Dimensional Fund Advisors is one of the fastest growing providers of mutual funds and ETFs. It was founded in the early 1980s, built upon University of Chicago research on efficient markets, passive investing, and other ideas that have since become extremely widespread. After having built up a huge following among financial advisors for their mutual funds, the company has been racing up the list of ETF providers. On this episode, we speak with Dimensional's co-CEO and chief investment officer Gerard O'Reilly on the firm's history, its approach to investing, and where he sees the fund management industry going. This transcript has been lightly edited for clarity.
Key insights from the pod:
The academic origins of Dimensional — 4:25
What is passive investing? — 6:57
What can you learn from the price of a stock? — 9:47
What we learned from meme stock mania — 11:17
The Dimensional approach to fund distribution — 15:33
How Dimensional launches new products — 19:56
What's happened to “value” stocks? — 22:51
What are Dimensional’s plans in the ETF space? — 29:43
The costs of indexing — 33:30
How Dimensional approaches costs — 38:40
The next growth areas for the firm — 40:56
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Joe Weisenthal (00:00):
Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway (00:15):
And I'm Tracy Alloway.
Joe (00:17):
Tracy, I have a big confession to make it actually speaks to everything that we do. Okay. You ready for it?
Tracy (00:26):
I'm bracing myself. Do it.
Joe (00:28):
So I sort of ascribed to the general belief that markets are fairly efficient, things are priced in, indexing, probably a pretty good strategy on the market portfolio. Things like that make a lot of sense to me. A lot of people seem to generally believe this is generally true.
Tracy (00:46):
So far this is not a confession.
Joe (00:48):
Okay. But the confession is given that I don't really understand why the investment industry exists and why do people trade at all? Why does anyone try to beat the market? Why is active management a thing? We all sort of accept these premises and yet the investment industry continues to exist.
Tracy (01:07):
Well, I applaud your honesty Joe...
Joe (01:09):
I've never understood this.
Tracy (01:10):
… Especially given that you work at a large financial organization dedicated to providing data and services to the financial industry. But I don't think it's actually an extremely unusual opinion. I think this has come up at various times that if the best thing for people to do is just index to the market and find the fund or the vehicle that does that at the lowest cost, then why do all these other services and FAs and things like that actually exist?
Joe (01:39):
What are we doing here? Right. Because we talk about all these different things and you know, sometimes on the show we talk about real economy things and sometimes we talk about sort of strictly market things. But why is anyone paying attention? Why is anyone talking about this? Why is anyone trading on any of it? Why?
Tracy (01:55):
If I was going to hazard a guess, I would say there is something innately human about the idea that you can beat the system or outperform the market in one way or another. Like it feels unsatisfying to think that no one out there in the entire investment world is able to outperform the market. And yet if you listen to efficient market hypothesis and things like that, that's exactly what it'll tell you.
Joe (02:19):
Or maybe you can outperform the market, maybe you just outperform someone else trying to match the market or something like that. Maybe you could beat me or I could beat you, but not necessarily the market. I don't know, this always has bothered me.
Tracy (02:31):
I love that you've started this podcast on the most existential note that you could possibly find.
Joe (02:36):
Well, I think it's really fitting because today we are going to be speaking — we're at a company that's sort of known for its deep academic data-driven understanding of markets and it has this like incredible lineage of people who have been at the forefront of a lot of this research about market efficiency and where pockets of inefficiency might exist and what is the best way to invest given certain premises of efficiency and what that even means, market efficiency. And so, I think that we can have a conversation today that sort of gets at like some of these existential questions about how markets operate.
Tracy (03:16):
I think that sounds great. I think we are also going to be speaking to our second maybe rocket scientist to have been on the podcast after Josh Younger.
Joe (03:25):
I love when we talk to actual rocket scientists because you know, obviously sometimes that is used as a cliche for very smart person, but as you mentioned, Josh Younger, former actual rocket scientist turned market econ guy and yes, we have another one today.
Tracy (03:38):
Alright, let's do it.
Joe (03:39):
Alright. I'm very excited. We are going to be speaking today with Gerard O'Reilly. He is the Co-CEO and CIO at Dimensional. Been here since 2004. We're actually recording this at Dimensional’s headquarters in Austin, Texas, right now one of the major providers of mutual funds and ETFs. Huge player in the industry.
Tracy (04:01):
The fastest growing.
Joe (04:03):
The fastest-growing ETF provider. And so we're going to learn all about this company's philosophy. Gerard, thank you so much for coming on Odd Lots.
Gerard O’Reilly (04:11):
Thanks for having me on the show.
Joe (04:12):
So, I mentioned that Dimensional sort of has this deep academic lineage. Why don't you sort of give us the quick history of the company and sort of like the ideas and the people from which this emerged?
