DFA (Dimensional Fund Advisors) Case Study Questions PDF

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Prof. Yang's Investments class. Mandatory case study answers...

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DFA Case #2 Questions 1. DFA is an investment firm dedicated to the principle that the market is efficient. Therefore, DFA adopts a more passive investing approach; however, they also believe in sound academic research and the ability of skilled traders. Though DFA charges fees that are higher than that of a pure index fund, they charge less than the average actively managed fund, thus providing value for their customers. Their customers also get to see the fruition of the best research being implemented in their portfolios in addition to receiving valuable input from skilled traders to spot anomalies in the efficient market. There are advantages to passive investing if a market is thought to be efficient. If the market is efficient then passive investing will yield the most optimized returns because there is no outside information that can influence the market. Thus, management fees are cheaper with passive investing because no one in actively managing the fund. The cons of passive investing depends of if one believes in the efficient market. If some do not think the market is efficient, active investing can locate securities that are mispriced and sell them at a profit. 2. The Fama and French findings do make sense for the most part. Their three main findings were that higher beta stocks did not consistently yield higher returns, stocks with high BE/ME ratios consistently exhibited higher returns, and small stocks outperformed larger stocks. It makes sense that stocks with higher BE/ME ratios exhibit higher returns because generally, if BE/ME ratio is higher than 1, a firm is considered undervalued. If the ratio is lower than 1, the firm is overvalued. Undervalued stock can be bought and sold for a profit. Small stocks generally outperform larger stocks because small companies can grow faster. They need less capital to generate growth than large firms

and their stock price reflects this. What does not make too much sense is the fact that higher beta does not always produce higher returns. This seems to go against the principal of CAPM and the principle of higher risk, higher reward. This finding may point to some inefficiency in the market or may reflect how economic conditions have a great effect on the market that no financial model can compartmentalize. In the future, we should expect smaller stocks to outperform larger stocks because of the explanation stated earlier and also because of the fact that smaller stocks are riskier. Given their small size, they are more susceptible to market fluctuations and these companies generally have a niche market that serves a smaller population, so supply and demand factors are amplified with these firms. If the higher risk equals higher reward model holds true, smaller stocks should yield better returns than larger stocks. The evidence in this paper points to the fact that value stocks outperform growth stocks. Looking at the historical data, this seems to be the trend; however, in more recent years, growth stocks have outperformed value stocks. Using historical data to predict the future is quite unreliable, so it is hard to say if value stocks will outperform growth stocks in the future. The outperformance of value vs growth stocks will depend on other factors such as economic factors and public perception of stocks/companies. 3. DFA’s trading strategy sought to lower transaction costs as well as to create value for the company and for its clients. DFA did not bid on stocks on the open market, but instead bought large blocks of small cap stocks from sellers who really wanted to sell. By buying in large blocks, DFA was able to gain a discount on the stock purchase from sellers who were antsy to sell. DFA reduced adverse selection problems by trading with parties that had proven their trustworthiness. If DFA traded with a broker that was not upfront about

all their knowledge on the stock, DFA would add their name to a large board that was visible from any spot on the DFA trading floor so no one would want to trade with them. By implementing this trade strategy, DFA was able to get buy stocks at a discount from trustworthy buyers. They effectively reduced costs for both the firm and its clients. A downside to this trading method was portfolio diversification. DFA was willing to buy small cap stocks that were already over weighted in the portfolio compared to the market; however, they needed to get a bigger discount on the purchase to make the purchase worth it. This brings up the question of diversification as well. If DFA held so much of one small cap stock in a portfolio, that portfolio would become increasingly susceptible to risk. Other competitors probably do not emulate DFA’s approach because it greatly limits their ability to diversify. Most large mutual funds have historically purchased large stocks because purchasing stocks of small companies could affect these firms’ stock prices significantly. Focusing on small-cap stocks is somewhat untraditional to what many investment firms do, so it’s probably not a popular method to copy. Though research shows small stocks yield higher returns, there are many risks involved in this investment method that were discussed earlier. 4. DFA mainly specializes in U.S. micro and small cap portfolios but also offers large cap,

real estate, and international portfolios. DFA’s tax-managed funds worked by reducing dividends and capital gains and by avoiding short-term gains. They also harvested capital losses. Doing these things helps to reduce taxation or gives investors some kind of taxation benefit. These new tax-managed funds were natural for DFA to pursue because many of their clients fit the profile of a person who would seek portfolios to reduce taxes. These tax-managed portfolios needed to be comprised of certain stocks to be effective.

For instance, stocks that did not give out dividends were sought after. However, it was hard to find stocks that did not pay dividends, and when a portfolio was comprised mostly of non-dividend stocks, more portfolio tracking error and volatility increased. There is essentially a trade-off for tax-managed portfolios. A client may not be taxed as highly on their portfolio; however, their tax-managed portfolios are susceptible to higher volatility. They themselves may also incur higher transaction costs because DFA cannot follow their block stock buying strategy as strictly given the constraints of tax-managed funds....