Originally Aired: June 4, 2014
Topic: Active vs. Passive Investing with Financial Specialist, P.J. DiNuzzo
The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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- Introduction of P.J. DiNuzzo, CPA, PFS
- Passive Funds Mimic the S&P 500 or Other Specific Index Funds
- Passive Index Manager Works to Keep Stocks in Proportion
- Active Investors Can Beat Indexes, but They Rarely Repeat
- Is the Potential Gain Worth the Extra Risk You’ll Assume?
- When Building a Portfolio, Think First of the Downside
- Fiduciary Advisor Is Legally Bound to Serve Clients’ Interests
- Portfolio Theories of Eugene Fama Were Mocked at First
- Active Investors Often Fail by Selling Low, Buying High
Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.
1. Introduction of P.J. DiNuzzo, CPA, PFS
Hana Haatainen Caye: Hello, and welcome to The Lange Money Hour, Where Smart Money Talks. I’m your host, Hana Haatainen Caye, and of course, I’m here with Jim Lange, CPA, attorney and bestselling author of the first and second edition of Retire Secure!, and The Roth Revolution, Pay Taxes Once and Never Again. Jim’s guest tonight in P.J. DiNuzzo, CPA, PFS. He is a nationally recognized expert in investment management who has appeared in or on numerous national and international publications and TV shows. P.J. has been rated by Paladin Registry Investor Watchdog as a five-star advisor, scoring in the top 1 percent out of over 800,000 advisors in America. His firm, DiNuzzo Investment Advisors, Inc., has been consistently ranked as one of the top 500 firms in the country, on numerous occasions by multiple national publications. On tonight’s show, P.J. and Jim will be discussing active versus passive investing. Many investors follow an active investing strategy where they pick their own stocks or mutual funds, but there is a growing minority who favor a passive index investment strategy. The show tonight will discuss who does better, active or passive investors when having a money manager makes a difference, and the truth behind published mutual fund performance numbers and what are the investor’s actual performance numbers. But before I turn it over to Jim, I want to remind our listeners that the show is live, so please feel free to call in with your questions for P.J. The number is 412-333-9385, again, that is 412-333-9385. Good evening, Jim, and welcome to the show P.J.
P.J. DiNuzzo: Good evening.
Jim Lange: Before we start, I am morally required to mention that I am not independent with P.J. P.J. and his company, DiNuzzo Investment Advisors, is one of the investment managers that we use to help clients reach their financial goals. I do have a sharing arrangement with P.J. and DiNuzzo Investment Advisors Inc. I function as the trusted advisor that provides big pictures, strategic financial planning, Roth IRA conversion analysis, estate and tax planning, and what I would basically call the big picture items, and I meet with clients at least once a year. I work hand-in-hand with P.J., who then develops asset allocation planning and a personal financial plan, and then he executes the investments, typically — not typically, I think almost solely — with Dimensional Funds. And that helps keep clients starting on the right track and then the annual reviews with both me and P.J. keep people on the right track and make adjustments as necessary.
Jim Lange: So anyway, welcome to the show, P.J., it’s great to have you.
P.J. DiNuzzo: Good evening.
Jim Lange: P.J. has been on the show before and he did a great job for us, and I’d like this to be a very substantive show, so I’d like everybody to get some good information about it. And I want to start with what might sound like a simple question, but I don’t think it is a simple question, and I don’t think very many people really understand the essence of the issues I’m about to bring up. And before we get to the difference between a passive and an active money management strategy, could we delve into the specifics of what a passive money manager does? So, let’s say that you’re working for the Vanguard S&P 500, which is a passively managed fund; does that mean he just sits on his butt and does nothing and it’s passive?
P.J. DiNuzzo: Yeah, Jim, the indexes, the S&P, for example, would be literally as you mentioned, a passive index. Any firm that would replicate that and have an S&P 500 fund would follow the data. If they’re following a Standard & Poor’s, S&P, fund or a Russell Index like the Russell 2000, would be charged with literally mimicking that index for whatever 500 stocks specifically were in the index, buying those 500 specific stocks, and when there’s any changes, making those changes.
Jim Lange: All right, well let’s just take a simple example. Does that mean that they would own all 500 stocks in exact proportion? Or would they, let’s say for Apple, for example, who is either maybe the first or second largest company, would they own much more than say one 500th of Apple, would they own the proportion of Apple to the entire index?
