Bloomberg’s “Odd Lots”: Gerard O’Reilly on the Future of Fund Management

The Bloomberg podcast Odd Lots recently featured Dimensional Co-CEO and CIO Gerard O’Reilly as a guest. Hosts Joe Weisenthal and Tracy Alloway joined him at Dimensional’s Austin headquarters to discuss everything from the firm’s history and investment philosophy to his views on market efficiency and where he sees the fund management industry going.

Below are some highlights from the conversation condensed for clarity. Listen to the full episode here.

Is Dimensional active or passive?

We are not in the business of trying to outguess market prices, so we are not active. We are passive in the sense that passive implies you accept market prices, you trust market prices, and you try to extract information from market prices. But we are nonindex. Index is too rigid. With indexing, you can leave money on the table.

What is the difference between passive and index?

It’s important to understand what the price of a stock or the price of a bond actually represents. Prices can be interpreted as predictions, or forecasts, of the future, and they’re informed by the actions of people trading in the marketplace. So what information is in the price of a bond or a stock? Overwhelmingly, academic evidence says the main information in there is the return that people require to hold the investment. That’s a really important point, because it tells you that you don’t have to outguess market prices but you can use them to determine which stocks or bonds people require a high return to hold and which they require a low return to hold. That’s one of the key insights that you glean from all this academic literature. And that’s what we do. We look at how we can extract that information efficiently for investors.

I think about market prices being fair and unbiased estimates of the future. They may not always be spot on, but you don’t know when they’re too high and you don’t know when they’re too low. And if you use them effectively, you can manage risk better and you can increase expected returns—and that matters. The nominal rate of return on the US stock market has been about 10% per year over the past 100 years.¹ That means that if you invest and earn a 10% annualized return, your money doubles every seven years. If you can take that 10% and turn it into 11% or 12%, your money doubles every six years. So, after a 40-year investment horizon, you have doubled the money you would have earned at 10%. The amount of consumption that you can afford by doing a little better than the market tends to be quite significant.

Why does Dimensional work with financial advisors rather than going directly to investors?

We think the combination of financial professionals and independent money managers is a pretty good combination in terms of serving the needs of families. There’s a lot of value that a financial professional can bring to the table. Financial professionals work with families who may not understand finance all that well. They help them create a financial plan and implement it with the right investment vehicles. Then, they help them stay disciplined and tune out the noise around markets.

What is the difference between systematic and active? 

We like systematic, or rules-based, approaches because you can explain to financial professionals the rules that are being used to manage a portfolio. You can give them the tools to monitor what you’ve done, and they can see that you did what you said you would do. That builds trust, which can build a longer investment horizon over time. And we believe that the probability of success goes up with the length of investment—probabilities of realizing positive value, size, and profitability premiums. A systematic approach is very important because people can understand what to expect from these strategies given different market environments.

What is your take on the overall rise of indexing in the industry?

I think people have overindexed on indices because there’s a lot that you can do to actually get your fair share of the returns that the market is willing to offer. But indexing can leave money on the table. Indexing is an active decision with respect to how indices are put together and how they decide to rebalance, and those active decisions can cost investors money. In my view, there’s no reason that you need to hold a perfectly market-cap-weighted portfolio of stocks, and indices typically aren’t perfectly market-cap-weighted in any event. It’s much better if you have some flexibility to deviate from market-cap weights to pursue higher expected returns, but also flexibility on how to turn the portfolio over and keep yourself focused day in and day out. You don’t need to wait for one or two events each year to rebalance.

Talk a little bit more about cost of ownership. Is there a limit to how low it can go? 

I think looking at the total cost of ownership is key, and you have to dig far deeper than the expense ratio to actually get there. There has been a strong focus on expense ratio, but that is not the only part of total cost of ownership. There are also things around implementation that are very important. If you look at securities-lending revenue, for example, it can vary across asset category. Depending on how you do that, that can be a material percentage of the expense ratio given back to the investors through a process that you can have going on inside the fund. When you look at the total cost of ownership of indices, it’s actually much higher than the expense ratio because of the way that they’re implemented and often the lack of focus on the asset category.

Where do you see the future for this industry?

One of the big areas that we’ve been working on recently is our application to the US Securities and Exchange Commission (SEC) for exemptive relief to be able to offer ETF share classes of mutual funds. If that becomes a high enough priority for the SEC and more folks in the industry are able to get that exemptive relief, we think that could be a big thing for the industry.

What is SEC exemptive relief to offer ETF share classes, and why is this important? 

If you have an existing mutual fund, this means you could offer an ETF access point. So let’s say an existing mutual fund is purchased by retirement investors through 401(k) accounts. Now, you can offer an ETF access point. Suddenly, you can commingle the retirement savers plus people who maybe have brokerage accounts that are in taxable accounts. That commingling provides economies of scale immediately to both sets of investors.

The SEC has to provide fund managers exemptive relief, or permission, to do this, but I think that if more of those types of structures appear in this country, that will be a game changer for the mutual fund industry and for the end investor. Folks who want to make a move from a mutual fund to an ETF could do so without trading if this were put in place more broadly in a very particular way. We’re excited and energized by that possibility.

FOOTNOTES

1. In US dollars. Based on S&P 500 index annual returns, 1926–2022. S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

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