Dfa institutional review 2007q4


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Dfa institutional review 2007q4

  1. 1. MARKET PERFORMANCE “IT IS HARD TO CAPTURE A RETURN PREMIUM IF ONE IS NOT I EXPOSED TO THE FACTOR THAT GENERATES THAT PREMIUM.” ” L LARGE ORDERS OF NEEDED NAMES AND ASK TRADERS TO ACT ON THEM WITH PATIENCE.” US EQUITY RESEARCH UPDATE QUARTERLY INSTITUTIONAL REVIEW “THE BOTTOM LINE IS THAT...DIMENSIONAL FOCUSES T ON THE OVERALL CHARACTERISTICS OF A STRATEGY.” FIXED INCOME E INTERNATIONAL EQUITY QUITY FOURTH QUARTER 2007 THE COST OF IMMEDIACY The inclusion of the ask-bid spread in transaction costs can be understood best by considering the neglected problem of “immediacy” in supply and demand analysis. Predictable immediacy is a rarity in human actions, and to approximate it requires that costs be borne by persons who specialize in standing ready and waiting to trade with the incoming orders of those who demand immediate servicing of their orders. The ask-bid spread is the markup that is paid for predictable immediacy of exchange in organized markets. Under competitive conditions the askbid spread, or markup, will measure the cost of making transactions without delay. A person who has just purchased a security and who desires immediately to resell it will, on the average, be forced to suffer a markdown equal to the spread found in the market place. This markdown (plus brokerage commissions) measures the cost of an immediate round-trip exchange. Under less competitive conditions, this spread may somewhat exaggerate the underlying cost to those who stand ready and waiting of quick roundtrip transactions, but, for any given degree of competition (since brokerage commissions do not vary with the time taken to complete a transaction), differences in spread will indicate differences in the cost of quick exchange. —Harold Demsetz “The Cost of Transacting.” Quarterly Q Journal of Economics 82, no. 1 (February 1968): 33-53. Research Update p. 2 Despite the magnitude and reliability of the value premium, there is evidence that the average value mutual fund fails to capture and deliver that premium to investors. Dimensional Fund Advisors, on the other hand, delivered the value premium in large and small cap value strategies to its investors from April 1993, the first full month in which Dimensional had large cap value and small cap value strategies in the US, to December 2005. The present article describes in detail the investment process that allowed Dimensional to succeed where so many others have failed. What’s New at Dimensional p. 11 The material in this publication is provided solely as background information for registered investment advisors and institutional investors and is not intended for public use. It should not be distributed to investors of products managed by Dimensional Fund Advisors or potential investors. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This article contains the opinions of the author but not necessarily the opinions of Dimensional. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as a recommendation of any particular security, strategy, or investment product.
  2. 2. QUARTERLY INSTITUTIONAL REVIEW RESEARCH UPDATE DIMENSIONAL INVESTORS DO CAPTURE THE VALUE PREMIUM Part II The first part of this article, published in the third quarter 2007 issue of Dimensional’s Quarterly Institutional Review,1 showed that the average value mutual fund has failed to capture a meaningful share of the value premium in stocks, and thus has failed to reliably deliver excess returns relative to the average growth mutual fund. On the other hand, Dimensional’s US small and large cap value strategies captured and delivered the value premium in stocks to investors from April 1993, the first full month in which Dimensional had large cap value and small cap value strategies in the US, to December 2005. Additionally, the Dimensional US Large Cap Value strategy outperformed the universe of large cap value mutual funds by an average of 17 basis points per month, while the Dimensional US Small Cap Value strategy outperformed the universe of small cap value mutual funds by an average of 30 basis points per month during that same period.2 Dimensional’s ability to capture and deliver that premium is not a random event,3 but rather the result of a skillful investment process that combines scientific research into the sources of financial risks and returns with rigorous portfolio design and expert implementation of the strategies through clever portfolio management and unique trading techniques. The second part of this article, published here, describes that process. From the set of clearly defined philosophical investment principles to the dynamic integration of portfolio engineering, portfolio management, trading, and the adoption of rules at every stage of the investment process, every step of the investment process facilitates that integration and, more importantly, contributes to the delivery of value-added returns to investors. Core Beliefs At the core of Dimensional’s investment approach is the proposition that public capital markets are informationally efficient. Competition among different firms for investors’ capital and between buyers and sellers to find the most attractive returns on their investments ensures that market prices reflect most available information about fundamental values. In these efficient and competitive public markets, 2 traded securities are fairly priced. For investors in search of large expected returns, the key, then, is to identify the dimensions of expected stock returns and to target those dimensions that are compensated with higher expected returns. Dimensional’s approach does not require one to determine which securities are mispriced today or to forecast which of those securities will be fairly valued tomorrow, or to have an ability to identify and profit