto, California.
For larger investors, Alison says, the tax efficiencies of ETFs are appealing over other collective investments.
“For smaller investors, the fact that most custodial firms have gone to no-transaction-fee pricing for ETFs allows an advisor or investor to create a broader portfolio with more positions without having to worry about trading and rebalancing costs to diminish growth,” he says.
Although DFA’s mutual funds have been tax-efficient and low-cost, the fact that custodians are now offering ETFs without transaction fees makes operational execution of portfolio management easier for the average advisor, Alison adds.
“This move ultimately is going to push other mutual-fund-only companies to strongly consider conversions to ETFs to match the demand,” he says.
Many advisors limit themselves to ETFs when implementing client accounts. Carlson says that may be a mistake.
“A great investment decision has to start with strategy, not structure. If you limit yourself to a certain vehicle, then you’re only browsing in one section of the store,” he says.
ETFs and the Changing Role of Advisors
The changing role of advisors may be playing a part in the shift away from mutual funds.
“As more financial planners opt for the fiduciary advisor model, we will likely see additional mutual fund families increase their ETF product offerings,” Stack says.
Advisors who adhere to the fiduciary standard cannot typically receive commissions. That means they don’t use funds with built-in sales charges. That’s one reason for Dimensional’s success among fee-only registered investment advisory firms.
Dimensional’s mutual funds also have low fees, another appealing element.
“The ETF structure can help pull fees down a bit, and that is seen in DFA’s recent move, making an already attractive cost more attractive,” Carlson says.