Dimensional Fund Advisors, further referred to as DFA, is an investment company that bases its strategy mainly on academic research and related theories. They work together with proponents of the efficient market hypothesis, indicating a relatively strong belief in this theory and thus in efficient markets. However DFA also feels that skilled traders have the ability to contribute to a fund’s profits even when the investment is inherently passive and DFA does adjusts its strategy to new findings in the field. In this report we will evaluate the relevance and accuracy of the theories used by DFA, especially the value premium and the size premium where almost all of their funds are based upon. This will lead to comments on the usefulness of these theories to increase the return of DFA’s funds and to recommendations about changes in strategy that will enhance the performance of DFA overall.
Performance and strategy so far
DFA has performed relatively well over the years, aside from some relatively rough patches in the late 1990s. Growth of the company had been stable and profits high. There was no need to sell shares for liquidity reasons and shares were only sold if they did not fit into a fund anymore. This didn’t happen very often though as DFA had several funds that were “connected”, when a stock in the Micro Cap portfolio grew too big it could be placed into a fund with bigger companies (Small Cap portfolio).
An important part of DFA’s strategy, that contributed to the performance of DFA so far, is aimed at achieving discounts in trades through buying in large blocks. Results from research by Donald Keim show that the average discount obtained by DFA on block trades was 3.33%. These discounts were largely responsible for the fact that DFA’s passively managed small-stock portfolio outperformed the typical small-stock indexes by about 200 basis points per year on average. Another factor contributing to the relative success of these small cap indexes is the thorough research that DFA performs when it trades with other companies, preventing adverse selection and the negative implications of this phenomenon.
Despite DFA’s historic performance, the investment company is “only” ranked 96th (in Pensions and Investments) among other investment companies, changes in certain elements of DFA’s strategy and an increased focus on its competitive advantages will lead to a higher position on this list.
The logic behind the funds – The use of the Size premium and the Value premium findings DFA manages several funds, based on academic research and different empirical findings. One of these funds is the U.S. Micro Cap Portfolio, which invests in stocks whose market cap fall below a certain cutoff point. This fund had been launched in 1981 as a reaction to findings of, amongst others, Rolf Banz (1981). Banz had found that risk adjusted returns on smaller stocks had been higher, on average, than returns on stocks of larger firms. DFA saw an opportunity to acquire investors by using this new insight, because many mutual funds in that time focused only on investments in stocks of large companies. Following the launch DFA added the U.S. Small Cap Portfolio and the U.S. Small XM Portfolio, which had different cut-off points regarding the market cap.
In addition to funds that are related to the so-called size premium, DFA also used findings of other economists, Fama and French, to set-up new portfolios. Fama and French had found that “value stocks”, stocks of companies with a high book-to-market value, had provided a higher return than “growth stocks”, stocks of companies with a low book-to-market value. As a reaction DFA used the preliminary findings of the authors to set up a U.S. Small Value investment fund in 1992 and several other value funds were created in the following years.
DFA thus used findings related to the value premium and the size premium through creating...