Episode 360 – Gerard O'Reilly: The Components of Net Returns

25:08So we exclude those from purchase. Another grouping is small cap stocks with high asset growth. So how do you grow your assets by a lot? You retain a lot of earnings, you issue a lot of stock, you issue a lot of debt. That's how you grow your assets. It turns out that companies that tend to do that over the past three to 12 months tend to continue to do it over the next three to 12 months. Well, guess what? If you're retaining a lot of earnings or issuing a lot of new stock, there's fewer cash flows for shareholders. So high asset growth, all else equal would imply lower expected returns. And historically, they have underperformed the rest of small cap by about five to 10 % a year.

25:43So again, that's about 1 % of the total market cap. We say, okay, let's keep those out of the portfolios or out of a broad market portfolio. So that would be a couple for expected return reasons. And there's more, but we can dig in there a little bit later. If you look at a tax reason or an asset category reason, these actually goes together, you might think of something like REITs or real estate investment trusts. When you look at REITs, and I'm going to use a US analogy, but this varies by region. And so in some regions, we will include REITs in a strategy. In some regions, we won't, but let's use a US example.

26:16So in the US, if you think about REITs as, let's say, being two to 3 % of aggregate market cap in the US, give or take. And the yield on REITs is between four and 5%, whereas the rest of the US market is like one and a half percent, some number like that. And then if you look at the tax rate that is applied to REITs, because in the US, they distribute a lot of what's called non-qualified dividend income, taxed at 40%, whereas most stocks will produce qualified dividend income taxed at 20%. So now you have this increased yield of about 3%, let's say, a tax rate differential of about 20%. So if you take REITs out and you have a separate REIT strategy, put it in your tax-deferred account, you save yourself about five basis points, give or take, on after-tax returns.

27:00So there's a tax reason that you say, there's nothing wrong with REITs. We think they have about market-like expected returns, but let's do something from a financial engineering perspective that gives tools to financial professionals that they can optimize the tax profile of their client. So that would be another example that fits into the asset category plus tax consideration. Can you talk about why IPOs are excluded immediately after the IPO? Yes, we also exclude IPOs immediately after the IPO. Probably it's good to use an example there. And the example I would use is Rivian. That's from a few years ago.

27:33It IPO'd at about$100 a share. In the first day or two, it climbed up to about$170 a share. And then afterwards, it declined and declined and declined. and now it's trading at whatever. It didn't have the best stock price experience of all IPOs. And that's a bit of an extreme, but it illustrates the point. When you look at IPOs, there's a few things that stick out. One is that they often have good first week returns after the IPO lists. And then if you look after that in about the six to 12 months after, they often have relatively poor returns or underperform the market in the six to 12 months after.

28:09Now, it depends on how you measure. So whether you use calendar or event-based studies, you get slightly different outcomes. But when you look at their characteristics, their characteristics look like small growth low profitability. So that kind of gives you an idea of why you might expect them to underperform. But then there's other things that happen. So for example, at an IPO, the insiders might be locked up for the first six months. And so in six months time, you may have a lot of stock that's coming to market. So a significant change in the free float over that first six months. and so that's an event that will happen.

28:42You may have some aftermarket trading support for the investment banks right after the IPO is launched. If you can't get in for that initial first week, which most people can't, and if you were trying to get in, you have the problem of selection bias in that you're working with investment banks. Are you going to get allocations to all the good ones, all the bad ones, or a mix of both? So there's some selection bias there. So our view is that when it comes to investing, you almost always have more time than you think. And I think that's a good philosophy in life in general. And so we wait about six to 12 months and there's analysis done before including an IPO in the portfolio.

29:20But that's a reason that we would exclude IPOs from the investment strategies. You mentioned six to 12 months. How is that decision made about when it's going to get at it? That's a portfolio manager decision. Within the firm, we have a financial data working group. So that provides all sorts of data across this broad universe that I mentioned that serves it up very efficiently to portfolio managers so that they can understand the specific facts and circumstances for each corporate event or each listing. with that then they can make an informed decision okay after six months has passed all the insider lockups are done things seems to be trading more like normal is this the right time to include it or should we wait a few more months so it's a pm decision so i'm curious to write what proportion of the market or the defined universe is actually excluded on a typical broad-based market dimensional portfolio like the core fund let's take the u.s and then i'll go outside the u.s for an example Probably when you say, how low do we go?

30:18So that first piece, how big is the market? In terms of number of stocks, it's probably about 3 ,500, give or take. Then when you take into account the REIT exclusion, IPO exclusion, when you take into account some of the small, low profitability growth exclusion, the high asset growth exclusion, you're probably down to about 2 ,500 stocks, give or take. Now that's not a massive percentage of market cap. So the small high asset growth and the small low profitability, that's probably at 2 % between the two of them of market cap. The REITs in the US is 2 % to 3%, depending on how REITs are. The IPOs will vary over time, depending on the activity in the IPO market.

30:59So you're getting pretty broad market cap coverage where you're probably at something like, I want to say around 55 trillion is what you might think of the eligible market cap that will be available in the US. That number of names is quite similar actually for developed markets outside the US and emerging markets. There's about a thousand from the starting to the end. But there you end up with far more securities. Developed market outside the US, you're probably like four and a half thousand. And in emerging markets, you're probably like six thousand somewhere around thereabouts. So you're ending up with a lot of stocks and the vast majority of market cap.

