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By Ian Salisbury
January 14, 2014
Time & Life Pictures/Getty Images

David Booth built Dimensional Fund Advisors on the idea that investors can’t beat the market. The mutual fund company’s assets now run to more than $300 billion. So what’s the secret of Booth’s smashing success? Beating the market.

Long before it was fashionable, Booth, 67, bet his career on “passive” investing — that is, buying and holding a representative slice of equities instead of trying to choose the next winners. As a grad student he was a research assistant to the economist who would later win a Nobel for showing that even smart investors can’t predict stock prices.

In the 1970s, Booth worked on one of the first institutional index funds, which simply held every listed stock on the New York exchange. He co-founded Dimensional in 1981 with a pioneering mutual fund that passively owned stocks of small companies.

So investors in Dimensional are just getting plain-vanilla index funds that track well-known benchmarks like the S&P 500, right? Not exactly. “If you want to hold a market portfolio, that’s fine. We think that’s pretty good,” says Booth, a self-described “aw-shucks” Midwesterner. “But we think you can do better.”

Dimensional’s portfolios look a lot like index funds. They are broadly diversified, have low management fees, and holdings are rarely changed. No manager is trying to guess the direction of the S&P or evaluate Tim Cook’s strategy at Apple .

Dimensional does, however, preach that investors can capture a better long-run return by “tilting” their portfolios to favor certain parts of the market (for example, smaller companies). Performance also differs: The company’s DFA U.S. Core Equity 1 fund earned an annualized 19.6% over the past five years, compared with 18.4% for an index of the total stock market.

It’s tough to buy Dimensional funds: They’re sold only through financial advisers who tend to work with the wealthy, and in 401(k)s and some 529 college savings plans. But you’re sure to be hearing more ideas like Booth’s. And bolder claims too.

The heyday of what you might call the artisanal fund manager — a stock picker who carefully selects, say, 50 or 100 companies — is waning. The success of index funds, now 28% of fund assets and growing, is a big part of that.

Some passive managers, however, are using historical patterns and statistical models to create funds that make broad strategic bets. Besides Dimensional, players now include BlackRock, the world’s largest asset manager. Taking a more radical position is MIT economist Andrew Lo. He’s aiming not only to improve on the academic theory that drives both traditional indexers and Dimensional but also to create a new breed of funds he hopes will be as transformative as the original index funds.

Proponents of these different approaches can marshal intriguing evidence. There’s also reason to be skeptical. Popular tilted strategies have done well in recent years, which can make it harder to see the risks they carry. And marketing, as much as research, is driving the industry’s enthusiasm. “Investors have woken up to the fact that it’s hard to beat the market, and investment managers need a new story to tell,” says Paul Baiocchi, an ETF analyst at the research firm IndexUniverse. “This is the new story.”

It’s also the investing debate that matters now — not the choice between passive and active stock picking, but between passive or passive with a twist. According to IndexUniverse, among exchange-traded funds (ETFs) that invest in stocks, one in three employ one of these new strategies.

Here’s a close look at the arguments behind the “do better” portfolios and lessons you can apply to your own investing, even if you decide to stick with simpler funds.

The Trailblazer: Tweaking the winning formula

Dimensional, which began as a two-man operation based in a Brooklyn apartment, has grown to 800 employees, with its headquarters in an airy, modern-art-filled campus on a hilltop in Austin. Booth’s success allowed him to give $300 million to the graduate business program at the University of Chicago. It’s now called Booth School of Business.

That gift was not for nothing. The University of Chicago gave Booth not just his MBA but a front-row seat for an investing revolution. Booth and Dimensional co-founder Rex Sinquefield were students of Eugene Fama, who had developed a powerful idea called the “efficient-markets hypothesis.”

The basic premise: When new information that could drive a company’s stock price up or down comes out — a new product, say, or an accounting scandal — information hits the street so quickly that it is instantly factored into prices. There is no reliable way for investors to beat the market.

That’s one reason, along with low costs, that index funds consistently beat the average fund manager. As of mid-2013, for example, 72% of U.S. stock funds lagged the S&P Composite 1500, an index of the broad market, over the past five years.

Fama, who is on Dimensional’s board, won the Nobel Memorial Prize in 2013 for the efficient-markets hypothesis. But in the early 1990s he made other findings that were just as important to investors like Booth. Along with economist Ken French, Fama showed that small companies and value stocks — those trading cheaply compared with the assets on their books — tend to earn higher returns than the market.

