Dimensional Co-CEO Gerard O'Reilly on the Future of Fund Management

26:11But what you had in the middle of that period ending in June 2020 was the worst three-year period in the past 100 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 the FAANGs 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.

26:51You can't tell me that people going back 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.

27:32But 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, the learning 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 tended to be underweight technology.

28:10We 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. 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?

28:43So 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 M &A 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.

29:27So 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 oh lucas films lucas films 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 to 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 massively high.

30:17And 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 intangibles, it actually hasn't changed that much over time. It's just that when you compare it to things like property and equipment, our 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.

30:54And 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.

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33:22Chase Sapphire Reserve for Business. With over$2 ,500 in annual value, it's the card that gives back all you put in. Learn more at chase.com forward slash reserve business. Chase for Business. Make more of what's yours. Accounts subject to credit approval. Restrictions and limitations apply. Cards are issued by JPMorgan Chase Bank and a member FDIC. 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 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, et cetera.

34:05Now you're really big. You're one of the fastest growing ETF. When did you get into ETFs? our three-year anniversary is this November. So given like ETFs have been a while and you're sort of late. I think it was as soon as the actively managed ETFs were approved pretty much, right? Yeah. 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. And you're one of the fastest growing ETF companies. Can you just give it a little bit overview? Like how big is that? How much of the ETF money is just sort of the same investor as switched from a dimensional mutual fund to a dimensional ETF?

34:44Like, 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? Yeah, 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.

35:21And we're 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 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.

36:14And 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 kind of many new clients actually have come on board over the past number of years, and that's also helped the ETF growth. 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?

36:54It'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, what I'd get a guess is maybe 50-50, something in around there or thereabouts. We have about 100 billion now in ETF assets globally. Hopefully, 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,$300 to$400 billion of U.S. mutual funds. So our U.S. mutual funds are still very important to us. We continue to innovate and push forward there.

37:32ETF is important. 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 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. 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.

38:17And 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? Well, this goes back to Joe's opening remarks, which I kind of take as evidence that the academic evidence is one, in the sense that academics for a long time have slated the performance of active managers and say, you know, there's no real evidence here that people can outguess the market.

38:54And 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 on 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 on 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.

39:43And 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. So here's 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 in 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.

40:24In 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. That 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.

41:07So 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? 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's differences in expected returns and you can use a systematic framework that's based on valuation theory to identify those.

41:51Two is be efficient. Don't do stupid things when you know they're stupid. Always good advice. 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 you know have deal with the corporate action a stock is spinning something off they're doing a tender or something like that and the index providers may not always choose the the value maximizing way to deal with the corporate action index managers often follow the index provider you 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 do you implement.

42:47Implementation 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. Just real 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.

43:24That'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 their end constituents is typically the right way to go. So that's the approach. We don't market directly to the retail public. 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.

44:05And 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? Right. Just to sort of add on to that, like I'm thinking in the Tesla example, someone has to be paying attention to that or that is someone that, you know, that takes some level of human work to be thinking about these dynamics of which I imagine isn't free. So yeah, what is the limit of? Yeah, 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.

44:39As 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 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.

45:14Let's take an example of securities lending. And if you look at securities lending revenue, it can vary across asset category. but I'll take the extreme one, emerging markets small. Emerging markets small over the past few years, typically those strategies have gained 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 the total cost of ownership is key and you have to dig far deeper than the expense ratio to actually get there.

45:53When 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. 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? Where are you investing for growth? 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.

46:31And 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. Sorry, just why is this important? What is this and why is this important? What this means is that, let's say you have an existing mutual fund. Okay. 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.

47:06That commingling provides economies of scale immediately to both sets of investors. The SEC has to provide fund managers what's called exemptive relief, so 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.

47:47You 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 the 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? 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.

48:28So 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, 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.

49:10They help us forge a path that we think is the right one, which may be different than others. 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 JP Morgan and more recently Morgan Stanley that have a lot of sort of natural internal distribution capabilities and both have wealth management arms and still have advisors for whom they can have a seamless brand. And how challenging of that from a competition perspective is that? Because obviously Dimensional does not have its own advisors or Dimensional Wealth Management.

49:49When 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 funds, how much of a challenge is that from a sort of competitive standpoint? We position it as a strength, in 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 organizations that are providing financial advice that the vehicles that we manage and deliver can put their clients in the very best position.

50:33So 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 going to get always 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. So one last question. We mentioned this in the intro, but then we kind of glossed over it.

51:10But you did study, I believe, physics, and you could have been a rocket scientist, but went into finance instead. You happy with that decision? 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 PhD at Caltech in aeronautical engineering. And so 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.

51:44And that's when true mastery actually happens. But applying those to the world of finance has been wonderful. I've been mentioned 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. Gerard O 'Reilly, thank you so much for coming on OddLots. This was a fascinating conversation. Thank you for having me. I enjoyed it.

52:24Tracy, I really enjoyed that conversation. It is funny, like, I guess maybe laziness is the right word. using some of these terms sort of interchange oh indexing passive systematic active like sort of certain things that i just sort of maybe use one of the other and that actually it's useful to think about the distinctions between these terms oh absolutely i i will say labels have their usefulness as well um as sort of like quick catch-alls but the 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.

53:06So you can be a bad indexer and leave a lot of money on the table when you don't have to. Right. 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. Well, also getting back to the starting point of, you know, why does the finance industry exist at all?

53:45I thought Jared'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. And then that makes sense of the education and all those sort of – building those deep relationships with the advisors and why that's a particularly necessary aspect of the industry and the company.

54:22But we're in Austin and I think it's time for barbecue. Let's go get barbecue. Shall we leave it there? Let's leave it there. All right. This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our producers, Carmen Rodriguez at CarmenArmin, Dashiell Bennett at Dashpot, and thanks to Moses Andam for his assistance. Follow all of the Bloomberg podcasts under the handle at podcasts. And for more OddLots content, go to Bloomberg.com slash OddLots, where we have transcripts, a blog and a newsletter.

54:54And check out our Discord, discord.gg slash OddLots, where you can chat 24-7 with fellow listeners. And if you enjoy OddLots, if you like it when we question the entire existence and validity of the financial industry, then please leave us a positive review on your favorite podcast platform. Thanks for listening.

55:20Thank you.

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