This article has been reproduced by permission of Objectif Conseiller.
Academic Investing
By Christian Benoit-Lapointe
September 2004
From the start, Dimensional Fund Advisors (DFA) has known academic research well. Eugene Fama, a University of Chicago professor who created a big stir during the sixties with the Efficient Markets Hypothesis, has led that research. According to his hypothesis, investment return is almost entirely determined by asset allocation, given that the price of a stock is based on all available information. So, an investor who wants to generate a better return must take on additional risk. This theoretical framework was likely a cold shower for advocates of market timing and stock picking!
Toward the end of the sixties, two of Mr. Fama's students, David Booth and Rex Sinquefield, were consumed with the theories of their mentor. Their desire to apply academic research to the real world of investing led them to found DFA in 1981. Since then, they have remained faithful to this philosophy. "To our knowledge, we are the only company whose entire suite of strategies is based on the belief that the market is efficient," affirms Brad Steiman, regional director of Canadian operations for DFA.
| Value Stocks Prevail |
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| Source: Dimensional Fund Advisors and E. Fama/K. French. |
The Three Risk Factors
In the decades since, researchers have deepened their understanding of the relationship between risk and return. Following in the footsteps of Harry Markowitz and Bill Sharpe, economists have tried to determine how much an investor would be compensated for each type of risk, and for what types of risk an investor would not be compensated. An investment that is too concentrated, for example, would represent one type of risk that could be eliminated in a diversified portfolio.
In the 1990s, Eugene Fama and Kenneth French furthered their research with the Three-Factor Asset Pricing Model. This model defines three factors:
The Nature of the Market. This principle is widely accepted: The risk and return associated with the stock market is higher than that of fixed income securities.
Company Size. There is a premium for small company stocks, since they are a riskier investment. "It's a continuum: the smallest-cap stocks in an asset class have the highest expected return when compared to the largest, but they are also the riskiest," explains Kenneth French, a professor at the Tuck School of Business at Dartmouth College.
Value Stocks. "Value" stocks, those that are priced relatively lower than their fundamental value (they have a high book-to-market ratio), have a return potential that is greater than that of "growth" stocks. According to the professionals at Dimensional Fund Advisors, value companies are riskier and have a greater cost of capital. When they borrow from the bank, value companies are required to pay a higher interest rate than growth companies and, when they issue shares, they receive a lower price. Since the cost of capital corresponds to the expected return of the investor, the return on value stocks turns out to be higher.
The Fama and French research resulted in new asset classes that the industry later adopted: small capitalization, large capitalization, value, growth, etc. "Their research demonstrates that up to 96% of the return can be explained by the exposure to different levels of risk and return; that is, to these asset classes," affirms Mr. Steiman.
How the Research Has Served Investors
Before DFA opened an office on this side of the border last year, no Canadian advisor was able to do business with them. However, PWL Capital, a company that has believed for a long time in the virtues of asset allocation and the use of index products, has fostered a relationship with DFA for over five years. Keith Matthews, vice president of communications, an associate and portfolio manager at PWL Capital, saw an excellent opportunity to gain access not only to Fama's and French's expertise but also to that of other renowned economists who are members of the board of DFA,1 like Roger Ibbotson, Rex Sinquefield, and two Nobel prize winners: Myron Scholes and Robert Merton. "Of course, the academic research is available to anyone. On the other hand, Dimensional is the only company to compile academic research information in order to work with institutions or advisors with the goal of implementing it," he maintains. "The essence of DFA is that researchers and professors work directly with investment professionals."
"This level of theory implementation is of interest to researchers," adds Mr. French, who is also the director of investment strategies at DFA.2 "It is great to be able to incorporate the complexity of real-world problems back into our research—all the more so since what we learn in the field is furthering our research. We discover elements that we otherwise would not have noticed."
Understanding Asset Class Returns
It goes without saying that Dimensional rejects the principles of active management, judging it to be more related to speculation than to investing. When building mutual funds, it attempts to capture as best it can the market rate of return for an asset class. To do that, DFA capitalizes on the advantages of index investing, like low management costs and broad diversification; but it avoids the negative aspects of indexing.
"DFA is thus able to create value on two levels," explains Mr. Steiman. "First, by constructing portfolios and asset class definitions." DFA defines asset classes the same way as do the economists and scholars with whom they collaborate. DFA is not confined by standard benchmark definitions. "Take the Russell 2000, an index widely used for US small cap stocks. Even though it incorporates real estate investment trusts, we choose not to include them in our small cap fund because recent research has shown that there is a correlation between these trusts and real estate itself, a distinct asset class. Consequently, we are not saying that they have no inherent value, but we are excluding them on the basis that we want to allocate 100% of our holdings to the small cap asset class."
The company is not restricted to the close tracking of an index, which also allows the company to add value. Primarily, when it comes to less liquid asset classes, transaction costs are immense; not necessarily with regard to commissions, but certainly with regard to their impact on the market price. By negotiating in large volumes, it is possible to raise the share price. DFA can take its time, benefiting from the negotiation of blocks of shares and taking advantage of discounts. Likewise, research of the reconstitution effect shows that when an index is reconstituted, the market knows which stocks will be added to or removed from the index, and at what moment. This information is reflected in the stock price. There is an increase in demand for the shares being added to the index, and vice versa. "If you need to match the index, you don't have a choice. You need to pay for the assets that everyone else is concurrently trying to get their hands on. That could be very costly. In the case of the Russell 2000, that could correspond to 150 basis points per year." DFA also employs strategies to improve the tax efficiency of its funds.
Finally, DFA has taken additional steps prompted by academic research: it avoids initial public offerings and refuses to invest in corporations that have less than four market makers, thereby ensuring more liquidity, lower transaction costs, and a certain level of protection against fraud. In brief, its criteria for investing in a stock are stricter than those of the National Market System.
The Canadian Debut
Last year, DFA opened an office in Vancouver. This is its third foreign market, following Great Britain and Australia. The company, based in Santa Monica, California, manages assets for licensed financial advisors and 175 institutional clients worth more than 65 billion dollars.
In addition to offering access to cutting-edge research, DFA emphasizes excellent communication. "I believe this is a key element in helping educate our clients so that they have a good understanding of the asset allocation concept," comments Mr. Matthews. DFA provides a lot of training, from research to communication. It also offers its clients high-quality tools for asset allocation and portfolio construction. It has made available six new strategies to Canadian advisors, such as the Canadian Applied Core Equity, launched at the beginning of the summer. This marks the first time that DFA's approach has been used in a Canadian equities strategy.
The Appoval Process
Though not a private club, DFA does not make its products available to all advisors. The company gives preference to long-term relationships with independent advisors that share its philosophy. They must deal with high-net-worth clients and be fee-based. They also must follow a six-step procedure, from which both parties may withdraw at anytime:
- Initial contact is established.
- Documentation is sent by DFA.
- A meeting takes place in person or online.
- The advisor attends DFA's introductory conference.
- A follow-up after the conference is made, and a business plan is submitted.
- Transition and business development take place.
This process protects advisors and their clients. "It keeps out advisors who would like to sell DFA's funds but do not share its investment philosophy," concludes Mr. Matthews. "In short, this maintains the integrity of the system."
1 The directors mentioned serve on the mutual fund boards of directors.
2 Kenneth R. French is a consultant for Dimensional Fund Advisors.
This article contains the opinions of the author(s) but not necessarily of Dimensional, and do not represent a recommendation of any particular security, strategy or investment product. The opinions of the author(s) are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.