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FAQs

FINANCIAL THEORY

In layman's terms, what is the Efficient Market Hypothesis? [ + ]

The Efficient Market Hypothesis says that market prices are fair: they fully reflect all available information. This does not mean that prices are perfect; some prices may be too high and some too low, but there is no reliable way to tell. In an efficient market, investors cannot expect to earn above-average profits without assuming above-average risks. Market efficiency does not suggest that investors can't "win." Over any period of time, some investors will beat the market, but the number of investors who do so will be no greater than expected by chance.

If everyone followed an indexing strategy, would markets still be efficient? [ + ]

This question has come up repeatedly ever since indexed strategies first appeared in the mid 1970s. Critics of indexing assert that markets would be less efficient if all investors adopted a market-fund investment approach. One can accept this theoretical viewpoint and still embrace indexing with enthusiasm.

If the adoption of indexed strategies became so pervasive that market efficiency were impaired, Dimensional believes it would be a self-correcting process. Mispriced securities would create opportunities for investors to earn profits in excess of their research costs, and their activity would drive prices back to equilibrium levels. We will never know how much information and liquidity are required for an efficient market. Markets for consumer durables such as homes or autos appear to be at least reasonably efficient, despite very poor liquidity, high search costs, and the absence of perfectly fungible assets. This behavior suggests a shift to passive investing would have to be very pronounced to have any effect on market efficiency.

Even if all professional investment managers adopted a passive approach, other market participants would continue to provide price-setting information. Sources of such information could include corporate stock buybacks, acquisitions, and the investment activities of officers, employees, competitors, and suppliers.

Despite the impressive commercial success of indexed investing strategies over the last twenty-five years, they still represent only a small percentage of total stock market wealth. The assets of all US equity index mutual funds* were approximately $695 billion as of December 31, 2010, or roughly 5% of the nation's total stock market value.


*US-domiciled equity index funds in Morningstar database, and which reported fund assets for December 31, 2010.

Isn't the success of indexing in recent years mostly due to a "self-fulfilling prophecy"? Index funds appear to push up prices of a handful of big company stocks simply because they're included in the S&P 500 index. [ + ]

Some critics of indexing assert that mechanical buying from index funds creates a "self-reinforcing trend" in a handful of large company stocks and that their price behavior is dictated by cash inflows to index managers, not fundamental business conditions at the underlying companies.

Evidence to support this assertion is difficult to find. Dimensional believes a more plausible explanation of pricing suggests it is the active money managers who dictate prices to indexers, not the other way around. As an example, an analysis of trading activity in General Electric Corp. stock (the largest component of the S&P 500 index) found that programmed buying from index funds in January 1997 accounted for approximately 1.3% of total GE monthly trading volume (Strategic Insight Mutual Fund Overview, February 1997). The notion that 1.3% of trading attributable to passive investors possessing no useful information determines the price-discovery process for the remaining 98.7% of market participants is far-fetched.

Advocates of the "self-fulfilling" viewpoint must also confront a wide disparity in performance of individual issues. If the behavior of large company stocks is primarily attributable to passive investors buying without regard to fundamental developments, it is difficult to explain why Coca-Cola shares appreciated only 1.3% in 1998 while Wal-Mart Stores soared 108.0% (Standard & Poor's "Stock Guide," January 1999).

Dimensional does not "pick stocks," so how do you decide which stocks to buy? [ + ]

Buying stocks for the funds is a detailed process but can be described in general terms. We create an eligible universe of all traded stocks of real operating companies. We then apply filters to exclude stocks that do not fit the asset class of the fund or that have specific pricing or trading concerns. The remaining stocks are eligible for purchase and are subject to rough market-capitalization target weights. We regularly monitor trading in the market place with real-time checks for current news that may impact prices, such as a looming takeover. Other than that, we're generally indifferent among the stocks in the eligible universe, which allows us to trade opportunistically and take advantage of liquidity premiums that benefit client returns. For additional information regarding the investment strategies of each fund, please read each fund's prospectus and statement of additional information carefully.

Can any single industry – for example, the high-tech sector – assure investors above-average returns? [ + ]

Detailed research into the sources of investment returns (Fama, Eugene F. and Kenneth R. French. "Industry Costs of Equity." Journal of Financial Economics 43 (1997), 153-93.) concludes that industries, or companies' products, are not a factor in expected stock returns. Industry effects can influence prices, but in a seemingly random, short-term way that can be mitigated in a diversified strategy. Therefore, industry effects, though they pose risks that are worth taking into account, are not a primary variable on which to sort securities for investment purposes.