Gerard (04:25):
So the company began in 1981. So we've been around for many decades now. And when you kind of go back and trace the history of the founders of the company, a lot of them had been at the University of Chicago. So they had studied under Gene Fama and others and they had worked on the first set of index funds in the early seventies, so David Booth and Rex Sinquefield. And in the early eighties, David and Rex had identified a need in the marketplace, which was, there was no real way out there to get systematic, broadly diversified exposure to small cap stocks.
They understood the limitations of indexing, they understood that that probably wasn't the best way to go, but they also understood some of the benefits of indexing, transparency, low cost, broad diversification. So they started the company based on a need in the market and a set of academic research that had been coming out at that time kind of demonstrating that small cap stocks had had higher returns than large cap stocks.
And from there the company began, it has its roots in academia. When the company first began, David and Rex went up to the University of Chicago and Gene Fama was there, he got on the board. You had folks like Mac McQuown, a very long-time industry expert. On the mutual fund board, you had Myron Schultz, you had Merton Miller. Interesting thing about Dimensional is that we've been associated closely with five Nobel Prize winners.
Tracy (05:51):
This must be the most credentialed fund manager ever.
Joe (05:54):
When you think of like the Mount Rushmore of academic finance, it sounds like they're all associated with Dimensional.
Gerard (05:59):
Pretty much.
Tracy (06:01):
So I have a really basic and perhaps embarrassing question, but I think it kind of gets to some of our introductory remarks and possibly I'm not the only one who has this question. When I think about Dimensional, I think about mostly indexing and really passive investing. But you do have a bunch of actively-managed ETFs. So in your mind, are you active or passive?
Gerard (06:23):
We're non-index. So passive is probably fine because passive implies that you accept market prices, you trust market prices and you try to extract information from market prices. Indexing is too rigid. You leave money on the table and so we're non-index, but we're not in the business of trying to outguess market prices.
Joe (06:43):
What does that mean? Okay, I guess you know, to your point, maybe in my mind I've always sort of elided the two or think that passive means index so that they're roughly synonyms, but clearly they're not. So why don't you talk a little bit further about what the difference is?
Gerard (06:57):
So maybe [it] would be helpful also to talk a little bit more about markets. You made some comments about market efficiency and so on. I think that it's important to understand what a price actually represents: the price of a stock or the price of a bond. And then you get a good idea of why not index but why be passive?
And the example that we often use is if you want to place a bet on a sporting event, typically you say ‘I think the favorite will win by X 20 points, 30 points, 40 points.’ And so why bring this up as an example is because that spread — how much the favorite is expected to win by — is an example of using the wisdom of the crowds to predict the future. The bookie tries to keep the same number of people on one side of the spread as the other side of the spread. If more people say ‘I'll take, you know, the favorite will win by more than the spread,’ the spread will change.
And you can look at how well that does at actually forecasting the outcome of the games. There was a study in the mid 2000s that looked at, you know, 8,000 NBA games and 5,000 NFL games and found that the favorite won by more than the spread 50% of the time, exactly what you would expect. So this notion of, there's a wisdom of the crowds, there's a marketplace by which they can express their opinion, they express their opinion by putting real money on the table. And that gives you a forecast about something that's going to happen in the future.
And so when you think about markets, think about them in the same way that prices are basically predictions or forecasts of the future, and they're informed by the actions of people trading in the marketplace. And the question then becomes, what information's in the price of a bond or a stock? There's lots of academic, you know, studies around that.
When it comes to the spread, how much will the favorite in this sporting event win by. When it comes to the price of our bond or stock, the overwhelming academic evidence is that what's mainly in there is the return that people require to hold the investment. And I think that's a really important point to make because it tells you that you don't have to be out there outguessing market prices, but you can use them to say, which stocks or bonds do people require a high return to hold? And which stocks or bonds do people require a low return to hold? And I think that's one of the keys and the key insights that you kind of glean from this, all this academic literature. And that's what we do, we say, how can we extract that information efficiently for investors?
Tracy (09:35):
So it's not that market prices are always necessarily correct, but rather that you can kind of glean, I guess, the risk assessment of investors based on those prices and then adjust for that?
Gerard (09:47):
You can glean how much investors demand in returns to hold a stock or a bond or many differences in those. And the way I think about them always being right or not always being right, I think about them being fair and unbiased. There's another set of academic studies that look at the performance of managers and what they find at the conclusion, the main conclusion you can draw from those studies is that they're unbiased estimates of the future. They may not always be spot on, but you don't know when they're too high and you don't know when they're too low. And what you find is if you use them effectively, you can manage risk better and you can increase expected returns.
So, you know, at the start you said why do people bother? Because let's take the US over the past a hundred years. The nominal rate of return on the US stock market has been about 10% over the past a hundred years. So that means that if you invest your money doubles every seven years, it's an explosive number. If you can take that 10 and turn it into an 11 or 12, your money doubles every six. So after a 40 year horizon, you have double the money. Now, a lot of people's investment horizon in the accumulation phase 30 or 40 years. That's why people bother because the amount of consumption that you can afford by doing a little better than the market tends to be quite significant.
