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When Value Outperforms, It Comes in Bunches, Says DFA Co-CEO

Gerard O'Reilly on why he’s keeping the faith in cheap stocks and why the firm is launching ETFs now.

Value stocks have taken their lumps in recent years, badly lagging those of faster-growing, pricier firms.

In a recent conversation on The Long View podcast, we asked Dimensional Fund Advisors co-CEO Gerard O’Reilly what to make of value’s slump. Building on a piece that DFA recently published, O’Reilly offered his perspective on how often value lags and why, despite that, it tends to pay off over the long haul.

We also discussed DFA’s recent entry into the exchange-traded fund business. DFA is a bit of a latecomer to launching ETFs, which it did for the first time in late 2020. But given DFA's scale and know-how in passive investing, O’Reilly jokingly likens the firm's ETF debut to Brad Pitt arriving fashionably late to an Oscars afterparty

The complete podcast recording and transcript also cover a number of other topics, including DFA's relationship with financial advisors, the sources of security returns, how the firm balances innovation and centered-ness, the biggest investment debate raging at the firm, and more.  

Christine Benz: In research pieces, you've found that it's not unusual for value to underperform growth for prolonged stretches. But the current slump has been unusual in both its length and its magnitude. Why? And what are the implications?

Gerard O'Reilly: The current slump, when you look at it, I often break the past 10 years into the first seven and the next three is often how I view it. Because the first seven, you had quite a few years where value outperformed growth. But end to end, in the first seven, there was a modestly negative value premium. When you look at the returns of U.S. value stocks, they outpaced their long run average. But growth stocks outpaced their long run average by even more, right? So, growth stocks up until that point had an average return in the U.S. of about 8%, 9%. They did about 16% year over the first seven. Value had an average long-pull return of about 12%, and they did about 14% in the first seven in the U.S., I'm talking about now. So, that's an outcome that's not expected but unprecedented. You have about a negative 2% value premium probably in about 10% of rolling seven-year periods. It's not so uncommon. But the last three years is probably, again, unexpected. But also, we said--I would say, no large return differences in terms of value versus growth. And so, that helps folks understand that it is very much a short time period phenomenon.

What we've been through over the past three years, in particular, this 2020, and we don't know what 2021 will bring, is a very short run phenomenon. And that helps them put it in context about is there some type of fundamental shift? Or is this some large unexpected series of events that have led to this outcome? And I think that is more of the latter. And so, that's certainly something that we focus on when explaining that time period to our clients.

On the bright side, when you look at the long-pull research, you're right, you can go through these time periods where value underperforms, but the averages are positive. And when you look at when value premiums are positive, you don't know when they will be, but when they are, they tend to be much bigger than the long-pull average. So, in the years when value has been positive, it's been two or three times the average. So, value on average has outperformed growth by 3% to 4%. In years when it's positive, it outperforms by almost 14%, right? And we've seen that in the last quarter, and the first week of 2021, where we've had very, very strong value premiums all around the world. And I think that time periods like that are just a constant reminder that when you're investing, keep your eye on the long pull, know that there's going to be ups and downs and keep yourself focused on the premiums that you're after, because you don't know when they're going to show up.

Benz: Dimensional recently entered the ETF market by launching three ETFs with more to come in 2021. You're kind of late to the party. Can you talk about some of the misgivings you previously had about launching ETFs and how you overcame those from an investing and a business standpoint?

O'Reilly: I don't know if you guys saw, there was an article yesterday on the Business Insider, and there the president of The ETF Store, Nate Geraci, was quoted. And I'm going to quote this because I found it so funny. “DFA arriving late is like Brad Pitt walking through the door of an Oscars afterparty at 1 am. Both are immediately the center of attention. It doesn't matter that the party is already in full swing with people dancing on the tables.” I just found it so funny. We had a good laugh at it yesterday between Dave Butler, myself and Catherine Newell, our general counsel. We were trying to decide who would be Brad Pitt, who would be George Clooney and all that sort of fun stuff.

But kind of taking it a bit more seriously, when you look at the ETF evolution over time, if you look at equity ETFs, even today, it's about 99% index. And what does Dimensional bring to the table? Well, Dimensional is systematic fundamental. And what does that mean? That means that we bring many of the benefits of indexing, low fees, transparent, well-diversified, easy to monitor, but a lot of the benefits of an active implementation, whether that's the innovative research, daily rebalancing, flexible trading, all these types of things. And so, when we look back at the history of ETFs, because of the ways that ETFs were managed, there wasn't as much flexibility in managing investment strategy inside an ETF structure over the past 10 or 20 years.

But that changed. That changed at the end of 2019. At the end of 2019, there was a new ETF rule, and that new ETF rule, kind of, paved the way for active transparent ETFs. I prefer to think of them as flexible, transparent ETFs. And that rule was kind of an important impetus into us deciding to launch ETFs, because we could bring what we've done in separate accounts, what we've done in mutual funds, what we've done in trusts and so on, to the ETF landscape. We don't mind that it's transparent, because we're well-diversified. We minimize unnecessary turnover. So, having transparency of holdings is not really a big deal.

So, I would say that--I would kind of turn it around a little bit and say that we're very early to the active transparent party, because that is somewhat in its nascency when you look at the overall ETF landscape. And it's been, kind of, a good launch so far. We launched three ETFs, as you mentioned, in November, December, you know, healthy volumes, healthy spreads. They're at about $500 million AUM over the first two months. So, they've done well. And then, we plan to convert six tax-managed funds over the course of 2021, and they're about $26 billion, give or take. So, I would say that it's, kind of, new, innovative investment strategies coming to the ETF space, and hopefully will be well appreciated by investors.