Active vs. Index Investing with Weston Wellington, Vice President, Dimensional Fund Advisors

Active vs. Index Investing with Weston Wellington, Vice President, Dimensional Fund Advisors

Episode 107
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The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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TOPICS COVERED:

  1. Guest Introduction: Weston Willington
  2. Passive vs. Active Money Management
  3. Active Investment Strategy
  4. Index or Passive Funds?
  5. The Reconstitution Effect
  6. Succeeding in Investing
  7. The Differences with DFA

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Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.


1. Guest Introduction: Weston Willington

David Bear:  Hello and welcome to this edition of The Lange Money Hour, Where Smart Money Talks, with Jim Lange, CPA/Attorney and author of two best-selling books, Retire Secure! and The Roth Revolution: Pay Taxes Once and Never Again.  I’m David Bear, here in the KQV studios.  One primary consideration that differentiates mutual fund companies is whether they generally follow an active or an index investment strategy.  Active firms try to identify and predict specific winners over a given investment sector.  Index firms focus on a sector as a whole, taking and maintaining positions in a representative selection of investments in that sector.  Active investments versus index investing: over time, which strategy produces the best results for you?  To provide some perspective on the subject, we welcome Weston Wellington to today’s edition of The Lange Money Hour.  Long-time vice president at index-oriented Dimensional Fund Advisors, and a member of its research team, Mr. Wellington brings more than 35 years of investment management experience to the conversation.  Known globally as an expert on capital markets, and one of DFA’s most engaging speakers, he works with financial advisors in the U.S., Canada, Europe, Australia and Latin America, demonstrating why an equilibrium strategy is the most reliable way to achieve investment success.  He also writes regular columns for DFA’s password protected website, Down to the Wire.  In addition to looking into investment issues, he and Jim will explore Dimensional Fund Advisor’s approach to investing, as well as its place in the broader financial industry.  Listeners, stay tuned for an interesting and informative hour.  And since our show is live, you can join the conversation.  Call the KQV studios at (412) 333-9385 with your questions and comments.  And with that, I’ll say hello, Jim and welcome, Mr. Wellington.

Jim Lange:  Welcome.

Weston Wellington:  Nice to be here, Jim. 

Jim Lange:  Thank you so much for agreeing to be on the show.  Before we get into the meat of the content, I do, by way of disclosure, have to tell our audience I am not completely objective to DFA.  So, normally, when I have somebody like John Bogle or Ed Slott or any of the many experts that we have had on, whether a client agrees, disagrees, buys the book, doesn’t buy the book, likes the approach, doesn’t like the approach, really doesn’t have any impact on me.  I always try to provide objective information, what I think listeners would benefit from, but I usually don’t have any ulterior motive, and if I do, I feel honor bound to say something.  I am a Dimensional Fund Advisor provider.  I actually work very closely with an advisor named P.J. DiNuzzo, where he actually is the investment advisor.  I do strategies like Roth IRA conversions, Social Security planning, how much people can spend, tax planning, estate planning, etc., and we work as a team together, and we actually charge what most advisors would charge separately.  That is, 1% or less, depending on how much money’s invested.  So, I wanted to be fair and say that I am not objective, and if somebody likes what they hear and they’re interested, I do have skin in the game.  So, I thought that that would be fair before I started.  I hope you don’t mind that, Weston.

Weston Wellington:  Not at all, and I should say that it would be helpful to the industry if more participants were motivated to readily disclose any relationships they might have the way you did.  I think everybody would be better off. 

Jim Lange:  Well, I appreciate that.  You know, P.J. and I are both what are known as fiduciary advisors, and we have both a moral and a legal obligation to do what is in the best interest of our clients, and to disclose everything.  So, I always think that if you disclose everything, that you don’t get in trouble.  That’s what the compliance people tell me.  That’s, to me, good business, and it’s also ethical.  So, again, I am not objective to Dimensional Fund Advisors, and I literally have skin in the game, both personally and through my business.  But perhaps we could get into some of the meat of the show, and if we could start off with maybe something that’s a little bit simple, and then kind of go on from there.  Weston, could you tell us the difference between a passive and an active money management approach?  And then, we’ll see what DFA does.