2. Passive Funds Mimic the S&P 500 or Other Specific Index Funds
P.J. DiNuzzo: Yeah, the index is, for example, the S&P is a market capitalization, cap-weighted index, so Apple does receive a larger fraction of the pie versus the, let’s say, for example, the 500th firm in size. They would have a lot larger portion, so Apple’s price movement has a lot larger effect on the S&P 500, than the 490th or fifth-hundred largest firm in the index.
Jim Lange: OK, so just as an example, Apple has done very well and I’ve had some clients who’ve done quite well with Apple, what would’ve happened is, and let’s forget the times that it has gone down, but let’s say in recent months, when Apple has gone up, basically if you own the S&P 500, that means that you would’ve owned an ever-increasing share of Apple. Is that correct?
P.J. DiNuzzo: Yes, Apple, we don’t buy any individual stocks, but Apple’s had a very large run this year, and if a stock is larger and increasing, growing at a higher rate, it would represent a larger percentage of that index.
Jim Lange: OK, all right, so let’s say that the goal then for an index advisor, he can’t just sit on his butt, I was just being a little bit facetious there, he actually has to own, and let’s just keep using the S&P because that’s probably the most popular index, he has to own, in proportion, all 500 stocks that are part of the S&P, and if one of the stocks goes up in value, presumably he would own more of that or if it goes down, he would own less of that.
P.J. DiNuzzo: Yeah, basically, yes.
Jim Lange: All right. Now, some of the stocks, let’s say from number 450 or 490, down, will occasionally go down, and then let’s say stock number 506 will go up. Will he then, in effect, pare off the weaker ones, or the ones that aren’t doing as well, that, well let’s say 506 goes up by 10 percent and 498 goes down by 10 percent, so now what used to be number 506 is now higher. Will he then buy 506 in the index and make it part of the index, and sell the weaker performing one that might be in the 490s?
P.J. DiNuzzo: Well, in the index replication, the manager following the S&P 500 index would own … they would not make those value decisions, those would be made by the company that has the rights, the patent and the rights to the index S&P, for example, or Russell would make that decision so …
Jim Lange: Well, let’s even go with the S&P. The S&P in effect would be shedding stocks and buying stock, though, is that right?
P.J. DiNuzzo: Just per Standard & Poor’s rule set, it’s just like a rote, mandatory, finite listing of those 500 stocks, and that’s what they would own until S&P came out and said, “We’re going to reconstitute the index. We’re making changes, we’re dropping 10 stocks, we’re adding 10 more.” Then the managers would make those adjustments at that time.
Jim Lange: All right, now if you’re working with a personal account and let’s say whether, and I know that you work more with index funds, but let’s even assume that you were an individual stockbroker and you were trading individual stocks. And let’s say you bought five or 10 or 20,000 or even a hundred thousand dollars or made a sale. The impact of that sale would not be all that significant to the market. In other words, this one relatively small, individual buy or sell is not going to have a huge impact on the price of the market.
P.J. DiNuzzo: No.
Jim Lange: Will it, if the S&P or a different passively managed index, will they have an impact on the price, and can they do that all in one day? Or do they have to announce ahead of time, “Hey, we plan to buy,” or “We plan to sell”?
P.J. DiNuzzo: Yeah, on a smaller cap index is the, I had mentioned the Russell 2000, that’s basically the S&P 500 of small-cap stocks, it’s the national benchmark. And since those are smaller capitalization stocks, whenever they’re added and subtracted, there’s some arbitrage opportunities for hedge fund type organizations, anyone approaching from an arbitrage position that will bid up the price of those stocks and there will be … that’s one of the things that makes our small-cap management strategy stand out very well, because of the reconstitution challenges, for example, with the small caps. With the large caps in the S&P doesn’t make quite as much difference because, again, you’re talking about behemoth, mega caps, very large companies.
Jim Lange: OK. Is that trading advantage, if you don’t have to reconstitute per formula, significant in the big scheme of things?
P.J. DiNuzzo: Yeah, that’s a large piece of the puzzle. The only index that we replicate is just the S&P 500. So, for example, our average portfolio has 15 indexes in it, we’ll have 11 stock fund indexes, and four bond fixed-income indexes and only one out of those 15 is just a standard index, such as the S&P 500, because it is an excellent representation of U.S. large-cap blendstocks.
3. Passive Index Manager Works to Keep Stocks in Proportion
Jim Lange: OK. All right, so I hope that the people get some idea that that means that a passive money manager has a very active role if he’s trying to keep the stocks in proportion and then having to shed and buy when necessary. How is that different from an active money manager, what does an active money manager do?
