Why DFA’s New Research is Flawed
DFA was provided with an advance copy of this article and chose not to respond to it.
Dimensional Fund Advisors (DFA) is a company with a laudable history, founded on solid principles and a valuable product concept. From its launch, the investment firm identified and filled a need at low cost to the client, based on elementary but sound theory and simple, compelling, transparent empirical research. It later increased its value to clients by pioneering passive trading strategies. I admire its founders and their accomplishments.
But I am afraid the company has succumbed to a dreadful descent into scientism.
The famed Austrian economist Friedrich Hayek defined scientism as “slavish imitation of the method and language of science” when applied to the social sciences such as economics. Scientism takes on the trappings of science without its depth or rigor.
DFA recently advocated for tilting an equity portfolio toward companies with higher profitability. The company’s argument begins with a spurious pseudo-mathematical “derivation” of a reason why companies with higher profitability should have higher expected returns. It then, without further ado, enshrines the results of this deeply flawed analysis into theory, using phrases such as “financial economics shows that…,” as if the principle were an integral part of a long-standing and thoroughly proven theoretical framework. DFA provides historical evidence for the relationship that is poorly presented and looks suspicious. Then, without further discussion or explanation, the company simply extrapolates the results found in historical returns to become “expected returns” – all the while displaying with each exhibit the obligatory statement: “Past performance is no guarantee of future results.”
I will first provide a brief sketch of DFA’s history and legacy. Then I will explain exactly what is wrong with DFA’s reasoning for its latest strategy. Last, I will speculate on how a fine company that has hired the top graduates of top universities could fall into such a slough of error. My speculation applies more broadly, unfortunately, to what I see as rampant developments in the financial industry as a whole.
The DFA legacy
In the late 1960s and early 1970s, academics and graduates of economics and finance programs began to realize that according to theory, the most efficient investment portfolio would mirror the entire market for liquid securities.
This realization launched several efforts to create “index funds” of stocks that would mimic a cross-section of the whole equity market. Those efforts involved some of the original leading-edge principals, co-founders and supporters of DFA, including Rex Sinquefield, David Booth, John McQuown and Eugene Fama.
The first index funds were too small to mirror the whole equity market. To include smaller companies in the same proportions as in the market portfolio, it would be necessary to buy less than a single share in some cases.
The solution was to mirror only the larger companies, the ones in the S&P 500 index. Thus, the S&P 500 index fund was born, and it became popular among pension funds.
DFA’s founders, Booth and Sinquefield, pointed out that holding an S&P 500 index fund did not reflect the entire U.S. domestic market for equities. According to theory, it was therefore not ideally diversified. Furthermore, small stocks had performed far better than large stocks over a 50-year history. Booth and Sinquefield built DFA to provide a small-stock index fund with a low expense ratio, which could supplement the index fund portfolios of pension funds. However, their fund required a high minimum investment of $250,000.