Dimensional Fund Advisors, 2002 – Case Solution

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Dimensional Fund Advisors, 2002 Case Answers

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1. What is the business strategy of Dimensional Fund Advisors (DFA)? What do you think of the firm? Does the DFA team really believe in efficient markets?

According to the case, Dimensional Fund Advisors (DFA) operates as an investment management firm that applies academic research in making strategic investment decisions.

The company’s business strategy involved taking advantage of the “size effect” and relying on stocks’ performance. The firm also developed strategies that entail value addition to its diverse services.

Through academic research, the business was able to identify high-performance stocks in other countries, subsequently proceeding to invest in international value-stock and creating funds for small-stock. It is a business strategy that made the company highly successful, resulting in a growth of assets from $8 billion in 1991 to an estimated $40 billion in 2002.

This growth was due to the good performance of value stocks. In addition to investing in well-performing value stock, Dimensional Fund Advisors also focused on maintaining the growth of its investor base, which the management identified as an important investment area.

The company’s philosophy emphasizes investments in small stocks while maintaining appreciation in the value of research and relying on the ability of skilled trades in the context of passive fund management.

Also, the business strategy involved discounting and reducing market attractiveness when investors are purchasing stocks. By focusing on high net-worth individuals, the company gains additional financial advantages.

We think the firm has unique attributes and insightful knowledge regarding its business strategies. The philosophy they operate on is efficient, as it is not inclined towards either active or passive management fund but rather involves both. Although they believe in the principle of stock market efficiency, they understand that the current market is not effective and try to find alternative ways to set up an active management strategy.

The company’s stable development and robust incomes play an important role in achieving its financial and investment goals. Dimensional Fund Advisors attempts to create a broad and value-based small-stock index, which would allow it to gain a stronger market position.

Ultimately, this strategy is expected to contribute significantly towards value addition by taking advantage of specific risk dimensions as informed by research.

2. Do the Fama-French findings make sense? Should we expect i) small stocks to outperform large stocks in the future and ii) value stocks to outperform growth stocks?

The Fama French Model expanded the Capital Asset Pricing Model (CAPM) by introducing two new risk factors, which are the stock size and book-to-market ratio.

Fama and French discovered that stocks with high beta can’t always generate higher returns than low-beta stocks. Large size stocks with high market beta and low book-to-market ratios will generate relatively lower returns.

To summarize, in the Fama French Three-Factor Model, the return is explained by three factors which are market, stock size, and book-to-market ratio.

For value stock and growth stock, Dimensional Fund Advisors think that value stocks outperform growth stocks because…