A deep appreciation for markets and scientific research are the foundations of Dimensional Fund Advisors’s success.
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When David Booth, ’71, was working for investment firm A.G. Becker, he noticed that his clients didn’t have any exposure to small company stocks. Sensing an opportunity to offer investors a new type of product, Booth decided to quit his job, rip out the sauna in his Brooklyn apartment to make way for a noisy Quotron terminal, and start his own investment management company in 1981. He called his former professor Eugene Fama to discuss his idea of creating a “small cap” index fund.
“It was just in time,” Fama says. He told Booth that Rolf Banz, PhD ’78, had recently finished a dissertation about how the investment returns of small company stocks could not be explained by the standard asset pricing paradigms at that time. Banz had discovered that stocks of smaller firms had higher risk-adjusted returns than the stocks of larger firms. Although Booth came up with the idea of a small cap fund even before he found out about Banz’s thesis, he understood the value of having sound academic research to back it up. In fact, it is this desire and the talent to bring together the theoretical and practical worlds of finance that truly sets Booth’s company, Dimensional Fund Advisors, apart from other investment firms.
Banz went on to work for Dimensional, and Fama came on as a consultant. Throughout the decades, Dimensional has not only chosen to keep tabs on the latest research but also to work closely with the scholars behind it—including some of the greatest minds in finance. Widely recognized as the efficient markets guru, Fama is one of Dimensional’s foremost advisors. Many of Dimensional’s equity products were created based on his groundbreaking work with Dartmouth College professor Kenneth French, a former Chicago Booth faculty member. Nobel Prize winner and GSB professor Merton Miller was on the firm’s mutual fund board until he died in 2000. Fellow Nobel laureate and retired Stanford University professor Myron Scholes, MBA ’69, PhD ’70, currently sits on that Chicago-dominated board, and so do GSB professors George Constantinides, Jack Gould, and Abbie Smith.
Booth’s deep connection with Chicago Booth and the school’s strong influence on Dimensional’s investment philosophy is unmistakable. A staunch believer in the power of free markets, Miller once said in an interview for the book Investment Gurus that “markets are amazingly successful devices for incorporating information into stock prices.” He argued that “information is not some big thing that’s locked in a safe somewhere” and that “it exists in bits and pieces scattered all over the world.” In fact, it was Miller who advised Fama, his first PhD student at the GSB, to pursue the development and testing of the efficient markets theory—a proposition that securities prices fully reflect the information in the marketplace.
Booth “took away the Chicago thinking about investments,” says Fama. Booth and his long-time partner and co-pioneer at Dimensional, Rex Sinquefield, ’72, now retired, were students of Fama and Miller at the GSB. “Both of them took my course. They took Miller’s course,” Fama says. “So, they got the full treatment.”
If markets are truly efficient such that information about a company or the economy that could affect securities prices are diffused in the hands of many and not just a few, then no one would be able to consistently pick winners and beat the market. Booth and Sinquefield took these lessons very seriously—and built a successful firm around it.
Markets Know Best
Fama is well known for organizing the knowledge on efficient capital markets and for making it more precise. Along with Fama, researchers inside and outside of Chicago were doing similar work to contribute to the understanding of this concept, whether it was to show that stock price changes are unpredictable based on past prices, that prices quickly adjust to public announcements of earnings or stock splits, or that the average professional money manager cannot systematically outperform the market. It is thus fair to say that the idea that markets are efficient was a prevailing view in the academic community in the 1960s. However, the same could not be said for an investment community that relished the idea of “adding value” by picking stock winners and losers.
If markets were not efficient, money managers would find it worthwhile to painstakingly gather and analyze information so they could choose stocks that they think will generate superior returns in the hopes that no one else spots that the stock isn’t correctly priced. Moreover, if it is truly skill rather than luck that drives the performance of such “active managers,” then they should be able to choose the right stocks year after year.
But many studies have shown that the returns made by active managers are not very different from the returns on simply holding the market portfolio. The problem is that they have to be paid for their effort. “Active managers charge high fees, but there’s no evidence that they provide returns commensurate with the fees,” explains Fama. “In fact, there is evidence that they don’t.” Booth likes to compare the situation to a roomful of orangutans picking stocks by throwing darts at the Wall Street Journal. The orangutans always look better than active managers after expenses since they only work for bananas. The underlying message is that although there may be a few lucky ones out there, most active managers are probably wasting their time and, more important, their client’s money. Investors might as well just buy a share of the market.
“If you step back and try to figure out how this company has been so successful, there’s been a lot of intelligence and thoughtfulness and energy from people like David.”
This idea was revolutionary in the 1960s because passive as opposed to active investing did not exist until the first index funds were introduced in the early 1970s. Index funds aim to track the performance of the market by buying all of the stocks in an index rather than selecting a few. Both Booth and Sinquefield saw the birth of the first index funds into the financial world. Booth was at Wells Fargo in San Francisco while Sinquefield managed to convince American National Bank in Chicago to introduce one of the first Standard & Poor’s 500 index funds in 1973.
When Booth and Sinquefield joined forces to found Dimensional, it was clear to them that a healthy regard for markets and what that means for investors would form the company’s core investment philosophy—one that avoids active management of the classical sort and provides investors with a simple way to cover the kind of risk exposures they want at a low cost.
By not trying to pick winners or losers, Dimensional allows its clients to hold thousands of stocks in a diversified portfolio that balances out individual companies’ risks. There’s still an overall risk involved that can’t be avoided, but a well-functioning market assures investors that they will be compensated for that risk. Riskier assets will naturally command a higher expected return. Similarly, an investor can expect to get a bigger payout only by accepting a higher level of risk.
