January 7, 2021

EMH, Expected Returns, Factor Investing, Financial Advisors, Financial Planning, Historical Data, Index Funds, Portfolio Management, Portfolio Theory

Episode 131: David Booth: The First Index Fund, Competing Fiercely, and Keeping it Simple

Angelica Montagano

January 7, 2021

EMH, Expected Returns, Factor Investing, Financial Advisors, Financial Planning, Historical Data, Index Funds, Portfolio Management, Portfolio Theory

David Booth, a founder of Dimensional Fund Advisors in 1981, is the firm’s Executive Chairman.

David has won numerous awards for his accomplishments in applying financial theory and research to the practical world of asset management, and has written numerous articles, particularly for his pioneering work in indexing and small capitalization investing. He has served on the Investment Company Institute’s Board of Governors and the ICI’s Executive Committee.

The University of Chicago Booth School of Business was named in his honor, and David also serves as a lifetime member of the school’s advisory council. David Booth Kansas Memorial Stadium at the University of Kansas was also named in his honor. David funded the Booth Family Hall of Athletics in Allen Fieldhouse at KU and donated James Naismith’s original 13 rules of basketball.

At its core, managing wealth is about finding the best solutions for the clients. This sentiment has guided today’s guest throughout his storied career. As the Co-Founder and Executive Chairman of Dimensional Fund Advisors, David Booth’s career is so illustrious that he’s been called the father of evidence-based investment products. We open our conversation by exploring David’s career, beginning with his job as a shoe salesman in Kansas to developing the first index fund. We ask David if he had been able to foresee the power that “geeks” would have over the asset management business. His answers highlight how immature the industry was when he founded Dimensional Fund Advisors and how they had to first convince people before selling them on small cap funds. Reflecting on his early successes and challenges, David opens up about how his clients reacted when small caps underperformed. A key theme this episode, David emphasizes the importance of making decisions that are grounded in academic research. We then dive into several topics ranging from David’s views on value portfolios to the stroke of luck that led Dimensional to open their products to financial advisors. After chatting about why Dimensional is now entering the ETF space, David shares his take on direct indexing and why he still favors simplicity over complexity. Near the end of the episode, we discuss how David built his company culture, how luck factored into his life, and how he defines success. An incredible conversation that touches on pivotal moments in the history of financial services, tune for more insights into the life and work of David Booth.

Key Points From This Episode:

Introducing today’s guest, Dimensional Fund Advisor Co-Founder David Booth. [0:00:14]
David talks about how his background informed his professional career. [0:03:57]
Hear about David’s role in developing one of the first index funds. [0:06:13]
Why David’s work creating index funds for Wells Fargo came to a close. [0:07:28]
Exploring the origins of Dimensional Fund Advisors. [0:10:24]
How David saw the future of his industry when he started Dimensional and how they created the first small cap funds. [0:15:18]
The reaction from David’s early clients when small caps underperformed. [0:27:04]
David recalls the “borderline character assassination” that he faced when pushing for small caps. [0:24:16]
How and why Dimensional first added value portfolios. [0:26:03]
Unpacking David’s view that values struggle relative to growth. [0:28:37]
The recent lessons that Dimensional has learned about value relative to growth stocks. [0:33:17]
What it would take for Dimensional to reconsider their entire approach. [0:37:50]
The importance of flexibility and believing in your solutions when dealing with uncertainty. [0:43:19]
David emphasizes that your financial solutions should be based on robust data. [0:47:00]
How Dimensional began giving financial advisors access to their products. [0:48:46]
Why, after so many years, Dimensional is now entering the ETF space. [0:52:25]
With widespread fee compression, hear how Dimensional is handling fee cuts. [0:55:53]
Answering the question — what’s the next big thing for Dimensional? [0:57:29]
David shares his take on direct indexing and customizable portfolios. [1:00:59]
How David built his company culture and the role that luck plays in his life and in business outcomes. [01:02:59]
We ask David how he defines success in his life. [01:06:48]

Read the Transcript:

Can you talk about your background, your upbringing, and the role that played in building Dimensional over the past 40 years?

Well, first off, I grew up in a small town in Kansas. Eventually, I went to the University of Kansas and then on to University of Chicago, which was a transformative event. While I was an undergraduate at University of Kansas, I sold shoes as a way of putting myself through school. That taught me a lot, probably as much about life as studying investments at the University of Chicago. Being a commission salesman, there's a huge incentive to try to sell whoever comes in a pair of shoes. I learned a lot about myself, which was, at the end of the day, it's nice making a commission, but what's even better is going home at night feeling good about myself. So sometimes I recognize when people would come in, we just didn't have the shoe that we're looking for, the size or whatever, and that's okay. Just be upfront with it and really try to help people out.

And I think in some ways, that's really what our firm is about, is helping people out. In fact, it's probably the reason I left business school. I was in PhD program. I was working for Gene Fama 50 years ago, if you can believe, and these ideas were just so powerful that were coming out of academia, and such a change from the way standard investment business worked, that these ideas just need to be implemented. They need to be out there, and somebody had to stand up. I think I reflected on selling shoes and I go, "Gosh, I'm never going to be as good a researcher as Fama. You kidding me? I don't see anybody out there really trying to innovate these ideas." And then Mac McQuown came along and Wells Fargo, and Fama lined me up with Mac, who was starting up index funds, and off we went.

Can you go into a little bit more detail about that story? A lot of our listeners may not realize, because they associate index funds with John Bogle, but you were actually involved with developing the first index fund. Can you tell a little bit more of that story?

I casually mentioned starting an index, now at Wells Fargo. It was an incredible experience. The amount of energy, first off, Mac was working, he ended up using half a dozen consultants that went on to get Nobel prizes. The chief outside consultants were Myron Scholes and Fischer Black, who came up with the idea of the indexing, and Mac is running a think tank for Wells Fargo. He calls it the management sciences department, which was, even though the bank had a trust department that was supposed to manage the money, it was [inaudible 00:07:03] group that was really the big push towards indexing, and that was working closely with Myron and Fischer. And of course, as you know, on their many trips out to San Francisco, they were working together on the indexing. They developed a whole thing called the Black Scholes option pricing model. These are heady days. You can't make this stuff up, right? All this stuff that was just happening all at once, incredibly exciting time.

