Return on principles

David Booth, MBA’71, built his investment career applying mentor Eugene Fama’s efficient-market research. Now he’s sharing the dividends.

By Lydialyle Gibson
Illustration by Allen Carroll

Just weeks after David Booth, MBA’71, arrived on campus in the fall of 1969—his Valiant convertible packed to the roof for the nine-hour drive from Lawrence, Kansas, to Hyde Park—he started thinking about leaving. “It wasn’t that I hated school,” he says. “I loved the whole thing. I loved the classes, I loved the work. I was in such a lucky spot.” Still, he says, “I just wasn’t sure I was cut out to be a professor.”

Academia had been his plan. With two degrees from the University of Kansas, a bachelor’s in economics and a master’s in business, he enrolled at the Graduate School of Business as a PhD candidate. In a few years, he figured, he’d return to Kansas and teach at his old alma mater. But by November, he was getting itchy feet. “I went to the director of doctoral programs, Tom Whistler, and said, ‘I know I’ve only been here a month, but I’m going home for Thanksgiving, and I don’t think I’m coming back.’” Whistler talked him out of immediately withdrawing (“You’ve got to stay out the first quarter at least…”). A year later, over Christmas at his grandparents’ house in Bronson, Kansas, a rural crossroads 112 miles south of Kansas City, Booth’s vexing uncertainty returned.

Photo: Booth
Photography by Matthew Gilson.

“Midway through,” he recalls, “I look up, and everybody’s happy. They’re laughing and having a bang-up time.” Everybody except Booth. He wasn’t relaxed at all. “And you have to understand,” he adds, “my grandparents’ house didn’t have indoor plumbing. The floors in their living room and dining room were linoleum. And all the guys”—Booth’s grandfather and uncles and cousins, who spent their days working outside—“came in, and they’re sunburned from the forehead down, white under their hats, and some are missing teeth.” His relatives had harder lives, but he was the one feeling anxious. “It’s like, what’s wrong with this picture?” he says. “Well, what’s wrong is, it’s just not me, being a scholar. Eventually I realized I’m more cut out for business.”

So after his second year, Booth took the MBA he’d earned and departed for a job with Wells Fargo Bank in San Francisco. In some ways, though, he never left the University at all—ever a student, if not a scholar. In 1981, along with Rex Sinquefield, MBA’72, Booth founded an investment firm, Dimensional Fund Advisors, organized around the financial theories of his first professor at Chicago, Eugene Fama, MBA’63, PhD’64. “When we decided to start the business,” Booth says, “Fama was my first phone call.”

The business model Booth and Sinquefield put together with Fama’s help—and with input, over the years, from a roster of prominent economists, most with Chicago ties—has grown to manage $140 billion in assets, from offices in London, Sydney, Vancouver, and across the United States. In November Booth returned to Chicago and made headlines—amid reports on the mounting economic crisis—with a $300 million gift to the business school. Renamed in his honor, it’s now the University of Chicago Booth School of Business, or, more concisely, Chicago Booth. When Dean Edward A. Snyder, AM’78, PhD’84, announced the gift and name change to a crowd in the Harper Center’s winter garden, Booth and Fama took the stage together.

Now the Robert R. McCormick distinguished service professor of finance, Fama was already a full professor when Booth enrolled. He’d joined the faculty in 1963 as a 24-year-old MBA grad still one year away from his PhD. Fama’s doctoral dissertation—“The Behavior of Stock-Market Prices,” a densely researched argument for the idea of “efficient markets”—was reprinted whole in the January 1965 Journal of Business. “That dissertation was probably the main reason I wanted to go to Chicago,” Booth says. “It was so innovative and so revolutionary. It was one of the catalysts for the paradigm shift in the field of finance, from being some sort of apprenticeship or trade school to a true academic discipline.”

The paradigm was still shifting when Booth took his first course at Chicago, Fama’s two-quarter sequence on finance. Twice a week, 40 or 50 grad students piled into a classroom in Stuart Hall (then home to the school) to take notes and ask questions while Fama—arms waving, voice rising as he flipped through slide after slide on his overhead projector—lectured on market equilibrium, asset pricing, and risk and return. “Gene was always incredibly intense,” Booth recalls. “In the middle of winter in Chicago, he would open the window. It’s freezing outside, and Gene Fama is sweating. He was that intense.”