Tracy (11:05):
How would your framework of understanding the market apply to a phenomenon like, say — this might be a little unfair — but you know, an extreme example, GameStop for instance.
Gerard (11:16):
So, when you look at a situation like GameStop and you look at any market mechanisms around that time, what was interesting is in order to keep what we think as prices as unbiased estimates of the future, there has to be some shorting going on, some long going on. And when one of those market mechanisms becomes a little bit more restricted, well then prices may deviate away from what people consider a fundamental valuation of the firm. So that market mechanism itself is important to keep running.
And as that market mechanism keeps running, then prices adjust from day to day. But you'll have people who think are too high, people who think they're too low and they will express their opinion on one side or the other. When the people who think they're too high can't express an opinion, what happens? That's where prices may deviate.
The thing I would mention about a company like GameStop is that when you have a systematic approach, it allows you to handle situations like that very, very efficiently. So you accept the price for what it is. It used to be a micro value stock, two weeks later it's a large growth company. Okay, if you're managing portfolios along those types of asset categories, you know what to do.
Joe (12:40):
Tell us a little bit more about the evolution of product offerings at Dimensional. You mentioned that the original, a lot of the original research was sort of based on this idea that there was potential outperformance in small caps that were not easily exploited by the offerings that were available. And I know you started in mutual funds. The one thing I always heard about Dimensional mutual funds is that there was sort of a screen to even get access to them and you wanted the advisors who put the client money into Dimensional.
Tracy (13:11):
There's a great Michael Lewis article that I saw and it kind of described the process, I guess the late 1980s, of getting access to Dimensional and it's almost like a revivalist meeting where you had to pledge your undying loyalty to efficient markets.
Joe (13:26):
Why don't you talk to us about this? So what were those initial product offerings and then we can get into sort of how it's evolved over time.
Gerard (13:32):
So when the firm started in the eighties, the initial product offerings were small cap strategies. Began with US small cap strategies, then moved to strategies outside the US, the UK, Japan, Europe and so on, so forth. Then fixed income offerings came along and the fixed income offerings started out short term and evolved to be global pretty early on by the kind of early nineties.
And there again, it's about using bond prices to understand differences in expected returns across bonds, effectively thinking about the shape of the yield curve, how much capital gain should I expect versus yield, right? That's at its heart. Then the value research came along in the early nineties and the firm really started to grow in two ways.
One, the product offering expanded and what drives our product offering is two things. One, we work very closely with financial professionals. So we don't go straight to retail. We work generally with financial professionals and we have deep relationships with them. So we understand what problems they're trying to solve and that informs what strategies we bring to the market. And you can see that in our track record. If you look typically in the industry, the closure rate for funds tends to be very high for Dimensional, it's incredibly low because we understand the need that we're trying to solve before we launch a fund or an ETF and have a pretty good idea of who has that need and who else might have that need.
Joe (15:00):
So you're not, sorry, you're not just like throwing, so it does feel like a lot of ETFs you get these throwing things at the wall and it's like, let's see if it sticks. And that's not your approach to launching new products?
Gerard (15:09):
That’s not our approach at all. It's work with clients who understand markets and it can express needs or fiduciaries for end investors and how we can build products and solutions to meet their needs.
Tracy (15:22):
To Joe's point earlier though, why not just cut out the middleman completely and sell directly? Because presumably you could lower your already pretty low fees even further.
Gerard (15:33):
We think that the combination of financial professional, independent money manager is a pretty good combination in terms of serving the needs of families all across the country. Because as you say, why not just hold the market? You mentioned that at the beginning of the podcast and set it and forget it. There's a lot of value that a financial professional can bring to the table.
And I'll get back a little bit to the product offering in a moment, but this is interesting in itself because until you define your goals with respect to your investment portfolio, you can't actually manage risk. You have no way to manage risk until you define your goals. Your goals define what assets actually have low uncertainty relative to what you're trying to achieve. And that gives you a risk management asset.
Financial professionals typically will work with families who may not understand finance all that well and will do two things. One, help them come with a financial plan and implement that financial plan with the right investment vehicles, and then two, help them stay disciplined and tune out the noise of all what goes on around markets. And so that's why we've gone down that path.
And you mentioned that that started in the early eighties. You're right. And that became another kind of large part of our business through the nineties and the 2000s, just back to the kind of how we decide on new strategies. The other area then is new academic research, or new research from our internal team. We have about a hundred plus folks on our internal research team, lots of PhDs and all types of disciplines. And as we learn something new about markets that can be implemented in a systematic way, we say, okay, great. Let's provide those benefits to all of our existing clients and it may lead to new strategies that we can offer existing and new clients going forward.
