Podcast Summary
The human desire to outperform drives the investment industry: Markets may be efficient on average, but opportunities for outperformance exist, and active players like Principal Asset Management help investors capitalize on these possibilities.
Despite the belief in market efficiency and the availability of low-cost index funds, the human desire to outperform and beat the market drives the existence and continuity of the investment industry. Principal Asset Management, with its global perspective and local insights, is an active player in this industry, helping clients navigate markets and identify potential opportunities. Gerard O'Reilly, co-CEO and CIO at Dimensional, shares insights on market efficiency and Dimensional's data-driven approach to investing. While markets may be efficient on average, opportunities for outperformance may still exist, and the investment industry continues to provide services and expertise to help investors capitalize on these possibilities.
Dimensional's academic roots and focus on small cap stocks: Dimensional, founded in 1981, focuses on systematic, diversified exposure to small cap stocks based on academic research, not trying to outguess market prices but extracting information from them.
Dimensional is a leading ETF provider with a deep academic background, tracing its roots back to the University of Chicago and founders who studied under Nobel laureates like Gene Fama. The company, founded in 1981, identified a need for systematic, diversified exposure to small cap stocks and began based on this need and academic research. Although often associated with passive investing and indexing, Dimensional is actually non-index and not in the business of trying to outguess market prices. Instead, they focus on extracting information from market prices and understanding the wisdom of the crowds in predicting future outcomes. The difference between passive and non-index investing lies in the acceptance of market prices and the flexibility to adapt to market conditions. The example of betting on a sporting event illustrates the concept of the wisdom of the crowds and how market prices can serve as a forecast for future events.
Market prices as unbiased estimates of future returns: Market prices reflect expected returns, guide investment decisions, and are generally fair and efficient, even in extreme market situations
Market prices reflect the expected returns investors require to hold an investment. Prices are not always correct but can be seen as unbiased estimates of future returns. Academic studies suggest that market prices are fair and efficient in this way. By understanding the required returns for various investments, investors can make informed decisions and manage risk effectively. Even in extreme market situations, such as the GameStop example, a systematic approach allows for efficient handling of price deviations. Market prices serve as valuable information for investors, guiding them towards informed decisions and potentially higher returns.
Dimensional's Unique Approach to Product Development: Dimensional's success stems from deep relationships with financial professionals, rigorous academic research, and commitment to clients' needs, resulting in low closure rate and value added services.
Dimensional Funds, which started in the 1980s, initially focused on small cap strategies and later expanded to include fixed income and value research. Their approach to product development is unique, as they work closely with financial professionals to understand their clients' needs before launching new funds or ETFs. This results in a low closure rate compared to the industry. The firm also believes that the combination of financial professionals and an independent money manager provides value to clients by helping them define investment goals, manage risk, and stay disciplined despite market volatility. Dimensional's success can be attributed to their deep relationships with financial professionals, their rigorous academic research, and their commitment to serving clients' needs.
Systematic investing with Dimensional: Dimensional's rules-based approach involves rigorous research, clear communication, and effective implementation for successful investment strategies.
A systematic, rules-based approach to investing is important because it provides transparency, builds trust, and leads to better long-term investment outcomes. Dimensional's approach involves rigorous research, clear communication, and effective implementation of new strategies. For instance, the profitability strategy, which pairs income statement variables with balance sheet variables to predict future profitability, is an example of this systematic approach. The research undergoes a thorough vetting process, and the implementation is carefully planned and executed. This focus on education, implementation, and transparency has led to successful investment strategies for Dimensional and its clients.
Value investing: Adapt and evolve: Value investing strategy faces challenges but staying informed, open-minded, and committed to learning can lead to success
The world of investing is dynamic and unpredictable, and it's important to remain introspective and adaptive. The value investing strategy, which involves buying stocks that appear to be undervalued based on traditional metrics, has had its challenges in recent years, with some arguing that the strategy is no longer effective. However, it's crucial to remember that there have been many strong periods for value investing, and the recent underperformance may be due to unexpected events and sector weights. Furthermore, the definition of value itself is evolving, with intangible assets becoming increasingly important. It's essential to recognize that intangible assets are often included in book value and have grown significantly since the year 2000. Ultimately, the key is to stay informed, be open-minded, and remain committed to continuous learning and improvement in the ever-changing world of investing.
Intangible assets not typically included on balance sheets: Balance sheets exclude intangibles like R&D and brand development due to their uncertain value, but they're crucial for understanding a company's worth. Principal Asset Management uses a holistic approach to deliver value through real estate investments and has entered the ETF market to access new opportunities.
