Comments on Barron's Dimensional Fund Advisors Profile

Friday, January 17, 2014 15,545 views

 

"Active management is a zero-sum game, and that's before costs. That's not opinion, that's math."

--Eugene Fama, 2013 Nobel Prize in Economics, Professor of Finance, Chicago Booth, as quoted in Barron's, "A New Dimension", January 4, 2014

 

Market Dimensions

Eugene Fama has had a busy few months. Thrust from relative obscurity in the investing world, the University of Chicago finance professor was awarded the 2013 Nobel Prize in Economics, and kicked off 2014 by capturing Barron’s full-page cover, alongside long-time business partner, David Booth—the two of them smiling under the all-caps epithet “MARKET BEATERS.”

The Barron’s story, written by Beverly Goodman, chronicles the success of Dimensional Fund Advisors (DFA), the mutual fund company Booth founded to put into practice what he learned from Fama, among others, while a student at the University of Chicago. Back in 1965, Fama set forth his Nobel Prize-winning theory that markets are efficient and that no amount of forecasting, analysis or stock-selection enables an investor to consistently beat the market.

Implementing Fama’s premises, Booth (and retired co-founder Rex Sinquefield) set out to capture market returns, while seeking to enhance those returns through very efficient trading methods and by tilting the market portfolio toward small companies and value stocks; Fama’s other research (together with Ken French) showed that small and value stocks delivered compensated risk exposures — additional returns for the additional risk taken. 

DFA has enjoyed stellar success in the 30 years since its humble start in Booth’s 2-bedroom Brooklyn brownstone. Today, this multi-national company’s home is a sprawling campus in Austin, Texas -- an impressive think-tank where academics and a handful of Nobel Prize winners put research findings into practice. Despite the fact the firm does not advertise, it has amassed more than $330 billion in assets. These two videos (Part 1 and Part 2) will give you further insight into this unique investment firm.

 

Changing the Way the World Invests

Since 1999, our firm, Index Fund Advisors (IFA) has educated investors the world over about Fama’s findings and the merits of a globally diversified portfolio built with low-cost index funds — namely from DFA. Leveraging the ability to communicate to the masses through the web, ifa.com set out to “change the way the world invests by replacing speculation with science.”

Through the free and ongoing distribution of information about Fama’s and other Nobel prize-winning research, along with hundreds of academic studies, articles, videos, charts and graphs, ifa.com has effectively communicated DFA’s value to investors. After 15 years of continuous education and 15,000,000 page views, and more than 1,000,000 blog views, we are proud to have played a role in bringing the lessons of market efficiency to the masses.

Education is a tall order. It’s not just about pushing out any information. It’s about research — combing through reams of studies, and discerning evidence from hype, and clarifying the difference. It’s also about clearly articulating a message about topics discussed within an industry that thrives on ambiguity and inconsistency — with no uniformly agreed upon terms that are clearly defined. 

The Barron’s piece provides an excellent example. It highlights Fama, who is known for his assertion that no one can fashion a strategy to consistently beat the market — and yet it credits him and Booth for developing a method that does just that. 

The “market” is a term used to describe a benchmark index, and there are many — each with differing styles and risk and return characteristics. The S&P 500 is the most commonly cited index, and it is usually what investors conjure up when they hear the term “the market.” Vanguard’s flagship index mutual fund, Vanguard 500 simply buys and holds the market-cap-weighted S&P 500 index, composed of a blend of large U.S. growth and value companies. Other funds, such as the exchange-traded-fund SPY, accomplish this same task.

One of the main culprits behind the confusion or inconsistency of statements found in the investing industry, in general, and also carried through in the Barron’s piece is that there are no universally applied definitions of terms such as “index funds.” While many have long viewed DFA as being a supplier of index funds (IFA included), the commonly held understanding of the term doesn’t easily fit DFA, leaving enough ambiguity to give rise to the notion that DFA is actually beating an appropriate index. And Goodman fuels the fire of confusion by stating that we should be wary to “liken what DFA does to indexing.” Why not?

 

What’s in a Name?

Wikipedia describes an index fund as a “mutual fund that aims to replicate the movements of a specific financial market, OR (emphasis added) a set of rules of ownership that are held constant regardless of market conditions.” A definition that our President Mark Hebner contributed to Wikipedia. DFA operates its funds under a defined set of rules, and those rules are held constant regardless of market conditions. DFA’s rules of construction allow for latitude beyond strict adherence to a known and widely used index (tracking error is not a worry). DFA’s indexes do not abide by the same rules of construction as other widely used benchmark indexes such as the Russell or S&P indexes, but the company certainly applies and adheres to its own rules within its funds.  

Barron’s cites various factors that DFA exploits to “provide market-beating returns,” along with “sophisticated trading strategies.” However, consider those “factors” and “sophisticated trading strategies” as part of the rules of ownership that define DFA’s funds, and DFA’s index or even "factor" or "rules-based" funds begin to take shape. 

 

Active About Passive

Index funds are sometimes referred to as “passive” investments a turn of phrase Booth rejects: “I recoil when people think that what we do is being passive, because it has nothing to do with being passive… We are trying to beat the market without forecasting in the usual sense,” the article quotes Booth. 

While Dimensional funds are easily parsed into index categories based on geography, market-cap size and value/growth dimensions, there are other rules that drive the decision to invest in one company at a given time — none of which are based on short term forecasts or speculation, and all of which are based on those pre-determined rules of construction, including the firm’s willingness to assess how badly a seller needs to part with their shares, and the seller's desire to sell the lot quickly, and at a discount.

IFA would broadly characterize actively managed fund managers as "short term speculators" and passively managed fund managers as "long term investors."

“Where people get killed is getting in and out of investments. They get halfway into something, lose confidence, and then try something else. It’s important to have a philosophy,” says Booth. DFA’s philosophy is embedded in their rules of construction. And, in an ironic twist, one could easily assert that DFA’s success is, in large part, attributable to those rules that afford the firm flexibility to provide instant liquidity to active managers when they “lose confidence” and need to sell a lot of shares, and fast. 

DFA very actively researches historical market data, and seeks to increase returns relative to traditional benchmarks, by keeping costs low through their proprietary and flexible trading methods. That said, in IFA's opinion, DFA is not a manager that has been applying a short term forecasting or speculating strategies to beat a benchmark index. Instead, they are very long term investors who have developed their own unique set of rules, and Dimensional Indexes, that are focused on the factor research of Fama, French and other academics, as well as internal trading rules-based strategies that minimize market impact costs and capture liquidity premiums for being a patient buyer and seller of stocks or bonds that meet their rules of construction.

While the investing industry is rife with vagaries and inconsistencies, Nobel Prize winner, Eugene Fama remains abundantly clear on this point: "Active management is a zero-sum game, and that's before costs. That's not opinion, that's math."

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