Joe (17:25):
So as you point out, you know, some of these terms don't mean the same thing. Passive certainly does not necessarily mean indexing. What is the difference between systematic and active?
Gerard (17:36):
For me, I'll use a systematic or rules-based approach. We like rules-based approaches when you can describe, ‘Here are the rules that are going to be used to manage the portfolio,’ because then you can describe that to a financial professional. You can give them the tools to monitor what you've done and they can see that you did what you said you would do. And that builds trust over time.
Trust builds a longer investment horizon over time. And what we know about longer investment horizons is that the probabilities of success go up with a length of investment — probability [of] realizing a positive value, premium size, premium profitability, premium. So, rules or systematic are very, very important because it gives you a way to say that I can understand what to expect from these strategies given different market environments.
Traditional active, there are probably a set of rules, but they're not as well articulated. It may be based on a hunch or some analysis. And the analysis may vary over time. And so the range of outcomes or the dispersion of outcomes that you get from the strategy is much greater. And you really can set a strong expectation.
A rules-based approach is the right approach in my view. If you have the right innovation, you've got to do the research and keep on pushing forward the boundaries, the right pricing. You mentioned that, you know, we have very well-priced and then the right support. So you say, you know, when we had advisors and so on come to conferences, what was that all about? It was providing the right support because education is key.
If you understand what to expect and how bad it can be before the bad times happen, you will be much better prepared to handle those bad times when they almost certainly will occur. So that support aspect is why we run conferences, why we write white papers, why we provide materials to financial professionals to help them understand the approach and communicate the approach.
Tracy (19:30):
Just on this note, could you maybe describe for us the process of coming up with a new product or a new systemic investing strategy? What does it look like from the initial research and maybe the pitching of the idea to the approval process? And could you maybe provide a favorite example where people were particularly creative, or one that illustrates the way Dimensional is thinking about markets?
Gerard (19:56):
Yeah, for sure. So let's take the example of profitability and it's going through its 10-year anniversary. It's been 10 years since Professor Novy Marx published one of the key papers on that particular topic. And so if you go back to, you know, 2011, 2012, 2013, effectively there was new research coming out that showed profitability, which kind of takes income statement variables and scales them by balance sheet variables; it had the power to predict future profitability. So it's an intrinsic firm characteristic. Tall parents have tall kids, well-run firms tend to remain well-run firms for some period of time. And if you paired that up with other price-based metrics like price to book, price to earnings, market cap, it actually enhanced your description of differences in returns across stocks. So we decided that we were going to incorporate that in how we managed the portfolios.
And so we went through a large process of educating clients on here's the research, here's how it will change the strategies that we manage for you, and here's the benefits that we perceive for you all from this piece of research. The research goes through a very strong vetting process here internally. We have an investment research committee that has Nobel Prize winners on it. People like Gene Fama, people like Professor Merton, Ken French are on it, Professor Novi Marks, that vets the research very, very thoroughly.
And then we have a lot of expertise in how to implement. And so that goes through the investment committee and the investment committee would review all the ways that it would be implemented. So there's a kind of a large emphasis on education and then also implementation and doing it well. And then we bring that to the marketplace with [a] series of new strategies, but also enhancements to all of our existing strategies.
And I think that's worked out very, very well. But we have these types of examples all the time that come where clients either express needs or there's new academic research and that helps us, you know, improve what we do. You can always get better, that's our mantra. You can always get better at what you do.
Joe (22:03):
So, I understand your point about support for financial advisors, education for financial advisors, education about potential downsides, periods of downsides, what to expect that maybe the premium exists over a long time and then there could be bumps in the road. I'm curious about a specific example like value, which is, you know, cheap stocks depending on how you measure it. Supposedly there was a lot of research that said they would do better. My understanding is that over the last, at least, 15 years that has not been an effective strategy. And some people have certainly called [it] into question. Like, was that wrong? Will it ever come back? Is that busted research? What has happened with value? And sort of, you know, with the research that you've done at Dimensional, how does that help you understand that factor?
Gerard (22:51):
When you have a time period like that, it's always important to be introspective, reevaluate your assumptions, reevaluate the data, and also understand what really happened. So I think that the idea that there hasn't been a value premium for 15 years, I disagree with that in the sense of there's been many months, quarters, years where value stocks have outperformed growth stocks. But what you had in the middle of that period, ending in June, 2020 was the worst three year period in the past a hundred years for which we have data here in the US of value stocks, in particular small value stocks versus large growth.
And you say, well, was that unexpected or was that a change in markets? If you look at the returns of some of the large growth companies during that time period, and even over the 10 years ending in June, 2020 and you looked at FANGS or whichever latest acronym you want to use, they had annualized compound return rates of 30% per year for about a decade. That's unexpected.
