`Investment Porn' Panned by DFA Funds Preaching Fama's Gospel By Seth Lubove
March 27 (Bloomberg) -- Weston Wellington looks out at his new recruits and warns them of one of the great evils of Wall Street: ``investment pornography.'' Wellington, a vice president at Dimensional Fund Advisors Inc., flashes slides of magazine headlines such as ``The Next Microsoft'' and ``Tech Stocks, Everyone's Getting Rich.'' Investors who read this stuff and scour stock research are deluding themselves, he tells the packed conference. DFA, which manages $123 billion, doesn't worry about what a company does or how much money it makes before buying its stock. ``We walk in blindfolded,'' Wellington says. Wellington and his colleagues at Santa Monica, California- based DFA preach that no one can predict which way stock prices will go. Their creed is rooted in the efficient-market hypothesis espoused by economist Eugene Fama. A University of Chicago finance professor and DFA director, Fama, 68, maintains that securities prices reflect the collective wisdom of all the participants in a market. Active investors -- people who actually pick stocks -- rarely beat the market over the long haul, his theory goes. To spread the word, DFA has recruited a small army of more than 500 independent financial adviser firms. The acolytes who work for these outfits are one of the biggest, and least-noticed, reasons why DFA's assets have almost quintupled in the past decade. Changing Tack DFA ignored individual investors for the better part of its 26-year existence in favor of pension funds, corporate accounts and other big institutions. Now, the firm is going in the opposite direction. DFA gets more than 60 percent of its assets from individuals these days compared with 43 percent five years ago. Money is pouring in. DFA ranked fifth among U.S. fund groups in raising money, with $14.4 billion in total new funds through December, according to Financial Research Corp., a unit of Roseland, New Jersey-based Bisys Group Inc. DFA has accomplished this with almost no advertising except for running a dense, graphically challenged Web site. The firm hired its first marketing officer in January. Consistent with Fama's theories, DFA is agnostic about which stocks it buys. Its fund managers do little or no company research. They don't schmooze with chief executives or dial in to earnings conference calls. DFA managers are devotees of quantitative analysis, or quants, who put their faith in financial theory, rather than human judgment, when deciding what to buy or sell. Bloopers So committed is DFA to passive investing that it hangs stock certificates of bankrupt companies it has ended up owning on the wall of a trading floor break room. When reporters call about any of the 500 companies in which the firm shows up as a 5 percent or greater shareholder, Wellington pleads ignorance. Unlike traditional index fund managers, which buy all of the stocks in, say, the Standard & Poor's 500 Index, DFA tries to capture an entire asset class -- small cap or value, among others -- with the purchase of huge, seemingly indiscriminate, swaths of stock. Instead of buying all of the stocks in an index devised by someone else, DFA defines each asset class itself, based on companies' market capitalizations and book-to-market ratios, or book values relative to market values. The firm weeds out the stocks that aren't traded much because those shares are relatively expensive to buy and sell. DFA US Micro Cap Portfolio, the company's flagship fund, holds 2,442 stocks out of a possible universe of 2,487 companies worth less than $500 million. DFA's 99 percent exposure to the microcap market virtually makes it the market itself, at least according to Morningstar Inc.'s Ibbotson Associates, which uses the returns of DFA's Micro Cap fund to illustrate the returns on small company stocks from 1982 to 2006. `Fatal Error' Thomas Nugent, chief investment officer at PlanMember Advisors Inc., says DFA made a ``fatal error'' early in its history by focusing on these microcap stocks, the bottom 10 percent of companies by market value. ``Companies in bankruptcy pass through the 10th decile before they go bankrupt,'' he says. While Nugent says he's a fan of DFA and a longtime acquaintance of DFA co-founder David Booth, he prefers the methodology of New York- based WisdomTree Investments Inc., which pitches exchange-traded funds based on earnings, dividends and other non-market-cap weightings. Morningstar awards DFA's oldest fund, US Micro Cap, three out of five stars. The fund has been burdened by ``greater volatility than most of its peers,'' Morningstar says. Morningstar analyst Sonya Morris, in a separate report on the fund, dubs the fund a ``fairly racy offering'' that has ``experienced its share of turbulence'' and is more volatile than 80 percent of similar funds. Wall Street Debate Which approach is best, active or passive investing, is a never- ending debate on Wall Street, where passive indexers such as DFA and Vanguard Group Inc. are the antithesis of celebrity stock pickers. If there's any criticism of indexing, it's that as goes the market, so go the indexes, which can lead to losses unless an investor also invests in active funds to mitigate the market