DFA case

Overview of the Business

• Dedicated to the principle that the stock market was
“efficient”
• Not simply an index fund manager
• Value of sound academic research
• Ability of traders to contribute in the firms profit
• Works with FAMA & French
• Factor based exposure in the market
Fees & Clients
• Fees lower than actively managed funds but higher than those of pure
index funds
• Began by managing money for major institutions
• Most of the clients are tax exempt
• HNI individuals through RIA
Product portfolio
Small-stock fund
• Ph.D. dissertation of Rolf Banz- Small size firm outperform large size
firm U.S.
• 9-10 Small Company Portfolio
• 6-10 Small Company Portfolio
• 6-7-8 portfolio
Fama and French: Cross section of the stock
returns
• beta is dead
• Stocks with a high ratio of book value of equity to market value of
equity (BE/ME) exhibited consistently higher returns
• Earning/price ratio
• Leverage
• Consistent with the earlier findings of Banz, small stocks
outperformed large.
• Rational market: Fama considered them as a Systematic risk factor
• HML and SMB portfolio
 Common factors in the stock returns
• Segregated portfolio in different bins based on their size and P/B ratio
• SMB portfolio is long small stocks and short big stocks while keeping
P/B ratio neutral
• HML stock is long HIGH BE/ME short low BE/ME while keeping size
and market beta neutral.
Portfolio construction
Explanation: Price Anomaly or systematic risk factor

• Popularity
• Default risk
• Decreasing premium over time
• High premium during crisis
• high level of correlation among value-growth portfolios across
countries
• Trading strategy based on beta is dead
• Measurement error
Performance Small-Stock and Value-Stock
Asset Classes
• Small stocks underperformed after and during the recession
• Recency effect
• Anomaly disappears
• Increased size risk premium
• Profitability and other economic measures of the performance of small
companies had been poor relative to their larger competitors throughout the
1980s and early 1990s.
Trading Strategy
• Liquidity provider for the illiquid small stock
• DFA saw about 1,000 potential trades in a typical day and executed only about 20.
• Mitigating the adverse selection
• DFA generally would not close a transaction within a few days before a company’s earnings announcement.
• Avoid stocks that were likely to negatively surprise in the near future by doing a thorough investigation of a
stock
• avoided stocks that had recently reported sales by insiders.
• penalty box
• Transacting full block of the stock
• Repeated games
• Does this trade increase or reduce the diversification of the fund?
• Discount on the trade
• Exit strategy
 DFA

Warren Buffet vs. DFA Efficient Market

Market timing/

Diversification

31 Dec 2020 - 38.42

3 Jan 2003 – 11.37
19% Annualized

Warren Buffet

Stock picking

Doesn’t try to time the market

Concentrated

31 Dec 2020- 347000

3 Jan 2003- 72000
24% Annualized
Alpha Generation
• Earning the liquidity premium
• 3.3% discount on the block trade (36%)
• Patiently buying the rest of the order (64% impact
cost is 0.58%)
• Weighted average = 0.36*3.3- 0.64*0.58= 0.83
• Beating the small benchmark index by 2%
• Avoiding adverse selection or doing stock
selection
• Exposure to the size factor
Tax exempted products
• Dividend are taxed as an ordinary income
• Capital gains are not tax until realized
• Invest in low dividend yield stock
• Avoid short term gains
• Reduce selling of the stocks
• Harvest capital losses
• “Wash sale rule”
Does Tax Savings make sense
• Reduction in dividend = 2.14%- 0.86%= 1.28%
• Tax benefit= 1.28*0.4= 0.51%
• 1% higher fees for the tax managed funds
• Assuming the average return without dividend management = 7%
• Sharpe ratio of the tax managed fund = (7+0.41)/16.3=0.43
• Sharpe ratio of the unmanaged strategy = 7/14.5=0.48
Way forward
Value Investing
• “If you are a value investor, you make your investment judgments,
based upon the value of assets in place and consider growth assets to
be speculative and inherently an unreliable basis for investing. Put
bluntly, if you are a value investor, you want to buy a business only if
it trades at less than the value of the assets in place and view growth,
if it happens, as icing on the cake” - Damodaran
Father of value investing: Benjamin Graham
PE of the stock has to be less than the inverse of the yield on AAA Corporate Bonds
PE of the stock has to less than 40% of the average PE over the last 5 years.
Dividend Yield > Two-thirds of the AAA Corporate Bond Yield
Price < Two-thirds of Book Value
Price < Two-thirds of Net Current Assets
Debt-Equity Ratio (Book Value) has to be less than one
Current Assets > Twice Current Liabilities
Debt < Twice Net Current Assets
Historical Growth in EPS (over last 10 years) 7%
No more than two years of negative earnings over the previous ten years.
Trading Game
• Screener.in to screen the stocks based on these criteria
• Screen at least one stock per group based on some set of screening
criteria and take position in that.