Magazine Issue: July 6, 1998

How the Really Smart Money Invests

Part 2

Shawn Tully

The object of their devotion, Eugene Fama, is a blunt, brilliant rebel, the scion of a working-class Boston family, whose greatest love is upsetting the status quo. As restless physically as he is mentally, Fama is a fanatic tennis player and athlete who rises at dawn to work out in his basement to blaring Wagner operas. On visits to DFA's California headquarters, he wears a special beeper that goes off whenever the wind is right for windsurfing. Once alerted, the 59-year-old Fama packs up his sailboard and heads for the beach--or if he's stuck in a meeting, he exhorts the participants to hurry up. Although considered a front-runner for a Nobel, Fama refuses to shed his curmudgeonly ways, even to compete for the prize. When well-wishers gently suggested that he might help his chances by chatting up the Nobel committee, his response was pure Fama: "If they come over here, I'll chat, but I'm not dragging my behind over to Sweden."

While other thinkers had long questioned whether stock prices were really predictable, Fama's work gave the efficient-market hypothesis its most rigorous intellectual grounding (as well as its name). Fama argued that the stock market is a matchless information-processing machine, whose participants collectively price shares correctly and instantaneously. Unlike the market portrayed in mutual fund advertisements and personal-finance magazines, it is not a place where the smartest managers outwit the less smart. Instead, the market is so full of well-trained, well-motivated investors avidly gathering information and acting on it that not even Nobel Prize winners can hope to beat it consistently. Sure, some managers will outpace the market for a few years, but it is impossible to prove that those runs are more than just sheer chance.

The efficient-market theory still raises hackles on Wall Street, for obvious reasons. But in academia the debate is all but over, and among pension fund fiduciaries Fama's theories are now so accepted that an estimated 24% of the trillions of dollars in pension assets is invested in index funds.

When Sinquefield and Booth joined the work force after leaving Chicago, however, the efficient market was a revolutionary idea. While working as a trust officer at American National Bank in Chicago, Sinquefield evaluated the bank's money managers and discovered just what Fama had predicted: Funds that actively pick large-company stocks collectively do no better than the S&P--worse, in fact, once you count their fees of 0.5 to 1.5 percentage points a year. Why not create a fund that simply tracked the index? asked Sinquefield. As long as fees were low, it would be all but certain of beating most professional stock pickers over time.

The new concept was the ultimate hard sell. "You think John the Baptist had it tough!" recalls Sinquefield. But he finally persuaded New York Telephone to invest in an S&P 500 fund if American National started one. So in 1975 Sinquefield and American National launched the first index fund to mimic the S&P. (Or maybe the second--Wells Fargo, which came out with a similar fund at the same time, claims it got there first.)

Meanwhile, at investment firm A.G. Becker in New York City, Booth was advising pension fund managers on where to put their money. He noticed that almost all the managers invested in big companies. Booth pleaded to start a small-cap index fund, but his colleagues guffawed at his presentation. "They were saying, 'Don't let the door hit you on the way out,' " recalls Booth. The next day Booth started DFA in his Brooklyn apartment, ripping out the sauna to put in a Quotron machine.

As Booth began looking for clients, another of Fama's graduate students, Rolf Banz, was researching the performance of small stocks vs. large. Banz's research proved for the first time what most professional investors take for granted today: that small-cap stocks produce higher returns than big ones over long periods. The reasoning is pretty straightforward. Smaller companies are riskier than larger companies and have a higher cost of capital. No one would invest except in expectation of earning a commensurately higher return.

Sinquefield, who had been following Banz's research, immediately proposed a small-cap index fund at American National. The bank nixed the idea. By coincidence, Booth called shortly afterward to say his fledgling firm was hatching a product just like the one Sinquefield's employer had deep-sixed. Sinquefield quit his job and joined Booth. DFA was in business.

In keeping with Banz's research, the fund would own all the stocks that made up the smallest two deciles, measured by market capitalization, of the companies on the New York Stock Exchange. (The name, the 9-10 fund, derives from the two deciles.) True efficient-market believers, Sinquefield and Booth made no effort to sort the winners from the dogs among the fund's holdings. Thus, there would be no research department or celebrity money managers, and costs could be held to a modest half percentage point, a third of what the average small-cap fund charges today. The result was a fund with the efficiency of an S&P indexer but the promise of higher returns in the long run.

One of DFA's first moves was to recruit Fama, Miller, Scholes, and Ibbotson as advisers. Fama was delighted with the idea of a fund based on his principles. "In class he kept telling us that the efficient-market theory was the most practical thing we'd ever learn," recalls Booth. "I think Rex and I were the only people who believed him." Over the years Wall Street firms, including Goldman Sachs, have tried to lure Fama away, but he always refused to leave his brainchild.

At first things went splendidly. From July 1982 to mid-1983, DFA's small-cap fund gained nearly 100%, and pension funds rushed to sign up. Then Sinquefield and Booth experienced a corollary of Banz's research: When small stocks fall, they fall harder than big ones. From 1984 to 1990, small caps went through the worst seven years in their history, returning just 2.6% a year, vs. 14.7% for the S&P. "At least it discouraged the competition," muses Booth.

To continue: What saved DFA during this period was...

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