This is the 12th in a series of interviews with some of the most influential people in the field of indexing and index-based investment. The interviews are also published in the November/December 2014 issue of the Journal of Indexes.
David Booth is known for his pioneering research on indexing theory and asset management, including the research paper he wrote with Eugene Fama, "Diversification Returns and Asset Management," which won a Graham and Dodd Award of Excellence from the Financial Analysts Journal in 1992.
In 1981, Booth founded Dimensional Fund Advisors, where he still serves as chairman and co-CEO. The company offers more than 100 equity and fixed-income funds, which have been designed to emphasize "dimensions" of expected return in the global capital markets.
In 2010, Investment News named Booth one of "The Power 20" in the financial services industry, and in 2012 he was awarded the Outstanding Financial Executive Award by the Financial Management Association International. The University of Chicago Booth School of Business was named in honor of him. Booth also serves as a lifetime member of the school's business advisory council.
Back in the day, you contributed seminal research about the value of diversification in improving one's portfolio returns. But as the correlations between asset classes keep rising, particularly post-financial crisis, is the story changing at all?
Well, over some time periods, correlations are rising, and over others, they aren't. It's left to be seen exactly what the trends are.
But whatever they are, the benefit of diversification is that it's the closest thing we have in finance to a free lunch. We have no control over how valuable it is, because that depends a lot on the volatility of the markets. But I still say diversification is worthwhile.
Diversification offers all of the widely touted benefits. We see additional benefits from diversification in our implementation. Because we favor securities exhibiting certain characteristics instead of picking specific names, diversified portfolios act as our ally. We have many possible securities that allow us to capture the underlying dimension, affording us flexibility when trading in competitive markets.
What exactly are "dimensions"?
Different securities have different expected returns, which is where dimensionality comes in. Dimensions point to systematic differences in expected return, which is what we care about when we design strategies. In identifying dimensions worth pursuing for our clients, we require them to be sensible, persistent, pervasive, robust and cost-effective to capture in well-diversified portfolios.
Is dimensionality-driven investing dependent on the efficiency of the market? Does it still hold true for, say, emerging markets? Or alternative asset classes?
Regardless of whether you think markets got it right or they got it wrong, the empirical evidence supports the existence of these dimensions across market segments and geographies.
Market efficiency can have many interpretations, but for us, it really comes down to the belief that liquid markets facilitate a very efficient transfer of knowledge from market participants into security prices—and these prices tell us something about expected returns. We choose to use that information in how we interpret the research, how we structure strategies and how we manage prices to add value over indices.
What do you think has been the biggest change in the indexing industry over the past 20 years?
I think it's the development of new indices based on academic research into dimensionality, particularly of equity returns. Nowadays you see many things like that coming under this loose heading of "smart beta."
Given your work on dimensional investing, did you anticipate the industry's interest in smart-beta indexes at all?
I didn't anticipate it, but this notion of dimensionality is something that's been around a long time. That it has picked up steam in the past 10, 15 years is very encouraging. But we've been in business 33 years now and I wouldn't have forecast that all of the sudden we'd see this big change in thought.
Let me back up. You start off in the mid-1960s with the capital asset pricing model, which was very simple, but never seemed to describe reality very well. In the 1980s, all kinds of anomalies started surfacing. Then, [Eugene] Fama and [Kenneth] French put together a paper in 1992 that showed we're living in a multifactor world. This theory had been developed by Bob Merton in the early 1970s, and Fama and French gave it empirical validity.
From there, it was only a question of time before indexing based on that research came to the forefront. Since 1992, we've had both the theory and empirical evidence to show that the market cap index is probably fine, maybe, but that there are other things you might want to consider too.
So I suppose with both theory and the empirical evidence supporting the idea, it's hard to believe it wouldn't have happened, eventually.