31:32But you are refining. You're making what I would say a better starting point for investors. It's a pretty low proportion of market cap that's getting excluded. How impactful do you expect those exclusions to be to expected returns? Let's say you're doing a plain market cap weighting strategy and you say that small high asset growth and small low prof growth underperform the rest of the market by 5-10 % and it's 2 % of the portfolio. Okay, that's 10 to 20 basis points of expected outperformance. when you look at the REIT exclusion for the US as an example, I mentioned a number of five basis points in after-tax returns.

32:10Okay, there's five basis points there. When you look at IPOs, IPOs have typically underperformed the broad market by on the order of a percent a month in that first 12-month period. So that will vary depending on how much IPO activity there is. So all of that in a broad market portfolio, you might be talking on the order of 20 to 30 basis points somewhere in that neighborhood. But then when you go to an asset category, like a small cap, then it can be even bigger. And those decisions can be more meaningful in terms of the level of return deviation that you will get year on year, but also in the level of expected outperformance that you would get from those decisions year on year.

32:49But in a broad market, 20 to 30 is probably not a horrible estimate. I'm using wide range to make sure people realize that it's an estimate. and all estimates of expected returns are noisy and therefore wide ranges are appropriate. I would guess that most listeners know that a small portion of stocks are responsible for a large portion of the realized returns. So can you talk about how risky you think it is to exclude parts of the market? The first thing that you have to keep in mind with that, Cameron, is opportunity cost. I always love the analogy from Professor Kevin Murphy at the University of Chicago, which is, is it a bad thing if your kids watch five hours of television a day or a good thing?

33:30And the answer depends on what else they might be doing. If what they might be doing is you're teaching them mathematics, reading them poetry, they're learning a musical instrument, it's a horrible thing. If the alternative is that they're out in the streets getting into a gang and getting into all sorts of mischief, it's a great thing. So it's all about the opportunity costs. And the first thing that I think you have to keep in mind, Cameron, is that there is no strategies, or are no strategies out there that don't exclude some portions of the market. Every strategy, whether it's an index market or a traditional active or dimensional, all of them are excluding portions of the market.

34:02Dimensional is very intentional in what portions of the market is excluding. It's excluding portions of the market that we think will contribute to returns over time. We're very intentional in how we do it. So I mentioned in the US, there's a thousand names. Those thousand names represent a few percentage points of market cap. Therefore, it's not like we're excluding Apple. Let's take Apple out of the portfolio. And therefore, the performance of Apple can make a big difference on what their returns are over any given time period. You're spreading that over many, many names. And so you put yourself in a way better position to get the average outcomes that you've seen historically because you're doing it in a very diversified fashion.

34:45So I think that the way that you do it matters and being intentional about why you're doing it matters and recognizing that there is no solution out there that doesn't exclude some portion of the overall market. You spoke to this just now, but any traditional active manager would say that they're also intentional about what they exclude. Can you talk about how these exclusions that we're talking about are different from traditional active management? I'm going to use another analogy here. Hopefully it will be helpful for part of the conversation. Something that I love is baking shows. Now people often ask why do you like baking shows?

35:19You don't eat any sweets, you don't eat any desserts, you don't eat any puddings, you don't eat gluten, you don't eat dairy. Why do you watch baking shows? I just like them, I don't know why I like them, but I do. Maybe it's the forbidden fruit, I don't really know. In any event, I love the Great British Baking Show. And I don't know if you're familiar with that show, but in each episode there's three rounds of competition. And one of the rounds is called the technical. And in that round, every baker is given the exact same ingredients. Every baker is given the same recipe. And every baker is told to produce the same bake.

35:51So let's say for example, it's a ciabatta bread, then they're all told to produce a ciabatta. But the recipe is not complete. So it might not tell them how long to knead the dough for, or it might not tell them what order the ingredients should be added. it. Or I might give them an oven temperature, but not tell them how long it should be in the oven. So the recipe is incomplete. And then what happens? They get judged based on criteria, which are what does the crumb structure look like? What does the color look like? How good is the bake? And who wins? The best baker. And investing is not actually all that different.

36:26Whether you're traditional active, you're dimensional, or you're index, we're all starting with the same ingredients. And we're focused here on market portfolios. So we're all trying to produce the same thing. We're trying to produce the same bake. But it comes down to who has the technical expertise to produce the best bake because the recipe is very unclear. When it comes to investing, there is no perfect rule book that says this is exactly how you should invest. It is very unclear. And so when you think about traditional active and you compare to dimensional, what are some of the differences?

36:56When we do something, it is based on very, very strong empirical evidence and very, very strong theoretical evidence. So that when we do it, there's high confidence and we can show you the evidence and the reasons why you should expect this in the future. Traditional active is predicated on a proposition for which there is no evidence to support. That's a proposition that you can make money by out guessing market prices. We have seen the evidence time and time again that show in the aggregate that is not a winning proposition and that show you can't identify those traditional active managers in advance that may have enough skill to cover their costs.

37:34That evidence is overwhelming. It's very, very strong. And so when I think about those differences, we're doing it in more of an engineered fashion where it's either evidence about expected returns or it's the goal of the portfolio when people tell us taxes are important to us. How can you make us more tax efficient? Okay, I can go back into the lab and figure out how to make your strategies more tax efficient without taking on too much tracking error for you, and then show you ways to locate assets to make you more tax efficient. So it's a very different mindset and a value proposition that then ends up being a better investment outcome, in my view, for the end investor.

