The Investment Scientist

The Power of Nobel Winning Investment Science

Posted on: December 1, 2013

images-42It is exceedingly difficult for mutual funds to beat market indexes. For the past decade, Standard and Poor’s has methodologically documented returns by mutual funds and what they found is something those fund managers do not want you to know: the majority of mutual funds under-performed their respective indexes literally every single time.

Here is an infographic published by MoneySense, a Canadian financial magazine, that shows 90% of Canadian money managers under-performed the market index in 2012; I can assure you that US money managers are doing no better.

But today I am going to tell you that there is a mutual fund company whose funds consistently beat the indexes. Is it a surprise that the company was founded by two PhD students of Eugene Fama, this year’s Econ Nobel Prize winner? The company is Dimensional Fund Advisors, or DFA for short.

For instance, in the last ten years,

  • DFA US Micro Cap beat Russell Microcap Index by 2.17% per year;

  • DFA US Small Cap beat Russell 2000 by 1.10% per year;

  • DFA US Small Cap Value beat Russell 2000 Value by 1.92% per year;

  • DFA US Large Cap Value beat Russell 1000 Value by 1.27% per year.

So what does DFA do that sets it soooo apart?

1. It does not hire any active managers to manage funds. This alone removes human errors and avoids those high salaries that contribute to all the underperforming in those other funds.

2. It does not do index investing like Vanguard does. With index investing, you can at best match the index, but not outperform it.

3. It avoids liquidity cost of index investing. With index investing, Vanguard is often time forced to buy a stock when it was added to the index and sell a stock when it was removed. Not only are all other index funds buying/selling at the same time, but also there is a horde of traders who will inevitably front run these index funds.

4. Without the limitation of indexes, DFA funds can expand into truly small cap and value stocks, thereby capturing small cap and value premiums.

5. By using an asset class investing approach but not following specific indexes, DFA funds are able to provide liquidity to the market, thereby extracting a liquidity premium.

6. DFA funds are closed to retail investors. By keeping away hot money, it avoids the return drag caused by money moving in and out of funds.

They are not doing something unusual, they are just applying the Nobel Prize winning investment science that most other fund companies have no clue about. If you want DFA to work for you, schedule an appointment with me. Let me see if I can help.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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