The Dimensions, Premiums and Factors of Index Investing, with P.J. DiNuzzo

Episode: 148
Originally Aired: November 10, 2015
Topic: The Dimensions, Premiums and Factors of Index Investing with P.J. DiNuzzo

The Lange Money Hour - Where Smart Money Talks

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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  1. Introduction of P.J. DiNuzzo of DiNuzzo Index Advisors, Inc.
  2. Value Stocks Have Outperformed S&P 500 the Past 87 Years
  3. Diversified Portfolio Can Protect Against Volatility of Large-Value Stocks
  4. Index Investment Accesses Capital Markets and Growth Across the Globe
  5. Don’t Bet on Growth Stocks to Outperform the Market Forever
  6. Companies With Higher Profitability Tend to Maintain Higher Stock Prices
  7. Corporate Bonds Yield More Than Government Bonds, Due to Risk
  8. Transparency of Indexing Gives the Investor Tremendous Confidence
  9. Exchange-Traded Funds Come With Risks, Including Ownership Issues

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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 Now get ready to talk smart money.

1. Introduction of P.J. DiNuzzo, Expert Index Investment Manager

Dan Weinberg: And welcome to The Lange Money Hour. I’m Dan Weinberg, along with CPA and attorney Jim Lange, and tonight, we welcome back to the program P.J. DiNuzzo. P.J. is a nationally recognized expert in investment management. He was approved as one of the first 100 Dimensional Fund Advisors, and rated a five-star advisor by Investor Watchdog. His Pittsburgh-area firm DiNuzzo Index Advisors Inc. consistently ranks among the country’s top 500 investment companies. Tonight, P.J. and Jim will be talking about a number of issues, including maximizing your retirement assets by using a strategy that’s both consistent and flexible enough to adjust with the times. They’ll touch upon issues like active versus passive investing, efficient market theory and more. Now, regular listeners know that P.J. is a frequent guest on The Lange Money Hour, and when he’s here, he and Jim always have a lively and informative conversation. If you’d like to call in and ask your specific questions, give us a ring at (412) 333-9385. And now, let’s say good evening to Jim Lange and P.J. DiNuzzo.

Jim Lange: Welcome, P.J.

P.J. DiNuzzo: Good evening.

Jim Lange: And before we get into the meat of tonight’s program, I do feel honor bound to disclose my relationship with P.J., and that is that usually when I have a guest, and typically they have written a book and they are a national expert and have a lot of information to offer, I typically read their book, develop some questions, have the best interview that I know how. If it is a book that I like, which it usually is, I usually put in a little plug for the book. But there’s no compensation, and by the way, I’ve never paid a guest. Everybody does it because they want to be on, and we’ve had the top people on multiple times because they get to talk for close to an hour with somebody who has actually read their book and asked them some reasonable questions. Anyway, it isn’t that way with P.J. I do have, what I would call, a disclosable relationship, and that is P.J. does have a money management firm that actually works very closely with our firm, and P.J. and I have an arrangement. Our firm likes to do certain conceptual things like how much money you can afford to spend given your situation, things like how much money you should convert to a Roth IRA, what is your best Social Security strategy, what should you be doing for your estate-type planning, what should you be doing for your wills and trusts, what should you be thinking about when you’re making a Roth IRA conversion, how much of a capital gain each year could you afford to incur and while incurring the minimum taxes, and we do that type of thing. P.J. and his firm, which is DiNuzzo Index Advisors, they actually manage the money, and he does a fabulous job. He has his whole process. He does a customized balance sheet for everybody. He does a customized income statement. By the way, he is a CPA, and that’s the way he thinks. And he does it because that helps him with the asset allocation decisions, and he’s literally the best money manager that I know, and we have an arrangement that if somebody starts by, let’s say, coming to my office or coming to a workshop or they’ve heard us on the radio and they come to us first, that our office does all the services that I had mentioned, the Roth conversions, some of the conceptual work. P.J. and his team, if it is a good fit, will then actually manage the money, and he uses what I believe is the best set of low-cost index funds on the planet, which is called Dimensional Fund Advisors.

So, in terms of fees, since part of the idea of index advisors are having low fees, rather than P.J. charging a fee and our firm charging a fee, what we do is we charge one combined fee of one percent or less, depending on how much money is invested. Now, we think it is a win-win-win because P.J. gets to do what he does very well, which is the underlying investments, the asset allocation, and all the traditional things that a financial advisor’s firm does. We do what we do, the Roth IRA conversion, the Social Security analysis through a process that we call running the numbers, and the client, rather than having to pay us a fee and P.J. a fee, the client actually pays one fee of one percent or less. P.J. and I then split that, and I feel that I am honor bound to disclose that relationship because I am not objective with P.J., and I do have financial motivation for you to want to do business with both of us. So, anyway, I did want to mention that because I thought that that was an important disclosure.