What ended up happening, ultimately, to that group, to that division of Wells Fargo?

It's complex. And some of the stories you can read at various places, but eventually, McQuown's group, they ended up irritating the trust departments so much that the bank decided to shut it down. So, we'd gotten the commitment for the first index portfolio in '71. That's five years before Vanguard launched its index fund. It was not an S&P fund, but it was a index fund. It had a lot of quirks to it. And along the way, the trust department said, "What are you guys doing? We're the trust department, we manage the money." And the fund that I was working on was called the Stagecoach Fund. Now, you have to understand that's in 1971. Nobody had heard of an index fund, almost nobody.

What the stagecoach fund was going to be was a levered index fund, and for every $100 of assets invested with us, we were going to buy $145 worth of stock, borrowing 45. Is that crazy? We were out there selling a levered index fund, and people didn't even know what an unlevered index fund was. What it actually reflected was, and maybe it ties into the question about client servicing, what it reflected was upon reflection, I realized what it was about. It was, we were a bunch of geeks out there and we came up with something, put a paper and pencil together, go, "That's a sensible idea. People want to beat the market. We can't out-guess the market, but we can use leverage." And I often think, had we gotten that sucker off the ground, and we would have started at the beginning of '73, which was right at the beginning of one of the worst downmarkets ever, we probably would have ruined indexing for a couple of decades, had we gotten that off the ground.

Anyway, what I realized was the investment business really is about people. It's about helping people develop solutions, rather than trying to convince people that we were really smart or something. I don't know what we were trying to do. Anyway, Wells shut it down, and I went on to work on a consulting division of AG Becker Investment Banking Firm, because I wanted to learn the business. I'll tell you one funny story on me. This is a University of Chicago type story. So I go out to San Francisco, started working on the first index fund, discussion came up, who should be the custodian? I thought, " Why are we wasting time on figuring out who's going to sweep the floors?" I didn't even know what a custodian was. I knew all about CUSIP numbers and ticker symbols and T statistics, and [inaudible 00:10:14] markets are heteroscedastic, but nobody had ever mentioned the role of a custodian, so I had a lot of real life experiences I had to learn.

2021 will mark Dimensional's 40th anniversary. Can you take us back to that time when the firm was being created, and what was it like?

Yeah, it was 40 years ago. Last month we decided, another guy [inaudible 00:10:38] went out to San Francisco and worked with Mac, trying to figure out how to set up this business. And then, we announced we were leaving at the end of April in '81. What had happened was that on a consulting project, I'd helped AT&T start a small company index type portfolio. And I'd helped them start an S&P 500 index portfolio that they managed in house. And I got to be really part of the staff at AT&T even though I was a consultant. I said, "I don't know what you guys are thinking about." At that time, they were the largest pension fund in the world. AT&T eventually got broken up into all these separate telephone companies that we see now. But that time, there was just [inaudible 00:11:30], really. They had 110 managers picking stocks. I go, "I don't know what you got here, but it's one incredibly expensive index fund because you have the whole market of anybody that's credible, and they're trading with each other, really."

And none of them were holding stocks in small companies. If you want to do yourself a favor, why don't you set up a portfolio of index of smaller companies? Because a portfolio of large and smalls is probably better than a portfolio of just large companies. And eventually I wore them down. I didn't have any ax to grind. As they say in Texas, I didn't have a dog in that fight, but I was just trying to do, again, trying to do the right thing for the client. And so they set up this portfolio, and the idea went viral, using today's terminology. Everybody goes, "That is so cool." A small company, the only index funds that were out there were S&P 500 and what was called EFA index, is now Morgan Stanley. There were the only two equity index portfolios. There weren't all the myriad of options like there are today.

So I went out to San Francisco, met with Mac, and we decided to start the firm. And one of my first calls was, back to Gene Fama, said, "Look, we're going to need some help with research." And then by that time, it had been about 10 years since I worked for him and said, "I'd like to have you head up research and be a founder of the firm." So Matt and Gene came on, were a couple of the founders, and I did one thing that we hadn't really done much of when I was at Wells, which was, we went around and talked to people, say, "Would you be interested? If we start this firm to do small company portfolios, would you be interested?" There was a lot of enthusiasm for it.

In fact, we'd announced that we were leaving, so the firm knew we were leaving. And so, we were working on setting up our own firm, with the company's permission, and we got four commitments to give us money, and we haven't even started the firm yet. And keep in mind, I've never actually managed money before. I'm a few years out of learning what a custodian was, and I was the first portfolio manager. Well, being cautious as I am, I said, "We don't want to go out and raise a whole bunch of money to start the firm. We don't even know if we'll be able to get it off the ground." So we took our meager savings, and got a little bit of money from friends, and established headquarters in my condo in Brooklyn Heights, back before Brooklyn Heights was fashionable, and got the fund registered.

And along the way, we were able to think through this whole idea of indexing. And as it changed, the main concern we had with indexing was it's too mechanical. If you put enough constraints on yourself, like zero tracking mirror, it's constantly. At the same time, we know now that option pricing model, that Black-Scholes and Bob Parton, those models, for which they eventually become Nobel laureates, really what that was about was saying flexibility has value. So we looked at these inflexible index funds, we said, "Look, we can do better. There are a lot of things we can do to add value over straight indexing." I hadn't had enough of innovation already. I hadn't learned my lesson. We're not going to come out with a small company index. We've got to come out with a small company portfolio, broadly diversified, low turnover, low cost, and with a goal of outperforming index funds, not trying to guess the market, but correcting for the mechanics, the operational deficiencies of indexing. So there we were, operating out of my spare bedroom, competing with the big index fund houses at the time. It's a David Goliath kind of story.

As you put it, the geeks were rallying to make a difference here. Did you have any sense that the geeks would end up, 40 years later, having so much influence in the asset management business?

