Speaker 1:
From the library of the New York Stock Exchange at the corner of Wall and Broad Streets in New York City, you're inside the ICE House, our podcast from Intercontinental Exchange on markets, leadership, and vision and global business, the dream drivers that have made the NYSC an indispensable institution of global growth for over 225 years. Each week, we feature stories of those who hatch plans, create jobs, and harness the engine of capitalism right here, right now, at the NYSC and at ICE's exchanges and clearing houses around the world. And now, welcome inside the ICE House. Here's your host, Josh King of Intercontinental Exchange.
Josh King:
Adam Smith first introduced the concept of the invisible hand to describe the unobservable forces that help supply and demand reach equilibrium, part of really, the incredible way that markets set prices across asset classes. And since then, financial wizards have sought to find ways to understand, beat, and outsmart the market. Brilliant minds have come up short, and we're still no closer to predicting how a trading day is going to net out. But this gave way to some of the most really important discoveries in the field.
Josh King:
Ideas like efficient market hypothesis and modern portfolio theory really are taking trading to new heights, melding academia and finance in a way that we've never seen before. The marriage of science and research with finance and economics may sound like an unoriginal idea, but at the time it was groundbreaking. Mathematicians and scientists wanted nothing to do with the world of finance, and stockbrokers didn't think that they could learn anything from the professors in their ivory towers.
Josh King:
Folks today think of the work that they do in finance, perhaps as rocket science. And sometimes it can sound like that. They throw around Greek letters and highfalutin ratios, but it isn't often that you literally find an actual rocket scientist making those investment decisions.
Josh King:
Well, Gerard O'Reilly is an exception to that rule, the CEO and Chief Investment Officer at Dimensional Fund Advisors, the investment management company that counts David Booth and Rex Sinquefield as its founders. O'Reilly is a bonafide aeronautical engineer. Gerard now leads the 41-year old firm, managing about $660 billion in assets across its 14 global offices. Our conversation with Gerardo Riley on the current macro environment and how DFA is thinking about the evolving landscape is coming up right after this.
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Josh King:
Our guest today, Gerardo O'Reilly is Co-CEO and Chief Investment Officer at Dimensional Fund Advisors, or DFA, a leading global investment firm that's been translating academic research into practical investment solutions for more than 40 years. He was named Co-CEO in 2017. He's been with the firm since 2004. Prior to joining Dimensional, Gerard earned his PhD in Aeronautics from the California Institute of Technology, and a master's degree in Aeronautics at Caltech, and a master's of science degree in high performance computing from Trinity College in his native Ireland. Welcome, Gerard, inside the ICE House.
Gerard O'Reilly:
Thanks for having me, Josh, and thanks for that very warm introduction. I really appreciate it.
Josh King:
So Gerard, the last time I was at College Green in front of Trinity College, December 1st, 1995, traveling there with President Bill Clinton after his famous trip to Belfast to help the peace effort along, coming back to Dublin to thank the Irish people for their efforts and bringing about the Accords. How has Trinity College changed since then, maybe 25 years?
Gerard O'Reilly:
Oh, I think it's changed in some ways a lot, and in some ways, not at all. I was there, maybe two or three years ago was the last time I got to visit the campus pre-COVID, and it looked quite similar in many respects to how it was when I was there in the late nineties. Lots of new buildings, and I think they're making investments in different types of topics. So, a really great university, I really enjoyed my time there. And of course, if you spent any time in Dublin, I'm sure you had a lot of fun there. It's a really great city-
Josh King:
Sure did.
Gerard O'Reilly:
... to go out in.
Josh King:
Some things never change, some things change a lot. Let's move to the present now, Gerard. We've got war, we've got inflation, we've got the lingering pandemic that have preoccupied investors. We've seen some pretty dramatic signals across both commodities, equities, and fixed income markets. How should investors be approaching what we see the current volatility?
Gerard O'Reilly:
There's a lot of themes in what you just mentioned there, whether it's volatility, whether it's inflation, whether it's crises, either in the real economy or in the markets themselves. And the thing to keep in mind is that you can't predict these unexpected events. They're unexpected for a reason. But you can plan for them in your investment portfolios, and that's the way that we think about it. You can always get a spike in volatility; therefore, the right asset allocation can help you manage the impact of that spike in volatility on your investment portfolio. You can always get a spike in inflation, and you can choose to outpace it or to hedge it. But again, that planning can be done in advance.