swoons. The indexers have been winning lately. According to the Standard & Poor's Indices Versus Active Funds Scorecard, which tries to add substance to the debate, the S&P 500 Index beat both actively managed large- and small-cap U.S. stock funds last year. The index topped 69.1 percent of large-cap funds, while the S&P SmallCap 600 Index led 63.6 percent of small-cap funds. The indexes posted similar results for the past three- and five-year periods. Dimensional's $8.8 billion DFA US Small Cap Value Portfolio holds shares in 1,313 companies, a portion of the firm's entire store of some 11,000 stocks. The fund posted a total return of 21.6 percent in 2006. Fidelity Investments' equivalent $1.27 billion Small Cap Value Fund, which invests in 181 stocks, returned just 15.6 percent. The MSCI U.S. Small Cap Value Index gained 16.9 percent. DFA Club Dimensional is selective about who it lets into the club. Individuals can invest only through independent financial advisers. The advisers responsible for the firm's recent success have to pay their own way to attend mandatory conferences, where they're treated to lectures by the firm's roster of academics and directors, including Fama and Kenneth French, a finance professor at the Tuck School of Business at Dartmouth College, who helped Fama refine the efficient-market theories in the 1970s. Booth and DFA co-founder Rex Sinquefield were early pioneers of index investing. Booth learned the trade at the feet of John McQuown, a DFA director who helped develop the first index fund in the late 1960s. Sinquefield's DFA biography says he ``virtually invented index investing'' while at American National Bank of Chicago in the early '70s. When Booth and Sinquefield founded DFA in 1981 in an apartment in the Brooklyn Heights neighborhood of New York City, they initially avoided taking money from individuals, who often chase flavor-of-the- month funds. Courting Investors Instead, the firm preferred the relative stability of institutional money. Early investors included International Business Machines Corp., McDonnell Douglas Corp. and Owens-Illinois Inc. In the late '80s, a financial adviser named Daniel Wheeler, now 62, convinced Booth and Sinquefield that pooling together his 15 individual investors would provide the stability of a small institution. It helped that at the same time Wheeler was banging on Dimensional's door, Charles Schwab Corp. was creating its Schwab Institutional unit, which handles the back-office work for about 5,000 independent financial advisers. The Schwab service made it easier for advisers to sell funds like DFA's. Impressed by Wheeler's persistence, Booth and Sinquefield gave him a one-year contract to attempt to build a financial advisory business. Tough Going It was tough going at first. Wheeler got Schwab to put up some money in the summer of 1989 to stage an eight-city, two-day series of seminars for the benefit of accountants and independent investment advisers. He sent out 40,000 invitations and rented out conference rooms that could accommodate up to 300 people. ``I thought this would launch it in a big way,'' Wheeler recalls. All of 42 people showed up. ``Fortunately, that didn't kill the deal,'' says Wheeler, a former Marine Corps officer who studied the efficient-market hypothesis while pursuing a Ph.D. (which he never completed) at the University of California, Berkeley. Chalking up the fiasco to a failure to articulate the message, Wheeler went back to the accountants with the promise that DFA could deliver the return investors expect, which resonated with advisers fearful of antagonizing clients. By the end of that first year, Wheeler managed to bring in $70 million from advisers. It didn't help Wheeler's task that the firm, even in its infancy, threw out any advisers who purported to be able to time or beat the market. Wheeler, now a DFA vice president, proudly recalls the tale of overhearing a visiting financial adviser indiscreetly boast in DFA's elevator of working with a big market timer. Parallel Universe ``I said, `What are you doing here?''' Wheeler says. ``I said, `I'm sorry, you're not welcome here. You're not invited. I want you to leave.''' Dimensional has become cozy enough with the financial advisers that it now vets potential new funds with them. ``The institutions don't have the same kind of clubbiness with us,'' Booth, DFA's chief executive officer, says. (Co-founder Sinquefield retired in 2005.) ``They think they may have to someday fire you.'' Many of the advisers travel in a parallel universe where the rest of the world seems to be completely out of its mind. `Lure of Quick Riches' ``I'm beating my head against a wall saying, how can we have all these people doing all this trading?'' says independent adviser and Dimensional convert Mark Hebner, who once issued a press release calling active money management a ``hoax.'' ``It's the lure of quick riches, the lure of an easy buck, like gambling.'' Hebner's Index Funds Advisers Inc. has become one of the leading proselytizers for DFA. Hebner oversees $795 million, all of it invested in DFA funds. ``I went through their program in June 1999,'' Hebner says. ``It was an epiphany, like a defining moment when you cross over and really understand what's