7-Minute Read

“Markets continually price themselves to attract new capital. Buyers in those markets must have a positive expected return.”

• David Booth, Founder of Dimensional Fund Advisors (2020 Investor Symposium)

Dimensional Fund Advisors (DFA) regularly hosts an educational event called the Investor Symposium. Normally this is an in-person event where I’ve had the opportunity in the past to take clients as guests. Due to the Coronavirus pandemic, DFA recently condensed a full-day event into a 2-hour virtual session.

The goal of this piece is to further condense the key messages from the Symposium into a reasonably short read, with a focus on the foundational principles of investing¹. From this viewpoint, gaining clarity on the principles comes down to understanding three things: Prices, Premiums and Process.

One – Prices

Prices reflect the aggregate expectation of market participants. Buyers and sellers are coming together daily to transact based on supply, demand, and the information available at that time. Our focus is often on the markets for investment securities (e.g. stocks and bonds), but this is true of any well-functioning market. An economy works because people trust the market prices they see every day, from the trips to grocery store to the online transactions made from mobile devices.

Prices incorporate relevant information very quickly. Because markets are so competitive, it’s difficult to identify and profit from mispricing. Think of it this way: the prediction business is so difficult is because you not only have to predict future events, but you must also predict how markets are going to respond to those events. Both feats are nearly impossible to do systematically.

In the recent decades, the indexing approach to investing has become extremely popular. This is also called passive investing. While indexing has some great characteristics (e.g. low costs, broad diversification), there are shortcomings. One example is that indexing does not incorporate the daily changes in prices. Why is that noteworthy?

Let’s say you buy an index fund for a particular asset class such as US Small Cap Stocks. Depending on the day of your purchase, you may not get a true representation of the US Small Cap Market. Prices continually change resulting in some companies entering that asset class and some leaving it. The result is you could end up being invested based on stale information. This staleness corrects itself periodically as we’ll see in the final section, but that comes with other hidden costs.

Is there a solution to this price puzzle? While definitive outcomes cannot be known in advance, what if we had a dynamic approach to the investment process that somehow incorporated those daily price changes? This might move us in the right direction. The key is understanding that there is always a connection between the price you pay for an investment and what you expect to earn from it.

Two – Premiums

Fairly prices securities can have different expected returns from one another. This gets to the concept of a premium. Let’s define a premium as simply the difference in returns between investments (or groups of investments) with different characteristics.

For example, take two stocks, company A and company B. If we could assume both are priced fairly and expect to produce the same level of cash flows to investors, they might still have different expected future returns. Put another way, if the market collectively agreed that company A was a riskier proposition than company B, the price of company A would need to be bid down to a lower price. All else equal, that lower price results in a higher expected return for company A than company B.

Many premiums have been discovered over the years by financial researchers, largely aided by academic institutions along with our vast and growing computing power. But more data does not always lead to more wisdom. If we look closely enough at a set of data, we can probably find a statistically meaningful relationship between stock returns and rainfall in the town where you grew up. That doesn’t mean you would want to build an investment strategy around that.

Among other things, a viable premium must be sensible and intuitive. If a premium is backed up by solid data, then it still a hurdle of being cost-effectively captured in a real-world portfolio. With that said, let’s look at the equity (stock) markets and three premiums that currently meet DFA’s criteria:

• Size – 2.0% annualized return difference between small cap and large cap companies (1928-2019)
• Relative Price – 3.1% annualized return difference between value and growth stocks (1928-2019). This is also known as the value premium.
• Profitability – 3.6% annualized return difference between high profitability and low profitability stocks (1964-2019)

Premiums can appear quickly, unpredictably and with large magnitude. Alas, knowing the information above does not provide a free lunch. One challenge with premiums (also known as dimensions of higher expected return) is that they are volatile. They also compete, so you can’t expect all premiums to show up at the same time.

Ultimately, despite these challenges, an equity portfolio that emphasizes the premiums above should have a higher expected return over time.

Three – Process

Finally, it’s not just about knowing how prices and premiums work. We need action and implementation. At some level there must be expertise to rationally use the information contained in prices. Then we need a process to reliably capture the premiums.

While we can’t explore every angle here, we can look at a couple of factors that can be detriments to a an investment process: Trading Costs and Fees.

Trading Costs Can Be Hidden

More trading can result in more costs and lower returns. One metric that can be observed for mutual funds is called turnover. It’s a percentage-based measure that indicates how long an investment position is held in a portfolio. The main idea is that higher turnover leads to higher costs. Take it one step further and the data suggests that higher costs leads to lower performance.

Trading costs are not just what you see. Explicit costs include things like commissions, custody fees and exchanges fees. But there are also implicit costs. These go by technical names such as bid-ask spread and market impact.

We’re almost done nerding out. Let’s go back to index funds for a moment. They might have low explicit trading costs, but they can larger implicit costs. The reason is index funds must deal with what’s called “immediacy-driven” price movement. This comes from adhering to rules that require index fund managers to “reconstitute” their positions periodically. This creates large trading volumes on specific days with demands for liquidity in a very tight time window. Now let’s put that more simply. The result can be buying and selling positions at less than ideal prices simply because there was less flexibility on when those trades could be made.

Beware of Fees

No more picking on index funds because this is one area where they shine. They have low fees or what is also called lower expense ratios. On the other hand, actively managed funds (a.k.a. stock picking) typically requires higher fees to offset the costs of doing rigorous analysis and research. The problem is in the aggregate, most active funds do not outperform the markets because the returns they yield must be offset by the drag of their fees.

Few US domiciled equity mutual funds have survived and outperformed². Out of all mutual funds (both equities and fixed income) over the twenty years ending in 2019:

• 41% of funds have survived and only 17% have outperformed benchmarks.
• 100% of DFA funds have survived and 81% have outperformed benchmarks.

Implementation Still Requires Expertise

In the end, it becomes a delicate balancing act. Implementation must balance the quest for expected premiums with the costs of capturing those premiums. It requires a careful process based on market prices, research insights and efficient trading.

Keep Evolving

While Krishna Wealth uses DFA as a core solution for designing portfolios, the hope is that these principles can bring some useful perspective to your current strategy no matter what your specific approach may be. Progress is made if we can keep asking the right questions and evolving our understanding of portfolio design. The goal at Krishna Wealth is to never lose focus on improving the investment experience for clients.

If you have comments or questions, or if you would like the source materials for this piece noted in the references below, please drop me a line at: [email protected]

References

1. The Foundational Principles – Jake DeKinder – From the DFA Virtual Investor Symposium (May 1^st, 2020)
2. Dimensional Overview (as of 3/31/2020)

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