You can't tell me that people, you know, going back, you know, in 2010 and so on, were going to say these stocks are going to return 30% a year for the next decade. That's an unexpectedly good outcome. And you can say why? Well, those firms did unexpectedly well. They served their clients' needs better than anybody had anticipated, grew their revenue better than anybody had anticipated and became dominant firms in the market. And that was an unexpected event.
You factor that in and you say, ‘No, there's nothing broken here.’ It's just that there's a lot of volatility with these premiums and this time period tells you that you can have large unexpected events, but if you break down a lot of those sub periods, you've had lots of strong periods for value. So for example, after that worst three year period on record June, 2020, we went into one of the strongest two to three year periods on record for value versus growth.
And so it's kind of tempting to try to summarize a 15 year period with one observation but typically that's not as helpful. The one comment I would make from that period is that sector weights matter a lot in a value strategy. And in particular, you know, value strategies when you just look at them generally tend to be underweight technology. We use a lot of sector caps and sector constraints and they were actually quite helpful for our relative performance during that period and subsequent periods. And I think that was one thing that was probably additive that that data gave you in terms of understanding of how better to build value strategies from that period.
Tracy (25:27):
What about the definition of value itself? Because over the past couple of years there's been this discourse that maybe traditional measures of value, such as price to book, which doesn't take into account intangible asset values. Maybe that's not the right way to do it. How are you thinking about actually measuring value?
Gerard (25:46):
So a couple of kind of quick reactions there. One, there are a lot of intangible assets that are in book value. So, let's take some examples. If company A acquires company B, then there may be line items booked through that merger and acquisition process that are called externally acquired intangibles. And so, as companies go through this Merger and Acquisition process, you get a lot of intangible assets on a company's balance sheet. In fact, if you look at S&P 500 companies, I think it's something like 25% of the value of the assets are intangible assets externally acquired. And so that's grown since about the year 2000 because the accounting mechanisms for how you treated M&A activity changed in the year 2000 in the US. So you see a lot of intangible assets on companies' balance sheets. Perfect example is when Disney acquired, what's the company I'm thinking of? For Star Wars?
Joe (26:40):
Lucas Films.
Tracy (26:41):
Lucas Films.
Gerard (26:41):
Lucas Films, that was about two billion in intangible assets and two billion in goodwill appeared on Disney's balance sheet. What doesn't typically appear on the balance sheet is internally developed intangible assets. And there's very good reasons that they don't. They're usually expensed, not capitalized, and so they flow through the income statement, not the balance sheet.
And the reason behind that is that as you do research and development, or you do things that develop brand and future intangible assets, the level of uncertainty around what the value of those will be when you're incurring the expense to build them is a massively high, and we've done lots of work on this. So in short, there's kind of a mix. There's a good chunk of intangibles on balance sheets and some that's internally developed intangibles that typically are not. And when you look over time, in fact, I think that the way that the data is presented can be misleading because if you look actually at the percent of balance sheets that are, that are intangibles, it actually hasn't changed that much over time.
It's just that when you compare it to things like property and equipment, they are subsets of what's on the balance sheet that you get the big changes. We've done a lot of work on this adjusted book values for intangibles with and without and what it really boils down to is that the estimates for internally developed intangibles are too noisy to be useful, so we don't use those. But when you combine it with profitability, asset growth, things like that, it actually doesn't matter. And you have to use multiple variables for it, not to matter. But it's actually not that relevant for computing value premiums.
Joe (28:35):
So, I realize there's multiple ways we could take this conversation and we could talk about different factors for a long time but I also want to talk about the sort of industry and, you know, the nature of products. You started offering mutual funds and as Tracy mentioned, there was this sort of whole process about getting access to them and education and screening, etc. Now you're really big, you're one of the fastest-growing ETFs, when did you get into ETFs?
Gerard (29:03):
Our three-year anniversary is this November.
Joe (29:05):
So very [recent], so given ETFs have been [around] while, you’re sort of late.
Tracy (29:09):
As soon as the actively-managed ETFs were approved, pretty much. Right?
Gerard (29:12):
In about October 2019 there's what's called Rule 6011, the ETF rule, and then about one year later we had ETFs in the marketplace.
Joe (29:22):
And you're one of the fastest-growing ETF companies. Can you just give it a little bit [of an overview,] like how big is that? How much of the ETF money is just sort of the same investor switched from a Dimensional mutual fund to a Dimensional ETF? Like how big is that and what is the relative weight of like the legacy or the mutual funds versus the ETFs today? What are we talking about?
Gerard (29:43):
The ETF business for us, I'll take a step back, was why did we do it to begin with? One was the rule change that allowed us to do what we do in mutual funds in an ETF wrapper, which was important to us because we don't sacrifice the investment principles and the investment proposition. We want to be able to deliver equally good investment propositions regardless of the wrapper. And two was that the financial professionals, whether those are advisors or institutions that we were working with, were using ETFs more and more frequently, and were asking for Dimensional to have an ETF lineup.