38:12I would say that's a pretty important difference. How does securities lending affect portfolio implementation? So we kind of touched on this earlier. So let me go back and just in case there's not a lot of familiarity with securities lending, what is it? So let's suppose Dimensional is managing a mutual fund or a Canadian fund or any of those funds on behalf of the end investor. We have well-diversified strategies. We have low turnover strategies. We're not beholden to any index. That flexibility is important. I'll get to it in a moment. So somebody comes and says they want to borrow a stock and they may want to borrow a stock to settle a trade.

38:45They may want to borrow a stock to short it. There There can be many different reasons to borrow a stock. And we say, okay, you want to borrow a stock. What are you willing to pay the investors in this portfolio in order to borrow the stock? That's a market like any other, maybe some negotiation, but we get to a price of effectively how much revenue is the portfolio going to get for loaning out this security. Now, if you look across Dimensional's equity complex, last year was about four basis points in return was added by securities lending revenue. Now that varies by market. The US market in a broad market portfolio is around two.

39:18If you're looking at developed markets, it's about five to 10. If you're looking at emerging markets, it's about 15. It varies by market and can be meaningful in certainly different markets. And they're all broad market portfolios, by the way. So that's all just broad market portfolio lending revenue. And it can vary by market. Dimensional does a few things that I think are important. Number one, Dimensional does not keep any of the lending revenue for Dimensional the advisor. We have agents, the agents have to be paid. All the remainder goes to the end investor, none to the mention of the advisor.

39:45So there's no conflicts there. Other things that are important though for the way that we invest is because we have such a diversified group of securities and that we have low turnover and that we have flexibility not to have to sell a stock at any particular time. That means that we're very attractive to many of the borrowers out there. They like to use our portfolios to borrow securities from. Because let's imagine in an index fund and you're loaning out security XYZ, you may not want to loan out as much of your position as you otherwise would, because if you have a redemption and you have to sell everything pro rata because you're trying to manage tracking error, if we have a redemption and one stock is out on loan at a very high fee, well, I don't have to sell that stock right now.

40:28And that type of characteristic is attractive to borrowers. And so you can command higher fees, better utilization. And as I said, general collateral is more of a volume game. And right now the US is more of a general collateral game. You remember from GME from a few years ago and all the shorting and what happened to hedge funds. So the US SEC lending revenue has gone off over the past few years. It may come back, but right now it's around two-ish. Outside the US in developed markets, it is a general collateral game again. So it's a volume game. Emerging markets is much more specials. So you have to have the diversified securities and then things just go on loan at a very high fee.

41:04And if you don't have them, you can't get that revenue. But if you do have them, you can. You mentioned what makes Dimensional attractive for people who want to borrow securities. Do you know how your securities lending revenue compares to other product providers? You can look at Morningstar and you can look at Morningstar category averages for those types of numbers. And the category average masks that there's lots of variation. But in the U.S., you're probably looking at a half basis point in the market portfolio. So not a massive amount. It's a small amount in the U.S. When you go outside the U.S.

41:31to develop markets, it's probably closer to five. When you go to emerging markets, it's probably closer to 10 in terms of how more relative to the Morningstar category average, a dimensional strategy would be getting in lending revenue for the end investor relative to what that Morningstar average is. And again, as I said, you will find variation across manager. It will vary. So you'll just have to do your due diligence there to see what the lending program looks like and how much is contributing to the returns of the portfolio. How do things like corporate actions, proxy voting, engagement with portfolio companies affect the implementation and also the net expected returns?

42:08Those are important too. It's probably best to illustrate with an example. You remember I said earlier on that there's about a thousand merger announcements in a given year. Not all of those are for cash, but many of them are, especially outside the US. Probably more of the mergers outside the US are for cash than in the US. But let's suppose you have a merger that's for cash. And the market thinks this is going to go through for sure. So the announcement happens, the stock that's the target, let's say it's trading at 20 bucks, the announcement is for 25, it's for cash. And the market thinks this is going to happen for sure.

42:41That price pops from 20 to 25. And then how do you think it trades between the announcement and the consummation of the deal? Trades like cash. When you look at small caps in particular, and you see the amount of merger activity. It's about, you know, in the order of 2 % of small caps are kind of in play for mergers, especially for cash globally at any point in time. An example that we had from October 23, it was called Energy Smart, I think was the name of the firm. It was in the Russell 3000 and it closed the deal in kind of January of 24. And over that time period, the Russell 3000 was up about 16%.

43:18So a pretty good return. And it traded for cash during that whole period. So what do we do here at Dimensional? Well, we're looking every day for those types of announcements. Then depending on the announcement, whether it's for all cash, whether it's stock and cash, we're going to do an analysis. And we're going to be looking at the price reaction in the markets to this announcement, because that gives us a lot of information about the probability that this announcement and this deal will actually go through. And depending on the market reaction, we're going to make a decision. And that decision might be the market is thinking this is going through at high likelihood.

