Gerard O'Reilly, Co-CEO and CIO of Dimensional Fund Advisors, talks about the firm's research-based culture and rules-based approach to investing. He discusses risk assessment, factor tilted portfolios, operating profitability, and the value of combining multiple metrics. He also highlights the benefits of including small-cap stocks in portfolios and the changes in Dimensional portfolios over the past decade. Gerard's scientific learnings inform his unique portfolio adjustments and Dimensional's integrated approach.
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Quick takeaways
Dimensional focuses on rules-based, higher expected return strategies driven by factors like company size, value, profitability, and momentum.
Dimensional considers goodwill as an asset and does not adjust or subtract it from book value, emphasizing the challenges in estimating internally developed intangibles.
The core premise of Fama and French's research remains valid, asserting that differences in expected returns based on factors like value and profitability persist over time.
Dimensional's investment philosophy includes targeting value and profitability together, overweighting firms with high value and high profitability while equal weighting those with low value and high profitability.
Deep dives
Dimensional Fund Advisors and the Evolution of the Investment Industry
Gerard O'Reilly, co-CEO of Dimensional Fund Advisors, joins the podcast and discusses his background in aeronautics and mathematics and how it relates to asset management. He explains that Dimensional focuses on rules-based, higher expected return strategies that meet the needs of clients. They use factors like company size, value, profitability, and momentum to drive their asset allocation. Gerard highlights the importance of market prices as predictions of the future and the value of capturing optionality for clients. Furthermore, he discusses the consideration of internally developed intangible assets in valuation and the challenges of including goodwill in portfolios. He emphasizes that the premises of Fama and French's research, which focus on discount rate effects and differences in expected returns across stocks, remain valid. Lastly, Gerard explains why Dimensional does not use multiple metrics to measure relative price, as they already consider a comprehensive set of variables in their strategies.
Evaluating the Role of Goodwill in Portfolio Management
Gerard O'Reilly discusses the concept of goodwill and how it reflects the value of intangible acquisitions made by companies. Dimensional considers goodwill as an asset and does not systematically adjust it or subtract it from book value. Gerard explains that adjusting goodwill may make book value less informative and may not accurately represent a company's assets. He cites the example of internally developed intangible assets, which pose challenges in estimation. While there is interest in incorporating estimates of internally developed intangibles, the current noise and lack of accuracy of estimates makes it difficult to implement. Gerard emphasizes that Dimensional continually evaluates and explores improvements in measurement techniques.
The Enduring Validity of Fama and French's Findings
Gerard O'Reilly discusses the ongoing relevance of Fama and French's research. He notes that the core premise of their work, which focuses on discount rate effects and differences in expected returns across stocks, remains valid. He highlights the uniqueness of their experiments, spanning multiple data samples over several decades, all yielding consistent findings. Gerard emphasizes that while accounting practices and market structures may change, the underlying principles that drive differences in expected returns based on factors such as value and profitability persist. He asserts that Fama and French's three and five-factor models continue to be benchmark factor models used in the industry.
Dimensional's Approach to Targeting Value and Profitability
Gerard O'Reilly explains Dimensional's approach to targeting value and profitability together. In their core strategies, they focus on overweighting firms with good value and profitability characteristics. They split the market into four buckets: growth with low profitability, growth with high profitability, value with low profitability, and value with high profitability. They give the most weight to firms with high value and high profitability, and equal weight to firms with low value and high profitability, and those with high value and low profitability. This approach is consistent across different market cap sizes. Gerard emphasizes that the combination of value and profitability is a key factor in Dimensional's investment philosophy.
The value of an integrated investment approach
Dimensional uses an integrated investment approach, considering factors such as value, profitability, and asset growth in their portfolios. They believe in the importance of combining these factors to maximize potential returns and improve diversification. By blending these factors together, they aim to capture different premiums and optimize their portfolios' asset allocations. This integrated approach also helps them manage risks more effectively and adapt to market conditions. Dimensional sees their investment approach as a distinct advantage that sets them apart from competitors.
Capacity considerations for investment strategies
As Dimensional continues to grow, they carefully consider the capacity of their investment strategies, particularly in small and micro-cap stocks. They recognize the importance of maintaining a balance between asset growth and strategy execution. By monitoring and managing portfolio turnover, they aim to minimize the impact on the market and ensure that their strategies remain effective and efficient. Despite their growth, Dimensional does not anticipate capacity issues and believes they have sufficient control over how they implement their strategies.
Securities lending and value add
Dimensional recognizes the value in securities lending as an additional source of revenue and an opportunity to improve the investor experience. Through their optimized and integrated securities lending process, they can loan out stocks, receive collateral, and invest that collateral in money market funds. This process allows them to generate revenue from lending while effectively managing risk. They emphasize the importance of stewardship and engaging with companies to improve governance and enhance shareholder value. Dimensional believes that securities lending and responsible stewardship are key aspects of their value-add proposition.
Sector weights and diversification
Dimensional employs a thoughtful approach to sector weights in their portfolios, aiming to strike a balance between diversification and deviation from the market. They consider the market-provided diversification at the security, sector, and country levels and strive to avoid excessive bet sizes that could compromise diversification. By limiting sector weight deviations from the market by no more than 10%, they ensure that their portfolios remain diversified while still allowing for targeted exposure to specific sectors. This approach aims to enhance diversification and manage risk effectively.
You don’t need to be a rocket scientist to work at Dimensional Fund Advisors, but Gerard O’Reilly sees it as an asset, particularly when it comes to problem-solving. Now the Co-CEO and Chief Investment Officer of one of the fastest-growing US investment businesses, Gerard received a Ph.D. in aeronautics before entering fund management, attracted to Dimensional because of the opportunity it afforded him to learn from the world-leading economists at the company; including Eugene Fama, Myron Scholes, Merton Miller, Robert Merton, and Ken French. We recently sat down with Gerard to discuss the firm’s research-based culture and rules-based approach to investing. In this episode, we get into the nitty-gritty regarding Dimensional’s distinctive portfolio management decisions and the data sources they draw from and Gerard answers some technical questions regarding risk assessment, factor tilted portfolios, operating profitability, goodwill, and more. We also touch on the value of combining multiple metrics, why small-cap stocks deserve a place in your portfolio, and some of the biggest changes that Gerard has witnessed in Dimensional portfolios over the past decade, as well as how he applies his scientific learnings to make unique portfolio adjustments and some of the various benefits of Dimensional’s integrated approach. Make sure not to miss this informative, insightful, and in-depth conversation with Dimensional CIO and Co-CEO, Gerard O’Reilly!
