Dimensional Fund Advisors Grapples With Its Future
The smart beta pioneer now manages $445 billion in assets. But can the privately held firm survive its original team?
Most CEOs are masters of saying nothing. David Booth is not most CEOs. “I hate complexity and a lot of changes,” the 70-year-old co-founder of Dimensional Fund Advisors says. “It undermines people’s trust in you. If people understand what you do, they’ll stick with you over the long haul, and if they do that, they’ll be okay.”
The pioneer of smart beta was more than okay one hot September evening in Austin, Texas, near the headquarters of the firm that has become his life’s work. He — along with the University of Chicago’s Gene Fama, who won the Nobel Prize for his contributions to efficient market theories and still teaches; Ken French, Fama’s longtime research partner and a finance professor at the Tuck School of Business at Dartmouth College; Booth’s designated successor and co-CEO, Eduardo Repetto; and a smattering of other executives — were sitting around a rustic table in the restaurant of the Hotel Granduca, a luxury hotel inspired by a 16th-century Italian villa. The conversation, food, and Italian red wine flowed freely.
The group was talking — arguing, really — about the differences between Dimensional’s funds and those pouring from its competitors in the ballooning catch-all category of factor and smart-beta investments. The table’s consensus: stark.
In 1981, Booth co-founded Dimensional with Rex Sinquefield to create real-world investments based on the academic theories about market efficiency that had been flowing out of his alma mater, the University of Chicago’s graduate school of business. Booth, who had been Fama’s research assistant, drafted his professor as a founding director.
From the beginning Dimensional’s goal was to improve passive investments at the edges, combining the best of objective models with human judgment. At its core the view is that investors should act as though prices are right. Dimensional has long had competitors in its push to sell factor-based investments — funds that take advantage of persistent market characteristics — but its success now has firms racing to create everything from simple low-volatility funds to portfolios based on multiple and interconnected factors, all starting with the same core research born at the University of Chicago. Foremost among that work is Fama and French’s seminal 1992 paper on the sources of stock returns. Dimensional’s rivals, however, don’t have Fama and French on staff.
After everyone at the restaurant table has ordered and the low-level chatter has meandered to such pressing topics as the number of Sicilian Famas in Boston (the professor’s hometown), Booth gets back to his favorite topic: Dimensional. “There’s one basic difference, and it may not sound like a big deal, but it’s a big deal”: The firm was founded on the idea that no one can predict securities prices.
French concurs. “Even if we don’t understand the world and whatever premium we were after turns out not to be there, our clients still have a good portfolio because we weren’t trying to do anything crazy. I don’t want to put words in David’s mouth —”
“— Please do, it sounds better when you say it —”
“— It’s not to say every price is right.”
“What do you mean?” injects Fama, ever alert to contentions that prices may be wrong. “There may be mistakes, but you won’t be able to tell what they are!”
“Well, there may be people out there who can tell,” French continues, “but if there are, they are the scarce resource and there is no reason for them to leave money on the table —”
“So much noise in the data. We’re only interested in stuff that is robust,” Fama says. “We want to see it in multiple time periods and markets — ”
“— and it makes sense,” adds French. “It’s not just a pattern.”
“‘Robust.’ I hate that word,” Booth says.
“It means fat,” laughs Fama.
“All this research testing out the models,” Booth responds, commenting on the competition. “As Gene says, models aren’t reality. If they explained everything, then you would need to call them reality. You wouldn’t have to call them models.”
The cross-talk continues. Yet one topic this group is less willing to banter over is the most complex issue of all for Dimensional Fund Advisors: Can the privately held firm survive its original team?
The succession problem is not unique to Dimensional, or to investment management in general. Companies worldwide are facing the retirement of their senior executives as baby boomers leave the workforce. But asset management has been hit uniquely hard by the problem, in part because its edge often lies in the collective experiences of talented people, not in factories or innovative patents.
Founded by now-wealthy men, asset management is a relatively new industry whose growth accelerated in the 1980s as individuals were forced to save for their own retirement and as institutions became more sophisticated investors. As the industry matured, many privately held money managers diversified beyond their core product, went public, or were bought by large banks, insurance companies, or consolidators like Affiliated Managers Group that promised to help with messy issues like succession. Private equity firms such as KKR & Co. and Carlyle Group have been a case in point, struggling to move beyond the famous faces of their founders (in branding, if not in returns). Mergers and acquisitions, which have been notoriously difficult to pull off, have also gone in the other direction, with companies spinning off their money managers, particularly after the financial crisis.
