Dfa and Market Efficiency

DFA and market efficiency

Dimensional Fund Advisors (DFA) is an investment advisory company dedicated to the principle that the stock market is “efficient”. It has close working relationship with a number of prominent academics, first of all Eugene Fama and Kenneth French.

Regarding the company’s philosophy we found some core principles that are followed by DFA from its inception, that are:

• importance of diversification: DFA passively trades within the equity market in different security classes like Micro Cap, Small Cap, Large Cap, Value Stock, but also across different equity markets, like Japan, U.K., and Emerging Markets. In 1993 they started investing in alternative investments, mainly in Real Estate.

• low turnover: DFA follows from the beginning a passive investment strategy by managing index funds, which helps it to reduce the turnover.

• low transaction costs: in order to avoid the liquidity problem that mark small stocks, DFA simply purchases large blocks of illiquid stocks from eager sellers. This trading strategy helps DFA to get a discount and minimize the price impact (DFA loses around 0.58% to costs).

• no fundamental analysis: as a believer in efficient markets, DFA feels, that on average the market price correctly incorporates all public information (that is it believes in the semi-strong EMH).

• know your customers: another huge problem regards the so called adverse selection problem, the possibility that each time a block is offered to DFA the seller has negative private information that are unknown to the market. In other words, DFA does not believe in strong EMH.

• high value of academic research: DFA believes in the value of academic research and the ability of skilled traders to contribute to a fund’s profits even when the investment is inherently passive. DFA encourages academics to work on subjects of interest to the firm, by giving any professor a share of profits from investment strategies derived from his ideas.

DFA strategy is mainly lead by empirical evidence, like the dissertation of Rolf Banz and the famous paper written by Eugene Fama and Kenneth French. Based on Banz’s findings that small stocks have consistently outperformed large stocks from 1926 to 1970s, DFA initially offered only a single investment fund consisting of small stocks. Later on though, they significantly enlarged the product line with e.g. U.S. Small Value investment funds, nevertheless small stocks continues to be their primary business.

Then its investment decisions is based on Fama and French’s empirical findings, implying that value stocks (high Book-to-Market ratio) tend to outperform growth stocks (low Book-to-Market ratio).

In our opinion DFA managed to obtain a strong and very profitable position in the market by combining its core