2. Passive vs. Active Money Management

Weston Wellington:  Sure.  Let me try to answer that question by taking another step backwards, if you will.  I’ll try to look at this big picture.  I think every investor, whether they are trying to assemble and manage a portfolio of securities on their own, or whether they engage some sort of professional to work with them and to do it on their behalf, every investor should have an investment philosophy that they understand and that they believe in.  They think it’s going to work for them.  Well, we find in too many cases is that investors are kind of like ping pong balls getting bounced around from one particular viewpoint to another, and they’re often frustrated in their efforts to have a successful investment experience, and part of the problem lies in not having an articulated investment philosophy and not demanding that the professionals that they work with also have articulated to them what their investment philosophy is.  So, the first order of business is to have some sort of agreement, how do you think the world works, and what are you seeking to accomplish?  What are you expecting your investment managers to accomplish? 

Now, why is that relevant for this distinction between so-called active or indexed or, perhaps another word, passive investing?  There is a broad and very fundamental distinction amongst these two types of overall approaches.  And the way I like to describe it is that it’s a different version of what people believe to be optimal investment advice.  For most people, there’s only one version of investment advice: find some smart people who can identify and understand what’s going on in the economy.  Are business conditions getting better?  Are business conditions getting worse?  What’s happening to interest rates?  What’s happening to inflation?  What’s the Federal Reserve up to and how will that affect my portfolio?  Do all the research you need to do to figure out what’s going on in the economy, and then figure out which companies, which industries, appear to be best positioned, and then hold securities using that research.  To most people, that’s the only sensible way of investing.  What else could there be?  Identify the most attractive companies, the most attractive opportunities in today’s economic climate, and invest in just those companies.  For most people, that’s, as I said, the only definition of investment advice, and to an overwhelming degree, the business of the financial services industry is organized, in a very broad sense, around that particular viewpoint.  They have all these squadrons of experts and analysts studying companies, studying economic trends, and trying to figure out what’s going to happen next, and they issue a constant stream of comprehensive research reports and recommendations, “This is what investors should be doing now with their money.”  If you take nothing else away from this conference call, I hope you will leave acknowledging that there is an entirely different definition of optimal investment advice. 

Jim Lange:  Before you go on, could you categorize what you just spoke of as the active investment strategy?


3. Active Investment Strategy

Weston Wellington:  Yeah, and as I say, it’s active and for most people, they don’t even call it active because they don’t make a distinction between active and anything else.  It’s the only definition they’re familiar with, and active simply means it’s some version of ‘predict the future for me.  Figure out where I should go next and take an active approach in selecting just which securities I want to own.’  So, there’s an alternative version, which essentially says…and it’s almost so simple, it sounds hopelessly naïve, that securities markets are so competitive, and there are so many smart people constantly analyzing companies and industries, and their opinions, their efforts to identify what are the right prices to pay for all these securities, are reflected in prices very quickly.  So quickly that it’s very difficult for any single investor to reliably outsmart all the other investors who are looking at the same information that you are.  And as a consequence, the optimal investment strategy, loosely speaking, is to diversify very broadly, and essentially hold all the securities in the market. 

In the stock market, for example, that would mean, in a very literal sense, owning every stock on the entire New York stock exchange from A to Z, doing no research on any particular company, simply holding a broad basket of securities.  Now, to many people, when they’re first exposed to that idea, it sounds, as I said, hopelessly naïve.  Isn’t it obvious that some companies are better than others?  Of course it is.  Some companies are better managed.  They have better products.  They’re more profitable.  They have a more positive outlook.  But typically, these characteristics are very easily identified, or certainly identified to thousands upon thousands of market participants, and the prices for these better managed, or faster growing, companies are higher than the less well managed, or slower growing, companies.  In other words, the odds, as it were, already reflect these distinctions.  What investors don’t have is reliable knowledge of future events that will arrive in an unpredictable fashion throughout any time period, pushing prices for some companies high or some companies low or ways that we cannot anticipate.  So, the alternative, this passive or indexed approach, is to eliminate all the expenses associated with all this effort to research companies carefully, and simply minimize costs and minimize risks of owning any particular security by owning a very broadly diversified portfolio. 

