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 …show more content…
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 “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
DFA’s investment strategy is based on their belief in the principle that stock market is efficient. They attempt to match a broad-based, value-weighted small-stock index and position themselves in the market as a passive fund manager that still claimed to add value by capturing specific dimensions of risks identified by financial science. DFA’s investment strategy incorporates elements of both passive and active management. It is passive in the sense that like many other index managers, it focuses on the importance of diversification, lower turnover and lower fees than actively managed portfolios. It is active in the sense that it develops its small-value stock focus based on academic research and uses certain techniques (such as
The basis of Efficient Market theory is considered to have a gap in theory and practice that
Dimensional uses the EMH to its advantage in coming up with its strategies. First the focus on stocks over bonds because there is a greater return on stocks. Second, they focus on several different kinds of smaller stocks instead of just one particular larger kind. The is always a risk when investing in anything. Time, relationships, and money. DFA is aware of the risks and do everything they can to make sure the best options are available to their clients. They focus on diversification of the market as a tool to reduce the risks involved. DFA uses research based portfolios that are specific to the task at hand. Its dimensional funds returned at 42% which is way above other firms in the same field.
“The Benefits of diversification are clear. Portfolio theory has played a crucial role in explaining the relationship between risk and return where more than one investment is held. It also enables us to identify optimal and efficient portfolios.”
The Efficient-Market Hypothesis (EMH) states that it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.
DFA’s founders believed in two principals (outside of efficient markets): 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. By working closely with the academic world, DFA is able to exploit opportunities generated from academic research before others are able to; this creates opportunities for short and long-term excess return. Also, working in stocks that other mutual funds do not participate (micro, small-cap) allows DFA to exploit opportunities in otherwise illiquid stocks. By having a large presence in this market, the company is able to take advantage of trading opportunities with counterparts (liquidity discounts from block purchases).
Thus, this block-trading strategy combined with adverse selection avoidance allowed the DFA to beat the market and thus the benchmark by about 200 basis points over the 20 year period. And as a result became the benchmark for these types of portfolios.
The Miller and Modigliani (1961) study was often used as a starting with Black and Scholes (1974); Merton and Rock (1995) and Bernstein (1996) who supported their findings. However, in later research, several studies disapproved of their findings (Walter,1963; Litzenberger and Ramaswamy, 1982; Fama and French, 2002 and Kajola et al., 2015).
Value investing is a way of investing in company stocks that are considered either undervalued or out-of-favor by the market. In other word, a value investment is one where the intrinsic value of the stock is not accurately reflected in the current market valuation. The underlying reason of too much decreasing in the stock price is that the company may be losing market shares or even in trouble due to market’s panic attributed to negative rumors as well as having management problems. Since the market price has dramatically descended, the book to market
CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.
To reduce brokerage fees, this fund aggregated all investment activity by plan participants on a daily basis, matching buying and selling activity. Participants could trade the company stock fund on any business day, but limited to only twice a month. In 1998, Amoco DC plan assets were valued at $5.1 billion. 55.5% of the assets were invested in company stock. The rest of the assets were invested in equity index funds and the money market fund. The plan had 27,290 participants with an average of $186,000 per participant, and contributions of about $4,182 per year from each one of them. The company matched contributions up to 7% of pay.
Investors hold diversified portfolios : One of the assumptions of CAPM model is that investors are holding only portfolios which are subjected to systematic risk , the unsystematic risk can be ignored , therefore the unsystematic risk has been ignored (Lakonishok & Shapiro , 1986)
CAPM on the other hand is based on microeconomic ideas such as concave utilities and costless diversification. Macroeconomic events mentioned include interest rates or the cost of labor, causes the systematic risk that affects the returns of all stocks. On the other hand the firm-specific events are the unexpected microeconomic events that affect the returns of specific firms for example the death of key people that would affects the firm, but would have a insignificant effect on the
Richard Roll, and University and Auburn, University of Washington, and University of Chicago educated economist, began his career researching the effect of major events of stock prices. This experience likely helped him reach the two conclusions he makes in his 1977 “A Critique Of The Asset Pricing Theory’s Tests”, one of the earliest and most influential arguments against CAPM. In the paper, Roll makes two major claims: that CAPM is actually a redundant equation that just further proves the concept of mean-variance efficiency, and that it is impossible to conclusively prove CAPM. His first claim relates to mean-variance efficiency: the idea that mathematically one must be able to create a portfolio that offers the most return for a given amount of risk. Roll claims that all CAPM is doing is testing a portfolio’s mean variance efficiency, and not actually modeling out projected future returns. The second claim in the paper is that there is not enough data about market returns for CAPM to ever prove conclusive. Even if modern technologies could help alleviate some of the burden of testing market returns for publicly traded equities, there is still no way to account for the returns of less liquid markets, where there is less public information. This means it is impossible for