Dimensional Fund Advisors, 2002
1. What is DFA’s business strategy? What do you think of the firm? Are the DFA people really believe in efficient markets? Dimensional Fund Advisors (DFA) is an investment firm based in Santa Monica, California, whose primary businesses are small stock funds. DFA’s core beliefs are efficient markets and two other principles: 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. With its founding, DFA surmised that acting on these beliefs would make it unique among investment companies. Besides, DFA charged fewer fees than those of most actively managed funds but more than those of pure index funds, which was fitting given DFA’s position in the market as a passive fund that still claimed to add value. Its business strategy makes sense, and that could be proved by its steady growth and strong profits. And with this strategy, it could pursue high-net-worth individuals, in addition to institutions, as clients through registered investment advisors (RIAs), which were a crucial conduit enabling DFA to reach the market without advertisement. Although DFA is dedicated to the principle of efficient market, but to some extent, the DFA people do not totally believe it. According to the efficient market hypothesis, when market efficiency is strong-form, stocks always trade at their fair value on stock exchanges and technical analysis, fundamental analysis and insider trading analysis are all fruitless. But DFA was not simply an index fund manager, it believed in the value of sound academic research and skilled traders’ contribution. Because DFA used the found that small size and high B/M ratio stocks had higher expected returns, its small-stock fund outperformed most small-stock benchmarks.
2. Do the Fama-French findings make sense? Should we expect small stocks to outperform large stocks in the future? Value stocks to outperform growth stocks? Fama-French model: E(Rit) − Rft = βi[E(Rmt − Rft] + siE(SMBt) + hiE(HMIt). Rft means risk-free rate at time t, Rmt means market return at time t；Rit means asset i’s return at time t；E(Rmt) – Rft means market premium，SMBt means the return of market capitalization factor at time t，HMIt means the return of book—to—market factor at time t. β、si and hi are coefficient of the 3 factors. In the CAPM model, the only risk is market risk and is measured by β,while in the Fama-French model we play much emphasis on idiosyncratic risk—the size of the company and the book—to—market ratio. This is true when the market is not effective. In addition, this result is evidenced by real data from Exhibit 6. First of all, the value premia of small stocks over large stocks as compensation for the additional risk that a small company is more likely to fail than a large company that has more assets. The “small firm effect” by Banz, discovered that historical performance of portfolios formed by dividing the NYSE stocks into 10 portfolios each year according to firm size, Average annual returns between 1926 and 2006 are consistently higher on the small-firm portfolios. the smaller-firm portfolios tend to be riskier. But even when returns are adjusted for risk using the CAPM, there is still a consistent premium for the smaller-sized portfolios. The second point is “the neglected-firm effect” by Arbel which interprets that because small firms tend to be neglected by large institutions, information about smaller firms is less available. This information deficiency makes smaller firms riskier investments that command higher returns. The DFA has reputation to overcome asymmetric information issue: it can get private information when cooperating with small companies. If semi-strong market efficiency hold, it is possible to beat the market having private information. At last but not least, we think is the “liquidity effect” by Amihud and Mendelson. Investors will demand a...
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