Dimensional Fund Advisors (dfa) Case Study

In 1992, Dimensional Fund Advisors was expanding their product line and beginning to market their new products. The investment strategy of DFA was essentially a passive investment strategy enhanced by their portfolio manager's ability to buy large blocks of stocks at a discount to the market. The strategy is somewhat similar to an index fund but DFA creates their own portfolios (indices) of stocks based upon the empirical research of academics. DFA's investment strategy was predicated on the belief that the market is efficient by incorporating all publicly available information. DFA never individually researches or picks stocks but rather buys groups of stocks that fit the quantitative characteristics of the research. In applying the results of the academic research, DFA realized there were two trends that could effectively be exploited in selecting investments. First, the stock of small cap companies has historically outperformed the stock of large cap companies. Second, stocks with a high book value of equity to market value of equity exhibited higher returns than stocks with low book value of equity to market value. In 1992 DFA's performance was outperforming the S&P 500 index, but underperforming an index of the smallest stocks as measures by the CSRP 9th and 10th decile index. For the 5 and 10 year periods leading up to 1992, the S&P 500 had actually outperformed DFA's small stock portfolios. This was putting DFA under pressure to not only perform better but also to explain their results to investors.

DFA built much of their portfolio strategy around the research of Eugene Fama and Kenneth French. Fama and French started with the observation that two classes of stocks have tended to do better than the market as a whole: (i) small caps and (ii) stocks with a high book-value-to-price ratio (customarily called "value" stocks; their opposites are called "growth" stocks). They then added two factors to CAPM to reflect a portfolio's exposure to these two classes: FSMB and FHML. Under the FF model beta is not useful because their study found that size and book/market ratio do the best job of explaining the cross section of average long-run returns and beta provided no information about average long-run returns, either alone or in combination with other variables. DFA does not use macroeconomic variables because of a belief based on the data that had been collected that size and price are more important variables in explaining the cross-sectional pattern of average long run returns of common stocks.

DFA provides vehicles to invest in these stock portfolios while also providing enhanced returns to the portfolios by focusing on active trading and not on fundamental analysis, saving money on management fees. In doing so, DFA accepted a level of market efficiency just below the semi-strong form. They do not believe that fundamental analysis on an individual stock level can produce excess profits, but they do believe that certain groups of stocks (i.e. - small caps, high Book to Market) can provide superior returns to holding the market as whole but possibly at increased risk. Because they believe that all public information is already reflected in current prices they do not employ a team of fundamental analysts and they do not conduct research into specific stocks. They do not conduct technical analysis either; believing that markets are at least weakly efficient and technical analysis will not add value. They do not believe in a completely strong-form efficient market, so they assume that insiders could be moving the market.

In rational terms (to efficient market enthusiasts), the DFA small and value stock strategy would be described as follows: The difference in DFA's returns reflects the existence of some sort of distress factor in the economy, however, value stocks are more prone to this source of risk than growth stocks and therefore have the higher average returns. So DFA's small stock strategy will have lower returns than its value focused strategy. In irrational terms (to behavioral market enthusiasts), DFA's strategy would be described as follows: growth stocks are glamorous and people rush in to buy them and drive up the prices, thereby reducing the level of returns for DFA's small stock strategy. Whereas the value stocks are neglected and their prices fall, thereby causing its expected returns rise.

DFA believes that their strategies offer a more focused, disciplined and cost-effective way of investing. The investment strategies of the firm generally rely upon diversification to reduce the specific risks of individual securities, and they attempt to deliver favorable risk/return characteristics by investing so as to replicate the performance of entire "sectors" of the equity or fixed income markets. DFA's execution/trading policies and intelligent screening mechanisms are believed to provide additional benefits not reaped by the traditional passive management with a fee structure that would still provide for superior returns to clients. Hence, DFA justified its existence based on its ability to better address the biases created through many of the frictional costs that are not part of any models that proved efficient markets.

Trading costs for the smallest decile companies are sometimes as much as 23 times as great as for the largest decile companies. As an example, an investor buying at the offer and selling at the bid would pay market impact costs of only 0.48% for the largest stocks and 11.32% for the smallest stocks. DFA manages these potential trading frictions by its active trading. On a typical day, DFA would execute anywhere from 15 blocks, ranging from as low as 10,000 shares up to 6% of the outstanding shares of a company. DFA attempts to minimize this trading cost by negotiating discounts on large block stock purchases.

DFA considered itself a passive manager that is able to enhance its returns through active buying and selling of blocks of stock in the market. The strategy is passive insofar as it attempted to match a broad-based, value-weighted small-stock index with no particular bet on any firms per se. Similarly, DFA only sells shares if a stock no longer fits the portfolio and does not sell stocks based upon negative market information or analysis.

DFA's clients included corporate pension funds, public pension funds, endowments, and large pools of tax-exempt capital. Most of these clients were tax exempt and therefore are less concerned with the tax implications of the investments. Many of these clients also have long investment horizons and have less liquidity concerns. To some people DFA appeared to be a high fee passive indexer but to those who preferred passive management DFA could appear to be