David Booth on 50 years of indexing

Updated: Nov 22

Several people have laid claim to inventing index funds, but John “Mac” McQuown has a stronger claim than most. It was in 1971 that the former farmhand from Illinois set up a think tank with the goal of turning academic research into a new way to invest. In July that year they launched an indexed portfolio. They were a brainy bunch: at one point McQuown had six future Nobel laureates working with him. Another team member was DAVID BOOTH, who went on to co-found Dimensional Fund Advisors ten years later. Here, Booth recalls those momentous events half a century ago and reflects what the next 50 years might hold for the investing industry.

Mac McQuown recruited me to help create the very first indexed portfolio in 1971. I was 24 years old and living in San Francisco, where more people my age were following the Grateful Dead than the stock market. The think tank Mac set up felt like a start-up, although it was long before anyone used that term. We were excited by the opportunity to turn academic research into a new way of investing. Many people thought we would fail. Some even called what we were trying to do “un-American”. But we didn’t worry about the attacks; we focused on how indexing could improve the lives of investors. The fund offerings available at the time were actively managed portfolios that tried to outguess the market and were expensive, lacked diversification, and performed poorly. So-called star managers sold investors on their ability to win against the market; they sold products as opposed to solutions.

Changing lives for the better

Problem was, there was no compelling evidence they could reliably beat the market. We were confident that indexing — a highly diversified, low-cost investment solution that relied not on a manager’s ability to pick winners but on the human ingenuity of hundreds or thousands of companies — would change lives for the better. 50 years later, $9.1 trillion is invested in index mutual funds and exchange-traded funds (ETFs).

This represents 51% of the total $17.9 trillion in equity ETFs and mutual funds. Six of the original academic consultants Mac hired to work on that first index fund went on to win Nobel Prizes. I have worked with four of them at Dimensional. When we started Dimensional in 1981, indexing was beginning to catch on. But the primary index used was the S&P 500, made up of 500 of the largest companies in America. My colleague Rex Sinquefield and I thought investors could be better served by adding small capitalisation stocks to the mix, since they were underrepresented in portfolios and offered diversification and expected return benefits.

The first small-cap strategy

We were the first to treat small cap companies as a separate asset category. It was an exciting idea, but it made many people nervous. An academic paper circulated that said the performance of small cap stocks couldn’t be captured because of trading costs. Many academics, even those who worked with us, were skeptical that we could deliver on our big idea of creating a small cap strategy. (After 40 years of results, the scepticism about our ability to deliver has subsided.) There was perceived risk in trading against professional investors who might take advantage of us with all their knowledge and experience. But we found a way to turn trading to our advantage: flexibility. Flexibility is one of the key differences between index investing and Dimensional investing and where so much of our innovation has taken place. Because we weren’t beholden to tracking any particular index, we could harness the power of markets, even beat the indices. The protocols, systems, and teams we’ve developed — as well as the experience we’ve accumulated — have shown to be applicable to a wide range of strategies, from fixed income to value to international investing.

What next?

So what happens next? Where will we be in 50 years? I’ve built a career in finance without making predictions, but I do believe that technological innovation is lowering barriers to entry for everyday investors and enabling greater personalisation. In 1971, there was one index fund. In 1981, there was one small cap strategy. Today, investors have more access to customised portfolios than ever before. Sitting down with a trusted adviser, investors can develop a plan and build a portfolio solution that gives them the best chance of having a good investment experience. For example, many people are interested in environmental, social, and governance (ESG) strategies, but ESG can mean different things to different people. So rather than choosing from what exists, new technology allows you to get exactly what you want. For me, working in finance has always been about improving people’s lives. We created indexing to improve upon stock picking. We created Dimensional to improve upon indexing. Each day we strive to help our clients in new and better ways. That’s why I thought 1971 was the most exciting time to be in this business. Then, I thought 1981 was the most exciting time to be in this business. But the truth is, it’s every day, as long as we’re able to keep helping people in innovative ways.

FOOTNOTE

Data obtained from Morningstar on July 6, 2021. The sample includes US-domiciled equity mutual funds and ETFs. Funds of funds and money market funds are excluded.

DISCLOSURES

Risks include loss of principal and fluctuating value. Investment value will fluctuate, and shares, when redeemed, may be worth more or less than original cost. Small and micro cap securities are subject to greater volatility than those in other asset categories. John “Mac” McQuown is a member of the Board of Directors of the general partner of Dimensional Fund Advisors LP. The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.