Dimensional Fund Advisors, 2002

1. What is DFAs business strategy? What do you think of the firm? Are the

DFA people really believe in efficient markets?

Dimensional Fund Advisors (DFA) is an investment firm based in Santa Monica,

California, whose primary businesses are small stock funds. DFAs core beliefs are

efficient markets and two other principles: the value of sound academic research, and

the ability of skilled traders to contribute to a funds profits even when the investment

was inherently passive. With its founding, DFA surmised that acting on these beliefs

would make it unique among investment companies. Besides, DFA charged fewer

fees than those of most actively managed funds but more than those of pure index

funds, which was fitting given DFAs position in the market as a passive fund that still

claimed to add value.

Its business strategy makes sense, and that could be proved by its steady growth

and strong profits. And with this strategy, it could pursue high-net-worth individuals, in

addition to institutions, as clients through registered investment advisors (RIAs),

which were a crucial conduit enabling DFA to reach the market without advertisement.

Although DFA is dedicated to the principle of efficient market, but to some extent,

the DFA people do not totally believe it. According to the efficient market hypothesis,

when market efficiency is strong-form, stocks always trade at their fair value on stock

exchanges and technical analysis, fundamental analysis and insider trading analysis

are all fruitless. But DFA was not simply an index fund manager, it believed in the
value of sound academic research and skilled traders contribution. Because DFA

used the found that small size and high B/M ratio stocks had higher expected returns,

its small-stock fund outperformed most small-stock benchmarks.

2. Do the Fama-French findings make sense? Should we expect small stocks

to outperform large stocks in the future? Value stocks to outperform growth

stocks?

Fama-French model: E(Rit) Rft = i[E(Rmt Rft] + siE(SMBt) + hiE(HMIt). Rft

means risk-free rate at time t, Rmt means market return at time tRit means asset is

return at time tE(Rmt) Rft means market premiumSMBt means the return of

market capitalization factor at time tHMIt means the return of booktomarket

factor at time t. si and hi are coefficient of the 3 factors.

In the CAPM model, the only risk is market risk and is measured by ,while in

the Fama-French model we play much emphasis on idiosyncratic riskthe size of the

company and the booktomarket ratio. This is true when the market is not

effective. In addition, this result is evidenced by real data from Exhibit 6.

First of all, the value premia of small stocks over large stocks as compensation

for the additional risk that a small company is more likely to fail than a large company

that has more assets. The small firm effect by Banz, discovered that historical

performance of portfolios formed by dividing the NYSE stocks into 10 portfolios each

year according to firm size, Average annual returns between 1926 and 2006 are

consistently higher on the small-firm portfolios. the smaller-firm portfolios tend to be

riskier. But even when returns are adjusted for risk using the CAPM, there is still a

consistent premium for the smaller-sized portfolios. The second point is the

neglected-firm effect by Arbel which interprets that because small firms tend to be

neglected by large institutions, information about smaller firms is less available. This

information deficiency makes smaller firms riskier investments that command higher

returns. The DFA has reputation to overcome asymmetric information issue: it can get

private information when cooperating with small companies. If semi-strong market

efficiency hold, it is possible to beat the market having private information. At last but

not least, we think is the liquidity effect by Amihud and Mendelson. Investors will

demand a rate-of-return premium to invest in less-liquid stocks that entail higher

trading costs. These stocks usually show a strong tendency to abnormally high

risk-adjusted rate of return. Thus we should expect small stocks to outperform large

stocks in the future.

Meanwhile, the value-growth effect is also found by Fama and French. This

finding is also verified by real data in Exhibit 6. The only reason is any asset

consistently outperforms in a rational, efficient market: because they are riskier. Thus

we can expect the value stocks outperform growth stocks,

3. Why has DFAs small stock fund performed so well?

We conclude 6 reasons for the stellar performance of DFAs small stock funds:

1) Distinct Investment Strategies.

Dimensional founders believed passionately in principle of "passive" stock

market investing. As passive investors believe in the so-called efficient market theory,

which maintains that almost no one can be smarter than the market as a whole in the

long run. Hence DFA buy and hold broad portfolios of shares, betting that their returns

over time will trump the gains of most "active" managers who try to find the stocks

that would outperform the market.

Dimensional does not actively pick stocks or passively track commercial indexes

but instead structures portfolios based on risk and returns as identified through

financial science. Their main objective is to help clients structure globally diversified

portfolios and to increase returns through state-of-the-art portfolio design and trading.

2) Investment Philosophy Is Grounded in Robust Academic Research

DFA 's investment strategies were based on sound academic research, which

proves successful.

DFA began as a small-stock fund in 1981, attempting to take advantage of the

"size affect" (excess performance of small stocks) that had been discovered by a

number of academic researchers. Most notably is the academic paper from the

University of Chicago PH.D. dissertation of Rolf Banz, small stocks had consistently

outperformed large stocks over the entire history of the stock market from 1926

through the late 1970s.

Later, research by Professors Eugene Fama and Kenneth French identified

equity market exposure, capitalization, and price relative to fundamentals as the 3

factors that primarily determine the returns of a broadly diversified portfolio. Their

work has held up through rigorous open review and Dimensional strategies focus on
their insight.

3) Combination of Theory and Practice.

By acting as a conduit between financial economists and practicing investors,

DFA has pioneered many strategies and consulting technologies now taken for

granted in the industry. This makes for an exchange of ideas that allows

Dimensional to position themselves at the forefront of innovative solutions.

The reason why DFA's RIA business has grown rapidly (see exhibit 2) was good

evidence that DFA educated its RIAs by providing them with access to top

researchers who were developing innovative theories and empirical analyses. The

RIAs then used what they had learned to advise their clients. And this advice

generated questions that DFA delivered back to the academics for continued

research.

