Dimensional Funds Advisors Case Solution
Describe the Philosophy and business strategy of DFA. What sort of market behavior are they counting on? What types of customers do they sell to and how do they distribute their products? What is DFA’s View on Efficient markets?
It can be evaluated from the case that, the business strategy and philosophy of DFA was to rely heavily on academic research for its investment strategies and efficient market behavior. Furthermore, the firm invested in those stocks with market capitalization rate lower than a cutoff point set by the 20% of all NYSE. The firm invested in two types of stocks including small stocks and value stocks. Where, the stocks were selected based on the paper published by French and Fama. The stocks with high book to market ratio (BE/ME) were considered value stocks and those with low Book to market ratio (BE/ME) were considered growth or small stocks. Furthermore, the firm kept two portfolio namely SMB (Small-minus-big) in which, the small stocks were kept with Shorted big stocks and HML (High-minus-low) in which, the value stocks were kept with long and shorted growth stocks. These portfolios were offered to the customers available in the market,which, in turn, had enabled the firm to record tremendous growth over the years and enhance its investor’s base.
Moreover, the firm cateredto two kindsof investors available in the market, which included those investor or customers, who required short-term investment opportunities, allowing them to generate high returns from their stock-term investments in the portfolio offered by the firm. Whereas, the firm also targeted those investors, who were looking for a long-term investment that would add value to their current investments. These investors invested in the value stocks portfolio of the firm.
In addition to this, the founder of the firm believed that, the market was efficient, in which, no investor could consistently outperform, while some of them might outperform from time to time but that would be based on their luck. Therefore, the corporate view of the firm was that, the efficient marketdepended on the investor’s ability to consistently pick stocks that would beat the market.
List the factors Used in DFA’s Equity model and highlight some of the academic research behind these factors. Why does DFA expect those factors to work?
DFA considered the factors that would affect the investment and their expected return generated in the market. The firm invested in two portfolio namely SMB (small-minus-big) and HML (High-minus-low). Where SMB held small stocks and HML held value stocks. Furthermore, the firm considered that factors based on the academic research conducted by Fama and French, through which, they created Asset pricing model or equity model. It was evaluated through this model that, value and small stocks outperformed in the market, compared to others. More specially, it was determined that small stocks outperformed large ones and value stocks outperformed growth stocks in the market.These factors were fundamental to the investment strategy development of the firm based on academic research.Additionally, SMB and HML were used by prominent researchers to measure the historic returns of small and value stocks. Thisenabled them to determine that, small and value stocks in domestic equity portfolios generated higher average returns than conventional portfolios. In likewise manner, they were able to determine that, the stock with relatively higher Beta’s did not necessarily account towards generating higher returns compared to low-beta stocks, which could be illustrated from their paper nicknamed “beta is dead”. Moreover, the researchers were also able to evaluate that, stocks with high ratio of book value of equity to market value of equity accounted towards generating consistently higher returns, compared to stocks with low BE/ME. Hence, the founders of the firm expected the factors to work in the market because of the extensive amount to academic research conducted by prominent researchers namely Fama and French. Where, the corporations core believe depended on academic research for its investment strategies.This, in turn, would enable the firm to add value to its investors through the academic researchconducted, which could enhance the amount of returns generated from their investments..........................................
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