Slightly long because the case is more like a chapter on fund management. Don’t need a book with these fat Harvard cases (love em).
Dimensional Fund Advisors
General facts
1. DFA - ranked too far down (96th) by pensions and investments. Should we increase assets?
2. Efficient market philosophy.
3. Sound academic research and skilled traders.
4. 130 employees. 100 in calif, rest in chicago etc.
5. Professors get a cut of profit.
6. Broad product line. Started by managing money for institutions - $25 bn. Nearly all institutional clients are tax exempt. In 1989, started HNW individuals through registered investment advisors (RIAs). Clients paid RIAs for advisory - total charges reasonable. DFA provided RIAs with a low fee product that clients could not obtain themselves. DFA also educated RIA using latest research that RIAs used to advise clients. DFA DID NOT ADVERTISE. Grew RIA businesse to $15bn in 13 years.
7. Core beliefs - diversification, low turnover and low transaction costs.
8. Small cap portfolios based on decliles. Research from Banz. Outperformance from 1926-1970. Size effect (small beat large) shown across countries. DFA added SM funds covering europe, UK, Japan and pacific rim.
9. Fama and french.
- Beta alone is not a good predictor of returns. High beta stocks did not outperform low beta stocks. Beta is dead.
- High BE/ME is a good predictor of returns. Book to market ratio was the most powerful scaled price variable for predicting stock returns (more than PE and A/ME).
- Size effect exists.
- High BE/ME ~ value stocks. Low BE/ME ~ growth stocks - growth were typically overhyped? that did not go well with efficient markets hypothesis. DFA believed value stocks outperformed because they were riskier companies. Value stocks could be infested with distressed companies.
- 1993 paper - Three factor model: {Small - big, High - low, beta}. Variation in these 3 factors explained the bulk of variation in stock returns (regression analysis). Effects consistent with research in behavioral finance (Kahneman et. al.).
- MSI substantiated Fama and French's research using international data.
- {Value - growth} performance highly correlated across countries. If this wasn't the case, a portfolio of value minus growth stocks from major countries would have very low risk due to diversification and produce very good returns.
- While value did well on average, in some years, growth stocks outperformed value across countries - high returns from value stocks were a reward for taking higher risk.
10. Small Stock and Value Stock Performance
- Small stocks continued to lag. Growing use of S&P 500 for comparing and fund management. S&P 500 - in favor, small stocks out of favor but that didn't explain the low returns of small stocks. Fama & French showed that profitability of small companies had been poor through 80s and 90s wrt large ones.
- DFAs funds lagged behind due to focus on small cap.
- Critics - DFA had started at the wrong moment - as the size effect became widely known, people crowded into small stocks.
- 1990s : value stocks rose through the decade but dwarfed by the performance of growth stocks (high tech!). DFA missing the boat but for a rational investor, high priced growth stocks appeared unattractive. DFA hoped 2000 and 2001 will stop investors from believing that by investing in value (style), DFA eliminated the edge of that style.
11. DFA Trading Strategies
- Block trades - absorb the selling demands of others and reduce transaction costs (36%).
- If a fund manager wants to move from retail sector to energy and owns 1m shares of saks 5th avenue, getting rid of 1m shares on the market is impossible. Fund manager enters into a block trade. Fund manager --> I bank's block trading desk or broker --> DFA. DFA saw a 1000 trades and took 20.
- Adverse selection problem - are these people selling because they have adverse information about the stock? Pay attention to the seller and the nature of the block it trades.
- No fundamental analysis - just ensure the seller has no negative private information about the stock.
- Trust : Ask seller for full disclosure and entire holding so that the seller can't seller part of the holding to DFA and then bring the price down by selling the remainder in the market. Blacklisting (whiteboard) was costly for those who cheated because DFA was a key player. If there is trust, can do smaller deals also. If no trust yet, negotiate a steep discount on block. Sterling reputation for secrecy (leakage could bring price down).
- As a result of buying large blocks, DFA ended up with >= 5% shares of many companies (this requires SEC disclosures - 13D and 13G filings).
12. DFA Portfolio strategies.
- Match a broad based value weighted small stock index. No interest in betting on particular firms (active managers do that).
- Precisely matching index would require going out as a determined buyer - expensive. Take the stocks you can get cheaply while maximizing diversifcation and minimizing tracking error with the small stock index. If a stock's weight in the portfolio was too much already, ask for a discount. More overweighted, more discount to make the purchase worthwhile.
- Discount on price = f(knowledge of broker, knowledge of markets).
- Average discount of 3.33% on block trades. 36% purchases via block trade route. For 64% trades, work the order (vWAP etc.) - cost 0.58%. Weighted average discount on all trades = 0.83%. In 2001, average purchase discount for all trades : 2.13%.
- In Kind Redemption - Ensure very large withdrawals do not force DFA to sell stock - when someone redeems, give them shares instead of cash.
- Buy in blocks, Sell in pieces (no more than 25% of daily volume of stock in the market each day). Any stock was a small part of the portfolio, so could take their time to sell without seriously affecting performance.
- Outperformance of 200 bp over the last 20 years.
- Ibbotson associates - DFA's passive fund - good benchmark for small cap - can't run such a fund without trading because small cap stocks come nad go. DFA converted the difficulty of trading small cap stocks into an opportunity.
13. New Product : Tax Managed funds
- reduce tax payments - only useful for taxed investors (not pension plans for example).
- SEC : assume highest trx bracket. Mutual funds just passed on dividends and capital gains so individual investors were the eventual taxpayers.
- Dividends taxed as ordinary income (39.6% highest) immediately whereas capital gains can be deferred until realized, and are taxed at 28% (sold within one year) or 20% (if > one year).
- Fewer stocks paid dividends every year due to the above tax treatment.
- Matching index with size weighted holdings --> higher weight on larger, dividend paying stocks --> tax cost. Need to keep D/Y low while matching index. Value stocks could pose a problem (high Dividend yield).
- Capital gains were generally avoidable if net fund inflows were positive. However, need to sell stocks to avoid drift from benchmark (need rebalancing).
- Avoid short term gains - don't sell within a year if possible.
- Harvest tax losses (sell at loss to reduce taxes, buy 30 days later. balance txn costs against loss harvest benefit).
- Tax managed funds - natural business (clients need it).
- Tax managed funds - higher txn costs - sometimes had to give up block trades to avoid dividend paying stocks. Tax loss harvesting added to costs
- Net benefit of stock to portfolio = f(tax benefit, txn cost, risk factor loadings, volatiity). Complex but DFA has the profs and skilled traders.
14. Finale:
- Added tax managed funds for small cap, small cap value and international value stocks. 2001 : market wide tmf - 10bp higher fees.
- 2000, 2001 - growth stocks plummented in the dot com crash, HML portfolio had tremendous returns.
Bottomline Question:
For growth, so far we have relied on word of mouth and occasionally adding products. we're so successful. Should we try harder to grow?
