Episode 55 – Enhanced Index Investing with Special Guest, Roger Ibbotson

Episode: 55
Originally Aired: June 15, 2011
Topic: Enhanced Index Investing with Special Guest, Roger Ibbotson

The Lange Money Hour - Where Smart Money Talks

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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World Class Investing
James Lange, CPA/Attorney
Guest: Enhanced Index Investing with Special Guest, Roger Ibbotson
Episode 55


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  1. Introduction of Roger Ibbotson, Professor of Finance at Yale
  2. Diversification Reduces Risk and Retains Returns on Investments
  3. Diversification Also Means Cutting Across Asset Classes
  4. Stocks Have Greatly Outperformed Bonds Over Past 85 Years
  5. Extra Return from Small-Cap Investments Can Make Big Difference
  6. Liquidity Has an Enormous Impact on Returns
  7. Perfect Liquidity Is Costly, Should Not Be Your Goal
  8. Passive Investor Doesn’t Try to Beat the Market
  9. Tracking an Index Too Closely Can Cost You

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1. Introduction of Roger Ibbotson, Professor of Finance at Yale

Nicole DeMartino: Hello, and welcome to The Lange Money Hour. We are talking smart money with CPA, attorney and estate planning expert, Jim Lange, and today, we are so honored to have Dr. Roger Ibbotson with us on the show. Dr. Ibbotson is one of the most famous names in finance. Currently, he is a finance professor at Yale University and chairman and CIO of Zebra Capital Management, a quantitative equity hedge fund manager. He is the founder, advisor and former chairman of Ibbotson Associates, which is now a Morningstar company. He has written numerous books and articles, including the famed Stocks, Bonds, Bills and Inflation, which serves as a standard reference for information on capital market returns for the entire financial industry. Also very important, Roger serves on numerous boards, including Dimensional Fund Advisors, which we will talk a little bit about that later, but Dr. Ibbotson, it’s our pleasure to have you.

Roger Ibbotson: Thanks! Great to be here.

Jim Lange: And I would add that your famous study, the SBBI, the Stocks, Bonds, Bills, and Inflation chart, that’s on virtually every financial advisor’s desk. I literally buy them in tablets, literally!

Nicole DeMartino: Yes, you have them on your desk.

Jim Lange: And I tear them off and I show them to clients that shows some of the long-term benefits of being in the market. But let’s get to some of the substance. For years, you and a number of your esteemed colleagues have preached the importance of asset allocation, many types of different investments to develop a well-diversified portfolio. You’ve also exhaustively compiled historical information, as in the SBBI, showing the superior long-term performance of stocks, and even more specifically, small company stocks, over fixed income investments. And then in 2008 and 2009, many well-diversified portfolios with a lot of money in equities lost a lot of money. Has your advice changed as a result of the recent problems that we have had in the market?

2. Diversification Reduces Risk and Retains Returns on Investments

Roger Ibbotson: Well, you know, it doesn’t really change. Diversification is the one sort of very easy way to not give up any return but reduce your risk. I mean, what better thing could you have than actually a way of reducing risk without giving up return? Because we know there’s a risk/return relationship. To get high returns, you typically have to take risks, but if you can be diversified, some of that risk can be taken off the table without giving up any risk.

Jim Lange: Now, when you say “diversified,” do you mean that you should have some Vanguard and some Janus and some of other types of mutual funds, or could you be a little bit more specific for some of our consumer listeners?

Roger Ibbotson: Well, you know, diversified can mean both at the stock level or the bonds or whatever types of securities, having many in your portfolio, or it can mean having many different asset classes in the portfolio. Both of those are important, and the most simplest thing, if you add one stock, and that stock might do great or it might do terrible, adding more stocks to portfolios smooths out those returns and reduces your risk. So, you can go to 2008 and 2009, if you actually held some of the worst stocks, and actually we did some studies on that, you could’ve lost 80 percent of your money instead of 30 percent to 40 percent of your money. By having the diversification of a lot of stocks in the portfolio, you definitely reduce the kinds of losses you’re going to have. So, that’s one form of diversification, having a lot of different stocks in the portfolio. You don’t have to do it all yourself, though. I mean, a mutual fund typically is going to own a lot of different stocks and will provide you that diversification.

