David Booth is one of the heavyweights of the investing world. The Co-Founder and Co-CEO of Dimensional Fund Advisors, he donated $300 million in 2008 to his alma mater, the University of Chicago Graduate School of Business, which has since been renamed the Booth School of Business. David was one of the key contributors to our documentary Passive Investing: The Evidence, and we were delighted when he agreed to give us an interview on a recent visit to London.
SITV: One of the big attractions of passive investing is its sheer simplicity. Dimensional, of course, follows a strategy that sits somewhere between passive and active, and that’s much harder to explain to people. Is that a problem for you?
David Booth: Well, when I hear the term passive, that usually means index funds and zero tracking error, and that is, as you point out, very simple. Any time you introduce complexity you have a communication problem. But what we try to do is the right thing. If the right thing involves creating a communication problem, I’d rather have that than not do the right thing.
The academic research over the last 50 years or so has really focused on two things. One is, can people who try to outguess the market do better than a simple index fund? And the answer appears to be not. The second question is, are there some things other than just using a simple cap-weighted index that you can do to add value? The answer is that there indeed appear to be ways that you can add value over an index fund, by structuring portfolios slightly differently, towards what we believe to be the dimensions of returns.
SITV: In simple terms, how would you explain the Dimensional approach?
David Booth: It has to do with academic research and how you interpret the results. Pretty much all of the academics agree on what the data shows. The issue is, why is the data the way it is? What insights can we gain from the past? And that’s where the difference is.
Our approach is to begin by having a healthy scepticism towards any research results. Probably all results that claim to show something are overstated because we never see all the thousands of studies that didn’t show anything at all. Keep in mind that we have some of the leaders in empirical research in our group - Gene Fama, Ken French and Bob Merton - so it’s not like we don’t have strong empirical research people. The question is in the interpretation.
What we do is we take the data and put it through a rigorous set of tests, to make sure the factors or dimensions we’re observing are persistent across time periods, pervasive across markets. We want to make sure that whatever we’re looking at shows up in more than just one time period and more than just one country.
Generally you have two explanations for why the data is the way it is: the market got it right, or the market got it wrong. For example, with price-to-book, low price-to-book stocks have higher average returns than high price-to-book stocks. That could either be due to a risk factor - stocks are selling at low prices because they’re riskier - or it could be they’re selling at low prices because the market got it wrong. We can’t distinguish between the two.
So at some level it comes down to interpretation and integrating your set of beliefs. Most of the quant firms come to the conclusion that the factors or dimensions we’re observing are due to market mispricing. We think that the factors we’re looking at are due to market equilibrium; we think the market got it right and that’s why the prices are what they are.
SITV: It’s often said that a Dimensional or Vanguard approach to investing works particularly well in highly efficient and well researched markets like the UK, but less well in less efficient markets - emerging markets, for example. Is that true?
David Booth: No, that’s not right. As a general rule, if you look at areas of investing that have no empirical research, that’s where people say active management will work. We started in 1981 with a small-cap strategy, when there really weren’t many small-cap managers, so nobody knew if active management, or trying to outguess the market, worked. There weren’t enough small cap managers to test it. People want to believe in outguessing the market, so surely, they said, that’s where it would work. Well, it hasn’t worked over the last 30 years of live data. We then went international with small cap, and people said that small cap may be efficiently priced in the US but not in developed markets outside the US. Well, it turns out, it appears to be efficiently priced and we don’t see active managers doing consistently better than what we’re doing. And then people said, surely active works in emerging markets, and it turns out just the opposite there too.
SITV: Many of your funds are still overweight in small caps. Of course small caps have performed well since the Millennium, but they did much less well in the late 1990s. Are you worried that the pendulum might swing again?
David Booth: We don’t think the pendulum will swing long term, because there’s a sensible story as to why small cap stocks have higher average returns: they’re riskier, and risk and return are related. When we started the firm in 1981, small cap was all we had, and that was the beginning of the worst nine-year run ever for small-cap stocks. So by the end of 1990 we had very disappointing returns relative to big-cap stocks. There was this seven-and-a-half year period where we produced 2% a year and big caps produced 14% a year. People were saying, Gosh, Has something changed? No, nothing’s changed. It’s just that a five- or ten-year period is a relatively short period of time when you look at the variability of returns relative to the size of the average return. That’s just the way markets work.
SITV: Dimensional has been very successful in the US. How are you faring in the UK and the rest of the world?
David Booth: We’ve also been successful in the UK and in every place we’ve established an office. We started the London office in 1992 and it wasn’t until 2001 that we started attracting money to invest from UK and European residents, but it’s gone very well. That’s the beauty of the story… It goes across cultures. It’s basically a story about risk and return, about dimensions of return, and about implementation. When we started the firm, there was a lot of scepticism that we could pull it off because we accept the prices as being fairly set, and when we go to the marketplace we’re trading with people who think they can outguess the market. So that created anxiety among a lot of academics as to whether we would be able to pull this off. It’s an innovative strategy and it works across all countries.
SITV: What was your reaction to Eugene Fama’s Nobel Prize?
David Booth: To me personally it’s been a very special relationship I’ve had with Gene. I was his research assistant back in school, I learned investing from him, and when we started the firm he became one of the founding shareholders and our director of research. He’s been a giant in the field and has deserved the Nobel Prize for a long time. I was just so incredibly proud of him and happy for him to see he finally got the recognition.
SITV: Now he and Ken French have come up with a five-factor model - an evolution of their famous three-factor model - so clearly the research into risk factors continues?
David Booth: Yes, and undoubtedly we’ll have more factors, and we’ll learn more about the factors that we’ve already identified. These factors in some sense sort of circle the notion of risk, and the circles will probably get smaller and smaller over time. Each increment adds something and, despite the diminishing returns, all these increments are worth fighting for. One of the fundamental principles of our firm is that if you can add just a little bit of value, however small the increment is, because of the magic of compounding, it can lead to significantly different results over the long haul.
SITV: Is there a final message you’d like to leave our readers with?
David Booth: Yes. I like the title of your service - Sensible Investing - because at the end of the day that’s really what it’s all about. A good investment experience is a function of two things: one is good returns, and secondly the way the returns are achieved. If you can achieve returns in a sensible way, using sensible ideas that are well-grounded in academic research and that have sensible fees, then I think people will have a good experience and they’ll be able to stick with their investment approach. One of the big difficulties is getting people to stay the course when results are disappointing. It should come as no surprise to people that markets go up and they go down. When they go down, there’s a tendency for people to go, gosh, are we on the edge of an abyss? Like in 2008-09. My heart goes out to these people who were invested in equities, lost half their money, then got out and missed the rebound. It’s going to take those people a while to get back even again.
Our philosophy is a philosophy that people can stick with. In the market downturn, in the US, the mutual funds lost $500 billion in client flows - about a third of their client assets. Dimensional was able to have inflows in every year throughout. Sure, people lost money in the downturn - we don’t claim to have magic - but if you take, say, a five- or six-year window from the peak of the market down and back, the returns are positive. They may not be exciting, but there were still positive returns over a very difficult period. That’s the behavioural part of this science of investing, and I think it’s incredibly important.