43:48We've already gotten the price pop. We don't want to have 2 % of our small all caps with cash drag because they're all in M &A mode. And so let's sell this stock way before the deal consummates. Then we're going to make decisions on how to sell it because we have a lot of different tools. Are we going to try get this stock out in kind so that it's a stock that we want to sell, but can we sell it without realizing again? Oh, that's a nice tool to have. Or if it's in a Canadian portfolio, well, what's the CGRM going to be at the end of the year and how are we going to work that in to make it more tax efficient?

44:19So then there's potentially a tax question. But that's an example of a corporate action that you can add value to the portfolio. And this goes back to, remember what we said at the start, market exposure in that asset allocation? This is a way that you can have hidden cash inside your portfolio that you don't know about unless you're taking care of the details and making sure that you're trying to minimize that kind of cash drag in the portfolio. That's super interesting. So there's an implied cash drag in equity portfolios from cash merger activity. Very interesting. We had a recent guest, Marco Salmon from Harvard on to discuss his research on how index funds incur what he calls in his paper, adverse selection costs.

45:02And that's coming from rebalancing, index rebalancing into new share issuance when firms issue stock, IPOs, which we've already talked about, and then selling out of buybacks when firms buy back stock to match the index. How does Dimensional deal with things like buybacks and new share issuance? So the new share issuance is very much aligned with the asset growth exclusion, because if a company is issuing a lot of new stock, then it's probably going to fall into that category of greater than 75 % asset growth over the past 12 months. Those will be examples of securities that we would just exclude from purchase because those stocks typically underperform in the months after that new issues has occurred.

45:43And again, it's back to that less cash for investors, all else equal, right? It's back to that concept. So that will be an example there. And I think that helps mitigate that issue. The other item though, and I think this is important to keep in mind, is that we have a piece of research that was done recently, which looks at either free flow changes or shares outstanding changes for companies in indexes. and what volume spikes look like around the time that those happen because of index activity. And what you typically see is on the order of 10 to 20 times, if you were to look at the closing volume over the prior 20, 30 days before the corporate event, you typically see about 10 to 20 times that volume in the day of the event.

46:29So it's kind of like the index and then the index funds are doing it, that causes a lot of abnormal volume that can push prices. How much is it push prices? Well, in about the 10 minutes into the close, it pushes prices by three to five basis points. That's a lot of push in 10 minutes. So I think that the other aspect then that you have to keep in mind with these is not just its implication for expected returns, but its implication for liquidity and trading costs, because these types of events cause indexes on a frequent basis to reshift to do a little bit of rebalancing to keep track of those changes in shares outstanding.

47:02And that can push prices up a little bit when they're buying and push prices down a little bit when they're selling. And that can be a different form of reconstitution effect that's not as popularized and not as well known as stocks coming completely in or going completely out of the index. It tends to be a bigger effect for those stocks, but can be a bit of a drag on performance. How do empirical realities like momentum, short-term reversals, and high securities lending fees actually affect the expected returns? Let's define some of those so we're all on the same page. Momentum is the tendency of stocks that have outperformed over the past 12 months or so to continue to outperform and stocks that have underperformed to underperform over the next few months.

47:44When you think about the securities lending fees, what our research shows is that when stocks go on loan at a very high fee, they typically underperform, especially in small caps over the next few days. And you might say, why would that be? Well, if they're going on loan at a very high fee, somebody probably knows something. They want to short it. They're willing to pay a lot. And so that information is going to work its way into the price one way or another. That could be an example there. And so how these things work into the process is that you have your buy and sell. So what you want to buy and sell, but then there's the timing of when you want to buy and sell.

48:18And I think that's, again, if you go back to our baking analogy, There's no recipe that says this is the perfect time to buy and sell. So we ask ourselves the question, well, if there's 100 or 200 stocks that we want to buy on a given day, and we know that things like momentum and securities lending information is gone very quickly, like a stock is in upper momentum for a couple of months and then it's not, or a stock is in high securities lending for a while and then it's not, or vice versa. Can we factor that into the timing of when we're going to buy the stock? We're going to buy them all, all the ones that we want.

48:50But as we have flows come in and go out, can we use that information to improve the expected returns over the short horizon so that we're not getting adversely impacted by some of these things over the short horizon? And that leads to better returns over the long pull as well. So you can think about it as our buys are overweight to upward momentum. They're not motivated by momentum, but they're overweight to upward momentum. And our cells are overweight to downward momentum. They're not motivated by downward momentum, but they're overweight to it in the way that we would trade. And the key piece of being able to do that goes back to something that we started with, which is the investment proposition.

49:28That prices change every day, flexibility adds value. You can only do this in an efficient manner if you're looking to adjust the portfolio a little bit every day, and you're not beholden to trying to lower your tracking error relative to some index. That's the only way that you can take these types of things into account. And incrementally, they add value to the portfolio over time. Have you guys modeled out the sort of expected economic benefits of doing the timing screening on these trades? Yeah, and it depends. It's related to the turnover for the strategy. So for strategies that have lower turnover, it's going to be less.

50:02For strategies that have higher turnover, it's going to be more. That's just the way that it is. As you vary the turnover strategy, you know, it's in the five to 20 basis point range, depending on the turnover. when you put all of those together, the momentum screens, the short-term reversal screens, the securities lending screens, that's what it may add over time is kind of some estimates. Again, not super precise. It depends on the strategy, but they're pretty reasonable estimates. I want to go back to something you just said, Gerard. You talked about how expensive to borrow stocks have lower expected returns, yet getting SEC lending revenue is a good thing.