So we said ‘Okay, now that we have this new rule, we can do what we did in mutual funds.’ So we launched the ETFs with that in mind. And we'll have, you know, close to 40 by the end of the year in terms of ETFs and all launched with input from our clients on which are most important to you and for your businesses.
There's no doubt that the industry has seen flows from mutual funds to ETFs. I think that's a trend that we've seen in the industry. And we have some advisors that have changed, kind of transitioned from our mutual funds to our ETFs. What's been interesting about the ETFs though is it allows us to access, I would say, new channels, new advisors, new wealth platforms that we traditionally haven't played in. And so if you look at the kind of large broker dealers, the wire houses, if you look at some of the bank trusts, all of those types of platforms and organizations, we traditionally haven't played there with mutual funds. But ETFs lend themselves much more so there's been many new clients [that] actually have come on board over the past number of years and that's also helped the ETF growth.
Tracy (31:30):
This was going to be my next question, actually. We've said fastest-growing a number of times now, and I think your assets under management are now above $500 billion, something like that. What proportion of inflows are new clients versus people migrating from mutual funds into ETFs?
Gerard (31:46):
It's a tricky question to answer because of the data constraints. But I'd say, you know, in terms of new flows into ETFs versus maybe transitions, my educated guess is maybe 50/50, something in or around there about. So we have about a hundred billion now in ETF assets globally. We kind of bounce around $625 to $650 billion in terms of total firm assets on what we manage on behalf of clients and our mutual fund business is still very, very large, three to $400 billion of US mutual funds. So our US mutual funds are still very important to us to continue to innovate and push forward there, ETFs important.
Kind of when Dave and I first got on the role, Dave is the other co-CEO, one of the things that we kind of agreed on is that let's make it [as] convenient as we can for financial professionals, whether they're institutions or advisors to access this investment approach. And that's why the ETFs, that's why the enhancements to mutual funds, that's why lowering our account minimum with SMAs, it's all about, you know, convenience of use for the professionals to serve their clients.
Tracy (32:54):
So I know you said earlier that you consider yourselves more passive, but not indexers. And I kind of want to get your take on the overall rise of, I guess, extreme passive. The indexation in the industry. And I know there's been a lot of hand wringing over this idea that if you're just benchmarked to an index and you're trying to hug that index as closely as possible, you're actually still making an active investment decision, it's just you're kind of outsourcing that active management to the benchmark index provider so MSCI or S&P or whoever, what do you think about that argument?
Gerard (33:30):
Well, this goes back to Joe's opening remarks, which I kind of take as evidence that the academic evidence has won in the sense that academics for a long time have studied the performance of active managers and say, you know, there's no real evidence here that people can outguess the market and people who outperform by stock picking and market timing are doing so by look versus skill or you can't disentangle the two.
And so there's been a large flow of money into indexes. I think the people have over-indexed an index because there's a lot that you can do to actually get your fair share of the returns that the market is willing to offer. And in my view, indexing leaves some of that money on the table.
So let's take some examples. Tesla was added to the S&P 500 in December of 2020. We all remember that event. It was one of the biggest new entrants to the S&P 500 in history. And if you look at the price pressure that index managers exerted on Tesla's stock on the day that it was added to the S&P 500, on that day the price was driven up and then after that price pressure came down, the price came down. You say, how much did that cost the index? It actually costs the index between five and 10 basis points in one month and you can come up with reasonable ways to make that estimate in one month to add one stock to the index.
Tracy (34:52):
Wow.
Gerard (34:52):
So here [are] the most liquid stocks in the entire world and to accommodate a rebalancing event, people spend two to three times, what's a typical expense ratio on an S&P 500 index fund on adding the stock. But it's never reported, people don't notice it unless they do the research to actually find out and there's an example of leaving money on the table by having too rigid an approach. In my view, there's no reason that you need to hold a perfectly market cap weighted portfolio of stocks and indexes typically aren't perfectly market cap weighted in any event.
It's much better if you have some flexibility to deviate from market cap weights to pursue higher returns, but also flexibility on how to turn the portfolio over and keep yourself focused day in, day out. You don't need to wait for one or two events each year to rebalance. So indexing is definitely an active decision with respect to how they're put together, how they decide to rebalance, and those active decisions have cost investors money.
Tracy (35:59):
So the suggestion earlier was that Dimensional doesn't try to outguess the market, but you do try to outperform. Is this market structure awareness a key plank of that outperformance? I know you talked about systematic strategies and having a rules-based approach, but is it also just understanding some of these market dynamics and recognizing alpha opportunities, for instance when there is an index rebalancing event?
Gerard (36:25):
Spot on, there's two major sources. One is does anybody think that all stocks have the same expected return or all bonds have the same expected return? No. There are differences in expected returns and you can use a systematic framework that's based on valuation theory to identify those. Two is be efficient, don't do stupid things when you know they're stupid. Always
Tracy (36:48):
Always good advice.