from any market inefficiencies that may or may not exist. It does require, however, that once the dimensions of expected stock returns have been identified, strategies be designed and implemented to target those dimensions accurately, continuously, and in a cost-effective manner. In addition, Dimensional believes that there are opportunities to provide value-added returns by managing around market frictions such as momentum and by providing services such as liquidity to other investors who want immediacy in their trades and are willing to pay for that immediacy. A Dynamically Integrated Investment Process Portfolio engineering, portfolio management, and portfolio trading are the three main steps of the investment process. At Dimensional, those three steps are dynamically integrated so that decisions made at one level of the investment process facilitate decisions made and tasks performed at the other two levels. For instance, how an asset class is defined—a decision made at the portfolio engineering level—will impact the flexibility of portfolio managers to manage around market frictions and to minimize turnover—a portfolio management function—as well as how efficiently trading can be implemented—issues related to the portfolio trading function. Other money managers, on the other hand, don’t necessarily take into account the impact that decisions made at one step of the investment process have on the other two steps, and they segregate their activities. Portfolio Engineering Portfolio engineering can be broadly divided into three steps: (1) finding the dimensions that determine expected returns; (2) designing strategies that target those dimensions; and (3) defining asset classes along those dimensions in such a way so as to (a) accurately capture the returns of those asset classes and (b) set rules that minimize unnecessary turnover. As shown in the first part of this article, US large cap value stocks outperformed US large cap growth stocks by an average of 4.4% per year from January 1928 to December 2006, while US small cap value stocks outperformed US small cap growth stocks by an average of 6.1% per year. In
  3. 3. QUARTERLY INSTITUTIONAL REVIEW international developed markets and in throughout the whole period. Having hold emerging markets, value stocks have also ranges in time may make an index easier “AFTER ALL, IT IS historically outperformed growth stocks. to track and reduce portfolio turnover, but HARD TO CAPTURE A Similarly, from January 1928 to it does so at the expense of what matters: RETURN PREMIUM IF December 2006, US small cap stocks continuous exposure to the asset class and ONE IS NOT EXPOSED outperformed US large cap stocks by an the investment of cash flows in the desired average of 4.6% per year. In international asset class. TO THE FACTOR THAT developed markets and in emerging Table 1 shows Russell indices’ average GENERATES THAT markets, small company stocks have also allocation in June, just before their PREMIUM.” historically outperformed large company reconstitution, to securities that leave the stocks. indices during the reconstitution process. Those patterns in the behavior of stock Between 1990 and 2006, an average of returns are consistent with the Fama/French three-factor 35% of the Russell 2000 Growth Index was allocated in model, which posits that, in equity markets, expected returns June to securities that left that Index at reconstitution. For are a function of an asset’s exposure to three common factors: the Russell 2000 Value Index, that percentage was 29%. So, a market factor, a size factor, and a relative price factor. if one wanted to gain exposure to the small cap value asset Thus, strategies that have higher expected returns are those class by investing $100 in a fund indexed to the Russell 2000 that have more focused exposure to those factors. Investors Value Index in June, on average, $29 of those $100 would be that seek high expected returns—and are willing to accept invested in securities that do not satisfy an updated definition the corresponding multifactor risks—should tilt strategies of the asset class. toward small cap and value stocks. To capture the return premiums associated with the TABLE 1 factors that determine expected returns, strategies need to AVERAGE ALLOCATION IN JUNE TO SECURITIES LEAVING THE INDEX AT RECONSTITUTION EA be designed in such a way so as to be continually exposed 1990-2006 to those factors. After all, it is hard to capture a return RUSSELL 3000 1.59% premium if one is not exposed to the factor that generates that premium. This may seem to be an obvious point—and, RUSSELL 3000 VALUE 11.86% perhaps, it is—but it is one that is often overlooked by many RUSSELL 3000 GROWTH 12.69% market participants, which may partially explain why the RUSSELL 1000 2.18% average value mutual fund fails to capture and deliver the RUSSELL 1000 VALUE 12.00% value premium. Achieving a continuous exposure to those RUSSELL 1000 GROWTH 12.77% factors has a cross-sectional component as well as a timeRUSSELL 2000 20.06% series component. RUSSELL 2000 VALUE 28.53% First, value strategies need to be broadly diversified across the universe of value stocks to maximize the reliability of RUSSELL 2000 GROWTH 35.17% the outcomes. As financial economists Eugene F. Fama and Source: Compiled by Dimensional from Russell securities data. