DFA case answers Essay

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1. Describe the investment strategy employed by DFA. Does DFA consider itself an active or passive manager? What aspects of its strategy are active? What aspects are passive?

DFA’s investment strategy is to use academic research to create specialized portfolios focused on Small Capitalization companies. DFA is dedicated to the concept that markets are "efficient," which means that over any given period, no one has the ability to consistently pick stocks that would beat the market. In addition, DFA’s founders believed that combining sound academic research with the abilities of skilled traders would together contribute to produce superior returns for the fund. As such, DFA considers itself to be a passive fund manager that still adds value. The fund’s investment strategy has both a passive component and an active component. The passive component is that the fund does not use managers’ judgment to pick individual stocks, but rather tries to match a broad-based, value-weighted small-stock index. Specifically, the fund looked for small cap companies with a high book value to market value as they had proven to outperform the companies with high P/E ratios and low book-to-market ratios. Similarly, DFA does not sell its stocks based on specific news or opinion on a particular company, but rather only sells if a stock no longer fit the portfolio (i.e. when a stock becomes too large or when a value stock becomes a growth stock). Despite these passive aspects, DFA’s investment strategy is more active than that of an index fund manager in that it does not slavishly follow an index, but uses various adjustments and modifications based on robust academic research, as well as a transactional technique called "patient trading" where the fund “works the order” by patiently buying shares to minimize the price impact. Lastly, DFA’s trading strategy also focused on maintaining low transaction costs. Since its core strategy was to focus on small cap stocks that are illiquid, DFA would simply absorb the selling demand of others by buying large blocks at a discount instead of bidding for stock in the open market. These discounts were largely responsible for the fact that DFA’s passively managed small-stock portfolio outperformed the typical small-stock indexes.

2. Who are DFA’s clients, and what are their concerns? What new clients is DFA trying to serve, and what are some of the new issues DFA will face in meeting these clients’ needs?

DFA’s original clients were major institutions, including corporate, government, and union pension funds, college endowments, and charities. These clients continued to make up the majority of DFA’s business. Institutional investors often concern about the diversification of their portfolio and need to insure that they maintain a balanced portfolio that reflects the overall market. Since the majority of mutual funds focus on mid to large cap companies, DFA’s small cap investing strategy makes the funds appealing to institutional investors looking to diversify their investment portfolio.

Starting in 1989, DFA began to pursue high-net-worth individuals, in addition to institutions, as clients. Due to the illiquid nature of DFA’s holdings, direct accounts with individual investors would lead to intolerably high costs. As such, DFA decided to serve the individual clients through registered investment advisors (RIAs). Similar to institutional investors, these individual investors and RIAs also have the same need for portfolio diversification, low turnover, and low
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