'The Evolution of Indexing' and ETFs, With Advisor P.J. DiNuzzo

Episode: 141
Originally Aired: September 16, 2015
Topic: ‘The Evolution of Indexing’ and ETFs, with Advisor P.J. DiNuzzo

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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TOPICS COVERED:

Introduction of P.J. DiNuzzo of DiNuzzo Index Advisors
Index Funds Don’t Outsmart Market, They Accept Market’s Rate of Return
Asset Allocation, Tied to Risk Tolerance and Time Frame, Is Key to Investing
On Roth Conversions, It’s Best to Pay the Tax From Outside the IRA
Getting the Beneficiary Designation Correct Is Crucial in IRAs
Cash Reserves Should Be 12 Times Your Monthly Living Expenses
Inflation Slowly, Silently Erodes Purchasing Power Over Time
Long-Term Value Stocks Have Outperformed the S&P 500 for 86 Years
U.S. Small Stocks Have More Risk and Therefore More Rewards
DFA Uses Momentum of a Stock in Its Buy and Sell Decisions
‘Direct Profitability’ Premium Based on Company’s Continued High Earnings
With ETFs, Be Sure You Have Ownership of the Actual Underlying Stock
Market Is Very Efficient, so Keep Fees and Expenses as Low as Possible

Welcome to The Lange Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.

1. Introduction of P.J. DiNuzzo of DiNuzzo Index Advisors

David Bear: Hello, and welcome to this edition of The Lange Money Hour, Where Smart Money Talks. I’m David Bear, here in the KQV studio with Jim Lange, CPA/attorney, and author of three best-selling books: “Retire Secure!” “The Roth Revolution: Pay Taxes Once and Never Again” and now, “Retire Secure! For Same-Sex Couples.” Looking to maximize your retirement assets? Long-term success requires a consistent strategy that can be adjusted for changing investment opportunities and tax regulations. For perspectives on the latest investing intelligence, The Lange Money Hour welcomes P.J. DiNuzzo back to the show. A nationally recognized expert in investment management, P.J. was approved as one of the first 100 Dimensional Fund Advisors and is rated a five-star advisor by Paladin Registry Investor Watchdog. His Pittsburgh-area firm, DiNuzzo Index Advisors, consistently ranks among the country’s top 500 investment firms. P.J. and Jim will discuss investment issues, such as indexing and active-versus-passive approaches. Without further ado, hello, Jim, and welcome, P.J.

Jim Lange: Welcome, P.J.

P.J. DiNuzzo: Good evening. Good evening, Jim and Dave.

Jim Lange: Before we start the show, I feel honor bound to have full disclosure of my relationship with P.J. Normally, when I have guests on the show, which I do virtually every show, I try to get the best, smartest, most articulate guests that I can, and usually, they have written a book. So, for example, after John Bogle writes a book, I’ll have him on the show. When Jane Bryant Quinn writes a book, I’ll have her on the show. When Ed Slott in the IRA world writes a book, I will have him on the show. And by the way, I never pay a guest. I’ve never paid a guest a nickel. But usually, as one reason the guests are willing to come and be on the show is because I usually put in a little plug for their book.

David Bear: A little, I’d say!

Jim Lange: Yeah. It’s not a pitchfest. But I never have a financial interest in the guest. In other words, whatever they sell in their books, whatever they do in their business, that really has nothing to do with me financially one way or the other. P.J. is a different story, and I feel honor bound to disclose that. P.J. and I have a business relationship that works something like this: I believe most people need two things. One, they need the kind of strategies that our firm provides that many of the shows are about. What should you be doing in terms of building money for retirement? Should you be using Roth IRAs? Should you do Roth IRA conversions? Which dollar should you spend first? What should you be doing for Social Security? How much money can you afford to spend? What about your estate? How can you best plan for your estate? That’s the kind of stuff that we do.
P.J. is actually a real, live money manager. What is the best asset allocation for you? OK, you have money in these funds that can’t be taken out. How can we change your existing asset allocation so that your whole portfolio is appropriately allocated? What about the bucket analysis (that we will get to)? And he uses low-cost index funds of what I believe is the best low-cost index set funds on the planet, which is called Dimensional Fund Advisors. Anyway, if we meet a prospective client, the way the deal works is if the person wants the combination of our services and P.J.’s services, rather than paying us a fee and P.J. and fee, what we do is P.J. and I combine our services. So, the client is getting all the strategies — Social Security, Roth conversions, how much to spend, et cetera — then P.J. does his thing which, by the way, is very extensive. He’s the hardest working financial advisor and the best, frankly, that I’ve ever met, and he does a personal balance sheet and a personal income statement and the asset allocation, blah blah blah, and then, together, we charge 1 percent or less, depending on how much money is invested, and then he and I share that 1 percent.
We think it’s a win-win-win because our firm can do what we like to do and what we’re good at, which is the strategies, et cetera, P.J. can do what his firm is very good at, which is actually managing the money, and yes, neither one of us gets a full fee. We split it, but that is still good, and the client, we think, is the real winner because they get the best of both for 1 percent or less. But anyway, I did feel honor bound to say that I do have a financial interest in P.J. and the arrangement that we just described. OK, with all that long introduction and disclosure, we wanted to start and talk a little bit about indexing because some people aren’t even exactly sure what indexing is and how indexing came to be. What is the evolution of indexing? And maybe P.J., if you can tell our audience what an index is and how the whole thing started, I think that would be a great start.