P.J. DiNuzzo: An active money manager …
Jim Lange: Or, for that matter, an active investor, which is probably, my guess is, the majority of listeners here are active investors, even though they say, “Well, I just bought something and did nothing,” and they don’t consider themselves active investors.
P.J. DiNuzzo: Yeah, the clearest example, I think, Jim, to follow along with your example of the S&P 500 U.S. large-cap stocks, there are managers, most of your listeners have heard of Morningstar, the mutual fund rating agency, and if they were a U.S. large-cap blend manager, which are hundreds if not over a thousand of those large-cap blend managers, that is (inaudible), their benchmark would be the S&P 500. So if someone wants to just think (inaudible) in Pittsburgh-ese that they’re looking at this S&P 500 and saying, “I have the ability to just buy 100 or 200 of these large stocks that are in the S&P, and I know which ones to buy and those will allow me to have a better performance than if I bought this entire basket of stocks.”
Jim Lange: OK, so let’s say that I’m an active money manager and that I study all the charts and the graphs and all the information that is available. And let’s assume that I don’t have inside information and I’m going to try to outperform the S&P. Now obviously I have costs and I have to pass those costs on, so I’m going to have some type of management fee on top of the investment results, or I should say, that takes away from the investment results. But I’m not limited to those exact 500 stocks. I could, like you said, pick a hundred of them or I could say, “Well, the S&P’s pretty good, maybe I’ll just look for five or 10 companies or 20 companies that aren’t so good in the S&P and replace them with five or 10 or 20 companies that are.” Is that an example of what an active money manager might do?
P.J. DiNuzzo: Yes, that’s an example. A lot of managers have to stay around their target, so if they’re a large-cap manager, they’re going to own a reasonable number of stocks that are in the S&P 500.
Jim Lange: OK, but hopefully, if they are doing what they purport to do, the performance will be so much better than it can pay for their fee and still have the person do better than the S&P, after fees. I mean, that is the goal of an active money manager.
P.J. DiNuzzo: Yeah that’s their target. The exact opposite has happened the last 10 years, yeah, but that’s their stated …
Jim Lange: All right, we’ll get to that but Hana’s jumping in her seat and I think she’s trying to tell me it’s time for a break.
Hana Haatainen Caye: Yeah, we do need to take a break. When we come back, we’ll continue this conversation and I want to remind our listeners out there, that we are live, so if you have any questions for P.J. or Jim, please give us a call at 412-333-9385. We’ll be right back with P.J. DiNuzzo and Jim Lange, on The Lange Money Hour.
Hana Haatainen Caye: Welcome back to The Lange Money Hour. This is Hana Haatainen Caye, and I’m here with Jim Lange and P.J. DiNuzzo.
Jim Lange: P.J., before the break, you just started to say something about the overall performance of active versus passive money managers. Now I think historically there’ve been a lot more active money managers than index or passive money managers. Is that right?
P.J. DiNuzzo: Yes, significantly more.
Jim Lange: All right. So active money managers have been around for a long time and the people out there listening, they might not consider themselves active investors but the fact that they are choosing their own investments whether it be mutual funds or individual stocks or individual bonds, the fact that they are, unless they invest in passive index funds, for example, I’m sure that we have a bunch of Vanguard Index Fund investors as listeners, but let’s say that you’re not a Vanguard or for that matter any passive index fund, you are by default an active investor. Is that right?
P.J. DiNuzzo: Yes. Basically, it’s a very clear, bright line, yes.
Jim Lange: OK. So, let’s not talk about the average guy, we’ll get to that later, we’ll talk about how the average guy does or even the average guy within an index fund or mutual fund, but let’s talk about the active money managers. Now, this is presumably a group, and frankly, by the way, as many people know, and as you know P.J., I actually work with a couple active money managers and they’ve actually done very well over the last 10 years, but maybe they are the exception. If you look at, let’s say all the money manager, and of course, there’s going to be some money managers that are going to be the passive approach, how, historically, have passive money managers done against active money managers?
