Marlena Lee Discusses Shortcomings of Indexing on “Jill on Money” Podcast

Marlena Lee, who serves as Dimensional’s Global Head of Investment Solutions, recently sat down with Jill Schlesinger to record back-to-back episodes of the Jill on Money podcast. During the conversation, the pair discussed everything from Dimensional’s core philosophy and the ways index investing leaves money on the table to the challenges of private equity investing and the biggest misconception about investing.

Listen to the first episode here and the second one here. Below are some combined highlights from the episodes, edited for length and clarity.

Q: What is an example of a hidden cost of indexing?

A: In any segment of the market, being forced to trade and having everyone know that you’re being forced to trade has costs associated with it. For example, we did a study about the Magnificent 7 stocks—seven very large tech companies that have done very well recently. In 2023, the Nasdaq-100 had to do a special rebalance because these seven names were so big in the index that they had to trim it. When an index trims the weight, they announce ahead of time what’s going to happen and when. With these kinds of announcements, we know that there are people who will need to trade at the single point in time—the rebalance. What we found in this particular case is that, if you had rebalanced that type of portfolio when they first announced the rebalance versus when the index actually rebalanced, you would’ve had about 40 basis points—0.4% higher returns—just from rebalancing a little bit early and not when every single other manager who’s tracking this index would’ve needed to rebalance.

Another simple example can be seen when a stock is added to a very widely tracked index. People know it is going to be added, so they start to buy it. The price often starts to go up before it is added to the index, and then once it is added, there is sometimes a bit of a price reversal as well. That means the index had to buy it at the highest price, which is not when you want to buy things. It’s called a reconstitution effect, and it is something Dimensional tries to avoid. We are not index trackers, and while we offer a lot of the same benefits, we try to add flexibility into the process so we’re not being forced to trade at prices we think would disadvantage our investors.

Q: What is the flagship fund at Dimensional?

A: I would say it’s our core portfolios. Those are marketwide, meaning they hold large caps, but then they also hold mid caps, small caps, micro caps, and they are much more broad market. We focus on stocks with higher expected returns. This is not based on a portfolio manager’s gut feeling about what will outperform. It’s all based on academic research that has really stood the test of time. This is research done on decades and decades of data where we see patterns and returns all over the world. We use that to tilt the portfolio to small caps, to value stocks, to stocks with higher profitability.

Q: How has Dimensional’s approach changed over the years?

A: Dimensional was founded in 1981 with a core thesis that remains true today: When it comes to investing, you should hold the entire market and get diversification; you don’t need a crystal ball to get there, and you must pay attention to costs as you trade. Our very first fund was focused on small caps and coincided with research that said small caps outperformed large caps. Since then, we’ve done research here at Dimensional to show that’s not just a US phenomenon, and it is actually quite robust in markets all around the world. Then, we’ve added to it. We’ve followed the academic research, which has shown there are additional variables that can help us identify which stocks have higher expected returns. In addition to small caps, we’ve added value and profitability. We’re also paying attention to things like momentum and securities lending.

Q: Why does Dimensional emphasize the importance of working with a financial advisor?

A: We work with financial advisors because we want people to really understand our approach and why we might look different from an index or the market. We want people to have the discipline and long-term perspective to prevent them from bailing at the exact wrong times. Being able to manage their emotions and stick with their investment plan over the long term, even when results are not as great as they were hoping, is so important.

Q: What’s your view on private equity investing?

A: Our Research team put together a paper where they looked at the performance of private funds. The team found a huge range in manager outcomes, way bigger than what you’d get in public markets. So, manager selection becomes important because the difference between finding a top-quartile manager versus a bottom-quartile manager is huge. Even if you add up all the funds and stick it all into a well-diversified portfolio of private investments to give you a diversification benefit, there’s still that tradeoff where you’re adding in manager risk. That’s really an important consideration. Everyone who invests in privates thinks they’re getting a top-quartile manager, but that obviously mathematically can’t be true.

Q: What is the biggest misconception about investing?

A: When it comes to investing, I think the biggest misconception is that there is magic to it, that you need to find the next big thing before it becomes the big thing. You don’t have to have a crystal ball. You can invest in something as long as it’s well diversified and pretty low cost, and it shouldn’t actually change much. Investing, I think, should be really boring. You should invest in a really well-diversified portfolio and generally don’t touch it. Then you can focus on the more planning side of things, making sure your beneficiaries are up to date, creating an estate plan—that’s so important—and tax planning. Also, you have to save in order to have money to invest. So how much are you saving? Are you saving an adequate amount? All those things, I think, are what’s going to really move the needle in terms of retirement preparedness.

Q: Do you think the advent of a lot of hot-money trading platforms has been bad for investors?

A: Absolutely. What’s happening in your everyday life—elections or whatever other news headline of the day—should very rarely impact your portfolios. The only things that should impact your portfolios are changes in your own circumstances: if you lose a job, if you get married, if you have kids, or if you just change your own personal financial goals. And if anyone has trouble imposing that type of discipline or that framework mindset, I absolutely think that there’s value to having a financial advisor who subscribes to this way of investing.