P.J. DiNuzzo: Sure, Jim. I’ll try to make this a brief as possible, but it is interesting, as you said, Jim, and I think it’s a great title you came up with for tonight’s show: “The Evolution of Indexing.” Even though it’s been sort of a tidal wave regarding an investment strategy, there are a significant amount of investors who still really don’t … maybe some haven’t even really heard of indexes and don’t really understand them. The evolution started at the University of Chicago back in the 1960s, and what was observed at that point in time was if you just bought and held the largest 20 percent of stocks in the U.S. stock market, and that’d be very close to the S&P 500. The large blue chips, the listeners in today’s market will be familiar with Google, Johnson & Johnson, Microsoft, General Electric, Coca Cola, Walmart, Apple, et cetera. If you just bought and held them over the average rolling five- or 10-year period of time, that you would do better than the average active manager about three out of four times. So, one thing that there’s a lot of misunderstanding about is people think that it’s a real static or monolithic strategy, or “close your eyes,” so to speak, but I tell folks the same thing all the time, that when I was in high school, Bethlehem Steel was one of the 10 largest stocks in the stock market. They’re long gone. When I was in high school, Microsoft wasn’t even a twinkle in Bill Gates’ eye, and now they’re one of the 10 largest stocks in the stock market. So, it’s truly a survival of the fittest. And again, the epicenter of this was at the University of Chicago, numerous Nobel Prize winners along the way.

Jim Lange: All right. You mentioned that there is a, I think you used massive shift from active money management to indexing. Can you give us some kind of scope, or is basically you’re saying more and more investors are turning to indexes as opposed to traditional active money managers?

2. Index Funds Don’t Outsmart Market, They Accept Market’s Rate of Return

P.J. DiNuzzo: Yeah, Jim. Just over my career, I founded our practice back in 1989, and it was a lot more difficult explaining this 20 or, heaven forbid, 26 years ago, but from the University of Chicago, David Booth and Rex Sinquefield, the founders of DFA, who you had mentioned earlier, Dimensional Fund Advisors, they’re credited with building, along with one other gentleman from Wells Fargo, the first S&P 500 index that you can invest in when they were working for a bank trust company. And that was around 1973. Jack Bogle and some of the powers-to-be at Vanguard had seen the research, and they launched the Vanguard S&P 500 fund in 1976, which was the first retail fund available. So, if we just think about something going from zero to being the largest mutual fund … if you just take a look at Vanguard, for example, which is, in our opinion, the best retail outlet if someone wants to manage their portfolio themselves. If one of the listeners just wants to go online and Google “largest mutual fund,” you’ll be shocked to take a look at the number of indexes that are in the top 10, the largest total stock market index at Vanguard S&P 500 index. So it literally has been a tsunami. It’s been a sea change in moving from trying to outsmart the stock market to being able to accept the market’s rates of return. And again, the evolution of indexing, your title today, I’m sure you have a lot of topics regarding the specific areas to be in. You just can’t do it blindly. There has to be a strategy behind it.

Jim Lange: Well, you also intimated that these Nobel Prize winners from the University of Chicago not only came up with indexing, but the original idea that you had mentioned where you own the top 20 or, in the classic case of the Vanguard S&P 500, the top 500 U.S. companies …

P.J. DiNuzzo: Umm-hmm.

Jim Lange: It seems that you, in your practice, are building asset allocation into the index world, and it’s not one or the other, but you’re actually doing both, aren’t you?

3. Asset Allocation, Tied to Risk Tolerance and Time Frame, Is Key to Investing

P.J. DiNuzzo: Yeah, we do both hand-in-hand. We’ve mentioned a number of times on the show, and any individual investor listening, that is the largest decision you’ll make, and most important in each of your portfolios, you have different account types: Roth IRAs versus IRAs versus taxable accounts, and that asset allocation, which would be tied into your risk tolerance, your time horizon, you know, when you need the money drawn out of the portfolio, that’s the most important decision you’ll make. So, for example, if the listeners decided that they were going to be 70 percent in stocks and 30 percent in bonds, then the next question with that 70 is, “Am I going to put all my eggs in one basket?” Of course, as your listeners know from listening to you, Jim, you’d fully diversify that, and we would be, let’s say, for example, two-thirds in the U.S., one-third in international, then we would go into large and small. But when we get into these areas that you mentioned, Jim, if we said that out of that 70-30 portfolio, if we wanted to have 14 percent in U.S. large and 14 percent in U.S. large value, each of these pie wedges, the listeners have often seen pie wedges in any investment information, in their 401(k) plan or 403(b), it’s each of these pie wedges that you are placing in a specific index for diversification.