No, we really didn't. We knew it should be, but those were just pipe dreams. It's totally irrational for everybody to try to out-guess the market because the market is what the aggregate performance is, before fees that are taken out. And there's just no compelling evidence people are going to out-guess the market, so I need to have ideas like this. That's the excitement. And really, the excitement was created because nobody believed it at that time. That was really the fun. It was poking, trying to bring down establishment, being a product of the '60s, a little bit of anti-establishment in there saying, "This is nonsense, and give me your best arguments why you think what you're doing makes sense. We'll give you our arguments, and I think over the long haul, we'll win." So we got started.

And since we had no track record, nobody had any track record in small cap. We were the first people to use the term small cap as an asset category. And Fama chuckles when he says, "How did you come up with the name Dimensional?" I didn't want index fund, because we weren't in indexing, and I thought of small companies in a different dimension. And then, we stumbled across the PhD dissertation of Rolf Mons, who actually, just by sheer luck, he had the Sherlock on our part. He had done the rigorous academic research on looking at the performance, company size, and broken companies on New York and the quintiles, the smallest quintile companies had much higher average returns in the fourth and the third. So we used that data, because it was objective data, hasn't been fed in the academic community. And so we had strong data, but I'll also mention, this is a story I tell new people coming into the firm a lot. We go out and try to drum up business. We start our firm, we're out there selling the idea of a small cap portfolio, to have large and small. That was the pitch. You go into a big institution, our client's initial, the first nine years or whatever, were just large institutions, the big DB plan, typically, corporate DB plan or public DB plan, pension fund. And we go in and say, "Look, we think you ought to have large and small stocks." People would nod their head, yeah. And I said, "Well, you're not holding any of the stocks of small companies, and in any meaningful way. The only small company stocks you're holding pretty much are ones that have fallen down in price. The ones for dogs, if you will." At that time, there were about 5,000 publicly traded companies and the smallest 4,000 was about 10% of the market. So look, it's going to be about 10% of your portfolio. I mean, argue against that.” They go, "Okay, well, that makes sense." So at that point I would pause because I knew what was coming. If you did it right, if you kind of set it up and they would say, "Okay, well, how are they done?" And I would say, "I'm not going to tell you." They said, "What?" Oh look, he believes this story. Why would you want to look at data?

So in some ways, that's really what I learned from all this academic training was models are important, research is important. But models don't explain everything, or research doesn't explain everything. If it did, you wouldn't call them models, you would call them reality. And also, what I learned was a healthy dose of skepticism about all this research. I mean, it's incredibly important and we built a firm around it. At the same time, you have to recognize its limitations is all I'm getting at. So we did have a good chuckle when we were right. And then I would show him the data and it would bring tears to your eyes because it's so good, about small companies versus the others.

But because we had no track record and it was a new idea, people gave us small amounts of money at first to invest. But we built up on that and at the end of the first year we had 80 million under management. That was a heck of a deal. So on, it just took off from there. And just a lot of fundamentals, just a lot of getting out there and hitting people with a new idea. But unlike the delivered index fund at Wells Fargo, everybody realized this was a sensible idea. There wasn't really a counter-argument other than how do we know you can implement this?

So the focus right from the beginning was on implementation. You take any sport, probably in hockey, all the clubs run the same plays or same technique, just some of them do it better than others. So execution is really the name of the game. If you think of Dimensional, it's really kind of where science comes to markets. By markets I mean you go out there with this idea, a small cap. When I was the first portfolio manager, I realized, holy cow, we've got this money to invest. You go to a pop-up on the screen and find out stock is trading $10 to $10 a nickel or something. What are you willing to pay for it? Are you willing to pay 10 to the nickel? That's a 5% cost.

So we're confronted with the reality of markets. And here again, going to kind of my geeky upbringing, what we realized was the value of flexibility. Flexibility is important because I realize investing in smaller companies, it's difficult to put a large amount of money to work in a smaller company. Put the poor guy on the other side is wanting to sell that has even more of a problem than I have, so. And I can make him blink first, then we probably have... we can probably implement small cap. And that's how we started off, and eventually we were able to show people that not only did we not lag to the performance of the benchmark indices, we actually outperformed them, which was a revelation. And now you can go to business school, people teach the value of flexibility on implementation and why this would work and all of that. But none of that was known back at the time.

Fascinating to think about. Now you mentioned the performance piece coming up as part of the pitch once people got the concept of the diversification argument, which just made the whole thing sound better. But then after Dimensional actually launched small caps, went on to trail the market for the next decade or so. What were the conversations with clients like when the funds were live and underperforming the market?

Well, and it's not unlike that the value of most discussions today, only more severe because we had no track record to fall back and we had no other strategy and small cap to talk about. To give you a little idea, the first year and a half actually, performance was pretty good. Within the next seven and a half years, our fund compounded at a 2% a year while the S&P compounded at 14% a year. So those were some serious discussions that people had. And we learned a very valuable lesson, which we see even today. Look, all you can do is come up with sensible ideas that are well documented by serious academic research and implemented well. Over that seven and a half year period, our fund actually outperformed small cap benchmarks. We did what we said we're going to do. We'll give you the performance of small cap.

It was disappointing, but seven and a half years is not a particularly long period of time. If you look at the ratio of average returns of the variants of return, that is just the... The variance of stock markets is so high, that its seven and a half year periods is not a long time to judge quality of outcomes. So we kept coming back to the same point. We think you ought to have large and small stocks. What are you telling me? You no longer believe in the idea of small cap investing? I mean, keep in mind that your return as an investor in the small cap portfolio is a company's cost of capital. Markets are where companies that are issuing capital meet investors that are wanting to invest in the capital and they strike a price for capital.

So if you want to make an argument that small stocks will always outperform, you're making an argument that they have a lower cost of capital when issuing their stock relative to big safe companies. I don't have a story for that. We don't know why big safe companies would have a higher cost of capital than smaller speculative, more speculative companies. I don't have a story for that. I mean, nobody has a story for that. So it's just one of those things. And furthermore, you shouldn't value the performance when it's out of favor. What you want to look at is when whatever style it is, whether it's small or value or growth or large cap, when that style is in favor, how did you do when your style was in favor? Because that's probably the true test.