But anyway, after that long explanation, welcome to the show, P.J.

P.J. DiNuzzo: Thank you very much.

Jim Lange: All right. So, I think we wanted to talk about premiums and investing target strategies. So, I know that you have some important information about premiums, and specifically with regards to risk and what a premium is and how we can do that in a cost-effective and transparent environment. So, if you could … maybe just it’s a broad question, but maybe take it wherever you like.

P.J. DiNuzzo: Yes, Jim, and I think this is a great topic for this evening because one of the most frequent questions that I’m asked, and again, as you had mentioned earlier, we were one of the first 100 DFA-approved advisors in the country, and basically, we’ve been getting asked this question for the last 20 years, is, how does DFA outperform other supposedly comparable asset classes, a small index versus a small index, small value versus small value, et cetera, and it’s really been their focus on what we refer to as either premiums or factors, and we’ll try to keep the audience here. I don’t want to do too deep of a dive, but the reason I thought it was really important is even because large organizations like Vanguard are even starting to pay very close attention. Now, DFA’s been doing this for four decades, and major indexing firms are starting to pay attention to it now. But these factors or premiums in the market … so, if we take the largest premium in the market just to start off with, we’d call that the equity risk premium or stock risk premium, and most of the audience listeners can recognize, they may not know that’s why they own stocks, but really, why they own stocks is because stocks have a very high expected rate of return versus bonds. So, if someone wants to invest for a longer period of time, they can put their money in stocks or bonds. So, stocks versus treasury bills, CDs, corporate bonds, U.S. government bonds, have had a very high appreciation, annual total return, annually for the last 87 years, as far as the database goes.

But what we were going to talk about this evening was the factors and premiums. The more specific factors and premiums, such as value. So, we could start with U.S. large value, for example.

Jim Lange: All right, and before you go on, can you tell our listeners what value is, as opposed to what growth stocks are?


2. Value Stocks Have Outperformed S&P 500 the Past 87 Years

P.J. DiNuzzo: Yeah. Value would be basically a low-price earnings stock. The audience may have heard of things. The S&P, let’s say, right now is around 17 times earnings, so the average company in the S&P, for every million dollars in earnings that they have, is valued now, let’s say, at around $17 million for every million dollars. So, value would be larger, more capital-intensive companies. Right now, let’s say, growth companies may be in 20 or the low-20 times earnings, and value companies may be trading at 13 or 14 times earnings. So, larger, more capital-intensive, and it’s these stocks, and it’s amazing when you look at the last 87 years, and I often say that that’s one of the main reasons that Warren Buffett has done as well as he has, and again, Warren Buffett doesn’t need any tailwind or any extra wind in his sail, but when you think that he’s just been fishing in that fishing pond for 50-plus years, and value basically has done a couple percent or better per year than even the S&P 500. So most people are amazed at the performance by the S&P 500.

Jim Lange: So, you’re saying even if you just got a bunch of value stocks that you would, at least historically, outperform the S&P 500?

P.J. DiNuzzo: Yeah, historically, you would have outperformed the S&P 500 over the last 87 years. And one thing that we have to mention, and it was further in the agenda for today, but this is a good point to mention it, that with the factor premium investing in a portfolio, and again, this is really related to diversification. How are you going to diversify your portfolio? And our professional recommendation is, and DFA has specialized in this, is accessing these various factors or premiums that are available. But yeah, if you were just to compound that couple percent more per year, even over the last 50 years, it would be an amazing additional growth regarding value versus even the S&P 500. So, these are premiums based on targets that achieve specific investment risk return. So, there is no free lunch.
We need to mention that as well, that large-value stocks, for example, will bounce up and down more. Technically, it would be called the standard deviation, but in plain English, they’ll bounce up and down more than the S&P would, given the higher return. But thank goodness for Harry Markowitz and the University of Chicago and the Nobel Prize that he won decades ago, that since these asset classes have low correlations with each other, and we talked to our … you’ve got a lot of engineering and a lot of professors, so for them, they like to hear a word like a “formula.” So, we talk about a formula. People who aren’t as quantitative, we’ll refer to it as a “recipe.” They like the idea of a recipe better than a formula. But thank goodness you can put these asset classes together in a formula —or recipe, as the case may be — and the fact that they have low correlations with each other, that is the true definition of diversification. So we know that every position that we invest in every year is not going to be up every year. Some things will do better than others, but when you’ve got a large database and a statistical level of confidence, and we’re talking about the indexes with the factors. You know, one thing I think that’s always a big positive point is that I think the average active mutual fund manager is in his or her chair managing that mutual fund. I think the national average is around seven years, give or take. Again, the U.S. database that we have for the U.S. indexes, large, large value, small, small value, we know what they’ve done for 87 years. So, I just think there’s a tremendous amount of confidence in and around what these expected rates of return are and the risk associated with them.