Gerard O'Reilly:
So no doubt, we've had a rocky start to 2022, with respect to fixed income markets, as well as equity markets, and then a war, a very tragic war in Ukraine. So it's a pretty rocky start, but for those investors that have planned for these types of things, I think their investment portfolios hopefully won't be suffering as much with the right plan in place.
Josh King:
Speaking of inflation, Gerard, Fed Chairman, Jerome Powell, signaled at a recent meeting that the US central bank was going to propose a .5% interest rate hike at its next meeting. Will the rate hike, you think, significantly change the market environment or have markets effectively priced in those heights?
Gerard O'Reilly:
I think markets are very, very effective at taking into account all relevant information and incorporating that information to market prices. So in as much as the Fed has been signaling what it's going to do to the Fed funds rate in the future, I think that we can be confident that that's well-known and factored into market prices.
Gerard O'Reilly:
I think what's more important though for investors, is not a myopic focus on the Fed funds rate, but acknowledging that there are many hundreds of different interest rates that drive the returns of a well-diversified bond portfolio. And we've seen that, of course, at the first part of this year, where not all interest rates move in lockstep, whether it's at the short end or the long end, or bonds issued in US dollars versus other currencies or different credit quality bonds. There's a lot of interest rates out there that will drive the returns of your portfolio. And diversification is the best way to kind of deal with the uncertainty around what the Fed may or may not do, or what you believe is or isn't priced into the prices of bonds today.
Josh King:
Let's talk about diversification of really, your own life and career. Because even before I was there with President Clinton, you grew up in Waterford, Ireland, one of Ireland's oldest cities, and a major port town that saw traders ranging from the Vikings to merchants coming from Newfoundland. I'm curious what brought the O'Reillys there in the first place?
Gerard O'Reilly:
Yeah, Ireland is a very old town, many thousands of years old from Viking times. And there's a lot of those types of remnants around the town, including different towers and lookouts and so on, so great spot to grow up. I was born in the seventies in Ireland, grew up there before coming to America in '98. So I did all my schooling, education and undergrad studies in Ireland. I think Waterford, great town to grow up in, a small town when I was growing up. So yeah, there was a lot of countryside to explore and hills to climb and seas to swim in. I went to Dublin then, to go to college in Trinity College in the early nineties, and decided to do theoretical physics at College in Dublin because science was kind of a passion of mine at that point in time. And had a really good time there, really enjoyed the subjects, really enjoyed the environment, really enjoyed the classmates. It's a special place in the world, is Ireland.
Josh King:
You said that science is one of your passions, Gerard. Both of your parents, I think, were in medicine. Did growing up among people who emphasized education enough to pursue a medical career shape how you might have looked at the world?
Gerard O'Reilly:
Yeah, for sure. You always learn a lot from your parents. They're probably the two folks that are going to influence you the most in the world, really. And when I think about some of the lessons that I've learned, in particular, this notion that you're always going to make a mistake, and a person that never makes a mistake never makes anything. So be willing to try things and fail. But as long as you learn from your failures, that will lead to improvements.
Gerard O'Reilly:
And also, it was kind of at that time, Ireland in the eighties, in particular, it was a great place to grow up. I'm not sure it was such a good place to raise kids, because economically, it wasn't in the best shape that time in the eighties, in particular, relative to other countries in Europe. And so, it was always very clear from my parents. The message was, "When you're finished in secondary school or high school, what they call it over here, you're going to college or you're out. And then, once you're finished in college, you're out, so you better get a job." So it was always education, get as much education as you can, and then be prepared to make your own way in the world.
Josh King:
Thinking from your time at Trinity College, you then head west young man, end up in California for even more studies. And toward the end of your time at Caltech, you meet up with this guy, Ken French, an investment management legend and expert on the behavior of securities prices. How did that meeting come about in the first place?
Gerard O'Reilly:
Yeah. In the late nineties, you're right, I went over to California to Caltech. And from my parents' perspective, that was it, because I was off their dime. I had a research scholarship to go to Caltech. But yes, I did end up meeting with Ken. There was a colleague, an ex-colleague of mine from Dimensional, who also had gone to Caltech. I was looking around when I was finishing up my PhD as to what to do next. And I had thought about finance. I didn't have any formal training with respect to finance, but thought it was something that would be important for me to learn. And then also an area where I might be able to make some contributions that could be helpful for other people.
