Dimensional Fund Advisers

This case discusses the unique value proposition of Dimensional Find Advisors (DFA), which used academic research to create specialized portfolios focused on Small Capitalization companies. Their investment philosophy particularly focused on research by Fama and French and Banz. They researched how small cap companies tend to outperform large cap companies over time. In addition, FDA created an additional competitive advantage by created trading efficiencies to reduce transaction cost.

1. Fama and French findings shocked the modern portfolio theory and their study was nick named "Beta is Dead". With respect to CAPM they found that stocks with high betas did not have consistently higher returns than low-beta stocks. Furthermore, Fama and French concluded that a high book value to market value was the most important variable related to predicting high stock returns on small cap stocks. These findings were published in a 1992 paper titled "The Cross-Section of Expected Stock Returns".

2. DFA's business strategy centers on the core concept that markets are "efficient" - that is that no one has the ability to consistently pick stocks that would beat the market. In addition, the founders of DFA believed that combining solid academic research with the abilities of skilled traders would complement each other to produce superior returns. DFA's Small Cap objective is to deliver the size effect (research has indicated that small companies provide higher expected returns than larger companies in the long term) and provide the diversification benefits of investing in small companies worldwide. Dimensional defines small companies as those whose market capitalization comprises the smallest 12.5% of the total market universe. On a quarterly basis, the market capitalization ranking of eligible stocks is examined to determine which issues are eligible for purchase and which are sale candidates. The US Micro Cap Portfolio invests in securities of US companies whose size falls within the smallest 4% of the total market universe. The US Small Cap Portfolio invests in securities of US companies whose size falls within the smallest 8% of the total market universe.

Dimensional's value strategies are based on the Fama/French research in multifactor portfolios designed to capture the return premiums associated with high book-to-market (BtM) ratios. DFA's value portfolios are constructed by first ranking the total market universe by market cap and identifying those companies that fall within the defined size range. This universe is then ranked by BtM ratio. The US Small Cap Value Portfolio invests in companies whose market capitalization is in the size range of the smallest 8% of the total market universe. The US Small XM (excluding Micro Cap) Value Portfolio invests in companies whose size range falls between the smallest 2.5% to 12.5% of the total market universe.

Their strategy was to buy the bottom decile of the NYSE. They relied on academic research versus a technical or fundamental driven strategy. Specifically, they looked for small cap companies with a high book value of equity to market value of equity as they had proven to outperform the companies with high P/E ratios which would be the opposite of high book/market value. In addition, DFA relied on the study of Banz, who proved that small company stocks outperformed large company stocks from 1926-1979. Lastly, their business strategy focused on maintaining low transaction costs. Since their core strategy was focused on small cap (illiquid) issues, DFA would simply absorb the selling demand of others instead of bidding for stock in the open market. They would do so by buying large block trades at a discount to what the stock was trading at in the open market.

3. Yes, DFA believes in the "semi-strong" form of market efficiency as they do not interview management or analyze fundamentals of a company stock. Further, DFA does not believe public information would allow them to exploit under-priced securities. Also supporting the position of "semi-strong" would be DFA's relationship with trading partners and the penalty box. If a firm was looking to move out of a large position in a small-cap security, DFA would hesitate until they got to know the prospective seller. In addition, they would not trade during time periods right before earnings announcements. These actions exemplify DFA's belief in "semi-strong" market efficiency as such actions would be inconsistent with true "strong-form" efficiency.