Now, when we say ‘broadly diversified,’ we take this to a level that many investors might find surprising.  We don’t think it makes sense to hold ten or twenty or even a hundred stocks in a portfolio.  In our suggested strategies, for example, we diversify around the world, and an investor, using this approach through very low-cost mutual fund-type structures, would wind up owning roughly 12,000 securities all around the world.  So, the impact of any one security is minimal.  Now, does that mean that some companies encounter hard times and do poorly?  Absolutely.  If you own, essentially, every stock in the marketplace over any period of time, some will do well.  Some will do poorly.  If we could reliably figure out which ones were going to do well and which ones were going to do poorly, well, we would want to focus our efforts in holding just the good ones.  But there’s a mountain of research conducted by some of the world’s leading economists over the last forty to fifty years which offers very compelling evidence that all this effort by the so-called ‘experts’ to figure out which companies are going to be successful, and which ones won’t, is no different in its outcome than throwing darts at the stock tables.  We just can’t tell reliably.  And so, over any time period, there will be companies that do better, those that do worse, but trying to figure out ahead of time which ones they’re going to be turns out to be, more often than not, an exercise in frustration.  And as a result, investors find, much to their frustration, that investment managers who come to them bearing a record of excellent past performance, more often than not, go on to disappoint them, which is actually exactly what we would expect to see if the capital markets are working properly, meaning in this very competitive environment, it’s very, very difficult for any single investor or investment manager to consistently outperform all the other people looking at the same information. 

Now, ultimately, this is good news for the investor.  It means that prices, on average, are fair.  It means that even people who work really hard and read the Wall Street Journal every day and constantly call companies seeking information can’t reliably do better than just simply holding a broadly diversified portfolio, and literally doing no research at all.  I would call it the Wal-Mart approach to investing.  You know, I’m not a particularly eager shopper.  I don’t want to spend a lot of my time trying to figure out if the shampoo is the right price, or the Band-Aids are the right price.  If I go to a big discount store like Wal-Mart, I can be pretty confident.  I can basically go through the aisles blindfolded, plucking products off the shelf, and I know they’re going to be fairly priced.  Why is that?  Because there are thousands upon thousands of shoppers who do check prices all the time, comparing prices at Wal-Mart or to Target or to other stores, and that competition keeps all the retailers on their toes.  And so, somebody like me can walk into a discount store like that and literally buy products blindfolded and be confident that I’m getting a fair price on all those products.  It works the same way in the stock market.  Because there are thousands upon thousands of highly trained professionals and other market participants all studying the markets, it means I can show up and buy a big basket of securities and be confident I’m getting a fair price, and fair simply means that the prices I’m paying are an appropriate price for the risk associated with securities I choose to own.  So, the upshot of all this is that for the investor, holding a broad, diversified basket of securities with very low costs is the most reliable way to either accumulate wealth or to preserve wealth.  And from a mechanical basis, the way to actually implement these ideas is to buy mutual funds, which follow this, what we might call, passive or indexed-type strategy, to buy and hold a large basket of securities. 

Jim Lange:  Well, I would imagine that Vanguard, although I know you don’t want to talk about other funds, but Vanguard would probably be the best known company that has a group of index funds, and…

Weston Wellington:  Absolutely, yes.  Vanguard has done a terrific job.  They helped introduce the idea of an index fund to the American marketplace, and they started from a very small base back in 1976, and they’ve been a key element in what you might call a minor revolution of sorts.  I can remember, in 1976, when Vanguard introduced their S&P 500 index fund, people laughed at them.  And they’re not laughing now.  It’s one of the biggest mutual funds in the country.

Jim Lange:  Yeah, it was referred to as ‘Bogle’s folly,’ and now it’s at $1.7 trillion. 

Weston Wellington:  Yes, that’s right.

Jim Lange:  All right.  So, Vanguard has a series of index funds.  They also have some actively managed funds, but what about Dimensional Fund Advisors?  Would you call yourself index funds, or passive funds?  And is there any difference between you and, say, a pure passive index approach?