3. Diversified Portfolio Can Protect Against Volatility of Large-Value Stocks

Jim Lange: Can I ask a question to make sure that I understand and our listeners understand a point that you made? So, you used the example of value, which has historically outperformed, say, the growth companies, but you’re saying the cost of it is there’s going to be some volatility, meaning that you can’t put all your eggs in value and hope that you’ll be OK. But you’re going to get additional safety by putting other investments in other things that also might have a premium, such as we haven’t got into it yet, but I expect that we’ll be talking about small-cap companies or international companies or emerging market companies, or any one of these different types of asset classes in and of themselves might have a higher volatility than, say, the S&P 500, but are you saying that if you put together a portfolio that includes some of these more volatile but higher return type asset classes that you can end up with a portfolio that, over time, will do better and actually will be at a reduced risk because even though each asset class might be a little riskier, or more volatile, that taken together, they reduce their risk by diversification?

P.J. DiNuzzo: Yes, that’s it exactly. And again, a typical portfolio would have U.S. large, U.S. large value, U.S. small, U.S. small value, real estate and, as you mentioned, international large or small emerging markets. So, it’s all of these different diversified asset classes. If we think of just U.S. large, for example, going through a five-year business cycle following … actually leading, it’s a leading indicator of the economy. But going through spring, summer, winter and fall through that entire cycle, there’s all of these different weather patterns and cycles going on, these five-year patterns basically all across the globe. So, if we’re able to access those, so if you look at, historically, a 70/30 portfolio —70 percent in stocks, 30 percent in bonds in fixed income — there have been many periods when that all-index portfolio has done close to a portfolio just the same as 100 percent in stocks, such as the S&P. But of equal importance, we’re always looking at risk as well as the return, with that portfolio having a quarter to maybe even one-third less risk than just having all your eggs in one basket in the S&P, for example.

Jim Lange: OK. And during the introduction, Dan said … or maybe it was you that mentioned that you were one of the first 100 DFA providers. Is it really special? Is it really hard to become a DFA provider? Because with some of the numbers that I have seen, in terms of returns, it seems to me that virtually every advisor in the country should want to be a DFA provider.

P.J. DiNuzzo: Well, when it comes to investing, there’s a lot of different ways that people would have an awful lot of different recipes or formulas out there. But the world predominantly is still overwhelmingly an active world, and one of the reasons why, you know, your firm has done as well as it has and I believe our firm as well, you know, we have a strict fiduciary standard. We place the client’s best interest first. It may sound counterintuitive from a business perspective, but I’m always looking into how we can charge the lowest possible fees, the lowest possible expenses and make things happen. All of the high fees and expenses are on that active side. So there’s a lot of firms out there that are able to get 2½, 2 percent a year. There’s products out there that can be sold, and there’s 3 percent, 5 percent, 7 percent, there’s even some products that have close to 10 percent commission just for selling that individual investment. So that’s one inherent benefit of the indexes. DFA right next to Vanguard, you know, arguably two of the lowest mutual-fund families regarding the indexes that they have, regarding expense ratios of all available mutual funds in the entire world.

Jim Lange: All right. So, you’re not only getting the index effect, if you will, but then you’re also getting these additional premiums, and, at least historically, if you compare head-to-head, like DFA small cap versus Vanguard small cap, or DFA value versus small-cap value, and you’re thinking, “Well, gee, how can one index fund outperform another, particularly after cost?” Is it these premiums, or is it the way that they actually construct the portfolios?

P.J. DiNuzzo: Yeah, it’s the premiums, but DFA was really the first organization. That’s how they’ve grown as well. I think they’re close to $400 billion now. They’re the, to the best of my knowledge, the largest pure index mutual fund manager on the planet Earth. But it is these premiums, and again, we’re at the point now that DFA has an extensive track record. I would’ve had a harder time explaining this 20 years ago! But the numbers speak for themselves now that they arguably have been the best mutual fund manager of accessing these premiums. So, in the small-cap area … and again, I never impugn Vanguard. They’re a tremendous organization, especially for do-it-yourselfers, but I believe DFA small index versus Vanguard’s DFA is better than 1 percent per year on an index-to-index, and they’ve really shined in the value, and internationally, they have a lot of indexes regarding emerging markets small and emerging markets value that a lot of people don’t even have. So it’s really their expertise on accessing these factors and premiums that have been identified by academia, a number of them decades ago, actually, and some other ones we’ve got to talk about tonight, just within the last couple of years.