For Booth, the course was “life-changing.” It supplied him with the concept that markets are efficient—that their stock prices reflect all the available information about any given asset. In other words, stocks are priced correctly, and investors who try to “beat the market” by studying patterns and trends are looking for a free lunch that doesn’t exist. Earlier economists laid the groundwork for efficient markets, but Fama coined the term and made it famous, and over the years he’s honed and advanced the theory.

That year Fama was writing a textbook called The Theory of Finance (Holt Rinehart & Winston, 1972) with the late Merton Miller, a Chicago faculty member for 32 years and 1990 Nobel laureate. Chapter by chapter, Fama tried out the rough draft on Booth and his classmates. “Everything was photocopies of data material,” Booth says. “You’d get a photocopied chapter one week and then another one sometime later.” New papers by other economists were regularly folded into the syllabus. “A study would come out on corporate finance or dividend policy, and it was the first of its kind,” Booth says. “It would be the reference paper the next week. All of this was happening in real time. It was incredible.”

Fama still teaches finance to Chicago Booth’s incoming PhD students and second-year MBAs, although the class and the subject have changed. “The whole course David took would now be about what I cover in the first two or three weeks,” Fama says. “After that, it’s all different.” But the data slides—now they’re digital files—and Fama’s taut energy persist. On a Wednesday morning this past November, three dozen or so students took their seats in an amphitheater-shaped classroom in the Harper Center basement, stripping off coats and pulling out notebooks and laptops and bottled water. Someone cracked open a Diet Coke. “OK,” Fama said when the clock read 9 a.m., “any questions?” It was eighth week, and finals were coming into view. The students had plenty of questions, about market portfolios, price momentum, arbitrage-pricing theory. Why, one young man asked, would strong companies have lower expected returns than weak companies? “How can that happen?”

“You answer,” Fama said. “No guesses, now,” he added with a teasing grin. “I know you can do it.” Wearing a turquoise button-down tucked into a pair of black slacks, he stepped away from the lectern and came to rest atop an empty table, legs crossed, hands clasped around his knees. At 69, Fama—a dedicated windsurfer, mountain biker, golfer, and tennis player—is as lean and wiry as he was 50 years ago, when he played football and baseball for Tufts University. He works seven days a week, usually rising at 5 a.m., and he knocks off by early afternoon to head outside with a bike, club, or racquet.

The student groped his way through an answer; Fama revised it and pressed him on. By the end of the exchange, the professor had coaxed from his student an explanation of how stock pricing influences returns. Priced higher, strong stocks pose less risk to investors, but also promise smaller profits. “Yes, it’s all about pricing,” Fama seconded, springing to his feet and aiming his laser pointer at a slide displayed on a blackboard-sized screen. “You’ve got to see that. That’s an important insight into markets.”

Other hands went up. For 15 minutes Fama took questions on the previous week’s discussion and the previous night’s reading before moving on to the day’s main lesson. Throughout the 90-minute class he often turned students’ questions back on them, or answered one question only to pose another, deeper query. At times the class unfolded like a tennis match: serve and volley, serve and volley again.

“I do badger them a little bit,” he explains later. “Sometimes it takes them a couple of weeks to loosen up, because I’m pretty aggressive when I question them, and I don’t always answer their questions. I think they’re going to learn something by getting introspective and actually coming up with the answer themselves.”

That’s how Fama learned. As an undergraduate, he first majored in French. Then during his third year, about the time he wearied of “rehashing Voltaire,” he took a couple of economics courses. He never looked back. One of his professors, Harry Ernst, ran a stock-forecasting service, and for extra money Fama worked for him. His job was to analyze the market and identify rules for when to buy and sell. He had no trouble coming up with them, but he found that they only worked for old stock-market data. When Fama tested the rules in real time, they failed. Wondering why was what led him to grad school and to efficient markets. “When I came to the University of Chicago and people were talking about these things, it suddenly dawned on me that maybe that was the nature of the game,” Fama told an interviewer in 2007, “that there just wasn’t much predictability of returns because markets were working efficiently.” They were rising and falling, in other words, because of new information, not established patterns and trends. “That was the beginning of the story.”

