Interview with Ron Ross, Author of The Unbeatable Market By John Spence October 23, 2002

Ron Ross is the author of a new book entitled The Unbeatable Market: Taking the Indexing Path to Financial Peace of Mind. This one caught our attention because of its accessability, and also because the author refuses to pull punches when it comes to conflicts of interest on Wall Street and elsewhere.

"The book is in the tradition of Burton Malkiel's Random Walk Down Wall Street," said Ross, an investment advisor and former economics professor at Humbolt State University. "By making liberal use of analogies and examples I have tried to make the book more engaging and reader-friendly, and I have taken a much more adversarial tone in the book."

Ross dicussed his new book and his ideas on investing from his office at Premier Financial Group in Eureka, California.

Q: Your book focuses on market efficiency. Vanguard founder John Bogle says index funds work over long periods because they are cheaper than active funds, not because the market is efficient. Do index funds fare worse in less efficient markets, for example small-caps or international stocks?

A: If you aggregate all actively managed funds and all index funds in a given asset class, the difference in performance will be roughly equal to the cost differences. The main reason actively managed funds cost more is because of their excessive and useless portfolio turnover. Looking only at the overall differences in the averages, however, hides much of the damage done by trying to beat the market. There is a wide range of outcomes among the active managers in any given time period, and there is no real persistence from one period to the next. That translates to more uncertainty, and more uncertainty is the same as more risk. Lower return is only part of the damage done when trying to beat the market.

As the second part of your question implies, some markets are more efficient than others. Nevertheless, in regard to practical implications, there is no real difference. In any reasonably well-developed market, the competition among the players will make it highly unlikely anyone will persistently beat the others. For example, the stock market in South Africa is probably less efficient than the stock market in the U.S., but it's also higher risk because it's less diversified. Collecting information about South African companies would also be more costly, and that would raise the hurdle you need to overcome before you make excess net returns relative to the market.

Q: One of the benefits of indexing is that you don't have to spend time researching fund managers or keeping on top of manager changes. Is this benefit overlooked?

A: It's a bit harder to put a price on time costs in comparison to out-of-pocket costs. Nevertheless, it's true that time is money. If anything time is even more valuable than money. You probably know people who say they have enough money, but do you know anyone who thinks he has enough time? Economists usually argue that the value of an hour's worth of leisure time is roughly equal to what you earn when working an hour.

Indexing saves time in numerous ways. For instance, there's not as much monitoring required. It's not necessary to compare your results to a benchmark - you own the benchmark. There's no natural limit on how much research is enough when using actively managed funds, and whatever research you do is highly unreliable and quickly obsolete.

Q: You discuss S&P 500 and total stock market funds in your book. Any thoughts on using the total market index fund approach vs. slice and dice with passive funds? Slice and dice essentially tilts more toward small and value.

A: The main problem with both an S&P 500 fund and a total market fund is they essentially consist of one asset class - U.S. large growth. What you refer to as slice and dice does usually tilt a portfolio toward small and value. Such a tilt is done for two reasons. First it's a way to deliberately take more risk, and those are two kinds of risk the market has rewarded, at least historically.

The second reason is to achieve efficient diversification. Small, large, growth, foreign and U.S. asset classes have a significant degree of independent behavior. The performance of those asset classes is not perfectly correlated. Using uncorrelated asset classes is a way of smoothing out the performance of the portfolio. The main benefit of asset allocation is not performance enhancement, but rather risk reduction.

Q: In your book you say Dimensional Fund Advisors (DFA) funds aren't really index funds, but rather asset class funds. What's the difference between an asset class fund and an index fund?

A: In most discussions the terms index funds, asset class funds, and passive management are used interchangeably. If you want to be more precise, there are some fundamental differences. An index fund attempts to match the performance of some pre-existing index - the S&P 500, for example.

The two important dimensions of investing are risk and return. Indexes are not necessarily created taking into account those two considerations. When DFA creates an asset class fund it does so by deliberately and systematically taking risk and return into account. Risk and return are far more relevant to investors than a fund's tracking error relative to some index.

Q: You write that manager style drift makes it impossible to accomplish effective and constant asset allocation. Why?

A: As I discussed earlier, the objective of asset allocation is what's known as efficient diversification. When constructing a portfolio, you're looking for building blocks with good risk and return expectations, as well as independent behavior.

When you buy a small value building block for your portfolio, and later discover the managers have switched their investments to large value, your plan has been undermined. A major benefit of asset class funds is that what you see is what you get - this year, next year and indefinitely.

The publication date for the book is November 5, although it is currently available at atlasbooks.com or amazon.com.