Jim Lange: All right. And one or two more questions, and then I’ll let you go back to what you were wanting to talk about. All right, so, in terms of safety, everybody agrees that the better diversified you are, that lowers your risk if you had a typical portfolio using Dimensional Fund Advisors as the underlying investments. So, let’s say, your firm doing the money management, if you will, the asset allocation and actually managing the money, our firm actually doing, let’s say, some of the strategic work, but how many different companies would somebody typically have if you added up all of the number of companies and all the mutual funds that they might have in a typical well-diversified portfolio with you?


4. Index Investment Accesses Capital Markets and Growth Across the Globe

P.J. DiNuzzo: Yeah, let’s say for example, Jim, our typical portfolio would have approximately 15 positions. We usually access approximately 11 stock-equity asset classes, U.S. and international, real-estate emerging markets included, and four, maybe five on the bond side, as far as bond indexes, and what’s really interesting of, let’s say, the 11 typical equity positions that we have, basically what we’re doing, in plain English, is indexing the planet Earth, accessing all the capital markets and economic growth that we’d want access to, but again, tilting towards these little factors. So, we’ve got a small fractional ownership, on average, in at least over 14,000 companies in over 40 countries across the planet.

Jim Lange: All right. So, let’s say that I was a typical client, and not that I have 5 million to invest, but let’s say I have a half a million or a million to invest. Are you saying that I would be invested in 14,000 different companies, which doesn’t include the fixed-income portion of the portfolio, in over 40 different countries? And maybe it’s not fair, and I also don’t want to say anything bad about Vanguard, particularly since Jack Bogle has been so good as to be a guest twice on our show. But is that typical of a set of index funds, or is that an extraordinarily high number?

P.J. DiNuzzo: Well, it’s a lot higher than typically what you would see. Even a lot of individuals who have come to us, and we got a lot of clients from Vanguard over the years, and it’s somewhat unique with a lot of folks that whenever I talk to them, they’ve got a Vanguard index or a few in their portfolio, that I’ll ask them, “You know, why do you have the Vanguard indexes in your portfolio?” And they say, “Well, you know, I did the research, and boy, these numbers are really good and the expenses are really low.” But they just don’t have any concept, anything about efficient market theory, why they’re investing in indexes, just that the Vanguard performance has been real good and the expenses are low.


Jim Lange: P.J., you were talking about premiums or factors that outperform the market, and whether it’s, let’s say, value or small or international, et cetera. Why do they outperform the market?

P.J. DiNuzzo: Yeah, we could probably have a show or two or a dozen or so on that topic, but there’s basically two broad theories of thought. One is the economic explanation. That would be along the lines of Professor Fama of the University of Chicago Graduate Booth Business School. Then there’s also a behavioral camp, and truthfully, there’s not an absolute, finite reason for a lot of these exactly why they’re outperforming. There’s a litany of reasons on both camps, economic as well as behavioral, but the one thing we do know is with an 87-year database, that they do exist. What we’re most sensitive at our practice, at our shop, is if any of these premiums were ever to dissipate and go away, so to speak, and, you know, we tell clients that’s part of our job to watch over this, and that’s one of the most constant conversations that we’re having with Dimensional Fund Advisors, and, of course, they’re sort of sewn at the hip, figuratively, with the University of Chicago Graduate Booth Business School. But they’re cyclical. There’s no free lunch. You can’t access them and have the benefit of them all outperforming at the same time, but they have shown to add that value, and especially when applied to a portfolio through proper diversification, again, spreading this out. You know, our typical portfolio, we’ve got about two-thirds of our stock exposure in the U.S., about one-third in international. In the U.S., for example, about two-thirds of that portfolio’s in large caps, large stocks, about one-third is in small, and then we’re breaking out into small core and small value, large core, large value. So there’s an awful lot of diversification to dissipate as much of that risk as possible.

Jim Lange: P.J., when somebody comes in to see us, and if I like them and they like me, we usually then set up a second meeting. We ask them to bring in all their statements, and we actually analyze those statements using Morningstar, and what is very, very common is a preponderance of the client’s stock portfolio is in these very large companies, usually companies that somebody has heard of.

P.J. DiNuzzo: Umm-hmm.

Jim Lange: Do you think that some of these premiums might be related to the fact that, you know, Warren Buffett says, “Don’t invest in it if you’ve never heard of it,” or you don’t understand it? And people say, “Oh, geez, I don’t really know about these small companies. You know, I’ve heard of IBM. I’ve heard of Apple. I’m only going to invest in companies that I’ve heard about and know of when they’re really passing out some gems.” Is that one possible explanation?

