time, energy, and money deciding what types ofstocks you want to buy, and then buying those index funds that cor-respond to the types of stocks you have chosen, thereby saving timeand money. Don’t try to reach for that brass ring because you won'tget it. Convert to passive management and your problems will be over.
Beware: this is the take-no-prisoners philosophy at this firm, whoseboard includes some the best known academics in the investment field,not to mention a Nobel Prize winner or two. If you believe in activemanagement, and that a good manager can beat the market, prepareto be just a little shaken: Sinquefield is very convincing. Judge foryourself.PETER J. TANOUS
Tanous:Let’s start from the beginning. When did you first get inter-ested in stocks? Was it as a kid? There’s usually an anecdote or twoassociated with people in our business who have been as successfulas you are.
Sinquefield: When I was studying to be a priest in the DiocesanSeminary at Cardinal Glennon College in St. Louis, I owned $200worth of one stock. I would check it periodically in the newspaper.Now here I was studying to be a priest, so why should I even be inter-ested in this? After three years, I left the Seminary. At that time Iowned two stocks. |] just got interested in the process, but I fell onwayward times. You see, I was dabbling with active managementwhen I was a college student. So, there is no question that in termsof financial experience, I’ve had a sinful past.
Tanous:Okay, Rex. As they say in the ring: “Let’s get ready torumble!” It’s time to get into the active versus passive managementcontroversy. I'd like you to start by defining active investing andpassive investing.
Sinquefield: It was originally just a question of, can you beat themarket or can’t you? Back in 1973 when the world was simple, thefirst index funds were started, one at American National in Chicagoand one at Wells Fargo in San Francisco. These funds were designedto emulate the performance of the market. I was fortunate enough tobe heading up the one at American National. Back then, you coulduse the word “passive” or “S&P 500” as perfect synonyms.
When our firm, Dimensional Fund Advisors, began in 1981, westarted creating a variety of passive or structured portfolios, to goafter a lot of different asset classes. [The reason for having differentasset classes is that different types of stocks, e.g. value and growth,or big and small, behave differently as a class.] None of these are pureindex funds. You can’t buy every stock in an index and perfectlyemulate the index. In fact, if you tried that, you’d get killed - becauseof trading costs and other restrictions.
We get back to the question, what is the difference between activeand passive management? Passive investing generally refers to theidea that you are going to get market rates of return from whatevercategory you're investing in. [If you are invested in stocks, you willdo no better or worse than the market over time. If you limit yourselfto, say, small-cap stocks, then your return, over time, will be no betteror worse than the returns on the aggregate of small stocks.] We believe
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that you're not going to be able to do much better than that becausethe market doesn’t misvalue securities. The prices are right. If youbelieve in active management, you’re saying that there are peoplewho can make valuation judgments that are superior to the market.
Tanous:We’ve set the stage for where you’re coming from. Let’sgrant that markets are efficient - the hypothesis we are discussing.Isn’t it reasonable to assume that some analysts are better at predictingfactors that may not be in a given stock price at a given time? Forexample, the fact that this particular company may grow faster thanmost people think, the fact that the public may develop an appetitefor a product, demand which is not widely anticipated. It could beBarbie Dolls, Hula Hoops, or Pentium chips?
Sinquefield: Your question is, basically, are there some people whocan systematically see the future? That’s what it comes down to. Theproblem here is understanding how the market mechanism works.The central point is that no one person has very much information.In fact, regardless of how smart they are, or how informed they are,they have a tiny fraction of the information that is available to theentire market at any point in time. The markets are completely inter-related. Do you think it is credible that there is one person who sys-tematically has more information than a dispersed market of six billionpeople? That’s not remotely credible. But that’s the condition thatsomebody has to prove. That there is such a person who has all thisinformation - and the information changes second by second - whois so good that he or she is going to come to better conclusions thanthe worldwide market that is setting hundreds of millions of pricesevery moment? That’s not plausible.
Tanous:Let’s put this in practical terms by talking about someoneyou know, a very successful active manager, Richard Driehaus[page53].