4. Active Investors Can Beat Indexes, but They Rarely Repeat
P.J. DiNuzzo: What we like to look at, Jim, we like to look at periods of five-year rolling periods, and especially 10-year rolling periods. Even our clients (who) are retired, when individuals come to us for retirement income planning, we tell them that we’re building at least a 30-year plan for them. So even heading into retirement, we want to have a 30-year time horizon. With that being said, when you start to look at five-year periods, and especially 10 years, for example, the most recent 10-year period of time, U.S. large-cap active managers, approximately nine out of 10 underperformed U.S. large-cap indexes or Russel 1000. About 69 or 70 percent active managers, in the small-cap arena, underperformed the Russell 2000 small cap index. And that’s generally what we’ll see over a, depending on a five to 10-year market cycle, between six, seven, eight, nine out of 10 active managers underperforming their relative benchmark index. And the thing that’s challenging about it is, we admit that there are active managers that outperform the indexes, certainly; we say statistically we’re surprised that there aren’t more of them, there really should be more. But the very challenging part in building a portfolio, and especially just in retirement it’s 30 years, heaven forbid if you’re a younger investor, if you’re in your 20s or 30s, you’ve got a 50, 60-year time horizon for your investible assets. And when you look at how strong the probabilities are, the thing (we) tell individuals is, that there is a small minority that will outperform, but the very large challenge is that they do not repeat on a regular basis. So, if you pick that one or two managers who outperform small caps, the one or two out of 10, who outperformed the last 10 years, very infrequently will they outperform again in the following 10-year period, the subsequent period.
Jim Lange: Well, what about some of the more famous guys, like Peter Lynch or Warren Buffett? Warren Buffett’s the greatest investor in the world. Does Warren recommend most people do active money management, or does he say, “Hey, even though I’m Warren Buffett and I might be one of the world’s best investors, for most people you’re better off with passive.” What would Warren do, and how has say, you know, some of the more famous funds, done over time?
P.J. DiNuzzo: Yeah, to answer the Warren Buffett question, we’ve been quoting Warren since the early 1990s, when he started to include in his annual report investment advice for the masses, so to speak. His annual report at Berkshire Hathaway, the company that is his holding company for all his investments, basically, his annual report is the most widely read report, arguably, by individual investors. But he began to be quoted in the early 1990s as saying that the best way for institutions, which are large investors, but also individuals to own stocks and have exposure to the stock market, is through an index fund that charges low fees and low expenses.
Jim Lange: All right, so even Warren Buffett, the arguably greatest investor in the world, says for most people, they’re better off with index funds, is that right?
P.J. DiNuzzo: Yeah, we have the quotes on our website, we have little video vignettes of Warren being interviewed at different places, we have him saying it live, being quoted. And for him to be the best, arguably, active stock picker of our lifetimes, for him to endorse our core beliefs is very impressive.
Jim Lange: OK. All right, so basically what you’re saying is, at least over time, may be subject to some exceptions, but you’re even saying the exceptions don’t stand the test of time, that the passive money managers, who are basically index investors, are doing better than the active money managers?
P.J. DiNuzzo: Yeah, Jim, and to your point, part two of your question, if I could answer, is very interesting as well. If we took a look at, you had mentioned Mr. Buffett and also many mutual fund managers, if we were to look back through the annals of mutual fund performance, and we looked at the Number 1 longest track record of any money manager beating the stock market, that would be Mr. Bill Miller from the Legg Mason Value Trust Fund. He beat the market for a consecutive period of approximately 15 years. So, this is a second to none record. He underperformed the market before he went on his 15 years run, approximately four or five out of six years and then subsequently, after that 15-year run, approximately he underperformed the market, again, four or five out of the next six years. So when you take a look at the overall track record, even someone who had outperformed, I believe over the 20, it was in the 20-plus year period of time, that Mr. Miller managed the fund, he ended up outperforming the S&P by approximately 1 percent per year and for the additional volatility that he took on. And so that’s one thing that we’ll point out to clients, that even if you were able to pick that Number 1 individual, I mean his performance was approximately 1 percent greater than the market over approximately 25 period of time, and that was a little needle in the haystack, it’s not a grand slam or grandiose outperformance, it’s just by a small margin. And when you look it on a risk-adjusted basis, you could argue it’s underperformed.
Jim Lange: All right, what do you mean by risk-adjusted basis, and is it safer, in terms of risk to own a widely diversified set of index funds? Or is it safer to just own mainly large company stocks? I have a lot of clients, particularly estate planning clients that are not investment clients, that are dyed-in-the-wool blue-chip investors and that’s what they like. And they see that as relatively safe. Would you say that that is safe, or is there ways that they could improve their safety and how do we measure safety?