Jim Lange: OK, and you said something that I want to pick up on. And by the way, we have had this identical conversation more than once with Roger Ibbetson, who is one of the great founders, if you will, of asset allocation, who’s still on the board at Dimensional Fund Advisors …

P.J. DiNuzzo: Yes, exactly.

Jim Lange: … that it’s more important to get the asset allocation right than picking the right stock. So, for example, you always hear people say, “Oh, I bought this stock!” “Oh, I bought that stock!” “Oh, I think this is a great mutual fund.” “Oh, that was a lousy mutual fund.” I don’t hear that many people say, “Well, I have 33 percent in large-cap growth, and then I have …” That’s not what people tend to talk about. But what you’re saying is, that’s really the important thing.

P.J. DiNuzzo: Yeah, the important thing is for the listeners to get their asset allocation correct. As you know, Jim, for our average client who’s retired, for example, we have three different asset allocations. So, that is just an example of how important it is, a more conservative asset allocation, for example, for food, clothing, shelter, health care and transportation; a balanced, middle-of-the-road type strategy for your want expenses on top of your needs; and then, finally, putting some growth in your top bucket, and again, that’s worked great with your clients, Jim, with the Roth IRAs and Roth IRA conversions, to have the growth. So, again, completely different goals, objectives, time horizon, risk associated with these timelines, as you said, that is the most important decision is getting that asset allocation decision correct.

Jim Lange: All right. Well, what I want to do now — and I hadn’t planned this, but it’s going to tie right in — is we do have an email question.

P.J. DiNuzzo: Oh sure.

David Bear: Do you want me to go ahead and read that?

Jim Lange: Yeah, why don’t you read that, David? This comes from Bob.

David Bear: It says, “I am married, retired, 68. My wife is 67, retired, and she gets a $12,000 a year pension. All our assets are in IRAs, having Roth and regular IRAs with allocations for both at 50 percent equity. Total IRAs are multiple eight figures. With Roth, it counts as 25 percent of the total. So I do not plan to spend much from my Roth account. I’m planning to change the Roth allocation to 100 percent equity. My thinking is, all dividends, plus capital gains, end up as regular income when distributed from regular IRAs, so we might as well put the high total return in the no-tax Roth. What do you think?”

Jim Lange: P.J., what I’d like to do is maybe make a comment on that, in terms of, let’s say, tax planning, which is my area of expertise, and then maybe you can chime in on what you might think of doing as an investment person, OK?

P.J. DiNuzzo: Sure, yeah Jim, if you want to do the tax aspect first, yes.

4. On Roth Conversions, It’s Best to Pay the Tax From Outside the IRA

Jim Lange: All right. So first, let’s take what he says at face value, which is that all his assets are in IRAs. So, the first question, to me, is, does it make sense to have any additional Roth IRA conversion? He already has some. Should he have more? The general rule of thumb, to me, is if you don’t have the money to pay the tax on the Roth IRA conversion from outside the IRA, if you work out the math, it’s usually a mathematical break even, unless you consider the change in minimum required distributions or estate planning. My own thinking is … and I have this reputation for being a Roth guy. The reputation I would prefer — of course, we don’t control our reputations — is that I am a “running the numbers” guy, and I like to tell clients the best course of action for them after running the numbers, which is one of the things that our firm does. But, typically, it’s not a great thing to do Roth conversions if you don’t have the money to pay the tax from outside the IRA. So, he didn’t give us numbers, but let’s just say he has a million dollars and a bunch of it’s in a regular IRA and some of it’s in a Roth, or even somebody has a million dollars in an IRA, no Roth and no after-tax dollars. They’re probably not a great candidate.
Now, there are some exceptions, and if people are interested in the exceptions, Barry Picker and I did a show that included the analysis of doing a Roth IRA conversion when you don’t have the money to do pay the tax from outside the IRA. So, the first thing is, probably, not necessarily, but probably don’t do any additional Roth IRA conversions. Now, in that case, by the way, when you do the estate plan, much, much, much more important than the wills — because the wills are almost irrelevant — is to get the right language with the beneficiary designation of the regular IRAs and the Roth IRAs, and we might want to have different assets go to different people, depending on if we have the law as is, or a law that we fear is going to come, called the “stretch IRA,” or the “death of the stretch IRA.” So we might want to have different assets going to different beneficiaries. But that’s the kind of thing that we would look at, as well as the safe withdrawal rates. P.J., maybe I’ll ask you to chime in on whether you think his idea of having the Roth be 100 percent equity, because, right now, all his accounts are 50/50.

