Regulars to this site will know that we favour an approach to investing based on index style trusts. One of the preferred providers of those trusts is Dimensional Fund Advisors originating from the USA. Dimensional offer more than what might be phrased plain vanilla index funds as they incorporate leading scientific research completed by Professors Fama and French in the early 1990s which has been referred to as the three factor model.
This is a major reason for preferring to use Dimensional trusts in our client portfolios. However another significant issue is the approach Dimensional takes to applying their investment philosophy through careful trading.
Jim Parker outlines an element of this approach in a recent article - The Flexible Shopper. Following is a reproduction of Jim's article highlighting Dimensional's careful approach.
March 2010 - The Flexible Shopper
Experienced negotiators know that the balance of power rests with the party who is prepared to walk away from the table. By contrast, those eager to reach a deal often make the biggest concessions. So it is with investing.
A financial market is like a giant electronic bazaar, filled with millions of participants haggling over the prices of individual securities. These people are all driven by varying needs. And that is where it gets interesting.
For instance, index managers who manage portfolios to a nominated benchmark will often sacrifice transaction costs, turnover and price to keep their "tracking error" as low as possible.
At the other end of the scale are managers whose convictions about particular securities can be so strong that they will treat as secondary the prices they pay, the turnover they generate, the transaction costs and the taxes.
In between is a third type, a participant who is neither sweating on matching an index nor infatuated with a particular security. Not pushed to trade, this manager has the advantage of being able to walk away from the negotiation.
This third type of manager is agnostic about one stock over another if both fit the desired characteristics of the portfolio. And with a wide variety of stocks to choose from, he doesn't have to buy a particular security at a particular time.
This gives him great flexibility so he can afford to wait for the market to come to him. In technical terms, he is not compelled to cross the "spread" that separates the highest price that someone is prepared to pay for a security from the lowest price that someone is prepared to sell it for.
This is the approach that Dimensional takes to investing. Being neither an index nor a traditionally active manager gives Dimensional unique advantages in the intense real-time electronic negotiation of global markets.
Those other participants that are compelled to trade are known as "liquidity seekers". This means their sense of urgency about trading a security is such they will pay a premium to "liquidity providers" like Dimensional.
A liquid market is one with lots of buyers and sellers. So naturally, the liquidity premium will be higher in those parts of the market where there are not many participants and where stocks are harder to trade. These are precisely the parts of the market that Dimensional specialises in.
So what is the evidence that Dimensional is earning a premium from its approach to trading? The table below tells the story. It is from in-house research carried out by Dimensional research vice president Sunil Wahal, an expert on market micro-structure. It is a study of all the US equity trades Dimensional made between January 2007 and October 2008.
This shows Dimensional over this period paid on average 15 basis points below the best ask price when it was buying stock and earned on average 13 basis points above the best bid price when it was selling stock. These price improvements were even better in small cap stocks.
The take-out for ordinary investors from all this is that Dimensional's patient, flexible and opportunistic approach to trading — its freedom to walk away from the negotiation — is a real source of added value.
And that flexibility grows out of the firm's investment philosophy. While it does not hold strong convictions about individual stocks based on earnings forecasts, neither is it focused on tracking an index.
Dimensional works with the market, keeping its transaction costs low and using its trading expertise in less liquid stocks to earn a liquidity premium.
It's smart, it's flexible and it works.