When you look back to pitching the product initially, the small cap portfolio, we hear stories about people on Wall Street sort of making fun of John Bogle when he was launching index funds. Did you receive any resistance like that when you had this idea?

I mean, it was really borderline character assassination. That was such a stupid idea. Fama has probably taken more abuse than any finance professor in the history of the world. Wall Street all ganged up on him in terms of saying what a stupid idea he had and how his type of research didn't make any sense. I mean, people were really... it wasn't just, "Oh, I disagree with you. I believe this is …” It was, "I disagree with you and you're stupid." It was really kind of the arguments.

Which made it fun, because we had the logic, reason, empirical evidence on our side. So you know eventually you got to win, right? If you can hold out. And that was really the big question. Because we were under capitalized as a firm, and can we last long enough to see the other side? It took us 15 years before we were able to pay out a dividend to our investors in our firm. So it was a lot of, re-investing. I'm happy to do it. I mean, because we were on the right side of the argument. Going back to working for clients, I mean, that was the whole purpose. We can improve people's lives by applying financial science. We can outperform index funds by using flexibility. And those were messages... I'm willing to still take those arguments.

So Dimensional, added value to portfolios around the time that Professor Fama and Professor French published the famous cross-section of expected returns paper. Can you talk about what went into the decision to start offering that value exposure?

Yeah. Well, keep in mind that my job right now is to tell stories. One of them is how the value portfolios got started. So it was September of '91 and Fama sent me a draft of this paper that he and Kim did, which turned out to be a classic, the cross section of expected returns, which got published in August of '92. So I called one of our clients, and I let him know that one person working on his account was leaving. And he said, "Okay, that's fine." So I said, "That went so well." He was like, "Yeah." Said, "What are you working on these days?" He said, "Well, I've been looking at this research into value and growth. Do you know anything about it?" I said, "Funny enough, Fama just sent me a draft of a paper. Why don't I come talk to you about it?"

So I went to talk to him and I realized I wasn't explaining very well. I said, "Do you ever get to Chicago?" He goes, "Yeah, I'm going there next month." I said, "I'll meet you there." This was our biggest client, by the way. And by far our biggest client. So I said, " We'll talk to Fama." So we met at Fama's office and Fama's sitting at his desk, we're standing behind them. He has this bald spot right there we're looking at. And he's scrolling stuff on the screen, and I'm looking at the client. Because I'm not following what Fama's saying, and so I know if I'm not following him, he's definitely not following him.

So afterwards we went out after hearing Fama, the three of us went out to the local kind of greasy spoon that you have near college campuses and sat down and had a greasy hamburger. And I called up the client the next week and said, "What'd you think?" He said, "Well, that was really exciting. Why don't we get a large value and small value, get that going?" So we had created our origin small value trusts and got them up and running in February of '92, six months before the paper got published. I think that's about as cool as it gets. Because of everything I know, which is great research, working well with clients, finding solutions for them in a way that even though you don't have any track record, this stuff just makes so much sense that it's worth a try. And unlike with a small cap experience, the value returns at first were pretty good.

You mentioned earlier that value has struggled relative to growth recently. What do you think when you hear all the narratives out there saying that this time is different?

Well, every time is different. So in that sense, there's nothing different here. Because it's different this time, it's different every time. I think people get confused. For example, we've used price-to-book primarily as our way of determining value. Other people use price to cash flow. And all of those things are fine, because it's not about the accounting variable. You're just trying to buy low price stocks. And it's a factology to say the lower the price you pay for something, the higher it will eventual return. So there's a lot of common sense associated with the value story.

That being said, we've gone through a difficult time with value. All investment styles will go through long periods of time when the results are disappointing. That's the nature of the stock market. The reason being here again, starting with Fama's, it was actually Fama's dissertation in the early sixties where we learned for the first time that the distribution of stock returns as fat tails. By fat tails, meaning they're more extreme events than you would expect things were normally distributed. And you have unusually good returns sometimes like the last nine months, and you have unusually horrible returns too often, like in the first three months.

And this year, we kind of have it all together. It's one story. I was looking at the market today in the US, Russell 3000's up about 18% period here a day. So if one of your clients had gotten too much to drink on New Year's Eve and went to sleep for nine months, or for 11 months and woke up and he said, "How's the market doing?" You say, "It's up 18%." He probably would have said, "Hey, that's pretty cool, good markets!" And you say, "Yeah, well, we got that 18% by being down 30 and up 70." People go, "Well that's markets."

My view of markets is people think too much about the psychology of markets. They think markets are irrational or something. And we have a more of a rational view of markets. With the market, we don't know what the expected return is on the market. We never do. I mean, Fama has spent 60 years and French trying to estimate what is the expected return on this stock or this market? We don't know. But over long periods of time, markets are down about 10% a year. Around the world, most markets in that ballpark. It doesn't make any difference. You think it should be eight or six, for purposes here, it doesn't make any difference. Return differences are clearly important, but the concept of expected returns, pick any number you want. Because what you observed is every year, it's rare that stocks have a 6% return or 8% return or 10%. It almost never happens.

And the difference between over long periods of time, 10% seems to be the number. I could have saved Fama a lot of work. Expected return is 10%. But now he has to do all this fancy research. And it can vary over time. I mean, that's what complicates it all. Every year, the difference between what happens in the market and 10%, you can think of that as being unexpected returns. And so every year, what we talk about are the unexpected returns. Take for example growth in value. This morning, Tesla announced it'speaking its third equity offering this year. Now, I don't think it's a coincidence that Tesla's up is 600% this year. I mean, companies do not issue stock so investors can have a 600% rate of return, or they don't issue stock so that... The FANG stocks have done 30% a year the last 10 years. They don't issue stock at such low prices to be good guys, let investors have a 30% rate of return here for over 10 years.

So, you know those are unexpected returns. Your expected return is really the discount rate attached to future earnings. The value, the stock price reflects all the future earnings of the company discounted back to present value. And that discount rate is your expected return. And it's on the order of 10%. Now going forward, what do I think the discount rate is on Tesla? Of course we don't know but it seems to me like 10% is a pretty good guess. I guess that for all large company stocks. I guess 12% for small company stocks.