P.J. DiNuzzo: Yeah, Jim. There was one thing in there that you mentioned as well. I know that since you’re the expert at it, oftentimes, it just comes second nature to you, but in your explanation to the audience, you had mentioned that the will would be almost immaterial, so to speak, in the estate planning. If you just wanted to explain to the audience, due to the account types, the way that the assets are held, if you can explain that, I think that’s an important point.

5. Getting the Beneficiary Designation Correct Is Crucial in IRAs

Jim Lange: OK, sure. IRAs are held by the individual. So, let’s say, if you were to look at the statement that Bob gets, it would be … I don’t want to name his last name, but let’s say “Bob Schmoe IRA.” And then, when he set that up, or maybe at some point he made a change, he filled out a beneficiary form that basically says what happens to that IRA at his death. Now, if he’s like many people, he might have said, “Well, Number 1, the first choice is my wife, and Number 2, second choice is my children equally.” Now, he might have went out and got a 30-page will from a financial advisor, but if you think about it, if all his money is in IRAs, everything is going to be controlled by that two-line beneficiary: Number 1, his wife; Number 2, children equally. What we might want to do is use that IRA beneficiary form — and there’s a number of ways to do this, but I’ll say one — and we actually put, let’s say, wife Number 1 and then, for the second choice, we would say “See attached” or “See the will dated …” and then we would have the will, and then, what we would say is, we would have all the what-ifs? All right? “If the child survives, they get it.” If they are predeceased, or in the event that it’s appropriate to disclaim, that is, have the money go instead of to each child, maybe one of the children wants that money to go to the next generation, which would give us a much greater, what’s called a stretch IRA. We might have the what-ifs if, again, on survival, on different situations, and you can have a much more complete beneficiary designation if you’re not trying to squeeze everything into two lines, but you have 10, 20, 30 pages to fill that out. So, that person, the key to that is getting the beneficiary designation right.

And a very quick reminder, I am not independent with P.J. P.J. and I have an arrangement whereby I do some of the strategic work like Roth IRA conversions and Social Security and estate planning and retirement planning, et cetera. P.J. actually does the actual investing, and rather than each of us charging a client a fee, we charge one fee of 1 percent or less of what we manage, and then P.J. and I split this, and it’s a win-win-win, meaning we get to do what we like and we’re good at, P.J. gets to do what he likes and he’s good at, very good at, and the client gets the best of both of us for 1 percent or less.
Anyway, P.J., you were going to talk about the investment choices for this guy who has 50 percent equity, 50 percent bonds or fixed income across all his accounts, and I think you were going to say if you were going to keep it that way, or whether you would recommend a change.

P.J. DiNuzzo: Yeah, Jim. The way I would look at this from the investment management and investment planning, along with the financial planning, retirement planning, you had mentioned — I made some notes — that when David read it off, the spouses were in the mid- to upper-60s …

David Bear: Yeah, 67 and 68, yeah.

6. Cash Reserves Should Be 12 Times Your Monthly Living Expenses

P.J. DiNuzzo: OK. And one spouse was receiving a $12,000 a year pension. Again, they have everything sort of lumped together at a 50/50 asset allocation rate now. So, the way we would look at that is, we would take a look at … if the audience wants to think of, the way we envision it is stacking up all your money from the floor to the ceiling, and the floor, that would go in your most important bucket, which would be your cash-reserve bucket. We like to have 12 months times your monthly living expenses in that bucket. And at the top of that bucket, if you can think of it, is where all of your activity goes on. If there’s just a layer on top of your cash reserves, that’s your checking account, the bank where your monthly expenses go out. So this household has a nice situation, or it will be nicer if they’re maximizing their Social Security … I’m not sure. But either way, they’re going to have Social Security coming in from both spouses into that top layer along with that nice defined-benefit pension plan.

What they had indicated was, from what I had written down in the notes, was that they don’t have a need for all of their assets. So, we would describe the majority of what they have, let’s say, if it’s from one-half to two-thirds or even 75 percent, that that would be in their needs and wants bucket, and we would recommend a maximum of 50/50 asset allocations. So, they’re right in the range for that for paying for, first of all, food, clothing, shelter, health care and transportation, and then, second of all, their discretionary expenses being into once. But we would recommend, again, we don’t know the exact elements of this case, but just on a piece of paper, for someone to consider having more growth in that top bucket. So, we tell the listeners, if you think of the very top of your stack of money, if you looked up at it and you saw all the activity down in the bottom and the middle stack, withdrawals coming out of the middle into your checking account on a monthly basis, if you looked at it and if you said there’s really not any activity from the ceiling to 2 or 3 feet below that, and then you really identified and looked at it and said, “You know, I’m really not going to have any withdrawals coming out of that portfolio for the next 10, 15, 20, 30,” maybe not over a probability of the rest of your lifetime. So then now we start thinking about those assets as being earmarked for, as you were saying earlier, Jim, beneficiary designations: children, grandchildren, et cetera. And it does make sense to have a more aggressive asset allocation, to have more in growth, because you’re tying that in to the beneficiary’s life expectancy.

