DFA Continues Cutting Edge Academic Research

One of the main reasons we have chosen to utilize DFA (Dimensional Fund Advisors) as our primary investment/mutual fund strategy is their scientific approach based on ongoing academic research.  Below is an excerpt of their newest “dimension” of investing.  We look forward to discussing how this new layer of investment strategy works in our client portfolios.

Adapted From “Despite its Success, Firm is Tinkering with the Way it Builds Equity Portfolios” by Jason Kephart of Investment News, 8/7/13.

For the first time in more than 20 years, Dimensional Fund Advisors is changing the way it builds equity portfolios. Thanks to a breakthrough in asset-pricing research last year, DFA is adding a third layer of screening to its equity portfolios, which already tilt toward small and value stocks. The new layer, or dimension, focuses on a company’s persistence of profitability — basically a stock’s ability to earn a profit consistently.

The idea that a profitable company is going to perform better than a less profitable company over time isn’t a new idea. In fact, it is kind of common sense. The challenge for DFA, which bases all its investment methodologies on academic research, was finding a reliable way to use data to identify future profitability.

“New research has to be very robust, very reliable and have real information that’s not already captured in the other dimensions,” said Eduardo Repetto, Dimensional’s co-chief executive and chief investment officer. The breakthrough came late last year when DFA began looking at companies’ earnings-to-assets and earnings-to-book, rather than cash flow or earnings-to-price.

The company found that using a stock’s price doesn’t lead to any reliable data, because the price of a stock can be very volatile. Using a company’s assets or book value, by contrast, provides a more reliable look at how profitable a company is and how likely it is to continue to be profitable.

When DFA looked at the back-tested results of overweighting the most profitable companies in its portfolios, the results weren’t inconsequential, Mr. Repetto said. In fact, the power of the profitability dimension is about par with the premium seen over time by overweighting value. When the two are combined, it leads to even better results.

“When it’s combined with size, and in particular with value, you can really form portfolios that add value relative to not using that dimension,” Mr. Repetto said.

The new overlay already has been added to seven equity portfolios with about $2 billion in assets, or less than 1% of DFA’s approximately $240 billion in equity portfolios. The plan is to roll it out across the entire lineup by year’s end, Mr. Repetto said. “Right now, we’re working with clients so everyone understands what we’re doing,” he said. “We don’t want anyone to be surprised.”  “This is not magic; it’s based on our understanding of asset prices,” Mr. Repetto said.

“Whenever we can do something good for our clients, it’s in our best interest to do it,” he said.