Gerard (36:49):
Always good advice and that is about how do you understand how markets operate, how to trade, how do you add value while you hold a stock in terms of the corporate actions that you elect? Some corporate actions, just as an example, an index will choose a way to deal with a corporate action, a stock is spinning something off, they're doing a tender or something like that. The index providers may not always choose the value-maximizing way to deal with the corporate action.
Index managers often follow the index provider. We say, well, why would you do that? There's another election on this corporate action that actually improves value. Pick that one. Right? There's things like that that add value. So there's a combination of the research to identify the systematic drivers of returns, and then how you implement.
Implementation is key and those are two big drivers of how we outperform indices. And by the way, just a quick stat, if you look at our US mutual funds, 80% of them over the past 20 years that have been alive for the 20 years have outperformed their benchmark indices, which is an incredibly unusual stat for our industry.
Joe (37:59):
Just really quickly on this sort of like product distribution side ETFs, obviously I imagine Tracy or I could log into a brokerage and buy a Dimensional ETF, but the still focus from a sort of corporate strategy perspective is to distribute them or sell them through advisors?
Gerard (38:16):
That's correct and I hope that you guys do that. We would love to have you as clients, but that is the approach. We know how to work with financial professionals, whether they're institutions or advisors. We know how to give them the tools to monitor what we do. And then we think that the advice they give to constituents is typically the right way to go. So that's the approach, where we don't market directly to the retail public.
Tracy (38:42):
Can you talk to us a little bit more about cost? Because this has also been a big conversation in the fund industry, the idea of a race to the bottom, the idea that especially in passive or indexing, the only thing that really matters is your cost ratio and so you want to get that as low as possible. Is there a limit to how low that can go? And do you yourself feel pressure to get it as low as possible?
Joe (39:07):
Just to sort of add onto to that, like I'm thinking in the Tesla example, someone has to be paying attention to that, that takes some level of human work to be thinking about these dynamics, which I imagine isn't free. Yeah what is the limit?
Gerard (39:22):
There’s two things that go on there. One is the explicit expense ratio, and there has been a strong focus on expense ratios. And we've reacted similarly as we've gained efficiencies with our systems and scale. We've reduced our fees over time. Our weighted average fee has come down by about 30% in the past, you know, four or five years.
So that's one aspect, but the expense ratio is not the only part for total cost of ownership. There's also things around implementation that are very, very important with respect to the total cost of ownership. So we spend a lot of time on education, which is why we have those conferences and so on, and work with financial professionals on what are some of the aspects that maybe aren't as obvious, but go into the total cost of ownership. Let's take an example of securities lending.
If you look at securities lending revenue it can vary across asset categories, but I'll take the extreme, emerging markets small, over the past few years, typically those strategies have gained, you know, 40 basis points in securities lending revenue each year. Depending on how you do that, that can be a material percentage of the expense ratio given back to the investors through a process that you can have going on inside the fund. So I think that there, the total cost of ownership is key and you have to dig far deeper than the expense ratio to actually get there. When you look at the total cost of ownership of indices, it's actually much higher than the expense ratio because of the way that they're implemented and often the lack of focus on the asset category.
Joe (40:56):
What's next for you? I mean, in sort of the big picture trends, we sort of trace the sort of lineage of the company and the introduction of various ETFs. What aspects, whether it's sort of industry market structure things like where do you see the future? Like where are you investing for growth?
Gerard (41:14):
One of the big areas that we've been working on recently is our application for exemptive relief for ETF share classes of mutual funds. And we think that if that becomes a high enough priority for the SEC and more folks in the industry are able to get that exemptive relief, we think that could be a big thing for the industry.
Joe (41:34):
Sorry, why is this important or what is this and why is this important?
Gerard (41:37):
Well, this means that let's say you have an existing mutual fund. You could offer an ETF access point. So let's say an existing mutual fund is purchased by retirement investors through 401K accounts. Now you can offer an ETF access point. All of a sudden you can commingle the retirement savers plus people who maybe have brokerage accounts that are in taxable accounts.
That commingling provides economies of scale immediately to both sets of investors. The SEC has to provide fund managers, what's called exemptive relief permission to do this. But I think that if more of those types of structures appear in this country, I think that will be a game changer for the mutual fund industry and also for the end investor, because folks who want to make a move from a mutual fund to an ETF could now do so without trading if this were put in place more broadly in a very particular way. So I think that's a big one to keep an eye on and we're definitely excited and energized by that possibility because we think it can be good for the end investor.
Tracy (42:39):
You know, we spoke a little bit about your assets under management, more than $600 billion now, but not the biggest by far. You know, Vanguard, BlackRock are still sort of, I guess, giant whales in the market. How does their growth or their size affect what you do? And I guess how closely do you keep an eye on what your competitors are doing in order to either identify market opportunities or perhaps alpha generation opportunities?