Gerard O'Reilly:
So I went down to Santa Monica, that was where our headquarters were at the time, Dimensional's headquarters are now in Austin, Texas, and met with Ken and met with the other members of the research team. There was about four or five folks on the research team at that time. Really said, "Yep, this sounds like a pretty good opportunity. I'll get to learn a lot." It has that nice plan between kind of real world application and academics. They take a very academic viewpoint, which you're doing things in the here and now, and it seemed like a good fit, and joined Dimensional in 2004, and it's been wonderful ever since.
Josh King:
Was it at all hard for you to steer away from the track of rocket science and aeronautical engineering?
Gerard O'Reilly:
At the start, you miss some of, I guess I'll call it more technical mathematics. And so, that was something that I was more on the theoretical side of things throughout my entire time in college, whether that was undergrad or at Caltech doing aeronautics. It was more kind of the theory of how different fluids interact, and how do you write the equations down, and how do you program those up on a computer.
Gerard O'Reilly:
And so, definitely there was a little bit of missing that, but that quickly gets replaced with kind of interesting projects that you get to work on when you're working for a firm like Dimensional. And those can be technical projects, from kind of a research perspective, working with the data. They can be projects that combine kind of legal with operations. They can be projects that are day-to-day portfolio management issues. And so, I got a pretty broad exposure to a broad range of projects early on across a lot of different departments. And that kept it interesting. It really broadened my horizons, that there's more out there than just writing down mathematical equations and solving them. There's other very interesting projects to work on that can be intellectually challenging as well.
Josh King:
Let's give some context, Gerard, to some of those projects for those of our listeners like me, who aren't rocket scientists or dealing quite in this domain. Dimensional's founders, pioneers of the first index funds, really evangelists for a product within an industry that was quite skeptical of them. Can you help set the scene for our listeners, and explain why an investment that tracks an index, something that really has been almost ubiquitous for investors today, was so revolutionary at the time that Ken was working?
Gerard O'Reilly:
Yeah. When you go back to the early seventies, in fact, this is before Dimensional was founded. David Booth had finished up his MBA at the University of Chicago, and he went and he started working with Wells Fargo, and in particular Mac McQuown who's on the Board of Directors today. And this was in the lab at that point in time, which was, "Are there other ways, systematic ways, that you can come up with that you can invest people's money without having to pick stocks that will give broadly diversified exposure, kind of give people a good investment experience?" And so, they came up with the very first index fund in '71 for an institutional investor. And so, at that point in time, it was always thought that you had to out-guess the market in order to do well when investing.
Gerard O'Reilly:
And that philosophy began to change with the work that was being done at the University of Chicago, with Gene Fama and so on. And what you mentioned earlier on, that there's a lot of information in market prices. And if you learn how to harness that information, use that information, you don't have to out-guess market prices in order to have a good investment experience. You can use the information and market prices to manage risk, to increase expected return, and so on.
Gerard O'Reilly:
So the index funds, I think, was the first stab at that, which was, "How do you get diversification, which is an investor's friend generally, in a very economical fashion?" And then you fast forward to '81, when Dimensional was founded, understand, "How do you take that next step? Now you've gotten a way to get broad diversification, some of those good tools. What else can you do with market prices to improve investor outcomes?"
Josh King:
For our listeners who may not be familiar with Dimensional's "one" investment philosophy, one in quotation marks, can you describe it for us?
Gerard O'Reilly:
So, when you look at Dimensional, philosophy starts with that prices are predictions of the future. They're forward-looking. And the question that we ask ourselves is, "How do we extract information from those prices about differences in expected return across stocks? And then how do we use that information to manage risk inside portfolios?" Because prices are forward-looking, which means they're updated real-time, all the time. As investors gather information and act upon that information, that information gets expressed in the price of the publicly traded stocks and bonds that we hold on behalf of our clients. So that's kind of concept number one. Concept number two is that optionality has value, and we should learn how to capture it on behalf of our clients. That's concept number two, and it's very intuitive. Concept number three is that systematic is useful for the end investor, a systematic approach or a rules-based approach.
Gerard O'Reilly:
So you mentioned indexing earlier on. Indexing is a very rigid rules-based approach. The question we ask ourselves is, "Can we have a rules-based approach that's less rigid as value goes beyond indexing, where we could communicate what our investors should expect from their investment strategies, and then demonstrate that we delivered what we said we would deliver; which then gives you a lot of the benefits of indexing, broad diversification, low cost, but you go beyond indexing where you have an active implementation, and you're able to add value above and beyond indexing."