We just went through one of the worst three-year periods for value relative to growth stocks. Is there anything that Dimensional has learned going through this most recent period?

Yeah, I'm thinking what you wat to do is every year, particularly when you have extreme outcomes, the negative side of that fat tail, you want to re-evaluate everything you've done. And Fama and French earlier in the year redid their work on value and they didn't find any compelling evidence to change. And I think part of it is a three-year period is just too short a period to conclude anything. We have about 90 years of data in the US, 95 years of data in the US. It's hard to throw out all that previous work based on the last three years were disappointing. But you have to also ask yourself, is it sensible that low price stocks have higher average returns than high price stocks? I think it is. That's not a proof statement, but it's supported by the evidence.

In some ways, you're really not looking at value doing poorly, it's that growth has been doing so well. In fact, I looked at our core funds and looking at their performance versus the market, and it's pretty close this year. We have some of our core funds actually doing better than the market. So it's how you assemble all this stuff together. But anyway, we were very comfortable with the approach. We've done everything we think we can do, which is you want to have test ideas out, back test them through all kinds of time periods, vet that research in the academic community, so pull it apart to make sure you're not data mining. At the end of the day, you've got to come up with what you believe. And it is what it is, I mean, that's what we believe. And there's not enough evidence yet to overturn that. And we're always looking at it.

It's not any fun to come home with disappointing returns. All I can tell you is the amount that value's underperformed growth isn't nearly as nasty as small cap underperforming larger in the 1980s. That was really tough. And what we're finding with our clients is the clients have been with us 10 or 15 years. They've been through this, something like it, although nothing this bad or this extreme. It's not this bad, it's just extreme. And the clients have been with us, so this is the first time they've been through a nasty period and it's a little tougher challenge. Just like it was in 1990 talking about small cap performance. We lost some clients in the '80s due to performance, it wasn't a lot of fun but the people that stayed with it got amply rewarded. And I think that's the way to think about it. Five years from now, or 10 years from now, as you look back on returns, do you want to say, "Look, oh yeah, we had a nasty three-year period for value, so we got out." Everything points to, if you look at fundamental values like PE ratios, or price to book ratios. This looks like expected premium is unusually high for value. I'm not forecasting, wipe my mouth out with soap if you heard me forecasting.

It only makes sense that it would. Anyway, it's what I've learned. Here's one thing I've learned from the business if you've probably you guys have in spades already anyway. Which is just empathy, we know this is the right way to manage money. What we've learned though in years like this is, or the last three years is it's really tough, no matter how good the research, no matter how strong the argument. When you have extremely disappointing numbers, it really tests your ability to stay with us.

We know one of the things that's incredibly important in investing long-term is having an investment philosophy you can stick with through a tough period. You're going to have tough times. What doesn't work is you go through a tough spell, so you get out. People that got out of the market in 2009, people that got out of the markets in March of this year, missed out on that 70%. Those are the people I feel sorry for. And I know it's tough and that's really your job and our job, is to give you really going to help people you're going to help them stick through the tough times in order to get the longterm returns they see on all these charts.

One of the questions that we get from clients, now and then, not super often, but in times like this, it does come up. Is what would it take for to rethink everything. You mentioned that we don't currently have enough evidence to do that, but at what point do we have enough evidence to say, "Okay, you know what, maybe value doesn't work anymore."

Well, to say it doesn't work. I guess there are three outcomes. One is value to debt and debt is better than growth and does the same as growth, or it does worse than growth. I can't imagine that there would ever be enough evidence to say, "We think, companies with good earnings prospects, big, safe companies. We think they should have higher expected returns because they're less risky.' At some point, these dimensions are got to be connected somehow to risk factors. We don't know how exactly.

We all know what risk is, well I think I know what risk is. Risk is a shortfall in meeting your client's goals. That's really, that's risk. It's hard to quantify, and do you have to do to get back on track that's risk. Maybe saving more, or waiting a year to retire, that's risk. I guess there could be... we have 95 years with a strong relation between a strong value of factor 95 years. You can probably take 95 years to say girls does matter than value.

I just couldn't believe it. I can see that it's perfectly reasonable that you can say, "It's a push they're the same." Maybe you could make that argument and maybe you can do it in another 25 years or something. You could make that argument, but it would take a lot of data and it would take it a lot of data and a lot of countries. We find this stuff everywhere. That's one of the first things, Fisher Black he was still alive when Fama-French came out with their original research. And he said, "How do you know this is not data mining?" So that's always the concern, particularly now, in my view.

In the US they there's one academic research database everybody uses, CRISP database. If you can only imagine how many thousands of people have been doing variations using that database over the last 50 years. Say, "Aha. I've come up with something new." I have a tendency not to believe that. A few years ago we actually added in profitability, but that was after a couple of years of research that had been going around on profitability. And we replicated it and there's a reason to think that it's sensitive. So after doing our homework for a couple of years and we invited them Novi Marks was the first person to come up with it. Probably the French said, "This guy Novi Marks he's defending his data."

One of the things that wears me out is clients will show us some research from somebody that says, "Oh, here's a new model for picking stocks." Vet it out in the academic community for awhile. Everything we do is in the public domain. That is so important and people lose sight of that. So by the time we got around to doing the profitability, we felt very comfortable. We understood it, why it's there, it should be there, and it hasn't been there and it's actually worked with us. So not everything we've... Even though value hasn't worked, the profitability has worked for me. These move in the same direction, but that's what it takes to come up with something new and different.

And the thing about empirical work is let's look at the data because you'd have to have more than data. You'd have to have a sensible story. Here's why, and it could happen just like, I don't know, but it would be a pretty extreme outcome. And we don't have to worry about it the next few years anyway.

And by the way, this functional thing different way. Which is here again, it ties in, it's not like it's book value or it's cashflow. Those things are important. They're important in terms of determining the level and his talk price and selling at. They're not important at, particularly earnings growth. It is important to help determine what the price should be. Earnings growth is not that important in terms of your expected stock return. What determines your expected stock return? Well, it's got to be related largely to uncertainty. And that's what investing is about and really ties into the theme here. Investing is complex, it's complex because of the uncertainty.

