The first two columns in this series by Brad Steiman offered answers to frequently asked questions about active vs. passive investing, and explored a general set of ideas around market efficiency. The main purpose has been to help build a framework for educating clients on the debate.

There are other good reasons to approach the topic carefully. Market efficiency and its offspring, passive investing, are counterintuitive for many investors. It is human nature to believe that one can beat the market (or identify someone who can) through intelligence, insight, and hard work. This belief is constantly reinforced by Wall Street and most of the mainstream media.

Even though some may characterize Dimensional’s approach as passive, it is only passive with respect to activities that don’t add value—mainly stock picking and market timing. One could argue that Dimensional is very active, however, in managing important considerations such as frictional costs and consistent exposure to targeted risks or asset classes.

Here are some examples of framing:

• We don’t speculate. We invest.Rather than relying on speculation, blind faith, or anecdotal evidence, our philosophy rests on a solid foundation of core principles from the science of investing.
• With capitalism there is always a positive expected return on capital.Capital markets are very competitive due to voluntary exchange between buyers and sellers. There is a buyer for every seller; for markets to clear, prices will adjust to new information and reach a level where there is always a positive expected return to providers of capital. Investors would not risk their capital without the expectation of a positive return. We invest in an approach that strives to capture a fair share of the capital market return based on the risk assumed.
• It is difficult to identify superior investment managers in advance.Capitalism breeds competition, and that makes markets difficult to beat. With millions of participants competing in capital markets, it is hard to identify in advance anyone who can systematically beat the market since past winners may have just been lucky and won’t necessarily win in the future. We eliminate the risk of choosing the wrong manager by following a broadly diversified approach that does not rely on stock picking or market timing.
• Diversification is the only antidote for uncertainty.Although diversification neither assures a profit nor guarantees against loss in a declining market, a properly constructed and well-diversified portfolio is a key component of a successful investment experience. We design portfolios that attempt to capture certain risks and eliminate others, depending on your preference and capacity for various types of risk.
• There is no free lunch. Risk and return are related.Higher expected returns only come from bearing more risk that cannot be diversified away. Much like a football player who chooses to play without a helmet, you should not expect to be paid more for taking risks that can easily be avoided. We focus on eliminating risks that you should not expect a reward for taking, such as concentrating your portfolio in just a few stocks.
• Control what you can.If speculation is futile, and trying to choose winners is more often a loser’s game, what can an investor do? The answer is to concentrate on what can be controlled: managing the transactional costs of investing, reducing the impact of taxes, and taking a long-term view. We implement portfolios in a way that is cost effective, tax efficient, and above all, disciplined.

Market efficiency and the active or passive decision are loaded with misconceptions that can lead to debate and confusion rather than constructive dialogue and understanding. More importantly, it can distract our attention from the most crucial element of all: discipline!

The studies comparing dollar-weighted returns to time-weighted returns are widely known, and behavioral research has documented the propensity for individual investors to skate to where the puck was (instead of where it is going). A decision to invest in an active, indexed, or Dimensional approach can often be differentiated in basis points, while percentage points often gauge the impact of an undisciplined or emotional decision unchecked by an advisor’s sound counsel.

This type of behavior is obviously hazardous to an investor’s wealth; therefore, we should attempt to determine if one of these alternative strategies has been able to mitigate some of these actions.

The charts below show the monthly cash flow into all equity funds (foreign and domestic) in the US , along with the prior twelve-month global equity market return. Cash flow bars that vary with, or more closely follow, the prior year return line could suggest more return chasing behavior among the investors within that universe of funds.

Source: ICI

Source: ICI Index is not available for direct investment; its performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

Source: Dimensional

A simple “eyeball” analysis of this anecdotal data suggests that investors in active mutual funds apparently were more influenced by short-term performance than those who held index funds, and advisors (and clients) who invested in Dimensional funds exhibited the most consistency.

The biggest difference between index funds and Dimensional relating to investor behavior may be the requirement for independent advice from a fee-only advisor. If part of the recipe for a successful investment experience is to stay the course, the advisor is the key ingredient to educating investors and keeping them disciplined through good times and bad.

The comments of Robert Dintzner are greatly appreciated.

Many thanks to Brad Barber for providing the ICI data.

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¹Dimensional cash flow data includes US, Canadian, UK, and Australian domiciled funds.

Dimensional Fund Advisors (“Dimensional”) is an investment adviser registered with the Securities and Exchange Commission.

This article contains the opinions of the author but not necessarily the opinions of Dimensional. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is provided for informational purposes only and should not be construed as an offer, solicitation, recommendation or endorsement of any of the products or services described in this website.

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