Dimensional Fund Advisors Case
1. Describe the investment strategy employed by DFA. Does DFA consider itself an active or passive manager? What aspects of its strategy are active? What aspects are passive? DFA’s investment strategy was centered on academic research, specifically on the findings of Banz’ “size effect” and Fama and French’s “book-to-market effect.” In Banz’ research, he found that small stocks consistently outperformed large stocks over the entire history of the stock market from 1926 through the late 1970s. See Exhibit 1 for overview of growth between large and small cap stocks. In the Fama & French paper, they found that: 1) stocks with high beta did not have consistently higher returns than low-beta stocks; 2) stocks with a high BE/ME ratio exhibited consistently higher returns than low BE/ME stocks; and 3) consistent with Banz, small stocks outperformed large stock. DFA favored the portfolio management implications of the book-to-market effect and took the stand that value (high BE/ME) stocks outperformed growth (low BE/ME) stocks in a rational, efficient market; this includes findings on Fama/French analysis on both domestic and international markets. DFA has a broad product line but business primarily is for their small stock, value stock, and tax-managed funds. DFA also differentiated themselves from others by charging lower fees than actively managed funds and the practice of purchasing large blocks of stock off the market for a discount. DFA would sell stocks in very small amounts, typically less than 25% of the daily volume. DFA’s strategy was to attempt to match a broad-based, value-weighted small-stock index. See Exhibits 2 and 3 for DFA small cap, value strategy. DFA has a passive strategy based on the principle that the stock market is “efficient”. DFA is passive in that it would simply absorb the selling demand of others by purchasing large blocks of stock at discount. DFA is active in selling stocks in very small amounts. DFA also is active in its strategy of specifically building portfolios that could considerably reduce the taxes paid by clients. The firm has no interest in attempting to bet on particular firms by taking especially large positions in them – it left this to the active fund managers. The traders at DFA have to balance two objectives: they want to get the stocks they could purchase at the best discounts but to do so in such a way as to keep the fund maximally diversified and thus have minimal tracking error with the small-stock index. DFA is willing to buy more of a stock that is already overweighted in the portfolio relative to the index, but the more overweight the stock is, the greater a discount DFA would have to obtain to make the purchase worthwhile. DFA’s passive strategy meant it did not sell based only upon a new, negative opinion about the company. In general, DFA sold shares only if a stock no longer fit the portfolio it was in – if a small stock becomes large, or a value stock becomes a growth stock. 2. Who are DFA’s clients, and what are their concerns? What new clients is DFA trying to serve, and what are some of the new issues DFA will face in meeting these clients’ needs? DFA’s clients are primarily major institutions (corporate, government, and union pension funds, college endowments, and charities), most of them tax-exempt because of their non-profit status or tax exemptions granted to retirement plans. In the latter part of the 80’s, DFA pursued high-net-worth individuals by offering services through registered investment advisors (RIAs). The typical DFA client cared about keeping low trading costs and reducing tax payments while understanding the importance of diversification. DFA will face the contradictions necessary to manage each specific mission of each fund which could be very tricky with all of the similar yet difficult strategies of each product. 4. Identify the sources of value DFA is proving its investors. DFA offers value by...
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