Fama’s classroom prodding helps nudge—or occasionally shove—students toward a similar questioning impulse. During the November class, few people took notes, even when the discussion hit upon some new insight or observation. Instead, pens down, Fama’s students were thinking. “I try to instill in students that when they read something, it’s almost always wrong in some way,” he says. “When they’re able to look at it critically and say, ‘There’s something in there that I don’t think is right,’ then they’re capable of educating themselves.” And in a field as fast-paced as finance, keeping up can be less a matter of knowledge than of learning. “I tell them at the beginning of the class: ten years from now, 20 years from now, the topics we talk about here will be irrelevant,” Fama says. “Something new will have come along. But I want you to the point where you can teach yourself.”

For Booth, that first year at Chicago cemented a bond. The work was stimulating—the whole campus seemed abuzz with exploration and discovery—and whatever his misgivings about academia, Booth was grateful for his “lucky spot” at the University (for one thing, it had kept him out of the Vietnam draft). Being in the PhD program felt like joining a club. “With the field changing so fast, there was this big cadre of young, new professors,” Booth says, “and we would all go to parties together.” Booth hosted many of those parties himself, in the Blackstone Avenue home he and four classmates rented from professor Joel Segall while Segall was away in Washington, DC. Professors and students ate together and drank together, Booth says. “It was kind of like Mr. Chips. That didn’t mean they’d cut you any slack the next day when you were presenting a paper in class, but it was all pretty terrific.”

He often stopped by Fama’s house for lunch with him and his wife, Sally, and Fama joined an intramural basketball team with Booth and his roommates. “We had six players, and we needed one more,” Booth says. “And Fama was the most competitive guy I’d ever met.”

Photo: Fama
Photography by Dan Dry.

Fama hired Booth as a teaching and research assistant during his second year (a job that helped keep him in school) and put him to work grading problem sets and leading review sessions. He spent hours, sometimes all night, in a computer center behind the Fermi Institute, using punch cards and mammoth computers to analyze data for Fama. “I’d come by his office in the afternoon,” Booth says, “and he’d have pages and pages of handwritten notes on work he wanted me to do.” Compiling it took Fama half the day. “You could tell that he could have done the work himself in less time, but he was trying to be helpful” by assigning it to Booth.

Sometime after his anxious Christmas back home in Kansas, Booth went to see Fama at his office. “I told him I was going to leave the program.” Booth had been a good student, but his departure didn’t surprise Fama. Even today, two-thirds of those who begin a PhD at Chicago Booth never finish; the journey is long, and along the way many find something else they’d rather do. Fama called his friend John McQuown, head of investments at Wells Fargo in San Francisco. Booth started work that summer, putting together some of the bank’s early index funds. “So basically,” he says, “Fama got me my first job.”

Fama didn’t hear from Booth again until 1981, ten years and several jobs later. Booth was living in New York, making plans for a new investment company with Sinquefield, another finance-course alum. (They met in 1970, when Booth was a TA grading Sinquefield’s homework.) He called Fama and asked him to serve on the firm’s board. Fama said yes. “It’s funny,” the professor remarks now. “Lots of students try to start businesses. They don’t usually try to get you involved.”

Dimensional Fund Advisors launched later that year from a spare bedroom in Booth’s Brooklyn Heights brownstone, equipped with six phone lines and a Quotron terminal. No one knew what to expect. “We weren’t sure the company would last a month,” Fama says. “It was a big risk for David and Rex.” Sales calls yielded few clients at first, but Booth and Sinquefield kept recruiting academics—today all but one board member have Chicago connections—and seeking out empirical research. During one early visit to Chicago’s finance department, they came upon former professors Miller, Myron Scholes, MBA’64, PhD’70, and Roger Ibbotson, PhD’74. “On the spot, we invited all three to be on the board of the mutual fund,” Booth says. “We told them we couldn’t pay any director’s fees initially, but they were willing to do it just to help out.” In later years professors George Constantinides, Jack Gould, and Abbie Smith joined Dimensional’s board. Dartmouth professor Kenneth French, a former Chicago economist, joined in 2006 and also heads the company’s investment policy. For two decades, French and Fama have collaborated on research into capital markets, asset pricing, risk and return, and international investment.