going on.'' While DFA itself shuns most forms of self-promotion, its corps of financial advisers serves as a tireless source of propaganda. Much of it consists of contempt for active investing and the financial media that it says dupes the public into thinking anyone can beat the market. Typical is something called Tribeca Financial LLC of Mesa, Arizona, whose ``7 Deadly Sins of Investing'' brochure starts with the sin of active investing and includes ``stock picking'' and ``investment porn.'' DFA Converts Overcoming the deadly sins involves ``investing with a diversified portfolio of low-cost index funds,'' preferably DFA's offerings that just happen to be sold by Tribeca. Few of DFA's advisers can match Hebner when it comes to the sheer volume of words produced on behalf of the firm. Weighing in at 392 pages, Hebner's recent self-published tome about index funds equates active investing with alcoholism. With numerous pages devoted to DFA, and just as many spent bashing active managers, the book amounts to an unpaid ad for the company. ``Here they have the best product on the planet and hardly anybody knows about it,'' Hebner says. ``I've always had a skill for communication.'' If anything, the passing of time has only hardened Wheeler and DFA's stance against the scourge of advisers who dabble in active investing. Early on, Dimensional didn't offer enough diversification in the asset classes of its funds to allow advisers to put all of their eggs in the passive basket. With 61 funds today, inclusive of U.S. and non-U.S. equities as well as fixed-income funds, there's no excuse for an adviser to stray from DFA when deciding how much money to put into various passive funds. Hazing Recruits To ensure advisers hew to the DFA line, prospects first have to submit a plan detailing how they'll sell DFA funds to their clients. Then Dimensional pays a visit to the financial adviser's office. ``They really put us through the wringer,'' says Michael Davis, whose Resource Consulting Group of Orlando, Florida, manages more than $1 billion for 315 clients. Among other things, he had to show DFA his Form ADV, a Securities and Exchange Commission filing that asks financial advisers whether they've ever been convicted of a felony to whether they've been sued. ``They asked for our business plan, what is our niche, how we get clients, how we retain clients, what is our business model,'' Davis says. Does he get such scrutiny from other fund companies? ``Are you kidding? Most investment houses say, `Just send us the money,''' he says. ``We can tell what their level of commitment is,'' Wheeler says. ``We have to screen them to find out if they're coming with views consistent with ours.'' Lessons From Fama After passing the sniff test, the adviser is then required to attend a mandatory, two-day seminar at his or her own expense at DFA's Santa Monica headquarters. ``We don't even give them pens,'' Wheeler says. Fama and French usually make an appearance, presenting slides of tables of historical stock data to prove their point that the market knows best. At a January introductory session at DFA's oceanfront headquarters, presenters included Fama and his son Eugene Fama Jr., a DFA vice president whose job includes translating his father's theories for human consumption. Fama Jr. livens up one morning's proceedings with a sense of humor that is the antithesis of the serious demeanor of his father. ``Saying my dad is a finance professor is like saying Michael Jordan is a basketball player,'' he deadpans. ``He's really the father of modern finance. But that doesn't mean I'm modern finance.'' Excitement Elsewhere Michael McClain, who helps oversee the $600 million asset trust department of Jefferson Bank in San Antonio, ended up at the conference after becoming disillusioned with the returns of active management. ``People want me to not find their money exciting,'' says McClain, referring to DFA's passive-investing philosophy. ``They want me to find excitement elsewhere.'' Once they've survived the hazing, the financial advisers are policed by other advisers to ensure they don't dabble in active investing. DFA converts keep tabs on other advisers to make sure they toe the line. ``Eyes and ears are out there,'' Wheeler says. ``We'll give that adviser a call and say, `You can't do that.''' ``They insist on educating you,'' says Brenton Kessel, a Pacific Palisades, California-based financial adviser who deposits a large chunk of the $550 million his firm oversees in DFA funds. ``Once you get their brand of education, you can't drink the rose. It's either red or white.'' Like many DFA acolytes, Kessel, 38, admires the firm's belief in the power of markets over individuals. ``I'm very numerical, notwithstanding the touchy-feely,'' says Kessel, referring to his passion for yoga. Hebner says it's really the rest of the world that's off its rocker. ``People say it's like drinking Kool-Aid, that we're in a trance,'' says Hebner, who is shown wearing a cheesehead hat on his busy Web site. ``That's a bunch of BS. All we did is become educated, and everyone who is doing active management is not.'' To contact the reporter on this story: Seth Lubove in Los Angeles at [EMAIL PROTECTED] . Last Updated: March 27, 2007 02:06 EDT