Firms developing new technologies have no assurance of earning above-average long-run profits. The competitive forces in a free market work constantly to disperse the benefits of innovation throughout the economy. The retailer using new high-speed computers to cut inventory costs, for example, may reap greater economic rewards than the company who developed them. And if competition pressures the retailer to pass the resulting savings along in the form of lower prices, the ultimate beneficiary is the consumer. Even if one could correctly predict technological trends, identifying the winners from an investment standpoint becomes an elusive exercise.

Consider the birth of the personal computer industry in the early 1980s and its subsequent explosive growth. Industry pioneers IBM and Apple Computer were responsible for many innovations, yet shares of both firms have lagged the broad stock market: total return for the 20-year period ending December 2001 was 333% for Apple Computer, 1360% for IBM, and 1606% for the S&P 500 index (Center for Research in Security Prices, University of Chicago; Ibbotson Associates).

What is CRSP? [ + ]

CRSP ("crisp") is an acronym for the Center for Research in Security Prices at the University of Chicago. Established in 1960 with a grant from Merrill Lynch & Co., the center undertook a massive data-gathering project to answer the question "how have stocks performed over the long term?" Under the direction of James Lorie, Ph.D., a professor of business administration, and Lawrence Fisher, associate professor of finance, a database of both price and dividend information was compiled for all common stocks listed on the NYSE beginning in 1926. Over two million bits of information were entered onto magnetic tape, and the commercial computers then becoming available calculated total returns. The results were published in a landmark article in the Journal of Business in January 1964. The center continues to add data on a regular basis, and with a substantial grant from Dimensional Fund Advisors in 1984, added data from NASDAQ markets starting in January 1972. The CRSP data files have been an essential tool in the study of capital markets by an entire generation of financial economists.

FIXED INCOME

Why do Dimensional fixed income funds have annual portfolio turnover of 100%-200% in some years? This appears inconsistent with a passive strategy. [ + ]

Dimensional's fixed income approach is "passive" in one sense — it involves no interest rate or economic forecasting — but is "active" in implementation. Research conducted by Eugene Fama at the University of Chicago suggests a shifting-maturity strategy that targets segments of the yield curve with the highest expected return can add value relative to a conventional indexed approach. The optimal maturity targets are constantly reviewed using information provided in the yield curve, and transactions are made if the increase in expected return exceeds the cost of making the trade. Annual portfolio turnover in excess of 100% is not unusual. An important element of the shifting maturity strategy is a focus exclusively on short-term instruments with the highest credit quality. These issues are very liquid, and can be traded at very low cost.

Why doesn't Dimensional offer portfolios investing in mortgage-backed securities, convertible bonds, or high yield debt? [ + ]

Dimensional believes that five factors explain the vast majority of returns in diversified portfolios (market, size, and value for equities; term risk and default risk for fixed income). They also appear to explain the behavior of hybrid asset classes such as high yield bonds or convertible securities. In general, Dimensional believes the behavior of these asset classes can be captured more reliably and at lower cost by using some combination of structured equity strategies combined with high-grade short-term fixed income securities.

BALANCED STRATEGIES

If academic research demonstrates that value stocks have higher returns than growth stocks or market portfolios over time, why not put 100% of the equity allocation in value stocks? [ + ]

For investors who define risk solely as the variability of returns, such a strategy might be appropriate. Whether such investors actually exist is debatable. Most investors are probably sensitive to the risk of being different from the market, even if overall variability is no higher. Value stocks do not outperform market portfolios regularly or predictably — if they did, they would not be riskier. To the extent an investor is likely to be disappointed with performance that differs from a market portfolio, a tilt toward value stocks should be undertaken cautiously!

GENERAL

What are the important dates surrounding a dividend or distribution? [ + ]

A shareholder must own shares on the record date in order to be entitled to distributions. The following business day is the ex-dividend date, when distributions or capital gains are deducted from the fund's assets or set aside to be paid to the shareholder. On this day, the fund's net asset value decreases by the amount of distribution to be paid out, plus or minus any market activity. The distributions are actually scheduled to be paid on the payable date.

Does Dimensional disclose brokerage commissions paid by each of the various Portfolios and Master Funds it advises? [ + ]

Yes. Dimensional discloses brokerage commissions paid by each Portfolio or Master Fund for the three most recent fiscal years ended November 30. The information appears in the Statement of Additional Information for each Portfolio. These commissions are compensation for transactions in portfolio securities and are not sales commissions.

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