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Dimensional Fund Advisors Analysis
Philosophy of DFA
Dimensional Fund Advisors (DFA) was an investment firm based in Santa Monica, California that was dedicated to the principle that the stock market was "efficient," therefore implying that while over any given period some investors by luck would outperform the market and others would underperform, no one had the ability to consistently pick stocks that would beat the market (Cohen 2002, pp.1). In addition to this initial philosophy, DFA founders believed strongly that 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 would not only prove to be a successful business model amongst other firms, but would allow DFA to foster a unique quality of investing that singled it out from competitors.
DFA investments counted on market behavior involving the purchasing and holding of small stocks, accounting for much of DFA's primary business. In this sense, DFA's fees tended to be lower than those of most actively managed funds but higher than those of pure index funds which worked in conjunction with DFA's position in the market as a passive fund that claimed to add value (Cohen 2002, pp.2). Over the years, DFA began to count on more varied market behavior including the pursuing and managing of money for major institutions including, corporate, government, and union pension funds, college endowments, and charities (Cohen 2002, pp.2). DFA additionally offered investment services to individuals, clients, and accounting firms that acted as intermediaries known as registered investment advisors (RIAs), who became crucial in DFA's eventual ability to reach a market of wealthy clients who poured significant investments into the firm, allowing the firm to become one of the fastest growing equity start-up firms of the 1980s, with more than $5 billion in U.S. tax-exempt assets under management by 1990 (P&I 1990, pp.3).
II. Pricing Framework and Strategies
In 1992, Fama and French published a breakthrough paper entitled, "The Cross
section of Expected Stock Returns," which contained a multitude of findings including: the idea that stocks with high beta did not have consistently higher returns than low-beta stocks, asserting that investors receive greater return for taking on more risks; the notion that stocks with a high ration of book value of equity to market value of equity (BE/ME) exhibited higher returns that stocks with low BE/ME; and included a reiteration that small stocks tended to outperform large (Cohen 2002, pp.3). DFA, basing itself largely in small stocks as mentioned in the paper began to implement such strategies in its own dealings and price framework that DFA began using to generate its performance record in the market.
DFA continuously focused on small stock investments, hoping that such investment decisions would not only maintain the firm's clientele basis, but its relative success in the market, especially in viewing its investment decisions in accordance with the Fame and French research that had been widely publicized since its release. DFA's strategy differs from that of its competitors not only in its focus on small stocks but in its ability to take its time. DFA has become a master firm in its ability to gauge the evidence that is present from the momentum of stock prices, which has allowed DFA workers to not only track the index of stocks, but include stock tracking error to make wiser stock investment decisions and trading decisions (Jacobius 2003, pp. 26).
III. Personal Investment Strategy
In viewing the aforementioned strategies noted in the above section, a certain few could be considered integral parts of the personal investment strategy. While DFA maintained its significant utilization of small stock-based strategies and techniques for success, in 1990, the firm's decision to do so brought about its first significant misstep in the market. During this time, value stocks, which had reliably beaten growth stocks in previous decades in a variety of different countries, began to rise steadily and would continue doing so throughout the decade, but these steady returns were consistently dwarfed by the spectacular performance of growth rate stocks, most especially high-technology stocks with very high market capitalizations and relatively few assets in place, which were the epitome of what DFA consistently avoided (Cohen 2002, pp.4).
In sticking to its focus on small stocks, DFA and its respective strategies brought on significant challenges to itself and its clients that could have been more easily avoided if the firm had chosen instead to bend with the market, and adjust its techniques and strategies even slightly in a manner that may yield more significant market presence and larger profit margins for itself and for stakeholders.
IV. Contradictions and Signs of Inefficiency
DFA's consistent assertion to model all of its market behavior and investments under its objective to "deliver the performance of capital markets and increase returns through state of the art portfolio design and trading" for its clients, along with its refection of stock-picking and market timing to utilize enhanced indexing to design portfolios and limit trading costs consistently proved beneficial within its own client base and aligned with the firm's emphasis on the dimensions that determine investment results (Skypala 2010, pp.4).
While DFA consistently communicated its strategy, information, beliefs and market philosophy to its investors and clients, the truth remains that certain contradictions have presented themselves over the years to show that perhaps the market is not always as self-correcting and stable as DFA would like it to be. DFA's instances of poor performance show that investors can't reliably outwit the market despite its assertion that its investment strategies are based on a very solid story about risk and return (Jung 2011, pp.C1). DFA's belief that the market will always work, even in times of significant economic downturn, continues to harness beta from small-cap and value stocks, estimating their returns by considering factors such as market, cap, cash flow and book value, utilizing equity strategies that use diversification to reduce risk (Jung 2011, pp.C1). However, despite blips of underperformance and inefficiency in investments and in market philosophy, DFA and its strategies have fared far better than others, allowing firm investors to continue relying on the notion that the ideas around which DFA was built holds significant ground in the market (Jung 2011, pp.C1).
V. The Future of DFA
At the time of the case study at hand's publication in 2002, the prices of technology stocks and growth stocks generally, plummeted in response to an overwhelming and general drop in the market. However, value stocks massively outperformed growth, with a net return on the HML portfolio of over 80% for the two-year period (Cohen 2002, pp.11). DFA had not only maintained and grown its loyal clientele base, but had become a well-established and successful firm, reaching massive levels of profitability and garnering significant respect of clients and onlookers alike. In understanding this facet, the future of DFA looked promising, and in maintaining its ability to stick to its original business model, even during times of uncertainty, DFA has maintained a steady success over the years, which still exists today.
Dimensional Fund Advisors points to academic research for much of its success, noting that its far-reaching academic affiliations allow it to comprehensively respond to client needs based on the theory that markets are efficient, so an investor will not be able to exploit any short-term inefficiency over the long-term (Global Investor 2005, pp.1). Such a basis for investments has proven solid enough to hold up through times of uncertainty and in times of market success. Among investment managers, Dimensional Fund Advisors is ranked among the nation's top five in its providing of the lowest transaction costs in the United States (Akasie 2011, pp.C3). For the past three decades, a basis in academic research has considerably aided in DFA's success, making note of how deeply the theories of academic finance have taken hold in mainstream investment practice (Tully 1998, pp. 148).
Additionally, by working through advisors, DFA doesn't need to advertise to consumers, and as a result, the fund fees average about 35 basis points, or hundreds of a percentage point -- higher than most of the biggest index funds and exchange-traded funds but far lower than most actively managed mutual funds (Lieber 2011, pp.B1). Such work has allowed DFA to consistently draw fans who have admired the firm's successes since its inception in 1981 and wish to get in on the action.
For over twenty-five years, DFA has walked a path between active money management, in which stock pickers use research to choose individual shares for a portfolio and the passive investment style of the Vanguard Group, that tracks stock-market indexes by buying whatever stocks are in them (Ossinger 2006, pp. R1). Apparently, such a style has proved more than successful for DFA, who has consistently made strides in the market since its years as a firm and continues on the path to future successes rooted in the basis and ideals of its initial development. Such a strategy should not be altered, and in maintaining this…[continue]
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