Thursday, August 10, 2006

William Bernstein and a question: Is Wisdom Tree attempting to dislodge Dimensional Fund Advisors (DFA) as the premier source of diverse indexes?

As I've mentioned before, I am currently reading William Bernstein's the Four Pillars of Investing. In it, he strongly advocates index fund investing and hints / discusses the benefits of value investing (through indexes / ETFs) as well. I'm only finishing the first 100 pp, so I can't talk to strongly of his oppinions, yet.

Bernstein's book has been highly successful in the market place and builds on the intellectual groundwork of John Boggle (founder of Vanguard) and Malkiel, author of Random Walk Down Wall St. Their ultimate critique is:

  1. It is almost impossible to beat the relevent market index over the long term - only very few people succeed - the odds are against you.
  2. Actively managed mutual funds almost never beat their indexes over a long period of time. Their aggregate expense structure (distribution costs, fees, impact costs) negate many of the profits they could otherwise make.
  3. The only way to effectively invest is to buy a basket of holdings, rather than an individual stock - usually through an indexed mutual fund or ETF
  4. An effective portfolio will have multiple categories of investment that are minimally correlated. When one does poorly another may do well.
  5. Portfolios investments need to be rebalanced to insure one buys investments when they are out of favor (cheap) and sells when they are expensives (high). This can only be done effectively with a portfolio of non-correlated investments.
  6. Market analysis and prediction is almost impossible for periods of less than 20 years. Invest for the long term, don't be distracted by the noise.

Bernstein is highly critical of most of the investment industry and their partners the financially oriented media. He firmly believes that the investment industry, on the whole, engages in unethical and self-serving behavior, while the news media feeds off of the investment industry and supports it's fee based activities. In his veiw, the media creates unnecessary noise that distracts investors from effective financial behavior.

Bernstein's thinking is becoming increasingly well accepted. The sources upon which he builds his thoughts have become many of the current thought leaders in modern finance. Think of Bernstein as an effective guide and creator of a synthesis for putting the great thoughts together.

Prof. Jeremy Siegel is a fellow traveller of Bernstein's. You can see his articles in the Wall St. Journal and in Yahoo finance right here. There thoughts are highly similar. Siegel is very involved with Wisdom Tree in developing index funds based on fundamental value; i.e. current index funds allocate investments by the capitalization of the index participants, therefore, really big cap companies have a much greater presence in your Fortune 500 investments than the smaller businesses. However, as Bernstein points out, over the long run, your opportunity for investment gain is not with the biggest and best run companies, but with the smaller less efficient companies who learn how to grow and execute more efficiently. Furthermore, a companies value is really based on it's profit stream (income stream) over time and the risk it requires. Siegel has been developing methods for valueing companies based on their fundamental characteristics; i.e. ability to increase profits over time instead of the status quo of market capitalization. If you can find companies that will become more profitable over time, the value of the investment will increase. In Siegel's eyes, profit growth is most tightly correlated to dividend issuance.

Wisdom Tree, who Siegel advices, has a large portfolio of dividend based ETFs. They are not truelly actively managed, as a computer formula selects which companies to include in the index, but they are more active than a traditional passive index fund which performed no fundamental calculation at all. Furthermore, Wisdom Tree is part of a flock of finance firms releasing international dividend ETFs, further diversifying their portfolio. You can see a very interesting article on the topic at the Wall St. Journal Sunday August 5th here.

After reading the article I remembered the increasingly large portfolio of fundamentally indexed ETFs wisdom tree offered. I also was impressed iwth the 0.48% expese ratio of Wisdom Tree International Large Cap Dividend. It seems like Siegel is advising wisdom tree well in a manner consistent with bernstein:

  1. provide a broad number of ETF investments
  2. focus on increased earnings (fundamental value)
  3. keep expenses low

With an increasingly large menu of ETFs offered (you can see them here), it struck me that Wisdom Tree is gunning for the entire shopping cart. If you believe in Bernstein's investment theory (and Siegels, et. al.) then you could buy all the ETFs you need from Wisdom Tree.