There's a good side to uncertainty, which is if there were no one certainty then wouldn't be a risk premium because there wouldn't be any risk. So it's about learning to deal with that uncertainty, making sure you don't take more than you can handle. Then monitoring outcomes to make sure you stay on track. And the discount rates that we've talked about in terms of discounts future cash flows or earnings back to the present value. That discount rate has to be largely related to uncertainty, which has nothing to do with digitization, or manufacturing, or healthcare. It's the uncertainty about all these earnings streams is what really determines largely your discount rate. And that will never change. So in that sense, it's not different this time, the market always looks different. But you're getting paid for taking uncertainty. And I don't see that ever changing.

Well, we were talking about this with someone in our online community that we have for the podcast. And I think I said something like this time is different in terms of the companies, they're different businesses. But that doesn't mean asset pricing is different.

Yeah, right. It's still a largely about risk and return. We don't know there again, exactly what risk is, but that's why at the end of the day, let me come back to this notion. So we start with uncertainty and learning to deal with uncertainty. How do we choose to deal with uncertainty? Well, we go to science, we look at academic research. We look at models, theories, which theories are basically models and look at what we have. And we try to figure out what are the insights we can gain from all of that? That can help us in developing investment solutions for clients?

That's what it's about now that only takes you so far. Because modeling and research only takes you so far because then you got to go out to the real world and implement. And that's where flexibility comes in. You can't be dogmatic about things. You can't be too overly mechanical. You can't just blindly go into the markets and throw out market orders. It's more complicated than that. So you need some flexibility at that point.

So it's uncertainty to science, to flexibility, and then the final step is empathy. Realizing after you've done all of that, it's very difficult for people to stay with things when results are disappointing and the results will be disappointing. About once a generation market lose about 50% of value. That happened in '73, '74 to me and when I was working and you have 2008, 2009 in the US. I hate to just use US numbers. But anyway, you're going to have those kinds of outcomes.

So if in March of this year, if you say, "Look, the pain of value is so much, I can't stand this. I need to get out." Then you shouldn't have been so much in value. We think you got to have value and growth. We don't say you should only invest in value. We think you ought to have value and growth. We have the same stocks in our core funds. We hold them in our various portfolios and we overweight, but we hold value in small companies in greater proportion than they represent in the market. That's what we believe. And we think there's a good reason to believe that. Other people can challenge your assumptions. Everybody has to come up with their own solutions.

You guys do a great job of coming up with solutions. And What you really do well is come up with stuff you believe in. You guys do a great job and I'm not trying to be overly complimentary here, but you deserve credit. We see advisors too often, when their clients come in overly excited about something or other shift around based on resident clients. Here's what we believe is the solution. Because I think people internally have kind of a BS counter terror. And even though whatever it is, you're saying people intuitively realize when you're straying away from what you believe.

And that's in some ways is the most difficult thing to get across to young people coming into the firm, new people. They've grown up hearing how bad people on Wall Street are, and investment business, and yadda the yadda. They think they're going to have to lie to people or cut corners or do something differently in order to succeed. You don't have to. That's probably the thing that surprised me the most is that we can make a decent living. And a decent living, telling people what we believe and backing up with great support. How cool is that?

The last thing you said is the key and we appreciate you obviously saying that we do a great job with our clients. But it's because of that, we tell people what we believe, but then we can back it up with the evidence. And that makes it a much easier conversation.

Well what else are you supposed to do? The only alternative is say, "Look I'm just going to be my hunch here. The taxi drive said he thought Tesla was a good shot." Whatever. That stuff wears me out. Unless you can back up, and unfortunately a lot of people run around with willy data that's mediocre or data. And so they have plenty of data it's just not robust. That's the thing about the research that we believe in and people.

There's only been one Nobel prize for empirical research and Fama got it. He's the top of the food chain in terms of research. It's not only his papers, but the intuition and the field for the data doesn't even get into the papers. It's been fantastic working with him. So I've been blessed. You go back to... You'd ask about business school. Leaving there 50 years ago, realizing I didn't want to be a professor. I want to change people's lives and getting these ideas out there. And to be able to still hang out with Fama, and Shoals, and Martin, and Martin Miller before he passed away and all the others. And having a great group of clients where you can tell them the truth.

And most clients don't believe everything we say. They have their own particular... Which is fine. As long as we keep the goal in mind, which is how can we come up with the best solutions for the end clients? Then we'll all be okay.

Speaking of the end client David, in 1988, that's when you allowed a financial advisor to have access to your products. Can you talk about that decision and your views on the impact that advisors have?

Yeah. Well, I wish I could say it was very clever on our part but it wasn't. This guy Dan Wheeler, you met Dan Wheeler? He approached us with the idea of getting access to our funds. At that time, we just had large institutional clients. We'd made the decision early on not to sell directly to individuals. The reason being, we don't know how to work with individuals. And what you read in the press all the time was it would get in and out of the funds too often. We just can't have them behavior. We have co-mingled funds, mutual funds, and trusts in Canada. Commingling is great. You can take a client with a relatively small amount of assets and get incredible diversification globally by investing in co-mingled accounts. Well, that works as long as everyone behaves themselves.

But if you have a few people out there in and out all the time, everybody else is paying for that. So that's why we decided not to sell individuals. So then it comes Dan Wheeler, financial advisor in Sacramento. Says, "I'd like to have access to your funds." We go, "Ah we don't know." And he said, "They don't go in and out. I have all index funds now and what you do is better than that. So I'd like to have access to your funds." So I said, "Okay, well, let's you try, but if we catch you doing a lot of trading, we're going to shut you off." Said, "Okay."

He did this for a year and comes back at the end of the year and he goes, "Well, I think there's a business in this, I've talked to a number of advisors who would love to have access to these funds because they're institutionally priced. You're getting institutional quality at institutional pricing for individuals. That's pretty cool." So we said, "Okay, but we put in some roadblocks." A lot of people find this funny when we tell them how we did it, but we say, "Okay, we got to make sure we have good advisors. So they have to call me on to our offices and spend the two days listening to why we do what we do and how we do it. And then afterwards, we will talk to them about it, see what their business plan is, see if we think they'll have good behavior."