That risk and return are related is the story that Dimensional has been telling its clients ever since it introduced its first product—a small cap index fund that invested in stocks of the smallest 20 percent of companies on the New York Stock Exchange. Banz’s dissertation had shown that stocks of small firms tend to perform well. But the trouble was that the fund’s first nine years were actually the worst for small company stocks—bad news for a firm that was just starting out. But Dimensional stuck to its story: small cap stocks offer higher expected returns in normal times, but there is a greater risk that they will do badly in bad times. Dimensional stayed the course and its belief in the markets paid off. Today, the company’s assets under management have grown to about $120 billion in just over 27 years.
Taking Risk and Reaping the Reward
Banz’s research as well as the work of an entire generation of financial economists have benefited tremendously from a massive historical data gathering project known as the Center for Research in Security Prices (CRSP), which was established at the GSB in 1960. Before that time, nobody could even say what the average rate of return was from investing in the stock market. Initially funded by Merrill Lynch, CRSP made it possible for researchers to work with quality data to test a model’s predictions and understand the way the stock market works. This, in turn, has helped Dimensional because it relies so much on scientific research for developing new products
One body of research that has benefited from the CRSP database is a series of empirical papers that challenged the predictions of the Capital Asset Pricing Model (CAPM). Risks that are unique to each stock can be diversified away when combined in a portfolio that contains all stocks in the market. The risk that is left over in the market portfolio after diversification is the risk that is common to all stocks and that is the only risk that is rewarded. Therefore, the CAPM says that the expected return of an individual stock must depend on its relation to the risk of the market portfolio. This relation is measured by a stock’s “beta.”
The CAPM predicts that if one looks across stocks, the difference in betas should be the only reason that expected returns differ. However, a very influential 1992 paper by Fama and French that brings together earlier papers that test the CAPM finds that beta actually does a poor job of explaining average returns. And of all the likely candidates that have come up in the literature, company size and book-to-market value seem to provide a good characterization of returns. In particular, small companies and firms whose stocks trade at a low price despite having substantial assets on their books (a high book-to-market value) show higher returns.
If stocks are always correctly priced, then investors must think that such companies are riskier compared to large companies and firms with a low book-to-market value. Small companies and firms that the market judges to have poor prospects have to offer investors a higher return to convince them to buy their stocks. This suggests that size and the financial health of a company are true “risk factors” that cannot be diversified away.
That has implications for how investors decide to allocate their portfolios. Investors now understand that they have the option of tilting their investments to get more exposure to small cap stocks and to so-called “value” stocks. But that depends entirely on their appetite for risk. “You’re basically giving a little more complicated risk story,” says Fama. “But that doesn’t imply that everybody will tilt in the direction of higher returns, because the higher returns are at the expense of higher risk.”
Dimensional comes in by offering its clients products to capture these dimensions of risk and return. Dimensional already had a small cap strategy in place when Fama and French told Booth and Sinquefield about their results, but the Dimensional heads were very eager to turn the new finding on value stocks into a product. The company immediately introduced a U.S. small cap value fund in 1993. And based on Fama and French’s later analysis of international stocks, international value funds made their debut just a year later.
The Dimensional Difference
Because Dimensional believes that markets work well, it avoids the complex and expensive business of analyzing every firm and timing the market. Once that’s stripped away, what’s left is a very coherent and orderly way of investing that gives Dimensional the freedom to innovate and create much value for its clients. “If you step back and try to figure out how this company has been so successful, there’s been a lot of intelligence and thoughtfulness and energy from people like David,” says Gould. “He brings a great deal of talent to it, which is seeing a way to carry the [research] ideas into a viable commercial product in the marketplace.”
Putting together a small cap fund, for instance, can be tricky because buying stocks of a very small company could move up its price substantially. Dimensional realized early on that one way to get around this is to let the seller come to them. Over time, Dimensional has come to be known as the largest buyer of small company stocks, so they often get calls from brokers with large amounts of shares to sell. Because it provides liquidity to the market, Dimensional can negotiate an attractive discount to get this stock off the seller’s hands.
Dimensional’s small cap value fund, for instance, has outperformed the Russell 2000 Value Index, a recognized benchmark, by an average of one and a half percentage points per year since the fund’s inception in 1993.
Even if a broker offers a Dimensional trader more than what he needs, the trader may decide that it’s worthwhile to overweight one stock and underweight another in order to get a good overall price. This is the sort of flexible yet methodical thinking that goes into each trade. Dimensional makes sure that its funds are broadly diversified but it doesn’t slavishly track the performance of an index because it understands that precisely matching an index would come at the cost of forgoing discounts or paying premiums.
The savings are passed on to its clients in the form of higher returns. Dimensional’s small cap value fund, for instance, has outperformed the Russell 2000 Value Index, a recognized benchmark, by an average of one and a half percentage points per year since the fund’s inception in 1993. “One of the things that emerged over time is that they got better and better at getting returns, even if they are a passive fund,” Gould says.
Dimensional has proven that research carried out in the academic world—combined with the ability to implement ideas—can produce significant value in business. Research will no doubt continue to stimulate Dimensional and the firm will always be surrounded by the best scholars in finance. Booth likes to say that it is a luxury to be able to accomplish all that his firm has without him having to be the smartest guy in the room.
He also argues that it would be hard to find anybody that benefited more from the GSB faculty than he has. But Gould thinks that the University of Chicago has gained just as much, if not more. “I think from the point of view of the University of Chicago, it’s great to have alumni who can point specifically to how useful Chicago was to them,” Gould says. “It’s good to have an enthusiastic spokesperson on behalf of the University of Chicago, and David is certainly that.”