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 Frequently
Asked Questions |
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Financial Theory If everyone followed an indexing strategy would markets still be efficient? This question has come up repeatedly ever since indexed strategies first appeared in the mid 1970s. Critics of indexing assert that markets would be less efficient if all investors adopted a market-fund investment approach. One can accept this theoretical viewpoint and still embrace indexing with enthusiasm. If the adoption of indexed strategies became so pervasive that market efficiency were impaired, it would be a self-correcting process. Mispriced securities would create opportunities for investors to earn profits in excess of their research costs, and their activity would drive prices back to equilibrium levels. We will never know how much information and liquidity are required for an efficient market. Markets for consumer durables such as homes or autos appear to be at least reasonably efficient, despite very poor liquidity, high search costs, and the absence of perfectly fungible assets. This behavior suggests a shift to passive investing would have to be very pronounced to have any effect on market efficiency. Even if all professional investment managers adopted a passive approach, other market participants would continue to provide price-setting information. Sources of such information could include corporate stock buybacks, acquisitions, and the investment activities of officers, employees, competitors, and suppliers. Despite the impressive commercial success of indexed investing strategies over the last twenty-five years, they still represent only a fraction of total stock market wealth. Isn’t the success of indexing in recent years mostly due to a “self-fulfilling prophecy”? Index funds appear to push up prices of a handful of big company stocks simply because they’re included in the S&P 500 index. Some critics of indexing assert that mechanical buying from index funds creates a “self-reinforcing trend” in a handful of large company stocks and that their price behavior is dictated by cash inflows to index managers, not fundamental business conditions at the underlying companies. Evidence to support this assertion is difficult to find. A more plausible explanation of pricing suggests it is the active money managers who dictate prices to indexers, not the other way around. As an example, an analysis of trading activity in General Electric Corp. stock* (the largest component of the S&P 500 index) found that programmed buying from index funds in January 1997 accounted for approximately 1.3% of total GE monthly trading volume. The notion that 1.3% of trading attributable to passive investors possessing no useful information determines the price-discovery process for the remaining 98.7% of market participants is far-fetched. Advocates of the “self-fulfilling” viewpoint must also confront a wide disparity in performance of individual issues. If the behavior of large company stocks is primarily attributable to passive investors buying without regard to fundamental developments, it is difficult to explain why Coca-Cola shares appreciated only 0.5% in 1998 while Wal-Mart Stores soared 106.5%. *Strategic Insight Mutual Fund Overview February 1997 What is CRSP? CRSP (“crisp”) is an acronym for the Center for Research in Security Prices at the University of Chicago. Established in 1960 with a grant from Merrill Lynch & Co., the center undertook a massive data-gathering project to answer the question “how have stocks performed over the long term?” Under the direction of James Lorie, Ph.D., a professor of business administration, and Lawrence Fisher, associate professor of finance, a database of both price and dividend information was compiled for all common stocks listed on the NYSE beginning in 1926. Over two million bits of information were entered onto magnetic tape, and the commercial computers then becoming available calculated total returns. The results were published in a landmark article in the Journal of Business in January 1964. The center continues to add data on a regular basis, and with a $180,000 grant from Dimensional Fund Advisors in 1984, added data from NASDAQ markets starting in January 1972. The CRSP data files have been an essential tool in the study of capital markets by an entire generation of financial economists.
Why does Dimensional use a ratio of book value to market value to construct portfolios for the value strategies? Book value appears to be increasingly unimportant in assessing stocks as investors attach greater significance to off-balance sheet assets such as technological expertise or brand recognition. The goal is to distinguish between companies with high and low investor expectations; using market price relative to some fundamental economic measure effectively captures these differences. There is no magic associated with book value; research shows that screening on other fundamental measures such as cash flow, earnings, or dividends produces similar results. Book value appears to do the best job in explaining differences in average returns over time between growth and value stocks, but the current reliance on book value does not preclude future refinements in screening techniques. Dimensional’s small company strategies employ a “patient buyer” trading strategy to purchase blocks of thinly-traded stocks at a discount. What happens if Dimensional gets a large redemption? Won’t it face the same transaction cost problem trying to sell these stocks? It would be difficult to manage our small cap portfolios cost-effectively if they were subject to large and unexpected redemptions. Unlike conventional mutual funds accessible by the general public, Dimensional strategies have been developed exclusively for a limited number of professional investors such as corporate pension plans, state governments and registered investment advisors. We work closely with clients to identify significant cash inflows or outflows in advance in order to minimize overall portfolio transaction costs. Although it has never occurred, the Portfolios are permitted to make redemption payments by a distribution of portfolio securities in lieu of cash (see DFA Investment Dimensions Group Inc. prospectus dated March 30, 1999, page 54). What is a reasonable expectation for portfolio turnover in the various strategies? A portfolio such as
U.S. Large Company will have relatively low turnover since companies in
the S&P 500 index which it attempts to track are replaced infrequently.