Jim Lange: OK. And just one quick thing: You did mention Social Security, and I don’t know if Bob wanted to ask this …

P.J. DiNuzzo: I didn’t write that down.

Jim Lange: All right. I’m going to skip all the analysis because P.J. and I have a lot of stuff to cover, but what I will say is, my inclination is when Bob was 67 and his wife was 66, I would have had Bob apply for Social Security and suspend collection. Then I would’ve had his wife collect as a spousal benefit. That pattern would continue until Bob is 70, at which time I would have him collect his full amount. The fact that he waited from 66 to 70, he gets an 8 percent raise for every year he waits. The fact that she collected against his doesn’t hurt him at all. It doesn’t hurt her record at all, and then when she’s 70, I would see which one is stronger: hers, which kept growing despite the fact that she was taking his, or half of his. That’s going to be one of the subjects of the workshop coming up on February 21st at the Crowne Plaza in the South Hills. By the way, we just about filled up the last one, and Crowne Plaza is usually our most popular one.
OK. So, why don’t we go on to the next issue, which is, let’s say, related, but we said that asset allocation between fixed income and equities is maybe the most important thing. Can you give us a preview of stocks versus bonds and how you decide how much of what should be in what bucket, et cetera?

7. Inflation Slowly, Silently Erodes Purchasing Power Over Time

P.J. DiNuzzo: Yes. On stocks versus bonds, again, the allocations would be based on the time horizon, goals, risks, objectives, et cetera, and the first thing we could say versus stocks versus bonds is the audience may have heard us talk before would be, we would call it a stock premium or an equity risk premium. Stocks basically have done, if we use the S&P as an example, approximately twice the rate of return over their history as U.S. treasury bonds if we’re looking at long-term U.S. government bonds. More importantly, they’ve done about three times the rate of CDs, which have been just layered right on top of inflation. So, again, there’s a lot of incentive to maintain our purchasing power. I know, Jim, when we both talk to clients, inflation is often at the bottom of their list. They’re not really thinking about maintaining purchasing power. But over the average 10-year period of time, if we add inflation just in the low-3 percent range, let’s say 3 to 3½ percent, an individual’s $100 bill would only purchase about $70 of goods adjusted for inflation just 10 short years later.

Jim Lange: So, is that another way of saying that if somebody thinks they’re being very conservative by putting everything in cash and CD that they actually could lose 30 percent of their purchasing power in 10 years?

P.J. DiNuzzo: Yeah, Jim. When we take a look at adjusted for inflation and withdrawals, I often refer to that as losing money safely or losing money slowly. You can think it’s a conservative portfolio, but again, at the end of the day, inflation is a silent cancer just eating away at the purchasing value of your portfolio that you have to consider when you’re building a portfolio for the rest of your life.

Jim Lange: OK, and speaking of building a portfolio for the rest of your life, can you tell our listeners what value stocks are and what growth stocks are and what is the difference and whether they should have one, the other or both?

8. Long-Term Value Stocks Have Outperformed the S&P 500 for 86 Years

P.J. DiNuzzo: Yeah, Jim. As the title of the show for listeners just tuning in, you had titled tonight “The Evolution of Indexing,” starting off with that big broad comment I made, stocks versus bonds, then the next layer in the evolution was value stocks versus growth, value doing better than growth. Because a lot of people are familiar with the S&P 500, or they’ve heard of it at least, if they think of those 500 stocks, just to oversimplify, you can consider 250 of those stocks being value and 250 being growth. The ones that have higher growth multiples, if they have price earnings maybe of 20 or 25 times, those would be considered growth stocks, the ones that lower PEs on the value side. And what’s happened consistently over time, let’s use the last 86 years plus, value stocks, both large value versus large growth and small value versus, small growth have outperformed. And again, Warren Buffett didn’t need any wind in his sails, but the fact that he was always picking out of that value bucket, which has done materially better than even the S&P 500 over the last 86 years, definitely helped assist him to some degree.

Jim Lange: OK. So, two quick points: One, when you’re talking about price to earnings ratio, what I think that you are saying is, let’s say a growth stock would sell for a lot of money relative to how much it’s making. So, let’s say, for example, Amazon, that doesn’t make any money, is selling for a lot, where maybe an electric company that makes maybe a fair amount of money, doesn’t sell for all that much relative to how much it’s making, and that would be a value stock. Is that correct?