3. Diversification Also Means Cutting Across Asset Classes

But that’s one level, having a lot of different stocks, or securities or bonds or whatever it is, in your portfolio. The other thing is having them cut across asset classes. So, I don’t know if I want to do all the talking here, but I’ll continue. In terms of asset classes, you need to have different types of stocks. Say, in your stock portfolio, you might have small stocks, small capitalization stocks, large capitalization stocks, stocks from big companies, stocks from small companies. You might want to have value stocks. These are stocks that typically have a lot of either earnings or book value for the price. You might want to have some growth stocks, companies that tend to be growing but perhaps not have as much in the way of earnings or book value. So, you need a variety. You might want to have U.S. stocks. You might want to have international stocks. International stocks can be from different regions. Asia and Europe are emerging markets, and having this broad spectrum of stocks is really what is going to reduce your risk. Of course, you can always go into other asset classes like bonds. You want to have some bonds in your portfolio, and there are various types of bonds. You can have U.S. bonds that pay in dollars or something, but you could have foreign currency bonds that will protect you against what happens in the dollar because they’ll pay you in another currency. And you can have some real estate in your portfolio, and actually, the biggest part of most of our portfolios is typically houses, and actually, the very biggest part of a portfolio tends to be what we economists call human capital, the fact that you’ve got all the wages that you’re going to earn over the rest of your life. So, your biggest assets are actually your earning power. Typically, your second biggest asset is your house, and then you go into your stocks and bonds portfolios.

Jim Lange: That makes a lot of sense to me. Let me tell you what I have encountered a number of times lately, and I’m going to ask what advice you would have for this. So, I’ve had some people in my office, and people who are smart. I’m not talking about people who are just clueless, and they claim to have lost confidence in our institutions, our corporations, and frankly, our government. When I sometimes encourage clients to have a better-diversified portfolio, and frankly, I even cite you, they start telling me what a mess the country’s in and how Obama doesn’t understand anything and how we’re all going down the tubes, and literally, one guy has basically all his money in gold and cash. This might sound irrational, and these are for people who have been in the market for years, but they’re just very pessimistic and very scared right now, and I think even some of the more moderate thinkers have a little bit of fear of what’s going to happen to the country, and they assume then that they shouldn’t be in the market. What would you say to somebody in that situation?

Roger Ibbotson: Well, I’m going to say that in the long run, stocks are going to outperform bonds. That’s almost assured. Historically, those are the kinds of numbers that I have run, and actually, I’m just going to pull out a number here, so I’ll let you talk for ten seconds here, Jim, until I look up a number here.

Jim Lange: OK. And the other thing that I would say is it’s probably even a little scarier, or even more volatile, for people … you mentioned human capital, which is presumably people in their 20s, 30s, 40s who are expecting to work another 20, 30 years, but I know a lot of my clients and a lot of the prospects that I see are older, and let’s say that they are retired, so that their human capital, other than their Social Security and maybe some incidental wages, is not there. So, how would you, let’s say, combine advice to both older and cynical people who think that we’re really in a mess and that Obama doesn’t understand anything, and what the heck should those people do?

4. Stocks Have Greatly Outperformed Bonds Over Past 85 Years

Roger Ibbotson: And now, I’ve got a couple numbers handy here. You talked about these charts and tables and so forth that I’m very well-known for, but one of the things I’ve measured is what have the returns been like over the very long spans, and some of the data starts in 1926, so we’re actually looking at data that covers about 85 years here, and the returns of stocks over that period is actually almost 10 percent, 9.9 percent over that period. Ten percent a year over that long-span period. Meanwhile, the return on bonds over the same time is about 5½ percent. So, it’s 10 percent versus 5½ percent. Inflation over that whole period has been 3 percent. You get a big payoff over the long run if you’re willing to invest in the stock market, and, of course, a lot of people were scared before. Imagine how scared people were in the Depression. But if they completely got out of stocks, they would’ve really missed all the big rises that came after that. I go back to very recently. Think how you felt back in March 2009. That’s only a little more than two years ago. That’s after the market had fallen about 45 percent. People were really scared at that point. The stock market had fallen so much.

Now, it turns out that if you had gotten out then, you would’ve missed this huge rise that just happened, and actually, we’ve recovered almost all of the losses that actually occurred in that financial crisis from the stock market. The market is about back to where it was, and the tendency is when you’re most scared is actually sometimes the best time to be in the stock market because when everybody’s really worried, they’ve essentially already gotten out. But most of us are in no position to judge when that market is going to go up and when that market is going to go down, and that’s why I’m really advocating that you hold these stocks for the long run because we can’t call it all the time. In fact, the evidence is quite the contrary. Individuals tend to miscall the markets. They tend to panic and get out at lows, and they tend to get really excited and buy in at the highest. Individuals in general do worse than the professional investors.