4. Index or Passive Funds?

Weston Wellington:  We try to resist labels because what we do really is a…it depends on how you view us, whether you call us a conventional index passive-type manager, or something else.  We’re somewhere in between.  We’re completely philosophically consistent with an index fund approach.  We don’t think conventional researched on individual companies is going to have any reliable payoff.  We think investors are much better off having a very broadly diversified low-cost approach.  Where we part company, to a degree, with conventional index funds is that we start with a very clean slate, so to speak.  If I’m an index fund manager, I’m taking my marching orders, so to speak, from some index provider, the Standard & Poor’s 500 index, the Russell 2000 small company index, and so forth.  These index providers that track the marketplace by publishing indices, you know, a list of stocks that belong to the index, if I want to track that index as an index fund manager, I can do that.  I can buy all 500 companies in the S&P 500 index.  I can buy all the 2,000 companies in the Russell 2,000 index, for example.  The question is: is that the best way to get the market rate of return across the various ‘dimensions’ (we like to call them) in the securities market?  We think it’s a good way, but perhaps not the best way. 

Going back to this notion that security prices appear to be fair, all that means is that the risk that I’m taking when I buy this basket of securities is related to the return I hope to achieve.  Riskier securities ought to have higher expected returns to compensate me for that risk.  It doesn’t mean it’s a guarantee, but it means it’s my best expectation.  Now, the economists have said a lot of times, you want to sort through all the thousands upon thousands of securities to try to identify what are these risks that investors care about, and how do they get reflected in security prices, and are there any distinctions we can make?  One early distinction coming off research in the late 1970s and early 80s was that small companies appear to be riskier in some way than large companies, and as a result, have higher expected returns to compensate for that risk.  Well, what’s the best way to capture that rate of return associated with small companies? 

One way would be to track a small company index.  We think a somewhat better way is to take a more flexible approach and buy a large list of small companies, but manage it in a somewhat different way.  Now, these are subtleties.  They’re not huge, gaping holes in terms of a distinction, but we think they add up over time to a material benefit to investors.  The actual mechanics of how an index is constructed and managed, it turns out it has an important role for investors that they should concern themselves with.  Particularly with small companies, for example, the costs of buying and selling these companies add up.  If you’re trying to maintain a list of 2,000-odd small companies, periodically, these indexes have to get reconstituted.  The Russell people do it roughly once a year.  Some companies get too big to be in the index.  Some go out of business.  You have to refresh the index on a regular basis, and the way you go about doing that has consequences.


5. The Reconstitution Effect

Jim Lange:  Could you just explain the reconstitution effect?  Because that’s actually one of my later questions, and it’s a very important question, and it might be one of the ways that Dimensional Fund Advisors is…

Weston Wellington:  Well, roughly speaking, an index has to pick a date when they say we’re going to add all these new securities to the index, and we’re going to delete some others, and they typically announce a date, a reconstitution date, ahead of time, and say, for example, “On June 30th, we’re going to add 200 companies to this index, and we’re going to kick out 200 companies on the same day.  Now, we’re going to do it after the close of business on, let’s say, Friday, June 30th.”  Everybody knows they’re going to refresh the index on that day.  What do you have to do if you’re an index manager?  Your job is to match the index.  You have to sell those several hundred companies that are getting kicked out on that day and buy the ones that are getting added.  The problem is, everybody else knows you’re going to do it on that day, and they’re watching, and they can figure out pretty easily which companies you’re going to be buying and selling. 

Now, when indexing was a very small part of the marketplace, perhaps it didn’t matter so much.  But now that we have index managers running billions of dollars, a lot of other investors are alert to this opportunity, and they engage in, what we would call, front running.  If they know you have to buy these companies on a certain day, you’ve effectively announced to the marketplace you’re going to do it, they’re going to buy the stocks ahead of time.  And this buying pressure from index funds, buying stocks at a very short window of time, on average, tends to push those prices up for a short period of time, and the selling pressure, on the reverse side, works the same way.  I guess the analogy I would use is it’s like going to the Ford dealership.  “You know, Mr. Sales Guy, I just totaled my car, and I have to buy a new car today.  I have all these new appointments lined up.  I’ve only got about two hours to make a decision.  I need to buy a car today.”  How much negotiating leverage do you think you have to get a great deal on that new car?  You already told the salesperson you have to buy a car that day.  You’re probably not going to get as good a deal as someone who says, “Look, I’ve got six weeks before my lease runs out on my old car.  I have got plenty of time to shop around.  I want your very best deal.”  Who’s more likely to get the best deal?  I think the person who’s patient.

David Bear:  Well, you know, speaking of patience here, can we take time for a quick break? 

Weston Wellington:  Sure.

