What Factor-Based, Active Investing Can Offer Your Clients

Passive investing has long been a popular and successful approach to investing, but sometimes opportunities are lost in seeking to track an index due to the constraints that indexing can carry. Gerard O’Reilly, co-CEO of Dimensional, appeared on a recent webcast moderated by Tom Lydon, CEO of ETF Trends, and Todd Rosenbluth, head of research for ETF Trends and ETF Database, to discuss the novel approach to factor-based investing that Dimensional offers.

Geopolitical risks and inflation remain top-of-mind for advisors in current market environment. O’Reilly explains that the ability of issuers and funds to be flexible becomes a major boon in times of inflation geopolitical risk, allowing for allocations to pivot into or away from certain exposures as needed.

Markets are currently baking in the expectation of higher-than-average inflation over the coming 12 months, and high inflation close to the 3% mark beyond that.

“The market is anticipating high inflation, and our viewpoint is that it may be higher or lower than expected by the market,” O’Reilly says. “There’s two things you can do: try to outpace it or hedge it, and there’s many good strategies that will allow you to do both.”

Valuations have been high for growth stocks, and O’Reilly explains that advisors should probably anticipate lower expected returns on growth stocks going forward, and value stocks could possibly be similar. Even by knowing this, O’Reilly says that it doesn’t really change most asset allocations or contribute to any kind of timing strategies.

Value premiums had a strong year last year, and could continue that type of performance this year as well.

“What I think that you’ll find as you look back historically is that you’ve had strong value premiums in times when spreads between value and growth stocks have been wide and in times when spread have been narrow, but you have had some extremely strong value premiums when those spreads have collapsed and in the periods when those spreads have narrowed greatly,” O’Reilly explains.

The Dimensional International Core Equity 2 ETF (DFIC), the Dimensional US Small Cap Value ETF (DFSV), and the Dimensional Inflation-Protected Securities ETF (DFIP) are all funds that were launched somewhat recently as ETFs but are sister funds to long-established mutual fund strategies. Dimensional was one of the first issuers to convert mutual fund strategies into the ETF wrapper in 2020.

The Dimensional Approach

“The ETF Rule almost felt like it was tailor-written for us, the 2019 rule where you could bring a broadly diversified, transparent but active strategy to the table that can add a lot of value above and beyond indexing for investors,” O’Reilly says. “I think there’s a definite appetite amongst financial professionals for those types of strategies right now.”

Dimensional uses a systematic approach to investing that is broadly diversified and sets clear expectations via the benefits of active management while pulling some of the best benefits of passive investing. It’s an approach that has allowed them to outperform passive strategies.

In 2021, DFSV outperformed both the Russell 1000 Index and the Russell 2000; in the case of the Russell 2000, it outperformed by 15 basis points, O’Reilly explains.

“Why? Because of the way we define the asset category and because we keep ourselves focused on that asset category day in, day out,” O’Reilly says.

Dimensional also utilizes securities lending to generated returns for their funds, taking advantage of the fees gathered while also gaining insight into prices from short-sellers and the like, which allows Dimensional the opportunity to respond before the price information gets worked into the broader markets.

“What’s clearly happening with Dimensional, they’re viewing this as an alpha opportunity, a way to generate returns and distance themselves from their peers, and advisors are clearly benefiting from it,” Rosenbluth says. “This is notable, this is double in every case, in some cases triple or quadruple what some of the peers are doing.”

O’Reilly also explained the tax efficiency of Dimensional’s funds, how the firm defines core allocations, and their focus looking ahead.

Financial advisors who are interested in learning more about factor-based investing can watch the webcast here on demand.