5. Is the Potential Gain Worth the Extra Risk You’ll Assume?
P.J. DiNuzzo: Yeah, the answer to the first part of your question, Jim, on the risk-adjusted perspective, I’ve always used the analogy, you can’t just look at one part of the equation, you just can’t say, “What was my return? Everything in the world of finances, what was my risk-adjusted return, how much risk did I take on for that return?” And, you know, a simple analogy or metaphor that I’ve used over the years is, there’s a national pizza chain for years that advertised that “We will deliver that pizza that you order, from the time you call it into your front door within 30 minutes.”But they stated, “We’ll deliver to your door within 30 minutes.” Now …
Jim Lange: Doesn’t have to good …
P.J. DiNuzzo: Yeah, but it’s …
Jim Lange: Doesn’t have to have mama’s sauce, but it’s going to be hot and it’s going to be there in 30 minutes.
P.J. DiNuzzo: So, if we look at that, that’s one part of the equation. Now let’s say, for example, that this national franchise got a phone call and they said, “We’ve got unbelievable delivery times out in Peoria, Illinois. We got a delivery guy out there that is just making this whole thing stand on its head. He’s getting the pizza delivered, from the time that it’s ordered, to houses in 19 minutes.” On the face of that, you say, you know, that’s better performance. I mean, he’s delivering it in 19, where the national average to try to get under is 30. So, you take a ride out to Peoria, Illinois, follow him around, running stop signs, going through red lights, you know, baby carriages flying up in the air, little old grandmas diving for cover. I mean, you look at the risk and what he had to do and all the danger that he had to create, to be able to quote, unquote beat that. So that’s really the risk-adjusted example, one of the many ones that I’ve used over the years. Some people may beat it by a little bit, but when you take … I refer to a scale, if you beat it by one pound on one side of the scale, such as the scale adjusted, so to speak, if you beat it by one pound on one side, but you put 10 pounds on the risk side for that one pound of performance, on a risk-adjusted basis, you’ve dramatically underperformed.
Jim Lange: And how do you usually measure risk? What is an objective measure of risk?
6. When Building a Portfolio, Think First of the Downside
P.J. DiNuzzo: Our most standard, initial measurement of risk would be, and I hate to use technical terms but would be referred to as the standard deviation. That is just simply, if you think about, when your portfolio goes up, if you think of a tabletop, and if you have a rubber band that you’re holding down with one thumb on the top of the table and you pinch it on the other end and you pull that up. And let’s say you pull it up close to the top and that’s 20 percent, if you were to let that rubber band go, when it snaps down below the table, however far down it falls, if that 20 percent, let’s say, was one standard deviation, you could start to develop models and make estimate of, if your standard deviation was twice as much as the market, that’s nice when the market’s going up, you may go up at a rate approximate twice of the market. But we’re concerned about the downside. We always play defense first when we’re building portfolios for clients, and on our website, it’s very straight forward and clients observing how that ties into the portfolio.
Hana Haatainen Caye: OK, we’re going to take another quick break here. When we come back, we’ll continue with the conversation. Again, I want to remind you that we are live and if you have any questions for P.J. or Jim, you can call in at 412-333-9385. We’ll be right back with P.J. DiNuzzo and Jim Lange on The Lange Money Hour.
Hana Haatainen Caye: Hello there, and welcome back to The Lange Money Hour, this is Hana Haatainen Caye and I’m here with Jim Lange and P.J. DiNuzzo. Gentlemen, let’s get back to our interesting discussion about active versus passive investing.
Jim Lange: And I want to change gears a little bit and talk about some of the differences between different types of advisors. And probably the issue of, I don’t think we’re going to have time to get to the issue of whether it makes sense to have an advisor, maybe we will. But one of the things that I did want to talk about is the difference between a fiduciary advisor and one that is not a fiduciary and the different levels of care that is owed to clients. And I think that this is not a well-understood area; in fact, we’ve had entire shows on this, and I think it would be important for people to know what the difference is and whether you are a fiduciary advisor. Could you comment on the difference between a fiduciary advisor and somebody who is not, perhaps a stockbroker or somebody who sells, well I don’t want to say anything disparaging about anybody, but let’s say a fiduciary advisor versus somebody who is not.
7. Fiduciary Advisor Is Legally Bound to Serve Clients’ Interests
P.J. DiNuzzo: Yes, Jim, there is a very clear divide. The minority of advisors in the United States operate under a model, which is the model we operate under as a registered investment advisory firm, we’re registered with the SEC in Washington, D.C. Per our registration, we have a fiduciary responsibility to our client versus the national standard, which is a suitability standard, we would claim, and as you said, you could devote a whole show to this topic …
Jim Lange: As we did.
