Dimensional takes Efficient Markets tack

(October 31, 2003) Fans of Efficient Markets Theory may have already noticed the arrival of a new family of funds in Canada, as Dimensional Fund Advisors made their debut in Canada this week.

Aimed primarily at the fee-based advisor, Dimensional’s funds are based on Efficient Markets Theory espoused by University of Chicago researchers Eugene Fama and Dartmouth College’s Kenneth French.

To boil the theory down to it’s very simplest: The market knows what it’s doing. It is virtually impossible to consistently beat the market. The best way to profit is through very broad diversification and a buy and hold strategy.

“We’re not passive in a traditional sense, but we don’t believe in any forecasting and we’re certainly not in the business of stock picking or market timing,” says Bradley Steiman, Dimensional’s regional director of financial advisor services. “We’ve got way too much tracking error to be an index fund, but we’re also not claiming to have a crystal ball and do any active management.”

Skeptics may ask why they should buy a Dimensional fund, instead of getting their diversification through a traditional index fund or an exchange-traded fund. Steiman gladly points out that Dimensional fund managers are not forced to buy a stock they don’t like because the index is reconstituted.

He also points out that the rebalancing required by index funds undercuts profits, as trade execution costs eat into the portfolio returns.

“Tracking an index is extremely expensive. We don’t understand why a lot of institutional investors are so obsessed with tracking error,” he says. “If you had a choice 20 years from now between having more money, or having really close tracking error to the Russell 2000, which would you choose?”

Steiman says that tracking error is evidence of Dimensional’s not-entirely-passive approach to fund management, as the funds’ mandates leave managers free to set weightings as they see fit. When a block trade of stock on the buy list comes to market at an attractive price, managers don’t need to worry about rebalancing the fund’s weightings.

“We’re not walking around with our hands tied behind our backs, just taking Russell’s definition of the asset class as the only appropriate definition,” says Steiman. “If we can add some value on the margin, and not in the traditional way of picking stocks or timing the market, we’re going to do it. If we incur a little tracking error along the way, that’s OK.”

Steiman outlines the firm’s process for building the Dimensional U.S. Small Cap Fund. From the initial universe of over 4700 stocks, Dimensional eliminates the top 1,000 largest firms as well as any foreign stocks, American deposit receipts, real estate investment trusts and closed-end investment companies.

This leaves the portfolio managers with an eligible universe of almost 3,600 companies. Using an additional list of company-specific criteria, Dimensional further reduces the field to 2,870 listings on its current buy list, excluding a total of 1,913 stocks.

“This is not stock picking. We’re not excluding any of these securities because we think they’re ‘bad’ and the ones we’re buying are ‘good,'” says Steiman. “We just want to make sure they fit the asset class the way financial economists would define it and that we can trade these efficiently.”

The elimination of so many companies leaves the fund with a collection of stocks, with a weighted average market cap of $819 million — smaller than the Russell 2000’s $1.004 billion and far smaller than the S&P 500’s $116.9 billion.

“In an ideal world, we would own all those in their market cap weights, but again, because we’re not trying to track anything, we’re going to give ourselves flexibility to not necessarily be forced to hold all these companies in their market cap weight.”

Filed by Steven Lamb, Advisor.ca, slamb@advisor.ca