P.J. DiNuzzo: Yeah. A utility-type company that does not have very good prospects for growth into the future would have a lower price-earning expectation. So the stock market is value companies for the last hundred years at approximately 15 times their earnings. So if the audience wants to think of a company that … let’s just make the math simple. They’re earning $1 million per year. The stock market for price discovery has valued that company at 15 times. So, they said, on average, that company is worth $15 million. And again, as you said, the growth stocks, Jim, that are priced up and are bid up higher, they would be at 20 or 25 or 30 times earnings much higher multiple.

Jim Lange: So, kind of what you’re saying is, is that the tortoise might beat the hare …

P.J. DiNuzzo: That’s a very good analogy.

Jim Lange: … in terms of long-term growth potential?

P.J. DiNuzzo: Yeah, long-term. Very accurate.

Jim Lange: All right. So, long-term value beats growth.

P.J. DiNuzzo: Yes, that has been our experience.

Jim Lange: All right. Now, what about big companies and small companies, and how big and how small? Are we talking mom and pop grocery stores, or are we talking a billion dollars when we talk about small companies? And how big are the big companies?

9. U.S. Small Stocks Have More Risk and Therefore More Rewards

P.J. DiNuzzo: Yeah. Looking at large companies, or large cap versus small, the next phase in the evolution was the identification that small stocks, which just inherently bear more risk, they’re more volatile, they bounce up and down more — of course, it’s a lot easier for them to go out of business — versus large caps. And since you’ve got that growth factor along with the risk, what we’ve seen, again, over the last 86-year database, is U.S. small stocks outperforming U.S. large, as, for example, the S&P 500 plan, on average, about 2 percent per year over their entire history. So, the market has rewarded small stock investors. And again, we’re talking about multihundred-billion dollar caps, et cetera, versus companies worth a couple of hundred million dollars. So huge differences. Most investors, if they looked at an index of microcap stocks or small cap stocks, would not recognize most of those names, whereas again, if you look at the S&P 500, most individuals would recognize the super majority of those names.

Jim Lange: Now, when I have clients in, I get questions like, “How can Dimensional Fund Advisors” — which is a set of index funds — “even after paying us a fee, how can we outperform Vanguard, that has very, very low expenses and they’re also an index fund? Is the fact that Dimensional Fund Advisors favors value over growth, and favors small over large, one of the contributing factors to why, even after fees, they outperform Vanguard?”

P.J. DiNuzzo: Well, that would be at the beginning of the pathway, Jim, that is an initial reason. I would say, at the risk of boring the audience to tears, that DFA just is able to … they have been able to, historically, for decades, maintain a pure exposure to the underlying security. So, for example, there’s something referred to as reconstitution risk and drift. Whenever mutual funds reconstitute, DFA’s actually, if you want to consider it reconstituting their average stock mutual fund on a daily basis, whereas other entities only reset that once a year, once a quarter, once per month, and you’ll get a lot more drift in there. So, if we do believe, as there has been, small stocks have done better than large by 2 percent a year for the last 86 years, the higher we can maintain our exposure … in plain English, the higher percentage of small stocks that are in that mutual fund, the better off we’re going to do over time.

Jim Lange: OK. And by the way, I will also mention that most of the difference in that 2 percent has actually come from 1975 until today. So, it’s not like way back when, small caps were better and now they’re not. It’s actually the opposite, which is, say, in the last 40 years, small caps have so significantly outperformed large caps. The other thing that is a relatively new thing to talk about, and I know that this is a very big thing with Dimensional Fund Advisors, and is maybe another reason why they are outperforming Vanguard, is momentum. Can you tell our listeners a little bit about momentum?

10. DFA Uses Momentum of a Stock in Its Buy and Sell Decisions

P.J. DiNuzzo: Momentum is what DFA incorporates into their buy and sell decisions when stocks are entering an index or exiting an index. So, a lot of the national indexes are following what I’d refer to as an off-the-shelf model: S&P, MSCI, Russell, et cetera, whereas DFA is following the Fama-French indexes. Professor Fama, who’s been on the board or in the investment community with DFA for four decades, won the Nobel Prize in 2013. He and Ken French, a fellow professor at the University of Chicago, a couple of decades, came up with the Fama-French indexes, and again, a lot more specific, exacting than the traditional off-the-shelf indexes, which has allowed DFA to … by being more exacting, having a purer exposure, allowed them to do better over time.

Jim Lange: All right, and the momentum is, does that mean that …?

P.J. DiNuzzo: Incorporate into the buy and sell decisions. So, for example, if you have some standard indexes; when Microsoft, decades ago, was a small stock in DFA’s small stock index, they have to sell, at the moment, that it doesn’t meet the rule set. DFA may allow a stock to stay in that portfolio for another three or four or five days, or six or seven trading days doesn’t seem like a lot, but there is a premium for momentum. So, there is momentum in the market. It’s sort of like the laws of nature. Stocks of a certain size rising at a certain rate of speed and stocks of a certain size, be it large or small, descending at a certain rate of speed will continue to stay in motion for a certain period of time. Again, DFA’s got algorithms for all these types of things, but they incorporate this. And again, around the fringes, you know, 5 basis points here, 7 basis points there, before you know, it starts adding up to real money.