P.J. DiNuzzo: … Yes, yes, that a fiduciary standard is a much higher standard. Our standard is to act in a client’s best interest, to avoid any and all conflicts of interest, and really basically to treat a client’s investments as if we were investing for yourself and for a close family member, for our mother or brother or children, to have that same degree of standard. A suitability, on the other hand, is just if something would be quote-unquote suitable for an individual, it could be a very aggressive investment, the individual could be 80 years old but it would be easy to meet a suitability standard and say, “Well, that was suitable.” It’s a lot lower standard than a fiduciary standard.
Jim Lange: All right, and just in the news recently, and I don’t want to repeat the name of the firm, but somebody who had resigned from the firm had kind of written an open letter saying that the advisors of the firm were not acting in the best interest of the client. And if I understand what you’re saying, is that you not only have a moral, by the way, I know you to be a good, righteous man, and I mean that in the best way, but even if you were not, that you would actually not only have a moral but a legal, obligation. Yeah, and by the way that is the same for me. So, if we make a recommendation for an investment, or in my case, sometimes an estate plan or something else, I’m not only morally required to say what I believe is in your best interest, I’m legally required to. And if I don’t, I can be called to the carpet on that. So, you talked a little bit about index funds, and we used the example of S&P 500 and I also mentioned Vanguard because Vanguard is probably the most famous set of index funds. And I do have a number of, let’s call it, do it yourself investors, who do utilize Vanguard as a choice of index funds. And I know, for example, in your professional history, that you have at one time worked with Vanguard funds. But now you do not, is that right? Now you work with a set of funds called Dimensional Funds?
P.J. DiNuzzo: Yes, Dimensional DFA. When I started our practice, when I launched our practice in 1989, initially the best indexes that I had available where Vanguard funds. And in subsequent to that, in the early 1990s, Dimensional, which also goes by DFA, DFA funds, which are institutional mutual funds, we made the greats, so to speak, and were allowed in the door. We were one of the first 100 DFA advisors approved in the United States. And since then, we’ve been building portfolios utilizing all the DFA index funds.
Jim Lange: All right, so DFA is an index fund though, how would … now I think that you mentioned that, for example, before that, the DFA had a small-cap fund that had different criteria than, let’s say, the Russell 2000. How would you construct, or what is the difference between a DFA fund and a comparable index fund?
P.J. DiNuzzo: Yes, just a real brief genealogy example, examination, rather, would be in store, and I’ll make it as brief as possible. The research for all the indexing for efficient market theory, primarily, if we could look at one point at the epicenter in the United States, would be at the University of Chicago Graduate Business School. There was a lot of research performed in the 1950s and 1960s, and in the 1960s it became obvious, at least to Professor Fama, who has taught at the Graduate Business School for 30, I think going on 40 some years, that the market was highly efficient, not perfect, but highly efficient. So, the indexes, the individuals who founded the DFA, Dimensional Fund Advisors, were all out of the University of Chicago. They’ve had a couple, anywhere from two to three Nobel Prize winners in their board of directors, pretty much since Day One. One of the questions we get asked the most often is how are these indexes doing better than Vanguard or how are the outperforming on a total portfolio basis? If we consider that DFA is arguably the largest index-only manager in the United States, mutual fund index-only manager Vanguard, although they have a lot of indexes, they’re approximately half active and half passive, half indexes.
Jim Lange: All right, so even Vanguard doesn’t go by the pure passive index creed then, is that right?
P.J. DiNuzzo: Yeah.
Jim Lange: They offer both passive and active management funds.
P.J. DiNuzzo: Yes, they have both.
Jim Lange: OK.
P.J. DiNuzzo: Yeah. And I just tell folks I just think some things just intuitively or pragmatically when you look at it and say, you know, think of any organization, it could be a not-for-profit organization you’re involved with or could be the company that you work at, and you go into one of the meeting rooms and you’re splitting up the budget. I mean, if all the budget, for moving the company organization forward, is being spent in one direction, or if their research and development budget is being bifurcated and split 50 percent going to the right, 50 percent going to the left, half going active, half going passive, I just don’t think, from a common sense perspective that you’re going to be as efficient. All DFA’s done from Day One is manage indexes, they have indexes covering the planet Earth, accessing all the areas that you would arguably want to have access to.
Jim Lange: OK, and you mentioned that there are some pretty bright guys on the board and doing this.
