Dimensional's ETFs, Private Equity, and Prescribed Rate Loans (EP.105)

Episode Summary

Executive Summary: The episode covers three main areas: Dimensional Fund Advisors’ move into ETFs and what it means for access and implementation; a deep dive into private equity showing it largely resembles leveraged small-cap value with high fees and no clear illiquidity premium today; and Canadian tax planning with spousal loans, including attribution rules, prescribed rates, and debt-forgiveness pitfalls. The hosts also flag a misleading Fidelity chart correction and mock a new longevity-themed fund as another marketing-driven product launch.

Main Topics: Dimensional’s entry into ETFs: The hosts discuss DFA’s SEC filing for three actively managed ETFs and interpret it as a response to client demand, ETF market growth, and the newer custom basket rule that makes DFA’s implementation more feasible. They stress that details like fees, structure, and Canadian availability remain unknown. Private equity as an asset class: A long segment argues that private equity buyouts are not a magical return source but mostly repackaged leveraged small-cap value exposure, with high fees and no strong current illiquidity premium. The hosts cite academic work showing expected returns have deteriorated and that valuation matters more than the old narrative suggests. Why investors like private equity anyway: The discussion highlights return smoothing, not just higher expected returns, as a major draw. Because private equity is not marked to market daily, it can look less volatile than it really is, which may attract institutions and obscure risk. Spousal loans and prescribed-rate planning: The hosts explain how prescribed-rate loans can shift income and gains to a lower-income spouse while avoiding attribution rules. They emphasize the importance of paying interest on time, handling unrealized gains/losses carefully, and avoiding debt-forgiveness issues. Misleading investor chart correction: They correct a widely shared Fidelity chart that overstated how many older investors sold equities during the downturn, showing how a minor subset actually made portfolio changes and only a portion reduced stock exposure. Bad investment product of the week: longevity fund: The hosts criticize CI’s Global Longevity Economy Fund as another thematic product that packages a broad social trend into a marketable fund, echoing past fad-driven launches rather than offering a compelling investment case.

Key Arguments: DFA’s ETF move is likely driven by advisor/client demand and implementation flexibility, not panic or a reactionary response to Avantis. The new custom basket ETF rule may be a real enabler for firms like DFA to implement their strategies more efficiently in ETF wrappers. Private equity’s historical appeal was stronger when public/private valuation gaps were wider; today that advantage appears much smaller or gone. Private equity returns can largely be replicated with leveraged public small-cap value portfolios, making the high fee structure hard to justify. A major reason private equity attracts capital is that smoothed, less visibly volatile returns are psychologically and institutionally appealing. The apparent low volatility of private equity is partly an accounting artifact because the asset class is not marked to market daily. Institutional flows into alternatives rose sharply after the financial crisis as pensions faced lower discount rates and funding pressure, pushing them toward higher expected return assets. Spousal loans remain a powerful tax-planning tool when interest is properly paid and attribution rules are respected, but the implementation is fiddly and can create problems if not documented carefully. The recent Fidelity chart that went viral was materially misleading; the corrected numbers show a much smaller proportion of investors actually moved money out of stocks. The longevity-themed fund is presented as a familiar example of marketing a narrative rather than proving an investment edge.

Data Points: Dimensional ETFs to be launched: 3 - Three actively managed ETFs filed with the SEC: U.S., non-U.S. developed, and emerging markets Dimensional fee reduction in Canada: 1 to 5 basis points - Management fees reduced on 16 Canadian funds Typical fee cut on older F-class portfolio: 30 bps to 26 bps - Example of fee reduction on a model portfolio Fee reduction size: 13% - Reduction from 30 bps to 26 bps on the example portfolio Private equity new assets in 2019: $301 billion - PitchBook data cited for record annual inflows Previous record private equity inflows: $267 billion - Prior high in 2007 Shift to alternatives by pensions: $1.8 trillion - Harvard paper estimate of allocations shifting to alternatives from 2008 to 2017 Alternatives share of AUM in 2017: About 20% - Private equity and real estate allocations among large pension systems Private equity estimated equity beta: 1.2 to 1.5 - AQR estimate after unsmoothing returns Naive private equity beta: Less than 1 - Raw regression on smoothed private equity returns Private equity fee estimate: 5.7% annually - AQR estimate including management fee, carry, hurdle, and other fees AQR expected return for private equity: 3.9% after fees - Net expected return estimate for U.S. buyouts AQR expected return for public equities: 3.1% - Comparison benchmark in the same framework Private equity management fee assumptions: 2% management fee + 20% carry - Fee inputs used in expected return modeling Fidelity investors age 65+ who made portfolio changes: 7.4% - Corrected statistic from the Wall Street Journal correction Among 65+ investors who changed portfolios, moved money out of stocks: Nearly one-third - Corrected interpretation of the downturn response All ages who made a portfolio change: 6.9% - Corrected statistic across all Fidelity investors Among all ages who changed portfolios, moved money out of stocks: 18% - Corrected subset of those who changed portfolios Current prescribed rate loan interest: 2% - Current quarter for spousal loans at time of recording Next quarter prescribed rate: 1% - Rate falling at the time the episode airs Interest payment deadline: January 30 - Interest on the loan must be paid by January 30 of the following year Example portfolio income yield: 2.6% - Used to show why a spousal loan could still make sense at 2% Annual income shifted in example: 0.6% - Difference between portfolio yield and 2% prescribed rate in the example

Pivotal Quotes: "We see them as a great complement to our mutual funds." — Jar O’Reilly (quoted by Cameron/Benjamin): DFA CEO comment about launching active ETFs "This paper went through three different approaches to estimating expected returns for private equity." — Benjamin Felix: Transition into the detailed private equity framework and expected return analysis "If you can achieve a similar result with a more diversified, lower-cost portfolio just by owning small-cap value equities, why would we allocate to private equity?" — Benjamin Felix: Core conclusion on why private equity does not belong in standard portfolios

Implications: Investors should be skeptical of headline narratives: ETF wrappers change access, not necessarily economics; private equity’s current case is weak versus public-market alternatives; and tax strategies like spousal loans can be valuable but require careful execution and professional advice.