What Went Wrong?

You Wrote That?
Last week, I exchanged emails with an investor named Alex Frakt, who mentioned that I had addressed one of his questions in an earlier version of this column, way back at the start of the New Millennium. What question, I asked. Which was the better fund company, Vanguard or DFA, he responded.

Oh, dear. I do recall. This was what I wrote, in May 2000:

"Vanguard, in a landslide. Don't get me wrong; I like and respect DFA. The company has always represented the best aspects of professional financial advice: a portfolio orientation, tax sensitivity, affordable costs, and ethical standards. Consequently, it attracts many of the best financial advisors in the business. Nevertheless, DFA’s position is illogical. Effectively, DFA believes that when allocating among investment styles, one should ignore the market’s judgments, but that when making stock-by-stock decisions, one should strictly obey them. Curious.

"At heart, DFA is by and for engineers. The company collected a ton of data, analyzed it extensively, and came up with an indexing scheme that it views as better and more-sophisticated than "naive" indexers like Vanguard. All this analysis is predicated on the premise that the future will mimic the past and, therefore, that the initial inputs are correct. I dispute the premise and therefore I dispute the results. More to the point, so has the market. In its 18 years of existence, DFA’s small-value tilt has harmed it more than helped. You would have made a lot more money following Vanguard’s cap-weighted approach. Surely that’s gotta account for something, too."

Jaunty, confident, and ... not good.

Although I couldn't have predicted that DFA's small-company and value-stock tilt would thrive from that day forward, thereby propelling the company’s lineup to spectacular gains, I certainly should not have implied otherwise. There was nothing wrong in contrasting DFA’s claims with its then-lackluster results. But I should not have left the analysis at that. Quite the contrary. Early 2000 was the ideal time to mention that, at long last, DFA might be ready to fly.

Also, what's wrong with having a view on an investment style (or, by extension, a geographical region or market sector), and then implementing that view by indexing the individual securities? That, Mr. Rekenthaler, makes no sense at all. Particularly because at that very time, you enthusiastically supported exchange-traded funds--which enabled investors to have a view on an investment style, and then index that style’s individual securities. Talk about illogical!

The three sources of error--

1) Succumbing to the recency effect

That one hurts. I knew very well that the most common investment mistake was assuming that the future would resemble the recent past. After all, I had been in the business for 12 years, had made my share of such assumptions, and had watched many others make the same error. For that reason, I had become quite the contrarian. I also knew that small-company and value stocks were desperately out of favor and were priced for a rebound. But even so, I stepped into the trap. The force is strong with the recency effect. 

2) Letting things become personal

At the time, I found DFA quite annoying. The company presented its research as if it had been written on stone tablets. It did so while strongly implying that it occupied a higher ground than did other financial-services companies. (For example, one of its founders, Rex Sinquefield, contrasted the high quality of DFA’s research with those who published "investment pornography.") Thus, the company’s performance struggles elicited more than a tinge of schadenfreude.

That irritation crept into the text. It should not have.

3) Become overconfident

I had my doubts about DFA’s small/value argument when I first heard it. My concerns were reinforced initially by the company’s brashness, and then by its funds’ performances. It seemed that DFA was not quite what it promised to be--and look who had been correct all along! Believing too heavily in my initial impression led me to overrate my knowledge of the subject, which in turn led to sloppy thinking.

To those three mistakes, I would add two other dangers that did not surface in the Vanguard versus DFA discussion, but which have also caused me problems in the past. 

One is being too trustful. Portfolio managers are rarely directly deceitful, but they also are rarely completely honest about their funds’ risks. It is my job, not theirs, to determine what might go wrong. If I have not yet figured that out, it is not because the danger does not exist. Keep searching. The second trap, related to the first, is falling for whiz-bang strategies. Funds with complex, opaque investment strategies are fun to analyze. But they rarely end up being sound investments. 

Wiser Guy
Lest you think I was (or am) a complete idiot, this autumn 2000 interview with Vanguard’s shareholder newsletter, In The Vanguard, has aged much better. There’s nothing in there that I would wish to take back--and several comments that might even be called astute. 

Wisest Guy
In preparing for this column, I asked Morningstar’s Russ Kinnel about his investment flubs. His response was to send me this article. Now there’s a man who is willing to brave the danger of overconfidence! Then again, even a blind squirrel doesn't usually find such a large nut. That was the best call of the first half of the decade, Russ. If you can be that correct once every five years, that is fine work indeed.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.