Dimensional Investing - Eureka Report Article
By Scott Francis
This article looks at Dimensional Fund Advisors, which applies academic research findings to investment solutions. With two Nobel Prize winners on its board, Dimensional has always had close ties to academia. Not surprisingly then, it focuses more on the science of capital markets than on speculation.First, a couple of disclaimers: I use Dimensional funds as a key part of the investment solutions for my clients. That said, I am not paid by Dimensional, nor do I receive commissions from them. I use them only because, as an independent financial planner, I believe they provide the best portfolio solutions for my clients. To take self-interest even further, I invest a significant portion of my own portfolio in Dimensional funds.The '3 factor model' In 1992, two University of Chicago professors, Gene Fama and Ken French, wrote a paper entitled The Cross Section of Expected Stock Returns. This long-term study of the US market, which was published in the Journal of Finance, found that the bulk of variation in portfolio returns could be related to three factors:
|PORTFOLIO POINT: Dimensional Fund Advisors' passive approach to investing, based on a belief that markets are usually right, produces good returns over time for the risks involved.
The small-company factor had been documented by other researchers and was the foundation of Dimensional's initial strategy on its formation in 1981. Intuitively, this concept sits well with people, because investing in smaller companies is considered riskier and therefore requires a higher return to compensate for that risk. "Value" is a commonly used investment term and, in its broader use, refers to stocks with low price/earnings ratios or high dividend yields. For their research, Fama and French identified value stocks by using the book-to-market ratio. This ratio, which compares the accounting value of a company's assets to its market value as measured by the share price, is less variable year to year than other ratios such as price/earnings and dividends.Value stocks, those with high book to market ratios, are companies that are out of favour with the market for one reason or another. So while value and small stocks offer a higher expected return, they also represent a greater risk. This means the additional return, which is the same as the company's cost of capital, can be seen as compensation for that additional risk.Early critics of Fama and French accused them of "data mining", of sourcing data to support the results that they wanted to find. Since then, however, significant out-of-sample testing of the results, across varying timeframes and different markets, found that both the value and size effects hold true. Today, almost all research into investment returns uses the three-factor model as a benchmark. And in the academic world, the Fama-French model is widely accepted as a premier standard of investment performance.A second important idea behind the Dimensional approach is the efficient market hypothesis. This theory, developed by Fama in the 1960s, is that markets do such a good job of pricing individual investments that it is difficult to "beat" them consistently. This is the theoretical basis for investing in index funds or using passive managers generally. Since the market is mostly efficient (no one says it's perfect), the long-term costs and tax implications of trying to beat it by picking individual stocks and trying to time your entry and exit points do not pay. Building funds from the '3 factor model'Dimensional has built four Australian equity funds based on the three-factor model and the efficient markets hypothesis: large caps, small caps and value. The fourth, the core equity strategy, provides a single vehicle to capture all three dimensions of risk. The large-company trust is similar to an index fund: simply investing in the market's biggest 100 companies. Designed to be a core component of an Australian equity portfolio, it distinguishes itself through patient trading and controlling transaction costs. Costs associated with the fund are 0.25% per annum.The small-company trust invests in companies smaller than the top 100 companies down to as low as $15 million in market capitalisation. It takes care to avoid extremely small or illiquid investments. As at June 30, there were 409 companies in the fund; the cost ratio is 0.6%.The value fund invests in companies that are in the 30% of the market with the highest book to market ratios; as at June 30, the fund owned 211 companies with a cost ratio of 0.36%.The relatively new core equity fund invests across the broad market with an increased exposure to small and value stocks than you would find in a market-weighted portfolio; the cost ratio is 0.35%.This style of asset class investing provides the individual investor with the benefits of diversification, cost effectiveness and tax efficiency:
- Stocks are riskier than bonds and have greater expected returns.
- Small stocks are riskier than large stocks.
- Value stocks are riskier than growth stocks.
The results from Dimensional funds The vast majority of fund managers in Australia do not publish after-tax returns. Two that do are Vanguard (which builds index funds) and Dimensional. That is because the approaches taken by Vanguard and Dimensional are tax-efficient and they are happy to publish the results. It seems to me that returns before tax are not of great use to investors; tax is a reality and only after paying tax are your investment returns really yours to keep.Five-year average annual returns, after expenses, for an investor in the 31.5% tax bracket to the end of August this year were:
- Diversification by holding nearly all the stocks in a particular section of the market.
- Cost effectiveness by not funding expensive research aimed at finding individual stocks that might outperform.
- Tax efficiency by reducing portfolio turnover; that is, the manager is freed from having to pick stocks.
- Australian Large Trust: 13.65% (13.46% after tax).
- Australian Value Trust: 19.30% (18.76% after tax).
- Australian Small Trust: 18.54% (18.41% after tax).
Dimensional has a longer history in the United States, where the company was established. It is interesting to look at the 10-year data for the similar funds there during a time when overall annualised market returns, as measured by the S&P-500 index, were 8.91%.
|mDimensional trusts: Five-year average returns to August 31
Building portfoliosDimensional's funds are available to individuals only through accredited, fees-only financial planners who have been through educational programs about the company's philosophy and approach to markets. Dimensional also asks that their funds not be used in isolation but as part of an overall portfolio with a clear focus on asset allocation, which research shows explains more than 90% of the variation in total portfolio returns.Having built an appropriate asset allocation, the funds are then used to diversify Australian shareholdings between large, small and value companies, depending on the client's tolerance of risk. Large, small and value funds are also available for international investments. To reduce volatility in a diversified portfolio, the company also offers fixed-interest trusts, which focus on short-maturity and high credit quality investments. Are markets are right or wrong?As an investor, the most profound question you have to ask is whether you are going to build your portfolio using an active approach, trying to pick stocks, sectors, fund managers and asset classes that will provide above average returns, or are you going to use a passive approach, employing index managers or structured asset class managers like Dimensional.The significant difference is that the active approach means you are working on the basis that markets are wrong. You are trying to identify shares (or sectors or asset classes) that are, for some reason, wrongly priced and that will have above-average returns in the future. Ironically, the investor in these supposedly mispriced securities is then banking on the market to somehow become more efficient in the future and get the price right, so that their true value will be recognised and the investor can earn an above-average return.The passive approach works on the premise that markets actually work well. Markets do a good job of rewarding you over time for the risk that you take on.
|mUS Dimensional funds, 10-year returns to August 31