Date: March 18, 2021

To: Potential Investors

From: Consulting Group 6 (John Dumas, Michael Zaccaria, Nicholas Scherer, Siddharth Khajuria)

Overview of DFA and Client Base

Dimensional Fund Advisors (DFA) is a fast growing investment firm based in Santa Monica, CA.
Founded in 1981 by David Booth and Rex Sinquefield, DFA is dedicated to the principle of efficient
markets. Using this emphasis, DFA has created a wide client base ranging from major institutions such as
corporate firms, government, union pension funds, college endowments, and charities. Additionally, DFA
has added high-net-worth individuals to its client base. DFA utilizes cost free word of mouth marketing,
capitalizing on their trusted relationships with current investors. Finally, DFA is able to grow its client
base through adding new products on occasion.

DFA’s Trading Strategy

When it comes to DFA’s trading strategy, the main risk that the firm is trying to avoid is the adverse
selection problem. Also known as the lemons problem, this problem states that an item is only available
for sale at its given price because there is something wrong with it. In order to circumvent this problem,
DFA would avoid stocks based on certain guidelines. These guidelines included not buying a stock if
news was predicted within the near future, avoiding stocks that were likely to negatively surprise in the
upcoming months, avoiding stocks that had recently reported sales by company insiders, and lastly,
paying close attention to the seller and the nature of the stock blocks it traded. Other risks that DFA is
trying to minimize are taxes. These can be taxes on dividends, capital gains, or short-term gains. The firm
does its best to offset these taxes by harvesting capital losses and by its high performing tax-managed
funds.

DFA’s method of buying stocks starts with absolutely no fundamental analysis of the firm in question.
This stems from DFA’s belief that the stock market is truly “efficient”, and prices reflect all public
information. Before making a trade, DFA had several questions they asked. First, DFA asked if there was
any important information about the company that they didn’t already know. This question relates to the
adverse selection problem that was discussed earlier. Next, the company asked if they were comfortable
trading with the seller. The third question DFA asked was whether the sellers were selling their entire
block of stock. DFA wanted to buy the sellers entire holdings to prevent a sell-off within the market. The
fourth question they asked was if the trade would increase or reduce the diversification of the fund. The
end goal for this question was to maintain a broad-based, value-weighted small-stock index. The last
question DFA asked before making a trade was how big of a discount could they receive on a trade. When
it came time for DFA to sell a stock the approach was quite simple. They would simply offer small
amounts of the stock to the market each day. This amount was usually less than 25% of the daily volume

Another aspect that DFA looked at while trading was the type of stock they were buying. DFA was
mainly focused on small company value stocks. Value stocks can be defined as stocks with a high ratio of
book value of equity to market value of equity. According to research, stocks with a high ratio of
book-to-market value consistently showed higher returns than stocks with low book-to-market value.

DFA’s strategy is effective in most market conditions. The company rarely had a need to sell for liquidity
reasons due to strong relationships with investors. DFA insured that very large withdrawals would not
force it to sell stock by reserving the right to redeem withdrawals by handing over shares in hundreds of
stocks.
Illiquidity also does not affect their marketing strategy. This is because DFA did not buy stocks on any
stock exchange. If they did, the price of the stock would move substantially. Instead, DFA would buy the
selling demand and also would go through intermediaries and purchase large amounts of shares in a block
trade from another holding firm.

Value Added
Outside of their current investment strategies, DFA adds value for investors through a few methods. First,
DFA utilizes thorough academic research to help both test and derive investment theory and
opportunities. DFA encourages academics to work on subjects important to the firm, kicking back some
profits from any professor whose investment research helped to implement a new investment strategy.
Furthermore, utilizes skilled traders who prove excess profits even with a passive investment strategy.
These methods enable DFA to create strong market returns, making their fund intriguing for new
investors.

Fama-French Model & Findings

As discussed above, DFA utilizes academic research to adjust and develop their investment strategies.
One key model studied by DFA is the Fama-French Model. This model was created by Eugene Fama and
Kenneth French, professors at the University of Chicago. The Fama and French concluded three
fundamental findings in regard to the stock market:

1. Higher beta does not necessarily correspond to higher returns. Beta is a measure of risk. At the
time, most believed that if an investor took on more risk they would see greater returns. The
article was known as “beta is dead” paper.

2. Book to market ratio is the most powerful scaled price variable. Stocks with a higher ratio of
book value of equity to market value of equity consistently saw higher returns than stocks with a
lower ratio.

3. Small stocks will outperform large stocks. This was consistent with the beliefs of the time.

These findings meant that Fama, French and the rest of the finance world now needed to pay attention to
the “book to market” effect and the “size effect”.

Following their initial paper Fama and French continued to prove their work. They did this by creating a
portfolio that was long on small stocks and short on big stocks. They also created a portfolio that was long
on stocks with high book to market ratios and short on stocks with low book to market ratios. These
portfolios performed well and the strategies can still be utilized to this day.

Other academics have tried to test these theories in different ways. Frazziniand Pedersen made a portfolio
that bet against beta. This strategy was similar to what Fama and French had done, but different because
Fama and French found that beta did not correspond with higher returns. Pederson instead constructed a
portfolio that went long on low beta stocks and short on high beta stocks. By doing this he could test if
high beta was correlated with lower returns or if Beta was instead just a scaled price valuable that tells us
very little about future returns. The portfolio seems to have returns that show no consistency in the
correlation between beta and returns.

We tried to replicate the results of their experiments. First we used results from Fama and French’s
market portfolio, Small - Big portfolio and High - Low portfolio.

When using the data to try and replicate Fama and French’s results there was a slight discrepancy. The
returns for the market portfolio, SMB, and HML were first averaged. Then the last three months for the
three portfolios were summed to find the return over the last three months. Finally, the last year of returns
was summed to find last year's return with all three portfolios. The values for the last three months and the
last year were very similar to Fama and French’s numbers. A potential reasoning for the small variance in
the two findings likely relates to the fact that the Fama-French findings were based on August 2020 data
while we utilized data through January 2021.

We then used the 25 Portfolios formed on size and market beta to try and replicate the “beta is dead”
paper. The returns of the two high beta portfolios, the two low beta portfolios, the two big portfolios and
the two small portfolios were averaged. These averages were then used to find the average return of each
statistic. Our results were consistent with those of Fama and French. The low and high beta portfolios had
a relatively similar monthly return. The small stocks had a higher average return then the larger stocks.

Market Efficiency
Based on our results, we believe that the market is efficient. However, certain anomalies have existed
over long periods of time. Small stocks tend to outperform large stocks and stocks with high book to
market ratios tend to outperform stocks with low book to market ratios. These anomalies do not mean the
market is inefficient. There are rational, fundamental reasons that these stocks generate higher long term
returns. Investors demand higher returns on smaller stocks because they believe these stocks are riskier
due to the lack of information about them compared to stocks of larger companies, thus matching
expected returns with the high real returns. Investors prefer stocks with high book to market ratios
because they have healthier balance sheets. Additionally, in recent years growth stocks have outperformed
value stocks, suggesting the market does follow more of a “random walk” and it is efficient.