Dimensional Fund Advisors, 2002

Case 2 Dimensional Fund Advisors, 2002

Dimensional Fund Advisors (DFA) philosophy is based on academic research that indicates that the stock market is efficient. In addition to efficient markets, DFA's founders also believe that the ability of skilled traders can contribute to a fund's profits even when the investment was inherently passive. DFA feels that all information is known and reflected in the stock prices, so he sees fundamental stocks analysis useless. They believe that the value stocks outperform the growth stocks because an EM, values stocks are more risky. DFA believes that passive investing is the only efficient strategy. Even though DFA was based on the principle of EMH people did not quite believe it. EMH states that it is impossible to "beat the market" because stocks always trade at their fair value on stock exchanges. Their strategy seems to be doing well.

If we look at the CAPM model we can see that there is only one risk which is market risk which is measured by bate. However, in Fama-Frenh model they look at the size of the company and to book to market ration which is called idiosyncratic risk. This is true when the market ineffective. The value of small stock over large stock shows the compensation for the additional risk that a company takes. Also, the large stock companies have more assets than small stock companies which are likely to fail. When dividing the NYSE stocks into 10 portfolios and putting them together according to the firm size and average annual returns between 1926 and 2006, the small firm effect by Banz is consistently higher on the small firm portfolio. Plus that the smaller the firms are the risker they are. Also by looking at the findings that was published in 1992 by Fama and French, it identifies two other risks that explain the variation of the stock price. As looking at DFA they have been doing well from the finding of Fama and French. Fema and French finding makes sense and DFA still uses it until now. We can't really predict if small stocks are going to outperform large stocks in the future but according to the exhibit 2 it looks like small valve outperformed large valve and you also can see that large growth outperformed a little bit more then small growth. But when we use CAPM to adjust return for risk, there is still a consistent premium for smaller portfolios.

Small firms are neglected by larger firms therefore; less information available about smaller firms, which is called the neglected firm effect by Arbel. Therefore, to invest in smaller firms, investors demand higher returns. While the DFA cooperate with smaller firms they can get more private information about that specific firm and make it possible to beat the market.