BARRON'S MFQ Ditching the Monkey
By ERIC J. SAVITZ
FOR A JOURNALIST WHO SPENDS MOST of his time trying to ferret out alluring stock ideas and smart stockpickers, a trip to the Santa Monica, Calif., headquarters of Dimensional Fund Advisors poses certain philosophical challenges. DFA's approach to managing money starts with the idea that stock-picking is basically futile.
You can go to its office to admire the stunning view of the Pacific, but you won't walk away with brilliant investment ideas; DFA's members consider the whole stock-picking exercise a waste of time. So, it doesn't try to hire market-beating portfolio jockeys.
The way DFA executives see it, as a result of chance there always will be managers who beat the market, but there's no way to identify them. Sure, there will be a new Bill Miller or Peter Lynch, but seeking them before they do their thing is like trying to pick out which of a million touch-typist monkeys accidentally would produce Hamlet.
IF THERE'S NO POINT in picking stocks or funds, you can only conclude that reading about stock picks and "must-own" mutual funds is a waste of time, too. Rex Sinquefield, DFA's co-founder and just-retired co-chairman, has famously derided the kind of prognosticating that's the stock-in-trade of this and other business magazines as "financial pornography." Given all this, I might have been tempted to ignore DFA, if not for one fact: Its funds have been cranking out remarkably high returns.
With more than $84 billion in assets under management, most of that in stocks, 25-year-old DFA is built around the theories of Eugene Fama, a University of Chicago economist who is perhaps the leading proponent of the "random walk" theory. Fama, in essence, argues that the market's efficiency at discounting information makes it largely impossible to beat over the long term by picking stocks. Sinquefield and co-founder David Booth, who studied with Fama at the University of Chicago in the 1970s, were among the earliest proponents of index funds, or "passive investing."
The two started DFA in the spare bedroom of Booth's Brooklyn Heights apartment. The fledgling firm had trouble getting New York Telephone to install six new phone lines in his apartment. Recalls Booth: "They thought we were bookies." The spare bedroom in Brooklyn eventually gave way to the swanky offices by the sea. But the firm still ardently preaches the efficiency of the market. DFA's execs compare active money managers to socialists: both groups, they say, refuse to believe in the marketplace's power.
SINQUEFIELD DERIDES "BEHAVIORISTS" who theorize that markets offer anomalies that can be exploited by those with the best information. "They have no over-arching theory," he scoffs. "They have a lot of ad hoc stuff based on empirical irregularities. If you look hard enough, you find patterns in the data. But they're not real." What's worse, he adds, "The average individual is really persuaded by all this stuff, and then asked to make decisions he can't possibly make well."
Argue with Sinquefield if you like, but there's no debating DFA's results. Even though DFA argues that you can't produce returns that beat the average mutual fund, it's done exactly that. But its success involves keeping fees low, being tax-efficient and investing with an eye on the only investment factors they believe can lift returns. Fama and his frequent collaborator Kenneth French, a Dartmouth finance professor, focus on small stocks, rather than large ones, and value, rather than growth. Both approaches, they assert, provide excess returns. (They define value stocks as those with a high book value-to-price ratio, a variation on low price-to-book.)
The firm starts with a simple screening procedure that begins with market capitalization. It sifts out stocks for procedural reasons, eliminating those with fewer than four market makers, for example, on the theory that it will be hard to get competitive pricing, while also avoiding companies in obvious financial distress, and shunning IPOs.
That still leaves plenty to buy: Their small-cap fund owns 3,000 stocks. For active managers, it's hard enough to run a fund with hundreds of names, let alone thousands. It's easier for DFA because it spends no time doing things like meeting corporate managements, listening to quarterly conference calls, or creating earnings models. DFA has taken 5%-plus positions in more than 500 companies, but without any real consideration for what any particular one does. Recently, a reporter called DFA Vice President Weston Wellington to ask what the firm might think about takeover talk brewing over theme-park operator Six Flags, for which DFA is the biggest institutional investor, with a nearly 9% position. Wellington says he replied that DFA hadn't looked at the situation, hadn't talked with Six Flags, and wasn't going to spend time trying to figure it out. His advice: call someone else.
Where DFA does invest energy is in aggressively seeking to buy positions by acquiring large blocks of shares at negotiated prices below the market. Dimensional also uses only fee-based financial advisers to sell its funds. It doesn't want investors who will jump in and out of the market. In fact, DFA requires its distributors to attend a two-day "boot camp" that lays out its academic underpinnings. It wants to do more than sell you a fund and collect a management fee; it wants you to believe that the right way to invest isn't the way most people do it.
"We don't proselytize," says Wellington, who handles the firm's communications with financial advisers, giving them, among other things, regular presentations on terrible market calls made in the financial press, this magazine included.
"Our view is, people have to be ready to hear this story. When you've decided it's not so easy to ID winning stocks or managers, then come have a chat with us, and we'll explain why you would expect this outcome more often than not."
What they don't want is people lured by the historic returns who don't understand why the system works -- and where the risks lie.
The Bottom LineSure, DFA often knows little about the companies in which it invests. But the firm's record shows there's a rewarding method to what some would consider its madness.
How to explain the Internet bubble, for instance? "Sure, I can look back and say it appears it might have been a bubble," Wellington says. "But could you have told me when it was going to burst? Most people who said we were in a bubble had been saying the same thing in '96, and '97, and '98, and '99. If someone got into the market for the first time in January 2000, I feel sorry for him. But over a 10-year cycle, people did fine. If you couldn't get your money out, I'm not so sure it was an inefficiency that you could have exploited."
Adds Booth: "The proof comes in the returns. We're like one giant test of market efficiency. And I can't think of any region of the market where active management has had better returns."
So why don't other people invest this way? "For one thing," Booth says, "people are overconfident. If you have a large group of people in a room, and ask them if they are above-average drivers, about 80% will say yes. In the financial markets, over-confidence leads to trading too much. We all have feelings, opinions and hunches." At the end of the day, he says, "you can't distinguish professional money managers from the universe of orangutans."
Indeed, based on DFA's record, investors have to wonder whether they'd be better off if they stopped trying to pick the next smart monkey.