David Bear:  And if you have questions or comments for Weston Wellington or Jim Lange, call the KQV studios at (412) 333-9385. 

BREAK ONE

David Bear:  And welcome back to The Lange Money Hour with Weston Wellington and Jim Lange, and we also have a third guest here.  P.J. DiNuzzo is on the line.

P.J. DiNuzzo:  Hello, Dave.  It’s P.J. here.  How you doin’? 

David Bear:  Good, good.  Join the conversation.

P.J. DiNuzzo:  Weston, how you doing today?

Weston Wellington:  Good.

Jim Lange:  All right.  Now, by the way, again, in the context of full disclosure, P.J. is my joint venture partner, where I said earlier that P.J. actually manages the money, and then I do the Roth planning, tax planning, estate planning, etc., and together, we charge a fee of 1% or less.  Anyway, this is P.J.  This is not a random person calling up.

P.J. DiNuzzo:  No, I was just calling to say hello, Jim.  We were talking earlier.  How’s the weather out on the West Coast out in Santa Monica, Weston?

Weston Wellington:  Oh, pretty nice.

P.J. DiNuzzo:  Pretty nice!  It sounds good!  Hey Weston, one thing that I was thinking of, from a big picture, is, you know, you’ve been one of the longest tenured team members at DFA.  In fact, there’re a lot of long-time DFA team members who’ve retired even since you’ve been there, and I would just think it’d be nice for the audience, you know, just to talk about the difficulty of discipline, the emotions involved, and, you know, try to make this like sort of a ubiquitous point about what the media’s affect would be on individuals who are trying to succeed in investing, can you give them some of your experience and your observations? 


6. Succeeding in Investing

Weston Wellington:  Well, I’ve been in the investment business for 37 years, and for the last 19 years, or roughly half of it, I’ve been with Dimensional, and I think the first half of my career, you could almost look at it two ways.  You could say it was kind of wasted because we were doing things the wrong way, at least in the viewpoint of how we do things now.  But it also provided a very valuable insight into how individuals and investment professionals go about making decisions, and what I feel is the real attraction to this low-cost diversified approach, call it whatever you want to call it, passive or quantitative or equilibrium-based, it really frees you from fretting and worrying constantly and fiddling with your portfolio, trying to outsmart the so-called ‘other guy’ by anticipating what might happen next.  And the upshot of it is, to an overwhelming degree, I believe that individual investors, whether they’re sophisticated or unsophisticated, institutional investors, whether they’re highly sophisticated or, perhaps, less sophisticated, to an overwhelming degree, they wind up spinning their wheels, spending too much money, and not achieving the simple market rates of return that are there for the taking. 

When we look at investor portfolios, people who come to us after many years of having their money managed elsewhere, or perhaps on their own, one of the first things we do, we sit down and say, “How have you done?”  Many times, we discover people really can’t say how well they’ve done.  They don’t know what rate of return they’ve managed to accumulate their wealth at.  They can tell you what they’re worth, but they really can’t tell you how they’ve done.  And when we do a calculation, more often than not, we find out (sometimes to an astonishing degree) you would have been so much better off if you simply had sat still for the last five, ten, fifteen, twenty, thirty years, whatever it might be, and gotten the market rate of return.  You know, it’s a lot like losing weight.  We all know how to lose weight.  Eat less, exercise a bit more.  But it’s pretty difficult to actually achieve that result.  And part of the problem is, it’s so tempting to try to outfox other investors, and there’s a huge industry, the financial industry and the publishing industry, which are constantly exhorting us to do something different.  Buy this, sell that, do something different in your portfolio, move the money around.  All these little transactions result in fees that chisel away at those market rates of return.  I don’t want to underestimate the difficulty, the discipline it can require to sit still and let the markets be your partner and not your adversary. 

Jim Lange:  Is that why DFA prefers that people work with an advisor because they might not have the discipline to just hang in there?

Weston Wellington:  That’s part of the reason.  I don’t want to suggest that we’re arrogant in some way and we don’t want to deal directly with individuals.  We’re just not organized to serve a huge number of individuals and provide one-on-one personal financial advice.  We’re an institutional money manager, so we have a very lean staff.  We focus on doing the best job we possibly can at the lowest possible cost to serve very sophisticated investors.  Now, when it comes to institutions, most of them have their own investment committees to fall back on.  We think, to an overwhelming degree, most investors are best served by having another investment committee, if you will, an investment coach, a financial advisor who can help them make financial decisions on their behalf. 

