Dimensional Fund Advisors Case Solution.docx
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Dimensional Fund Advisors Case Solution.docx
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DimensionalFundAdvisorsCaseSolution
DimensionalFundAdvisors,2002
1.WhatisDFA’sbusinessstrategy?
Whatdoyouthinkofthefirm?
AretheDFApeoplereallybelieveinefficientmarkets?
DimensionalFundAdvisors(DFA)isaninvestmentfirmbasedinSantaMonica,California,whoseprimarybusinessesaresmallstockfunds.DFA’scorebeliefsareefficientmarketsandtwootherprinciples:
thevalueofsoundacademicresearch,andtheabilityofskilledtraderstocontributetoafund’sprofitsevenwhentheinvestmentwasinherentlypassive.Withitsfounding,DFAsurmisedthatactingonthesebeliefswouldmakeituniqueamonginvestmentcompanies.Besides,DFAchargedfewerfeesthanthoseofmostactivelymanagedfundsbutmorethanthoseofpureindexfunds,whichwasfittinggivenDFA’spositioninthemarketasapassivefundthatstillclaimedtoaddvalue.
Itsbusinessstrategymakessense,andthatcouldbeprovedbyitssteadygrowthandstrongprofits.Andwiththisstrategy,itcouldpursuehigh-net-worthindividuals,inadditiontoinstitutions,asclientsthroughregisteredinvestmentadvisors(RIAs),whichwereacrucialconduitenablingDFAtoreachthemarketwithoutadvertisement.
AlthoughDFAisdedicatedtotheprincipleofefficientmarket,buttosomeextent,theDFApeopledonottotallybelieveit.Accordingtotheefficientmarkethypothesis,whenmarketefficiencyisstrong-form,stocksalwaystradeattheirfairvalueonstockexchangesandtechnicalanalysis,fundamentalanalysisandinsidertradinganalysisareallfruitless.ButDFAwasnotsimplyanindexfundmanager,itbelievedinthevalueofsoundacademicresearchandskilledtraders’contribution.BecauseDFAusedthefoundthatsmallsizeandhighB/Mratiostockshadhigherexpectedreturns,itssmall-stockfundoutperformedmostsmall-stockbenchmarks.
2.DotheFama-Frenchfindingsmakesense?
Shouldweexpectsmallstockstooutperformlargestocksinthefuture?
Valuestockstooutperformgrowthstocks?
Fama-Frenchmodel:
E(Rit)−Rft=βi[E(Rmt−Rft]+siE(SMBt)+hiE(HMIt).Rftmeansrisk-freerateattimet,Rmtmeansmarketreturnattimet;Ritmeansasseti’sreturnattimet;E(Rmt)–Rftmeansmarketpremium,SMBtmeansthereturnofmarketcapitalizationfactorattimet,HMItmeansthereturnofbook—to—marketfactorattimet.β、siandhiarecoefficientofthe3factors.
IntheCAPMmodel,theonlyriskismarketriskandismeasuredbyβ,whileintheFama-Frenchmodelweplaymuchemphasisonidiosyncraticrisk—thesizeofthecompanyandthebook—to—marketratio.Thisistruewhenthemarketisnoteffective.Inaddition,thisresultisevidencedbyrealdatafromExhibit6.
Firstofall,thevaluepremiaofsmallstocksoverlargestocksascompensationfortheadditionalriskthatasmallcompanyismorelikelytofailthanalargecompanythathasmoreassets.The“smallfirmeffect”byBanz,discoveredthathistoricalperformanceofportfoliosformedbydividingtheNYSEstocksinto10portfolioseachyearaccordingtofirmsize,Averageannualreturnsbetween1926and2006areconsistentlyhigheronthesmall-firmportfolios.thesmaller-firmportfoliostendtoberiskier.ButevenwhenreturnsareadjustedforriskusingtheCAPM,thereisstillaconsistentpremiumforthesmaller-sizedportfolios.Thesecondpointis“theneglected-firmeffect”byArbelwhichinterpretsthatbecausesmallfirmstendtobeneglectedbylargeinstitutions,informationaboutsmallerfirmsislessavailable.Thisinformationdeficiencymakessmallerfirmsriskierinvestmentsthatcommandhigherreturns.TheDFAhasreputationtoovercomeasymmetricinformationissue:
itcangetprivateinformationwhencooperatingwithsmallcompanies.Ifsemi-strongmarketefficiencyhold,itispossibletobeatthemarkethavingprivateinformation.Atlastbutnotleast,wethinkisthe“liquidityeffect”byAmihudandMendelson.Investorswilldemandarate-of-returnpremiumtoinvestinless-liquidstocksthatentailhighertradingcosts.Thesestocksusuallyshowastrongtendencytoabnormallyhighrisk-adjustedrateofreturn.Thusweshouldexpectsmallstockstooutperformlargestocksinthefuture.
Meanwhile,thevalue-growtheffectisalsofoundbyFamaandFrench.ThisfindingisalsoverifiedbyrealdatainExhibit6.Theonlyreasonisanyassetconsistentlyoutperformsinarational,efficientmarket:
becausetheyareriskier.Thuswecanexpectthevaluestocksoutperformgrowthstocks,
3.WhyhasDFA’ssmallstockfundperformedsowell?
Weconclude6reasonsforthestellarperformanceofDFA’ssmallstockfunds:
1)DistinctInvestmentStrategies.
