Dfa Case Study free essay sample

INVESTMENTS DFA Case study Introduction 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. We will write a custom essay sample on Dfa Case Study or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page 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 â€Å"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 Keim1 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 â€Å"only† ranked 96th (in Pensions and Investments) among other investment companies, changes in certain elements of DFA’s strategy and an increased ocus 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 Banz2 (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 â€Å"value stocks†, stocks of companies with a high book-to-market value, had provided a higher return than â€Å"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. 1 Donald Keim, Exhibit 10 from Harvard Business Case (2003). 2 Banz, R. W. , ‘The relationship between return and market value of common stocks’, Journal of Financial Economics, 9 (1981), pp. 3-18. DFA thus used findings related to the value premium and the size premium through creating several funds. DFA’s strategy is as a result of this to a great extent depended on the actual existence and persistence of both effects. Did DFA react too quickly to these still relatively controversial findings, do they fit in with the relatively strong beliefs in efficient markets by DFA and could a change in DFA’s strategy increase both the performance of its funds and the company overall? These questions will be answered by a thorough analysis of the value, and the size premium. Value premium A lot of criticism on the CAPM has arisen over the last decades. One finding by Basu in 1977 is often used by opponents of the model in order to take down the foundation of the CAPM. Basu3 found that stocks with a low price –earnings ratio, called value stocks, tend to outperform stocks with a high priceearnings ratio, named growth stocks. As the CAPM only allows for fundamental risk to explain excess returns on stocks, the finding that stocks from companies with high fundamentals (earnings, sales, dividends) relative to price outperformed growth stocks was in contradiction with the classical CAPM. Proponents of the CAPM and the efficient market argued that the value premium could be explained by their â€Å"classical† risk-and-return rewards, value stocks they argued earned higher returns due to higher risk related to poor performance in the recent history of the firm. Fama and French4 however also concluded that the value premium did exist and even found in the same paper that the book-to-market ratio and size premium together were able to explain excess returns of a stock while fundamental risk, the only ingredient in the CAPM, had no explanatory power anymore. After these findings by Fama and French a lot of other papers have been written about the value premium, while some of these are highly critical on the value premium5 most of them conclude that there has indeed been a premium on returns of stocks with a high book-to-market ratio at least for some periods in time. This premium has been quite extensive in certain times, Fama and French6 for example found that small value stocks had made 8% per year on average in excess of market returns from 1934 till 2006 and that the premium for big value stocks had been 2. 8%. When you look at the graph below however you can also see that the value premium has been far from constant over time. In most of the 90’s for instance growth stocks outperformed value stocks, while after the internet bubble a reversal set-in and value stocks did a lot better than growth stocks. Some argue that cyclical circumstances can clarify these changes in the value premium7, but if you take another look at the graph it is hard to defend this explanation since the value premium was negative and didn’t go up during the most recent â€Å"financial crisis†. 3 Basu,