Jim Lange: Well, let me ask you this. Some of these same people are saying, “Well, gee, we’re about to default on our credit. There’s not going to be a consensus for extending credit. Things are really going to get bad.” Would you still tell them that what they’re, in effect, doing when they’re talking about getting out and turning to cash and turning to gold is market timing that historically has not worked?

Roger Ibbotson: Gold’s a good example. I think gold obviously would’ve been a great investment over the last five or 10 years. It would’ve been just super. But now, gold is at record highs, and it’s kind of late in the game to get into gold. But in general, commodities are a good thing to diversify your portfolio. So, I’m all for these diversified portfolios. It’s just one more asset class to get into here. But the problem is, individuals somewhat perversely look at what has happened and say, “Well, gold’s gone up so much. I really should get into that.” That’s probably not what you should get into at this point.

Jim Lange: Well, that makes some sense for me. By the way, I actually have a copy of the chart that you’re referring to. I actually grabbed it on my way out and I have the 2009 version. But just to further, let’s say, clarify, when you said that the bonds are around 5½ percent, so that means if you started with a dollar in 1926, today, you’d have about $84 or $85 and you’d maybe have about $2,600 if you were in the large cap, and then you would actually have about $12,200 if you were in the small cap. And before, you had mentioned the importance of all types of assets. Could you comment a little bit on just the enormous difference in how much better, particularly in the last, say, 40 years, the small cap … and when I say “small cap,” I’m not talking about mom and pop corner drug store, I’m talking about maybe companies that are capitalized at maybe a billion dollars. But can you comment a little bit on that? Because I think that most of the portfolios that I see, where people think that they are diversified when that have money in, let’s say, the Vanguard S&P, and then they have some money in Janus, and they have some money in some of the other mutual funds. They have a lot of overlap in the large cap area, but they don’t have a lot of representation in the small cap area.

5. Extra Return from Small-Cap Investments Can Make Big Difference

Roger Ibbotson: That’s probably true, and I’ll give you the historical number. Historically, over that long period that I mentioned, starting in 1926, small caps were up 12.1 percent a year, whereas large caps were 9.9 percent a year. That extra little 2.2 percent actually has pretty dramatic effects as a compound. Some of you may have heard of the Rule of 72. It’s kind of a quick way to do some compounding. You take a number like 10 percent per year and divide it into 72, and it tells you that in about 7.2 years, you’ll double your money. So, if you’re running at 10 percent and you’re doubling your money in 7.2 years, that means that in about 14 years, you’ve quadrupled your money. In 21 years, you’ve made eight times your money. Well, that kind of compounding actually is very explosive. That’s why you actually get the kind of numbers that Jim just mentioned there, that a dollar could actually grow, and I guess you have those numbers in front of you, but I’ll look it up right here.

Jim Lange: I’ll give you the 2009 numbers again. Sorry, I don’t have the 2010, but if you start with a dollar in 1926, you would have $2,592 today, and that’s in the large-cap markets. You’d have $12,231 if it was in small-cap markets, and actually, 2010 was a good year, so you’d even have more money. So, I think you’re right. The long-term compounding, and then, I can’t resist saying that if that money was in a Roth IRA, because you either put money in a Roth IRA or you made a conversion to a Roth IRA, and all that compounding was tax-free, that the added purchasing power of that money where you don’t have to pay tax would just be a phenomenal result for you and your children and grandchildren.

Roger Ibbotson: Now, you do have the inflation rate in there, which also compounds, but it’s a much lower rate, it’s only 3 percent inflation over the period. And sometimes people talk about magic. In some sense, compounding is magic, but it takes time to accomplish because it has this exponential process here, that a dollar invested can turn into thousands of dollars over your lifetime. That’s really almost a magical type of thing. But it only really happens in the stock market. It especially happens in smaller caps or value stocks. I’m going to discuss later less liquid stocks. These kinds of stocks have tremendous compounding impact that creates huge amounts of wealth in the economy. Now, you can lose some of that wealth to inflation, you can lose it by paying taxes on it, you can lose it by paying fees in various ways, whatever, some of that definitely goes away. But the potential to make large amounts in the markets is there, but you have to be willing to take some risk. You won’t get it in the bond market.

Jim Lange: Well, that sounds a little bit like Jeremy Siegel. I know that you were at the University of Chicago with so many of the great economists, the thinkers, literally the creators of asset allocation of which you might be the head. What was it like being with some of those guys, doing some of the really revolutionary, almost an era-type new thinking, back then? I know now you’re at Yale, and maybe it’s not fair to say that that was the heyday at the University of Chicago, but I would imagine that those were pretty exciting times for you and that group.

Roger Ibbotson: By the way, Jeremy Siegel was at the University of Chicago with me at that time.