Jim Lange:  Well, P.J. likes to use the analogy of a coach, and he would be an example of somebody that you have approved to represent Dimensional Funds, and rather than them talking with people like you and the other people at Dimensional Fund Advisors, who I kind of consider back office, the individual investor would talk to somebody like P.J., and there’s only, what is it?  Like a thousand people that you have approved in the United States?  Is that fair?

Weston Wellington:  Well, probably about 1,500 is a better number.

Jim Lange:  About 1,500 by now?

Weston Wellington:  But it’s a tiny fraction of all of the professional financial providers of advice out there. 

David Bear:  Jim, I’m going to interrupt here.  We actually have another call from Jerry from Florida.

Jerry Kurt:  Yeah, it’s Jerry Kurt.  Can you hear me?

Jim Lange:  Yes, we can.

Jerry Kurt:  Yeah, I appreciate and respect the philosophy that you’re espousing, the Dimensional Fund philosophy, if you will, and I’m wondering is there proof in the pudding?  Do you compare yourselves against the performance, not of other stocks or other mutual funds, but against the performance of other index funds? 

Weston Wellington:  Sure.  In a public format like this, it’s not appropriate to discuss performance numbers, but I would urge you to have a discussion with P.J. or Jim, and we’d be very pleased to show you the results where the…as you say, the proof of the pudding is, do you actually deliver?  And let me just point out that we started life as an institutional-only money manager, which is an extremely competitive business.  We would not have gone from zero to nearly $300 billion in assets over the last 31 years if we were not able to deliver very satisfying results. 

Jerry Kurt:  Thank you.

Jim Lange:  Yeah, I will take the liberty of mentioning that I was kind of instructed not to talk about performance, that that’s probably better done in a private setting for compliance and other reasons, but I will tell you that is a discussion that P.J. and I love to have, rather than avoid to have.  So, I think you can probably get an idea from that answer what DFA’s performance has been. 

Jerry Kurt:  Do you have any online sites that might do that, as well?

P.J. DiNuzzo:  Yeah, Jerry.  If you called in, we could get your number offline and direct you to that.  Again, Weston is maintaining somewhat of a neutral position from DFA.  We’re not going to discuss performance, but we’d be more than happy to direct that to you.  If you can get that to David, we’ll be more than happy to give you a call back. 

Jerry Kurt:  Fair enough, thank you.

P.J. DiNuzzo:  Well, thank you for calling in. 

Weston Wellington:  Thanks for calling.

Jim Lange:  All right.  Well, you were talking about some of the differences that DFA does.  So, you started with a couple things: you were talking about small companies, and you were talking about the reconstitution effect, and can you tell us some of the other things that DFA might do differently than, let’s say, and I know we don’t want to compare any one company, but let’s say a generic index, if you would?


7. The Differences with DFA

Weston Wellington:  Yeah.  One way of thinking about this is that when you start with a clean slate and you say, “I want to get compensated for the risks that are out there in the capital markets.”  Well, what are these risks?  And it’s not obvious what these risks are, or exactly how to define them.  I’m not saying we have the only answer, but we have a somewhat different answer than some other industry benchmarks or providers.  And again, the analogy I might use, the research has shown that there’s a distinction between what we call ‘growth’ stocks and ‘value’ stocks.  We won’t go into a long explanation, but it appears that in the U.S. and in markets all around the world that value stocks, low-price stocks, if you will, have somewhat higher expected returns than growth stocks.  We think that’s because there’s something about these stocks investors find riskier than safer, more profitable growth companies, and so it’s an appropriate relationship. 

Well, the question is how do you define and distinguish value from growth stocks?  Well, one way to do it is, what I would call, the ‘sandwich approach.’  You have the whole marketplace of stocks, you cut the sandwich in half, and you say, “Well, this half of the sandwich is growth stocks.  This half of the sandwich is value stocks, and I’m going to have an index that tracks each half of the sandwich, so to speak, each half of the market.”  You can do that.  And that’s a very rough approximation how most index providers do it.  It’s neat.  It’s simple.  It’s easy to explain.  And it doesn’t require a lot of complicated engineering.  You just divide the market in half.  We take a somewhat different approach.  We don’t think that the difference between value and growth is just a matter of so-called style.  We think it’s actually some sort of a risk element that’s driving these differences.  Well, if it is risk, then it probably makes more sense, at least for some investors, to focus on that risk.  If there’s something about value stocks that makes them riskier, and therefore have higher returns than the more extreme value stocks, it seems sensible ought to even have even higher returns than the ones that are sort of right in between, you know, the value and growth sort of dividing line. 

