Revisiting the Debate Over the DFA Research
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Advisor Perspectives published an article by Michael Edesess last month that raised a number of issues about research done by Dimensional Fund Advisors. DFA’s research led that firm to introduce a “profitability” screen into its investment process. The Edesess article prompted a storm of responses, which were published in Advisor Perspectives Sept. 17. Much of the response took issue with the facts and conclusions contained in that article. The blogosphere also lit up with commentary generally supporting DFA’s approach to investing.
The nature and intensity of the negative response to the Edesess article was of such a character that it bears some comment. First, it is hard to escape the sense that the DFA supporters have elevated that firm’s investment philosophy to the level of religious doctrine. The pitch and fervor of some of the responses suggest that Edesess sinned mightily by questioning the faith. However, an examination of DFA’s approach to investing suggests a more measured reaction: The firm’s approach is sound, but it falls short of the magic that its disciples impart to it.
Passive investing is now a well-established feature on the investment landscape and comes in many different forms. According to the company’s web site, the DFA approach is based on the “science of capital markets.” This “science” appears to be comprised primarily of:
- The Nobel Prize winning work of Harry Markowitz in the area of portfolio diversification (Modern Portfolio Theory).
- Eugene Fama’s research in the area of efficient markets (for which Fama was awarded the Nobel Prize in economics this month).
- Research done by Rolf Banz (published in 1981) and by Fama and Ken French (published in 1992) on the relative performance benefits of small-cap over large-cap stocks and value stocks over growth stocks.
That’s quite a bit of science. But it is not magic.