Jim Lange: Right, right, right.

Roger Ibbotson: Now he’s at Warden and I’m at Yale.

Jim Lange: Right.

Roger Ibbotson: But Jeremy was at the University of Chicago, too, at that time.

Jim Lange: Right, and he’s a very nice guy. I’ve actually shared the stage, and we’ve sometimes been in the same speaking circuit.

Roger Ibbotson: But, also, really, he wasn’t really one of my mentors. I’ll tell you, I got my Ph.D. at the University of Chicago and then I was a professor there for ten years. But if I could just tell you who was on my dissertation committee at the University of Chicago when I got my Ph.D.: The chairman of my committee was Gene Fama, who you know has been working with Dimensional Fund Advisors all these years. I also had on my committee Fischer Black and Myron Scholes, and even retail consumerists may know that Black-Scholes and the Black-Scholes model, which is the predominant way to value options theory, and the producers of those models. You know, Myron Scholes got a Nobel Prize for that. Another person that I had on my committee was Merton Miller, and Merton Miller also won a Nobel Prize, I might add, and he’s really famous for showing how really unimportant, really, dividends are, in the end, because they get offset by capital gains, and he’s also shown how the capital structure of a firm doesn’t really matter in many contexts. And one other person I had was actually Arthur Laffer, who’s sometimes famous now for the Laffer Curve. It was really a great group of people that were on my committee at the time, because they worked me so hard, I sometimes thought, “I wish I had another committee.”

Jim Lange: I was just thinking, you really asked for it, to get those guys on your committee!

Roger Ibbotson: But then I stayed on the faculty, and of course they were my colleagues then, so then that was even better.

Jim Lange: Yeah, and by the way, for the listeners who might not know these people, this is like the Babe Ruth, the Lou Gehrig, the Joe DiMaggio of finance. These are all just household names in the area, frankly, as yours is.

Roger Ibbotson: So, the University of Chicago actually is full of Nobel Prizes and sort of, somehow collects them, you know, more than any other institution in the world, and of course, we’re talking in Pittsburgh here, right?

Jim Lange: Well, it is Pittsburgh, but actually interestingly enough, we have a lot of listeners in Pittsburgh who are often consumers, and frankly, many of them are in their car. Many of them actually listen online, which is probably a higher sound quality, at www.kqv.com, but we also actually have quite a few financial advisors as listeners, and they are actually all over the country, people who have read something that I’ve done at one point or another. And a lot of times our questions, and we’re limiting our questions tonight, because frankly, there’s so many things I want to ask you, that are literally from all over the country. And I am getting the break signal from Nicole.

Nicole DeMartino: We are going to take a break, and I do want to remind our listeners out there, we are live with Dr. Ibbotson tonight, so if you want to give us a call, (412) 333-9385. You can talk directly to these two gentlemen. You’re listening to The Lange Money Hour. We’ll be right back.


Nicole DeMartino: Welcome back to The Lange Money Hour. We are here this evening with Jim Lange and Dr. Roger Ibbotson.

Jim Lange: OK, Roger, we’ve talked a little bit about some of the esteemed colleagues you’ve had, and I guess we’ll get back to some of the studies that you’ve done, but a lot of times in today’s world, people are saying, “OK, but what are you up to lately?” And I know that you sit on a number of boards and that you are very involved in Zebra Capital and you have, let’s say, some new stuff. So, can you tell us about some of your new stuff, and specifically, things with additive liquidity and what you are doing and recommending for clients and prospects?

Roger Ibbotson: You know, I want to talk about liquidity and I want to talk about it a lot, but I just talked about those University of Chicago colleagues, and in some sense, I want to mention that, you mentioned that I’m on the Dimensional Fund Advisors board. Some of those same colleagues turned out to be my fellow board members there. So, I just want to pick up on that point first.

Jim Lange: That’s fine.

Roger Ibbotson: Because it turns out that, for example, Myron Scholes is on the board with me at Dimensional Fund Advisors, of the Black-Scholes models, and it turns out, Merton Miller, who is now deceased, he was on the board at Dimensional Fund Advisors. So, some of my esteemed colleagues and professors have actually turned out to be long-term friends who actually were with me over the years on the Dimensional Fund Advisors board. The Dimensional focuses on buying small cap stocks and buying value stocks. But this sort of leads me into the Zebra Capital, because we’re doing something in many ways that fits in well with those categories, as well, by focusing on liquidity.
Actually, I think of liquidity as the missing style, because … some of you are familiar with the Morningstar Style Box, where they take small, mid- and large-cap stocks, and they take value, growth, mid- and value stocks and make a nine style box, where they say, “What do you want out of your portfolio? Do you want to buy a large value stock or a mid-value stock or a small growth stock?” Morningstar basically categorizes all the stocks into one of those nine possibilities, across the two dimensions: size and value and growth.