Gerard O'Reilly:
So those core principles have been in place since day one. It's not about out-guessing market prices, it's about understanding how to use them. It's about understanding then where the friction is in the market, how do you give yourself flexibility in the day-to-day management of a portfolio? And then, how do you use that flexibility to benefit the end client?
Josh King:
Talking about your end client, you've mentioned Dimensional's clients a number of times so far, Gerard. What are the types of clients that dimensional principally serves?
Gerard O'Reilly:
So Dimensional works predominantly with intermediaries. And so, we work with sovereign wealth funds who represent the citizens of a nation, all the way to independent financial advisors that represent moms and pops saving for their retirement. So ultimately, our end clients are people saving to afford a better future. They're saving for something, sacrificing today so they can have a better future.
Gerard O'Reilly:
We work with the intermediaries who represent those people. And so, that means that we can take a kind of a more involved, a more in-depth approach to education, because we're working with financial professionals. So we can really help financial professionals understand what to expect from us, how to monitor us, and how to demonstrate that we've delivered what we said we would. So we have a very broad client base from the sovereign wealth down to the independent advisor and everything in between, all financial professionals who then in turn serve a set of actual investors.
Josh King:
You started at DFA in 2004, rose pretty expeditiously, named Head of Research, and promoted to Chief Investment Officer, currently serving as the Co-CEO along with Dave Butler. How does the role of Co-CEO work in practice? And why has that model been so effective for you and Dave helping to ensure continuity for the firm's clients?
Gerard O'Reilly:
Well, I think in order for the role to be effective, there's one key ingredient that has to be there, and that's a sense of respect and kind of comradeship between the two people in the role. Dave and I get along very, very well. He brings certain items to the table. I bring certain items to the table. And we respect each other's views and opinions. I think that's one of the reasons why it's worked very well for us.For me, over the past five years in working with Dave, I'm very happy, to be perfectly honest, to have had a Co-CEO in the role, because it's a true peer, and it's somebody that you can discuss ideas and concepts with in a very open fashion.
Gerard O'Reilly:
What I found over the course of my career at Dimensional since 2004, is the higher up in the organization, that's wonderful, but it seems that every time you get a promotion, you become funnier and more intelligent, when actually you don't. But if you're just judging by how people interact with you, that's the inference that you might make. And so, the informational quality of the interactions maybe becomes less. People tell you what they think you want to hear, not what you need to hear. And so, I think that having a peer like Dave has been super helpful in that fashion.
Gerard O'Reilly:
He's grown up more on the sales and marketing side of the business. So he's been with the firm for almost 30 years now, and he's grown up with financial advisors and working with clients directly, and thinking about how to help clients understand what we do. I grew up on the investment side of the business, starting with the Research Team, then becoming the CIO, so overseeing the Investment Team. So we have nice complimentary skill sets that I think can be helpful for the firm and for our clients.
Josh King:
After the break, Gerardo O'Reilly, the Co-CEO and Chief Investment Officer at Dimensional Fund Advisors and I are going to talk about the active versus passive debate, the investment landscape, and the future for Dimensional. That's all coming up right after this.
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Josh King:
Welcome back. Before the break, Gerardo Riley, Co-CEO, and Chief Investment Officer at Dimensional Fund Advisors and I were talking about the macro factors moving the markets now, and really throughout his career. Gerard, why was the efficient market hypothesis so game-changing? And how did Booth and Sinquefield take that hypothesis to the next level when they actually founded Dimensional?
Gerard O'Reilly:
It was game-changing because it gave a framework about what a market price meant and how good a job a market price was doing at forecasting the future. And so, it kind of gave this notion that prices are forward-looking. The question is often asked, "Well, can you out-guess them very easily?" And so, there's a lot of different experiments that you can do. And the efficient market hypothesis has kind of set up the framework on how you could do those experiments, whether there's performance studies, whether they're event studies, to say how good a job or how easy is it to out-guess market prices?
Gerard O'Reilly:
And pretty much the data comes back conclusively every time, that market prices are pretty good at doing their job. And markets are pretty good at allowing buyers and sellers to come together to express an aggregate view on what the future holds. And that aggregate view can change, and it can change quickly at times, which will mean prices can change quickly. That aggregate view is incredibly challenging to out-guess.
Gerard O'Reilly:
And when you accept that view of markets, what it means is that you can focus on controlling what you can control. You can't control what is going to happen in the real economy next year. You can't control what country might go to war with another country. You can't control what inflation might happen in the future. But you can control your investment approach. You can control how you turn over your portfolio. You can control the way and the efficiency by which you give investors exposure to different segments of the market. You can control your asset allocation. And you can control your processes, such that they're ready for a crisis, always ready for a crisis. So it really frees up your thinking. You're no longer thinking about how to out-guess the rest of the world, you're thinking about how to use the information that the rest of the world is ready to give you, and control what you can control then, to improve investment outcomes.