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of Kenneth R. French have shown,4 the value premium largely an actual portfolio. comes from an unpredictable set of value companies that dramatically outperform their peers and move from value A look at the difference between the weighted average toward growth. A value strategy that is not well diversified market capitalization of the Russell 2000 Index and that of may exclude from its holdings the very same companies that the Dimensional US Small Cap Portfolio over time leads to generate most of the value premium, which may prevent a similar conclusion. On Chart 1, as we move further away value investors from capturing that premium. The size in time from reconstitution, the difference between the two premium is the result of a similar process. These processes weighted average market capitalizations gradually increases. reinforce the need to have diversified portfolios to reliably At reconstitution, the weighted average market capitalization capture the factor premiums. of the Index sharply drops and moves closer to that of the Second, strategies need to maintain that broadly diversified Dimensional US Small Cap Portfolio. That is an indication exposure over time. To minimize turnover, many indices and that, unlike the Dimensional strategy, the Index does not money managers have hold ranges in time, whereby they necessarily maintain a focused exposure to the small cap asset hold a set of securities for a given period of time regardless class throughout the year—only during the reconstitution of whether those securities fit the definition of the asset class period and soon thereafter. 3
  4. 4. QUARTERLY INSTITUTIONAL REVIEW CHART 1 WEIGHTED AVERAGE MARKET CAPITALIZATION OF THE RUSSELL 2000 INDEX – US SMALL CAP PORTFOLIO 300 250 200 150 100 50 1/2005 2006 2007 4/2007 Russell data copyright © Russell Investment Group 1995-2007, all rights reserved. turnover will be higher and that portfolio trades will be more exposed to downward and upward momentum—that is, the tendency of losers (winners) to continue to perform worse (better) than indicated by their exposures to the market, size, and relative price factors. Table 2 shows the annualized returns from 1977 to 2006 for various momentum factors around the world. These factors are derived by ranking stocks on their cumulative performance over the previous twelve months.5 For US small cap stocks, the difference between the returns on a portfolio of winning stocks and the returns on a portfolio of losing stocks rebalanced on a monthly basis is 15% per year. For large cap stocks in the United States and in international developed markets, that difference is around 5.5%. Given those magnitudes, the failure to take into account the effects of momentum when evaluating the costs and benefits of rebalancing a portfolio and the frequency of rebalancing can have a large impact on returns. The failure of many in the investment industry to rebalance strategies on a continuous basis to ensure that exposure to TABLE 2 an asset class is maintained throughout the year introduces MOMENTUM RETURNS 1977-2006 unnecessary uncertainty into an investor’s asset allocation. In the case of managers whose strategies are indexed to the Russell UNITED STATES ANNUALIZED RETURNS indices—or, to any internally developed or commercially US Large Caps 5.6% available index—their rigid tracking of the indices ensures US Small Caps 15.0% that they do not have continuous exposure to the asset class WORLD DEVELOPED EX US they are targeting. The reason is that those indices allow their Large Caps 5.4% exposure to the asset classes they intend to represent to drift WORLD DEVELOPED EX US, EX JAPAN from one reconstitution period to the next, in some cases Large Caps 7.3% twelve months later. As they drift away from higher expected return dimensions toward lower expected return dimensions, Source: Kenneth R. French and Dimensional Fund Advisors. the long-term performance of those indices and the strategies indexed to them suffers. The effects of hold Fortunately, those costs can be mitigated ranges in time are even more pronounced during the portfolio management process “HAVING HOLD when we analyze investors’ cash flows. if portfolios are designed to give portfolio RANGES IN TIME MAY Because those flows are unexpected, they managers and traders flexibility. In the could come in on reconstitution day, in absence of flexibility, a security may MAKE AN INDEX EASIER which case the manager would be buying have to be purchased or sold at specific TO TRACK AND REDUCE the desired asset class on the perfect day points in time, regardless of whether PORTFOLIO TURNOVER, (i.e., on the day on which the index most that security is exposed to downward or BUT IT DOES SO AT closely approximates the targeted asset upward momentum. With flexibility, the THE EXPENSE OF class); or those flows could come in on negative impact of new value or small cap WHAT MATTERS: any other day, in which case the manager companies with downward momentum may be forced to buy what used to be the characteristics can be mitigated by delaying CONTINUOUS desired asset class. their purchase, while the positive impact EXPOSURE TO THE Having a continuous exposure to of securities leaving the asset class with ASSET CLASS AND THE an asset class is not costless, however. upward momentum characteristics can be INVESTMENT OF CASH Frequent rebalancing can continually captured by delaying their sale. The idea is FLOWS IN THE DESIRED expose a strategy to the asset class whose not to become a momentum trader and try ASSET CLASS.” returns it is targeting. However, frequent to capture the returns of the momentum rebalancing also means that portfolio factor—which trading costs will prevent; 4