So, rather than the sandwich analogy, you can think of our approach as taking kind of a barbell approach, where we look at the extremes of the marketplace growth or value, and we form portfolios that isolate and focus on those somewhat greater extremes.  And what you find is that our small company portfolios, on average, own smaller companies than a conventional small company index.  Our value strategies own somewhat more focused, what we would call, ‘deep value stocks’ than a conventional value index.  What does that mean?  It means if these risk dimensions get rewarded with higher returns, when the value of the small cap areas are paying off with higher returns, we should be generating higher returns for investors than a conventional benchmark approach.  It works the other way, too.  When the large companies, or growth stocks, when they’re paying off, as they sometimes do, more often than not, our strategy is losing to a conventional indexed approach.  But more often than not, those expected returns are in our favor, and as a result, that’s one reason (not the only reason) why our strategies have tended to outperform conventional benchmarks, not by clever stock picking, but by engineering the portfolio to focus more precisely on these risk dimensions that seem to matter to investors. 

Jim Lange:  Weston, would it be fair to say that unlike, say, a traditional active money manager who says, “Well, I think Apple is going to go up, so I’m going to buy Apple, and I think IBM’s going to go down, so I’m going to sell IBM,” that you’re saying, “I like the index approach, but perhaps, I’m going to define the types of stocks a little bit differently than other indexes.”  So, for example, like you just said, your smalls might be smaller.  Your values might be on the more value extreme, and when you have that plus the reconstitution effect and a few other things that we will talk about later, that that might be adding a lot of value to a portfolio.  Is that a fair statement?

Weston Wellington:  Yeah, yeah, that’s a fair summary.  We think the more you delve into these little distinctions, we think they’re just a very sensible approach.  We’ve been doing this for a long time.  We’re constantly seeking small ways to enhance portfolio returns, not by forecasting the future, but by finding ways to define risks more precisely, to trade the portfolios less expensively, more efficiently, try to squeeze out a few extra basis points wherever we can.  Once you abandon this search for the stock that’s going to double overnight and you just diversify, that frees up your resources to look at every other way that we can possibly add value that doesn’t depend upon making a prediction or a forecast that’s probably unlikely to be a long-term source of returns.

David Bear:  Well, listen, can we take one final break here?

Weston Wellington:  Sure.

BREAK TWO

David Bear:  And welcome back to the final ten minutes of The Lange Money Hour, with Weston Wellington, Jim Lange and P.J. DiNuzzo.

Jim Lange:  Weston, you had just said that because you are not spending gobs of time and resources analyzing each particular stock and whether it’s going to go up or go down, that you could spend more time, let’s say, looking for value-added features for investors, and you had mentioned the reconstitution effect, and some of the differences in the way you looked at smaller companies, and the way you looked at value versus growth companies, and actually, it seems to me that your advisors, that is, your face to the public, which is guys like P.J. DiNuzzo and others, don’t have to spend their time trying to figure out if IBM is going to go up or down or Apple’s going to go up or down, and then they can appropriately do more things.  So, for example, determining how much money should be available for years one and two, and what type of…I know you have many different portfolios, and typically, an individual, at least with P.J., might actually have four or five or even more portfolios.  Would it be fair to say that sometimes your advisors have an advantage over other active advisors in that they can concentrate on things that might be of greater value to the client rather than trying to outguess, you know, the other hundreds of thousands, maybe close to a million advisors trying to outsmart the market? 