Josh King:
People in your world, Gerard, sometimes like to say that investing is as much science as it is art. But I think Dimensional, in what you're saying right now, throws that notion out the window, and puts a very scientific and technical approach to the work, using rigorous academic research to support the decisions that you and your colleagues are going to make. Can you tell us a little bit about the approach that you use when you create actually a new fund or product?
Gerard O'Reilly:
The way I think about the scientific method and how we apply it here at Dimensional is along the lines of you're asking questions, and then you're gathering data to help you answer those questions. And so, you don't go in with a very strong prior about what the data may show, but the scientific approach says, "How do you ask the right question? And then how do you gather the data in such a way that you're going to be able to learn something meaningful from it that allows you to address the question that you began with?"
Gerard O'Reilly:
And so, it's about the data, it's about interrogating the data, and then letting it speak and letting it tell you what it can tell you, and recognizing there's certain things that it won't be able to tell you. And how can we say something reliable about the relation between current profitability, future profitability, current profitability, future returns?
Gerard O'Reilly:
That also translates into how we build strategies, which always start with what's the client trying to accomplish? What's the client goal? What's the client need? Then we have all these tools in our toolkit, with respect to the research that we do and how we manage money. And we take those tools and we say, "Okay. Given those tools, how can I construct the best portfolio that I know how that will solve that particular client problem?" So if you look at the ETF launches that we have done over the past year and a half, a lot of those were driven by feedback from financial professionals. "We want an ETF that takes what you've done in the mutual fund format. So it's not index, it goes beyond indexing, but gives us that in a ETF vehicle."
Gerard O'Reilly:
And how we do that then is we say, "Okay. What are the processes that we have available today? What do we need to develop in order to be able to do what we do in mutual funds, in an ETF?" Because it's a slightly different vehicle, so it doesn't translate perfectly well. "How do we take that and do what we do, for decades, in an ETF?" And then put all those processes in place and then deliver that out to the client. So there's a client feedback loop, there's a research loop, and then there's looking at what tools we have and what tools do we need to build to bring these types of strategies to life for our investors.
Josh King:
And based on these feedback loops, Gerard, some of the firm's early successes were focused in the small cap equity space. What made that part of the market really ripe for the innovation that you brought to it?
Gerard O'Reilly:
When you go back to the eighties, there were not many diversified, if any, small cap strategies available to institutional investors. And so, what made the approach very appealing was that it could be done in a diversified fashion, in a low cost fashion, but in a fashion that wasn't expected to leave a lot of the returns on the table through trading costs. Because the consensus view at the time was that if you had a small cap strategy that was broadly diversified, you were going to get killed by trading costs. And that was probably true if you're an index-based approach, but we were able to take that and do something that wasn't an index-based approach that didn't suffer from some of those issues. And so, we started with that in the US, and then we added non-US small cap strategies, whether it was Japan or Europe or UK, and so on and so forth over time.
Gerard O'Reilly:
We also had our fixed income strategies that will line up for our clients at that point in time. So our first fixed income strategy came in '83. And so, that evolved over the course of the eighties, and then come the early nineties, Fama and French of course, had their seminal paper on the cross-section of returns. And that kind of opened up the pathway. "Okay. How do we do something now in both large and small caps?" And that's where value investing really started to come into its own, both at Dimensional, and then subsequently in the industry at large.
Josh King:
From small caps to fixed income, you mentioned both of those, Gerard. In fixed income markets, they are far less liquid than the equity markets. Some of the most actively traded paper might only trade only once a month. Building an active, transparent, fixed income fund generally requires more specifications than an equity portfolio might require. What considerations do you take into account when you're building out a credit fund?
Gerard O'Reilly:
So flexibility is even more important for that reason, Josh, in fixed income than in inequity, and I think you make a reasonable argument there. And while an individual issue may trade less frequently than an individual stock, there are many more issues. So the breadth of bonds is quite a lot broader than the breadth of stocks, and that's because one issuer, like an Apple or an IBM or a company, might issue a lot of different types of bonds, different maturities, and so on and so forth, maybe different terms in the bond and indenture, things of that nature, whereas they might issue only one or two classes of stock. So it's very, very important to have that flexibility built in.