Gerard (43:10):
So we definitely try to understand who's doing smart things with respect to investing, because as I mentioned before, you can always improve on yourself and what you do. So if somebody comes out with a smart way to solve a problem, we're interested in learning that.
I think that in terms of how we decide where to go next and what strategies to launch, typically there we're not looking at our competitors [but] we're looking at our clients and our clients give us far more precise, informed, useful information on what can be helpful for them and therefore what can lead to more sustainable business opportunities for us.
So in that sense, we're maybe a little bit different than others in the industry in that, you know, we kind of march to the beat of our own tune in some respects. Because we have these strong relationships with academics and clients, they help us forge a path that we think is the right one, which may be different than others.
Joe (44:07):
Just to get back to the competition, real quickly, Tracy mentioned BlackRock and Vanguard, but also we've seen more and more ETF offerings from the likes of JPMorgan and more recently Morgan Stanley that have a lot of sort of natural internal distribution capabilities and both have wealth management arms and so have advisors for whom they can have a seamless brand. How challenging is that from a competition perspective, because obviously Dimensional does not have its own advisors or Dimensional wealth management, when companies that have this sort of end-to-end sort of vertically integrated wealth solution, their own people on the ground, their own local offices, their own ETFs, their own fund, how much of it challenges that from a sort of competitive standpoint?
Gerard (44:55):
We position it as a strength in the sense that with us in the loop in terms of as conflict free advice as you can possibly get. Because we compete on the merits of our investment proposition only and so that's how we compete. And so we have to convince independent, you know, organizations that are providing financial advice, that the vehicles that we manage and deliver can put their clients in the very best position.
So we put it out there as a strength. It means that we have to continue to innovate, we have to continue to be introspective, and that when you work with Dimensional in our view, you're always going to get the leading edge of what academics have to say about investing in the right way to do it. And so that's how we've kind of positioned it. So it's a source of strength for us and something that keeps us on track, keeps us disciplined and keeps us improving. And, you know, that appeals to a lot of different financial professionals out there in the marketplace.
Tracy (45:58):
So one last question. We mentioned this in the intro, but then we kind of glossed over it. But you did study, I believe physics and you could have been a rocket scientist, but went into finance instead. You happy with that decision?
Gerard (46:11):
Yeah, very happy. I started out in theoretical physics, actually, in my undergrad. Then I did a master's in high performance computing, and then I did a Ph.D. at Caltech in aeronautical engineering. I really enjoyed it, it was great lessons learned in terms of how to be detail-oriented, but also see the big picture.
I always think that if you're going to be a master at something, you have to be able to see the forest, the trees, and the leaves all at the same time and that's when true mastery actually happens. But applying those to the world of finance has been wonderful. I've been [at] Dimensional now almost 20 years, and I've learned a lot of new things here and served a lot of people here and hopefully improved people's lives. So I think it's been a wonderful journey and I wouldn't change it for anything.
Joe (46:57):
Gerard O'Reilly, thank you so much for coming on Odd Lots. This is a fascinating conversation.
Gerard (47:02):
Thank you for having me. I enjoyed it.
Joe (47:16):
Tracy, I really enjoyed that conversation. It is funny, like, I guess maybe laziness is the right word, using some of these terms sort of interchangeably [like] indexing, passive, systematic, active, like sort of certain things that I just sort of maybe use one or the other and that actually it's useful to think about the distinctions between these terms.
Tracy (47:36):
Oh, absolutely. I will say labels have their usefulness as well as sort of quick catchalls, but the nuance that Gerard used in describing their own strategy, so the idea of being passive but not indexed. Also the idea that, you know, you can be an indexer, but there are different flavors and skills within indexing itself. So you can be a bad indexer and leave a lot of money on the table when you don't have to.
Joe (48:04):
The Tesla example was fascinating. Also the idea that, to your question, cost is not everything or that the cost that you see on the page is like, this is our expense ratio or this is the fee for being in this is not necessarily the all-in cost because maybe they're not doing a good job of getting revenue for you for securities lending and that if you build in that capacity and you find ways to do that efficiently, that's really, you know, that makes a difference.
Tracy (48:32):
Well, also getting back to the starting point of, you know, why does the finance industry exist at all? I thought Gerard’s point that it's not necessarily about trying to have a bunch of smart people beating the market because according to the efficient market hypothesis, that is impossible, but more about having financial professionals who are able to interpret clients' needs and figure out what kind of risk profile they need, and then look at those risk-adjusted returns in the market and figure out what's best.
Joe (49:02):
And then that makes sense of the education and all of that sort of building, like those deep relationships with the advisors and why that's a particularly necessary aspect of the industry and the company.
Tracy (49:13):
But we're in Austin and I think it's time for barbecue.
Joe (49:16):
Let’s go get barbecue.
Tracy (49:17):
Shall we leave it there?
Joe (49:18):
Let’s leave it there.