Dimensional Fund Advisors Puts Academic Theory Into Practice
Austin, Texas-based investment firm Dimensional Fund Advisors has hit a speed bump. So far this year, many of its equity funds have dramatically underperformed the S&P 500. But that doesn’t faze chairman David Booth.
Dimensional Fund Advisors has hit a speed bump. So far this year many of the Austin, Texas–based investment firm’s equity funds have dramatically underperformed the Standard & Poor’s 500 Index, which had fallen more than 10 percent as of September 22. That doesn’t faze David Booth, Dimensional’s chairman and co-CEO. Booth says his 600-person shop, which manages $214 billion in equity, fixed-income and other strategies, won’t go changing. Dimensional’s poor 2011 performance shows that investors can’t reliably outwit the market, says head of research Gerard O’Reilly. That’s no surprise coming from a firm whose board includes University of Chicago economist Eugene Fama, father of the Efficient Market Hypothesis. Booth, 64, has applied academic research to the investment world since he launched the first passive small-capitalization mutual fund three decades ago. “Our investment strategies are based on a very solid story about risk and return,” says the Chicago MBA graduate, who donated $300 million to the university in 2008; the Booth School of Business bears his name. “Our competition is largely trying to say they can do better than market returns,” Booth adds. “Every time we have a downturn, that attitude sends more people our way.”
Net inflows to Dimensional, which offers its mutual funds through advisers and counts the California Public Employees’ Retirement System among its institutional clients, reached an all-time high this year. The firm attributes this record haul to transparency, precise risk exposure, broad diversification and low cost. But its flagship $3.2 billion US Micro Cap Portfolio I dropped 14.35 percent through September 22, while its $2.3 billion Emerging Markets Portfolio I plunged 15.84 percent.
As an analyst at Wells Fargo & Co. in the 1970s, Booth helped create some of the first index funds. In 1981 he started Dimensional out of his New York apartment with former MBA classmate Rex Sinquefield. Informing the pair’s strategy was a seminal paper by fellow University of Chicago alumnus Rolf Banz showing that in the long run small-cap stocks tend to outperform larger ones.
Dimensional believes that markets work, even during a crisis like 2008. Rather than seek alpha, it harnesses beta from small-cap and value stocks, estimating their returns by considering factors such as market cap, cash flow and book value. The firm’s equity strategies use diversification to reduce risk. In a given year Dimensional holds about 12,000 stocks; its small-cap portfolios consist of companies from the smallest 4 to 10 percent of the market universe.
The firm made a few tweaks after 2008, O’Reilly concedes. It now puts more weight on momentum, or how quickly a stock’s price changes. In times of stress smaller companies tend to suffer more than big ones; those that newly meet Dimensional’s balance-sheet criteria are probably shrinking, O’Reilly says.
Dimensional works closely with several noted academics. In addition to Fama, its directors include economists Kenneth French and Roger Ibbotson and Nobel laureates Robert Merton and Myron Scholes.
Ibbotson, a professor at Yale University and chairman and CIO of Milford, Connecticut–based Zebra Capital Management, flags one potential problem for Dimensional: For most of the 1980s, small-cap stocks lagged their larger counterparts, and the same thing could happen again. Based on Dimensional’s models, certain funds might take more than ten years to outperform, Ibbotson says.
Long term, some Dimensional strategies have fared better than others. The US Micro Cap Portfolio I, which launched in 1981, posted a 7.28 percent annualized return for the decade ended August 31. During the same period the Emerging Markets Portfolio I gained an annualized 15.84 percent. Meanwhile, the S&P 500 climbed an average 7.53 percent annually. “With 30 years in the business, our overall body of work has been impressive,” Booth asserts. “It shows that the ideas around which we built the firm were indeed the right ones, and we’re optimistic about the future.”