Sinquefield: Yes, I know him. Before Richard Driehaus was on theDePaul endowment committee, the committee had raised the subjectof hiring an active manager. That didn’t happen in my tenure aschairman, although it’s happened since then. At one point during mytenure, Richard Driehaus’ name came up. I expressed my reservationsand nothing happened. Then someone mentioned that Richard wasthinking about giving a substantial sum of money to the University.It turned out he was going to give an amount equal to about half ofwhat we were considering having him manage. So | said, not only is
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it an excellent idea to hire him, but I think that sets the appropriatestandard for hiring any active manager. I have reminded them of thatconsistently, and I think all universities should follow that model.
Tanous:No doubt that Richard Driehaus is the quintessential ex-ample of the active manager.
Sinquefield: Driehaus is an unusual example because he has anexceptionally good track record. He is what we call an “outlier” asfar as active managers go.
Tanous:Rex, please explain “outlier” for some of our readers.
Sinquefield: This is someone on the far right tail of a normal dis-tribution curve. [The classic bell curve, figure 1. Those on the far righttail have above average returns. Those on the left tail are also outliers,but their returns are below average.] Richard has an incredible recordbut he also has, as he will acknowledge, an extremely high variance[a measure of volatility or risk] strategy. I've not seen a strategy withas much variability as his. Nor with as high a return as his. It is notfor the faint-hearted.
Normal Distribution Curve
 
Keen* ~~,i Pm,:3 ;} ' *%:; \Ouiliers t Mh ‘Outiors: ‘ /, :4 ate : Na—~ i 4Lott Trit Rolums Flight TailFigure 1
Tanous:But my point is that there is a method to his success.Richard primarily seeks what he calls “positive earnings surprises.”
Sinquefield: I know. I’ve heard his presentation.
Tanous:Perhaps his methodology works. Here’s one of his examples.The Street is expecting XYZ company to earn $0.24 per share thisquarter. The Street is wrong; the analysts are wrong; the companycomes in with $0.38. All of a sudden the estimates start getting revised
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and now this stock is on a tear. They’re doing a heck of a lot betterthan everybody had thought they were going to do. Now this is whatDriehaus looks for, and this is how he makes his money. How doesthis differ from what you’re saying?
Sinquefield: Clearly, if someone comes up ahead of time with anexpectation that is much higher than what is expected in currentprices, and their expectation turns out to be right, then, in that partic-ular case, the stock price will shoot up and they’re going to look likea genius. There’s no way we can explain those particular anecdotes,or gainsay them in any way, with any of the models or concepts ofefficient markets. In fact, it’s good to think about the differencebetween social sciences, like economics, and physical sciences in thenature of what they are able to predict. Physical science can makepredictions about things in the physical world in great detail. Oncethey have figured something out, that prediction is always going tobe true down to the nth degree.
Tanous: They behave systematically.
Sinquefield: In physical science, they’ve got to behave the sameway all the time. It is as if they are subject to whatever new rule wasdiscovered; there is no deviation from it. That’s why predictions inthe physical sciences can be precise and detailed. In the social sciences,like economics, predictions are going to be very general. They’re goingto be more pattern-type predictions. They will not be able to predictdetail at all. The good social scientist or economist would never at-tempt to do so. Why? Because social science involves people who canchange their beliefs and their objectives at any time. What is importantone day may cease to be important the next.
So, when someone says, how can you explain this event or thatevent, the point is that the social sciences, including economic science,wouldn’t even pretend to be able to explain a specific event by theirmodels. It could be the case that Richard [Driehaus], or any otheractive manager, made a superior forecast and ex post facto the marketwas wrong. It could also be the case that it was just plain luck. Thereis no way to know for sure.
Tanous:Let’s talk about lucky people then. How do you explain thecoterie of managers who appear to consistently beat the market overtime? And I don’t mean the guy who has one or two lucky years.
Sinquefield: The answer to that is contained in your question. Theguy that had one or two lucky years isn’t the one we look at any
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mote. We only look after the fact at those who ended up having avery good long-term record. We pull these people out from the righttail of the distribution. These are the most successful managers. Howdo you explain them? | could counter by saying how do you explainthe three people at the left side of the tail, but we don’t know whothey are. They dropped out of the game. Table stakes were taken awayfrom them a long time ago. In fact, there are probably many more ofthem than there are at the right end of the tail. So we have this hugeproblem of ex post facto selection bias when we look at these verysuccessful people. We know 20 years from now, 30 years from now,there will be three or four or five other people. But we don’t knowwho they are now. It would really be helpful if we could tell in ad-vance. There have been loads of scientific studies looking for evidencethat one can tell successful managers based on prior records. Thesestudies do not meet with success. There is just no reliable evidencethat there is persistence in professional manager performance.