Weston Wellington:  Absolutely.  No, that’s the key advantage of this approach, and I think (as you suggested) applies with particular force to individual investors, many of whom come with specific issues: family, transition issues, business ownership issues, estate planning, Social Security integration, a whole host of decisions that most of us just don’t have the time, the energy or the knowledge to arrive at the optimal solution, and when we’re no longer tempted to focus on this issue of ‘how can I outsmart the markets and try to make a little more money,’ and instead focus on ‘have I made the right big decisions about how my financial affairs are ordered?  What’s my money going to be used for?  What’s my real time horizon if I’m only going to consume a portion of my wealth and hope to pass it on, perhaps, to my heirs or charity in the future?’  Most people often times have a time horizon much, much longer than they may initially think.  It could easily be a hundred years.  Then, this again, it provokes a different kind of discussion when advisors meet with investors to review their financial affairs, and you wind up focusing on the big things that really matter, not the small things that, it turns out, don’t matter very much, over which you have essentially no control.  So, this entire approach both urges the investor and facilitates the process by which you focus on things that you can control: your spending, your human capital, your charitable activities.  And you don’t focus on things that you can’t control. 

Jim Lange:  Well, one way that I’ve always thought an advisor could add value, and I’m not even talking about the type of work that I do, which is, let’s say, in the Roth area, Social Security, how much you could spend, estate planning, etc., is actually developing an appropriate portfolio for different people.  So, for example, P.J. likes to say that every person’s like a snowflake and there’re no two individuals that should have identical investments.  So, for example, a teacher that might have a guaranteed pension fund should have a significantly different investment portfolio outlook than, say, somebody who doesn’t have either Social Security or a pension fund.  And is it fair to say that a Dimensional advisor, if they’re not spending all their time trying to figure out if IBM is going to go up or down, and if they do a good job, and I know that you guys are VERY fussy in terms of who you will let represent Dimensional Funds, that they are much more likely to have that kind of meaningful conversation than something that might end up being a historic blip, which is whether IBM or Apple went up or down. 

Weston Wellington:  Again, that’s a very good description of how we think the investment experience can be improved, by focusing on those distinctions.  Trying to arrive at an investor’s appetite for risk and return is a pretty subtle and difficult process, and there’s no obvious right answer.  Different people will come to the table, even with identical personal financial profiles, same age, same income, etc., and they may have very different perspectives on how they feel based on market events, and one of the, I think, most valuable aspects that an advisor brings to the table is not just a sense of competence and professional experience, but also a willingness to engage with that client and try to come to some agreement.  You know, what is your appetite for risk, and how can we explore that?  How could we get the portfolio that you can sleep with, no matter what is going on in the capital markets?  It’s all very well and good to say, look at some book or some table, and say, “Here are the returns you could have gotten,” but all those numbers don’t mean much if you’re in the middle of a financial hurricane, and you get so uneasy that, in effect, you jump overboard, and then you aren’t around to participate in a recovery.  You’ve bailed out at what may be the worst possible time. 

So, this relationship with an objective advisor, even for people who bring a lot of experience on their own, you know, sophisticated business executives, who often times are prone to believe, “Oh, I can do this myself,” is important.  Well, they certainly have the financial training to do it themselves, but to have the emotional discipline when it’s their very own money, their family’s money, that is a very different challenge to face.  And I’m not saying there aren’t people who can’t do it themselves.  I’m sure there are, but we find there are so, so many literally heartbreaking stories of people who have endangered their family’s financial future by failing to understand and implement some of these fundamental principles.  This is what motivates many advisors to do what they do and how they do it. 

Jim Lange:  Weston, we have about one minute.  Do you have any final parting thoughts for our listeners today?

Weston Wellington:  You know, investing is often made to seem far too complicated.  At its very most elemental level, it’s quite simple.  You want to diversify, keep your costs down, and match up your risk preference with what the capital markets have to offer.  And then spend time doing things that you like to do. 

Jim Lange:  Weston, you have been a wealth of information, great, objective information, and I want to thank you so much for being on our show tonight. 

Weston Wellington:  Thank you.

David Bear:  And thanks again to Weston Wellington of Dimensional Fund Advisors.  Thanks to Dan Weinberg, our in-studio producer, and Lange Financial Group program coordinator, Amanda Cassady-Schweinsberg.  As always, you can hear an encore broadcast of this show at 9:05 this Sunday morning here on KQV, and you can always access the audio archive of past shows, including written transcripts, on the Lange Financial Group website, or you can call the Lange Financial offices directly at (412) 521-2732. 

END

 

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James Lange, CPA

Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania.  He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again.  He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger's Retirement Reports and The Tax Adviser (AICPA).  Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.

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