50:33How do you balance that off in a portfolio? When something goes on loan at a high fee, our view is as follows. If somebody knows something and it's material to the company, it's going to be reflected in the price sooner or later. Should we loan somebody a stock to get it reflected in the price sooner? If they're willing to pay us so that we get paid when the price goes down, let's do it. We're not going to buy any more of it. So it's excluded from purchase while it's on loan at a high fee, but let's get paid while that information goes into the price of the security. And it's interesting because depending on the time period that you use, the data set that you use, the amount of underperformance is quite similar to the amount of lending revenue that you can get for the security.

51:12And so it can be helpful for the overall portfolio. We're not going to sell it necessarily. We're happy to keep on getting the lending revenue. Then we're not going to buy any more of it over time. One classic example there is GME, because when that went through the roof, I think the annualized rate on that loan that we were getting for GME in the portfolios was like over 10%. It was giving a lot of securities lending revenue. And we had about$60 million worth of exposure at the beginning of that January, the GME globally in our portfolios across all of our strategies. And by the end of the month, we had a billion dollars worth of exposure to GME.

51:45We didn't buy any more, but we had a billion dollars worth of exposure because of how much it went up. And we sold it all at that point because it was a stock that was in small cap portfolios, value portfolios, micro cap portfolios, and it was a large cap stock. There's an example of, we were happy to have it in while it was giving the lending revenue. When it started to change characteristics so quickly, we were able to react. So we turned all of those paper gains into real gains for our investors. And when you look at the difference to indices, indices held it up and they held it down. Markets change every day.

52:18Prices change every day. If you're not reacting every day, you're going to leave money on the table for your clients. But you're using information you're getting paid to have, which is so interesting. It's quite an opaque market too. If you're not in the market, you may not know the information because a lot of the short interest in real time information is just very restrictive. You can't really see the short interest in real time. So it's kind of a proxy for that. It's really interesting. That is an interesting one. Can you talk about the main ways that trading costs affect net returns? This is another good one on the kind of implementation cost side of things because trading costs, there's explicit costs like the commissions or whatever it is that you might be paying.

52:57But then there's bid offer spreads and there's price impact which are implicit. And the interesting thing about trading costs is they don't go into the expense ratio. They come out of the NAV. So unless you have a process to ask the manager about their trading costs, you don't know what they are. The other interesting thing about trading costs is they're built into index returns because of the index managers. So trading costs are tricky. It's important to manage them well. So how do you manage them well? Flexibility is your friend. How you manage them well is that you have flexibility on what you can buy or sell on any given day.

53:32And how we do that is that a portfolio manager may generate a list of order candidates trading on that day based on the portfolio on that day. I might say, here's$10 million worth of orders, but I only want to execute 5 million. And then the trader has flexibility on that day to do what we call participate, don't initiate. There's a lot of market volume that happens. Last year, if you look, over 800 billion US dollars was traded every single day in markets around the world. There's a lot of volume that happens. So if you participate, don't initiate, you can be part of that flow, never move prices.

54:07And that can be very, very helpful to the end return for investors because you're leaving less money on the table as you try to implement your strategy. And how significant are the magnitudes of trading costs? It can vary. So we do a whole ton of experiments on trading costs. And we have a lot of different charts that illustrate it in different ways. But one of our charts, we call it the lollipop chart because it's all these little straight line with a little circle on top. It shows US large caps, US small caps, non-US developed markets large and small, emerging markets large and small. And what you see in that chart is we try to estimate our relative price advantage to others in the marketplace trading.

54:45So what do we do? We run a set of experiments where we look at what we traded on a given day. So the actual name that we traded, the amount that we traded, and then we say, if we were to trade those and use other people's trade prices, because we sign all the trades, we use an algorithm to sign the trades, whether it was a buyer initiated or seller initiated, what would it have cost us relative to what we executed? So we're looking at how others trade relative to how we trade, and we're saying, what's the price differential? And in US large caps is like five to 10 basis points and small caps is 10 to 20.

55:17When you go outside the US, then you're in that 20 neighborhood. And when you get to emerging markets, it might be as high as 30, that differential. And that means buying lower, selling higher than others. And then how that impacts your overall returns depends on the turnover and how much trading you're doing. If you're doing very little trading, then it's not as impactful. If you're doing a lot of trading, it's more impactful. And so I think that kind of gives you a way of understanding the trading costs relative to what else is going on in the market at that time. Those basis point figures were dimensionals per trade price advantage over competitors that you're measuring.

55:50Yeah. That makes sense. You mentioned this being less of an issue for lower turnover funds. We also talked a little bit about the price pressure on index fund reconstitution or index changes. How much exposure would index funds have to trading costs? The index reconstitution effect is very well documented. It's when a stock is added to an index, then the market knows that if that index has a lot of assets attached to it, then the managers who are trying to minimize tracking error versus the index are going to have to trade a lot of that stock, buy a lot of that stock on a very specific day. And if a stock is deleted from an index and there's a lot of assets attached to it, then the reverse is going to be true.

56:33They're going to have to sell a lot of that stock on that particular day. Now, the market is happy to provide anyone a service as long as the people in the market providing the service are getting paid. How they end up getting paid is what you typically see is you see a price ramp up in excess of the index return for stocks that are going into the index and a price decline below the index return for stocks that are coming out of the index. And that typically tends to reverse after what's called reconstitution day when all the managers trade in the index. And so then if you look at that, we have a number of papers on this that use very recent data, the past 10 years to try and measure.

