Passive investing is an increasingly popular strategy which involves buying and holding a portfolio of investments for the long term. The idea is to track the performances of benchmark indexes instead of trying to beat them, which bodes well for many investors as these strategies typically cost much lower than actively managed funds.
David Booth is no stranger to passive strategies. Dimensional Fund Advisors — the firm he co-founded in 1981 — was one of the earliest to offer passive investing strategies in the US, growing to become a firm with US$614 billion ($825 billion) in assets under management as of March 31.
He is also known for his US$300 million donation to his alma mater in 2008, which he graduated from in 1971. The renamed Graduate School of Business at the University of Chicago is known today as one of the top US business schools.
Booth tells The Edge Singapore that the firm was built around ideas developed for the academic community. He explains that science in finance emerged in the 1960s when it became possible to test hypotheses and theories within the industry.
“At the time, the money management industry claimed they could add value to investors without any empirical evidence to support their ideas. When academics started to test out whether there are any values to traditional active management, they could not find it,” he says.
In 1970, Nobel laureate Eugene Fama detailed the prominent “Efficient Markets Hypothesis” theory in his book, which discusses that when new information comes into the market, it is immediately reflected in stock prices. There is no room to make excess profits by investing as everything is already accurately priced, implying that it is virtually impossible to beat the market, although one may be able to match market returns through passive index investing.
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Based on this belief that markets are “efficient” and that investors’ returns are determined principally by asset allocation decisions instead of market timing or stock picking, Dimensional offered a different approach to investors.
Rather than attempting to predict the future or outguess others, the firm draws information about expected returns from the market itself, leveraging the collective knowledge of millions of buyers and sellers as they set security prices. The firm structures its portfolios along the “dimensions” of expected returns based on academic research insights — with five Nobel laureates joining its boards at different points in time, including Fama.
For Booth, the ideas that gave birth to Dimensional have now been around for over five decades and have shown to work as index funds continue to beat active management — just like the original research has found. “Despite this, conventional active management — which is more costly — is still a thriving industry, which I find puzzling,” he adds, referring to how so-called actively managed funds tend to incur higher management fees than passively-managed ones.
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When indexing was first developed half a century ago, investors participated because they wanted to make a passive investment. “Eventually, it was found out that indexing is the ideal market timing device, which led to an explosion in index funds investing. But I believe most are active management in disguise,” says Booth.
He is convinced this is the case as trading volumes have yet to plummet significantly, although indexing accounts for a significant part of the equity markets. In 2022, for example, a record 558.4 million S&P 500 Index options contracts were traded, beating the previous high of 371.3 million contracts in 2018.
Booth says the financial industry is good at “twisting the idea of passive management around for clever marketing”. Given the distinctive nature of general market dynamics, indexes are not based on static rules. Due to these dynamics, managers make certain decisions throughout the life of portfolios, which does not sound passive.
Over the years, Dimensional has evolved from focusing on indexing to combining active management and factor-based investing. Following a change in US regulations in 2019, Dimensional launched its first exchange-traded funds (ETFs) in 2020.
By the end of 2021, it had launched 13 equity and fixed-income ETFs, quickly becoming one of the US’s largest so-called “active transparent” ETF managers. As of November 2022, Dimensional has a total of 27 ETFs which complement its mutual funds and separately managed accounts offerings.
Demand for robo-advisory services
The growth of passive indexing strategies paved the way for robo-advisory services, which leverages these strategies to provide a convenient and low-cost solution for investors, especially those looking for a low-barrier diversification alternative.
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Robo-advisory platforms enable automated investment services, typically through ETFs. The platforms make investment decisions using algorithms, which have developed through the years following rapid technological advances in machine learning and big data.
Being a low-barrier alternative is one of the main reasons why robo-advisory services have grown its popularity exponentially over the past decade. For example, Singapore’s fintech platform Syfe does not impose a minimum investment amount, while Endowus has a minimum initial investment of $1,000. The latter partners with Dimensional, citing a common belief in market efficiency.
In the US, robo-advisory services have grown steadily since its launch in the late 2000s. Betterment, which is said to be the first robo-advisory platform launched in 2008, currently has over US$32 billion in assets under management.
Over the years, players have also started offering their services to more high-net-worth individuals (HNWIs) and ultra-high-net-worth individuals (UHNWIs) to disrupt the traditional financial advisory industry further. US financial institution Empower, for example, provides a robo-advisory service previously known as Personal Capital with a minimum investment amount of US$100,000.
Can these platforms truly capture the HNWIs and UHNWIs market? Booth has his doubts. He says it is a viable option for those needing help to afford a traditional advisor as long as they pick a provider with a low turnover.
Ultimately, investing is complex and full of uncertainties. “Many things can affect one’s investments unrelated to the market movements, such as career and family dynamics. When one gets a new job or has more kids, they may want to make major portfolio changes. This is where having an advisor who understands them and their investment objectives can be very helpful,” says Booth.
He adds that robo-advisors — like other forms of money management — would have some good and bad players, so it is important for investors to select the providers carefully. He commends the ability of these providers to democratise investments, bringing down management fees, administrative costs and fees associated with custodial accounts.
“I think that in the future, the cost of operations will get lower over time. Nevertheless, I think most people prefer human judgement. For instance, I don’t feel comfortable driving on the road knowing that some driverless cars are coming my way.”
