Asset Management

1. Asset Management Lecture 8

2. Outline for today • Today: DFA case • A brief review of innovations in financial market research • A discussion on the efficient market theory and the validity of CAPM • Quiz: from the mid-night of March 4, Wednesday to the mid-night of March 10, Tuesday.

3. Dimensional Fund Advisors 2002 • The purpose of this case: • To introduce many of the major empirical findings during the past five decades. • How to turn new academic findings into productive investment strategies. • Lemon’s problem • Fund taxation

4. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • Conventional Wisdom circa 1950 • "Once you attain competency, diversification is undesirable. One or two, or at most three or four, securities should be bought. Competent investors will never be satisfied beating the averages by a few small percentage points.“ Gerald M. Loeb “The Battle for Investment Survival”, 1935 • Analyze securities one by one. Focus on picking winners. Concentrate holdings to maximize returns. • Broad diversification is considered undesirable.

5. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1952, Diversification and Portfolio Risk • Harry Markowitz (Nobel Prize in Economics, 1990) • Diversification reduces risk. • Assets evaluated not by individual characteristics but by their effect on a portfolio. An optimal portfolio can be constructed to maximize return for a given standard deviation.

6. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1958: The Role of Stocks • James Tobin (Nobel Prize in Economics, 1981) • Separation Theorem: • 1. Form portfolio of risky assets. • 2. Temper risk by lending and borrowing. • Shifts focus from security selection to portfolio structure • "Liquidity Preference as Behavior Toward Risk," Review of Economic Studies, February 1958.

7. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1961: Investments and Capital Structure • Merton Miller and Franco Modigliani (Nobel Prizes in Economics, 1985 and 1990) • Theorem relating corporate finance to returns. • A firm's value is unrelated to its dividend policy. • Dividend policy is an unreliable guide for stock selection.

8. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1964: Single-Factor Asset Pricing Risk/Return Model • William Sharpe (Nobel Prize in Economics, 1990) • Capital Asset Pricing Model: • Theoretical model defines risk as volatility relative to market. • A stock's cost of capital (the investor's expected return) is proportional to the stock's risk relative to the entire stock universe. • Theoretical model for evaluating the risk and expected return of securities and portfolios.

9. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1965: The Random Walk • Paul Samuelson, MIT (Nobel Prize in Economics, 1970) • Market prices are the best estimates of value. • Price changes follow random patterns. Future share prices are unpredictable. • "Proof that Properly Anticipated Prices Fluctuate Randomly,“ Industrial Management Review, Spring 1965

10. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1966: Efficient Markets Hypothesis • Eugene F. Fama, University of Chicago • Prices reflect values and information accurately and quickly. It is difficult if not impossible to capture returns in excess of market returns without taking greater than market levels of risk. • Investors cannot identify superior stocks using fundamental information or price patterns.

11. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1968: First Major Study of Manager Performance • Michael Jensen, 1965; A.G. Becker Corporation, 1968 • First studies of mutual funds (Jensen) and of institutional plans (A.G. Becker Corp.) indicate active managers underperform indexes.

12. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1971: The Birth of Index Funds • John McQuown, Wells Fargo Bank, 1971; Rex Sinquefield, American National Bank, 1973 • Banks develop the first passive S&P 500 Index funds.

13. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1972: Options Pricing Model • Fischer Black, University of Chicago; Myron Scholes, University of Chicago; Robert Merton, Harvard University ( Nobel Prize in Economics, 1997) • The development of the Options Pricing Model allows new ways to segment, quantify, and manage risk. • The model spurs the development of a market for alternative investments.

14. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1975: Converting to Indexing • New York Telephone Company invests $40 million in an S&P 500 Index fund. • Helps launch the era of indexed investing. • "Fund spokesmen are quick to point out you can't buy the market averages. It's time the public could.“ Burton G. Malkiel, A Random Walk Down Wall Street, 1973 ed.

15. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1977: Database of Securities Prices since 1926 • Roger Ibbotson and Rex Sinquefield, “Stocks, Bonds, Bills, and Inflation” • An extensive returns database for multiple asset classes is first developed and will become one of the most widely used investment databases. • The first extensive, empirical basis for making asset allocation decisions changes the way investors build portfolios.

16. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1981: The Size Effect • Rolf Banz, University of Chicago • Analyzed NYSE stocks, 1926-1975. • Finds that, in the long term, small companies have higher expected returns than large companies and behave differently. • Dimensional Fund Advisors is founded in 1981 and launches the first passive small cap strategy (the US Micro Cap Portfolio).

17. Dimensional Fund Advisors 2002 • A brief history of innovations in financial markets research • 1992: Multifactor Asset Pricing Model and Value Effect • Eugene Fama and Kenneth French, University of Chicago • Develops the three-factor asset pricing model • Identifies market, size, and "value" factors in returns. • Dimensional introduces value strategies based on the research. • Lends to similar findings internationally.

18. Dimensional Fund Advisors 2002 • 1. evaluate DFA’s business strategy • Would you like to invest in DFA? • A $30 billion investment fund based in Santa Monica • A strongly professed belief that the capital markets are efficient • A passive, buy-and-hold investment approach • The use of academic research to define and assess the fund’s strategies • A specialization in the purchase of large blocks of small stocks at discount prices

19. Dimensional Fund Advisors 2002 • DFA philosophy

20. Dimensional Fund Advisors 2002 • DFA philosophy

21. Dimensional Fund Advisors 2002 • DFA as a business • Clients: • Institutional, registered investment advisors • Fees: • Lower than active funds, higher than index funds • Given that DFA outperformed most active funds, were managers wise to charge lower fees than competitors? • Marketing: • Low-key approach, astute or misguided? • Value of the firm: • $40 billion in assets x 0.50% (typical fee) = $200 in revenue • Staff of 130 • 50 top professionals at $1 million each • 80 support staff at $200,000 each • $134 million of annual profit

22. Dimensional Fund Advisors 2002 • 2. What are the Fama-French findings? • The Cross-Section of Expected Stock Returns, Eugene F. Fama and Kenneth R. French, The Journal of Finance, Vol. 47, No. 2 (Jun., 1992), pp. 427-465

23. Dimensional Fund Advisors 2002 • 2. What are the Fama-French findings?

24. Dimensional Fund Advisors 2002 • 2. What are the Fama-French findings? • Fama French, 1993, Common risk factors in the returns on stocks and bonds, JFE 33 • High returns of small and value stocks are compensation of risks not captured by CAPM. • The difficulty in identifying the sources of SMB and HML risks • Stock market efficiency • High returns are compensation for high risks. The knowledge of the performance is widespread. • Outperformance is historical fluke and unlikely to continue • Stock market is not efficient: • An opportunity for sophisticated investors to consistently outperform the market. No explanation for risk-return compensation. • Short window of opportunity

25. Dimensional Fund Advisors 2002 Are small stocks really risky? What about the risk of value stocks? What about growth stocks (low return, high beta)? Stock market efficiency: High returns are compensation for high risks. How do you explain the international findings: table Stock market efficiency: outperformance is a historical fluke and unlikely to continue. Stock market is not efficient: Compensation for sophisticated investors The outperformance of value stocks has been common knowledge since Graham and Dodd in 1930s. How can they still offer an opportunity? Yet why should they stop working now? Stock market is not efficient: Short window of opportunity

26. Dimensional Fund Advisors 2002

27. Dimensional Fund Advisors 2002 • Fama French also found that high-beta stocks on average do not significantly bring higher returns than stocks with lower betas. • Joint test of market efficiency and CAPM • Long low-beta firms and short high-beta firms with cash borrowing? • DFA: short growth stocks (high beta) • The true betas are unknown • More related research: • Consumption patterns of individuals (Lettau and Ludvigson 2001, A cross-sectional test when risk premia are time-varying) • Value stocks with cash flow risk (Cohen, Polk and Vuolteenaho, 2003, Does risk or mispricing explain the cross-section of stock price levels) • Irrational behavior (Daniel and Titman, 1997, Evidence on the characteristics of cross-sectional variation in stock returns)

28. Dimensional Fund Advisors 2002 • 3. costs and benefits of DFA’s trading strategy • No stock-picking • Liquidity provider to the markets • Buy large blocks of illiquid stocks at a discount • Low turnover brings low costs • The lemon’s problem • Known customers • Penalties and reputation costs