Turnover is generally higher for strategies focusing on the small capitalization
or value dimensions of the equity market. In order to maintain the desired
small cap or value characteristics, stocks are sold as they move out of
a pre-determined buy/hold range.
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International Equities Why is dividend reinvestment required for all Dimensional international stock Portfolios? Paying dividends in additional shares rather than cash is intended to reduce portfolio expenses, thus enhancing investment returns. Transaction costs are relatively high in some international markets – bank custody fees alone are $90 per trade in Spain, for example. Paying cash dividends at a specific time each year would either require the fund to set aside cash for future dividend payments (thus remaining underinvested in equities) or sell securities to raise cash, incurring transaction costs.
Why do Dimensional fixed income funds have annual portfolio turnover of 100% - 200% in some years? This appears inconsistent with a passive strategy. Dimensional’s fixed income approach is “passive” in one sense – it involves no interest rate or economic forecasting – but is “active” in implementation. Research conducted by Eugene Fama at the University of Chicago suggests a shifting-maturity strategy that targets segments of the yield curve with the highest expected return can add value relative to a conventional indexed approach. The optimal maturity targets are constantly reviewed using information provided in the yield curve, and transactions are made if the increase in expected return exceeds the cost of making the trade. Annual portfolio turnover in excess of 100% is not unusual. An important element of the shifting maturity strategy is a focus exclusively on short-term instruments with the highest credit quality. These issues are very liquid, and can be traded at very low cost. Click to read more on Dimensional´s Fixed Income Strategies. Why does Dimensional offer a global fixed income strategy but no international-only fixed income strategy? Shouldn’t the allocation decision between domestic and international fixed income be made by the advisor? Dimensional’s global fixed income strategy reflects our view that the sole purpose of fixed income in a balanced account is to dampen the volatility of equities. Returns for a U.S. investor in non-dollar denominated securities are determined by a combination of changes in foreign currency exchange rates and the return on the underlying fixed income securities. The return component attributable to fluctuating exchange rates frequently exceeds that of the fixed income securities by a wide margin. The additional volatility attributable to the currency fluctuations defeats the purpose of holding fixed income securities. If one could predict future changes in foreign exchange rates, it would be possible to engage in selective hedging activity in an effort to improve the reward-to-volatility characteristics. There is little evidence, however, that active managers are able to extract excess returns from foreign exchange trading with any consistency. As a result, Dimensional employs foreign currency forward contracts to hedge exchange rate risk at all times. High-grade securities from eight major international bond markets (Australia, Canada, Denmark, Euro, Japan, Sweden, U.K. and U.S.) are placed in competition with each other. Non-dollar denominated assets are purchased only when their expected returns (net of all hedging costs) exceed those of comparable U.S. instruments. No more than 30% of portfolio assets can be invested in any single country outside the U.S. It is not unusual for the portfolio to own issues from major multinationals such as G.E., Hewlett-Packard, or McDonald’s in several different currencies. By eliminating both the potential profit and loss from currency movements, the strategy eliminates the greatest source of risk in a global bond portfolio. The increased diversification provided by owning securities in multiple bond markets suggests it is appropriate to consider using Dimensional’s global strategy as a substitute, not just a companion, for a U.S-only approach. Why doesn’t Dimensional offer portfolios investing in mortgage-backed securities, convertible bonds, or high yield debt? Dimensional believes that five factors explain the vast majority of returns in diversified portfolios (market, size, and value for equities; term risk and default risk for fixed income). They also appear to explain the behavior of hybrid asset classes such as high yield bonds or convertible securities. In general, the behavior of these asset classes can be captured more reliably and at lower cost by using some combination of structured equity strategies combined with high-grade short-term fixed income securities.
If academic research demonstrates that value stocks have higher returns than growth stocks or market portfolios over time, why not put 100% of the equity allocation in value stocks? For investors who
define risk solely as the variability of returns, such a strategy might
be appropriate. Whether such investors actually exist is debatable.
Most investors are probably sensitive to the risk of being different from
the market, even if overall variability is no higher. Value stocks do
not outperform market portfolios regularly or predictably - if they did,
they would not be riskier. To the extent an investor is likely to be disappointed
with performance that differs from a market portfolio, a tilt toward value
stocks should be undertaken cautiously. Source: DFA |
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