Dimensional’s funds are vehicles for capturing such effects. The original fund, DFA U.S. MicroCap , is an index-like portfolio of small companies. The newer U.S Core Equity 1, launched in 2005, owns a wider swath of the market but is weighted to smaller and cheaper. It charges annual fees of 0.19%, compared with as little as 0.04% for a plain index, but far less than the average 1.4% for stock funds.

Tilting presents a ticklish problem. If there’s evidence that certain stocks outperform, how can markets also be efficient? Why don’t investors pile into those great stocks, bidding up prices and thereby eliminating the higher returns?

“They are riskier,” explains Booth. Small companies often have untested business models. The value effect is less intuitive; it seems like a cheaper stock should be safer. Yet the discount could mean the market sees something wobbly in the business.

James Montier, of the active fund managers GMO, says you may be disappointed if you get in on tilting now. “They are not priced to work,” he says. “They are quite expensive.” Booth, of course, doesn’t make such calls but cautions that a tweaked approach can leave you out of step with the market at times.

U.S. MicroCap has annualized returns of 12.5% since its 1981 inception, compared with 11.6% for the S&P 500. But the fund lagged for almost a decade before the winds shifted. “People were disillusioned, but they realized that for a long-term strategy, you’ve got to accept that risk and return are related,” says Booth. “We were able to defend it.”

It’s not that Dimensional never changes its thinking. Booth is excited about new research showing that companies with higher profits, relative to the assets on their books, seem to earn better returns. Dimensional is adding that factor to its tilts. “The really good ideas come along about every decade or so,” he says.

The takeaway for you. If you can’t get into a Dimensional fund, there are other ways to tilt. On the Money 50 recommended list, the Vanguard Small Cap Value ETF captures both the value and size effects; it’s earned an annualized 21.1% over five years, vs. 16.9% for the S&P 500.

There’s a lesson, too, even for those who prefer to stick with a broad-market index. Popular S&P 500 index funds tilt away from the small-cap effect because they hold more of the biggest stocks. A better core choice is Vanguard Total Stock Market , which includes small companies.

The Next Boom: They will build it if you come

The fund industry writ large follows what’s hot. And nothing is hotter now than trying to outsmart the market with an index fund.

Look at buzzwords in the world of ETFs, which are nearly all index funds. From “fundamental” to “smart beta” to “dynamic,” they all point to the notion that there’s a more clever way to index.

Fundamental funds have been around since 2005. Their designers say there’s a flaw in standard indexes: The greater a company’s total market value, the bigger place it holds in an index.

So when investors go gaga over Google and drive up its price, an index fund must own more of it. Fundamental funds rank companies by other measures, such as sales and dividends. As a result, they lean, like Dimensional, toward value. But their creators argue that this may be more than compensation for risk. Rather, there’s a chance to take advantage of behavioral biases, underweighting stocks the crowd loves too much.

“If you’re contrarian, in the long run you can do better,” says Jason Hsu of Research Affiliates, which built the index behind the $2.6 billion Power-Shares FTSE RAFI U.S. 1000 ETF .

The competition to create new indexes is getting stiffer. Among the entrants is BlackRock, a $4 trillion money manager that runs 7,000 different investment strategies. You may know the company better for its iShares brand of ETFs. BlackRock has since late 2011 launched 10 iShares funds offering some kind of enhanced index, and investors have poured in nearly $8 billion.

BlackRock’s biggest unit has roots (via acquisitions) in a company that in 1971 created the first indexed account for a pension fund. David Booth worked on that fund. Two of BlackRock’s new ETFs tilt based on the same small and value effects Dimensional goes after. But if Dimensional is akin to elegant, cultish Apple, iShares are like open-source Android. Since ETFs trade like stocks, they are available to anyone with a brokerage account, to combine in any way.

“There’s a place for active and passive strategies,” says Amy Schioldager, 51, BlackRock’s head of beta strategies. (“Beta” is finance-speak for capturing the market’s return.)

BlackRock has found particular success with iShares MSCI USA Minimum Volatility . It’s built on research arguing that staid stocks, such as utilities with hefty dividends, may in the long run match or beat market returns without as much pain along the way. (A hypothetical version of the index the ETF follows would have earned 8.2% annualized over 10 years, vs. 7.2% for the S&P 500.) So-called low-volatility funds have had enormous appeal since the financial crisis.

“This is a great strategy for someone who’s been a heavy bond user,” says Schioldager, who adds that BlackRock launched the strategy at the request of institutional clients. At a time of measly bond yields, investors want other ways to capture income or reduce volatility.

