Getting to Know Dimensional Fund Advisors: Part I
In our last blog post, we introduced you to a “secret investment dimension” that’s been hiding in plain sight for more than 30 years: Dimensional Fund Advisors. Now that Dimensional board member Eugene F. Fama has received the 2013 Nobel Prize in Economics, will this low-profile fund manager become a common household name? We won’t hold our breath on whether they can beat out Miley Cyrus in this year’s Google rankings; it’s hard for the science of capital markets to compete with Miley’s new tattoo. Still, among investors, it’s a name well worth following.
Dimensional Fund Advisors Goes Mainstream
Founded in 1981, Dimensional is the eighth largest mutual fund company today. The same article reported that Dimensional was second only to Vanguard Group in 2013 sales. It also was recently listed as financial advisors’ favorite fund company in this Cogent Research report. A trim 30-year-old, this fund manager seems to be hitting its stride.
So how is it that Dimensional more closely resembles a cult classic than a box-office hit among individual investors? Quietly, almost clandestinely, they’ve succeeded by offering investors an improved way to think about investing … for those willing to listen.
To describe Dimensional’s distinct fund management style calls for a short history lesson, which we’ll offer in this post. In our next post, we’ll describe how Dimensional has applied the academic lessons learned to help position investors for whatever may lie ahead in our unknowable markets. Bear with us; this will be fun, really!
Dimensional’s Roots: A Brief History of Active vs. Passive Investing
Once upon a time in the 1960s, University of Chicago Professor Eugene Fama formed the Efficient Market Hypothesis (EMH), for which he recently received his 2013 Nobel Prize. He later became a board member at Dimensional and continued to work alongside a Who’s Who list of financial economists who have collectively contributed to our understanding of efficient capital markets.
Before EMH, it was commonly assumed that the best way to make money in the markets was to find and profit from pricing errors. This required investors to consistently pick future winning securities, or move in and out of rising/falling markets at just the right times. This became known as “active management.” It required ongoing, active decisions that were correct often enough and profitably enough to overcome the variety of expenses involved.
EMH challenged active management by offering a novel way to think about investing. It demonstrated that current prices set by the overall market are usually the best guess as to what unknowable future prices will be. In other words, the market’s collective wisdom results in largely efficient price-setting. (There are some fascinating illustrations on how collective wisdom works so well, which we’ll share in an upcoming post.)
The impact of this seemingly modest finding is enormous. It means that active investors cannot expect to profit by regularly outguessing a largely efficient market. Simply put, the costs of trying to actively beat the market at its own game will ultimately eat active investors alive compared to other market players.
A startlingly simple mathematical equation provided by Nobel laureate William F. Sharpe demonstrates why this is so. Essentially, since the total market must be the sum of active plus passive market players combined, any above-and-beyond costs taken on by active players detract from their slice of the pie. Of course, due to random luck, some within the body of active investors will happen to succeed. But, as in a game of Pin-the-Tail-on-the-Donkey, the odds are stacked against them. Especially since there’s a better way.
In case you haven’t recognized it, that last sentence is our teaser, to encourage you to read our next post in which we describe that “better way.”
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