6. Liquidity Has an Enormous Impact on Returns

Well, what I actually believe is that there’s a whole other third dimension to this, and that’s liquidity, and that liquidity has just as much of an impact on return as the size of a company, and even more I might say, and just as much of an impact on returns on the value of a company, whether it’s value or growth. And in particular, what I’m saying is that stocks that are less liquid turn out to be stocks that you can effectively get at lower prices. There’s a liquidity premium here, and if you buy them at lower prices, the less liquid stocks tend to have higher returns than the most liquid stocks. And that’s the essence of this liquidity premium. It’s not just the stock markets, it’s in bond markets, or real estate markets, or anything. It’s a basic principle. The basic principle is, just like risk, the more risk you get, the more return you’re going to take. The less liquidity you take on, the more return you’re going to typically get. And so, we’re saying, if you look at a risk-return chart, there’s a whole other dimension here, and that’s liquidity. If you look at this value growth size nine-style box type of thing, there’s really a whole other dimension, that the less liquid stocks actually explain more of a return than even the size of a company. And what we’re talking about here though is stocks that are traded every day. They’re not private equity or something. We’re talking about stocks that are just somewhat less traded. They’re sort of out of favor. They’re sort of the forgotten stocks of the market.

Jim Lange: And by the way, that’s consistent with everything I’ve learned. So, for example, some of the estate planning techniques are literally making investments less liquid to reduce their value, and then you make gifts or Roth IRA conversions and things like family limited partnerships and privately held LLCs. And some people are actually dividing up their IRA and giving away and selling interest in it and then taking discounts. So, what you’re saying is perfectly consistent with well-established valuation principles. So, I think that that’s actually pretty exciting because it sounds like you have, in effect, identified a whole missing link, or a whole asset class, if you will, or even a subclass of all the other asset classes.

7. Perfect Liquidity Is Costly, Should Not Be Your Goal

Roger Ibbotson: Yeah, I think that’s the case, and every appraiser knows this, of course, as you said. Every appraiser says, “Well, if you take something very liquid and now put it in some less liquid form —often they used to do it with limited partnerships, just family, and things like that but whatever — you buy it in a closely held form or something, they would routinely take off 35 percent of the value by having it in a less liquid form. So, you, of course, make something of less value. The more risky it is, the less valuable it is. But they also know that the less liquid it is, the less value it has. On the other hand, when that value goes down, the return goes up. So, you can think if the cash flows are there, but if you get to buy it at a lower price. And you’re going to buy risky things at lower prices, and you’re going to buy less liquid things at lower prices. You’re going to get higher returns. So, we’re saying, here now, three of the magic to getting good, excellent, long-run returns is to buy, take on some risk, but give up a little liquidity. You don’t need that perfect liquidity at all times because you’re mostly wasting that liquidity, and it’s not cheap.

Jim Lange: And I would say that that’s particularly true for a lot of our long-term investors. Even some of our older investors, we sometimes talk about time frames and they say, “Well, you know, I’m 68 and I’m retired, so really my time frame is short”, and I’m thinking, “Well, if you really think about it, you might live another 20, 30 years, and that’s a significant time frame.” And for many of our older clients, realistically, given their spending and given how much they have, they’re never going to spend all their money, and sometimes the time horizon of an investment might not be just their lifetime, but the lifetimes of their children and grandchildren. So, if you can, in effect, get a much better deal or much more value by accepting some reduced liquidity that you don’t likely need anyway, then you can end up doing a lot better. Is that consistent with what you’re saying?

Roger Ibbotson: Absolutely. I mean, everybody needs some liquidity. We don’t need perfect liquidity, though. For example, going from … we actually find that going from the sort of minute-to-minute liquidity to hour-to-hour liquidity, or something like that actually has a substantial premium. You actually get much higher returns by buying stocks that trade maybe every hour instead of every minute, and going from minute to daily liquidity actually gives you a lot of extra return. You could take it to the extreme and say, “Why don’t I buy private equity?” And this is a way, you usually, with private equity, these are non-publicly traded companies, and they may lock up your money for five or 10 years. You might get a higher return for that kind of liquidity, but what I’m really saying is you don’t have to go that far. Even in the publicly traded markets, if you give up just small amounts of liquidity, you can actually get substantially extra returns.