P.J. DiNuzzo: Yeah, I’m not sure about that, but that does bring up a good point, Jim, and one thing that’s been interesting over the course of the last decade that I’ve seen is a lot of active managers, recognizing basically the point that you were saying when you see individuals that they’ve got these large concentrations in basically U.S. large-cap stocks, and unfortunately, sometimes in U.S. large-growth stocks, and they’ve got all these holes in their strategy in their diversification. So, you even see a lot of active managers, you think that they’ve got a proclivity and their technique is in the U.S. large area, and they realize they need to be diversified in their portfolio. So they’ve been purchasing indexes or ETFs to fill those gaps for them to build a proper portfolio in the U.S. small, in international space, in the emerging market space as well. So using those to fill the portfolio out, but I just don’t see any correlation or don’t know of any research that would tie into, yeah, that individual thought, as far as …

Jim Lange: That does tend to be the pattern because people will come in, and we will typically tell them — if we like them and they like us and it makes sense for us to at least consider working together — you know, when we analyze their Social Security and their Roth IRA conversion, how much they could spend and that type of thing, but again, we do do the portfolio and we, almost inevitably, find people are overweighted in large growth and, very frankly, I guess I have to be a little careful about talking about performance, but it’s not all that tough to outperform somebody over time, even if they’re a low-cost indexer, if most of their money is in large-cap growth. And it’s because of these premiums, is that right?

P.J. DiNuzzo: Yeah, large growth actually is sort of a counterintuitive one that people like mentally stub their toe on. Growth stocks are the easiest stocks to buy because they’re the most well-known companies. They’re the Starbucks, the Googles, the Facebooks, Avon years ago …

Jim Lange: Apple.

P.J. DiNuzzo: Apple. But whenever these companies …

Jim Lange: Amazon would be an example.


5. Don’t Bet on Growth Stocks to Outperform the Market Forever

P.J. DiNuzzo: Yeah, Amazon is a very good example at the multiple that they trade at. And what happens over time, again, with the growth stocks are, they’re growing very, very well, and if we get back to that number that I had mentioned earlier, the stock market trades at 15, 16, 17 times earnings, these stocks are often trading at, when you buy them, they’re trading at 30 times earnings, 50 times earnings, 70, a hundred times earnings, and one thing we know that the market regresses to the mean, that no company … if we go back and look at data from the last 100 years, they may have some type of first move or advantage. They may be on the leading edge of some technology, but eventually, the rest of the market catches up to them, and they lose that advantage that they have, and we know that basically it’s like a gravitational pull that someone may be willing to pay for them when they’re trading at 50 times earnings today, but they’re going to be back to that 16 or 17 times earnings number at some point in time in the future. So, basically, at the risk of oversimplifying some Nobel Prize-winning research, what happens is people are betting that they’re going to continue to outperform and beat the averages when something invariably happens and they’re not able to.

Jim Lange: OK.

P.J. DiNuzzo: And then that’s when that price, that’s where the underperformance comes in. So people actually don’t realize they’re actually overpaying for it upfront and they never get a return on that investment.

Jim Lange: OK, I’m sorry. I interrupted you when you were talking about why utilizing these factors or premiums outperforms the market.

P.J. DiNuzzo: Yeah, and that really gets back to that recipe, Jim. I mean, when you take a look at that portfolio, you could do the good old-fashioned, you know, we talk about Jack Bogle, you know, you’d mentioned him. You know, Jack’s strategy for decades was use two indexes in your portfolio, use a total stock-market index, use a total bond-market index, and if your asset allocation, for example, to make the math easy, was 50/50, put 50 percent into the total stock-market index and 50 percent into the total bond-market index. And then he got excited a few years ago when they did a total international stock market index, so he says, “Oh, now you can use, you know, two parts U.S., one part international.” But again, that just captures what we were talking about earlier in the show when you were asking me, that just captures really that equity premium, that market premium. That’s the one you are going to capture the premium of being in the market over bonds, over treasury bills, and that’s a big fat premium. Stocks do a lot better than bonds over time, but again, you’re missing out on all the other available premiums, value, small cap, the newer one that DFA had identified in the academic community called direct profitability. I don’t want to bore the audience to tears, but there is new research, and it’s very exciting as far as what is available to continue to refine and build better portfolios.

Jim Lange: Well, it is good to understand because it just isn’t intuitively obvious that one index, even after fees and slightly higher fees than Vanguard can outperform Vanguard or any other index.

P.J. DiNuzzo: Yeah, and that’s why I thought it was a great contemporary topic for today that, I mean, Vanguard has actually been doing a lot of presentations talking about factors, which is almost heresy because they were anti-factor for the longest time. But, you know, they recognize, and there’s a lot of people out there that love Vanguard, so, you know, sort of that’s the Good Housekeeping seal of approval. Vanguard recognizes it. But really, this is what DFA, this is what the halls of academia came up with about 40-plus years ago, and DFA’s been doing since Day 1, is accessing these factors, these premiums as well as possible, and as I said earlier in the show, you know, that’s really a big part, you know, that there’s been a lot of wind in the sail of Warren Buffett or any value managers that value has done better over time.

