David Booth, Founder and Executive Chairman of Dimensional Fund Advisors, shares his thoughts on indexing, Dimensional's improvements, and future innovation.
The 50-Year Battle for a Better Way to Invest
by David Booth
Mac McQuown recruited me to help create the very first indexed portfolio in 1971. I was 24 years old and living in San Francisco, where more people my age were following the Grateful Dead than the stock market. The think tank Mac set up felt like a start-up, although it was long before anyone used that term. We were excited by the opportunity to turn academic research into a new way of investing. Many people thought we would fail. Some even called what we were trying to do “un-American.”
But we didn’t worry about the attacks; we focused on how indexing could improve the lives of investors. The fund offerings available at the time were actively managed portfolios that tried to outguess the market and were expensive, lacked diversification, and performed poorly. So-called star managers sold investors on their ability to win against the market; they sold products as opposed to solutions. Problem was, there was no compelling evidence they could reliably beat the market. We were confident that indexing—a highly diversified, low-cost investment solution that relied not on a manager’s ability to pick winners but on the human ingenuity of hundreds or thousands of companies—would change lives for the better.
Fifty years later, $9.1 trillion is invested in index mutual funds and exchange-traded funds (ETFs).1 This represents 51% of the total $17.9 trillion in equity ETFs and mutual funds. Six of the original academic consultants Mac hired to work on that first index fund went on to win Nobel Prizes. I have worked with four of them at Dimensional.
Flexibility is one of the key differences between index investing and Dimensional Investing and where so much of our innovation has taken place.
When we started Dimensional in 1981, indexing was beginning to catch on. But the primary index used was the S&P 500, made up of 500 of the largest companies in America. My colleague Rex Sinquefield and I thought investors could be better served by adding small capitalization stocks to the mix, since they were underrepresented in portfolios and offered diversification and expected return benefits. We were the first to treat small cap companies as a separate asset category. It was an exciting idea, but it made many people nervous. An academic paper circulated that said the performance of small cap stocks couldn’t be captured because of trading costs. Many academics, even those who worked with us, were skeptical that we could deliver on our big idea of creating a small cap strategy. (After 40 years of results, the skepticism about our ability to deliver has subsided.)
There was perceived risk in trading against professional investors who might take advantage of us with all their knowledge and experience. But we found a way to turn trading to our advantage: flexibility.
Flexibility is one of the key differences between index investing and Dimensional Investing and where so much of our innovation has taken place. Because we weren’t beholden to tracking any particular index, we could harness the power of markets, even beat the indices. The protocols, systems, and teams we’ve developed—as well as the experience we’ve accumulated—have shown to be applicable to a wide range of strategies, from fixed income to value to international investing.
I thought 1971 was the most exciting time to be in this business. Then, I thought 1981. The truth is, it’s every day.
So what happens next? Where will we be in 50 years? I’ve built a career in finance without making predictions, but I do believe that technological innovation is lowering barriers to entry for everyday investors and enabling greater personalization. In 1971, there was one index fund. In 1981, there was one small cap strategy. Today, investors have more access to customized portfolios than ever before.
Sitting down with a trusted advisor, investors can develop a plan and build a portfolio solution that gives them the best chance of having a good investment experience. For example, many people are interested in environmental, social, and governance (ESG) strategies, but ESG can mean different things to different people. So rather than choosing from what exists, new technology allows you to get exactly what you want.
For me, working in finance has always been about improving people’s lives. We created indexing to improve upon stock picking. We created Dimensional to improve upon indexing. Each day we strive to help our clients in new and better ways. That’s why I thought 1971 was the most exciting time to be in this business. Then, I thought 1981 was the most exciting time to be in this business. But the truth is, it’s every day, as long as we’re able to keep helping people in innovative ways.
David Rappaport, CFP®