Because it's really about end client. It's easy to take anybody. Right? But that's not good for the people in the front. And once you're lucky enough to get clients, you want to keep them and you want to do everything for them. So that's how we got started. And the people find it funny that we were such a pain in the neck to deal with. It was for a good cause and eventually word of mouth spread. And the business took off from there. We did very little, almost none direct selling. We just waited for people that read about what we do, and believe in what we do. And they'd give us a ring. And now it's two thirds of our business are online comes from financial advisors.

Because our initial client, the large corporate pension fund is kind of disappeared. It's gone into 401k plans and so forth, defined contribution plans around the world. So we lucked out there. It's been fun. Symposium where you bring your clients into a conference and we get to meet him. I used to get such a kick out of that. That's the real world there. That's why we're doing all this. I tell people, "When you get to be my age, you want to look back, think it was all worthwhile." I can tell you, it was all the worthwhile.

David, you mentioned the co-mingled funds and that being a big part of how Dimensional went about distributing to financial advisors. Wanted to make sure that they were good advisors that were going to keep their clients invested, to make managing the funds easy to do cost effectively. But recently Dimensional has made some pretty big waves in the financial services industry. I've seen tons of headlines about it by launching ETFs. So converting some existing mutual funds to ETFs and also launching some brand new ETFs. What went into that decision to enter the ETF space after sticking with mutual funds and mutual funds, being such a big part of the story for so many years?

Also I'll throw in next year, we'll be hopefully getting also into the smaller, separate accounts. We've always done separate accounts, but minimums have way too high. But the administrative costs have come down a lot and I think we'll be able to do some interesting things in separate accounts. Probably won't be total separate account, probably separate account mixed with some commingled funds. Nobody wants to emerging market, small cap, separate accounts. So that's the innovation stream.

A part of it has to do with tax considerations in the US or tax treatment. Keep in mind your total return is a combination of capital gains and income. So what sprang up a couple of decades where the index ETFs in the US and the index ETF has some capital gains benefits. You don't have to distribute, basically there's very little capital gains distributions, it's all built up inside the fund, which can be an advantage to taxable investors. At the same time they haven't done anything on the income side. Now our mutual funds, for the last 15 years, have worked on making sure our income that we distribute for the taxable funds, the ones that ... You know these tax managed mutual funds are the ones being converted to ETFs. There you want to make sure all the income is being distributed as qualified income. And I won't bore you with all the details but, for example, the income from investing in REITs in the US is not qualified income. It's non-qualified income.

So if you have an indexed ETF and it has REITs in it, which some of them do, then you're going to be distributing out a non-qualified income, which we have been able to avoid. So the FCC, in the last year or so, has developed rules which enable us to do both in an ETF format. Until now they have not allowed any flexibility in an ETF. And an indexed ETF has to be indexed, and in an ETF stocks go in and out in kind, and it has to be a really total index, there's no ... So all the stuff we've been doing on flexibility over the years you couldn't do in an ETF format, now we can, the rules have changed. So now we're able to come out with flexible ETFs to compete with the indexed ETFs. These flexible ETFs will have the same capital gains treatment as the indexed ETFs, plus we'll be able to make sure the income is qualified.

So you ask why did we come out? Because we've figured out a way to do something better. I mean, that's the kick in the pants that we always look for. We look at something out there, "Can we do something better than what's out there?" And once we're convinced of that then that's when we come out.

You mentioned competing there David and I believe competing fiercely, or something like that, is one of Dimensional's core values. The industry is seeing significant decompression lately. Can you give us some comment on where you see the future of fund fees going?

I think they're getting close to bottom. I think most people would love to have an advisor, most people would like to have their money managed in the best way they know how, and they're willing to pay fair amounts. What's a fair amount? Well for our fees they have been coming down and I think ... I doubt if they come down much from here. I mean, we'll see. Look, we have to be price competitive and we don't get to set prices. We have to compete for business and part of competing aggressively is making sure our pricing is right. Over the near-term pricing is not that important but over the long-term it's everything. You got to get the pricing right.

And we're kind of unusual in that when we come out with new funds we typically try to price them to whatever the long-term average and where the article seven long-term is not ... I don't like to cut fees. I mean, I like to be competitive but I like to have the pricing right, right from the get-go. But there's been a lot of price competition and that has backed up into us as well, so it is what it is. So we don't have much control over that but we want to make sure clients feel like they're getting good value from us.

One of the ways that Dimensional adds value, and that we've talked about, is by implementing the academic research. We talked about small and value, and you alluded to profitability, asset growth is another one that was implemented in portfolios very recently. Is there a next big thing in the research that Dimensional's looking at implementing in portfolios?

Well we're looking at everything. I mean, if you look at the academics there's a lot of good research going on and we always want to, if we can add a little bit. Let's say like even the asset, that isn't a huge ... We're not building portfolios around that, we're just saying there's certain companies that have to invest huge amounts, if those don't appear to be doing particular well then we exclude those. It's not a big exclusion but it can be meaningful. I mean, it's ... And that's what you're dealing with. Whatever the next big thing is will have a very modest benefit. It's like everything else in life, decreasing marginal then the first dimension brings tears to your eyes, the second one, "Wow, that's cool." The third thing, "Eh, okay." Fourth thing, "Well you know I" ... So it's always worth fighting for any basis points but you got to keep in mind this caution that we have to have about given all the research that's been [inaudible 00:58:56] of this same database for so long they have to approach a lot of these things pretty guardedly.

And I think that's one of the strengths of Fama and French, once they see a research they try to disprove it. They're not trying to convince people that they're right, they're trying to show people that it shouldn't be there or something. That's so important. And as a result we've never had to pull any types of strategies. You look at money management, and I'm sure it's true up in Canada as well, you look at the funds that are available now most of them or many of them ... Most of them, probably, weren't around 10 years ago. People pulled these funds. They have bad performance they pull the funds. We have disappointing returns on value we're not pulling the value, you still believe in us. I mean, if we ... We would shut down the funds if we didn't think we were doing things the right way. I wouldn't hold my breath for a new dimension that makes your pupils dilate. I mean, I think that's probably unrealistic.