Gerard O'Reilly:
And once you have that flexibility built in, then you can bring together kind of very, very innovative, fixed income strategy, because the aggregate volume and the aggregate trading volume and fixed income is very, very high. You wouldn't look at the aggregate traded volume in fixed income markets and say they're less liquid than equity markets. No. On aggregate, they're as liquid as equity markets. But if you're very precise on which issuer you need, then you're going to struggle.
Gerard O'Reilly:
So the way that we think about it is we take in data, thousands of bonds every day, real-time, all the time, every day, we construct expected returns from those data. We construct our own credit ratings from those data. And what that allows us to do is in real-time, build fixed income strategies that are broadly diversified, that are rules-based approach, or that are doing a little bit of incremental turnover every day to say, "Who has the highest expected returns in the marketplace today? Let me increase my weight in those bonds, and let me reduce my weight in bonds that have lower expected returns, given a portfolio's guidelines." So I think that there's differences in the markets; but conceptually, the approach is similar, but practically, how you have to implement that approach tends to be different.
Josh King:
I'm curious how Dimensional is approaching, considering, in addition to everything you just said, ESG and sustainability. There is a lack of standards, certainly when it comes to ESG reporting, throughout. The SEC recently announced a proposal to improve the consistency and reliability of climate-related information, for example. What do you think needs to change to help investors better factor in sustainability and ESG to the decisions they're making?
Gerard O'Reilly:
I think that it's important to understand which aspects of sustainability are most important to you, because you're right. There are a lot of different ways of looking at a company and deciding whether it's a "good" company or a "bad" company, a sustainable company or an unsustainable company. And when you look across the typical sustainability ratings, you'll get companies that are the same company rated as the most sustainable by one rating agency, and the least sustainable, that very same company, by another rating agency. And it's because they're focusing on different things.
Gerard O'Reilly:
So as an investor, I think it's important to decide what are your values? And do you need to invest along those values? A set of values that the clients that we work with have expressed is strongly focused around climate change and the potential that climate change may have to impose high costs on future generations. And so, with that in mind and those set of values, then we can go to work and understand what data are available to help if those investors express the values in investment strategy. We can work with the experts. We have a network of experts of on ESG from climate change and data, kind of experts when it comes to those types of data. And then we can take in, and we take in about eight different ESG data sources now across many thousands upon thousands of securities.
Gerard O'Reilly:
And what that allows us to do is say, "Okay. These are your values. We can demonstrate to you in things like weighted average carbon footprint or greenhouse gas emission, or potential emissions from reserves that you're not investing in those types of companies, but you're still getting a broadly diversified investment portfolio. And with quantitative data that is robust, that is reliable, and less subject to opinion, you can really then give investors a good investment experience while investing along their values. So I think it's an area today that first off, you have to decide what your values are, narrow in to what's most important, and understand if there's data available that's rigorous, that allows you to quantify firms based on what you find important, and then get an investment approach that doesn't sacrifice the investment itself in pursuit of those values.
Josh King:
I teased this before we went to the break, Gerard, but there really is still no let up in the debate in investment management circles about both active and passive investing. From your perspective where you sit, where does the debate stand at the moment, and how does DFA think about it?
Gerard O'Reilly:
Passive brings a lot of nice benefits to the table, and indexing has done that. Indexing is transparent. It's well-diversified. It can be low turnover, and it can be low cost. And those are all nice features of an investment strategy.
Gerard O'Reilly:
Active brings some good things to the table, in terms of understanding markets well, understanding firms well, understanding how firms report well, understanding market microstructure well. All of those things are also important when it comes to delivering a good investment experience. The way that I think about it is that let's take the best from both. And that's what we've been doing for over 40 years, which is let's deliver solutions that are low-cost, that are broadly diversified, that are transparent, systematic, rules-based, so we can describe to people what they should expect and what the strategies will do in different market environments.
Gerard O'Reilly:
But let's not be rigid. Every investment approach requires judgment. When an index provider designs an index, there's a lot of judgment involved about how to design that index. When a traditional active manager decides to pick stocks, there's a lot of judgment involved. There is judgment involved in what we do, and the way that we think about the judgment is let's keep all the benefits of an index, but make those judgements that we think can really add value, whether it's how we turn over the portfolio.
