trading

When It Pays to Be Patient

trading

One of the reasons that Index Fund Advisors advises the use of Dimensional funds is their patient and opportunistic approach to trading which differentiates them from traditional index fund providers. All too often, managers of traditional index funds require immediacy in their trades. For example, a Russell 2000 index fund is reconstituted annually in the middle of the year, selling the equities that are no longer in the index and buying the equities that have been added to it. The problem, of course, is that all the Russell 2000 funds are attempting to complete these same trades at the same time, which opens up the possibility for exploitation by the sharpies of Wall Street.

In past discussions of DFA’s approach to trading, we have focused on the equity side, but a recent internal whitepaper1 from DFA highlights the advantages on the fixed income side. One important underlying principle is the substitutability of securities with similar risk characteristics. If two companies have similar valuation characteristics (e.g., market capitalization and price-to-book ratio), then we can be indifferent as to which one we would add to an equity index fund, allowing us to buy the one that can be traded at a more favorable price. If companies can be interchangeable on the equity side, then they can be even more interchangeable on the bond side because a bond is simply an obligation to make fixed payments while equities have unlimited potential for appreciation or depreciation. Thus, two companies whose bonds have similar term and credit risk can be considered substitutes for each other.

The researchers from Dimensional analyzed $30 billion of fixed income trades in 2011 and 2012 across 18 countries using data from the Trade Reporting and Compliance Engine (TRACE). They compared Dimensional’s execution prices to those of other market participants in the same or similar bonds. Specifically, they looked at trades that were placed immediately before or after Dimensional, they compared similar sized trades in the same bond within a five day window, and they compared trade costs of purchases of similar bonds within a one day window. They found an overall price advantage of 14 basis points for corporate bonds and 6 basis points for US agency bonds. While this may not seem like much, in today’s low yield environment, every little bit counts. While we think of index funds as adhering to rigid rules of construction, there is no reason why the rules cannot include flexibility in trading to seek superior execution compared to other market participants. We consider this to be an example of acting in the best interest of investors, something to which we, as a fiduciary for wealth, continuously aspire.

1Shao, David and Dave Twardowski, “Trade Price Advantages of Flexible Fixed Income Portfolios”, Dimensional Research, February 2014.