This article is one in a long series which I hope will help explain the ins and outs of DFA – Dimensional Fund Advisors. NOTE: This is my interpretation and explanation only. For the final word, please refer to the DFA Canada Website.
While many readers of this blog are completely up to speed on the debate between active and passive management and are eager to move beyond this, I feel it is necessary to continue with supporting this background information for those readers who are new to this concept. So for those who find this information redundant, I will ask you to please bear with me a bit longer… :)
The Warren Buffett Argument
Undoubtedly one of the best defenses surrounding active management has to be the performance record of Warren Buffett. But consider that Warren Buffett himself has indicated that he only comes up with a few good ideas every couple of years and then contrast this to the average money manager who may easily have 100 ideas per year. Clearly we are dealing with two separate schools of thought on active management and even though there are many money managers out there declaring they follow a deep value investment philosophy, they do not have the same results as good old Warren. Part of this is due to the ‘institutional imperative’.
The institutional imperative can be thought of as the tendency for managers to do what everyone else is doing out of fear (or ignorance). For example, if a manager follows the crowd there is less chance that he will get fired as if everyone does poorly he can simply point to his relative performance being no worse than everyone else. If everyone does well, than he can look good because he has done well notwithstanding how everyone else has done. But consider what happens when someone decides to stick their neck out and do something different. In this case, if you outperform the crowd you can look like a star. But if you underperform the crowd than you are more likely to be pointed towards the door.
So, if you follow the crowd you should be fine. If you stick your neck out and do something different, you stand to potentially lose your job (or investors who invest their money with you). In order for a money manager to reference Warren Buffett as proof that active management works, they will need to be as different from the crowd as Buffett is. Otherwise, it’s a meaningless assertion in my mind.
The Berk Green Study
In the 2002 paper entitled Mutual Fund Flows and Performance in Rational Markets the authors find that 80% of money managers actually have enough skill to make back their fees. However, while some people have erroneously cited this paper as being support for actively managed investing, that is not the case the paper is trying to make. Rather, it explains that capital flows freely to managers who are perceived to add value to the point where the manager can no longer add value. The paper is in effect an argument for capitalism. In a rational market, investors will see the past performance of a manager and direct their capital to the exceptional managers to the point where the inflows become less and less effectively deployed by the manager. In the end, the study concludes that partly due to this reason, future outperformance cannot be predicted by past performance.
In Part IV of this series, we are going to look at investing versus gambling after which I will start getting into some of the details I know many people have been waiting for. Part V will start by examining the Capital Asset Pricing Model – which is where we get the concepts of Alpha and Beta from – and serves as a good launching point to get into the Fama-French 3 Factor model details which plays an instrumental part of DFA’s philosophy and products.