Dimensional Funds claim to offer superior returns with lower risks. The key to their success is using the 3 factor Fama/French to select a portfolio of value stocks. It claims to have all the benefits of indexing while still outperforming the market.
My question is, how can an index manager outperform the market? by definition, an indexer cannot outperform the market.
Thanks,
Pago
An index adds/drops stocks as they meet, or depart from, the defining parameters. A mutual fund tracking an index necessarily has some transaction costs at these points. DFA "models" the index parameters but does not necessarily buy or sell stocks on the same schedule as the index itself, spreading large transactions. In the case of their micro-cap fund (their first), they are a large player in the market and have developed some clout/strategies that enable them to do a particularly good job of managing spreads in their transactions.
Similarly, their modeling of an asset class is nuanced (e.g. with respect to value, their criteria are a bit more sophisticated than just book-to-market).
You can see their general comments on their approach on their web page,
Whether they "beat" an index (on a regular basis) is arguable, but in general they often do better than most other fund providers in their target asses class funds.
They can't. What they can do is select their markets more carefully than the published indices. So, for example, their small-cap funds stick to smaller compmanies than most others.
As another example, just try to find an international small-cap value index fund that's open to new investors.
The other thing they claim to do is to deviate slightly from the index when it would be more expensive to stick to it. For example, suppose a company in a small-cap fund grows to be a little too big for the fund. Then if the fund is trying to stick to the index, it has to sell that stock immediately. Then the company shrinks a bit, so it fits in the index again, and so the index has to buy it back. Sell high, buy low.
DFA claims to solve this problem through hysteresis. When a company crosses the boundary of their index, they don't sell (or buy) it immediately. Instead, they wait until it has gone past the boundary by some amount.
Another thing they claim to do is pay attention to transaction costs in a way that index funds generally don't. For example, when they sell stock, they look for buyers who are willing to pay a premium for fast execution.
There are a few other tweaks that they claim to make. However, I think that the biggest advantage they offer is access to market segments that aren't well covered in general.
The question is, can DFA index funds outperform "the market."
If by "the market" you mean the entire US equity market (represented by e.g. Vanguard Total Market Index Fund to allow for transaction costs etc), the answer is YES.
DFA funds represent distinct asset classes within the overall market. Academic research strongly suggests that "small" and "value" stocks do better than the overall market. (Like all statements about market returns, this is true only on the average in the long run.) So if you choose, for example DFA US Small Cap Value Fund, you can indeed expect to do better (on the average in the long run).
In fact (I only have 5-yr data, from Morningstar):
DFA US Small Cap Value 17.56%/yr std dev 14.08% Vanguard Total Market 8.30%/yr std dev 7.73%
Note that the usual holds true: higher return accompanies higher risk (that is, higher volatility).
David
They outperform the market -i.e., they obtain a higher rate of return than the market average- because the type of stocks they typically invest in (small cap value stocks) are riskier than the market average. That's actually what the 3-factor Fama and French model tells you: in the long run, the only way to obtain higher returns is if you are willing to accept higher risks (that's a consequence of the efficient market hypothesis).
In another group -
As I recall, DFA claims to have *negative* expense ratios in some of their microcap funds, because as a major market-maker in the space, they are capturing spreads instead of paying them.
so Dimensional Fund managers are not passive managers like Vanguard, ie they do not track the market and they manually intervene to achieve their outperformance by being using smart buying and selling strategies.
pago
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The phrase "track the market" is too vague, because there is no single index that represents "the market" (unless maybe you consider some composite of all the stocks available worldwide). So in general, an index fund doesn't track "the market;" it tracks a particular index.
My understanding of how DFA works is that each of their funds tracks an index. However, the index they track isn't usually one of the widely published ones. In other words, they don't decide on the basis of individual research whether to include a company; but rather they have rules that they apply mechanically, just like any other index fund.
Here are two differences I've seen on their website between their indices and some of the others. Of course I may be misinterpreting their statements, or their policies might have changed since I read about them, but this is what I remember:
1) They don't include newly public companies until one year post-IPO. They say that their experience is that there's too much volatility in the first year without an attendant performance gain, on average. 2) They exclude companies for which there are too few market makers, as it is difficult to buy and sell those companies quickly.In addition to having slightly unconventional indices, they allow their funds to deviate slightly from the index in the interest of minimizing transaction costs. For example, their funds have some hysteresis about companies leaving or entering the index, so that they rarely have to buy a stock and then sell it again quickly.
I personally consider these strategies, as described, to be very far from what I would ordinarily expect from an actively managed fund.
I think Vanguard tries to mimick or copy Dimensional Funds' value funds but they haven't been peformed as well as the DFA funds. It's interesting how Vanguard can't replicate what DFA does even though Fama/French have put out a paper on the value premium works many years. Obviously not all indices are built the same way. Some are better built than others.
pago
Many modern *indexes* have hysteresis built in - they call the mechanism "buffers". If a stock crosses a boundary, it is not immediately removed from (or added to) the index. It is in a buffer zone, from which it may return to meet the index criteria, or may subsequently be removed. This is a key reason why Vanguard switched to MSCI indexes.
Here's a brief description of how the Morningstar index buffers work - by overlapping regions (what you described, except that the overlap is built into the index, not into the tracking fund):
Even with full replication, timing comes into play - you suggested this (e.g. not selling when the price is depressed), but (I think) from a different perspective. A fund may add a new index component a few days prior to its actual inclusion into its benchmark index, knowing that the price will rise on the inclusion date (due to other funds being forced to buy on that particular day). Options can be used to keep the performance tracking better (no, I haven't thought this sentence through carefully; just repeating market-speak here).
Vanguard uses a variety of such techniques, which is why I credit them with a few more basis po> 1) They don't include newly public companies until one year post-IPO.
That's not as unusual as DFA might lead you to believe. (That's a problem with referencing market-speak; it's prone to hyperbole, aka "puffing"). According to S&P's methodology:
"Treatment of IPOs. Initial public offerings should be seasoned for 6 to 12 months before being considered for addition to an index."
Mark Freeland snipped-for-privacy@sbcglobal.net
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