57:09And for those pure additions and pure deletions, and that's a subset of index turnover, it's not all index turnover, a subset of index turnover, then you find that there's about a 4 % price run up in excess of the index return for the stocks coming in and about a 4 % underperformance for the stocks going out that reverses. So what does that mean? that the index itself has the trading costs of the index managers built into its return. You can nail the index. That does not mean that you've had zero trading costs because your trading costs have been built into the index return. You'll never, ever see it if you don't understand where to look.

57:47One of the best examples, I think, was Tesla when it went into the S &P 500. And that was, was that December 2020 or was it 22? In any event, that was one of the biggest additions to the S &P 500. And we have a strategy here in the US that's a large company portfolio that looks a lot like the S &P 500, but we don't do exactly what it does. And we delay sales or purchases or we go early when there's a stock coming in. And we did that for Tesla on that particular month in December. And that strategy outperformed the index by eight basis points in that month. Most of it because we chose to include Tesla at a different time than the index did.

58:21So that gives you a sense of how that impact of the index returns itself in that given month. Eight basis points, by the way, is like four times the expense ratio for most S &P 500 index funds was spent in a month. But even then, if you look subsequent to that, Ben, Tesla has changed the number of stocks that have been included in the index multiple times. And each one of those, you see little price pressures around when that occurs. So those things are built into the index returns. And so then it's what people often refer to as the hidden cost of indexing. It's not in the expense ratio, but it definitely impacts the returns.

58:56Just looked it up. December 21st, 2020 was the date Tesla joined. 2020. There you go. So you mentioned expense ratio, and I think I know your answer to this question, but I have to ask it anyways. Fees are important, of course, and paying attention to fees are important. But do you think there's currently way too much emphasis on fees relative to these other components of net returns? I would say yes, and I agree. Fees are important. And if you look at dimensional over time, whether it's our Canadian fund lineup, whether it's our U.S. fund lineup or OIC lineup or user lineup or trust lineup, you've seen that we've reduced our expense ratios over time, both the management fees and the other expenses.

59:32And we've committed to doing that over time. And I'm sure in the future we'll continue to do so. We look at that ongoing and make sure that we're competitive with what's out there in the marketplace. But I think that there's a whole concept of value for service. Value for service is something that you have to have expertise to make a good assessment around. Are you getting value for the fees that you're paying? Are you getting excess returns for the fees that you're paying if they're in excess of the index? You look over the past 20 years, over 80 % of the dimensional funds here in the U.S. that were around 20 years ago, they're all still around today, by the way, have outperformed their perspectives benchmarks.

1:00:10That's a hell of a number, much larger in the industry. 100 % survival, where the industry is about 50 % survival, and over 80 % outperformance, where the industry is like 14, 15, 20. And it's about doing these things to control what you can control. And so I think that for folks, all we ask is give us a chance to explain why we think all of these things are important. And hopefully we can convince you that we're giving you value for service. Because just like you don't want to put your investors or your clients in$100 skis, not necessarily do you want to put them in the cheapest investment product that you can find because that can be accretive to value over time.

1:00:50I'll give you a couple of examples there just to illustrate one long pull example and one kind of recent. We've had a strategy in the US for over 40 years. It's a small cap strategy and it's outperformed as prospectus benchmark Russell 2000 by about one and a half percent annualized compound return difference over a 40 plus year period. Well, what does that mean in terms of returns? We say the market about 10 % return means your money doubles every seven years. Not bad. If you can take that 10 and turn it into 11 or 12, your money doubles every six. So over a 42-year period, you got double the money from what you started with.

1:01:21And that 1.5 % is net of all fees and expenses, where there's no fees and expenses extracted for the index. That's an example. And when we break that down, that's a small cap strategy. So some of the things we talk about are probably bigger, but around 50 to 100 basis points came from the universe definition. All the things that we were talking about that are very important for small caps some came from momentum screens, some came from high asset growth exclusions, some came from the smaller profitability growth exclusions. They all came from different sources that added up to about that one and a half percent.

1:01:52And different things were important different times because the strategy hasn't been the same the whole time period. It's always been a small cap strategy, but we've gotten better. As we learn more, we improve our strategies. So our commitment is to get better at the same time the expense ratios are coming down. So you're getting a better product for less, which I think is pretty good. The other example I'd use, Cameron, is over the past year, if you look at 2024, we've won in 2024 about 18 billion US dollars in new mandates from institutions that were leaving indexing behind and going to our approach.

1:02:25So they weren't asking for a lot of overweight society, value profitability. They were asking for build us a better market portfolio. And they used some of the existing mutual funds that we had, that we had around for a long time as examples. And And the components of net return conversation was what was starting to change their mind to get them to dig deeper. Because there's a big trend in the institutional marketplace for a long time, where it's get your public market exposure at as low expense ratio as you can and spend all your time in the private market stuff. And I think that hopefully we've gotten a bit better at explaining the benefits of our approach and the value for service at Dimensional.

