Dimensional fund advisors

Dimensional Fund Advisors

Investments 3500
Booth School of Business
Winter 2012

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Introduction:
Dimensional Fund Advisors (DFA) is an investment firm founded by David Booth and Rex Sinquefield in 1981. For the first 20 years, DFA has based its investment strategies on sound academic research led by Rolf Banz during the 80’s and thenby Eugene Fama and Kenneth French during the 90’s. Although DFA missed out on the growth-stock boom during the 90’s, its investment strategy based on small stocks and value stocks complemented with diligent trading techniques produced stellar performance, growing the fund from $5 billions in 1989 to almost $36 billions in 2002. Now, DFA is seeking new ways to add value for its investors whilemaintaining a manageable level of risk exposure. This paper evaluates DFA investment strategy and tries to complement it with new alternatives.

Dimension Fund Advisors Investment Strategy:

DFA’s investment strategy is based on two trends derived through extensive academic research: 1) in the long term, small companies have higher expected returnsthan large companies, and 2) stocks with a high book value of equity to market value of equity (“BE/ME”) exhibit consistently higher returns than stocks with low BE/ME. Therefore, DFA’s investment strategy focused on creating funds that invested in small companies and companies with high BE/ME ratios (US Micro Cap Portfolio and US Small Cap Value Portfolio, respectively).

On theone hand, this is a passive investment strategy. Consistent with the firm’s core belief in efficient markets, which holds that all publicly available information has already been incorporated into stock price, DFA avoids picking individual stocks based on fundamental analysis. Instead, it tracks a broad-based, value-weighted small-stock index, following the guidelines of the Fama-French Three-FactorModel. Fama’s research findings show that small and value stocks consistently yield a higher expected return than justified by their respective systematic risk, expressed as correlation with the market portfolio.
Fama’s rational market hypothesis explains this phenomenon by contesting that small and value companies present a higher degree of risk than suggested by their betas:
* Smallcompanies are more likely to fail unexpectedly
* Value stocks tend to be companies with poor recent performance
The behavioral hypothesis, in contrast, states that small and value stocks provide a higher return than justified by their risk profile because investors irrationally undervalue small and value stocks due to psychological effects. DFA subscribes to the rational market hypothesis.
Onthe other hand, DFA also relies on skilled traders to implement some active trading approaches in the context of an otherwise passively managed portfolio. Because DFA believes that market efficiency is only semi-strong, the firm is concerned that sellers may have private information that is not yet incorporated into stock price and can present adverse selection and asymmetric information risk. DFAhas developed specific trading techniques to reduce these risks and minimize the likelihood of investing in “lemons.” For example, DFA avoids transactions within a few days of a company’s earnings announcement and does not buy stocks that have recently been sold by insiders. DFA also encourages trading partners to disclose all information available to them by maintaining a “penalty box” fordishonest sellers.
DFA’s trading techniques also allow the firm to secure significant discounts on stock purchases. Buying high volumes of small stocks on the open market would involve a number of transactions and push up the stock price, leading to higher average purchase prices and high transaction fees. DFA manages these frictions by purchasing small stocks in large blocks through OTC markets....