Jim Lange: OK. So, basically, you’ve mentioned three areas of why Dimensional funds could outperform Vanguard. One is a greater emphasis on value versus growth, and even their value, having a lower price-earnings ratio, the other one being more of an emphasis of small versus large companies. Again, their smalls are even smaller than Vanguard’s …

P.J. DiNuzzo: Incorporating the momentum, yeah.

Jim Lange: All right, and the momentum.

P.J. DiNuzzo: Yeah.

Jim Lange: I want to switch to the concept of direct profitability. Can you tell our listeners what you mean when you say direct profitability and how it might have an impact on their portfolios?

P.J. DiNuzzo: Yeah, Jim, and I think that’s a great topic that you included in tonight’s show because we’ve talked about the equity premium stocks versus bonds for the last 86-plus years. We’ve talked about the value premium doing better than growth for an extended period of time, as well. Small doing better than large, and there really hasn’t been an academic breakthrough in the last two decades. It’s been a little bit over 20 years, since the early 1990s, and the value discussions that came through from the University of Chicago.

11. ‘Direct Profitability’ Premium Based on Company’s Continued High Earnings

Now, we’re looking at, potentially, another identifiable premium in the market referred to as direct profitability, and without getting too technical, the academic community has identified a manner in which to stabilize and analyze different companies versus each other. And it’s not really a momentum, but the momentum of a fact that companies that have a high degree of profitability tend to maintain a high degree of profitability for a number of years. Companies that are less than optimal regarding profitability tend to remain below average. So, to get back to what we were talking before the break on the market pricing companies on their earnings, the direct profitability has been included in DFA’s portfolios now for the last couple of years. I just need to remind the listeners that the premiums, in plain English, don’t add on top of each other. There’s a diminishing value as you add premiums to the portfolio. So, the stock premiums, stock versus bonds, you can get a material bump over time, again, with value and small cap. So it starts to diminish, but nonetheless, what we tell folks is anything can change anytime, but with the University of Chicago Graduate Business School sort of tied in as close as possible with Dimensional Fund Advisors in their research and development department, I don’t know if something were to change how we wouldn’t be, with our relationship, the first people to know as far as what to access and how to access it.

Jim Lange: OK. Would you say that that is another reason for Dimensional Fund Advisor’s superior performance?

P.J. DiNuzzo: Well, going forward, that’s what the projections are. That has been the case for approximately, as the data that you mentioned earlier, Jim, the last approximate 40 years, and that’s what the expectations are moving forward as well.

Jim Lange: OK. And the other thing that we have discussed in the past, and maybe you could tell our listeners about beta, and specifically, smart beta.

P.J. DiNuzzo: Yeah, I think it was important to include that for tonight’s show. There’s been a proliferation of … just certain words catch fire and they become part of the lexicon, especially the investment lexicon. Smart beta’s just a way of sort of oversimplifying what DFA’s done for over four decades regarding … you could refer to that as accessing, again, the value premium in the market, the small-cap premium, now direct profitability. So there’s really nothing new to spin incorporated developed in the market, just different ways of phrasing it, but the listeners will see a lot of ETFs especially, that are touting smart beta or fundamental approaches or active quantitative approaches. And what you need to be careful from, if the audience wants to think whenever people start tinkering with free-market theory, with market efficiency, is that if you take a look at it and say … you would think, from common sense, that someone would be able to look at the S&P 500 and identify five stocks. Let’s say, on January the 1st of this year, you identify five stocks that absolutely are going to do below average. Just common sense would indicate that you could find five companies out of 500 whose prospects look very dismal for the following 12 months. Conversely, you would think you could find five companies that would be superior over the next 12 months, that they would outperform. They’re going to grow really well, et cetera. If you could just identify five that are going to outperform or five that are going to underperform, if you knew the five that were going to underperform, just don’t buy them. You’d own 495 stocks and you would outperform the S&P 500. If you could identify five to do better, you’d leverage up on them by more and outperform the S&P 500. It’s just that hard to do.
But I just caution, it’s just a point to caution the audience that there’s a lot of sort of smoke and mirrors when it comes to some of the fancier titles, smart beta, a lot of ETFs that were tracking indexes are leaning more towards active money management, and again, the audience has heard us say this before, but if someone is a do-it-yourselfer, if they’re self-directed, if you’re going to manage your own portfolio, not a surprise here, again, but Vanguard, in our professional opinion, would be, by far and away, in fact, in my opinion, the only absolute source for someone to use for ETFs in their portfolio and, of course, index ETFs in the entire portfolio.

David Bear: P.J., could you just explain for listeners what ETF stands for?