Tanous:! believe you have made the point in your writings that theburden of proof is on the active managers. Active managers mustprove their ability to predict future price movements in a systematicway. Are you saying this has not happened?
Sinquefield: It hasn’t happened. Let’s think about what wouldhappen if someone was able to give a convincing proof that activemanagement works across a broad sweep of managers. If so, whatthey’re proving is that the raison d’étre for the capitalist system iswrong. Market prices are wrong. But the study of market efficiencywon't allow you to take a specific manager and prove whether or nothe beat the market by skill or by luck. That’s getting down to a levelof forecast that is too precise and too detailed. All we can do is exam-ine the vast array of managers and see if in aggregate, their perform-ance conforms to a model that says, yes, it seems that market pricesbehave with uncanny accuracy.
Tanous:What does that mean, “Market prices behave with uncannyaccuracy?”
Sinquefield: The best assumption is that market prices are alwaysright. Yes, they fluctuate, but that’s because there’s constant newscoming to the market.
Tanous:This is important. You’re saying that the changes in marketprices are nothing but a reflection of changes in circumstances?
Sinquefield: Right. Every moment in time. The information that
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comes and affects a given company need not even come from thecompany. Let’s take an American drug company. We can see the pricefluctuating and not understand what is going on. But perhaps therewas a development made by a drug company in Europe that is goingto have devastating consequences for the American drug company.Asa result, people over there are taking action on the price. You don’tknow where the information is going to come from. But the marketwill impound it quickly as long as somebody acts on it.
Tanous:Let’s get into that. Let’s talk about some of the studies thatback up your thesis. Let’s start with market efficiency.
Sinquefield: Start with the two big experiments of the twentiethcentury. You have the consistent success of what we today call capit-alism, and capitalist societies survived. But without exception, wewitnessed the failure and collapse of systems, like communism, thatare organized around the idea that you don’t need free market prices.That’s one very general and repeated experiment in mankind’s history.Idon’t know how many civilizations there have been, several hundredor several thousand, but it’s that many versus zero. It all goes oneway.
Then we have all the work in the academic world for the last fortyyears. Nobody has been able to find that traditional managers havebeen able to out-guess markets by anything more than you get bychance. If all of these funds had been run by orangutans, we wouldget the same distribution of returns.
Tanous: You mean we'd still get a Warren Buffett and a Peter Lynch?
Sinquefield: You'd get Warren Buffett; you’d get Peter Lynch. Andthey’d probably work for less. In fact, they’d probably work for pea-nuts! All of this research suggests that you just can’t find any evidencethat active managers do well.
From a practical point of view, investors are probably better off ifthey just assume that markets are efficient. It will save them the dis-traction of wondering whether this fund manager is better than thatone. There’s huge risk in buying an active portfolio. The average in-vestor is not able to assess all of the risks of an active manager.Suppose this active manager suddenly starts holding a concentratedportfolio and it falls 60%. Well, I hope no one has a serious amountof money in that portfolio! That kind of risk isn’t going to happen toa marketwide portfolio. It’s always possible that the entire marketwill fall 60%, but that’s a much different event than an individual
237PETER J. TANOUS
portfolio falling 60% because the managers have concentrated posi-tions. Investors can have a much simpler life if they say, okay, I’mjust going to assume that markets work. Now I’m going to think interms of asset-class portfolios or index funds. What I really want tothink about is how much risk I want to take. [An investor who wantedto take market risk could just buy an index fund that emulated themarket. An investor who wanted to take less risk than the marketmight put a portion of his assets in the market index fund, and therest in a fund that emulated short-term interest rates, for example,since that is less risky than the stock market.]
Tanous:How do I configure my portfolio using asset classes?