  5. 5. QUARTERLY INSTITUTIONAL REVIEW rather, the idea is to deny liquidity for The value added by rebalancing momentum traders, which would ease this monthly and applying both momentum “DIMENSIONAL market friction, and to avoid being hurt filters—117 basis points in total for the DESIGNS ITS by downward momentum while enjoying US large cap value strategy and 82 basis STRATEGIES IN the benefits of upward momentum in the points in total for the international large SUCH A WAY THAT strategies. cap value strategy—can be delivered for PORTFOLIO MANAGERS Table 3 shows the effects of having a at least two reasons. First, Dimensional AND TRADERS continuous exposure to an asset class—in designs its strategies in such a way that this case, large cap value stocks in the US and portfolio managers and traders have HAVE ENOUGH in international developed markets—while enough flexibility to delay the purchase of FLEXIBILITY TO DELAY at the same time controlling for the impact stocks affected by downward momentum THE PURCHASE OF of upward and downward momentum. and to delay the sale of stocks affected STOCKS AFFECTED Moving from a large cap strategy to a large by upward momentum, even if doing BY DOWNWARD cap value strategy increases the annual so temporarily increases tracking error MOMENTUM AND TO return by 3% in the United States and by relative to some target portfolio. That 4% in international developed markets. flexibility limits the negative impact that DELAY THE SALE OF Adding a momentum filter to avoid buying momentum can have on the strategies. It STOCKS AFFECTED BY companies that are exposed to downward also denies momentum traders the liquidity UPWARD MOMENTUM.” momentum mitigates the negative impact that they need to lower their trading of downward momentum and adds an costs and perhaps make a momentumadditional 44 basis points per year to the based strategy profitable. Second, the international large cap value strategy and 89 basis points per momentum screens that Dimensional has implemented year to the US large cap value strategy. Because there is more have enabled portfolio managers to incorporate momentumrebalancing and trading in value and small cap strategies, related information when deciding potential trades. momentum effects become more important for those types The final step in the portfolio engineering process is to of strategies. For that reason, the monthly rebalanced strategy define an asset class in a way that accurately captures the controls for both upward and downward momentum. These returns of that asset class and makes implementation of asset monthly rebalanced strategies add 38 basis points to the class strategies less costly. international large cap value strategy and 28 basis points to Value stocks are often defined as stocks with a low market the US large cap value strategy. price relative to fundamentals such as book value, cash flows, earnings, dividends, or sales. That definition, while appropriate in most cases, is not appropriate in all cases. TABLE 3 PROVIDING A CONTINUOUS EXPOSURE AND CONTROLLING FOR Recognizing those cases in which it is not appropriate can MOMENTUM INDEX RETURNS (NO COSTS) help us capture more accurately the returns of the asset class. 1976-2006 Let’s instead define value stocks as stocks with high expected WORLD DEVELOPED EX US LARGE CAP LARGE CAP VALUE returns. This definition allows us to exclude from a value REBALANCING FREQUENCY ANNUAL ANNUAL MONTHLY portfolio stocks such as real estate investment trusts and regulated utilities that are often considered to be value stocks DOWNWARD MOMENTUM FILTER YES YES but are fundamentally different from value stocks.6 UPWARD MOMENTUM FILTER YES Table 4 shows monthly average returns and three-factor AVERAGE ANNUAL TOTAL RETURN (%) 13.08 17.28 17.72 18.10 regression coefficients for REITs, utilities, and several UNITED STATES MARKETWIDE MARKETWIDE VALUE indices. From 1979 to 2006, the monthly average return for REBALANCING FREQUENCY ANNUAL ANNUAL MONTHLY the REIT portfolio was 1.28%, while the monthly return for the Dimensional US Small Cap Value Index was 1.58%. DOWNWARD MOMENTUM FILTER Looking at the factor exposures to the market, size, and relative UPWARD MOMENTUM FILTER price factors—as measured by the b, s, and h coefficients, AVERAGE ANNUAL TOTAL RETURN (%) 13.43 16.54 17.43 17.71 respectively—for REITs and small cap value stocks, we Source: Data simulated by Dimensional Fund Advisors. Simulated returns do not represent can see that 27 basis points, or 90%, of the performance trading in actual accounts, and the performance results do not represent the impact that material economic and market factors might have on the decision-making process of a prospective investor differential between REITs and the Dimensional US Small if the assets had been actually invested during that period. Simulated performance may differ from Cap Value Index can be attributed to their different exposure actual performance because simulations are built through the retroactive application of a strategy designed with the benefit of hindsight. to the market factor.7 REITs and small cap value stocks had 5
  6. 6. QUARTERLY INSTITUTIONAL REVIEW a similar exposure to the value factor (0.64 for REITs vs. 0.69 for small cap value stocks), so they both capture a comparable fraction of the value premium. TABLE 4 ASSET CLASS RETURNS 1979-2006 MONTHLY AVERAGE RETURN E Utilities 1.12% Dow Jones Wilshire REIT Index 1.28% Russell 3000 Index 1.15% S&P 500 Index 1.15% US Large Cap Value Index Inde 1.38% US Small Cap Value Index 1.58% AVERAGE MONTHLY PREMIUM MKT – T-BILLS 0.65% b 0.66 0.66 1.01 1.00 1.11 1.07 s -0.16 0.45 -0.08 -0.22 -0.06 0.81 SMB 0.17% h 0.61 0.64 0.02 0.01 0.60 0.69 HML 0.42% Sources: Utilities data provided by Fama/French. Dow Jones Wilshire data provided by Dow Jones Indexes. Russell data copyright © Russell Investment Group 1995-2008, all rights reserved. The S&P data are provided by Standard and Poor’s Index Services Group. US value indices are compiled by Dimensional from CRSP and Compustat securities data. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. A similar story emerges when we look at regulated utilities and compare them to large cap value stocks. From 1979 to 2006, the monthly average return for the utilities portfolio was 1.12%, while the monthly average return for the US Large Cap Value Index was 1.38%. Again, most of the performance differential between utilities and large cap value stocks can be attributed to their different exposures to the market factor. The differences in exposure between utilities and large cap value stocks to the size and value factors are trivial, as is the impact on the performance of utilities relative to large cap value stocks that arises from those differences. In contrast, Russell and other fund managers do not exclude these lower expected return securities from their value indices and strategies, which drives down their expected returns by not capturing a fraction of the largest of the three factor premiums, the market premium (see Table 5). TABLE 5 REITS AND UTILITIES ALLOCATION WITHIN RUSSELL INDICES AS OF DECEMBER 31, 2006 RUSSELL 1000 RUSSELL RUSSELL RUSSELL RUSSELL 1000 1000 RUSSELL 2000 2000 VALUE GROWTH 2000 VALUE GROWTH UTILITIES 3.9% 6.5% 1.4% 3.0% 0.1% 5.6% REITS 2.2% 3.5% 0.8% 7.5% 11.8% 2.9% Source: Russell data copyright © Russell Investment Group 1995-2008, all rights reserved. Finally, we look at how an asset class is defined, as that 6 can have a considerable impact on portfolio turnover and, by extension, trading costs. For instance, let’s focus our attention on an example that is easy to explain, the international small cap asset class. There are at least three ways of establishing the breakpoints that separate small cap stocks from large cap stocks. First, size breakpoints can be determined using a market percentile approach, in which a fixed percentage of the market (e.g., the bottom 12.5% of the total market capitalization of a country or group of countries) is targeted. Under this approach, each country or group of countries has a weight in the strategy that is proportional to the size of its market and, additionally, each country’s weight is identical across all size segments (e.g., all countries have the bottom 12.5% of the total market capitalization in the small cap universe and the top 87.5% of the total market capitalization in the large cap universe). However, the market percentile approach has two well-known problems. First, it does not have size integrity across markets. For instance, the company at market capitalization percentile 87.5 in New Zealand has a market capitalization of approximately $370 million. In Switzerland, the company at that same percentile has a market capitalization of approximately $8.5 billion. Second, the value of the market percentile breakpoint that divides large caps and small caps in a market is driven by the performance of the mega cap companies in that market. That performance induces large turnover in small caps due to breakpoint movements and not due to companies outgrowing their size range. Mega cap companies tend to represent a large fraction of the market capitalization in each country; so, given that the breakpoint is a function of the market capitalization (e.g., 12.5% of a country’s total market capitalization), differences in performance—and volatility— between those large companies and the rest of the market affect the breakpoint between large and small companies and generate unnecessary turnover. A second way of defining size breakpoints is to use a fixed market capitalization level measured in USD or some other international currency (e.g., small cap companies are defined as those companies with a market capitalization of $3.2 billion or less). The main advantage of this approach is that it achieves perfect size integrity across markets. The main disadvantage of this approach is that the percentage of the market that falls under a size segment can vary widely across countries. For instance, using a $3-$3.5 billion breakpoint, the small cap universe would cover as much as 47% of the total market capitalization in New Zealand and as little as 4% of the total market capitalization in Switzerland. In addition, a hard-dollar ceiling does not reflect market movements, which can lead to an inaccurate definition of an asset class and unnecessary turnover. This breakpoint methodology may also trigger higher turnover due to currency volatility, which is an
  7. 7. QUARTERLY INSTITUTIONAL REVIEW external factor. In the particular case of a USD breakpoint in portfolio management can be expressed by the Fama/French a world ex US portfolio, it is not natural to have a breakpoint three-factor model as shown in the following equation: denominated in a currency that is not the currency of any of the countries in the portfolio. A large appreciation or R – Rtarget = a + (b – btarget) (Mkt – Tbills) + depreciation of the US dollar relative to the currencies of (s – starget) SmB + (h – htarget) HmL + e (1) the countries in the portfolio could trigger large—as well as costly and unnecessary—rebalancing events. Equation 1 gives us an indication of how close an actual The third approach to defining size breakpoints, the portfolio is to the target portfolio. It is the responsibility approach that Dimensional developed more than five years of portfolio managers to move the actual portfolio in the ago, is to use a fixed number of names to define size segments direction of the target portfolio. Pure indexers and other within each market. This approach avoids the turnover rigid portfolio managers intend to have zero tracking error generated by the performance of mega cap companies in with respect to some target portfolio, which means that those a country or group of countries and the turnover due to portfolio managers need to closely match the target weights currency volatility. It also provides good of every security in their portfolio at every asset class stability because changes in point in time. In the case of pure indexers, “THE MOMENT A the value of the breakpoint are correlated those weights are determined by the PORTFOLIO MANAGER with the performance of small caps, behavior and composition of the index; in and turnover is generally a function of the case of active managers, those weights WANTS TO HAVE companies outgrowing the asset class, are a function of their real or perceived ZERO TRACKING not the