Index Funds Pay 4% More on Rebalancing: Passive Investing Is More Than Just Indexing
David Booth breaks down the difference between index funds and passive investing: index rebalancing pushes stock prices up 4%, true passivity is scientific pricing plus fine execution; the 10% annual stock return over a century is driven by humanity's desire to improve life.
The argument · tap a timestamp to hear it
Not selling ill-fitting shoes matters more than closing the deal
David Booth worked as a commission-based salesman during high school and college. He found that although he wanted to make the sale, he wanted to feel good about himself when he went home at night, so he never sold shoes that didn't fit. This experience has nothing to do with investment philosophy, but it shaped Dimensional's business philosophy: be honest with clients, and if there's no suitable product, say so directly. He admits he made sales he regretted early on, but decided never to repeat that. In the long run, scientifically grounded practices plus good arguments naturally earn trust.
— David BoothOutsiders don't get taken advantage of and dare to challenge assumptions
David's parents lived through the Great Depression and always considered themselves outsiders to the capital markets, afraid of being taken advantage of by insiders, so they never invested. But he points out that the financial science of the 60s and 70s boiled down to two points: long-term returns on stocks and bonds meet expectations, and professional fund managers underperform the market after fees. These two points made it clear to outsiders that public markets are fair to everyone. The outsider mindset also brings a benefit: a willingness to challenge assumptions. The scholars who changed finance back then were also outsiders because they had data, making conclusions that Wall Street hated hard to refute.
— David BoothIndex funds are a product of marketing genius, not scientific conclusions
David emphasizes distinguishing passive management from index funds. He notes that the most important change in the financial industry from the 20th century to today is the shift to passive management, but index funds are a product of marketing genius, not what a scientist would conclude. Scientists would not impose the constraint of 'must track an index' on a portfolio because constraints have an economic cost. Indices themselves are human-managed portfolios; for example, the S&P 500 is not strictly the top 500 companies, and inclusions and deletions involve judgment. Dimensional considers itself passive, not indexed.
— David BoothThe cost of trading at the closing price is paying 4% more
When a stock is added to the S&P 500, index funds must buy at the closing price on that day. David says you can ask your broker to guarantee execution at the closing price, but the cost is 'willing to pay any price.' When all S&P 500 managers do this simultaneously, they push the stock price up by an average of 4% above fair value. It's like a three-card monte game: investors think they're not paying transaction costs, but the 4% premium reverts the next day. This is the hidden cost of index funds and the reason passive managers can do better.
— David BoothInvestors in 1971 had it an order of magnitude worse than today
Asked whether he'd rather be an investor in 1971 or today, David unhesitatingly chose today. In 1971, management fees were as high as 1-2% per year, and NYSE-set commission rates were an order of magnitude higher than today—10 to 20 times higher. To absorb these high commissions, institutions spawned the 'soft dollar' industry, similar to paying high ticket prices for double miles. Custody costs were also high; some banks still kept handwritten ledgers. In contrast, today's fees and transparency give ordinary investors a much fairer deal.
— David BoothResearch is a public good; the gap lies in execution
David points out that financial science has become public knowledge, especially because Fama and French insisted on publishing their research, but competitors' new research may not be peer-reviewed. He believes that with thousands of professors repeatedly mining the same data over decades, it's unlikely there will be a revolutionary new result. The real difference lies in implementation: Myron Scholes said, 'Ideas are cheap; execution matters.' Execution is not just placing orders; it includes the engineering of portfolio construction. Ken French treats execution as engineering; always buying at the ask and selling at the bid in trading accumulates losses over time, so Dimensional developed sophisticated trading techniques.
— David Booth10% annual return isn't magic; it's people refusing to sit still
David explains why stocks have returned about 10% annually over the long term: it's not magic, but humanity's instinct to improve life. In the early days of the pandemic, U.S. stocks fell about 30%. He told clients he didn't know what would happen, but he believed companies would not sit idly; they would innovate, shut down, and pivot. The recession lasted only one quarter. This is also why one should hold a market portfolio rather than individual stocks—individual stocks can go to zero, but the market won't. Holding the market portfolio is a bet on the overall economy and the human creativity within it.
— David BoothNo matter how hot private markets get, it's not worth leaving your comfort zone
Pressed on his view of private markets, David said bluntly, 'I'm not tempted.' He likes the transparency of public markets: listed companies must disclose a lot of information, there is price discovery many times a day, liquidity is always available, and tax reporting is timely. He says he already has a strategy he considers fair and doesn't want to leave his comfort zone for something unfamiliar. He even said that if he were an advisor, he would allow clients to play with 10% of their money in individual stocks, private equity, or venture capital, but the remaining 90% must follow 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
| Dimensional Fund Advisors assets under management | about $1 trillion | 0:03 |
| Long-term annualized stock return | about 10% | 6:14 |
| Average price increase when a stock is added to an index | 4% | 31:34 |
| 1971 trading commissions relative to today | 10-20 times higher | 35:37 |
| Samsonite account initial capital | $6 million | 24:30 |
| Dimensional small-cap strategy performance: first 9 years vs. next 35 years | Significantly underperformed in the first 9 years; performed very well in the next 35 years | 26:31 |
Glossary
- Jensen's alpha
- Measures a portfolio's risk-adjusted excess return; for professional managers, it averages negative.
- soft dollar
- In the high-commission era, brokers rebated commissions to institutions in non-cash forms such as research services.
- beta
- A measure of a portfolio's risk relative to market fluctuations; the market beta is 1.
- passive vs indexed
- Passive management builds portfolios scientifically and executes finely; indexing forces tracking an index and may incur hidden rebalancing costs.
How to listen
Passive fund practitioners, financial advisors, individual investors skeptical of index fund efficiency, and quant novices who want to know how 'scientific investing' is implemented.
The opening shoe store anecdote and the closing art collection passage can be fast-forwarded without missing the main thread.