At first glance, Dimensional and its $445 billion in assets under management are well poised to manage the succession issue. The firm embraces a passive approach based on economic science. Its transparent investment process doesn’t rely on star managers. It does business under a structure favored by institutional investors, which often prefer private firms that aren’t subject to the vagaries of public markets and whose key executives have ownership stakes. Publicly owned companies, on the other hand, need to maximize their returns for stock owners by gathering assets and launching products, and that often conflicts with maximizing the return for investors in their funds.
Another advantage for Dimensional: Fama and French. Both are directors and work closely with research, investment, and client service teams; they also sit on the investment policy committee. That the two are so actively involved in the firm may be surprising given their central place in financial history. Yet there they are — and with them, at least in spirit, is the University of Chicago’s famed business school.
In 1960, Chicago started developing the first database for historical securities prices and returns information, allowing researchers to analyze the performance of the markets and kicking off the modern era of finance. Four years later Fama — a Chicago student now known to many as the “father of finance” — published his famous Ph.D. dissertation concluding that stock price movements are unpredictable (Fama used his own data for the dissertation). That set the stage for the Efficient Market Hypothesis and the advent of index funds that sought to match rather than beat the market. (Institutional Investor published a less technical version of the dissertation in 1968.)
Booth, who was pursuing a master’s degree at the University of Kansas, read Fama’s work. He decided to apply to Chicago and graduated with an MBA in 1971. Although Fama thought he should work toward a Ph.D., Booth was more interested in applying the theory in the real world. “Clearly, leaving Chicago helped me and the university. Everyone won with that one,” Booth joked during a predinner interview that day in September. He wasn’t wrong: Chicago’s business school is now branded the Booth School of Business, renamed after Booth made a $300 million contribution in 2008.
Upon Booth’s rejection of the Ph.D. track, Fama called Mac McQuown, a former student who was working to develop the first index fund at Wells Fargo & Co., to recommend his onetime research assistant. McQuown hired Booth to work at Wells Fargo’s think tank, which also employed as consultants Fischer Black and Myron Scholes, who would publish the Black–Scholes options pricing model a few years later.
After the Wells Fargo group split up, Booth and Sinquefield formed Dimensional. By then Jack Bogle’s Vanguard Group and others were enjoying success with large-cap index funds, so the new firm decided to focus on small-cap stocks. At the time, there were no small-cap indexes — and no empirical research existed showing that small-cap stocks outperformed large caps.
Yet Booth and his partners had an intuition that higher-risk companies would return more than less-risky large caps and offer diversification. (Rolf Banz, a Ph.D. student of Scholes’ at Chicago, would publish the results of his doctoral research on small-cap outperformance shortly before Dimensional’s launch.)
The challenge was to cost-effectively buy and sell thinly traded small-cap stocks so that the outperformance wasn’t eaten up by expenses. With few institutions, or even mutual funds, owning small caps because of the headache involved, Dimensional had the field to itself if it could make it work. The trick, which is still at the heart of Dimensional despite an expanded product lineup, is almost embarrassingly simple: Trade as little as possible and hold out until stocks can be had at good prices. And Dimensional went beyond just keeping transaction costs down, buying blocks of illiquid stocks to earn a discount. Though the firm didn’t do fundamental analysis of the stocks it bought, it avoided companies that were about to make big announcements or had reported insider sales. The idea was to add a premium to a market portfolio by incorporating human judgment.
It worked. Even though the firm’s first nine years coincided with one of the worst-ever periods for small stocks, Booth proved he could create a passive vehicle for investors. Then, in 1992, Fama and French, both professors at Chicago’s business school, published a paper that laid the groundwork for their three-factor model, identifying the sources of stock market returns, including value and size. But before the paper was published in the Journal of Finance, Fama and French showed their findings to Booth and Sinquefield. Dimensional launched small-cap and large-cap value funds soon after.
The subsequent years have been just as kind to Booth and his team. They’ve won the argument that a basic index fund can be improved upon — Dimensional, after all, is the fastest-growing fund company in the U.S. — and they’ve shown that a methodical culture can still work in the age of faceless computers.