Also, DFA encouraged academics to work on subjects of interest to the firm by

giving any professor a share of profits from investment strategies derived from his or

her ideas.

4) Low Costs low management fee to attract client

Their investment management fees are positioned well below those of traditional

active managers. DFA's fees tended to be lower than those of most actively managed

funds but higher than those of pure index funds. This was fitting given DFA's position

in the market as a passive fund that still would add value. And this competitive and

well-positioned pricing helped attracted client.

5) Smart Trading Can Increase Returns

 a. Purchase discount

DFA's buy-hold approach and trading strategies are designed to minimize

costs. Careful trading can reduce or even reverse the costs borne by traditional

managers. Because Dimensional focuses on capturing the systematic performance

of broad market dimensions rather than the random fluctuations of individual

securities, they can keep costs low. They can keep costs low, patiently and expertly,

by reducing turnover and concentrating on favorable price execution.

Instead of bidding in the open market to buy stocks, DFA would prefer to absorb

the selling demand of others. In return for accepting large blocks of stock from market

participants who had a strong desire to sell, DFA was able to extract a discount on the

stock purchase. From the exhibit 10 for the Small Cap Portfolio,

In 2001: 36% of purchases were block trades, whose average discount reached

3.33%. Considering the loss of 0.58% to costs on remaining 64% orders that DFA had

to patiently buy shares from open market, the weighted average discount was 0.83%

for all orders.

We also note from back earlier to 1998: 50% of purchases were block trades,

with average discount reached 3.56%. A weighted average discount for all orders was

higher, being 1.64%.

b. Avoidance of adverse selection

DFA saw about 1000 potential trades in a typical day and 20, which indicates that

DFA's selection process is careful and tactful. They applies "adverse selection

problem" so as to avoid anything wrong in the stock orders that they are going to buy.
This is also another important reason that enabled FDA's passively managed

small-stock portfolio to outperform typical small-stock indexes by about 200 basis

points per year over the past 20 years.

6) Professional team

The ability of skilled DFA traders to contribute to a fund's profits even when the

investment was inherently passive and their ability to turn the difficulty of trading small

stocks into an opportunity. DFA team's professionalism and ability is also a critical

reason for the success of DFA's small stock fund, although the case did not obviously

mention this.

4. DFAs tax-managed fund family likely to be successful, or remain just a

small niche market?

From my point of view, DFAs tax-managed fund family will remain just a small

niche market.

We can learn from the case material that DFAs newest products typically aim to

limit distributions of income and capital gains. Investors in the funds thus will owe little

or no tax until they sell their fund shares. In addition to selling losing positions to offset

gains and avoiding high-dividend stocks, a fund manager might hold stocks for more

than one year. As shown in Exhibit 11, after the inception of those funds, they are

likely to become increasingly important in determining total returns for investors. The

losses in most stocks between 1999 and 2002 gave those funds a reserve of capital

losses that they have carried forward over the intervening years to offset subsequent
gains. However, as the bull market progresses, they will eventually use up all of these

losses, and investors will again begin to see a substantial flow of taxable distributions

as a result.

Taxes can have a big impact on your overall portfolio returns. DFA managers of

tax-managed funds employ a variety of tactics to avoid taxable distributions. They

might trade less frequently or they might purposely sell lagging stocks for a loss to

offset gains. Looking at DFA U.S. Tax-Managed Funds' performance information, their

after-tax returns were very close to their pretax returns.

But on the other hand, taxes shouldn't be the primary factor in choosing a mutual

fund. After all, the main reason why investors choose to have a money manager

actively overseeing their fund's portfolio is to make good decisions about when to buy

and sell stocks. If fund manager believes that one of the fund's holdings is going to fall

in price, they want the manager to feel comfortable dumping that stock without

necessarily worrying too much about the tax impact. As many investors have learned

the hard way, it's much better to pay taxes on gains than not to have any gains at all.

And just as DFA realized by itself, such tax-managed funds were not appropriate for

all investors. For investors who want active and tax management, tax-managed

mutual funds may make sense. But when fund managers don't outperform the market

or do worse than the market partly because they're somewhat restricted by concerns

about taxes, some in the industry question the value of these funds.

Furthermore, why not invest in ETFs in the long run? ETFs are similar to

tax-managed funds as they tend to throw off fewer taxable distributions. In contrast,
ETFs have a special legal structure which typically gives investors fewer capital-gains

distributions than traditional mutual funds. While ETFs don't allow investors to avoid

capital gains, they enable investors to delay them until they sell the ETF. The greater

certainty and control that ETFs give investors in estimating their tax bill is a reason

that some investors may choose ETFs over tax-managed mutual funds.

5. What should be the firms strategy going forward?

DFA can consist on the path that had brought them so far and help clients build

broadly diversification portfolios across a range of asset classes in the market. Those

strategies include small cap, value, ETF approaches and offer precisely defined

exposure to the underlying sources of risk.

DFA has been the leader in small stock research since inception according to its

philosophy. Over the long term, small companies provide higher expected returns

than larger companies. Thus, DFA can deliver a small cap performance premium and

provide worldwide diversification.

Based on the Fama and French research and are designed to capture the return

premiums associated with high book-to-market ratios. DFA and construct their

portfolios by first ranking the total market universe by market cap and identifying

those companies that fall within the defined size range.

The historical data show DFAs tax-efficiency. Their tax-managed funds target

market segments that have higher expected returns but are otherwise costly or

unsuitable for taxable investors, and ETFs can open new opportunities for taxable
investors. The vast majority of these funds have a clever tax structure that helps

management to easily avoid making any capital gains distributions.