8. Portfolio Theories of Eugene Fama Were Mocked at First
P.J. DiNuzzo: Yeah, we refer to it, at our firm, as standing on the shoulders of giants, we look sort of tall, but we’re standing on the shoulders of giants. These are really mental giants, you take a look at the portfolios, I mean Professor Fama, in the early 1960s, when he wrote the initial, the seminal paper on efficient market theory, the efficient market hypothesis, he was looked a little bit like heresy, like he was a little bit out there, so to speak, to put it mildly. Subsequently, trillions of dollars, and that’s trillions with a T, as in Thomas, trillions of dollars by the smartest portfolio managers on Earth, institutions, foundations, endowments, major pension plans, et cetera have moved from the active side over to the passive index strategy in managing trillions of dollars within their portfolios.
Jim Lange: All right, and earlier you had said that the indexes have done better than the active money managers. And you’re saying now, Dimensional Funds are doing even better than other passively managed funds, is that correct?
P.J. DiNuzzo: Yes, so on average, that is the track record that they’ve achieved, it’s basically one step above the typical indexing strategy.
Jim Lange: All right, is that because they define what companies they want to buy? So, they’re still not actively saying, “Hey, I want IBM and let’s sell Apple,” they are saying, “Well, we’re going to maybe have a slightly different definition of, say, international small cap, then perhaps a different passive manager,” is that right?
P.J. DiNuzzo: Yes, we would argue that they have the tightest and most refined definition of all the stocks in each of their index baskets that they manage.
Jim Lange: All right, and if you had a well-diversified portfolio, I think you mentioned 10 or 15 index funds, how many companies, roughly, would you have some representation of?
P.J. DiNuzzo: Our typical portfolio with the 15 index asset classes, generally 11 on the stock side, and four on the bond side, we have fractional ownership of over 18,000 stocks in over 40 countries on Earth. On average.
Jim Lange: That sounds pretty good to me.
P.J. DiNuzzo: Pretty good coverage.
Jim Lange: I think Hana is getting back to me, it’s time for a break so-
Hana Haatainen Caye: Yeah, we’re going to have to take another break.
Jim Lange: … why don’t we take one.
Hana Haatainen Caye: When we come back, we will continue this conversation. And there’s about 10, 12 minutes left for listeners to call in, so if you have a question for P.J. or Jim, please give us a call at 412-333-9385. We’ll be right back with P.J. DiNuzzo and Jim Lange on The Lange Money Hour.
Hana Haatainen Caye: Hello there, and welcome back to The Lange Money Hour, this is Hana Haatainen Caye and I’m here with Jim Lange and P.J. DiNuzzo.
Jim Lange: P.J., before we wrap up, I want to bring the human element into this because right now, we’re talking about a lot of numbers, and I guess we’ll actually finish up by I’ll ask you what the DFA performance has been, but we have been talking about numbers and kind of taking the human … we really haven’t examined the human element. How do people in the real world … let’s say that you buy, whether it’s a mutual fund or individual stocks, but even let’s take a mutual fund, how would the average mutual fund investor do, compared to the average mutual fund that he invests in?
P.J. DiNuzzo: Yes, Jim, that’s, to the credit of a company by the name of DALBAR, D-A-L-B-A-R, out of Boston, that’s the exact type of research that they do, is tracking individuals from when they purchased a mutual fund to when they sold it. Before they started doing the research, most people just assumed that if you owned a mutual fund and it did 10 percent a year, that everybody did 10 percent, who owned the fun. But lo and behold, DALBAR’s research over the last 20 years indicates that the average individual who has owned the average stock mutual fund in the United States has only done, I believe it’s in the low 40s, 41, 42 percent of the return of that fund, is what they’ve actually achieved. So, in layman’s terms, if that mutual fund returned 10 percent, their return was approximately 4.2 percent. The behavioral science and the emotions of investing causes the average individual to dramatically underperform.
9. Active Investors Often Fail by Selling Low, Buying High
Jim Lange: Is that because people, in effect, get nervous when the market is low, and they sell when it’s low and they get euphoric when the market’s high and that’s when they go in? So, they basically buy high and sell low?
P.J. DiNuzzo: Yes, they basically do the exact opposite of what you’d like to. And surprisingly, this happens over and over, it’s just not all, “Well, you know, you can point back to 2001 and ’02, or even 2008 and 2009.” But even in other periods, when there’s other cycles going on, individuals will get out of a fund, it may go down 10 percent in January, February, then that fund recovers and it ends up the year up 10 or 15 percent, but that individual actually lost 10 percent because they sold their position after the first couple months of the year. Basically, the individuals consistently come to the party late and leave the party early and, as you just mentioned a moment ago, tend to buy when the market’s high and they sell when the market’s low, over and over.
