How the Creators of the First Index Fund Influence Financial Innovation Today

On this episode of The Long View, David Booth, the chairman of Dimensional Fund Advisors, discusses pivotal moments in financial history and the pioneers that led them from his new documentary Tune Out the Noise.

Here are a few excerpts from Booth’s conversation with Morningstar’s Christine Benz and Amy Arnott.

How Mac McQuown Helped Make Indexing What It Is Today

Amy Arnott: People who aren’t as steeped in the development of passive investing might not be as familiar with the contributions of Mac McQuown, who passed away late last year. Can you talk about how you came to know him and what his contributions were to indexing as we know it today?

David Booth: Yeah, and he was an amazing guy and really important in the development of investing. So my second year at Chicago, I was working for Eugene Fama as a research assistant. And I decided I didn’t want to be a professor. And I talked to Gene and he goes, “OK, well, I’ll call up Mac McQuown for you.” Mac ran a think tank at Wells Fargo called the Management Sciences Department. And he was trying to play all the great new science that was coming out in a way that almost nobody else was trying to do it. And along the way he used a lot of the main academics that were involved in this change, one of them being Gene. And the fact that the consultants that Mac used, six of them went on to become Nobel laureates. So it was a pretty heady atmosphere. And I was excited to join. And Mac, of course, was larger than life himself, very urbane and sophisticated. But he ran a highly talented group. And that’s what appealed to me—as they teach you in school about comparative advantage, my comparative advantage wasn’t in developing the next great academic idea. I felt my comparative advantage was in trying to apply the ideas. And Mac was willing to apply the ideas.

And so I went to work for him at Wells. The month that the first index-linked portfolio went live, it was an account for Samsonite. And Mac had also led the way to get the trust department at the bank to offer the first S&P 500 indexed portfolio. I don’t know if it was the first one that actually went live, but they were the first to offer one. And it was slow-going at first. It’s quite a shock when you tell people, look, the way you’ve been approaching investing is all wrong. Doesn’t make any sense. There are things you can do to improve your investment results that tie into how to make life better overall, that it comes from this new way of thinking—passive management. The implication of passive management is fees are much lower, and you get better-structured portfolios. So individuals today are much better off investing today because the fees are lower, and the portfolio designs are better. And now we have Morningstar. I didn’t have that back in 1971 either.

How Vanguard Founder Jack Bogle Contributed to the Popularization of Index-Based Strategies

Christine Benz: So, Vanguard founder Jack Bogle receives just a passing mention in the film. Can you talk about what you view as his key contributions to the popularization of index-based strategies?

Booth: Well, he played a critical role. At Wells we were working with institutional investors—big pension funds, and insurance companies, and so forth. And because of what was enforced at the time, Glass-Steagall, they couldn’t really sell to individual investors. So that was Bogle’s idea to create a mutual fund company that would provide people with access to an S&P index fund. And it was real slow-going for him at first as well. I remember going to his offices and he would tell me how much money was coming in and he was pleased. It was typically a few hundred thousand or a few million every day. And he stayed the course and turned it into having a huge impact on the mutual fund industry. And as a side note, when we decided to start Dimensional, I went down to Valley Forge to talk to Jack about doing all the administrative work for the fund. As a portfolio manager, once you decide to buy and sell whatever you are going to do, then that’s when really all the work starts. You got to come in and verify that the trade you thought you made was what the broker on the other side thought the trade was and so forth.

So the incredible number of administrative issues. So I said to Jack, hey, why don’t you do all that stuff? We’ll do the trading—and it seems strange today—but we’ll fax down what our trades were for the day. From that point on, you do the managing of the fund, for a fee. And I don’t know why he did it, but he said, OK, and so that’s how we got started in the mutual fund business, with Jack’s help. And after a few years, they decided they didn’t want to do it anymore, which is fine. But by that time we’d learned how to run a mutual fund. And years went by and one of the things I feel good about was shortly before he died, I happened to run into him at a conference, and I pulled him over, bought him a cup of coffee. And I said, “Look, Jack, I just want to say thank you. I don’t know what we would have done had you not been there. We probably would have figured out something, but you made everything much easier for us. So thank you.” And he passed away not long after.

The Challenges Original Efficient-Market Pioneers Faced in Pursuit of Truth in Finance

Arnott: That’s great. That’s another kind of serendipitous event is that you were able to touch base with him shortly before he died. One of the key messages in the film is just how painstaking the pursuit of truth in finance was in the early days. And you had computers just being developed and the data was very limited and often hand-curated. You had the CRSP database just being put together in the 1960s at the University of Chicago. Can you talk about some of the challenges that the original efficient-market pioneers were confronting back then?

Booth: Well, you hit on it. Data and computers, before 1960, computers weren’t big enough. And until the University of Chicago created their first research-quality database—and I think it came out in 1963—it was really the Dark Ages of investing. People could claim anything they wanted to claim about investing. And without the ability to test it, it was all kind of meaningless. So that changed with the data. And you’re right, you mentioned Fama’s Ph.D. dissertation, for example, used data that he had hand-collected. So it was just a different world then. And as Eugene Fama says, for him, it was like shooting fish in a barrel. Once you have the data in the computers, and the work hadn’t been done before, everything you did was new and exciting and different. So it was really just an incredibly stimulating time, particularly at the University of Chicago. You look over the last 50 years or so, all the Nobel laureates and economics that came from Chicago. A lot of them were there back then. Incredible, incredible buzz, and really at the end of the day, being overly simplistic, it was about data. Without data, you can’t have a science because you need to be able to test out hypotheses and so forth. And so with data, all of a sudden, this science got kick-started.