Sinquefield: Current research looks at three dimensions. How muchdo I want to have exposed to equities? Within equities, how much doI want to have exposed to companies that are really struggling, ie.,value stocks? How much to small stocks? The person who wantsequities that will earn more than market returns over time, and recog-nizes that it entails above market risk, has only two avenues to pursue,based on current research, value and size attributes. [That’s becauseresearch shows that value stocks have higher returns than growthstocks and small stocks have higher returns than large stocks. Butboth value stocks and small stocks are riskier than the market as awhole.] And, you can go domestically and internationally with both.There are lots of index funds available to do this. Those are the dimen-sions from which investors must choose.
If an investor decides to think in these terms and makes choicesusing asset class portfolios, life suddenly gets real simple. He doesn’thave to burn the midnight oil figuring out what stocks to buy or whatfund to buy. He doesn’t have to buy all of those reports that list mu-tual funds; he doesn’t have to read publications or listen to programsthat are void of substantial content. I like to refer to this as “invest-ment pornography.”
Tanous:Let’s move to another discussion, which I know is dear toyour heart; that is, the style question. Let’s say that the world nowagrees that the efficient market theory is correct, that over time it’spretty hard to beat the market consistently. If there are people outthere who predict the future, we’re not sure who they are or whetherthey’re just lucky or not. That’s the thesis. Now, once we decide toinvest in the market, we still have some choices to make. Asset classesare the choices. Let’s start there and move on to growth versus value.
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Sinquefield: Okay. It’s one thing to say that markets are generallyefficient. We have to add a second thing which is that, in any well-functioning market, the only thing investors get compensated for istaking risk. If people need to lay off some risk, they are going to haveto compensate the people who will take that risk. It turns out thatresearch over the last ten or fifteen years has really enriched our un-derstanding of the types of risk that are in the market and that arepriced accordingly.
There are lots of risks in the marketplace, but if the market doesn’treward them, then the investors will stay away. People can take allsorts of foolish risk, but the market won't reward them for doing that.What seems to emerge, in the equity markets at least, are three typesof risk. There’s overall market risk. Then there’s value-type risk, whichis a poor choice of words but we’re stuck with it. This refers to therisk in companies whose current and future earnings are not goingto be very good. The market seems to correctly assess who thosecompanies are. That risk factor is at one end of the spectrum. At theother end, are the growth companies, those companies that are havingfabulous earnings and will continue to do so. So we have thisvalue/growth dimension.
Another dimension is the big/small dimension. Small companiesseem to be similar to value companies in that, on average, they’regoing to have future earnings problems. That’s a source of risk. Themarket doesn’t like that. So, small stocks and value stocks seem tobe associated with higher rates of return. But it’s really a cost ofcapital question. The value companies are struggling, and becausethey have this type of risk, they have to pay more for equity capital.The high cost of capital for the firm means a high rate of return forthe investor. Investors should not look on that as a free lunch. Theyare simply getting compensated for risk that they are bearing.
So getting back to your question, the choice is that, if lam goingto buy equities, I still have to make decisions as to which classes ofequities I want. Then I have to say, do I really want to take a lot moretisk than is contained in the market in general to go after abovemarket returns, or would I be happy with just marketwide risk? Aswe know, marketwide risk has provided returns on the order of 10%per year since 1926. There are now studies that go back much farther.
Tanous:In fact, Jeremy Siegel, in his very well received book: StocksFor The Long Term, goes back much farther.
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Sinquefield: There were also two professors, Wilson and Jones, atNorth Carolina State University, who some years ago came out witha paper on studies of rates of returns from about 1870 to 1925. Theirsubtitle could have been “The World Before Ibbotson and Sinquefield.”What surprised me was their finding that the average inflation-adjus-ted return and the distribution of real returns on stocks was virtuallyidentical to what Roger [Ibbotson] and I had found through the sev-enties. This was remarkable. It would suggest that now that we haveover 100 years of data, the market says it wants about a six to sevenpercent premium over inflation for marketwide risk. So investors canthink in those terms. I can buy a CD or a Money Market Fund. Or, ifIam willing to take marketwide equity risk, I get another six or sevenhundred basis points per year on average with acceptable risk.