Such success is even more surprising given the firm’s counterintuitive approach to marketing, which largely relies on word-of-mouth and dates back to 1988, when a newly independent financial adviser named Dan Wheeler called Booth and Sinquefield to ask if he could sell the firm’s funds. Wheeler had spun out of Merrill Lynch & Co. to start something that was rare at the time: an advisory firm that was paid directly by clients rather than through controversial commissions earned by recommending his employer’s products. Although Dimensional’s co-founders worried that mainstream investors would move in and out of funds and raise turnover and costs for the firm’s pension and other institutional clients, they gave it a try.
The bet paid off handsomely. Dimensional raised $90 million in the first year, and Wheeler soon came on board to build a dedicated business that remains content to wait for advisers’ calls. From the start he pummeled financial advisers with questions about their intentions for the funds. In a rather cheeky move, he also required advisers to pay to attend what has become known as “boot camp” to learn about Dimensional’s philosophy directly from Fama, French, and others before being anointed to sell the funds. “People were shocked we wouldn’t take their money immediately,” says David Butler, the group’s current leader, a former basketball player for the University of California, Berkeley, who was Wheeler’s fourth employee. Yet that approach has earned Dimensional unheard-of loyalty. In 2008, while investors pulled an overall $500 billion from equity funds, the firm had positive flows. It wasn’t because of performance: Dimensional’s funds lost more than the market. According to the group gathered for the September dinner in Austin, clients chose to stay because they understood the firm’s philosophy and the small judgment calls it was making on market portfolios.
Another example of the firm’s unique culture — working slowly in an industry that often values the opposite — can be understood from how long Dimensional waited before launching a target date retirement fund, the industry’s best-selling product for a decade.
Not having a target date fund when the category has almost $800 billion in assets is not much of a moneymaking scheme, it turns out. Tim Kohn, head of Dimensional’s defined contribution business, who launched the now-largest target date funds more than 20 years ago when he was at Barclays Global Investors, says Dimensional could have put together its own version in a day if it had wanted. However, Robert Merton — a Nobel-winning MIT Sloan School of Management professor who came on board as Dimensional’s chief scientist in 2010 — believed that the existing model was all wrong: It only addressed savings. In his view, the funds needed to focus on accumulation as well as income in retirement.
Merton is well known for a body of research on life-cycle investing and retirement funding, but Dimensional needed to solve an engineering problem, according to Gerard O’Reilly, the firm’s head of research. “The solution needed to manage uncertainty about in-retirement consumption and provide customized participant information that helps them make informed saving and consumption decisions,” says O’Reilly, who studied theoretical physics after reading Stephen Hawking’s books when he was a teenager in Waterford, Ireland, and now shares the CIO role with Repetto. The co-CIOs met at the California Institute of Technology when both were pursuing Ph.D.s in aeronautics.
The target date funds, launched late in 2015, were built using an approach from the institutional market: liability-driven investment. For, say, every $100 invested 20 years before retirement, $50 is socked away for growth and $50 is put into risk-managed assets that hedge inflation and interest rates. With the risk-managed assets, Dimensional can then provide some clarity around the actual income that investors can count on in retirement. “In my mind, we should have solved that earlier,” says O’Reilly in his thick Irish brogue, which is untouched by 20 years in the U.S. But, he adds, “when we thought we had something better than everybody else and at the same time solved a problem that hasn’t been solved — that’s when we launched.”
At Dimensional passion for the outcome verges on the evangelical. “In ten years people will say, ‘Do you have a wealth-based or an income-based target solution?’” Kohn says. “It’s definitely a new class. That’s why it was worth waiting. To work with people like Bob Merton and define a class, that’s it. We want everyone to create a [target date income fund] to compete, because it’s the right solution. It should be the standard.”
To some outsiders, it’s surprising that Booth waited so long to try and crack the defined contribution market; he has repeatedly emphasized that he wants to reach investors who don’t have enough wealth to be of interest to advisers. But the academic in him stopped him from rushing to market with something mediocre, he says. Plus, Dimensional didn’t need the money. Kohn supports that view, noting that at any other firm, not having the hot product of the moment for a hungry sales force
wouldn’t work. But Dimensional doesn’t have goals for its salespeople. Sales teams are judged on their client relationships, including how well they service them.
