Dimensional Fund Advisors, 2002

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Investments Analysis and Management
Group 5: Dimensional Fund Advisors, 2002

DFA Overview
Dimensional Fund Advisors (DFA) is an investment firm founded in 1981 by David G. Booth and Rex Sinquefield, both graduates of the University of Chicago Graduate School of Business.

The firm has three Nobel Laureates sitting on its board: namely Myron Scholes, Robert C. Merton, and the late Merton Miller. Other directors include leading economists such as Eugene Fama and Kenneth French; they jointly created famous “Fama-French Three-Factor Model”.

DFA has more than $230.9 billion of asset under management (AUM), as of 30 June 2011, rising from slightly over $35 billion in 2002. Its mutual funds are not offered to individual investors, but only to institutional investors and approved fee-only Registered Investment Advisors (RIA).

Principle of DFA’s investment philosophy - Efficient markets

DFA was founded on the premise on efficient market hypothesis (EMH) and that no one could consistently outperform the market. This passive approach to investments is contradictory to Wall Street where the belief is that through expert stock selection, one can out-maneuver the market.

Since DFA believed that markets were efficient, their fees were lower than most actively managed funds but higher than pure index funds since they were positioned as a passive fund that claimed to add value. As such, they employed a combination of passive investments but active trading.

There are three major premises surrounding the efficient market hypothesis: "weak", "semi-strong", and "strong". Weak EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. Semi-strong EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. Strong EMH additionally claims that prices instantly reflect even hidden or "insider" information. There is evidence for and against the weak and semi-strong EMHs, while there is powerful evidence against strong EMH.

Fama-French Findings and CAPM Theory
Fama and French published a paper entitled, “The Cross-section of Expected Stock Returns” which turned the CAPM theory on its head. These were the top findings: 1.   Stocks with high “beta” did not have consistently higher returns than low-beta stocks. – This finding makes sense because the beta is the measure of volatility of a stock comparing to that of the market. So during the time of market downturn, the price of stocks with higher beta would fall more, creating negative returns.

2.   Stock with higher B/M ratio exhibited consistently higher returns than stocks with low B/M ratio – We believe this, however we were not totally convinced by the rationale behind it. We do not think that the higher return was due to the higher risk exposure but because of stocks misevaluation and market inefficiency. Stocks with high B/M ratio are considered “value” stocks, meaning that they have all the tools to perform better and they’re being undervalued. In this case, the market might have overreacted causing its price to fall but the fundamental of the company remains the same. Eventually, the company will be able to bounce back, creating a high rate of return for investors. 

“Growth” stocks are those with low B/M value, meaning that these companies are not well established and are being overpriced. Investors are bidding for its growth, which is very uncertain. We therefore assume that the rate of bankruptcy for these companies might be high and, therefore, could generate high negative returns. If we averaged the return on both types of stock, the return on “value” stocks should be higher as they represent more stable and established companies.

3.   Small stocks outperformed large – According to a dissertation written by Rolf Banz, he found that small stocks outperformed large based on data taken from 1926...
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