Gene Fama is vice president of Dimensional Fund Advisors (DFA),
the funds management firm founded on the academic principles of
diversification first articulated by his father, Eugene Fama,
in the 1960s. He explains to David Chaplin how the DFA philosophy
works in the real world.
David Chaplin: What is the Dimensional investment philosophy
in simple terms?
Gene Fama Jr.: Markets work. A company's cost of capital is
the investor's expected return for investing in that company.
Diversification is crucial-non-diversified portfolios add uncompensated
risks.
Risk and return are positively related-the only way to add
to expected investment return is by taking more (compensated,
or "priced") risk. A portfolio is best structured by taking
advantage of the risk factors that best suit an investor's preferences
and circumstances.
Portfolios should be tax-efficient.
Dimensional's portfolios are not index funds-the academic process
of competing ideas breeds the best definitions of investment
classes. Indexes are not sacrosanct or cost-effective and need
not be slavishly followed.
With no stock picking or market timing, minimising trade costs
adds value. Lower fees help too.
Can active managers add value in the long term? If not,
why?
The aggregate of active manger investments is, of course, the
market (or pretty close to it). So by definition, the aggregate
of active managers delivers market performance minus expenses.
The more expensive the active manager, the lower its expected
return. But the real problem is that picking stocks and timing
markets generates excess variance that in economic theory is
considered uncompensated.
Is a belief in the virtue of capitalism all that investors
need? Why shouldn't people try to beat the market?
You don't have to believe in the virtue of capitalism so much
as the efficacy of it. Markets appear to be pretty good at pricing
and allocating resources, including investment capital. I don't
begrudge anybody the attempt to outguess the market, I just
don't think it pays in terms of effort and cost.
Australia and the US are fundamentally different markets.
How does the DFA model deal with these differences?
I'm not sure this is true. If you mean Australia seems less
efficient, my hunch is that it just has less data history and
fewer stocks. The dominance of a few companies can cause managers
to randomly outperform simply by holding the big names in different
proportions than the market portfolio. We can't tell if it's
a skill until we see it work over significant investing cycles,
which statistically means several decades, not several years.
I like to think people, and therefore markets, are the same
everywhere, otherwise the differences would be arbitraged away.
Is the current market turmoil indicative of a fundamental
change or just normal volatility? Why?
We've studied this. Stock volatility is up maybe by a tad,
but the increased volatility you see in portfolio performance
is not from the overall stockmarket. It's from increased differences
across the returns of individual stocks. The differences between
stocks are more pronounced than they were 10 years ago by a
factor of three. This means active portfolios that hold fewer
stocks will have exaggerated performance differences while broadly
diversified portfolios will tend to be a bit more stable.
This has occurred in the past so it's not clear anything fundamental
has changed. I say it's always safer to assume it's permanent
and to diversify.
How is the threat of war affecting US markets? Is that a
factor DFA would take into account when constructing portfolios?
By the time something like the threat of war is plastered across
newspaper headlines it's probably already incorporated in the
current prices. Since we believe markets work well, we don't
try to anticipate or forecast events. We read the papers, but
we don't use them to form long-term policy.
What is long term investment?
I'm different on this one. Some people think it means a specific
time horizon, like 10 or 20 years. I think it's the life-cycle
of all your investments taken together. If you buy a house and
it doubles in price by the time you sell it in 10 years, you
didn't earn 100 per cent on real estate in the long term unless
the next house you buy with the profits doubles in price too.
Since even long periods are uncertain, the sum of all your transactions
over your entire investing career might be the most effective
way to think about the long term.
DFA has made a point of not paying commissions to advisors?
Why, and has this held up its growth?
That policy has not only helped growth but it's helping change
the face of financial advice. The old brokerage model is being
replaced by fee-only advice. It only makes sense: everything
works best when the person you're working for is the person
who pays you. It avoids conflicts of interest. Fee-only advice
aligns the interest of the advisor and the client so advisors
have no reason not to offer their best advice. The whole industry
here seems to be following suit, so it must be a good model.
What is the appropriate role of the financial advisor?
To educate clients about portfolio theory and clarify the process,
not to deliver product and fill orders. The days when an advisor's
chief role is to find good investments are fading away, maybe
because it has so little history of working well. But most people
are not born long-term investors-they need to be taught how
markets work and how to stay disciplined, and that's the advisor's
most valuable function.