Some market watchers think low-vol stocks may be about to run out of steam. Money has poured into the space — not just via indexers but from active funds too — driving up valuations. “It’s always worrisome when a product becomes the darling of investors,” says Morningstar analyst Samuel Lee.

Will the low-vol investors stick around when performance fades? BlackRock says the company keeps funds open even when strategies go out of style. Schioldager says it isn’t necessarily BlackRock’s job to take sides in philosophical debates about investment strategies. The company aims to create cheap, well-designed tools. (Minimum Volatility charges 0.15%.) “We offer building blocks,” says Schioldager.

The takeaway for you. As indexish strategies proliferate and advisers push the latest, greatest ways to do better, figuring out which theories hold water could be daunting. Getting this precisely right may not matter.

Research Affiliates tabulated results for approaches including value tilt, a version of low volatility, holding stocks in equal proportions, and even monkeys throwing darts at the stock pages. Every one, (simulated) monkeys included, beat the market. Why? Almost any strategy other than ranking stocks by market value, as normal indexes do, tilts to small, value, or both, said RA.

The upshot: Many of these funds may lag together when blue-chip growth stocks lead, and you shouldn’t pay up just because a new index sounds sophisticated. If you buy an ETF with a twist, stick to the cheaper options.

The Bleeding Edge: Get in touch with your inner animal

When economist Andrew Lo, 53, was working on his Ph.D. in the mid-1980s, he had little reason to doubt the theory that stock prices can’t be predicted. Then he started on a paper that he thought would show that the market’s weekly ups and downs were random.

Things didn’t go right. More volatile periods and less volatile periods were strung together.

“We discovered, to our shock and amazement, that the theory failed,” recalls Lo, sitting in his tidy MIT office overlooking the Charles River in Cambridge, Mass. He and collaborator Craig MacKinlay spent a decade confirming and trying to explain their results. The answer involved a bit of economics, a bit of psychology, and a bit of evolutionary biology.

Lo, who has advised the government on how to avoid another financial crisis, calls his competing theory the “adaptive-markets hypothesis.” He says markets are efficient at processing information into prices most of the time. But traders aren’t computers: At certain moments, especially in a crisis, investors respond to physiological cues we developed when threatened in the wild by, say, being eaten or speared.

“We’re a biological species,” Lo says. “We’re subject to the same kinds of dynamics as fish in the ocean and springbok on the plains of the African savanna.”

Like indexers, Lo doesn’t think picking stocks per se is worthwhile. From there, however, he goes off in a totally different direction. He thinks our biological hardwiring causes other aspects of the market, like investors’ appetite for risk, to follow patterns.

While you are accustomed to hearing that you must ride out the market’s gut-wrenching ups and downs, Lo believes this is not only unnecessary but often counterproductive. Just as trying an extreme diet can backfire with late-night junk-food binges, white-knuckling through a crash won’t work if you eventually cry uncle and cash out.

“You’re being unrealistic to assume that people will happily see their retirement assets drop by 30% or 40% without doing anything,” says Lo. “Let’s create a mechanism by which you can react in a safe and orderly manner.” He’s not just talking theory. In addition to his academic work, Lo co-manages mutual funds. His Natixis ASG Tactical US Market , launched in September, uses mathematical models to monitor changes in volatility.

The aim is to predict when investors’ biological imperatives to flee the market are about to kick in. The fund uses futures contracts to shift money in and out of equities exposure, to maximize returns in bull markets and sidestep losses amid panics. Because futures involve borrowed money, stock exposure could range anywhere from zero to 130%.

For investors inclined to indexing, the fund throws up a lot of red flags. It charges a 1.4% expense ratio plus a sales load. The fund doesn’t have a long record or hypothetical index results to evaluate. Big investment decisions hinge on complex formulas.

“It’s got 8,000 knobs and levers,” says adviser Josh Brown, author of the blog The Reformed Broker. While he calls Lo “brilliant,” he’s skeptical of the fund’s staying power. “Getting that complicated works against you,” says Brown.

Lo says his fund can get cheaper if assets grow, and argues that for all their seeming simplicity, index funds were once regarded as odd too. Then they worked. “It’s the natural evolution of financial products,” he says.

The takeaway for you. You can hang back from Lo’s unproven fund and still learn from him. Contrary to what efficient-markets purists say, markets go through bubbles and panics. Similar assets may move together in those times, which argues for lots of diversification.

And recognize that your own hard-wiring means you’ll be pulled to join the fleeing herd when a bear appears. Even if you think you are risk-tolerant, build an asset allocation with enough safer assets to keep you from feeling threatened. You may not know the next turn of the market, but knowing you can survive it helps.