Dimensional Fund Advisors Case Study

EC 545 Financial Economics

November 7, 2018

DIMENSIONAL FUND ADVISORS

 Case Study Write-Up

Dimensional Fund Advisors (DFA), founded in 1981, is an investment firm with the goal of leveraging the efficiency of the market using a pool of the top academic finance researchers to create value for their investors. The investment firms core beliefs in the stock market are semi-strong efficient. This is the belief that at times there will be some who outperform and some who underperform in the market, and no one can consistently outperform the market. The DFA uses its pool of academic researchers especially Kenneth French, and Eugene Fama and compensates them on any gains the company makes from their investment strategies.

DFA has a mix of both active and passive management investments. In active management, the DFA relies especially on its research to know what and how much to trade. They also have passive management where the investment strategy is based on low turnover and low transaction costs. DFA believes this is the strategy that will benefit them in the long term.

The strategy for DFA in the beginning was a single investment fund of stocks, which has remained to be their primary business till this day. Their strategy included buying small stocks as they have outperformed large stocks significantly during the period between 1926 and the 1970s. This is also known as the size effect, which was founded by Banz in his academic paper. In 1986, DFA began introducing new funds such as the small caps fund for Japan and the UK after their researches indicating similar outperformance of the small stocks in international markets. They now carry a broad product line ranging from fixed investments to equity products. The company’s main focus has been consistent: take advantage of small and value anomalies to outperform the market.

In the beginning, DFA started offerings its product line to corporate, government, and union pension funds. During 1989, however, the DFA decided to take on high net worth individuals. The reasoning behind this strategy was to keep the costs of dealing low with these clients. They offer investment services through other financial institutions such as investment and accounting firms which are known as registered investment advisors (RIAs). DFA assisted RIA by providing them with useful advice at very low costs. DFA also granted RIA access to its academic researchers works on innovative theories and empirical analysis.

        More recently, after capital gains and dividends were taxed, DFA introduced tax managed strategies aimed to reduce client tax payments. One of these strategies include reducing dividends given to clients, which would reduce the capital gains tax, which are charged upon the sale of a stock. Also, gains on the stock which were less than a year old were taxed more than stocks held longer than a year. So instead of selling stocks in the short run, investors would only buy stocks that they believe will benefit them in the medium term. Another strategy employed by DFA helps clients make use of capital write-off.

They believe their existence is due to their ability to benefit from portfolio management. DFA does not try to defeat the market, instead they try to meet the needs of different groups of investors according to their specific levels of risk aversion, and use the complicated tax systems to their advantage by creating strategies that minimize tax payments. Due to their low management fees and costs, DFA is still able to also make profits in an efficient market.

The belief DFA operates under is that of semi-strong market efficiency. This is an assumption employed by the organization that assumes all public prices and publicly available information is accounted for in the portfolios current prices. This belief also asserts that analyzing further into data would not give them an advantage over the market. There is a possibility that access to private information can prove to be beneficial and give the investor an edge over the market, DFA believes that pursuing such private information through company’s datasheets would go against their belief of maintaining low costs and low turnover. This is reflected in their principle being not of a strong form market efficiency, but a semi-strong form. The DFA avoids engaging in fundamental and technical analysis, they prefer to focus on the due process of trading, which grants them with the ability to overcome the market using strategies derived from academic research.

Concretely, DFA uses the findings of Fama and French’s Three-Factor Model, published in 1993 following their famous “beta is dead” 1992 paper. They based their model on the historical data after realizing that small stocks and high book to market ratio stocks outperformed large and low book to market ratio throughout the years which they had the data on. They claimed that the beta in the CAPM model is not enough to explain the systematic risk and that this risk could be explained better by the combination of size and value factors and the beta in CAPM. They also were confident that the reason why high book to market ratio stocks (value stocks) outperformed the growth stocks as they were much riskier in efficient market. Furthermore, they found that assets that have high beta don't necessarily perform well on a consistent basis compared to low beta assets. They did research where they designed a couple of new portfolios. First is “SMB,” a portfolio that had small stocks and shorted big ones while keeping value and growth stocks on the long and short side. The second is “HML”, a portfolio that was long in value and short in growth stocks. They concluded that size and value together with beta could explain the most of the change stock prices. By analyzing the data, they could find that even though there would be times when systematic risks could potentially result in opposite results when large and growth stocks outperform small and value stocks, efficient market would eventually dominate and expected results, which is higher performance of small and value stocks, would happen again in the future.