Jim Lange: And that is something that Zebra Capital is doing right now?

Roger Ibbotson: That is basically our mission. Because we’re buying the less liquid stocks, we do it in lots of different forms. We do sub-advise on some mutual funds, we have some American Beacon mutual funds that we sub-advise on, we sub-advise … the American Beacon funds, they are U.S. large-cap and U.S. small-cap funds. We sub-advise for Destra. We sub-advise a global fund and an international fund. Actually, we just launched a fund, I was just in Japan two weeks ago and we just launched a global fund in Japan. Most of you don’t know Nikko, but it’s the second largest financial firm in Japan after (garble), and we sub-advise on some funds for them as well that we’ve launched. So, we actually sub-advise on a lot of different mutual funds. We have some hedge funds where we … hedge funds means instead of just buying the stocks, we actually have long and short positions, and we actually have negative positions of stocks, so they’re hedged. Our hedge funds have, we would say, zero-betas, so we would presumably be immune to whenever the market goes up or down. We just have a hedged position in these funds. But they’re based on this liquidity, too. We are buying the stocks that are less liquid. We are shorting or taking negative positions in the most liquid, most exciting stocks.

Jim Lange: And can you give our listeners a website or a contact place if they are interested in some of the things that you are saying about liquidity?

Roger Ibbotson: Yeah, I’ll give you our website, which is www.zebracapital.com. By the way, the name Zebra came from zero betas.

Jim Lange: Oh, I like that. If we could switch gears a little bit, along with Rex Sinquefield, you executed a large volume of academic studies looking and examining performances of mutual funds, under actual market conditions, and the way I read it, established that many of the funds that attempt to beat the market and to time the market didn’t do as well on some funds that, in effect, attempted to be the market, as a passive index type approach. Is that consistent with what you have found recently? First, is that fair summary of your findings?

Roger Ibbotson: Actually, the work that I do with Rex Sinquefield didn’t cover that, because that was more on the original Stocks, Bonds, Bills, and Inflation.

Jim Lange: Oh, I didn’t mean to take away any credit. Sorry about that.

Roger Ibbotson: But I have done work with Rex Sinquefield, though, so it’s perfectly reasonable to mention, because Stocks, Bonds, Bills, and Inflation, it’s often called the Ibbotson-Sinquefield studies, and more recently, or actually, Rex Sinquefield is retired from Dimensional Fund Advisors, but also, the Ibbotson part of this — my name, Ibbotson — this became Ibbotson Associates, and Ibbotson Associates was the firm that always distributed Stocks, Bonds, Bills, and Inflation. But I don’t really do that so much now because Ibbotson Associates was sold to Morningstar in 2006. So, I’ve since then really focused my efforts on Zebra Capital, but I’m still a professor at Yale, of course.

Jim Lange: Right, well, is it fair, though, that…

Roger Ibbotson: To go back to your statement, yes.

Jim Lange: So basically, the question is: Are you more of a believer in passive or active funds, and what would be a way that many consumers, and probably not your multimillionaire, but let’s say your $1, $2, $3 million, or even $500,000 liquid asset or liquid net worth consumer, are you more of a fan of active or passive or do you like both, depending on the situation?

8. Passive Investor Doesn’t Try to Beat the Market

Roger Ibbotson: Well, you know, this gets to the core question of our market’s efficient, and that is: Can you beat the market? And there is, of course, some evidence that people can beat the market, and academics are always fighting about how efficient the markets are. And of course, if you believe markets are really efficient, the correct way is to be passive in your investments. If you believe markets are inefficient, there’s all kind of mispricing in the market, then it’s actually not clear what you should do. If markets are inefficient, that means that there would be a lot of distortions in the markets. But then you have to ask yourself: Am I the one who can take advantage of these distortions, or am I the one who’s going to get ripped off by these distortions? And you can think of it like a giant poker game here, that if markets are inefficient, and they are to some extent, then some people are going to win and some people are going to lose. Now, do you want to get into that giant poker game? The passive investor avoids the poker game and basically rides up and down with the market. The poker game is all about Alpha. It’s all about beating the market or getting beat by the market. And so, the active investor is the one who joins the poker game. Now, what you have to ask yourself is: Even if you believe that there are enough distortions that there’s a lot of money to be made in that poker game, poker, by its nature, is a zero-sum game. That is, that whoever wins money takes it out of the hide of those who lose money. So, the markets go up and down, and we all ride the waves of whatever happens in the market. But if you actively invest, you’re not going to actually participate directly in the ups and downs of the market because you’re going to make your very specific bets, and you’ll either do better or worse.

