The Dimensional Fund Advisors model is known for bridging that gap between pure indexing and active investing. Do you feel the world is finally catching up to your way of thinking?
Well, I think it comes back to an issue of language. When you talk about "active" and "passive," these words have evolved in a way that's different from their original meanings.
I worked on the first index fund out at Wells Fargo in 1971. There, it was an equal-weighted index portfolio that tried to track 2,000 stocks on the NYSE with 100 stocks. The tracking error was enormous. But back in those days, tracking error wasn't something people worried a whole lot about. That's opposed to now, where people can get obsessed about it. But in those days, indexing could allow for large tracking error; you could have a wide range of portfolio strategies under the heading of "indexing." Back in the early days, indexing just meant you weren't trying to outguess the market. Nowadays, it means no tracking error.
The reason I bring that up is that when we have Fama speak, people ask, "Do you still believe in passive management?" He says, "Sure." Because in his view, dimensional investing is passive investing, simply because we're not trying to outguess the market. But I think most of our clients view us as active, because we incur tracking error in order to beat the market.
It's the darnedest thing. Labels are tough sometimes. But we haven't changed strategies. At Dimensional, we don't think we're outguessing the market, but indexing with a goal of zero tracking error is something we decided to not do. Our thought is, if there are things you can do through implementation and execution that can add value, then we're happy to incur some tracking error to do it.
Do you think that ETFs will replace or overshadow mutual funds?
Right. And when we started out, this was not an idea people thought was foolproof. There was a lot of skepticism. The question is, why do people want zero tracking error. Well, the answer is that makes your cost of monitoring go way down. Did your managers track the indices or didn't they? That's a simple way of monitoring, and a huge benefit of indexing.
But we're willing to incur a bit more tracking error, and that takes a bit more faith on clients' part that we are doing a good job. After all, what we could view as a negative tracking error, they might view as the result of poor management. But over time, I think we've shown that we've been able to add value, and having some tracking error has been worth it.
How much further do you feel that indexing has to go before it becomes truly mainstream in the investment industry? Or has it already "arrived"?
I thought it had "arrived" in 1971. But for the average investor, I think the development of ETFs has likely been the big new event that has really made indexing go more mainstream. Especially because now you see so many active managers claiming they can time the index funds. A lot of the same people who were selling active management by picking stocks are now saying, "Well, we can't pick it, but we can time markets using ETFs." We see a lot of that now. That too has helped make indexing more mainstream.
Do you think indexing would have become as widespread as it is now without the development of ETFs?
I think it may have taken longer, but it would have happened. I mean, ETFs do have some good uses. They are basically a way for people to easily access market segments that they're interested in. The concern is always, though, that we're just setting up a gambling casino, meaning investors will find different ways of making bets and increasing their portfolio turnover, which is antithetical to the purpose of indexing. People motivated to index want low turnover, so if the ETFs are providing a way to increase turnover, that's probably inconsistent with the basic motivation for indexing.
But I do think a lot of people now see the advantages of indexing. So I think some investors will try to time markets using ETFs, while others will conclude that timing is too difficult a thing to achieve, so they'll just use index funds long term.
When it comes to ETFs, it's all about how you use them. If you build that great Aston Martin, even if the car's terrific, you can't be sure people will drive it all that well.
What do you feel is left for indexing, whether it's in terms of growth, asset classes, strategies, etc.?
My guess is that the trends we've seen in the past five to 10 years will continue on for quite a while. The financial services industry doesn't move on a dime. It took a long time for smart beta to gain steam—I would say the notion goes back to that '92 paper by Fama and French—so if you think about it, it's been 20-some years for it to really get into full swing. These trends are probably good for another 20 years.
Beyond that, though? I don't know what it'll be. But it'll be something; something we haven't thought of yet.