Jim Lange: And I assume that that would be an argument in favor of having a money manager.
P.J. DiNuzzo: Yes, that would be in favor of having a money manager. A lot of times, the way that I explain it, because people sometimes even refer to … we refer to ourselves as wealth managers. You hear people talk about financial advisors, I simply refer to it as having a financial coach, literally just having a coach. And most of my clients, whether they’re trying to learn the guitar or the saxophone or taking singing lessons, they’re working out at the gym, most individuals will find that they do better with a professional coach in the area that they’re trying to improve.
Jim Lange: OK, and let’s get down to the bottom line. The bottom line, ultimately, is how has … if people are interested, and actually, before I wrap up, I should also ask you for the name of your company and your contact information, in the event that people were interested in talking with you.
P.J. DiNuzzo: Yeah, our contact information is DiNuzzo Investment Advisors, our home office is in Beaver, PA but we have an office in Squirrel Hill too.
Jim Lange: And how do you spell DiNuzzo?
P.J. DiNuzzo: OK, yeah, DiNuzzo’s D-I, capital N as in Navajo, U-Z as in zebra, Z as in zebra, O. DiNuzzo.
Jim Lange: OK.
P.J. DiNuzzo: And then the easiest way is just our website is just dinuzzo.com. I’ll mention also, Jim, we’re in the process of changing our name since we’ve grown into the largest pure indexing manager. We build more all index mutual fund manage portfolios than anybody else in Pittsburgh. We’re in the process of changing our name to DiNuzzo Index Advisors, Inc. So, it’s going to be a lot easier …
Jim Lange: Oh, I didn’t even know that.
P.J. DiNuzzo: Yeah, that’s hot off the press. Yeah, we just were on the phone with the SEC today with the paperwork. Yeah, so it’ll soon be DiNuzzo Index Advisors, but if you just got to dinuzzo.com, you’ll be able to take a look at a lot of the items that Jim was talking about this evening from the portfolios because it’s really tough talking about numbers on the air, but the portfolios and performance. And then also we post a lot of articles on there, individuals are interested they’ll find a lot of quotes from national, The Wall Street Journal, Kiplinger’s, Money magazine, etc., talking favorably about strategic asset allocation and indexing.
Jim Lange: And what is your telephone number, in the event somebody just wanted to give you a call.
P.J. DiNuzzo: Sure, yeah, phone number, the toll-free line is 877-728-6564.
Jim Lange: One more time, please.
P.J. DiNuzzo: 877-728-6564. And if anyone would call, if they could please let us know that they did hear us on The Lange Money Hour.
Jim Lange: I appreciate that, and I have to repeat what I said at the beginning, which is I am literally morally required to mention that I am not independent to P.J., that P.J. and I do work together, and if you come to P.J. through me, that we have fee sharing agreement. And that I function as a trusted advisor that provides big-picture strategic advice, Roth IRA conversion analysis, estate, and tax planning, and then P.J. does the asset allocation through Dimensional Funds that we have mentioned, and make sure that clients stay on track.
Jim Lange: And then with about two minutes left, P.J., can you tell us what the big drum roll is, which is, OK, how has DFA done against some other benchmark, let’s say over a 10-year period? And this, by the way, is after subtracting …
P.J. DiNuzzo: Our fees and expenses.
Jim Lange: … fees, right, and if people saw us together, that would be the same fee. So, we’re splitting one fee, it’s not like we’re adding one fee on top of the other.
P.J. DiNuzzo: It doesn’t cost a penny more, now. For example, Jim, our 100 percent stock portfolio over the last decade of the DFA index, has done about 6.8 percent, the S&P 500 is a little bit over 2.9. We would not generally project that much out-performance, but it has averaged from one to two percent or above, over the last 20, 30, 40, 50 years.
Jim Lange: Well, and that’s outperformed after paying your fee.
P.J. DiNuzzo: Yes, net of all fees and expenses.
Jim Lange: Well, that sounds pretty impressive.
Hana Haatainen Caye: OK, I just want to really thank you, P.J., for being with us tonight and offering your insights. And I also want to thank our listeners for joining us for another Lange Money Hour, Where Smart Money Talks. If you want to reach P.J., again, his number is 877-728-6564, and you can access our vast library of past shows on our website at www.paytaxeslater.com. And as always, you can catch a rebroadcast of this show at 9:05 a.m. on Sunday morning, right here on KQV. Join us at 7:05 p.m. on April 4th, when our special guest will be bestselling author Paul Merriman.