Smart emphasizes profitability, company size and price within the context of the overall market in this multi-factor approach, which he describes as four dimensions.
“Three of them are price-driven: the market, size and relative price, while profitability is cash-flow driven,” Smart says, and all are used as a measure of potential returns.
The selection process limits style drift. In fact, Smart says the holdings of DFA’s funds tend to better represent the market factors they are trying to represent than their underlying indexes.
Though it was founded in 1981, Dimensional’s factor-based style hit its stride in the 1990s after Eugene Fama and Kenneth French published a landmark paper on their three-factor fundamental asset pricing model. Fama was awarded the Nobel prize in economics in 2013 for their work. Both economists now sit on DFA’s board of directors.
Dimensional’s asset pricing mode has since expanded to include profitability, defined as an adjusted operating profit priced to book, in its thinking.
“With size, style and profitability, the historical difference in returns is important, but the manager’s implementation is what delivers the benefits of these dimensions to investors,” Smart says, adding that keeping portfolio turnover to a minimum is also key to DFA’s strategies.
DFA can customize its portfolio methodology while keeping the costs of its funds well below industry averages. The company doesn’t bind Smart and other managers to an index or a set schedule for rebalancing their portfolios, but instead allows them freedom to implement and build their strategies as the firm’s research progresses.
“Implementation involves thinking about the benefits from buying or selling a holding and the costs of trading,” Smart says. “Our research on portfolio structure allows us to make those decisions in a consistent and transparent way.”