Jim Lange: All right. So, you have mentioned, let’s call it, the market premium, the value premium, you mentioned the size premium, we didn’t get into it a lot, but you also mentioned direct profitability. Are there other premiums that our listeners should be aware of?


6. Companies With Higher Profitability Tend to Maintain Higher Stock Prices

P.J. DiNuzzo: Yeah, there’s a direct profitability premium, and basically, to make that as simple as possible, the hardest part, if any listeners can think when they’re listening to a stock channel or anything on the radio, an announcer will say that a company made, let’s say, $3 billion, and they’ll say, “Well, I’m not so sure.” After accounting charges and the accounting shell game, they move things around, we’re really not sure if they made any money or not. I mean, did they make $3 billion last quarter? Did they not make any money or lose money? So you got all these accounting tricks and gimmicks that go on. So what they were finally able to do, Professor Fama and French had wrote a groundbreaking paper to start this off in around 2006-2007, and Professor Novy-Marx, I think he was at Rochester University up in New York at the time, but they were able to stabilize companies. So, we can compare Company A to Company B to Company C equally, and to make a long story short, companies that have a higher profitability tend to maintain a higher profitability and stock prices are priced off of earnings. So it’s been a good predictor in those stocks have outperformed a lower profitability.

One other one’s being worked, and I don’t think it’s really going to get incorporated into the portfolios, but DFA and the direct profitability started to … by the end of last year, by the end of 2014, they had some type of direct profitability factor included into most of their equity portfolios. So, again, it gets back to that formula or recipe, they’re doing the same thing. And albeit, there’s sort of a law of diminishing returns. You don’t get the full value of all these premiums by placing all of them into one portfolio strategy. So, for example, DFA’s U.S. small value, you do get the benefit that you are in stocks, you do get the benefit that you are in small stocks, and you also get the benefit that you’re in value. So that has the highest expected returns for a U.S. asset class, and when they dovetail a little bit of this direct profitability in, they’re just small improvements around the margin, but, you know, one-tenth of a percent is one-tenth of a percent. I mean, there are big numbers from a portfolio perspective.

Jim Lange: All right. Just so I understand, when you say direct profitability and then you kind of alluded to accounting tricks, and we’re both CPAs here, are you saying that they have a different measure other than, say, generally accepted accounting principles to measure profitability, and that they use, in effect, their own accounting system to evaluate companies?

P.J. DiNuzzo: They’re doing it within the constraints of our current accounting system, but what they did, basically, is move up high enough on the income statement to get above the shenanigan part. So, they’re, you know, getting more to the core, you know, growth sales, direct cost to goods, et cetera, to be able to get that common number, and it’s worked very, very well. It’s been very accurate. So we have exciting hopes that we’ve got a new premium there. There’s the capital investment, which will take a while.
One other one that needs to be mentioned is, a number of the listeners may have heard of the word momentum before. We know that momentum exists in the market. Again, a real brief, maybe a metaphor analogy, is we know that stocks of a certain size, accelerating at a certain rate of speed, tend to maintain a certain upward rate of speed. We know that stocks decelerating at a certain size tend to maintain that deceleration. Again, we could be talking about hours, days, a week, but again, these are very important elements in building a portfolio, and that’s another big part of DFA. Their trading strategy accesses a material amount, I should say, of the momentum premium in the market, and that is another one of the, I don’t want to say litany of reasons, but a number of reasons that DFA has been able to add value in the performance in the portfolio.

Jim Lange: All right. So, it’s not like they ring a bell at the top, but you’re trying to ride a rising stock or a market.

P.J. DiNuzzo: Yeah. They can’t pick it exactly, but they’re very good on a consistent basis of eking out modest additional returns.

Jim Lange: OK. Are there other premiums or factors that we should identify to help explain why certain indexes like DFA will outperform other index funds?


7. Corporate Bonds Yield More Than Government Bonds, Due to Risk

P.J. DiNuzzo: Yeah, I think since we’re talking about factors and premiums, that it’s worth talking about … it’s surprising with all the information that’s available, there’s really only two reasons to invest in the bond market. There’s only two premiums in the bond market. They’ve been identified eons ago, and there are still only two. There’s the term premium in the bond market, which sort of makes sense that a five-year bond, on average, pays higher interest than a one-year bond. The 10-year pays a higher rate of interest than a five-year bond. The credit is also pretty straightforward. The most obvious manifestation of the credit premium would be that corporate bonds, everything else being equal, a five-year corporate bond has to pay a higher rate of return and produce a higher yield than a government bond because it’s riskier than the U.S. government, for example.

Jim Lange: Though a few of our listeners might disagree with that one!

P.J. DiNuzzo: Yeah! So, it’s tough talking about bonds right now whenever the 10-year U.S. treasury is yielding about 2.2 percent. It’s a very tough environment for bonds. But again, that’s a good segue, Jim, just to remind our listeners that, you know, the bond component, again, you know, what DFA’s philosophy has been, Professor Fama, and ours has been to use that to mitigate risk in the portfolio.

