Prior to the 1950s investors analyzed securities one by one, focused only on picking the winners, and concentrated their holdings in an effort to maximize returns. However, in 1952 Harry Markowitz (Nobel Prize in Economics, 1990) introduced Modern Portfolio Theory and demonstrated that diversification was actually beneficial and diluted risk rather than performance. This was the beginning of many important innovations in finance. During the following decade, in 1964, William Sharpe (Nobel Prize in Economics, 1990) introduced the Capital Asset Pricing Model (CAPM) which provided a framework for evaluating the risk and expected return of a portfolio based on it’s exposure to the overall market. Two years later, Eugene Fama (Nobel Prize in Economics, 2013) developed the Efficient Market Hypothesis asserting stock prices reflect all available information, therefore making it difficult if not impossible to outperform the market without assuming additional risk.
Around the same time, computers came on the scene and academics began examining the performance of mutual funds and pension plans. They overwhelmingly discovered that managers tended to underperform their benchmark indices. Realizing the failure of active management, the index fund revolution began. Instead of trying to beat the market, why not create a fund that tracks the market with as little expense as possible?
The idea of earning only market returns was scoffed at by most money managers of the time (and still many today). However, a determined John Bogle pushed forward and created the first publicly available index fund in 1975 after founding Vanguard. Today Vanguard is the largest mutual fund company in the world and their total stock market index fund is the single largest mutual fund in the world.
By the 1970s the advent of index funds had created a simple and reliable way to obtain market performance. Additionally, William Sharpe’s Capital Asset Pricing Model (CAPM) had given us the tools to begin evaluating the performance of active managers on a risk-adjusted basis.
In 1993 Eugene Fama (Nobel Prize in Economics, 2013) and Kenneth French published new research that built off of Sharpe’s CAPM. After testing thousands of portfolios they discovered that CAPM was only able to explain about 70% of the return in a diversified portfolio and the remaining 30% was driven by unrelated factors.They identified “size” and “value” as additional risk factors and their new three-factor model was able to explain 95% of a portfolio’s return, a significant increase over the 70% explanatory power of CAPM.
The implications of their research were significant. It demonstrated that most alpha (outperformance attributed to manager skill) was nothing more than exposure to the additional risk factors. Therefore, an investor wanting to build a portfolio with higher expected return than the overall market could do so more reliably and with lower cost by using passively managed funds targeting small and value risk factors, instead of trying to pick individual stocks.
The first to adopt this research and put it into practice was Dimensional Fund Advisors (DFA), a mutual fund company where both Fama and French are on the board of directors. Today, DFA continues to be heavily guided by academic research and is now the 7th largest mutual fund company in the world.
By incorporating the academic research of the past 60 years investors have the ability to create portfolios with targeted risk exposure, higher expected returns, broader diversification, and lower costs. This systematic, almost scientific, approach to portfolio design is a significant advancement over traditional active management which requires faith in a manger’s ability to pick individual stocks.