1- Describe the philosophy and business strategy of DFA. What sort of market behavior are they counting on?
Dimensional Fund Advisors (DFA) bases their strategy on the notion that stock markets are ‘efficient’. The implication that they draw from their assumption of market efficiency is that an active portfolio management strategy cannot bear superior returns. Therefore, they manage their portfolios passively. However, they do believe in the importance of sound academic research and its value in selecting appropriate stocks. They believe that diversification remains an important consideration in passively managed portfolios. Likewise, they also believe that skilled traders can make a significant contribution even when the investments are passively managed. Traders can make an impact by ensuring low turnover, and low transaction costs when managing the portfolios. DFA even incentivize academics to work on relevant topics (such as trading strategies) by giving them a share of profits obtained on the basis of their findings.
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DFA believes that small-cap stocks produce higher returns than large-cap stocks. The company was a pioneer in small cap research dating back to as early as 1981. DFA also believes that value stock with high book-to-market ratios tend to outperform the growth stocks. DFA reached this assertion on the basis of research conducted by many academics including Fama and Fench – two distinctive economists. On the basis of these findings, DFA’s passive fund has gained considerable popularity in the market. Recently, DFA also launched a new fund strategy for investors in the high-tax bracket. This strategy targets the market segment that offers a high return but is not attractive because of the imposition of high taxes. The tax-managed strategy, therefore concentrates on the after-tax returns while providing access to a well-diversified asset class.
Although DFA puts forward a notion of passive investment strategy by promoting the notion of efficient markets, their business strategy is not characteristic of a perfectly efficient market. If the followed a strictly passive investment strategy, they would have tracked a suitable equity market indexed and managed their portfolios in accordance with the index. In such a case, their returns would be correlated with the general market sentiments and mirror the performance of the index. Instead, the company targets certain types of stocks and takes advantage of superior information and their employee expertise to produce superior results.
2- Do they add value for investors?
Even though DFA claims to follow a passive investment strategy, it has been able to perform quite well. The main reason behind its good performance is its trading strategies. DFA has emphasized on practices that aim to reduce transactions costs. They not only engage in open market bidding to buy stocks but also buy the stock is large blocks. For instance in 2001, DFA purchased 59% of its micro-cap stocks through block trades. Purchasing in bulk quantities obviously reduces the transaction costs (such as brokerage fees) for each share purchased.
Moreover, the traders of DFA take several steps to ensure that there are no problems relating to adverse selection. First, DFA avoids the purchase of stock if their new announcements are not known to arrive in the near future. Second, they carry out a thorough investigation to ensure that the selected stocks are not likely to give negative surprises in the foreseeable future. Third, they avoid stocks that have experienced a recent sale of shares by the company’s insiders. Finally, DFA scrutinize the seller of the shares and the nature of the stocks traded in order to minimize mishaps. All these features lead to the provision of superior results by DFA. This creates value for their investors.
Furthermore, DFA’s passive investment strategies are also an important source of value for investors. DFA strives to keep its funds diversified and ensures that the indexed funds have minimal tracking error. It takes a portfolio approach and only sells a company’s shares if they do not fit well within the portfolio. For instance, a company’ stock will not be excluded from the portfolio solely because some negative information has come to light; but it will be excluded if it no longer meets the fund’s objectives – such as a stock in a small-cap fund becomes too large. These practices of DFA lead to a well-diversified funds with minimal transaction costs and low turnover. The factors add value for the investors of DFA.
Do the DFA people really believe in efficient markets?
There are three different levels of market efficiency: weak-form efficiency, semi-strong form efficiency, and strong-form efficiency. Weak-form efficiency argues that markets are not very efficient and investors can spot trends in historical stock prices and, thereby, generate superior returns. Semi-strong form efficiency dictates that markets already reflects data about past prices and investors can only generate superior returns by carefully studying the fundamentals of stocks and indentifying underpriced securities. Proponents of semi-strong efficiency believe that all public information is already reflected in prices, but private information can still be used to generate superior returns. Strong-form efficiency conveys that stock prices reflect all kind of information about the stock – both private and public. Therefore, no investor can consistently earn superior return as he or she does not possess any superior information about the stocks. Under strong-form efficiency, the optimal approach is to follow a passive investment strategy.
In proposing a passive investment strategy, DFA is implying that the markets are strong-form efficient. However, their approach towards fund management does not fully comply with strong-form efficiency. Under strong-form efficiency, DFA would not have been able to create value for their investors through low transaction costs as the transactions costs would have had no effect on the returns. Furthermore, DFA claim to create superior returns through diversification, but there would be no diversification benefits under a strong-form efficient market. The difference in return between small-cap and large-cap stocks and between value and growth stocks is probably the most glaring evidence against strong-form efficiency. Similarly, DFA scrutinize the company fundamentals for evidence of private information, but the private information should already be incorporated within the stock prices if the markets are efficient. All this evidence necessitate that DFA itself do not believe that the markets are strong-form efficient. If they did, they would not be putting so much effort into creating value for their investors as that would be a near-impossible ordeal. They probably believe the market to be semi-strong form efficient.
What should be the firm's strategy going forward?
In recent years, DFA exhibited superior returns when the prices of technology stocks and, more generally growth stocks, plunged. Although the overall market experienced a drop, value stocks massively outperformed the growth stocks. This may not always be the case because if the value stocks always outperformed growth stocks, arbitragers would have taken advantage of the opportunity until the difference no longer existed. Indeed, DFA was not so successful in the late 1990s when growth stocks were outperforming the value stocks. This limited approach adopted by DFA is detrimental to its growth. It is expected DFA is ranked only 96th amongst the investments companies, in terms of size (exhibit 1). The firm should adopt a more flexible strategy in the future. Limiting your product portfolio to small-cap and value stocks is derivative of the modern investment philosophy. In a modern and more efficient market, it may not be surprising if some large-cap stock and growth stocks may also generate superior return for their investors. The company may be able to attract a larger target audience if it expands its product variety to other categories including emerging markets and fixed income funds.
Moreover, the company may be justifying its passive investment approach by preaching the notion of an efficient market, but their actions indicate that even they do not believe in such a notion. The company may be better-off if it fully braces the fact that markets are not fully efficient. An obvious implication of accepting a weaker form of efficiency will be that the company will have to be more open towards offering actively managed funds. Similarly, the company may be able to identify more appropriate stocks and hence add more value for investors if it engages in fundamental analysis. Fundamental analysis is an important component of semi-strong form efficiency and DFA may find it a potent tool in creating value for their investors. DFA has done well to keep its investors happy in challenging market conditions. However, it will have to be more flexible and evolve with future market dynamics.
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