ETF Edge - The First Mutual Fund-to-ETF Conversion

Episode Date: June 14, 2021

CNBC's Bob Pisani spoke with Gerard O’Reilly, co-CEO of Dimensional Fund Advisors – along with Dave Nadig, Director of Research at ETF Trends. They discussed what’s fueling the rapid rise of ETFs … Dimensional Funds just converted four of their mutual funds into ETFs over the weekend in the industry’s largest conversion ever. In the ‘Markets 102’ portion of the podcast, Bob continues the conversation with Gerard O’Reilly from Dimensional. Hosted by Simplecast, an AdsWizz company. See https://pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ, Supporting the Innovators Changing the World, Invesco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds, you are in the right place. Every week we bring you interviews, market analysis, and we break down what it all means for investors. I'm your host, Bob Pisani. Today on the show, we'll drill down on what's fueling the rapid rise of ETF's dimensional funds just converted four of their mutual. funds into ETFs over the weekend in the industry's largest conversion ever from mutual funds to ETFs. We'll talk to the man in charge. Here's my conversation with Gerard O'Reilly. He's the co-CEO.ROW of Dimensional Fund Advisors, along with Dave Notick, Director of Research at ETF trends.

Gerard, you're the master behind that. You're talking about nearly $30 billion in mutual funds, four of your mutual funds converting into ETFs. Just briefly explain the rationale behind doing this, this is the biggest one that's happened to date, and potentially you're going to be a leader doing this. Yeah, thanks, Bob. It certainly was a big weekend for us. We're very excited about the conversion over the weekend. When you look at these four mutual funds, Bob, they have a long and strong track record. They go back almost 20 years, some of the mutual funds that we converted. And they were all managed with an eye towards tax management. So they have tax management in the name, and tax efficiency is part of their objectives. And so what that means is that the investors in these strategies, you know, think about after-tax returns, thinks about

tax efficiency. And so while they've done a very good job in terms of maintaining high tax-efficiency ratios, in fact, similar to many of ETFs out there, this ETF wrapper gives us an additional tool to help achieve the investment objectives and increase the tax-efficiency ratios of these strategies. So that was a big driver behind why to convert these mutual funds to ETFs, Bob. You know, Dave, Gerard, likes to say he's rapper neutral. In other words, he manages money. And if it's in an ETF, fine,

a mutual fund, fine, whatever. But we're interested in the ETF business covering that. And Citigroup had a great report out last week saying dimensional conversion of the mutual funds into ETS. We provide some kind of benchmark for having this happen in the future. I'm wondering what your thoughts here. Will it push a lot more of the mutual fund industry? it's 21 trillion, something like that, into the ETF? Is this going to be another accelerant? I think it has to be, right? I mean, first of all, congratulations, right? I mean, I think it's a monumental day to see this large a conversion, but I think we have to recognize this is a fairly narrow product set. These aren't funds that are in 401ks. That would make it much more difficult. They're not

actively managed funds that really rely on non-transparency. That's a whole other discussion. So there's a bit of a Venn diagram overlap where I think these funds are in a real sweet spot for conversion. There are also funds that now investors can get access to. I mean, historically, it's been a little tough to get access to some dimensional funds unless you had a dimensional approved advisor who could help you do that. Now, anybody can get access to these what are great strategies, you know, very, very tightly managed strategies, great trading under the hood. So I think it's a great sign, but I'm a little skeptical that somehow a trillion dollars is going to follow suit. We know that a lot of active managers like to

keep their trading private, their different structures for that. And a lot of the mutual fund industry is very focused on the 401k industry, and that makes conversions really difficult. Yeah, but what about that, Gerard? I mean, you've been very successful. I look at the money flowing into some of these that are already out there that you've had. The three so you've already had out there that are an ETF space. You've attracted a lot of money. That's very attractive to get people out there who might not have been in your mutual funds before or qualified or had a platform, as Dave mentions, to go in there. The ETF wrapper, besides the tax advantages, does have that advantage. You can bring in a lot more people, potentially.

