Lqwefbgiy34G

ECFS845 - Applied Portfolio Management

Dimensional Fund Advisers – DFA

Fund Client

Part 1 – What are the major finance ideas and inventions employed by DFA?

1. Portfolio selection model (Harry Markowitz, 1952)

• Rather than seeking to track specific indexes, DFA creates its own indexes to provide more flexibility in how and when to buy or sell stocks. DFA focuses on diversification to reduce risk and seeks to minimise adverse stock selection by paying careful attention to ensure there is no negative private information known to the seller but not to the market.

• Consistent with Markowitz’s formal model of portfolio selection embodying diversification principles and the identification of an efficient set of portfolios based on the means and variances of stocks’ returns.

2. Investments and capital stucture (Merton Miller and Franco Modigliani, 1961) and tax management

• Miller and Modigliani Theorem essentially states that a firm’s value is unrelated to its dividend policy and dividend policy is an unreliable guide for stock selection.

• DFA seeks to increase after-tax returns by decreasing taxes though the reduction of stock dividends and the timing of stock sales to reduce capital gains taxes.

3. Capital asset pricing model (CAPM): single-factor asset pricing risk/return model (William Sharpe, 1964)

• The CAPM defines risk as volatility relative to market and serves as a theoretical model for evaluating risk and expected return of securities and portfolios. Along with this, there is an analysis of the covariance matrix of portfolio stocks to minimise residual variance.

4. Efficient Market Hypothesis (Eugene Fama, 1965)

• DFA believes in “passive” stock market investing which is based on the principle that the stock market is efficient and that over a given period, no one has the ability to consistently select stocks that would beat the market. Investors cannot identify superior stocks...