Wow, that sounds alot like the approach of DFA Advisors - doesn't it? DFA is the preeminent provider of diversified index investments (usually mutual funds). They are deeply associated with Eugene Fama (U of Chicago) and Kenneth French (Darmouth), two of the biggest players in index portfolio theory. They are also tightly tied in with a number of other leading finance figures - some of whom Bernstein draws on in his work - here's a list. DFA has long held a very unique position in the market place as a comprehensive provider of diverse index funds - diverse enough to have very strong long term performance. Their academic models compiled the various non-correlating index funds into model portfolios designed for different risk and timing priorities be their clients. If you wanted to obtain long term returns of 10% or more using a passive indexing strategy, DFA was the place to find your funds. For example, how easy is it to find international small cap value index funds? It was even harder two years ago!

DFA's funds often have very low expense ratios, however, they required customers to participate through third party financial advisors. For personal finance hobbiest and students, this was often viewed as unattractive - especially the 1% assset management fee such advisors often charge. The bottom line, if you believed in a diversified portfolio of indexes, you had to pay 1% of your assets each year to play the game with DFA.

I am sure there are many valid reasons for people to obtain advice when creating their portfolio allocation model, rebalancing their investments and changing their model when their lives and goals change - however, I find 1% of assets to be distasteful and an archaic relic of the past when investors were less educated and there was truely less competition in the financial services industry.

Jim a thoughtful intelligent blogger at Finance and Investments blog has assembled a model portfolio that seems to draw on DFA type allocation models using publicly available mutual funds.

Apollo at Dollarz and Sense is also trying to create a diversified index allocation model using publicly available funds (without paying an advisor an asset management fee). He has a discussion of the DFA model portfolios here. Here is Apollo's investment strategy using public funds to model a specific high performance DFA portfolio. Like Jim, Apollo is an intelligent and thoughtful individual. His comments are quite interesting.

Hmm... Wisdom Tree is beginning to assemble a marketplace of funds that have the potential breadth of DFAs very unique assembly - the same asembly that gave DFA their market advantage. Furthermore, Wisdom Tree will employ enhanced indexes utilizing fundamental value calculations. Does this mean the average investor can build a DFA like investment portfolio without spending 1% of assets on a financial advisor? Will the enhanced fundamental value indexes provide superior returns?

Jeremy Siegel is well regarded and has excellent academic credentials - will these be enough to offset the Fama and French titans at DFA? How will DFA respond to this threat?

I'm very interested in several things here:

  1. Can a well indexed and diversified portfolio be built without exhorbitant investment advisor fees?
  2. Will DFA respond to competition by lowering their fees?
  3. Will the enahnced indexes using fundamental value deliver their promise?
  4. What role will Wisdom Tree play in this game? Are there other viable competitors - ishares - powershares? New fundamental value products are coming on line every month. Check out the First Trust DB Strategic Value Index - it's been out for over a month now.

One issue that benefits marketplace providers like DFA and Wisdome Tree is the ability to provide non-overlapping investment options. It's very possible that two index funds could actually have a large number of overlapping holdings - which would destroy your diversification and alter portfolio management assumptions.

I will probably call Wisdom Tree and ask to speak with them to learn more about their product positioning and their business model viz a viz investment advisors. As one who is uncomfortable with asset management fees, I certainly hope they will not follow DFAs model.

Have a wonderful day,


(c) 2006 all rights reserved


Barry Barnitz said...

Bill Bernstein has some thoughts on the recent spate of non-capitalization "fundamental" indexes, which are at least close cousins of the Wisdom Tree dividend index approach. See his Efficient Market article Fundamental Indexing.

makingourway said...

Thanks alot for the great article reference from Bernstein.
I just read it.
He's intrigued, but concerned that transaction costs endemic to moving holdings in and out of a fundamental value index may exceed the benefits of its gain.
Good points. I too am waiting to see how these horses run, but am becoming more and more interested in the diversification some of them offer.
Have a wonderful day,

Barry Barnitz said...


I e-mailed Bill Bernstein and provided him with a link to your post, along with a note that I had linked his EF essay. Dr. Bill was kind enough to respond. I will quote his email


if i took the time to answer everyone in this world who had questions for me, i'd have to hire a small office full of assistants to comply.

i really don't have any opinions this way or that about wt, but you do have to ask yourself three questions:

1) do these folks know how to transact as well as dfa and vanguard?
3) do they have the sort of long-term business ethic that dfa and vanguard has?
3) what will be the effects of unfiltered buying by unsophisticated, hot-money investors in trendy asset classes on long-term shareholders?

the best,


makingourway said...