12. With ETFs, Be Sure You Have Ownership of the Actual Underlying Stock

P.J. DiNuzzo: Yeah, electronically traded funds. The reason why Vanguard is the only, or one of the few firms out of thousands that are available that would meet our criteria is that Vanguard, for example, in their ETFs, if you purchase an ETF through Vanguard, you have a representative ownership of actually that underlying stock. You own a micro fraction of Google or Microsoft or Apple, Johnson & Johnson, et cetera. With a lot of other ETFs, again, in our professional opinion, you have to be careful that you own a right to those securities, and for some of the listeners who lived through 2008 and 2009 and what happened in the market, you may remember that a lot of people who were on the other end of the trade and they had a right to produce something for you, did not produce what they were supposed to. Not even legally, in a lot of cases.

Jim Lange: P.J., we have only about six minutes left, and we’re only about halfway done with the things that we were going to talk about …

David Bear: Speak quickly.

Jim Lange: So, no, rather than trying to squeeze in six things, I thought I would tell you the things that we had planned to talk about, have you pick, let’s say, one, or maybe two, but let’s start with one of the most important, and then talk about that. And let me give you a choice of what is market cap, non-cap weighted, how important is cost, fixed income indexing, how active managers perform versus passive benchmarks and is there a correlation between lower expenses and higher returns?

P.J. DiNuzzo: Well, yeah, Jim. You’ve got enough material there for another show.

Jim Lange: Well, yeah, we do.

David Bear: Stay tuned for the second hour!

Jim Lange: How about if you just pick one of those?

13. Market Is Very Efficient, so Keep Fees and Expenses as Low as Possible

P.J. DiNuzzo: Yeah. The most important, I think, Jim, by far and away, the most important I think that strikes me of what you had just mentioned is the importance of cost for an individual managing their portfolio. The average mutual fund operating-expense ratio, as of the end of last year, is approximately 1.3 percent. So, the average stock mutual fund that the average person owns in their portfolio, be it a 401(k), 403(b), individually, et cetera, is around 1.3 percent. Now, albeit, there’s more money in lower expenses, but again, that’s just the average across the board. The average, for example, in a portfolio of all DFA indexes that we manage is around 0.3 percent, a little bit over 0.3 percent, maybe 0.3 percent to 0.35 percent, in that range. So that is really one thing that’s made Jack Bogle at Vanguard and David Booth and Rex Sinquefield at Dimensional Fund Advisors, DFA, very successful, that it’s just a simple math … you know, I quote Ben Franklin, “A penny saved is a penny earned.” One percent less in fees and expenses for Mr. and Mrs. Jones is 1 percent higher total return. So, again, it’s often overlooked, but having low fees, low expenses, and Professor Fama, again, had done a famous research that you can’t predict from expenses anyone outperforming the market, but the top or bottom quarter, as you may want to refer to it, so the mutual stock manager are in the highest quarter of highest expenses consistently end up in the bottom 25 percent in returns. So it’s a huge drag on performance. The market is very, very efficient, and the audience listeners need to keep all their fees and expenses as low as possible.

Jim Lange: All right. Now, to be fair, if the audience uses the combination of our services, there’s 1 percent charge on top of that, let’s say, 0.3 percent. So, let’s say the total might be 1.3 percent or a little less, but for that, they are getting all the asset allocation, all the bucket analysis that you’re doing, the tax planning, the Roth IRA conversion, the Social Security maximization, et cetera.

P.J. DiNuzzo: Yeah, the day-to-day handholding, I mean, I tell individuals we are all-in with our fee and the DFA index expenses, approximately the same overall fee as the average mutual fund if someone does it themselves. And for what we bring to the table, and again, I would maintain I have a number of coaches in my life who help me and coach me with business items, that you’ll do better with a coach. Again, not everyone’s comfortable with that, but I would maintain that on average, you’ll do better with a coach, and what we have been able to do for 26 years, and you’ve been at it even longer than I have, Jim, is what we would refer to in business as add value. We have tons of clients who come on board with us. We have a 99 percent retention rate, and they are satisfied that we are more than paying for ourselves over the course of year-in, year-out services.

Jim Lange: And finally, in less than a minute, can you mention the objective measurement of having the value of an advisor? Because I believe there was a study that talked about the value of an advisor.

P.J. DiNuzzo: Yeah, they were actually quite high. And I don’t very often get embarrassed, but the numbers were really high. They were by very reputable organizations. Vanguard, who’s done major research, they’ve referred to it as advisor alpha. Morningstar, another immensely reputable financial organization, referred to it as advisor gamma. You know, fancy names, but basically, taking a look at all of the things that you mentioned, Jim, withdrawal hierarchy, Roth IRA conversions, Social Security maximization, correct asset-allocation decisions, behavioral coaching, aka handholding, keeping clients in their seats when the average investors getting on …

Jim Lange: You’re going to have to wrap up.

P.J. DiNuzzo: Yeah, a lot of items throughout the year.

END