Gerard O’Reilly, co-CEO of US quant shop Dimensional Fund Advisors, is not your typical investment firm boss. And that is not because of his youth or lack of experience in major bank-linked houses.
Rather than talk about macro trends, industry changes or geopolitical challenges, which form the standard chit-chat of most fund house CEOs, he is forensically obsessed with just two things: market prices and the needs of the group’s clients.
This strategy seems to be working. Dimensional oversees $586bn, is one of the fastest growing global asset managers and has been reported as having ambitions to join the $1tn club of fund firms.
“The first thing any new employee of ours would get exposure to is that it’s our clients’ money, not ours,” ventures Mr O’Reilly, a 42-year old aeronautical engineering graduate who joined the systematic funds firm in 2004, as vice-president of research after a friend persuaded him that a change of direction might be interesting. “Everyone wins when we sit on the same side of the table as our clients,” he ventures.
The second thing new recruits discover – and this was one of the reasons Mr O’Reilly was attracted to the company – is that the culture is “data-led and data-driven”, with the notion of securities pricing right at the core of the proposition.
“When launching a new fund, I ask: ‘What problem is this solving for our clients?’ Is it innovative? We are not interested in me-too solutions. For us, it is all about interpreting market prices,” says Mr O’Reilly, with the hint of a glint in his eye. “This forms the core of our strategy.”
Academic roots
This no-nonsense mantra, linked to research by “empirically-motivated academics”, comes as a culture shock to observers and clients used to story-telling CEOs, talking about fund management as a mixture of “art and science”.
Not so to Mr O’Reilly, intensely proud of the academic roots of DFA, co-founded in 1981 by his friend David Booth “in his spare bedroom in Brooklyn, before moving to the west coast in Santa Monica”.
Mr Booth had been completing his MBA at the University of Chicago Business School – later renamed in his honour in 2008, following a $300m donation – where he was research assistant to Eugene Fama, a pioneer of asset pricing, portfolio theory and the “efficient market hypothesis”.
The legendary economist put his pupil in touch with like-minded colleagues at Californian quant specialists Wells Fargo, the first house to launch indexed funds for institutional investors back in 1971.
But it was the lack of understanding of smaller companies which captured Mr Booth’s imagination and later that of Mr O’Reilly. “Institutional investors are not broadly diversified with systematic exposure to small cap stocks,” says the Waterford-born Irishman with almost endearing sincerity.“There is a need for this in the marketplace.”
There is clearly a huge regard for the founding fathers of “modern” portfolio theory in the halls of DFA’s headquarters in Austin, Texas, and its global network of 13 offices, including the London outpost, close to Regent’s Park. Mr O’Reilly’s conversation is regularly peppered with the names of academic royalty, all of whom he knows personally.
These include: Nobel Laureate Myron Scholes, co-inventor of the game-changing Black-Scholes option pricing model; Nobel Prize winning economist Robert Merton, who developed the SmartNest retirement planning computer software technology, bought out by DFA in 2009; and Tuck School of Business professor Kenneth French, who built the three-factor stock pricing model together with Mr Fama, to explain 90 per cent of a diversified portfolio’s returns.
The plan now is to take these strategies, famous through the institutional pensions world, and roll them out to wealth managers and financial advisers, a market which the company started to dip its toes into as long ago as the early 1990s.
“We focus on large, sophisticated asset advisers,” he says. “These are clients who know what to expect from a strategy. With us, they will encounter fewer surprises. They make better investment decisions and can become long-term partners.”
He expects to take the same sort of approach today with financial advisers and wealth managers as the firm did with pension schemes and endowments in the 1980s and has done since with central bank and sovereign wealth fund money.
“That is how our business grew over time,” says Mr O’Reilly. “We work with intermediaries, who already have good financial literacy. But we can educate them on how we believe investments work and how we can enhance returns. Our common theme is always to make sure there are fewer surprises.”
Products include US fixed income and a variety of equity strategies, including funds focusing on global, US, UK and emerging market stocks, plus a handful of alternative plays investing in commodity and real estate securities.
He admits the conversation with private banks and family offices can be an awkward one, especially for an academically-minded technician such as himself.
“It’s never easy to explain smart beta and factor investing,” says Mr O’Reilly. “But we emphasise a few things to private banks when we come in to see them. We have a lot of information on prices of publically listed securities. They are indicators of the future. Market prices are essentially our crystal ball and we try to use them to enhance market returns.”
The belief at Dimensional is that a systematic investment process is good news for investors, because it is repeatable and understandable. “We can set expectations and be monitored very well,” he claims.
“We can demonstrate that we did what we told you we would. A family office or private bank is investing on behalf of their clients. They want a robust risk monitoring process and to be able to explain to their clients if things go wrong, what happened and why.”
Once burned, twice shy
While Dimensional’s link with research from famous academics, still lauded in European and US business schools, certainly acts as great comfort and reassurance for Mr O’Reilly, he is reluctantly coming to terms with the fact that this may appear threatening or off-putting to private banks who have seen black box funds struggle or crash over the years.
Dimensional, he says, has systematically managed money for four decades, with respectable track records in equities and fixed income.
While performance has sometimes struggled – including in recent months – he has never questioned the empirical principles which constitute the firm’s systematic, fundamental approach. Acknowledging that different asset prices may have moved in tandem during tough times, such as the global financial crisis of 2008, he refuses to accept that the ‘modern portfolio theory’ about benefits of diversification and efficient market hypothesis of his academic guiding lights may somehow have been left obsolete by recent economic history.
Many investors had unrealistic expectations of how their assets performed in crisis scenarios, he suggests. “We never claimed diversification would protect you from all losses,” he says. “Who said that in times of distressed risk, assets wouldn’t move together? Modern portfolio theory never claimed that this could not happen. The financial crisis was not about idiosyncratic risk. You could have done a lot worse if your portfolio was not diversified.”
He just stops short of suggesting there is a heresy among those who claim the tenets of portfolio theory no longer apply to today’s markets. “Good quality government bonds held up pretty well during the financial crisis,” suggests Mr O’Reilly, slightly rattled that his deeply-held convictions are being questioned. “Those who claimed diversification did not exist anymore did not understand what modern portfolio theory was telling them or perhaps they were expecting too much from diversification.”
In fact he would rather double down on his academic principles, believing they work even better with changing market conditions. “Market prices do an even better job today to predict the future behaviour of stocks as there is more information available and implementation costs are lower. Just because we might see disappointing outcomes, it does not mean markets have stopped working or diversification is not useful anymore.”
Although his clients may have suffered during the financial crisis, “the returns of our strategies were not down catastrophically”, he adds. “We didn’t get caught up in the hubris of models and that our model was more important than market prices.”
Fund managers who get carried away with a belief in their own model and expertise and take their eye off the lessons the markets are teaching them are doomed to failure, he believes. “If you bet your house on the model, then you can lose your house.”