Jim Lange: And before I get back into the meat of the show, I just … and I mentioned this very early at the beginning, so I’m going to do the abbreviated version. I am not independent with P.J. P.J. and I have an arrangement where if somebody starts by coming to our office, and after meeting with us and we like them and they like us, and going through our process, and then they meet P.J. and his office, P.J. and I actually have a fee-sharing arrangement. So, where our office does some of the conceptual work — we run the numbers, we do the Roth conversion analysis, the Social Security analysis, the gifting analysis, the estate planning, the tax planning, et cetera — P.J. and his team actually do the actual money management using low-cost index funds, and specifically a set of index funds called Dimensional Fund Advisors, one of the things that we think is important for everybody’s low overall fees. So, rather than P.J. and I each charging a fee, we charge a combined fee of 1 percent or less, depending on how much money is invested, and we think it is a win-win-win because P.J. gets to do what he and his team are wonderful at doing, and we get to spend time in our strengths, and the clients gets really a double win because they’re getting an excellent money manager using the best set of index funds on the planet, with our firm running numbers and providing strategies, and that’s probably one of the reasons we have a 99 percent retainage rate.
But anyway, we were talking about why some of these premiums outperform the market, and, of course, by the way, we have a list of about 20 and we’re only going to get to about four, but that’s just the nature of these things. But one that you have talked about before, P.J., and I think it makes a lot of sense, is, let’s call it, smart or strategic beta. What is smart or strategic beta?

P.J. DiNuzzo: Yeah, and I think it’s good to mention this to the audience that the factors, as time goes on, and again, organizations like Vanguard are starting to pay attention. It’s good to know whenever a reader, if they see something in Kiplinger’s magazine or Money magazine or a national article online, what we’ve been talking about the entire show, what is smart beta or referred to as strategic beta? So, beta would be the return of the market of the asset class, the broad market. But, again, value has a higher expected rate of return, U.S. large value versus the market, so the financial media have been referring to that as smart beta or strategic beta. So it sounds a lot more exotic, but it has been just these factors and premiums we’ve been discussing today.

Jim Lange: All right, and what about return cyclicality?

P.J. DiNuzzo: Yeah, and that’s one, Jim, that I thought, when we were talking earlier, you had mentioned regarding just building a portfolio, let’s say, with a single-factor approach such as a U.S. large value. And again, in our academic empirical heart of hearts, we do believe that that would do the best. It may take five years, 10 years, 15 years, but once it gets to a full cycle, we believe that premium is going to show up. But they are cyclical in nature, so what happens is, you know, we all know that the numbers in the market, you know, we firmly believe, we think it’s been disseminated into education pretty well that the mistakes in the market really aren’t on the quantitative side, they’re on the behavioral side. So it’s on the emotional side. And what happens, because sometimes, listeners may be listening and say, “This sounds a little bit too good to be true. I mean, you’ve got available premiums out there, that I can include exposure to my portfolio to things other than just the basic asset class of U.S. large stocks, et cetera, and help to increase my returns and decrease my risk.” But again, they are cyclical.
One of the toughest periods of my life was 1995 through 1999. That’s when we went through the dot-com craze, if the listeners remember the internet craze. Companies were trading on sales multiples, not making any profit and selling for crazy prices. So, that was a bad time to be a value investor such as ourselves! We made it through there. Warren Buffett made it through and a lot of other value folks have, but you have to be comfortable that these premiums that you’re accessing are going to be out of cycle or out of sync for maybe one, two, three years or even a little bit longer at a time. But again, when you’ve got a worldwide diversified portfolio, more times than not, more things are working than less. So it works well over time.

Jim Lange: All right. So, are you saying that when some of these growth stocks were trading at crazy multiples, and frankly, some of them were making a lot of money, that you had to tell your clients, “No, no, no. That’s not really what we think is going to be in your long-term best interest.” And I remember that very well. Everybody was buying these crazy technology stocks. A bunch of people were making money, then your clients are telling you, “Hey! My buddy just made a lot of money on a technology stock. You should get me in technology stocks!” And you’re saying it was tough in your life …

P.J. DiNuzzo: Very tough.

Jim Lange: … because you had to tell people, “Well, yeah, I know that they made money, but the foundation isn’t there, and that’s not appropriate.”

P.J. DiNuzzo: Yeah, well, you know, all these crazy stocks, I mean, well, Cisco’s still around, you know, Sun Microsystems, Micro and Technology, you name it, that were going crazy for that period of time, but again, then they obviously did more than crash down to earth, you know, starting in March of 2000. So, you know, we’re staying with the time-honored, time-tested portfolio, 87 years, as far as our database, so we’ll put our full faith and credit in that.

