Index funds overpay 4% on rebalancing days; passive investing is more than indexing
David Booth takes apart the difference between index funds and passive investing: index rebalancing pushes a stock's price up 4%, while real passive management means scientific portfolio construction plus careful execution. And the roughly 10% a century of equity returns rests on the human desire to make life better.
The argument · tap a timestamp to hear it
Not selling the shoe that doesn't fit matters more than closing the sale
David Booth worked on commission as a salesman through high school and college. He found that while he badly wanted to make the sale, he wanted even more to feel good about himself when he went home at night, so he refused to sell customers shoes that didn't fit them. The lesson had nothing to do with investment philosophy, but it shaped Dimensional's business philosophy: be straight with clients, and if you don't have the right product for them, say so. He admits he made sales in his early years that he later regretted, and then decided not to repeat them. Over the long run, an approach grounded in science plus a good argument earns trust on its own.
— David BoothOutsiders aren't at a disadvantage, and they question assumptions more readily
David's parents lived through the Great Depression and always saw themselves as outsiders to the capital markets, afraid the insiders would take advantage of them, so they never invested. But he points out that the finance science of the 1960s and 70s comes down to two things: the long-run returns on stocks and bonds are in line with what you'd expect, and professional fund managers underperform the market after fees. Those two facts tell an outsider that public markets are fair to everyone. The outsider mindset carries another benefit: a willingness to challenge assumptions. The academics who changed finance back then were outsiders too, because they had the data, which made conclusions Wall Street hated hard to argue with.
— David BoothThe index fund is a work of marketing genius, not a scientific conclusion
David stresses the distinction between passive management and index funds. He argues the most important change in the finance industry from the 20th century to now is the shift toward passive management, but the index fund is the product of marketing genius, not the conclusion a scientist would reach. A scientist wouldn't impose a "must track the index" constraint on a portfolio, because constraints have an economic cost. An index is itself a humanly managed portfolio: the S&P 500, for instance, is not strictly the 500 largest companies, and both additions and deletions involve judgment. Dimensional considers itself passive rather than indexed.
— David BoothThe price of trading at the close is paying 4% too much
When a stock is added to the S&P 500, index funds have to buy it at that day's closing price. David says you can go to your broker and demand a guaranteed execution at the close, but the price of that is being "willing to pay any price." With every S&P 500 manager doing this at the same time, the average effect is to push that stock's price about 4% above fair value. It's like three-card monte: investors think they paid no trading costs, when in fact that 4% premium comes back out the next day. This is the hidden fee inside index funds, and it's the reason a passive manager can do better.
— David BoothAn investor in 1971 had it an order of magnitude worse than one today
Asked whether he'd rather be an investor in 1971 or today, David picks today without hesitation. In 1971 management fees ran 1-2% a year, and the commission rates set by the NYSE were an order of magnitude higher than today's, as much as 10-20 times higher; to absorb those high commissions, institutions spawned the "soft dollar" industry, something like trading an inflated ticket price for double miles. Custody costs were high too, and some banks were still keeping their books by hand. Against that, today's fees and transparency give the ordinary investor a far fairer deal.
— David BoothThe research is already a public good; the gap is only in execution
David points out that finance science has become public-domain knowledge, thanks especially to Fama and French insisting on publishing their research, while competitors' new research hasn't necessarily been through peer review. He thinks that with thousands of professors mining the same body of data over several decades, a revolutionary new result is unlikely. The real difference is in implementation: as Myron Scholes puts it, "ideas are cheap, it's the execution that matters." Execution isn't just placing the order; it includes the engineering of portfolio construction. Ken French treats execution as engineering; in trading you are forever buying at the ask and selling at the bid, and over time those losses accumulate, which is why Dimensional developed refined trading techniques.
— David BoothThe 10% annualized return isn't magic; it's people refusing to sit still
David explains why stocks return roughly 10% a year over the long run: it isn't magic, it's the human instinct to make life better. In the early days of the pandemic US stocks fell about 30%, and he told clients he had no idea what was going to happen, but that he trusted companies wouldn't sit there and take it — they'd innovate, shut things down, pivot — and the recession lasted only one quarter. This is also why you should hold the market portfolio rather than individual stocks: a single stock can go to zero, the market won't. Holding the market portfolio amounts to betting on the economy as a whole and the human creativity inside it.
— David BoothHowever hot private markets get, they aren't worth leaving your comfort zone for
Pressed on his view of private markets, David says flatly, "I'm not tempted." He likes the transparency of public markets: listed companies have to disclose a great deal, there is price discovery countless times a day, there is liquidity whenever you want it, and tax reporting is timely. He says he already has a strategy he considers fair, and he doesn't want to leave his comfort zone for something he isn't familiar with. He even says that if he were an advisor, he'd let clients take 10% of their money and play with individual stocks, private equity or venture capital, but the other 90% would have to go through a rigorous process.
— David BoothIn their own words · checked verbatim
I believe it and I have data. You don't believe it and you don't have data. So, uh once you get some data, come back to me.
David Booth0:03
indexing is okay but uh there have to be better ways to invest.
David Booth29:34
ideas are cheap it's execution that counts
David Booth34:36
models are inherently incomplete
David Booth42:44
you know more about investing than you think you know cuz you've learned how to deal with uncertainty in life.
David Booth45:48
education is the antidote to fear
David Booth50:54
providing investment solutions is our business and trust is our product.
David Booth53:56
the cost of being out of the market isn't something that is fully uh appreciated by most of your clients.
David Booth57:01
Figures
| Assets managed by Dimensional Fund Advisors | about $1 trillion | 0:03 |
| Long-run annualized return on stocks | about 10% | 6:14 |
| Price impact when a stock is added to an index | 4% on average | 31:34 |
| 1971 trading commissions as a multiple of today's | roughly 10-20 times higher | 35:37 |
| Initial funding of the Samsonite account | $6 million | 24:30 |
| Dimensional's small-cap strategy, first 9 years vs the next 35 | significant underperformance in the first 9 years, strong performance over the next 35 | 26:31 |
Glossary
- Jensen's alpha
- A measure of a portfolio's risk-adjusted excess return; for professional managers it averages negative.
- soft dollar
- In the era of high commissions, the practice of brokers returning commission value to institutions in non-cash form, such as research services.
- beta
- A risk coefficient measuring a portfolio's volatility relative to the market; the market's beta is 1.
- passive vs indexed
- Passive management builds a portfolio on scientific grounds and executes it carefully; indexing forces the portfolio to track an index, potentially bearing hidden rebalancing costs.
How to listen
People who work in passive funds, financial advisors, individual investors skeptical of how efficient index funds really are, and quant newcomers who want to know how "scientific investing" gets implemented.
The shoe-store anecdote at the start and the art-collecting section at the end can be fast-forwarded without losing the main thread.