Why are the dimensional investments so effective?
While most of the financial planning industry chooses to ignore the body of research into how investment markets work, Dimensional (like us) have chosen to incorporate this research into effective portfolio solutions. The measure of Dimensional's links to the academic community are seen in the way that two nobel prize winners in economics sit on their board, alongside other highly regarded investment researchers like Gene Fama and Ken French.
In 1965 academic Gene Fama proposed that "In an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value." This is the theory known as the efficient market theorem. What does this mean for investors? It means that if investment markets are fairly priced, then the best way to get a good investment return is to use a low cost, well diversified investment portfolio - rather than spending money on research and trading. Index funds and passive funds, such as Dimensional, follow this approach - they are extremely well diversified funds with low costs that own all the investments in a universe - rather than trying to pick and choose the best. There is overwhelming evidence from academic studies that this low cost, highly diversified approach is superior to the more expensive active management approaches.
Here is a key difference. This passive approach says that investment markets work - that over time they do a good job of rewarding patient investors. If, 35 years ago, you have invested $10,000 in a simple index fund it would be worth just over $500,000 today - an average annual return of over 13% a year. Surely an outstanding return!
Active management, in contrast, says that investment markets don't work - that money is made by investing in ?undervalued or mispriced' companies, sectors and markets - while looking for the next ?undervalued or mispriced' company sector or market. There is a bit of a paradox with active management here - while they look for these opportunities from an apparently inefficient market, they rely on the market to eventually become efficient so that the undervalueing or mispricing is recognised and corrected - allowing them to profit from this.
In 1992 Gene Fama and Ken French, then University of Chicago Professors published a seminal work that has changed the way that investment academics look at markets. They studied the performance of US shares over a long period of time, and found that:
- Small Company Shares had a higher return than the average market return
- Value Company Shares had a higher return than the average market return
(Value companies are those companies that are slightly out of favour or under some financial stress - they are identified because people pay less for the value of the assets of the company compared to other companies).
As an update to their original research, in 2002 the returns from US shares from 1927 - 2001 were analysed with:
- The average market return being 12.67% a year
- The return from small companies being 16.31% a year
- The return from value companies being 16.19% a year
This is similar to results around the world when the Fama and French study was repeated: small companies and value companies have a higher expected return.
The efficient market theory and the Fama and French research is combined by Dimensional, who passively invest in small companies and value companies. In Australia, their small company fund is made up of a widely diversified portfolio of Australian shares that are outside the biggest 100 companies. Their value fund is made up of a portfolio of the 30% of the Australian companies that show the greatest value characteristics.
As you have seen, the careful practical application of these theories leads to outstanding investment results!
The power of the Dimensional approach is simple: in the investment world it is extraordinarily difficult to beat the average market return, in a large part because of the fees you pay to do it. The Dimensional approach allows you to have a higher than average expected return, through exposing your portfolio to small and value companies in a systematic and cost effective manner.