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Case 1 summary.docx

5 Pages

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FINA 411
Yuan Wang

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Dimensional Fund Advisory was an investment firm composed of small stocks. This firm believed in the efficient market theory. They believed in diversification to reduce firm specific risk, but they did not rely on indexing or passive investment. They believed in the “small stock effect”: small stocks provide greater returns than large stocks for the same amount of volatility. Their strategy was to invest in small cap stocks based on deciles. They started with thethDFA 9-10thtrategy”, in which they invested in companies chosen from the 9 and 10 deciles of the NYSE, the American Stock Exchange and the NASDAQ. Later, they added the “DFA 6-10 Strategy” and the “DFA 6-7-8 Strategy”. The implemented an active strategy by searching for attractive purchases. They screened stocks. They looked for impatient or desperate sellers. They rejected stocks that were expected to divulge news soon. They questioned themselves about the seller and the nature of the sells. Once they ensured that sellers were not selling because they had adverse information or negative private information about the stock, they then negotiated for a good price. DFA had an additional competitive advantage by creating trading efficiencies to reduce transaction cost. They charged an active management fee that was higher than passive management fees, but smaller than what the average active manager charges. It was part of their core beliefs to offer low transaction costs. They traded in blocks to extract a discount on the stock purchase, which in turn reduced transaction costs was able to extract a discount on the stock purchase. When stocks became too large, they sold them. They eventually added to their original product line until they had a full product line. They turned new academic findings into productive investment strategies. Their products were based on research results from academic sources. In fact, if research papers were used by DFA to build a new product, they offered the researches a percentage of their revenues. DFA’s investment philosophy is particularly focused on research by Fama and French. The two university professors had the goal to understand how beta explained returns. They found that beta did not predict long-run average returns. High beta stocks did not outperform low beta stocks. Size and book/market ratio explained average long-run return. Small and cheap stocks (high book/market ratios) have the higher average returns. What Fama and French had discovered was an opportunity for DFA to add new products to their product line. There is a relation between book/market and profitability. Book/market and earnings are negatively correlated. There are only 3 factors to consider when constructing a portfolio: The stocks market’s overall performance, the size-effect, and the “book-to-market” factor. Case oral presentation 1:  They purchase large blocks of small stocks at discounted prices.  They believe than the market is efficient. No one can beat the market. In the long run, investors will be rewarded for the risk they take. Their target clients are institutional investors. Large and sophisticated. External money  managers to help with their business. The company’s strategy: based on academic research and efficient market. They have elements from both: the passive and active strategy. DFA is in between active  and passive. They use diversification to reduce specific risk of individual stocks. They  replicate entire sectors.  How does a DFA screen stock: 1. Block trade through DFA system. 2) computer  screening size requirements. 3) Pros:  1) DFA small stock strategy: provides greater historical returns. Buying at large block  eliminates the sellers volatility 2) Academic oriented 3) DFA trading strategy:  4) Offer hybrid strategies: believes in efficient market. Allows them to diversify the risk Cons:  1) Rely mainly on computer­based systems choosing stocks 2) Did not rely upon indexing or completely passive investment strategies 3) Extreme liquidity problems in the smallest deciles: it’s hard for them to find a seller 4) Putting to much funds on small stock goal of Fama and French:  they examined: beta, size, leverage, e/p, and b/p size and b/p showed th
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