I think the innovation is going to be coming through smaller separate accounts, being able to have software applications where a person can kind of get their balance sheet updated on their smartphone every day, whatever. Those are the ... A number of innovations like that. I think, also going back, probably long-term and derivatives we'll be able to ease them a bit more to ... Now this is more futuristic thinking, this is not around the corner, what you would really like to have is stock and bond returns have a distribution of outcomes. You know it kind of looks normal, maybe fat tailed, or whatever. What you would like to do is take these distributions and transform them into a distribution that a client would like to have. And I think the technology is really there, it's just trying to figure out if anybody's interested.

These are the kind of things we tinker around. Sometimes ... You know James Bond movies I think most people identify with James Bond. I've always identified with Q, you know the guy who tinkers around in the lab and says, "Now James don't blow it at this time." Anyway, we still have plenty of things going on in our lab.

You mentioned a couple times the small separately managed accounts. Is that kind of like the direct indexing idea that people have been talking about?

And the advantage is ... There are several advantages but you have to be very careful, the cost can explode, custody administrative costs. You really have to have a sharp pencil and you can't have a lot of flexibility, but administrative costs are coming down because computing costs are coming down. You just have to look at that trade-off. We're looking at it and if any of your clients are interested I'd be happy to chat about it up there, it's getting close for a lot of people. But here, again, I think you would think of say a Canadian large cap separately managed account with emerging markets. . And I know you like to have one main fund. I mean, you have to look at all these things. Eventually, sometimes, the darnedest things pop up. You look at them and things that you thought were silly 10 years ago now aren't so silly.

We've heard a lot about the direct indexing and this idea that building these super customized portfolios, which arguably adds more complexity, is going to be the future of asset management. And, like you mentioned, we've been very happy with having single portfolios. We have one portfolio for all of our different asset allocations. What do you think about that trade-off between complexity and simplicity? Is simplicity ever going to be a bad thing?

Hey I'm on the side of simplicity. I put all my ... We have a 25/70, 25% equities, 75% fixed income. I put all my money in that. Why? I'm old, 25% equities probably is all I should have. And I can't tell you how it's done this year, I mean I don't pay attention. There's no evidence that complexity adds value. There is a lot of evidence that people like complexity. So if that's what they want. So I'm on your side, in terms of keeping it simple, but we have to follow our clients.

How do you view culture and how do you approach it?

That's one of those things I struggle answering. I think the first thing you need to do is focus on respect. In some ways managing a firm is kind of like managing kids, you start with respect. You're the boss and you can tell people what to do, and you'll get a certain outcome. You're much better off helping them find their own way. You have to have sensible policies but I kind of always try to figure out if somebody's coming in with a new idea or a different way of doing things my bias is, "Maybe we should try that." They're not going to come into my office unless they've probably thought it out pretty well. I don't have all the answers.

The story I told you about Dan Wheeler coming in, he wasn't an employee, but he came to us. I said, "It doesn't make any sense to me but it's worth trying, what the hell?" And it turns out to be incredibly important. I think that's the way businesses work. You've got to adapt, and fermenting, and listen to people. And if they get the feeling like they're being heard ... Probably all the management techniques you've ever read about probably work, I never read any of them. Keep in mind I was a geek, so I never managed people before starting a firm, so I'm kind of learning as I go. But I think if people understand you're trying to do the right thing, you're trying to do it the right way, and you treat them with respect I think you have a pretty good chance of ending it with good culture.

Your career in finance has been historic. I mean, we talked about you being there at the inception of index funds and then, obviously, founding Dimensional. And no doubt some of that's due to your personal attributes, but things like leaving Kansas to become Fama's teaching assistant, when EMH was still relatively young and index funds didn't exist, that can't be reliably replicated. How do you think about the role of luck in life and business outcomes?

Well luck is ... I mean, look at almost any successful person, they've had a lot of luck along the way. Had they had bad luck in the way that turned out, instead of good luck, they probably would have found some other way to do things and eventually they would have found something where they had good luck. There's a country western song, "If I didn't have bad luck I wouldn't have no luck at all." I'm not that way. I think I approach things as being an optimist. I think Will Rogers, who was a early 20th century homespun philosopher, he used to say, "Farmers are inherently optimistic because if they weren't optimistic they wouldn't be farmers." People always ask for advice, I never give advice, but I do point out that if you find something you're passionate about and that you have a comparative advantage in doing, and you're obsessed about doing the right thing in the right way, you'll probably have some pretty good luck along the way. And the main thing is when it occurs you don't let it slip through your fingers. When you do have that ...

I mean, as I start my career we started off with an unfortunate outcome, like Wells Fargo shutdown our group. I viewed that as an opportunity. I think that's one of the things that is kind of a working hypothesis anyway, which is uncertainty creates opportunity. You always have to focus on that and that opportunity doesn't always work out well, that's why they call it uncertainty. If you do things the right way you have a good chance of having a string of good luck.

How do you define success in your life David?

Well, I mean, I've had the opportunity to think about that, and revise.. Success is when you get to be my age you look back and you take pride, maybe too much pride, I don't know maybe it's false pride or ... Pride's one of the deadly sins but I feel really good about what's happened to me and I think I had some positive impact on that, and I've been able to hang around extraordinary people, I've been involved with my whole career all these great academics and great clients. So being able to hang around good people, and accomplish something, and look back ... I mean, you can see we really improved people's lives versus ... Now we didn't do all of that. I'll include the index on people in with us as well, but all this movement towards better diversification, risk controls, and lower fees, that's really helped people out. You can feel good about that. And that was kind of why I left school to begin with, is to help people out.

We don't like to talk about ourselves but I think it's I'd rather point out to people, "Look, you can have a career in finance and at the end of it all feel good about yourself." There are plenty of good examples. There are plenty of horrible examples too, but if you do things the right way you can carve out a good career for yourself in this business.