1:03:00But I also think that the market is getting to see that due to their own experiences of what they've experienced, these large institutional investors in implementing these indices in-house of what some of the frictions are and how they leave some money on the table. And they're willing to go and increase the management fee they're paying because they feel that they're getting value for service. I find DFUS to be a fascinating product because it's kind of what you just said, take the market and do it a little bit better, addresses a lot of things we've talked about. But can you say how much of a difference in net expected returns you would expect between it and a total market index fund?

1:03:33And DFUS has a nine basis point expense ratio, I think, and say an index fund with a three basis point expense ratio. About five or six basis point difference in expense ratio. If you look at that fund, and actually that fund, Ben, is part of an overall series. We call it the market series here in the U.S. So we have two US funds in that market series and one non-US developed and one emerging markets. And they all have very, very, I would say, market-like characteristics. So they're not doing a lot of small cap and value and profit, but that's not what they're doing. They're doing more of the things that we talked about, some exclusions, some implementation and so on and so forth.

1:04:09And they've all been live since January of 2021 because we started our ETF business, standalone DF business here in the US in November of 2020. And we launched two in November and one in December. So they've all been live since then. The one that you mentioned, DFUS, is probably on the order of 50 basis points outperformance since then. And the ones outside the US are even higher. They're, I don't know, 50 to 100, somewhere in that neighborhood. I would say that's a little higher than I would have expected, to be honest with you. I think that we've just had a good run. Things like small, low profitability growth and high asset growth have had really poor performance over that time period.

1:04:44So not holding them has been very, very helpful. But I wouldn't be too put off by 20 to 30 basis points in terms of performance, difference, net of differences in fees and expenses, and especially after taxes here in the US in particular. Like I'll give you an example, that REIT exclusion makes a difference to the after tax return. But then things that we do around the timing of when we buy and sell securities, when they're paying a dividend to make sure that the percentage of qualified dividend income is higher for our strategies relative to some of our competitor index funds, I think is also an advantage.

1:05:18So after tax returns, we need 30 basis points, some number like that. And for a five basis point or six basis point expense ratio differential, we think that's a pretty good deal. Back to our baking analogy, we're all making ciabattas here in the sense that we're making portfolios that look like the market, smell like the market, taste like the market. They don't have a lot of differences. When the the market's up, you kind of know what your portfolio is doing. But how do you squeeze that little bit out, even though it's a broad market portfolio and all of the things that I mentioned that are very systematic, they're all rules based.

1:05:49We improve over time. They're all very, very rational. It's not like we're doing outlandish things. We're just using common sense and how to approach the market. They've all added value over time. So I think that expected outperformance, I'm always reluctant to put a number on for a strategy because returns are very, very noisy. So we've had a good run. We may have disappointing outcomes in the future, but I think over the long pull, 20 to 30, some number in around there, which could make a difference, makes a difference to your long pull wealth. I just ran the numbers for DFUS since June 14th, I think is when it listed as an ETF.

1:06:22And then compared that to a total market index fund, it's actually closer to 100 basis points annualized since the conversion. There you go. And you know, it's interesting, the conversion itself. This is something that I think, you know, it's a bit of a challenge for financial professionals, but it's not an insurmountable one. That was a mutual fund before it converted to an ETF. And it's been around since maybe 2001 or so. So it has a long track record, but it's done slightly different things over that time period, which is why a conversation with the manager is important to understand its relative performance, because it was a tax managed mutual fund back when it launched.

1:06:55And so we did things around delaying the realization of long term capital gains, trying not to realize any short term capital gains, some things around how we manage the dividends, our exposure to companies paying dividends. We had different types of security caps. We didn't have the small low profit exclusions at the beginning. We didn't have the high asset growth exclusions. And so when you look at it now versus its long pull history, it's a little bit different than it was then. And that's why a conversation with a manager when you're trying to understand any fund, ours or anybody else's, I think is appropriate for a financial professional.

1:07:27I like to tell a story. So I have a 10 year old daughter and she's very active. She's into all sorts of things. One of the things that she likes to do is Brazilian Jiu-Jitsu. And I don't get to go to all of her events, but I do get to go to the Jiu-Jitsu events because they're on the weekends and her training is on the weekend. So we go on a Saturday morning. And I don't know if you know, in Brazilian Jiu-Jitsu, their black belts are called professors. Every morning before they start class, there's a little life lesson. And some of them are actually really good. I listen, I take notes. And so one of these life lessons was the professor said, okay, what does practice make?

1:08:00And one of the kids put up their hand and said, perfect. And he goes, no, practice makes progress. You can never be perfect. It was a really nice life lesson that we embrace here at Dimensional, which is we get better all the time. And so that is reflected in the strategies all the time. As far as strategies aren't identical through time, the main themes of the strategies are very, very similar, but how we implement gets better because practice makes progress. And that's what we're trying to do day in, day out is get better at how we implement. Amazing. So you've been sharing information over the past hour.

1:08:35That's very interesting. And I'm curious how you pull this all together when you build portfolios that have the tilts towards the higher expected returns. We've talked about portfolios in the market series. So now let's say we want to have a bigger tracking area budget. What comes into play? All All the things that we just talked about still work, but now we're going to do a lot more weight deviation relative to the weight in the market. So those market series, so what you mentioned, DFUS, you look at the individual security weights, they're very close to their market cap weight. But in Canada, we have a lot of cores, we have a lot of vectors.

