When Index Funds Were Born, Wall Street Said It Was Gouging Their Eyes Out
Dimensional founder David Booth says active managers can't beat the index over the long run because the market has already priced in the bad news; the only things investors control are their risk exposure and their long-term plan.
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The first index fund was built for Samsonite
Mac McQuown built the first version of an index fund at Wells Fargo for Samsonite's pension account. At the time two groups ran in parallel: one using a high-beta portfolio to try to beat the market, the other simply building an S&P 500 index fund. Booth says the high-beta approach was "incredibly naive," while the S&P 500 index fund idea was pushed by a "marketing genius" because "everybody can understand that." That index fund business changed hands several times and ultimately became a cornerstone of BlackRock.
— David BoothWall Street opposed it because of the commission model
Booth says the index fund met enormous opposition when it launched, because at the time almost all financial services were distributed through commission salespeople. If clients don't trade frequently, commission brokers have no income. Booth's exact words: "Trading is a negative expected outcome. kind of like gambling in Vegas." And Wall Street's entire business model was built on trading. He says the other side had no data, only bluster, but the fight went on for 50 years.
— David BoothThe small-cap factor was DFA's starting point
DFA's first fund was a small-cap strategy. Booth says that in 1981 large institutional investors didn't hold small-company stocks, so "if you want to be diversified, you need large and small, not just large." Later Fama told him that a student, Ralph Bonds, had written a dissertation that sorted NYSE stocks into five buckets by market cap, and the smallest bucket had dramatically outperformed all the others over the long run. Booth says: "putting my marketing hat on, I go, I think we'll define small to be the smallest quintile of companies on New York."
— David BoothIndex funds are forced to trade at bad prices
Booth points out a structural flaw in index funds: when the S&P 500 announces it is adding a new stock, every index manager has to buy at that day's closing price, and they all know the stock will have risen beforehand. He says recent research shows that for stocks added to the index, the index pays about 4% more than fair value at entry. Conversely, stocks that are deleted tend to outperform the S&P over the following 12 to 24 months, because people sell ahead of time and the price has already become cheap. DFA exploits this predictable trading behaviour, executing with "a little bit of human judgment."
— David BoothIn a pandemic crash, human creativity backstops the market
Booth says that when bad news hits, the instinct is to see the market fall 20% and want to run. But he believes the market's foundation is "human ingenuity" — people won't just sit and wait to be wiped out, they'll find a way back on track. He cites 2020: the market fell 34% in the first quarter, but from the end of that quarter to year-end, the S&P rose 69%. He says the consensus then was that the pandemic would last two or three years, and a 20% to 30% market decline "seems about right to me," so the bad news was already in the price, and acting on what everybody already knows is a waste of time.
— David BoothThere are only two investment decisions: stock/bond mix and buying the whole market
Booth reduces investing to two steps: first, decide the split between stocks and a relatively risk-free asset (money market fund or bonds); second, in the stock portion, "buy the whole market." He says doing this "makes you as good as the insiders," letting people who think of themselves as outsiders earn market returns too. He mentions his own parents never invested in public markets because they felt like outsiders, and their retirement was harder than it should have been. He says everyone has access now: "The market is good for everyone."
— David BoothAn advisor's job is to stop clients from hurting themselves
Booth quotes a DFA advisor: "I don't have clients with investment problems. I've got investments with client problems." He says an advisor's value isn't in designing portfolios but in preventing clients from abandoning the portfolio in a panic and interrupting compounding. DFA began working with fee-only advisors in 1989, when such advisors were still rare but "highly energized." Booth says they have always sold through education — running seminars, writing books — all to help people understand how markets work and thereby be more confident.
— David BoothThe SEC approved merging ETFs and mutual funds into one pool
DFA long avoided ETFs because advisors said they didn't need them. Booth says mutual funds trade at the day's closing net asset value, "That's about as clean as you can come up with." ETFs trade in the public market, which is a bit scary for some people. But DFA eliminated most of the ETF tax advantage through a dual class structure. Booth reveals the SEC has approved DFA merging mutual funds and ETFs running the same strategy into a single asset pool, with both wrappers accessing the same pool. He says: "So that will eliminate, take away the argument."
— David BoothIn their own words · checked verbatim
No, there was a huge pushback. It was stuff they didn't want to hear. I mean, they've been claiming for years, oh, yeah, we can beat the market.
David Booth8:33
Trading is a negative expected outcome. kind of like gambling in Vegas.
David Booth18:53
The simplest of all ideas is if you're trying to buy a stock at the same time everybody else is, that's probably not a good trade.
David Booth22:58
the cornerstone of all of my belief in markets and how they work is human ingenuity. That's what ends up bailing us out.
David Booth31:05
By the time you get a certain piece of information, the market's already reflected it. It's already in the price. You're too late.
David Booth40:16
I don't have clients with investment problems. I've got investments with client problems.
David Booth47:33
people don't flock to new ideas just based on. On new research or new ideas, you have to soak the ground down around them, let them sink into it.
David Booth1:07:02
Figures
| Premium on stocks added to the S&P 500 | about 4% | 22:58 |
| Market decline in Q1 2020 | 34% | 30:02 |
| S&P gain from end of Q1 2020 to year-end | 69% | 30:02 |
| Booth's donation to the University of Chicago business school | $300 million | 52:42 |
| Booth's donation to University of Kansas athletics | $300 million | 54:46 |
| Auction price of the original Naismith basketball rules document | about $4.5 million | 56:54 |
| Year DFA was founded | 1981 | 47:33 |
| Year DFA launched its first ETF | 2020 | 47:33 |
Glossary
- beta
- A measure of a portfolio's volatility relative to the market, where the market is 1 and above 1 means greater volatility.
- fee-only financial advisor
- An advisor who doesn't rely on commissions and charges clients a fixed advisory fee, as opposed to a commission broker.
- dual class
- Offering the same strategy in both ETF and mutual fund share classes, to balance tax and trading convenience.
- NIL
- The rule allowing US college athletes to be paid for their name, image and likeness.
How to listen
Suited to investors interested in the history of index investing, factor investing and DFA's business model, as well as wealth management practitioners and financial history buffs.
The final segment on art collecting and the auction of the original Naismith basketball rules can be skipped.