Jim Lange: Well, I sometimes think about, if you’re at a poker game and you can’t spot the sucker, that it’s probably you.

Roger Ibbotson: That’s a very good way of putting it because that’s the danger for most of us, as individual investors. The game may be distorted, but most individual investors are not the ones to take advantage of the distortions here. And that’s why you might want to be a passive investor.

Jim Lange: Well, just for discussion’s sake, let’s say you do, and by the way, I should put in a little disclaimer here, through an association with a Dimensional Funds Advisor, which is the company that you are still on the board, I do offer Dimensional Funds, so I guess I am not 100 percent independent with this question, but could you tell us a little bit about Dimensional Funds and whether you would consider that a passive index fund? I’ve heard others describe that as an enhanced index fund. Would that be a good way to go for passive investors?

Roger Ibbotson: Well, let me say, first we’ve got to get the vocabulary right. Dimensional Fund Advisors is clearly passive. That’s definitely the way they view everything they do. They do not view themselves as active. However, they think of being an index fund as a dirty word because they don’t want to waste their time tracking indices. They think, in fact, you can actually generate extra costs by tracking them too tight, that it’s more important to basically be passive and diversified rather than artificially tracking an index. So actually, they would never consider themselves an index, but they certainly would consider themselves passive, and what’s confusing about this is, of course, we know that indexes are passive. Indexes are passive, and DFA is passive, but DFA is not index funds, I guess.

Jim Lange: Is that one of the reasons why their returns have been so good? And they’ve, frankly, even just with a classic 60/40, that’s 60 percent stock, 40 percent bonds, you know, they’ve done quite well, and I have to be a little careful talking about performance, but some of the numbers that I’ve seen just really impressed me. Is that one of the ways that they have done that? By keeping down costs, not having to artificially meet and index, like, for example, a Vanguard S&P 500 index that must hold the top 500 companies?

9. Tracking an Index Too Closely Can Cost You

Roger Ibbotson: Yeah, because index is a way to be passive, but at Dimensional, we believe that a better way to be passive is not worry about your tracking because there are additional costs associated with trying to track too tightly. Essentially, their costs are going to be lower, which means that their performance is going to be higher, and they’re still very diversified, these funds, so …

Jim Lange: What I tried to do, a little bit, was to compare Dimensional Funds with Vanguard, or even CREF, because we have a lot of college professors, and what I found was, it was very hard to do apples to apples, and even though the performances were better, Dimensional funds seemed to have more small company stocks and more value companies, and very specific asset classes that Vanguard and other places didn’t have, so, for example, international small-cap value or some other things that were a little bit unique. Is that one of the ways that Dimensional Funds, in effect, develop more Alpha?

Roger Ibbotson: Well, they wouldn’t call it Alpha. Again, Alpha only comes when you’re active, so they would never call that Alpha, but they do go into the niches of the market here, and they look so they can be higher returns. They would say these are risk premiums, that by going into these niche areas of the market, and they’re picking up these risk premiums. So, yes, Dimensional is going into the niches, and more deeply than, say, TIAA-CREF and Vanguard. Generally, though, of course, Vanguard is all passive, mostly indexes. They have some active, too, I shouldn’t say they’re all passive, but they’re primarily passive funds and TIAA-CREF has a broad section of relatively low-cost funds, too. So, I have high regard for all three of those organizations, but they’re different from each other, of course, and they’re serving different clientele. Dimensional Fund Advisors are the ones that are going into the corners of the market, the niches, the sort of underserved areas of the market.

Jim Lange: And one of the things that I should point out for our listeners is, both Vanguard and TIAA-CREF are probably available to most investors. You know, that is, you can on your own invest with Vanguard or TIAA-CREF, but with Dimensional Funds, you actually have to go through a Dimensional Funds advisor. They actually have a pretty stringent set of requirements to become a Dimensional Funds advisor, and in our case, his name is P.J. DiNuzzo, who is a Dimensional Fund advisor, and he does the actual investments, and then our firm does the strategic things, like Roth IRA conversions, how much you can spend, gifting, estate planning, et cetera. And we do that for a combined fee of 1 percent or less.

Nicole DeMartino: Jim, you know what, let’s take one more break before the end of the show.

Jim Lange: OK, last one.

Nicole DeMartino: OK, last one. We’re not doing three this time because we wanted to spend as much time with Roger as possible.

Jim Lange: That’s true, Roger, we usually take three.

Nicole DeMartino: Yeah, we just did two, so we’ll be right back with more of The Lange Money Hour.


