Dimensional Fund Advisors Case
1 - Dimensional Fund Advisors Case introduction. Describe the investment strategy employed by DFA. Does DFA consider itself an active or passive manager? What aspects of its strategy are active? What aspects are passive? DFA’s investment strategy was centered on academic research, specifically on the findings of Banz’ “size effect” and Fama and French’s “book-to-market effect. ” In Banz’ research, he found that small stocks consistently outperformed large stocks over the entire history of the stock market from 1926 through the late 1970s. See Exhibit 1 for overview of growth between large and small cap stocks.
In the Fama & French paper, they found that: 1) stocks with high beta did not have consistently higher returns than low-beta stocks; 2) stocks with a high BE/ME ratio exhibited consistently higher returns than low BE/ME stocks; and 3) consistent with Banz, small stocks outperformed large stock. DFA favored the portfolio management implications of the book-to-market effect and took the stand that value (high BE/ME) stocks outperformed growth (low BE/ME) stocks in a rational, efficient market; this includes findings on Fama/French analysis on both domestic and international markets.
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DFA has a broad product line but business primarily is for their small stock, value stock, and tax-managed funds. DFA also differentiated themselves from others by charging lower fees than actively managed funds and the practice of purchasing large blocks of stock off the market for a discount. DFA would sell stocks in very small amounts, typically less than 25% of the daily volume. DFA’s strategy was to attempt to match a broad-based, value-weighted small-stock index. See Exhibits 2 and 3 for DFA small cap, value strategy.
DFA has a passive strategy based on the principle that the stock market is “efficient”. DFA is passive in that it would simply absorb the selling demand of others by purchasing large blocks of stock at discount. DFA is active in selling stocks in very small amounts. DFA also is active in its strategy of specifically building portfolios that could considerably reduce the taxes paid by clients. The firm has no interest in attempting to bet on particular firms by taking especially large positions in them – it left this to the active fund managers.
The traders at DFA have to balance two objectives: they want to get the stocks they could purchase at the best discounts but to do so in such a way as to keep the fund maximally diversified and thus have minimal tracking error with the small-stock index. DFA is willing to buy more of a stock that is already overweighted in the portfolio relative to the index, but the more overweight the stock is, the greater a discount DFA would have to obtain to make the purchase worthwhile. DFA’s passive strategy meant it did not sell based only upon a new, negative opinion about the company.
In general, DFA sold shares only if a stock no longer fit the portfolio it was in – if a small stock becomes large, or a value stock becomes a growth stock. 2. Who are DFA’s clients, and what are their concerns? What new clients is DFA trying to serve, and what are some of the new issues DFA will face in meeting these clients’ needs? DFA’s clients are primarily major institutions (corporate, government, and union pension funds, college endowments, and charities), most of them tax-exempt because of their non-profit status or tax exemptions granted to retirement plans.
In the latter part of the 80’s, DFA pursued high-net-worth individuals by offering services through registered investment advisors (RIAs). The typical DFA client cared about keeping low trading costs and reducing tax payments while understanding the importance of diversification. DFA will face the contradictions necessary to manage each specific mission of each fund which could be very tricky with all of the similar yet difficult strategies of each product. 4. Identify the sources of value DFA is proving its investors.
DFA offers value by giving investors several ways to get a piece of the stock market not covered by the S&P 500 with a number of strategies that produce better returns, considers tax issues, and offers services at a lower fee than actively managed funds. DFA’s founders believed in two principals (outside of efficient markets): 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.
By working closely with the academic world, DFA is able to exploit opportunities generated from academic research before others are able to; this creates opportunities for short and long-term excess return. Also, working in stocks that other mutual funds do not participate (micro, small-cap) allows DFA to exploit opportunities in otherwise illiquid stocks. By having a large presence in this market, the company is able to take advantage of trading opportunities with counterparts (liquidity discounts from block purchases). 5. What level of market e?ciency does DFA accept? Why this level and not any other?
DFA accepts the semi-strong form efficiency of the market. DFA feels that on average the market price correctly incorporates all public information. Its concern is merely that there is no negative private information known to the seller but not to the market. If DFA did not have concern of negative information known by the seller and not the market, the strong-form of efficiency would be appropriate (this version of the efficient market hypothesis is quite extreme). The semi-strong form of efficiency states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price.
Such info includes, in addition to past prices, fundamental data on the firm’s product line, quality of management, balance sheet composition, patents held, earnings forecasts, and accounting practices. The strong-form states that stock prices reflect all information relevant to the firm, even including information available only to company insiders; as was mentioned in the first paragraph, DFA does not accept this form of efficiency. 6. Does DFA believe in “fundamental analysis”? Why or why not? What other sources of value is DFA providing then?
DFA does not conduct any fundamental analysis because it believes in the semi-strong form of market efficiency. DFA will not close a transaction within a few days before a company’s earnings announcement; they avoid stocks that are likely to negatively surprise in the near future by doing a thorough investigation of a stock with news sources and company reports; and they also avoid stocks that had recently reported sales by insiders. Most importantly, DFA minimized adverse selection by paying careful attention to its seller and whether the transaction was the entire block of the stock.