Yeah, Dave hit on a couple of great points. And one of those points is that when you look at that Venn diagram that he mentions, where these funds are managed with an eye towards tax management, when you think about dimensional's approach to investing, it has a lot of benefits. of indexing, you know, it's low cost, you have broad diversification, low turnover, but then a lot of the benefits of an active implementation, whether there's the trading under the hood, consistent focus on the asset category. So a lot of those things put us in a real sweet spot, and these funds in particular in a real sweet spot,

to have this conversion kind of go through successfully and make a lot of sense for the shareholders in the strategies. I do think that when you look at the ETF landscape out there, you know, it's 99% is a lot of it. index approaches on the equity side. And what this brings and offers investors is a systematically managed strategy that you can observe its live track record for some of them over 20 years in all types of market environments. And I think that's somewhat unique to the industry.

So we're very excited about being able to offer this and in that kind of, you know, tax-efficient wrapper, which will, I think, benefit the investors in those funds. And in particular, because, you know, there's a lot of talk and concern about what might happen to tax rates going forward. So for those folks that are kind of thinking about that, tax management can be important. I want to drag, Gerard, you into the whole value versus growth debate and small cap versus big cap. Dave, I want your thoughts on this as well. But, you know, dimensional has always been associated with low cost, but value investing in general. And I wonder if you could comment on what's been going on this year.

What we've seen is for the first time in a long time for many years, six, seven years, value has outperformed growth. Small caps have outperformed big caps and large cap, or excuse me, small cap value has outperformed everything. This hasn't happened in a long time. Growth is generally outperforming, rather notably. Why is this happening? Do you think it's going to continue? Obviously, I'm sure you're happy about that, but just comment on what we've been seeing this year. Yeah, a couple of high-level comments come to mind.

Bob, first off, when you think about small and value, there's a reason those stocks have lower prices and investors demand higher returns in terms of holding them. So every day when we come in to the office, we expect a positive small and value premium. And we've certainly seen that in spades over the course of the year. Even if you go back 12 months, Bob, and you look at Fama French large growth versus small value, kind of a very pure, I guess I call a definition of large growth and small value. The return differential is almost 60 percentage points, so a really big return difference. And something we expect a positive premium, but not always that large. The other thing I'd put out there that I think is important is that when you look at the volatility that we've had over the past few years, it highlights the importance of the financial

professional and helping keeping you disciplined and a money manager who stays focused on the asset category. Those two in combination make a powerful combination for the end investor. We're fully committed to the financial professional, and we think that the new, you know, the ETF conversion will give them more tools to help manage for their clients. And we stay focused on those asset categories so that when those big returns show up, we're there to capture them. And I think that that's something that we've seen year-to-date and over the past 12 months. Dave, weigh in on this. I just put up a board of growth versus value in the last six years, and it's a notable outperformance by growth.

Why are investors paying so much money for growth in the last few years over value? This year we're seeing a little bit of a mean reversion, as Gerard mentions. But your read on what an investor is supposed to take away from the last five or six years of growth outperformance? Yeah, I think a lot of it has been flow-driven, right, Bob? I mean, we've seen the flows that have come into cap-weighted traditional ETS. That has a quality of making the large-cap market look very momentum-y. We already know that a lot of the growth companies have historically been at the top of the cap spectrum, really since the dot-com era. So there's a bit of a winner-take-all scenario here. Interestingly, that's flip that we've seen where some of the small-cap or mid-cap value plays have started to catch investor attention means a lot of those individual stocks are now showing up in momentum ETFs and funds.

That's going to really change the dynamics here. I don't think we talk about value momentum all that often. But if you look at some of the bigger traditional momentum funds, that's what you're seeing. So I think we are in a bit of a rotation. A lot of it is it's because there's a no alternative market, right? Investors and advisors are really sticking to the equity markets. They don't want to move into bonds. That means they're looking a little bit away from some of these large cap go go go growth companies like the Teslas and Amazon's of the world down the cap spectrum into mid and small caps, into a little bit more traditionally valued companies, even a little like for dividends. So I think that's a bit of a risk off rotation while staying in equity, which is a bit of an oxymoron, right? We don't talk about small cap being a

risk-off rotation, but I think that's some of what we're seeing. Yeah, Gerard, we are seeing the rather bizarre spectacle. I think we talked about this on the phone last week, about GameStop and AMC are in the Russell 2000 value index. And of course, they've completely blown up in the last year. I don't know, they're certainly not value stocks. They won't be anymore, but you do have that rather strange situation. I just want to go back to this growth thing because this is the thing the investors really keep hitting me on and asking me about how much longer is growth going to outperform. But why is the question? And a lot of comments I get around the Federal Reserve that there really is a Fed put, that growth is hard to come by.

