Dimensional Fund Advisors, 2002 Case Solution

DimensionalFundAdvisors,20021.WhatisDFA’sbusinessstrategy?Whatdoyouthinkofthefirm?AretheDFApeoplereallybelieveinefficientmarkets?DimensionalFundAdvisors(DFA)isaninvestmentfirmbasedinSantaMonica,California,whoseprimarybusinessesaresmallstockfunds.DFA’scorebeliefsareefficientmarketsandtwootherprinciples:thevalueofsoundacademicresearch,andtheabilityofskilledtraderstocontributetoafund’sprofitsevenwhentheinvestmentwasinherentlypassive.Withitsfounding,DFAsurmisedthatactingonthesebeliefswouldmakeituniqueamonginvestmentcompanies.Besides,DFAchargedfewerfeesthanthoseofmostactivelymanagedfundsbutmorethanthoseofpureindexfunds,whichwasfittinggivenDFA’spositioninthemarketasapassivefundthatstillclaimedtoaddvalue.Itsbusinessstrategymakessense,andthatcouldbeprovedbyitssteadygrowthandstrongprofits.Andwiththisstrategy,itcouldpursuehigh-net-worthindividuals,inadditiontoinstitutions,asclientsthroughregisteredinvestmentadvisors(RIAs),whichwereacrucialconduitenablingDFAtoreachthemarketwithoutadvertisement.AlthoughDFAisdedicatedtotheprincipleofefficientmarket,buttosomeextent,theDFApeopledonottotallybelieveit.Accordingtotheefficientmarkethypothesis,whenmarketefficiencyisstrong-form,stocksalwaystradeattheirfairvalueonstockexchangesandtechnicalanalysis,fundamentalanalysisandinsidertradinganalysisareallfruitless.ButDFAwasnotsimplyanindexfundmanager,itbelievedinthevalueofsoundacademicresearchandskilledtraders’contribution.BecauseDFAusedthefoundthatsmallsizeandhighB/Mratiostockshadhigherexpectedreturns,itssmall-stockfundoutperformedmostsmall-stockbenchmarks.2.DotheFama-Frenchfindingsmakesense?Shouldweexpectsmallstockstooutperformlargestocksinthefuture?Valuestockstooutperformgrowthstocks?Fama-Frenchmodel:E(Rit)−Rft=βi[E(Rmt−Rft]+siE(SMBt)+hiE(HMIt).Rftmeansrisk-freerateattimet,Rmtmeansmarketreturnattimet；Ritmeansasseti’sreturnattimet；E(Rmt)–Rftmeansmarketpremium，SMBtmeansthereturnofmarketcapitalizationfactorattimet，HMItmeansthereturnofbook—to—marketfactorattimet.β、siandhiarecoefficientofthe3factors.IntheCAPMmodel,theonlyriskismarketriskandismeasuredbyβ,whileintheFama-Frenchmodelweplaymuchemphasisonidiosyncraticrisk—thesizeofthecompanyandthebook—to—marketratio.Thisistruewhenthemarketisnoteffective.Inaddition,thisresultisevidencedbyrealdatafromExhibit6.Firstofall,thevaluepremiaofsmallstocksoverlargestocksascompensationfortheadditionalriskthatasmallcompanyismorelikelytofailthanalargecompanythathasmoreassets.The“smallfirmeffect”byBanz,discoveredthathistoricalperformanceofportfoliosformedbydividingtheNYSEstocksinto10portfolioseachyearaccordingtofirmsize,Averageannualreturnsbetween1926and2006areconsistentlyhigheronthesmall-firmportfolios.thesmaller-firmportfoliostendtoberiskier.ButevenwhenreturnsareadjustedforriskusingtheCAPM,thereisstillaconsistentpremiumforthesmaller-sizedportfolios.Thesecondpointis“theneglected-firmeffect”byArbelwhichinterpretsthatbecausesmallfirmstendtobeneglectedbylargeinstitutions,informationaboutsmallerfirmsislessavailable.Thisinformationdeficiencymakessmallerfirmsriskierinvestmentsthatcommandhigherreturns.TheDFAhasreputationtoovercomeasymmetricinformationissue:itcangetprivateinformationwhencooperatingwithsmallcompanies.Ifsemi-strongmarketefficiencyhold,itispossibletobeatthemarkethavingprivateinformation.Atlastbutnotleast,wethinkisthe“liquidityeffect”byAmihudandMendelson.Investorswilldemandarate-of-returnpremiumtoinvestinless-liquidstocksthatentailhighertradingcosts.Thesestocksusuallyshowastrongtendencytoabnormallyhighrisk-adjustedrateofreturn.Thusweshouldexpectsmallstockstooutperformlargestocksinthefuture.Meanwhile,thevalue-growtheffectisalsofoundbyFamaandFrench.ThisfindingisalsoverifiedbyrealdatainExhibit6.Theonlyreasonisanyassetconsistentlyoutperformsinarational,efficientmarket:becausetheyareriskier.Thuswecanexpectthevaluestocksoutperformgrowthstocks,3.WhyhasDFA’ssmallstockfundperformedsowell?Weconclude6reasonsforthestellarperformanceofDFA’ssmallstockfunds:1)DistinctInvestmentStrategies.Dimensionalfoundersbelievedpassionatelyinprincipleofpassivestockmarketinvesting.Aspassiveinvestorsbelieveintheso-calledefficientmarkettheory,whichmaintainsthatalmostnoonecanbesmarterthanthemarketasawholeinthelongrun.HenceDFAbuyandholdbroadportfoliosofshares,bettingthattheirreturnsovertimewilltrumpthegainsofmostactivemanagerswhotrytofindthestocksthatwouldoutperformthemarket.Dimensionaldoesnotactivelypickstocksorpassivelytrackcommercialindexesbutinsteadstructuresportfoliosbasedonriskandreturnsasidentifiedthroughfinancialscience.Theirmainobjectiveistohelpclientsstructuregloballydiversifiedportfoliosandtoincreasereturnsthroughstate-of-the-artportfoliodesignandtrading.2)InvestmentPhilosophyIsGroundedinRobustAcademicResearchDFA'sinvestmentstrategieswerebasedonsoundacademicresearch,whichprovessuccessful.DFAbeganasasmall-stockfundin1981,attemptingtotakeadvantageofthesizeaffect(excessperformanceofsmallstocks)thathadbeendiscoveredbyanumberofacademicresearchers.MostnotablyistheacademicpaperfromtheUniversityofChicagoPH.D.dissertationofRolfBanz,sm