DFA also considered balancing two objectives: stocks with the best discounts but at the same time keep the fund maximally diversified. See also the sources of value mentioned in question 4. 7. Explain the DFA small and value stock strategies in both rational and irrational/behavioral terms. What do e?cient market enthusiasts say about the performance of small stocks over large ones, and the performance of high book-to-market equity (BE/ME) or “value” stocks over low BE/ME or “growth” stocks? How do behavioralists view the size and value premia?
What does DFA believe? DFA argued that small and value stocks outperformed growth stocks for the only reason any asset consistently outperforms in a rational, efficient market: because they were riskier. DFA also believed that small cap and value stocks were priced at a discount to reflect the underlying risk associated with holding the securities. This provided increased financial upside as compensation for assuming the risk. Value stocks tended to be companies with poor recent performance of both stock return and profitability.
Behavioralists believed that the “growth” stocks performed poorly because they were overhyped and glamorized. DFA did not believe in behavioral descriptions of the market. 8. What are some of the trading costs associated with small, value stocks? How does DFA manage these potential trading frictions? When traded, small, value stocks suffer from a liquidity problem where the trade itself could substantially move the stock’s price. DFA tried to reduce transaction costs and create value by absorbing the selling demand of others in the form of large blocks of illiquid stocks and not bidding in the open market to buy stocks.
In return for accepting large blocks of stock from market participants who had a strong desire to sell, DFA is able to extract a discount on the block purchase. When selecting stocks for purchase, the DFA trader would think of the following questions when selecting companies: 1) Is there important information about this company that we don’t know; 2) Is this someone we are comfortable trading with; 3) Is this the entire block of stock; 4) Does this trade increase or reduce the diversificatiosn of the fund; and lastly 5) How big of a discount can we obtain from the trade? . Explain the Fama and French three factor model, and the rational argument behind it. Is beta a useful measure under the Fama and French model? Why or why not? Why does DFA not utilize macroeconomic variables to explain risk and design investment products? (Why do you think? Make a convincing argument as a DFA representative. ) The Fama-French model was designed to help predict sources of systematic risk that affect stock returns. The factors chosen are variables that on past evidence seem to predict average returns well and therefore may be capturing risk premiums.
In addition to the market index (so, yes, beta is important in this model as well), the model also incorporates a small minus big factor (i. e. small stocks may be more sensitive to changes in business conditions than large stocks) and a high minus low factor (i. e. high book to market value stocks are more likely to be in financial distress). These two factors are empirically motivated by the observations that historical average returns on stocks of small firms and on stocks with high ratios of book to market equity are higher than predicted by the security market line of the CAPM.
These observations suggest that size or the book to market ratio may be proxies for exposures to sources of systematic risk not captured by the CAPM beta and thus result in the return premiums seen associated with these factors. As mentioned above, the three factors, market, size, and book-to-market value are believed to capture a great deal of the variation in stock prices. With these factors taken into account, other variables, such as macro factors, do not necessarily need to be included in the model as they may partly be captured in the two other factors of the model. 0. If DFA believes its size and BE/ME strategies are tied to systematic risk, then how do they justify these strategies as sound investments for their clients? Specifically, if DFA believes in efficient markets, how do they justify their existence? Consistent with the research of Banz and Fama/French, small cap stocks and value stocks outperform large stocks in the long run. Because of the underlying risk associate with small cap stocks, the market rationally discounts their prices, thus giving a greater upside as compensation for bearing systematic risk.
Moreover, within the validity of their research, Fama and French, along with James Davis, proved again through research, that value stocks outperformed growth stocks during a more historical and longer period of study both in domestic and international markets. 11. Over the five years (1994-1999), growth stocks outperformed value stocks. Should DFA have reconsidered its strategy in 2000? If you worked for DFA in 2000, how would you have explained the poor performance of the fund to your clients?
DFA recognized the sky-high valuations of growth stocks in 2000 and 2001 and that value stocks, being relatively cheaper, provided more tempting opportunities. Ultimately, DFA’s bet to stick with its overall small cap/value strategy, proved to be the right move. By sticking with that strategy during the tech run-up, the company was able to avoid the pain that tech and growth investors experienced in the subsequent downturn. DFA’s value funds had tremendous returns, justifying the faith of its long-term investors and solidifying DFA’s grip on the loyalty of its clients.
The poor performance could be explained by the excessive relative valuations placed on tech and growth stocks. Some companies, with multiples of 50x and greater placed on its earnings (and in some cases negative earnings for tech stocks) could be viewed as excessive and not reflecting true fundamentals of the company. It seemed like investors were not being “rational” when viewing these companies and were too involved in the hype. 12. What future strategies would you recommend DFA pursue? Make a specific recommendation and justify it.
Should they abandon/modify/maintain their current size and value strategies? Should they explore other interesting anomalies and adopt similar strategies? Keep in mind DFA’s objectives and beliefs when making these recommendations. There tend to be more small cap stocks in existence than large, established companies (think the GE’s, GM’s, Honeywell’s of the world). This prevalence of small companies provides the investor with more sources of growth and opportunity in the future. There is only so much room for further growth with an established company as it is in a maturity phase of its life.
Small stocks, for the most part, tend to be in a new, emerging industry, with significant opportunities for growth and development. In addition, DFA could look to bolster its return by implementing its strategy in Non-US developed markets. From 1975-2009, value stocks and small cap stock both saw greater growth than domestic securities. Value stocks during that timeframe realized a 15. 85% annualized compound return and small cap realized a 15. 58% return. See Exhibit 4 for complete illustration.