Traditional managers fall into two groups – active and indexing.
Active managers are looking to find market inefficiency or mispriced assets, which in turn leads to frequent trading, higher turnover, costs and lack of diversification.
An index managers goal is to closely track the index results, which leads to forced trading. Index managers are judged by their ability to track the index. As indexes change the list of stocks once or twice a year, index fund managers are forced to buy and sell the same securities at the same time. With hundreds or thousands of index funds all attempting to place the same trade at the same time, index managers are consequentially affecting the price of that security and driving the cost up. This results in buying and selling at the worst possible time and price.
An additional issue to consider is style drift. A traditional index, representing one asset class, may review and adjust their holdings only once a year. During the course of the year many stocks may drift from the asset class, small companies may become mid companies for example. The index does not make an adjustment until the next scheduled review, leading to investors holding positions that are not appropriate for the targeted asset class, or even holding positions of the same stock that may have drifted into another category already owned by the investor through a different fund.
There is a better way to capture an asset class. Unlike a pure indexing approach, Dimensional Fund Advisor’s (DFA) approach allows a flexible portfolio composition and does not force managers to buy or sell securities at a certain time or price. DFA funds may have many of the same companies in their funds as the traditional indexes, but they are free to add or exclude certain companies when and if they choose to do so.
DFA has its own definition of asset classes, built with flexibility. Starting with the total market, Dimensional applies a quantitative sort that identifies the desired asset class by market capitalization, book-to-market, or other risk characteristics. This results in an initial universe offering more precise exposure to the underlying risk factor. Dimensional then applies qualitative screens to exclude securities that do not exhibit the general characteristics of the defined asset class. This includes stocks that research has documented to have lower expected returns. For a US strategy, questionable securities may include foreign stocks, ADRs, REITS, and closed-end investment companies. This reduced set is the eligible universe.
DFA further reduces the universe by eliminating certain securities that may compromise the return. For example, stocks that may result in adverse selection in the portfolio. Examples are stocks from recent IPOs, those experiencing financial difficulty or distress, and those in bankruptcy. Additional examples include stocks that are involved in a merger, the target of a merger, or in a corporate action.
DFA excludes stocks that may be difficult to trade, or that trade too expensively. These include stocks that may become delisted, those with insufficient liquidity, and/or those with a limited operating history. In addition, limited partnerships and stocks with inadequate data can be excluded as well.
Dimensional is not in the active or index category, some call it enhanced indexing, some call it evidence-based investing.
Active managers are looking to find market inefficiency or mispriced assets, which in turn leads to frequent trading, higher turnover, costs and lack of diversification.
An index managers goal is to closely track the index results, which leads to forced trading. Index managers are judged by their ability to track the index. As indexes change the list of stocks once or twice a year, index fund managers are forced to buy and sell the same securities at the same time. With hundreds or thousands of index funds all attempting to place the same trade at the same time, index managers are consequentially affecting the price of that security and driving the cost up. This results in buying and selling at the worst possible time and price.
An additional issue to consider is style drift. A traditional index, representing one asset class, may review and adjust their holdings only once a year. During the course of the year many stocks may drift from the asset class, small companies may become mid companies for example. The index does not make an adjustment until the next scheduled review, leading to investors holding positions that are not appropriate for the targeted asset class, or even holding positions of the same stock that may have drifted into another category already owned by the investor through a different fund.
There is a better way to capture an asset class. Unlike a pure indexing approach, Dimensional Fund Advisor’s (DFA) approach allows a flexible portfolio composition and does not force managers to buy or sell securities at a certain time or price. DFA funds may have many of the same companies in their funds as the traditional indexes, but they are free to add or exclude certain companies when and if they choose to do so.
DFA has its own definition of asset classes, built with flexibility. Starting with the total market, Dimensional applies a quantitative sort that identifies the desired asset class by market capitalization, book-to-market, or other risk characteristics. This results in an initial universe offering more precise exposure to the underlying risk factor. Dimensional then applies qualitative screens to exclude securities that do not exhibit the general characteristics of the defined asset class. This includes stocks that research has documented to have lower expected returns. For a US strategy, questionable securities may include foreign stocks, ADRs, REITS, and closed-end investment companies. This reduced set is the eligible universe.
DFA further reduces the universe by eliminating certain securities that may compromise the return. For example, stocks that may result in adverse selection in the portfolio. Examples are stocks from recent IPOs, those experiencing financial difficulty or distress, and those in bankruptcy. Additional examples include stocks that are involved in a merger, the target of a merger, or in a corporate action.
DFA excludes stocks that may be difficult to trade, or that trade too expensively. These include stocks that may become delisted, those with insufficient liquidity, and/or those with a limited operating history. In addition, limited partnerships and stocks with inadequate data can be excluded as well.
Dimensional is not in the active or index category, some call it enhanced indexing, some call it evidence-based investing.