While balance sheets include some intangible assets, the uncertainty surrounding the value of internally developed intangibles, such as research and development or brand development, makes it difficult to accurately estimate their value. Therefore, they are typically not included on balance sheets and instead flow through the income statement. This is because the value of these assets can be highly uncertain when the expenses to build them are incurred. However, when analyzing a company's value, it's important to consider multiple variables such as profitability and asset growth, rather than just the balance sheet. Principal Asset Management, as a leading real estate manager, leverages a 360-degree perspective to deliver local insights and global expertise across various investment types. They have been successful in uncovering opportunities in the market, giving their clients an exclusive advantage. In the financial industry, there has been a shift from mutual funds to exchange-traded funds (ETFs). Principal Asset Management entered the ETF market in 2019, following the approval of rule 611, and has since grown to have close to 40 ETFs. The trend of flows from mutual funds to ETFs has allowed the company to access new channels and advisors that they traditionally haven't worked with. While some advisors have transitioned from mutual funds to ETFs, the industry as a whole has seen this trend.
ETF inflows: Half from new clients, half from mutual fund transitions: BlackRock estimates that half of ETF inflows come from new clients while the other half comes from mutual fund transitions. They focus on making it convenient for financial professionals to access ETFs and other investment approaches, acknowledging the challenges of extreme passive investing and indexing but arguing for the benefits of flexibility.
While ETFs have been gaining popularity and contributing significantly to BlackRock's growth, the proportion of inflows coming from new clients versus transitions from mutual funds is difficult to determine precisely. However, it's estimated that around half of the new flows into ETFs come from new clients, while the other half may be from mutual fund transitions. BlackRock continues to manage a large amount of assets in mutual funds, but they are focusing on making it convenient for financial professionals to access ETFs and other investment approaches. Regarding the rise of extreme passive investing and indexation, BlackRock acknowledges the academic evidence suggesting that it's challenging for active managers to outperform the market consistently. However, they argue that indexing leaves money on the table due to its rigid approach. For instance, when a stock is added to an index, index managers may exert price pressure on the stock, which can result in additional costs that are not reported to investors. BlackRock believes that having some flexibility to deviate from market cap weights and rebalance more frequently can lead to better returns for investors.
Understanding market structure and implementing efficiently: Dimensional focuses on market structure awareness and efficient implementation to outperform indices, not just on low cost ratios.
Dimensional's approach to outperforming indices involves both identifying systematic drivers of returns through research and implementing those findings efficiently. Market structure awareness, or understanding how markets operate and recognizing alpha opportunities, is a key component of this outperformance. Dimensional doesn't aim to outguess the market but instead focuses on being efficient and adding value through corporate actions and other implementation strategies. While the industry focus on cost ratios is important, it's not the only factor in total cost of ownership. Dimensional spends time educating financial professionals on these less obvious costs and how to minimize them. For instance, securities lending revenue can significantly impact the cost of ownership, particularly in emerging market small strategies. Dimensional has reduced its fees by about 30% over the past few years, but it also places a strong emphasis on implementation and the total cost of ownership.
Impact of Mutual Fund Costs and Competition on Dimensional Fund Advisors: Dimensional Fund Advisors prioritizes client needs and competition drives economies of scale in the mutual fund industry
The total cost of ownership for investors goes beyond just the expense ratio, and the implementation and focus on specific asset categories can significantly impact the overall cost. The mutual fund industry could see a game-changer with the potential approval of ETF share classes for mutual funds, allowing for commingling of investors and immediate economies of scale. Dimensional Fund Advisors, with assets under management over $600 billion, keeps an eye on competitors for potential opportunities but primarily focuses on client needs to guide their strategy. The increasing competition from larger players like Vanguard, BlackRock, JPMorgan, and Morgan Stanley, with their integrated wealth solutions, is viewed as a strength due to Dimensional's conflict-free advice.
DFA's Unique Approach to Investing: DFA focuses on merits, innovates, introspects, and stays ahead in academia. Seeing the big picture while detail-oriented leads to mastery. Finance industry goes beyond market-beating, focusing on clients' needs and risk profiles.
Dimensional Fund Advisors (DFA) sets itself apart in the competitive investment industry by focusing solely on the merits of its investment proposition, rather than relying on labels like passive, active, or systematic. This approach requires continuous innovation, introspection, and staying at the forefront of academic research in investing. Gerard O'Reilly, a physics PhD turned finance professional at DFA, emphasized the importance of seeing the big picture while remaining detail-oriented, which he believes is crucial for mastery in any field. The conversation also touched upon the role of the finance industry, which goes beyond trying to beat the market and focuses on understanding clients' needs and risk profiles to provide optimal investment solutions. O'Reilly shared his personal journey from physics to finance and expressed satisfaction with his decision, highlighting the valuable lessons he learned along the way. Overall, the conversation provided insights into the unique approach of DFA and the importance of deep relationships and expertise in the finance industry.
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