Gerard O'Reilly:
So I'll give you an example. An index might turn over one time or two times or four times a year. Well, that seems a terribly inefficient way to keep yourself focused on an asset category if you're investing in small caps. Why don't you do a little bit of turnover every day? It can be rules-based, but it's a little bit every day. That little bit every day, you can be way more flexible. So that allows you to drive down trading costs. It allows you to emphasize the stocks that you really want to buy, because they have all the right characteristics on that particular day. It allows you to react to situations like GME. GME went from a micro cap stock to a mega cap stock in a couple of weeks. Index-based approaches don't deal with that well. But if you have a daily-based approach, it can deal with those types of situations while delivering a lot of the benefits of indexing.
Gerard O'Reilly:
So we don't really get involved in the debate in as much as we say that there's benefits and attractive items from both sides. Let's take them and put together a set of strategies that put our clients in the best position to win.
Josh King:
Best position to win, give them more products. Gerard, in 2020, Dimensional announced that it was going to be wading into the world of exchange traded funds, or ETFs, and launched three ETFs: the US Core Equity Market ETF, the International Core Equity ETF, and the Emerging Core Equity Market ETF, all of which are traded right here in the New York Stock Exchange Arca. Why was it the right time to launch these ETFs?
Gerard O'Reilly:
Well, there was two big drivers there Josh, and one was in 2019 with the ETF rule, what's called Rule 611. And that rule effectively paved the way for an active, transparent ETF structure. And what I mean by that is that the way the ETFs were brought to market previously was less standardized, may be the right word, and that brought a lot of standardization, which in my view, helps investors understand better what they're getting, but also allowed for things like the use of what they call custom baskets. Now that may be a technical term, but effectively, it allows you to move past indexing, and do a little bit of rebalancing through the ETF, what they call create and redeem process, every single day. That rule, and certain aspects of the rule, were important for us to be able to do what we were doing in mutual funds, in an ETF wrapper.
Gerard O'Reilly:
The second was our clients. And over the years, going up to 2020, our clients were expressing more frequently that they wanted a dimensional ETF. And that was in part because our clients are intermediaries. They're financial professionals, financial advisors who work with an end investor. And those end investors were wanting ETFs for lots of different reasons: some of it was the lower transaction fee on various different platforms, some of it was the lower capital gain distributions, lots of different reasons.
Gerard O'Reilly:
So that led to June, 2020, when we made the announcement and filed our initial documents, to November, when we launched our first three ETFs, as you mentioned, listed on NYSE. And it's been a really good experience since then. We have 23 ETFs as of today, almost 24. We have one more conversion coming up this weekend, a mutual fund ETF, which puts us into kind of I think the top 10 of ETF managers in under 18 months. We've had about $11 to $12 billion of flows into the ETFs in the 18 months since their inception. So I think that we really got it right, in my view, for the clients that we work with; that we delivered something that they were asking, something that they need, and we did it in a way that was really helpful for them and their clients.
Josh King:
So, most recently, to talk about all the things that you've been doing in this space, Gerard, you launched three new emerging market ETFs on just April 27th of this year. And I think the total ETF AUM now sits somewhere around $48 billion. You'll tell me if I'm in the ballpark. More mutual funds have continued to be transitioned into the ETF wrapper. What do ETFs offer as a vehicle that the mutual fund rapper just doesn't?
Gerard O'Reilly:
So, ETFs and mutual funds both have their advantages. And some of our clients prefer one and some of our clients prefer the other. You write about the AUM, it's around there, depends on what markets are happening on the day. We have one more to convert, which is an $8 billion ETF, which happens over the weekend. And so, then that will up into the $50 billion category, assets under management in ETFs.
Gerard O'Reilly:
So when it comes to mutual funds, they trade and end a day in NAV. And some people prefer that; they don't have to deal with all what's going on in the marketplace. They get end of day NAV, they trade for cash, so people prefer that than trading for shares. So there are some folks who prefer the way mutual funds trade.
Gerard O'Reilly:
When it comes to ETF, ETFs trade throughout the day. They generally don't trade at NAV, which means you're dealing with a bid-offer spread, you're dealing with liquidity in the marketplace. We have a very strong capital markets team here at Dimensional. That means that we end up with healthy volumes, healthy spreads in our ETFs, and we work with our clients to make sure they have a good trading experience. But again, some investors prefer one over the other.
Gerard O'Reilly:
On money platforms, for good reasons, ETFs often trade without a transaction cost. So they trade with a bid-offer spread, but no transaction cost. Mutual funds trade with a transaction cost, but no bid-offer spread, and so investors prefer the ETF over the mutual funds.