Nicole DeMartino: OK, we’re back for the last segment of The Lange Money Hour. We are here with Jim Lange and Dr. Roger Ibbotson, and if you do want to hear this show again, it will be replayed Sunday morning at 9 a.m., and then it will appear on www.paytaxeslater.com. You’ll be able to download the audio file and we’ll have the transcription up there, as well, if you want to read it.

Jim Lange: Roger, if I’m out there listening and I’m thinking, “Wow, this guy really knows what he’s talking about, he’s been around, he literally created the field of asset allocation, et cetera. I’m interested in learning more.” What are some of the favorite sources of information that you might have for consumers, for people who are interested in some of the things that you were talking about, the long-term benefits of the market, passive versus active? Do you have any preferred sources of information for our listeners?

Roger Ibbotson: Well, my favorite source, actually, for asset allocation and so forth, is actually Ibbotson Associates.

Jim Lange: Well, I was kind of expecting that, but that’s fine.

Roger Ibbotson: And Morningstar, by the way. It’s Ibbotson Associates and Morningstar, actually this has now pretty well-blended into the Morningstar products, so maybe over time the Ibbotson name, my brand, might be dissipating a bit, but essentially, Ibbotson and Morningstar, and I’ll give you the Ibbotson website: www.ibbotson.com, and I don’t actually know the Morningstar. I think it’s www.morningstar.com. But some of the stuff you’ll find on our Zebra Capital website that we gave you earlier, www.zebracapital.comM, but Zebra Capital isn’t necessarily in the asset allocation business at this point, because we’re much more involved in running all these stock portfolios. But Ibbotson Associates and Morningstar still are, and so I’d say, that would be my favorite source to find a lot of these, and most of the articles that I’ve written, I think you could find a lot of them, in often more palatable form, sometimes I write more technical articles, but in a more palatable form on these sites.

Jim Lange: All right, that is great. By the way, I think I wrote you a thank you note, but I’ll also publically thank you for giving my book, Retire Secure!, a very favorable testimonial. I have another question about sources. I mentioned earlier that we have quite a few financial professionals from all over the country that are listening, and let’s assume, for discussion’s sake, that we’re talking about ethical financial advisors who want to do the best for their clients. What advice would you have to some of the advisors, either in their actions or in the sources of information, or anything about how they should run their businesses?

Roger Ibbotson: Well, it does start out with being ethical. You think of your job is to serve your clients first. That is so important. And sometimes the people in the financial industry get bad names, people feel that we’re greedy in some sense, and so forth. Well, I just can’t stress enough that you want to serve your clients first, and I will say, also, one of the benefits of passive management, even though there’s a lot of inefficiency in the market, a lot of individuals should behave as if the markets are efficient. They shouldn’t be playing the poker game. They should be keeping their fees down and getting diversified portfolios. That’s the first order of fact of having good portfolio management is to actually have diversified portfolios with relatively low costs. Your main core is not to try to beat the market, and most of the people who try to beat it spend a lot of money at it and actually underperform.

Jim Lange: Well, wouldn’t you say that really that’s what Dimensional Fund Advisors is really all about, which is passive investing?

Roger Ibbotson: Yes, it is. It’s definitely all about that.

Jim Lange: And then again, a little short plug. If you do it in the Pittsburgh area and you do it through me, you not only get the expert advice of Dimensional Fund Advisors, and by the way, I will also mention that I think that you would have representation in roughly 18,000 companies if you were just in your standard 60/40 asset allocation. So, that’s the ultimate in terms of true diversification, and then you get the strategic information like Roth IRA Conversions, etc. from me. So, I think we only have two minutes, but the next question is: What’s next for Roger Ibbotson?

Roger Ibbotson: To me, my mission has to do with Zebra Capital now, and I really think I’ve discovered the next big thing here, because we’ve talked about growth and value and small and large, but liquidity, I think, has the big impact on returns. We talk about risk, we talk about growth and value, we talk about small and large, but liquidity is like the missing piece here, and that’s what’s got me so excited. I really want to bring that investment opportunity to the investment world.

Nicole DeMartino: All right. Well, thank you, we are at the end of our hour. Thank you so much, Dr. Ibbotson, for spending the last hour with us.

Jim Lange: You gave us wonderful information. Thank you so much.

Nicole DeMartino: Excellent, it really was. Thank you for listening. Good night. Next show, we will have Dr. Larry Kotlikoff. We will be talking Social Security. You’ve been listening to The Lange Money Hour, Where Smart Money Talks.




jim_photo_smJames Lange, CPA

Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania.  He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again.  He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans.  Jim’s advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger’s Retirement Reports and The Tax Adviser (AICPA).  Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.