Reprinted compliments of Canadian MoneySaver, PO Box 370, Bath, Ontario K0H 1G0 (613) 352-7448 http://www.canadianmoneysaver.ca
DFA Comes to Canada
By John DeGoey
Assante Capital Management, Ltd.
September 2004
About a year ago, perhaps the best money management firm that most people have never heard of came to Canada. In that short span, they have already gathered over $150 million in retail client assets. Total Canadian assets (including institutional money) stands at over a billion dollars. Not bad for a company that only offers its products through a select number of financial advisors. In fact, at the time of writing, there were only about 40 advisors in all of Canada who were approved to offer DFA funds for sale. That’s right—advisors have to demonstrate that they understand DFA’s products before the company will allow them to sell it. How's that for being discerning about your "distribution channel"?
In short order, DFA gained a reputation as the "smartest guys in the business". The full name of the company is Dimensional Fund Advisors, and it was co-founded over 20 years ago by David Booth and Rex Sinquefield. Booth and Sinquefield are imposing academics themselves, but other people at the firm are perhaps even more impressive. Industry giant Roger Ibbotson is currently on the Board of Directors and over the years, DFA's Board of Advisors has also included the likes of Merton Miller, Robert Merton and Myron Scholes—all Nobel Prize winners in the field of economics. Two other leading candidates to win a Nobel some day, Eugene Fama and Ken French, are on staff as the primary drivers in developing the company’s products. To say these guys are "smart" is rather like suggesting Einstein was "brighter than most". It’s a huge understatement.
What sets DFA apart from virtually all other money managers is that their products are predicated on the Fama/ French three factor model of stock returns. In short, they have determined that markets are essentially "efficient", meaning security selection is essentially useless. As a result, the company does absolutely no research or fundamental analysis—something they consider to be a colossal waste of time (and money). Although they don't necessarily believe all prices are always exactly right, they do believe that they are just as likely to be too high as too low and that there is no way any modest idiosyncratic mispricings can be consistently exploited to add value over time and after fees. They see it as their mission to assist advisors in being properly grounded in both portfolio theory and investment logic. They’re indexers, but with a twist.
The twist is the three-factor model, which Fama and French developed after testing a theory developed earlier by their friend Bill Sharpe (another Nobel Laureate, by the way). Sharpe had just developed the Capital Asset Pricing Model (CAPM), which basically suggested that risk and return were related—the more return one wants, the more risk one needs to take. Their job was to see if they could find consistent sources of risk and return, given that there were a number of instances where CAPM didn't seem to work. They found that risk and return essentially exist on three "dimensions", those of market, company size and company price. In essence, the Fama/ French model says that stocks have higher expected returns than bonds, small stocks have higher expected returns than large stocks and lower priced "value" stocks have higher expected returns than higher-priced "growth" stocks.
Their research has shown that about 96% of the variation in returns is due to the three risk factor exposures they identified. Stock picking and market timing explain the other 4% in variation. After fees, DFA has shown that the effect of these other factors is actually negative. In short, DFA set out to make a name for themselves by effectively seeking out risk wherever they believed there was a reasonable chance that additional risk would lead to a positive expected return based on systematic, economically proven, long-term investment principles. In so doing, they would ignore the random error generated by earnings pronouncements and the like. By tilting their index-based portfolios toward value and small cap stocks, DFA essentially pursues what some people call an “enhanced indexing” strategy. Their philosophy is based on passive investing, but it is not so slavish in its application that it fails to take into account some reasonable expectations that are based on research supported by time series data going back nearly 80 years.
The problem most people have with indexing is that they intuitively want to believe that there’s someone out there who can add value after fees by exploiting whatever market inefficiencies might exist. In essence, DFA halfway agrees. They believe in various dimensions of risk and return and that these dimensions can and should be profitably exploited. They just don't believe that security selection is a part of the exploitation process. Instead, if small stocks and value stocks outperform a broader benchmark, then people should simply seek to own all the small stocks and values stocks and not spend a minute of time or a dollar of capital in trying to determine which of those companies will actually add to returns.
The great irony of all this is that DFA have now painted themselves as the alpha males of the capitalist world. They continue to believe in the fundamental premise of Sharpe’s work that risk and return are related. They’ve just built what they believe is a better mousetrap and continue to delight in pointing out that "the market works". In fact, one of Rex Sinquefield’s favourite quips is that the only people who don’t think markets work are communists and active managers. Most active management types don’t find that kind of “in your face humour” all that funny. Then again, they’re probably just envious of all those Nobel Prizes on the DFA mantel.