Thank you very much for obtaining Bill's thoughts.

His key points are very consistent with his earlier writings and his skepticism seems valid.

I would hope the less managed (automaticly managed) nature of the Wisdom Tree ETFs would be less susceptible to SOME of the ethics issues that plagued the mutual fund industry (i.e. the canary scandel, etc...).

How would you discover the answers to Bill's questions (besides waiting 10 years to see by experience)?


makingourway said...

Another thought...

The Wisdom Tree ETFs would probably not be an effective replacement for small amount dollar cost averaging and some retirement plan instances due to commissions / transaction costs.

Another question: how tax efficient are the DFA funds? Common wisdom indicates holding ETFs in non-retirement accounts to enjoy their tax efficiency - but will the increased transaction volume cause increased tax liabilities for the owners?

Have a great weekend,

Barry Barnitz said...

A few comments:

1) DFA has a series of tax-managed funds (domestic, international, and value) which are designed for taxable accounts. Vanguard also provides tax-managed passive portfolios for domestic and international stocks (but not for value indexes)

2.) The institutional creation/redemption mechanism should help Wisdom Tree reduce capital gains distributions. Dividend tax efficiency is another matter. Here is a link to a query of my blog entries on this matter:
Financial page: Qualifying Dividends
If this link does not work, let me know and I will try and link individual posts.

3.) Commission and spread expenses make ETF's and expensive proposition for the regular dollar-cost averaging investor (and since most of us invest a portion of our earned incomes as we earn them we can say "life is dollar cost averaging).

4.) Only time will tell us if Wisdom Tree is managed more for the investor or more for management, i.e. the integrity of the firm.

Jim said...

Makingourway, per your request I have added a link to your blog on my blog.

You wrote that Bernstein's first point is "[i]t is almost impossible to make a profit in idividual equities over the long term - only very few people succeed - the odds are against you." Did he really argue that in his book? I don't agree with that statement one bit. There are many, many people who have been investing for 20+ years who have made tremendous profits over the years. Maybe he meant that, adjusted for risk, it is nearly impossible to beat the market (as opposed to making an absolute profit). I would agree with a statement like that.

DFA has some of the best actively managed mutual funds. Unfortunately, they must be purchased through a financial advisor or through some 401k plans. As I recall, some of the DFA money managers are Nobel laureates. Fama, one of the DFA money managers, is the guy who came up with the "efficient market theory."

makingourway said...


Thanks so much for catching that egregious error regarding profits versus beating the relevent index.

I read Bernstein as saying that most stock pickers and mutual funds fail to beat the relevent index. If you accounted for risk, it seems like they would have even more trouble - but I do not recall Bernstein qualifying the failure by risk specifically. In his book he indentified numerous transaction costs, portfolio size hazards, impact costs and buy/sell spread issues that effected actively trading and actively traded mutual funds.

Barry, I'm sure you've read Mr. Bernstein's book quite thorougly - can you help clarify?

BTW, Jim, I'm very glad to see your comments on the blog.

Jim, regarding DFA, I'm under the impression that their mutual funds are NOT actively managed - they built their reputation by creating a comprehensive and well-diversified marketplace of passively managed index products. Actually, check out this link for a good explanation of the DFA products - from a financial advisor that uses(searching for better word?) their products. Interestingly enough, he charges less than the annual 1% fee many advisors charge for access to DFA products.

thanks for the comments,

Panther said...

Here's my diversified equity portfolio. I'm using 2 Wisdom Tree funds as surrogates for 2 Intl Value asset classes. Each asset class gets a 10% weighting. I also use one high expense ratio fund for Intl small growth (PISRX). This is the only fund available through my 401k that was truly a small company fund.

U.S. Large Growth - VIGRX
U.S. Large Value - IWD
U.S. Small Growth - IWO
U.S. Small Value - IWN
U.S. Micro Cap - IWC
Intl Large Blend - VDMIX
Intl Large Value - DOL
Intl. Small Growth - PISRX
Intl. Small Value - DLS
Emerging Mrkts - VEIEX