Gerard O'Reilly:
Then the final aspect is because of the way ETFs are managed, they tend to have fewer capital gains distributions. And that means that the investor is more in control of when they realize the capital gains inside their investment vehicle. Now, a plus for some investors, some investors prefer that, and that's something that ETFs generally offer over mutual funds.
Gerard O'Reilly:
So there's some differences between the two. I think that ETFs have certainly been garnering a lot of the cash flows from investors over the past number of years. But both vehicles are good vehicles. The mutual fund industry is still much bigger than the ETF industry at this point in time. And that may change in the future, who knows, who knows how, regulation and technology and so on. And innovation will kind of tip the scales to one side or the other.
Gerard O'Reilly:
But our viewpoint is they're both great investment vehicles for folks to get diversification and save for their investment goals. And so, we want you to learn what we mentioned, that "one" investment philosophy about Dimensional, and then you choose your own adventure as to what vehicle you want to consume that investment philosophy through.
Josh King:
In our last stop on our tour around the world of DFA, Gerard, let's focus on separately managed accounts, because you have also announced that DFA is going to be entering this world, separately managed accounts. They offer investors even more flexibility and customization. Why was now the right time to enter this space?
Gerard O'Reilly:
Yeah. So Josh, we had been managing separately managed accounts for decades, and we've traditionally managed them for large institutions and high ultra high net worth individuals. So, $20 million and up was our minimum. And about three or four years ago, we started asking ourselves the question, "Can we use technology to take what we've done with managing institutional size assets, and bring our account minimum down to a half a million dollars, such that somebody that's kind of in the high net worth, our mass affluent kind of categorization of investor, could get a strategy that's customized for them, but with all what we've learned over four decades of managing assets for institutional asset owners. And the answer that we arrived at was yes, we can. That took a lot of work, a technology built. We built rather than bought. We built basically a FinTech solution to that problem, to drive economies of scale that are acquired to manage separate accounts at smaller account minimums.
Gerard O'Reilly:
We launched that officially last September, and it's been going wonderfully since. We have over 200 accounts launched since last September, so we're passing around $400 million in the first few months of launching that program. So, typically, account size half million to a million dollars, in and around there, $1 million to $2 million, in and around there. So it's been kind of good journey with the financial professionals that we work with.
Gerard O'Reilly:
Really, it's all about convenience with customization. When you look at the convenience factor, because we've built this whole FinTech solution from the ground up, a financial professional can go on there, design a strategy in about two or three minutes, hit the go button, it gets shipped off to our investment team. We can do analysis on what they're submitting, hit the go button, it goes back automatically to that financial professional. They get the analysis that they need. They say, "Yes, we're good to go."
Gerard O'Reilly:
The convenience aspect of it, technology has really enabled. In the customization aspect, we've enabled that through what we offer those financial professions, whether it's customization from the tax management, from the securities that you want to include or exclude, from the asset allocation that you want to pursue, or from the values that you want to express inside your investment strategy. So it's kind of that nice intersection between customization and convenience, which I think more and more people expect in the world today than maybe they did 20 or 30 years ago.
Josh King:
So, if I'm a qualified investor with a half million or so that I want to put to use through DFA, where would I head next, Gerard?
Gerard O'Reilly:
You could head to our website and look at "find an advisor," who then can help you understand what are maybe some of the right solutions, given your financial goals and what you're trying to accomplish with your savings. And then if that financial professional says, "Yep. We think that a Dimensional SMA is the right SMA for you," and then that financial professional will take care of the rest, and set everything up and get you off to the races, with respect to a customized strategy for you.
Josh King:
Off to the races sounds pretty good to me. And with that, I'll let you get off Inside the ICE House, and back to work at Dimensional. Thanks so much, Gerard, for joining us Inside the ICE House.
Gerard O'Reilly:
Thanks, Josh. It was a pleasure talking to you today.
Josh King:
That's our conversation for this week. Our guest was Gerardo O'Reilly, Co-CEO and Chief Investment Officer at Dimensional Fund Advisors. If you like what you heard, please rate us on iTunes so other folks know where to find us. And if you've got a comment or a question you'd like one of our experts to tackle on a future show, email us at [email protected], or tweet at us, @askicehousepodcast.
Josh King:
Our show is produced this time for the last time, unfortunately, by Stephan Capore, who's moving on. Best of luck to Stephan, with production assistance from Pete Ash, Ken Abel, and Ian Wolff. I'm Josh king, your host, signing off from the library of the New York Stock Exchange. Thanks for listening. Talk to next week.
Speaker 1:
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