1:09:10So the cores now will take much bigger differences in terms of their weight relative to the weight in the market to pursue another area of value add, which is overweight the highest expected returning securities in the market. And I think that's another tool or lever that you have in your toolkit. And you just have to decide how much tracking error can you take as an investor? Because the more tracking error you take, the worse at certain points in time you will feel. In the long pull, we think you're going to be happier, but you have to be able to live with the unhappiness to get the long pull happiness.

1:09:46Because the more tracking error, the bigger the a chance for underperformance and that underperformance will show up at certain periods of time. That's just how it works. And so when you look at the core to the vector, it's kind of a trade-off of how different you want to be for your expected outperformance. So in core, we often quote like one to 2 % expected outperformance with two to 4 % tracking error. That's what we'll quote. And vector, we might go two to three with 6 % tracking or something like that. So we can go a little higher. The example that I use for Vector, because Vector now is kind of a market portfolio, but not a broad market portfolio, and that is excluding more stocks.

1:10:23So the stocks that will be included in a core are pretty much the same group as would be included in the market series that we were talking about. But Vector, now you're going to exclude about 40 % of the market cap. The way that I often describe it is if you look at the US market as the end of last quarter, the profitability. So that's aggregate profits divided by aggregate book value, about 60%, 0.6 profitability. You look at valuations and they change, but at the end of last quarter, first quarter of 2025, you're looking at price to book ratios is like four and a half, PE ratios, 20 to 25. So people were to say, yeah, very high valuations for the US market.

1:10:57But the US market has about twice the weighted average profitability as developed markets outside the world. Because developed markets outside the world are about 0.3 weighted average profitability and about half the valuation. So it's not clear that the U.S. was so much higher value because of the weighted average profitability. So you say, what does value do? Value would typically take that profitability and cut it in half. So a value strategy in the U.S. in the last quarter would have taken the profitability and turned it down to about 0.3. I would have taken the price-to-book ratio or price-earnings ratio and also cut that roughly in half.

1:11:25So the vector, what it tries to do is kind of have a better blend of value and profitability. So you look at the profitability of vector, it's about 0.6, It's about the same as the U.S. market. But then you look at the valuation ratio, it's about 30 to 40 % of the U.S. market. Not quite like value, but getting there. So what's it doing? It's focusing on those stocks that are either high profitability, deep value, or both high profitability and value. And so between the core and the vector, you can put those together to get a very tailored exposure to these size value profitability premiums, which also then contribute to expected outperformance over time.

1:12:05Super interesting. That idea of making a value portfolio, and then you can see it if you look at any product and its profitability just drops, but then seeing how the vector funds, you get that value, but your profitability doesn't drop below market. It's cool to see the implementation in action when you look at product characteristics. You guys are in tons of cool stuff. The products we just talked about are cool. All the stuff that we've talked about on implementation is incredible. You guys got into the ETF business relatively recently and become a big player there. What are you most excited about at Dimensional right now?

1:12:34There's probably a few big themes to get me going. One is that it really does feel like investors are looking beyond either the wrapper or the expense ratio. And we're back to what is the investment proposition? What's the investment strategy first? And let's talk about those other things second. And I think that there's more of a focus on that that I think is good to see. because if you don't have that focus, in my view, you can leave money on the table. And by the way, that money comes out of your client's pockets. That's not a good thing for the end investor. So I think that's good. And we see that with institutions.

1:13:11We see that with financial advisors. That's a good direction of travel. And I think that Dimensional is trying to contribute to that conversation in the marketplace and in the community and trying to push in that direction of travel. That's been exciting. We've done a lot of work on that front to improve how we communicate and to improve the set of strategies that we have for investors. The other one that's a broad team that I find pretty exciting, and this is something that Dave and I, so Dave Butler, he's the co-CEO along with myself, we've been together now as co-CEOs for almost eight years.

1:13:42So time goes by real fast. One of the things that we said when we first got into the seat together was we want to make dimensional convenient to work with. And in part, what that means is that we have to have all the vehicles that clients like to consume an investment proposition through. So one investment proposition, then choose your own venture on how you want to consume it. And we've done a lot of work on that, whether it's launching ETFs here in the US, we're looking at use of ETFs, ETF access points for Australian trusts, or whether it's what we're working on right now, ETF share classes, which could be huge for the industry here in the US and Dimensional is leading the charge on that to try get that exemptive relief over the line with the SEC.

1:14:25SMAs, we've done a lot of work on separately managed accounts, tax managed separately managed accounts, a lot of fintech solutions. I would love to be able to take that to other places in the world outside the US. And I think that can be helpful, but it depends on when the infrastructure in each one of those markets is ready. And so that's not within our control, but something that we can probably push along. That is kind of exciting is figuring out all the ways and the vehicles that we can put in place so that the financial professionals that we work with can choose what's best for them. Because what we do is we listen to what's important to them and then try to build vehicles that meet those needs with that underlying solid core investment proposition.

1:15:06So those are two big themes that I think are important that drive a lot of what we do. And hopefully we'll improve over time and bring more things to the market that people find useful over time. Very cool. All right, Gerard, this has been a fantastic conversation. We really appreciate you coming back on the podcast. Oh, it's been a pleasure. Thanks again. And I love that you're always as detailed as you are, but I'm detailed too, so it suits. I was going to say, meeting the minds here, Gerard. Great to have you on and great to see you as always. It's a great conversation, lots of value added.

1:15:48Thank you.