Jim Lange: All right, and what is rules-based factors?


8. Transparency of Indexing Gives the Investor Tremendous Confidence

P.J. DiNuzzo: One things that a lot of folks like, yeah, a lot of people, and you’ve got a lot of engineers, as I said, Jim, obviously a lot of professors. What a lot of people like about, who gravitate towards and like the strategy of efficient market theory, indexing, tilting towards these factors, is that it’s very transparent, rules-based, very transparent. So, the Fama-French, if we talk about U.S. large value, U.S. small value, we can go back on the Fama-French indexes, Professor Fama and Ken French are the ones that identified this. That’s one of the reasons he won the Nobel Prize. And we know exactly which stocks every month would’ve been in that index going back into the 1920s, so there’s just a tremendous additional amount of confidence in an investment strategy that is that rigorous and that objective transparent data-based, rule-based, versus, again, the active varieties that are out there on TV and in newspapers.

Jim Lange: Well, I like transparency and, I think, so do our listeners because unfortunately, in the financial sector, sometimes it’s such a mystery what costs are: How much money the advisor who’s recommending perhaps a certain fund that might be a load fund, or it actually might be an annuity that might have a commission to the advisor as high as five, seven, 10 percent, and they don’t really say what the internal cost of the fund is, or what the external costs, or what they’re making, or what the fee is, and it seems to me that your firm and mine are the exact opposite. That we’re as open a book as you can get, and somebody with a portfolio could know to a dollar how much money went to you, how much money went to Dimensional Fund Advisors, how much money went to me, and literally, to the dollar, that there is no hidden cost. I think people like that. So, if there’s transparency in the underlying investments and transparency in your dealing with the advisor, that just seems to be a win-win.

P.J. DiNuzzo: Yeah, clients and folks do … I say the folks that love us, that’s one of the main things they love about us that, you know, every investment that I have and our advisors is invested exactly the same way as what we recommend to our clients. Of course, there’s different asset allocations, but myself, my mom’s, God bless her, well into her 80s, I mean, her whole portfolio that she has invested in equities and fixed income is all in DFA indexes. So, you know, we believe it’s the best way to invest. We’ve got our 401(k), our SEP IRAs, individual accounts, joint accounts, Roth accounts, our, you know, into DFA indexes, and yeah, the transparency, of course, no front-end loads, no back-end loads, no 12b-1 fees, you know, lower expense ratios than probably 99 percent of all available mutual funds. So, yeah, clients do really like the transparency in the process.

Jim Lange: All right, and you had mentioned ETFs and, let’s say, some of the impurities in that market. Can you, let’s say, elaborate on some of those impurities in ETFs?


9. Exchange-Traded Funds Come With Risks, Including Ownership Issues

P.J. DiNuzzo: Yeah, but I would caution the audience, Jim, I mean, and this is a male-based problem, so the women, as usual, they’re on the right side of the facts here. But, you know, men just can’t keep their hands off of things, basically, and I’m blaming the men here. You know, they get the ETFs and the indexes, and there’s a lot of companies out there that, and it sounds sort of counterintuitive, but they’re wanting to put an active component into these indexes, and they want to, around the fringes, say, “OK, I think the index could do pretty well, but what if we trade actively 10 or 20, 30 percent around the core of some index?” A lot of them don’t have, and again, I had mentioned this before, if a listener does look to purchase ETFs, if they are a do-it-yourselfer, by far and away, Vanguard is our preferred choice for their ETFs. They have, I believe, the highest quality in the ownership. If you own an ETF that you have a legal right to a share that’s in their mutual fund. It’s basically a subset, so to speak, of the mutual fund. So you have to be real careful is, if you just have a right to a security and you don’t have a direct-owner lineage, linkage, that we all remember what happened in 2008 and 2009. There was a lot of people that you had a right to something of a financial instrument, and the other person walked away from the other side of the table. That’s basically why we had the meltdown. People didn’t own up to their obligation. They just said, “No, it’s going to hurt me tremendously financially. I’m not going to fulfill my obligation to you.”

Jim Lange: You know, I know that we could go on and on. We have a whole list in front of us of things that we could’ve talked about if we had time. Unfortunately, we don’t have time, so could you maybe summarize some of the things that you have said and maybe any important point that we didn’t get to because we just ran out of time?

P.J. DiNuzzo: Yes, I would just, to sum it up, Jim, I would say just to remind the listeners of the importance of having a core belief in your investments. You need a strategy to build on top of your philosophy. You need to implement that. You need to maintain a discipline. One thing when you’re talking about this long track record, this huge database, the transparency, the rule-based structure, these elements I have found to be a lot easier to maintain over time. Again, remind the audience to diversify as well as possible across the premiums that we discussed this evening.