result of breakpoint volatility. To ability to identify mispriced securities that ERROR WITH RESPECT maintain a consistent market capitalization will be fairly valued at some time in the TO SOME TARGET representation and size integrity across future. Zero tracking error also means that PORTFOLIO, HE markets, the number of names can be the difference between the actual and the CHANGES THE NATURE chosen so that (a) it represents a similar target exposures to the market, size, and fraction of the total market capitalization value factors is always equal to zero (i.e., OF HIS TRADES IN A of each country or group of countries and b = btarget, s = starget, and h = htarget), as is the WAY THAT IS HARMFUL (b) the market capitalization value of the error term, e, in Equation 1. FOR THE PORTFOLIO. breakpoint in any country is within a But there are no clear benefits to that HE NOW REQUIRES given range of the market capitalization type of rigid management style. The IMMEDIACY IN HIS breakpoints of all the other countries. These expected return on the error term is equal TRADES.” two goals can be enforced with bounds to zero, so making the error term equal zero to minimize turnover and guarantee the produces no net benefits (i.e., it does not appropriate asset class exposure. increase the expected return of a portfolio) We have attempted to describe some of the steps of the beyond the reduction of tracking error relative to an arbitrary portfolio engineering process. In the next two sections, we benchmark. What is worse, zero tracking error with respect explain how those steps and rules in portfolio engineering to some target portfolio is likely to have a negative impact facilitate the task of portfolio managers and traders. on performance because it leads to higher trading costs as a result of trading specific securities at specific points in time. Portfolio Management The moment a portfolio manager wants to have zero tracking error with respect to some target portfolio, he changes the Because trading does not occur in a vacuum, portfolio nature of his trades in a way that is harmful for the portfolio. managers must balance the benefits of implementing He now requires immediacy in his trades, which forces him portfolios that achieve the desired asset class exposure versus to conduct those trades as a liquidity seeker, not as a liquidity the costs of achieving that exposure. How portfolio rules are provider, and pay a cost for that immediacy. implemented can have a significant impact on (a) whether At Dimensional, on the other hand, actual portfolios are the actual portfolio achieves what it set out to do (i.e., deliver close but not exact approximations of the target portfolios. the returns of the asset class); and (b) at what cost. The rules How close of an approximation will depend on transactions also give portfolio managers enough flexibility to deal with costs and, in some cases, taxes. But, clearly, in a world where events that cannot easily and efficiently be codified into rules, trading is not frictionless, continuous rebalancing to achieve such as cash flows from clients, for instance. the exact target portfolio weights at all times is not a sensible The interaction between portfolio engineering and strategy. 7
  8. 8. QUARTERLY INSTITUTIONAL REVIEW Therefore, accepting some tracking limits, indifferent as to stock A or stock error with respect to a target portfolio B, than if he has to hold X shares of stock “IF THERE IS NO NEED gives portfolio managers and traders a A and Y shares of stock B at all times, or FOR IMMEDIACY IN lot of flexibility. For instance, a portfolio if he has to buy X shares of stock A and ANY GIVEN NAME, manager expecting cash inflows or outflows Y shares of stock B at a specific point in PORTFOLIO MANAGERS in the near future can use those flows to time. And this is what allows portfolio CAN CREATE LARGE rebalance portfolios closer to their target managers to manage portfolios around ORDERS OF NEEDED weights by buying securities that belong market frictions such as momentum to the asset class or by selling securities using substitution and a patient trading NAMES AND ASK in the portfolio that no longer meet the approach. To be sure, flexible trading can TRADERS TO ACT ON definition of the asset class. Although generate biases in the portfolio, but it is THEM WITH PATIENCE, the portfolio engineer obviously does not the responsibility of portfolio managers to BUYING WHEN have information about cash flows when control those biases over time without the LIQUIDITY SEEKERS designing the portfolios, the portfolios need to pay for immediacy. Like herding ARE WILLING TO PAY are designed in such a way that portfolio cows, you do not waste resources imposing managers can use that information in a the right position to each cow; you just get FOR THEIR IMMEDIACY valuable way. all of them moving in the right direction. NEEDS.” This flexibility allows portfolio managers to substitute, for instance, securities that are not currently affected by momentum for otherwise similar securities that are affected by momentum. Portfolio Trading It also allows portfolio managers to create flexibility when trading. If there is no need for immediacy in any given name, The final element of the investment process is trading. portfolio managers can create large orders of needed names Since its inception in 1981, Dimensional Fund Advisors has and ask traders to act on them with patience, buying when sought to enhance net returns by keeping trading costs low, liquidity seekers are willing to pay for their immediacy needs. avoiding trades that greatly impact market prices, trading The ability to substitute names and the interaction between patiently and with flexibility, and trying to provide liquidity traders and portfolio managers create unique opportunities to the market. Dimensional supplies liquidity to index and to capture