Dimensionalfoundersbelievedpassionatelyinprincipleof"passive"stockmarketinvesting.Aspassiveinvestorsbelieveintheso-calledefficientmarkettheory,whichmaintainsthatalmostnoonecanbesmarterthanthemarketasawholeinthelongrun.HenceDFAbuyandholdbroadportfoliosofshares,bettingthattheirreturnsovertimewilltrumpthegainsofmost"active"managerswhotrytofindthestocksthatwouldoutperformthemarket.
Dimensionaldoesnotactivelypickstocksorpassivelytrackcommercialindexesbutinsteadstructuresportfoliosbasedonriskandreturnsasidentifiedthroughfinancialscience.Theirmainobjectiveistohelpclientsstructuregloballydiversifiedportfoliosandtoincreasereturnsthroughstate-of-the-artportfoliodesignandtrading.
2)InvestmentPhilosophyIsGroundedinRobustAcademicResearch
DFA'sinvestmentstrategieswerebasedonsoundacademicresearch,whichprovessuccessful.
DFAbeganasasmall-stockfundin1981,attemptingtotakeadvantageofthe"sizeaffect"(excessperformanceofsmallstocks)thathadbeendiscoveredbyanumberofacademicresearchers.MostnotablyistheacademicpaperfromtheUniversityofChicagoPH.D.dissertationofRolfBanz,smallstockshadconsistentlyoutperformedlargestocksovertheentirehistoryofthestockmarketfrom1926throughthelate1970s.
Later,researchbyProfessorsEugeneFamaandKennethFrenchidentifiedequitymarketexposure,capitalization,andpricerelativetofundamentalsasthe3factorsthatprimarilydeterminethereturnsofabroadlydiversifiedportfolio.TheirworkhasheldupthroughrigorousopenreviewandDimensionalstrategiesfocusontheirinsight.
3)CombinationofTheoryandPractice.
Byactingasaconduitbetweenfinancialeconomistsandpracticinginvestors,DFAhaspioneeredmanystrategiesandconsultingtechnologiesnowtakenforgrantedintheindustry.ThismakesforanexchangeofideasthatallowsDimensionaltopositionthemselvesattheforefrontofinnovativesolutions.
ThereasonwhyDFA'sRIAbusinesshasgrownrapidly(seeexhibit2)wasgoodevidencethatDFAeducateditsRIAsbyprovidingthemwithaccesstotopresearcherswhoweredevelopinginnovativetheoriesandempiricalanalyses.TheRIAsthenusedwhattheyhadlearnedtoadvisetheirclients.AndthisadvicegeneratedquestionsthatDFAdeliveredbacktotheacademicsforcontinuedresearch.
Also,DFAencouragedacademicstoworkonsubjectsofinteresttothefirmbygivinganyprofessorashareofprofitsfrominvestmentstrategiesderivedfromhisorherideas.
4)LowCosts–lowmanagementfeetoattractclient
Theirinvestmentmanagementfeesarepositionedwellbelowthoseoftraditionalactivemanagers. DFA'sfeestendedtobelowerthanthoseofmostactivelymanagedfundsbuthigherthanthoseofpureindexfunds.ThiswasfittinggivenDFA'spositioninthemarketasapassivefundthatstillwouldaddvalue.Andthiscompetitiveandwell-positionedpricinghelpedattractedclient.
5)SmartTradingCanIncreaseReturns
a.Purchasediscount
DFA'sbuy-holdapproachandtradingstrategiesaredesignedtominimizecosts. Carefultradingcanreduceorevenreversethecostsbornebytraditionalmanagers. BecauseDimensionalfocusesoncapturingthesystematicperformanceofbroadmarketdimensionsratherthantherandomfluctuationsofindividualsecurities,theycankeepcostslow.Theycankeepcostslow,patientlyandexpertly,byreducingturnoverandconcentratingonfavorablepriceexecution.
Insteadofbiddingintheopenmarkettobuystocks,DFAwouldprefertoabsorbthesellingdemandofothers.Inreturnforacceptinglargeblocksofstockfrommarketparticipantswhohadastrongdesiretosell,DFAwasabletoextractadiscountonthestockpurchase.Fromtheexhibit10–fortheSmallCapPortfolio,
In2001:
36%ofpurchaseswereblocktrades,whoseaveragediscountreached3.33%.Consideringthelossof0.58%tocostsonremaining64%ordersthatDFAhadtopatientlybuysharesfromopenmarket,theweightedaveragediscountwas0.83%forallorders.
Wealsonotefrombackearlierto1998:
50%ofpurchaseswereblocktrades,withaveragediscountreached3.56%.Aweightedaveragediscountforallorderswashigher,being1.64%.
b.Avoidanceofadverseselection
DFAsawabout1000potentialtradesinatypicaldayand20,whichindicatesthatDFA'sselectionprocessiscarefulandtactful.Theyapplies"adverseselectionproblem"soastoavoidanythingwronginthestockordersthattheyaregoingtobuy.ThisisalsoanotherimportantreasonthatenabledFDA'spassivelymanagedsmall-stockportfoliotooutperformtypicalsmall-stockindexesbyabout200basispointsperyearoverthepast20years.
6)Professionalteam
TheabilityofskilledDFAtraderstocontributetoafund'sprofitsevenwhentheinvestmentwasinherentlypassiveandtheirabilitytoturnthedifficultyoftradingsmallstocksintoanopportunity.DFAteam'sprofessionalismandabilityisalsoacriticalreasonforthesuccessofDFA'ssmallstockfund,althoughthecasedidnotobviouslymentionthis.
4.DFA’s
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