It’s instructive to consider other things Dimensional doesn’t have. For example, it doesn’t offer a momentum stock strategy even though the pattern of outperformance is seen clearly in the data. The firm believes a portfolio of momentum stocks generates too much turnover and creates a fund whose characteristics look very different from a market portfolio. Instead, Dimensional uses information on momentum to inform its trading strategies, such as delaying purchases and sales at certain times. It only started offering funds that focus on the profitability factor in 2012.
Whether such a conservative pace and structure are the result of a committed founder or the firm’s physical and emotional ties to academia is a question left unanswered. O’Reilly, for his part, believes they are rooted in the firm’s philosophy that it’s difficult to outguess the market. “Rather than saying the market has something wrong, we say, ‘What is it telling us?’” he explains, adding that “listening” to the models in this way makes him appreciate the complexity in markets and the wide gap that has to be crossed to get from academic theory to working product.
Perhaps Dimensional is cautious and humble because it employs the men who wrote the code for the Efficient Market Hypothesis and the three-factor model. As Repetto says: “Gene and Ken and the other academics on our staff have been writing the book about these things. It’s not only what they have published — think of the work that has never been published. We have that.”
The question of succession comes down to two related but distinct issues: organization and culture.
Organizationally, Dimensional seems secure. An initial public offering — an obvious route to ensuring that the lights stay on, the building gets cleaned, and the right people take over — has been discussed. Over dinner Booth is frank, if hesitant, about the possibility. “It’s hard for me to imagine. We all have a good gig going here,” he says, over Fama’s laughter. “Maybe we could make more money if we had an IPO.”
“I don’t think so,” Fama says.
“But it would change the character,” Booth notes. No one at the table disagrees.
Booth’s seriousness fades as he turns to Fama and French: “Would these guys still work seven days a week?”
French is quick to respond: “He pays us a lot, what could be better? I’d work for free, but I don’t have to!”
An IPO or a sale to a bigger firm might be hard for Booth to imagine, but Dimensional is private, and private firms need a way to pass ownership from one generation to the next. Booth gets serious again. “It’s something we worry about a lot — succession, the next generation.” Almost unable to stop himself, he continues to riff: “We love what we’re doing. That’s as good as it gets. What a gift.”
But an IPO doesn’t solve for cultural persistence. The members of Dimensional’s executive team, replete with engineers, Nobel Prize winners, physicists, and fluid-mechanics experts, believe that succession is less important because the firm’s products are based on science. They have built a firm on the back of the Efficient Market Hypothesis, and judging from the popularity of their products, they’ve won the argument that investors should act as if prices are right.
Yet survey the number of competitors’ products that are currently available and use the same foundational research: It will quickly become clear that it is the implementation of such insight into the investment process, not the research itself, that is essential. This implementation is a matter of culture, and culture is always in the hands of people.
Booth and the rest of his team feel strongly that their culture, not the financial concerns of individuals, is at the root of their success. What will become of Dimensional’s methodical, almost anticommercial ways when the first generation has cashed out?
“We thought you’d forget about succession,” laughs French when the subject is once again brought up at the dinner table.
“I’ll give it a shot, then probably all these guys will tell me how wrong I am,” says Repetto, the man who represents the next generation — and who will decide whether that generation will continue in its founders’ footsteps.
“I don’t think anybody has anything against public companies that are well run,” Repetto says. “This idea that you have to report to analysts every quarter, be short-term thinkers — there is no need for that. I’m not saying it’s going to be, but if it’s going to be public, then I’m sure Dimensional would be a great public company. But there are tons of possibilities — could be private, public, many possibilities.”
Booth says, “Last time Gene and I talked about it, he said, ‘Let’s wait until we have to do something, a big event’ — like me falling out of an airplane.”
“The ownership structure: You may think it matters; I say no, it doesn’t matter. It’s the culture, it’s how we think about our clients,” Repetto says.
“We have spent a lot of time thinking about if something bad does happen —” says French.
“Something bad will happen!” Booth says.
“The real question is what happens after the three of us are . . .” says Fama.
“I don’t plan to go anywhere,” French says.
“There’s a good model there, but then the issue is how do you pass it along?” Fama asks.
“That’s it,” says Booth. •