The Fed has made it very easy, essentially, to own riskier assets because there is a Fed put because they're out there buying constantly. Is that, isn't that a factor? I know you can't say, oh, we're up, you know, 200 percent since. 2009 because, you know, half of it's because of the Federal Reserve. You can't quantify it, but isn't there something to be said about the Fed helping out the whole market and particularly the growth market? You know, Bob, I think the Fed is certainly one market player and one market participant, one market participant among many.

And I think one question that's an important question for the investor is, should you expect large growth to be a 20% asset category? And, you know, if you look back over the 10 years ending last June, and you were looking at large growth in the US is about 20% returns, when its long-pulled return had been around 10%. So I think that the takeaway that I would take from that is that some of those returns were largely unexpected. And that's important to keep in mind, because when you're investing, you're investing based on expectation.

And if something is unexpected, it doesn't mean that the expected return of growth stocks going forward is 20%. It means they got unexpectedly looking or unexpectedly good windfall, which may be because of the Fed or maybe because of other reasons. So I think that's really an important takeaway, Bob, when you look at the past data, do you think large growth is a 20% asset category? Most people would say probably no. When you look at small value, does it return to its long-run average returns,

which are more in the 14-15% asset category? I think most people would say, yeah, that's plausible, given the types of stocks that you have in small value portfolios. Yeah, Dave, you're more willing to sort of stick your neck out on these things. is it fair to say that the growth has been helped by the Federal Reserve? I keep pounding on this, but it's the thing investors keep asking me. And what happens if the Fed withdraws that liquidity? Does that mean that growth no longer will outperform?

Yeah, I think, I mean, it's a combo platter, right? Yes, we have the sort of the Fed put, if you will. But at the same time, we have a bond market that's really unattractive. And I think we have to look at that. And with that unattractive bond market, that means people are making blanket allocations to equities. When they do that, they tend to use cap-weighted, large-cap indexes. is very cheap beta. What that has a tendency to do is really reinforce this winner-take-all market, and it pushes those large-cap growth companies even higher. And I don't really see a way

that that unwinds unless we start getting a lot of really thoughtful reallocation. And honestly, we haven't seen that kind of thoughtful reallocation, right? So there is this bit of this endless bid in the market that I think is hard to get away from. Yeah. Dr. Rowe, let me just change things a little You are very big on managing accounts for tax efficiency, which makes a lot of sense. It always amazes me how many people try to get four basis points out of changing ETFs and don't care about the tax situation that they're encountering. And that always amazes me. And I laud you for being concerned about that.

I wonder if you can get your take on the Biden administration's plan to hike capital gains, corporate taxes, and personal income taxes. I know you're not a handicapper for politics, but what are you telling your clients now about that prospect? I think there's two big things that are important when you consider what future tax code may look like. One is what will the market's response be. And if the market perceives that something will lower future cash flows to investors or increase discount rates, that will have an impact on prices. And whatever the market already expects is already in the price.

So the price is forward looking, don't worry about it, move on. The second is control what you can control. And when it comes to taxes, you've got to look at whatever the tax code is at that point in time, and then make sure you have the flexibility to be able to maximize after tax returns. And that happens both inside the fund or the ETF for a separately managed account and also at the end client level. So there's a lot that you can do to help maximize your after tax returns, whether it's how you dividends, whether it's how you rebalance, as you mentioned, Bob, you know, you sell from one fund into another and realize a large capital gain or the types of distributions that you get from funds. So control what you can control, and I think a flexible approach allows you to adapt to changing tax code over time to make sure that whatever the tax code is, you make the most of it as an investor.

Yeah, Dave, I get that this is not going to necessarily create an avalanche of conversions from mutual funds into ETFs, but I'm wondering about your take on the 401K system. I've been waiting for 10 years for even small cracks to occur and make it a little easier to own ETFs in the 401K situation. Where are we on that? Just give us a brief update. Yeah, so there are a few record keepers, some small, some large, that do have ETFs. in 401K plans. Generally, you kind of have to decide that when you're setting the 401K plan up. So that doesn't help most of us who are already working for a company that already has a 401k plan in place. 401K plans don't change record keepers very often. It's a huge pain in the neck. And so because of that, we haven't seen a lot of innovation in the 401k recordkeeping space.