Conversely, an investor could say, you know what? I want thehigher returns of equities, but I want to be much safer. Then that in-vestor can choose the growth stocks; stocks with high earnings. Thosestocks will have lower returns, on average, because the companieshave low cost of capital. They don’t have to pay a lot to raise equitymoney or to borrow money. This is very counterintuitive. It goesagainst everything we were raised on in the markets. This is the es-sence of the three factor story which I'll explain later. What Fama[page 167] and French were able to show very well was, that whenit comes to companies with high earnings growth, the market knowswho they are. Companies that are shooting the lights out in terms ofearnings do not have high costs of capital. They are not risky. So,why should they provide unusual rates of return? If they’re going toprovide a 25% per year return on equity, that’s not the same as sayingtheir cost of capital is 25%. They’re the safest companies around. It’sthe companies that are struggling, hanging on for dear life, that shouldhave to pay 25% for their equity capital. That’s the essence of thestory.
Tanous: Yeah. But, the other side to that - the side we were allbrought up on - is that the safe thing to do is to buy a value stockbecause it’s on its back and it’s going nowhere. It’s selling at a dis-count to its book value, and the downside risk is real low because it’salready flat on its back.
Sinquefield: Right. That was part of the story. But you left out apart. If it’s flat on its back, it’s in the intensive care unit. You forgot
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to mention that, for a lot of people in the intensive care unit, the nextstop is the cemetery.
Tanous:Okay. Let’s talk about value. The concept that’s goingaround is the value stock thesis based on book value, Warren Buffett’sapproach. Now you wonder whether or not, in the new economy weare experiencing, this approach still has merit. The real value of manycorporations in the technological age is not in hard assets. We’re nottalking steel plants or automobile manufacturers any more. We’retalking about technological developments and software, the Microsoftsand the Sun Microsystems. Doesn't this change the way we valuecompanies in terms of their assets or the nature of their assets?
Sinquefield: Some things might change but that’s no reason tothink that the three-factor model will. Even in an industry that doesn’thave a lot of plant and equipment, you're still going to have a rankingof, say, book-to-market ratios. The companies with the lowest pricesrelative to their book values are probably those in trouble. And thosewith the highest prices relative to their book values are those that arehaving great earnings success and are going to continue to do so.Typically, we don’t find a wide dispersion within an industry becausecompanies in the same industry, to some extent tend to thrive orstruggle together. The time periods covered by many of these studiesalso witnessed changes of many types. Accounting variables are alsosubject to changes which pose problems.
Tanous:The point here is not so much that we will still rely on highbook-to-market ratios alone. The question is, how do you value theassets today in the new technological age? Aren’t you convinced thatthe economy has changed enough so that the way we value assetsought to change? That is, the basis for book value.
Sinquefield: I don’t know because I’m not an accounting expert.Book-to-market is not the essence. That’s simply a measure that helpsus spot prospective success or failure. Other, better, measures mayemerge. The driving force is really the fluctuation in the price. Allthe news being equal, a falling price is a market statement that thiscompany is in trouble and, if they want to raise money, either equityor debt money, they’re going to have to pay a lot for it. That’s thesame as saying that you investors, you have a high expected returnif you buy this company, and there’s a reason you have a high expec-ted return. It’s because you’re taking a lot of risk.
Tanous:Let’s get down to the investor. You obviously have a value
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bias. This might be a good time to examine the value versus growthconundrum.
Sinquefield: Sure. Let’s rank companies in terms of size, breakingthem arbitrarily into large and small. First, we rank the New YorkStock Exchange companies in terms of market capitalization [that’sthe stock price times the number of shares], from large to small.Companies larger than the median size NYSE company we considerlarge; the rest are small. American Stock Exchange and NASDAQcompanies are then assigned to these two size groups. We create indexfunds like this, using the different size groups.
Tanous:I presume you do this because the largest 50%, say, behavesdifferently from the smallest 50%.
Sinquefield: Right. The smaller companies have a higher return,on average, and more risk. The next cut is book-to-market. We usethe same ranking, from lowest to highest. Now we have a sort basedon book-to-market, which separates value from growth [the companieswith a low book-to-market value are the growth companies; thosewith a high book-to-market ratio are the value companies]. We alsohave a sort based on size [large companies versus small companies].Now we take the intersection of these. Any company that is both alarge company and a value company will be in the large value strategyand any company that is a small company and a value company, willbe in the small value strategy. Same is true for the growth strategies.Now let’s look at the returns.
