The U.S. Securities and Exchange Commission (SEC) has indicated its intent to approve a request from Dimensional Fund Advisors to offer an exchange-traded fund (ETF) share class for its existing mutual funds. This decision, announced on September 29, 2025, concludes a two-year application process and opens the door for a new fund structure previously exclusive to Vanguard.
This regulatory development could significantly alter the investment landscape by allowing mutual fund investors to access the tax efficiencies and trading flexibility of ETFs without selling their current holdings. While Dimensional is the first to receive this preliminary approval, over 75 other asset management firms have submitted similar applications.
Key Takeaways
- The SEC has signaled its approval for Dimensional to create ETF share classes for its mutual funds, a structure pioneered by Vanguard.
- This hybrid model allows a single fund to offer both mutual fund shares and ETF shares, extending ETF tax benefits to all investors in the fund.
- Investors may be able to convert mutual fund shares to ETF shares without triggering a taxable event.
- Despite the approval, a widespread rollout is expected to be slow due to significant operational and compliance requirements for fund companies and brokerage platforms.
Understanding the Hybrid Fund Structure
Most investors are familiar with mutual funds, which are priced once per day, and ETFs, which trade like stocks on an exchange throughout the day. A dual-share-class structure combines these two vehicles into a single, unified fund.
Under this model, an established mutual fund can launch a new ETF share class. Both share classes hold the same underlying portfolio of securities and are managed by the same investment team. This approach allows investors to choose the format that best suits their needs—the traditional mutual fund or the exchange-traded ETF.
Vanguard's Precedent
Vanguard introduced the first ETF-as-a-share-class in May 2001 with its Vanguard Total Stock Market Index Fund (VTSAX). For over two decades, a patent protected this structure, limiting its use to Vanguard's index-tracking funds. That patent expired in May 2023, prompting a wave of applications from other asset managers seeking to adopt the model for their own funds, including actively managed ones.
The key innovation is that the actions within one share class can benefit the other. Specifically, the unique creation and redemption process of ETFs can improve the tax efficiency of the entire fund, a significant advantage for long-term mutual fund holders.
Benefits for Mutual Fund and ETF Investors
The introduction of ETF share classes presents clear advantages, primarily for existing mutual fund investors. However, ETF investors may also see benefits from this combined structure.
Enhanced Tax Efficiency
The primary benefit is improved tax efficiency. ETFs typically distribute fewer capital gains than mutual funds due to their "in-kind" creation and redemption process. When large investors redeem ETF shares, the fund can hand over appreciated stocks directly instead of selling them for cash. This avoids realizing a capital gain that would need to be distributed to all shareholders.
In a dual-class fund, this mechanism can be used to purge low-cost-basis securities from the entire portfolio. This means mutual fund shareholders in the hybrid structure are less likely to receive annual capital gains distributions, which are taxable events. This has been a key reason for the low capital gains distributions from many of Vanguard's index mutual funds.
Flexibility Without Tax Consequences
Another major advantage is the potential for a tax-free conversion. Funds are expected to offer an "exchange privilege," allowing investors to convert their mutual fund shares directly into ETF shares of the same fund. This would not be considered a sale, thereby avoiding capital gains taxes that would normally be incurred when switching from a mutual fund to a separate ETF.
"Bolting on an ETF share class gives them the tax advantages of the ETF’s redemption mechanism that can reduce, if not eliminate, capital gains distributions."
For ETF investors, being attached to a large, established mutual fund provides immediate scale and a proven track record. The cash flows from the mutual fund side can also provide greater flexibility for portfolio managers during rebalancing, potentially lowering transaction costs for the entire fund.
Potential Drawbacks and Limitations
While the hybrid model offers significant benefits, investors should also be aware of the potential trade-offs and limitations associated with this structure.
The shared nature of the fund means that tax liabilities are also shared. In rare circumstances, large-scale redemptions from the mutual fund share class could force the portfolio manager to sell securities and realize capital gains. If the ETF share class does not have corresponding outflows to purge these gains, ETF shareholders could unexpectedly receive a taxable capital gains distribution.
Furthermore, this structure is not suitable for all investment strategies. Some active managers close their funds to new investors to protect their strategy from becoming too large and unwieldy. Because ETFs must be open to new investments to function, a dual-class fund forfeits the ability to close. Additionally, ETFs are required to disclose their holdings daily, a level of transparency that some active managers may resist to protect their proprietary strategies.
The Road Ahead for the Fund Industry
The SEC's decision marks a pivotal moment for the asset management industry, which has seen a consistent flow of assets from mutual funds to ETFs over the past decade. Over 75 firms, including industry giants like BlackRock and companies with no current ETF lineup like Lord Abbett, have applied for this exemptive relief.
This unified push highlights the industry's desire to offer its successful mutual fund strategies within the popular ETF wrapper. Until now, managers had two main options: launch a brand new ETF or undertake the complex process of converting an entire mutual fund into an ETF. The dual-share-class model provides a more seamless path.
However, investors should not expect an immediate flood of new hybrid funds. Significant operational challenges remain.
- Board Oversight: Dimensional and other firms must first establish and receive approval for new board oversight procedures to ensure the structure serves the best interests of all shareholders, as required by the SEC.
- Platform Readiness: Brokerage firms, retirement plan administrators, and other investment platforms must update their systems to handle the trading, clearing, and record-keeping for these new hybrid products.
- Ecosystem Adaptation: The broader ETF ecosystem, including market makers and authorized participants, will need to adapt to a potential increase in new, and possibly less liquid, ETF share classes.
Even with these hurdles, the approval for Dimensional is a clear signal of regulatory acceptance. It paves the way for a future where the line between mutual funds and ETFs becomes increasingly blurred, offering investors more choice and potentially better outcomes.