Fama’s efficient-market research, dating back to the 1960s, remains Dimensional’s polestar. A 1998 profile in Fortune bore the headline: “Nobel Prize winners entrust their nest eggs to DFA, where investing is a science, not a spectator sport.” The story called Fama a “blunt, brilliant rebel.” A Dimensional consultant as well as a board member, for years his official title has been “director of research,” which he takes to be a fancy way of saying that the company left him alone to follow his curiosity. “They let me do what I do,” he says, “and then they try to take advantage of the bigger ideas we come up with.” 

Sinquefield retired in 2005, and in 2006 Booth opened Dimensional’s Austin, Texas, office, its second major U.S. location after Santa Monica, California. Booth likes to think his company’s success lends credence not only to his old professor’s research—he and Fama talk one or two times a week—but also to the Chicago academic model. “When I was in school, the University of Chicago was viewed as an ivory tower, that somehow it wasn’t practical, what they were teaching,” Booth says. “That somehow, having a rigorous approach with extensive quantitative research wasn’t real-world. I didn’t know anything about investing when I walked into Fama’s class. And right away he said, ‘This is going to be the most practical course you’ll ever take.’ And so I believed him—what did I know? But you know what? He turned out to be right.”

Chicago economists add important dimensions to David Booth’s business

It’s only human nature, says David Booth, to believe in the ability to beat the market, to think that an investor with enough smarts and information can pick which stocks will outperform the rest. “It must be in our hardware.” But it just isn’t so.

Photography by Michele A. H. Smith.

“The empirical data is overwhelming,” Booth explains. “If you take the universe of professional money managers and put them up against hypothetical orangutans selecting stocks by throwing darts at the Wall Street Journal, what you find is that the distributional outcomes from the professionals looks like the distribution of the orangutans.” That is, totally random. “One orangutan in a thousand will beat the market every year for ten years in a row.” The problem is, “most MBAs think they’re that one special orangutan.”

When Booth and business partner Rex Sinquefield started their own investment firm in 1981, they paid attention to the research, building a business plan around the assumption that they were not special orangutans. Instead of selecting stocks here and there, Dimensional Fund Advisors practices what’s called “passive management.” It buys portfolios that act as a proxy for the market as a whole because it’s less costly and less risky to buy the market than to try to beat it.

Dimensional debuted with a product Booth and Sinquefield had each been mulling for years: an indexed stock portfolio made up of companies that occupied a small share of the market. Today index funds, whose portfolios mimic a particular segment—or index—of the market, are common. (The best known is the Vanguard 500, which tracks the S&P 500). But in 1981 fully indexed funds were still rare and somewhat radical, and Booth and Sinquefield’s passively managed small-capitalization portfolio was the first of its kind. In the years since, Dimensional has introduced index funds of international stocks and value stocks (which trade at low prices relative to fundamentals like book value or earnings), and other small stocks.

Underlying Dimensional’s investment philosophy is Eugene Fama’s efficient-market theory, the idea that stocks are priced correctly because their prices reflect everything publicly known about any given asset. Every product the company offers is informed by academic research—much of it Fama’s and nearly all of it by Chicago-connected economists. Back in 1981, for example, Booth and Sinquefield compiled that first small-cap fund using research by Rolf Banz, PhD’78, a student of Fama’s whose dissertation found that small-company stocks had higher risk-adjusted returns than large-company stocks.

There are still risks. In a letter to his clients this past fall, Booth rejected the suggestion that the current financial crisis leaves a dent in the efficient-market theory. “We believe that markets are always moving toward equilibrium. … Markets don’t always get pricing right in the short run. That’s the nature of risk.” Fama agrees, arguing that in finance, nothing could be more practical than academic research. “No other branch of economics has had such an impact on practice. The world of finance has changed over the last 40 years basically in response to the research that was done during that time.”—L.G.

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Watch the entire recorded Webcast of the Chicago Booth announcement ceremony or listen to David Booth, MBA’71, talk about his time at the business school. (1 min, 30 sec)

View a narrated slideshow about efficient-market theory narrated by Abby Smith (Fall 2008)