When we do these combinations of value and growth, large andsmall, [see figure 2] you can see that value stocks outperformed boththe overall stock market, represented by the S&P 500, and also largegrowth companies, by substantial margins.
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investment Dimensions: Size of Company and Financial Strength
 
Historical Returns
Quarterly DataJanuary 1904—December 1995US LargeCap Stecks U.S, SmslbCap Stocks6aia9630Large S&P Large Sruill CRSP* SmallValo 3 Gromtly Value S10 Growth
Straicgy inden = Suatwgy Straicgy index Stratopy
AnnvalizedCompound 1457 1092 9.97 W7h 13.24 1230
Reaurn Gs)
AnnualizedStandard 1566 1556 17,96 2226 42418 26.60
Deviation
“Center lor reoearoh in Security Prices, Univernity of Chicage, sad Fame & French,Stocks ranked by Size deciles, 10 declise are the lower (smalioc} hat! of companinswaded on MYSE end equivsient sine companier on AMEX snd MASDAD.
 
Standard & Poor's data courtesy: Ibbotson, Roger and Sinquefield, Rex
Stock, Bonds, Bills, and Inflation Historical ReturnsDow Jones Irwin 1989Updates by Ibbotson Associates yearbook
Figure 2
Tanous:This is particularly counterintuitive. The difference in thesereturns is staggering. The annualized compounded rate of return forthe large value strategy is 14.57% per year for 32 years, versus10.92% for the S&P and only 9.97% for large growth. Who wouldhave thought? And interestingly, and I suppose this is just a coincid-
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ence, the standard deviation for the marketwide value strategy is al-most the same as for the large growth strategy.
Sinquefield: That’s a coincidence. But the way you read this is thatthe standard deviations are about the same. The point here is that theadditional return in large value strategy doesn’t come at the cost ofhigher variance [risk]. It doesn’t mean that it doesn’t come at the costof additional risk. It’s just that the risk isn’t in the form of highervariance.
Tanous:!’m afraid you need to explain that.
Sinquefield: It goes back to the old model that the market portfoliois the only source of risk. Portfolios that were more variable relativeto the market were deemed to have higher expected returns; thosethat were less variable were deemed to have lower expected returns.The working assumption is that variability is the only source of risk.When you have a world with multiple risk factors, it need not be thecase that variability is the only source of risk. In fact, it need not bethe case that variability is a risk factor at all.
Tanous:If I follow you, Rex, you’re saying that variability, orvolatility, in a stock is a source of risk, but not the only source ofrisk. Another kind of risk you take when you buy stocks is the sizerisk, because small stocks are riskier than large stocks. You also takestyle risk, because if you buy a value-type stock, you are adding valuerisk to the portfolio. Can you give me an example of assets that havedifferent returns but the same risk, measured in terms of variability,or volatility?
Sinquefield: Sure. Long-term corporate bonds have higher returnsthan long-term treasury bonds both er post and er ante.
Tanous:That’s hardly surprising. Corporate bonds are consideredriskier than U.S. government obligations, so you should get paid morefor them.
Sinquefield: Yeah, but they have the identical standard deviations,and that’s over 70 years. Or pick any sub-period and it’s the same.
Tanous:Is the reason they have the same standard deviation thatthey react to one common external factor - changes in interest rates?The risk is clearly different, since the risk in corporate bonds ishigher than in U.S. government-issued treasuries.
Sinquefield: Right. But that doesn’t show up as additional variance.Yet it’s definitely a risk.
Tanous:Okay. Then, how do I measure these other risks?
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Sinquefield: A simple way to do it is to look at a portfolio’s overallprice-to-book ratio, or book-to-market ratio. In general, stocks thathave high book-to-market ratios are these value-type companies, andgrowth companies are those that have low book-to-market ratios. Theonly industry that seems to be an exception to this are the highlyregulated utilities. They look like they are value stocks, but they reallyaren’t. They have below market rates of return. This is the story inthe large-cap arena. The same kind of story holds in the small-caparena. Small value stocks have much higher rates of return than smallgrowth stocks, and higher returns than the overall small stock uni-verse. And in this size universe, the standard deviations are basicallythe same.
Tanous