Plus, let's be honest, right? The mutual fund industry is in the 401k industry partially because they can fund recordkeeping through 12b1 fees. And that's something. that most ETFs just don't have to offer. So to put a, you know, 10, 20 basis point ETF in a 401k means somewhere in the system you've got to pay for that recordkeeping and education and statements and all that jazz that goes along with running an ERISA approved retirement plan. So what we really need is a restructure of how corporations think about funding these plans, how they think about managing these plans. And honestly, we just haven't seen it. Some cracks in the system, bulks like Schwab have done a lot of really interesting work around it. But so far,

not a ton of uptake. Yeah, that's a separate topic, Dave, and a very important topic. Low-cost funds may not necessarily be feasible the way they're currently set up, at least in the 401K plan. It's a great point, Dave. Now it's time to round out the conversation with some thoughtful analysis and perspective to help you better understand ETFs with our Markets 102 portion of the podcast. Today we'll continue the conversation with Gerard O'Reilly from dimensional funds.

Gerard, for people who don't know that much about dimensional funds, I'm wondering if you could just give us a brief overview of your investment ideology. You're associated with value investing, but tell us why you're associated with it a little bit. I think it's important for people to understand what your investing ideology or philosophy is. Absolutely, Bob. You know, the firm was founded over 40 years ago. this is their 40th anniversary and when the firm was founded it was founded with a couple of ideas in mind first that market prices contain a lot of information so we're not trying to outguess markets but we are trying to outperform them and second that there are differences in expected returns across stocks

so small cap or value and a lot of that was driven by academic research that David and had a lot of of access to. So when you think about FAMA and French, in particular FAMA, was associated with the firm from the get-go. And when you look at our overall investment offering, you know, you mentioned Bob earlier on, it's over 600 billion, almost 650. You know, that's invested in over 45 different equity markets around the world towards small cap value, high profitability, and then in fixed income, a lot of different types of fixed income strategies from short, out to long duration, high credit quality to lower credit quality. So it kind of spams the overall range, a lot of the benefits of indexing, but then an active implementation overlay on how you

keep the portfolio focused or how you trade, things of that nature. So that gives you kind of a very brief overview of the investment thesis. That was terrific. You mentioned Eugene Famos on your board. This all goes back, if I can give my 20-second synopsis to the concept of efficient market hypothesis, which held that all of the available information, for trading stocks is in the market at that moment. And the implication being that it would be difficult

for anybody to outperform the market overall if all the available information is already there. Nobody has an information advantage. And I think Professor Fama's contribution and his colleague, Kenneth French's contribution, was that that's not entirely true, that for whatever reason, there is some evidence that value stocks,

which are associated historically with cyclical stocks and small caps over long periods of time tend to outperform. I think that's the primary contribution there when we're talking about Professor Phama. Do we have any idea why that actually happens? Most people who've watched the market in the last few years see growth outperforming, but historically it's been value. Is there a particular reason why that occurs? Because I think that goes to the core of your investment philosophy. Yeah, Bob, I think it goes back to when you, you know,

you think about efficient markets, what does it really mean? It means the prices are forward-looking and they are our best guess of what the future holds, their predictions of the future. And when you think about value or small-cap, effectively it's, well, is every stock in the world the same expected return? No. Investors require higher expected returns to hold some stocks and lower to hold others. That's reflected in the prices that they're willing to pay and they're forecasted cash flows. So when you look at size, value, profitability, effectively what is trying to systematically identify are those stocks where investors have demanded a higher expected return to hold.

So the two are not in opposition at all. You can have value premiums, profitability premiums, small-cap premiums, and markets can be very, very efficient. It just says there's differences in expected returns. It's a discount rate effect. And here's a way to systematically identify which stocks have higher expected returns. Why? That's an open question, Bob. Nobody has a good answer to that question.

but there's probably an aspect of taste and preference, risk. There's all sorts of theories that have been proposed there. But risk is probably a big driver of why those differences in expected returns. That's it for today. I'm Bob Bizani. Thank you for listening. And make sure you tune in next week. And in the meantime, you can tweet us your questions or topic ideas at ETF Edge, CNBC.

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