value. For example, using fictitious numbers, a active managers in search of immediacy. The bid/ask spread is portfolio manager can give traders $100 million in orders to a very simple measure of the cost of immediacy for a nominal trade the best $50 million, the $50 million worth of trades in amount of shares.8 Liquidity providers earn the spread, while which he can trade as a liquidity provider and earn a premium liquidity seekers pay for it. Table 6 shows bid/ask spreads for for doing so. In contrast, a non-flexible portfolio manager stocks in international developed markets in different market must give $50 million in orders to trade $50 million, and capitalization segments. The spread increases from 20 basis these $50 million must be allocated to points for the largest stocks to 189 basis a specific number of shares for specific points for the smallest stocks. “THE BOTTOM LINE names, regardless of liquidity constraints To get an idea of the benefits of being or other market conditions. able to trade as a liquidity provider instead IS THAT, UNLIKE The bottom line is that, unlike indexing of a liquidity seeker, we conduct a simple INDEXING AND ACTIVE and active management, which focus on experiment. We take the Russell 1000 MANAGEMENT, WHICH exact numbers of shares for each individual Value Index, the Russell 2000 Index, FOCUS ON EXACT stock, Dimensional focuses on the overall and the Russell 2000 Value Index and NUMBERS OF SHARES characteristics of a strategy. This allows reconstitute them at the end of September, FOR EACH INDIVIDUAL portfolio managers to treat stocks that approximately three months after the have similar characteristics and belong official reconstitution date, for every year STOCK, DIMENSIONAL to the same asset class as close substitutes between 1990 and 2006. We then look FOCUSES ON for one another, which facilitates trading. at the monthly average returns for the THE OVERALL In other words, a trader will have more actual indices and for the lagged indices CHARACTERISTICS OF A chances to trade opportunistically and take from July to June, from October to June, STRATEGY.” advantage of favorable trading conditions and from July to September. The lagged if he is, within certain diversification indices outperform the actual indices 8
  9. 9. QUARTERLY INSTITUTIONAL REVIEW by an average of 3, 15, and 18 basis points per month, respectively, from July to June (see Table 7). In the case of the Russell 2000 Index and the Russell 2000 Value Index, those performance differentials are statistically reliable. From October to June, when the actual and the lagged indices are the same, there are no differences in performance between the two sets of indices. But from July to September, when the actual indices and the lagged indices have different components, the differences in performance between the two sets of indices are huge: 13 basis points per month in the case of the Russell 1000 Value Index, 59 basis points per month in the case of the Russell 2000 Index, and 70 basis points per month in the case of the Russell 2000 Value Index. TABLE 7 THE COSTS OF IMMEDIACY MMEDIAC LIQUIDITY SEEKERS VS. LIQUIDITY PROVIDERS JANUARY 1990-DECEMBER 2006 INDEX (%) LAGGED INDEX (%) DIFFERENCE (%) S.E. (%) T-STAT RUSSELL 1000 VALUE 1.05 1.08 -0.03 0.02 -1.79 RUSSELL 2000 1.03 1.19 -0.15 0.04 -4.32 RUSSELL 2000 VALUE 1.20 1.38 -0.18 0.04 -4.31 RUSSELL 1000 VALUE 1.45 1.45 0.01 0.01 0.95 RUSSELL 2000 1.59 1.60 -0.01 0.01 -1.87 RUSSELL 2000 VALUE 1.73 1.74 -0.01 0.00 -0.01 JULY-JUNE OCTOBER-JUNE TABLE 6 TRADING COSTS MARKET CAP ($ MILLIONS) NAMES > 5,000 1,500-5,000 677 842 PERCENT OF BID/ASK TRADING VOLUME MARKET CAP SPREAD (%) PER ISSUE ($) 79.3 0.31 0.20 0.31 111,044,603 14,558,882 500-1,500 1,128 5.3 0.56 3,542,329 200-500 1,150 2.0 0.86 965,087 25-200 1,848 1.0 1.89 312,924 Source: Bloomberg (accessed Nov. 10, 2006). The bid/ask spread is generally regarded as an indication of the cost of liquidity. The twenty-two developed markets are those in Dimensional’s eligible universe (Canada, Europe, Japan, Asia Pacific, UK). Having flexibility allows portfolio managers to avoid the costs of immediacy in the execution of trades, and traders may participate in the market anonymously with the intent to capture liquidity in different ways and in different trading venues. The cumulative performance drag created by trading as a liquidity seeker instead of a liquidity provider, as quantified in our simple experiment, ranges from 40 basis points for the Russell 1000 Value Index to 211 basis points for the Russell 2000 Value Index over the threemonth period following reconstitution. The behavior of pure indexers around reconstitution time, when they give priority to immediacy of execution of trades to minimize tracking error over cost of execution, tends to depress index returns. The prices of stocks that enter the indices are pushed up around reconstitution and then gradually come down, while the prices of stocks leaving the indices are pushed down at reconstitution and then gradually increase. Although we cannot predict the future costs of immediacy and careless trading, for as long as those costs remain positive there will be market participants, Dimensional included, who will try to take advantage of situations in which providing liquidity earns some premium. JULY-SEPTEMBER INDEX LAGGED S.E. (%) INDEX (%) DIFFERENCE (%) (%) T-STAT CUMULATIVE RETURN DIFF. OVER THREE MONTHS RUSSELL 1000 VALUE -0.15 -0.02 -0.13 0.06 -2.34 -0.40 RUSSELL 2000 -0.63 -0.05 -0.59 0.12 -4.69 -1.76 RUSSELL 2000 VALUE -0.40 0.31 -0.70 0.15 -4.82 -2.11 Source: Russell data copyright © Russell Investment Group 1995-2008, all rights reserved. Note: The lagged indices are reconstituted at the end of September, three months after the official reconstitution date for the Russell indices. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Conclusion At the end of the first part of this article, we stated that Dimensional’s delivery of the value premium is not a random event, but rather the result of a skillfully designed and implemented investment process. This process, schematically described here, has been successfully tested in real markets for more than twenty-five years. As markets evolve and our understanding of the sources of financial risks and returns continues to improve, Dimensional’s dynamically integrated investment process will remain focused on the issues that matter: providing a diversified and continuous exposure to the dimensions of expected stock returns, balancing the different premiums and costs related to the factors that determine expected returns, and giving portfolio managers and traders the flexibility to trade patiently as a liquidity provider and using substitution to efficiently capture the desired premiums. Together, all these ingredients form the basis of Dimensional’s value-added proposition. — Eduardo A. Repetto and L. Jacobo Rodríguez 9
  10. 10. QUARTERLY INSTITUTIONAL REVIEW R REFERENCES 1. See Eduardo A. Repetto and L. Jacobo Rodríguez, “Dimensional Investors Do Capture the Value Premium: Part I,” Quarterly Institutional Review (Dimensional Fund Advisors), third quarter 2007: 2-7. 2. The data presented do not reflect recent market conditions, values, or returns. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. To obtain performance data current to the most recent month end, access our website at www.dimensional.com/strategies. 3. From July 1927 to June 2007, the value premium, the difference between the average returns on a portfolio of value stocks and the average returns on a portfolio of growth stocks, was about 5.6% per year on average. Despite the magnitude of the value premium in the United States in the eighty years for which data are available, there is a risk that the premium will not be positive in any given period of time. If the premium is compensation for common, non-diversifiable risks associated with the ratio of book-to-market equity or with any other measure of relative prices, investors must be exposed to the risks that produce the value premium if they seek to capture it. 4. See Eugene F. Fama and Kenneth R. French, “Migration,” Financial Analysts Journal 63, no. 3 (May/June 2007): 48-58. Fama is a director and consultant and French is a director, consultant and head of investment policy at Dimensional Fund Advisors. 5. For more information on how these momentum measures are constructed, please see http://mba.tuck.dartmouth.edu/pages/faculty/ken .french/Data_Library/det_mom_factor.html. 6. For more information on REITs, see L. Jacobo Rodríguez, “Real Estate Investment Trusts,” Quarterly Institutional Review (Dimensional Fund Advisors), fourth quarter 2006: 2-8. 7. The monthly market premium (0.65%) times the b coefficient for REITs (0.66) gives us the contribution to the return of REITs from exposure to the market factor (0.43%). Similarly, the market premium times the b coefficient for the US Small Cap Value Index gives us the contribution to the return of small cap value stocks from their exposure to the market factor (0.65% × 1.07 = 0.70%). 8. See Harold Demsetz, “The Cost of Transacting,” Quarterly Journal of Economics 82, no. 1 (February 1968): 33-53. 10
  11. 11. QUARTERLY INSTITUTIONAL REVIEW WHAT’S NEW AT DIMENSIONAL • New Products Launched Dimensional Fund Advisors launched a US Social Core Equity 2 strategy in October. This strategy targets the same universe of companies as the US Core Equity 2 strategy—that is, marketwide coverage of US stocks with increased exposure to small cap and value stocks—but excludes certain companies and industries that do not pass the social screens set up by an independent third-party provider of social issue exclusions. These screens do not necessarily reflect the beliefs held by or causes supported by Dimensional. Dimensional also launched a TA US Core Equity 2 strategy in October. This strategy targets the same universe of companies as the US Core Equity 2 strategy and employs a tax-advantaged investment approach to minimize the federal income tax implications of investment decisions. For more information about these new strategies or any other Dimensional products, please contact your regional director. • Quarterly Institutional Review Wins Spotlight Award Dimensional Fund Advisors’ Quarterly Institutional Review was honored with a Spotlight Award by the League of American Communications Professionals. The Spotlight Awards recognize excellence in print, video, and web communications. The Quarterly Institutional Review won a platinum award for being ranked first in its class— magazine/newsletter for companies with $100 million to $1 billion in annual revenue—and number 72 overall out of more than 900 entries from industries and organizations in seven countries. In its class, the Quarterly Institutional Review edged out publications from ESPN and Wells Fargo Institutional Services, among others. All of us involved in the production of this newsletter would like to thank the League of American Communications Professionals for their recognition of our work. OFFICES SANTA MONICA Main Office, 1299 Ocean Avenue Santa Monica, California 90401, USA Phone: (310) 395-8005 | Fax: (310) 395-6140 AUSTIN 2901 Via Fortuna, Terrace V, Floor 2 Austin, Texas 78746, USA Phone: (512) 306-7400 | Fax: (512) 306-7499 CHICAGO 10 South Wacker Drive, Suite 2275 Chicago, Illinois 60606, USA Phone: (312) 382-5370 | Fax: (312) 382-5375 LONDON 7 Down Street London W1J 7AJ, United Kingdom Phone: +44 (20) 7016-4500 | Fax: +44 (20) 7495-4141 SYDNEY Level 29, Gateway, 1 Macquarie Place Sydney NSW 2000, Australia Phone: +61 (2) 8336-7100 | Fax: +61 (2) 8336-7199 VANCOUVER 1075 West Georgia Street, Suite 2630 Vancouver BC V6E 3C9, Canada Phone: (604) 685-1633 | Fax: (604) 685-1653 www.dimensional.com 11