Dimensional Fund Advisors Paper

DFA Case Study

Dimensional Fund Advisors (DFA) is an investment firm founded by David Booth and Rex Sinquefield. Major institutions clients continued to make up the majority of DFA’s business but the company also pursuer high-net-worth individual clients though the help of registered investment advisors (RIAs). DFA’s fees tended to be lower than those of most actively managed funds but higher than those of pure index funds. This was fitting given DFA’s position in the market as a passive fund that still claimed to add value.

The philosophy of DFA is a strong belief in the efficient of market (which means no one has the ability to consistently pick stocks that would beat the market). Founders of the company also believe passionately in two other major principles: the value of sound academic research, and the ability of skilled traders to contribute to a fund’s profits even when the investment was inherently passive.

Strategy: size effect and value stocks

As a strong believer in efficient market, DFA invests for long-term and abides by a buy-and-hold strategy-that is, sell stocks only when it does not fill the portfolio anymore.

DFA built its investment strategies based on sound academic researches. The results of Benz’s research suggested that small stocks had consistently outperformed large stocks over the entire history of the stock market from 1926 through the late 1970s. Based on this finding, DFA's value portfolios are constructed by first ranking the total market universe by market capitalization and identifying those companies that fall within the defined size range. In terms of US market, there are three portfolios: U.S. Micro Cap Portfolio (also known as the U.S. 9-10 Small Company Portfolio because it contained stocks in the ninth and tenth NYSE deciles based on size), U.S. Small Cap Portfolio (U.S. 6-10 Small Company Portfolio) and U.S. Small XM Portfolio (U.S. 6-7-8 Small Company Portfolio.

One of the major academic supports of DFA is finding of Fama-French’s research. The research used a new model to capture market equilibrium more precisely:

E(Rit) − Rft = α + βimE(Rmt − Rft) + βsiE(SMBt) + βhiE(HMIt)^[1]

In the CAPM model, the only risk is market risk and is measured byβ,while the Fama-French model plays much emphasis on idiosyncratic risk: the size of the company and the book-to-market ratio. Additionally, α indicates how well the fund manager is capturing the expected returns, given the portfolio's exposure to the (Rmt – Rft), HML and SMB factors, and α could be measured as portfolio actual return minus benchmark actual return (risk free rate here, but for DFA, it could be small-cap benchmarks like Russell 2000 Index).

Results from this research not only confirmed Benz’s findings, but also suggested that, stocks with a high ratio of book value of equity to market value of equity (BE/ME) exhibited consistently higher returns than stocks with low BE/ME. It appeared that in considering the expected returns on stocks, investors would need to consider the “book-to-market effect” in addition to the “size effect.” Based on this suggestion, DFA adjusted its strategy to focus on value stocks (high BE/ME stocks) and eschewed growth stocks (low BE/ME stocks) as shown in exhibit.

Moreover, assuming the size effect was a global phenomenon, DFA later introduced these small cap value portfolios to other countries’ markets, and tried to help clients structure globally diversified portfolios and to increase returns through state-of-the-art portfolio design and trading.

Reasons of success

DFA’s passively managed small-stock portfolio has outperformed typical small-stock indexes by about 200 basis points per year over the past 20 years. We could summarize the following reasons to explain DFA’s success: