Dimensional Fund Advisors is a unique investment company, bringing together leading financial economists and experienced investment professionals to design and manage state of the art asset class portfolios. I recommend Dimensional funds because I consider them to be the best investment vehicles available. What follows is some of the thinking behind my judgment.
The first step in moving away from traditional active management is simply observing what markets are, how they work, and that they work. Observing this much, we can become skeptical about the claims of active managers to be able to beat the market. We can find ourselves in the camp of passive management.
The basic strategy of passive management is to own the market as a whole so as to gain market returns. But this is really a beginning point, one that opens the door to new ways of thinking about markets. If we take as our first principle of investing that markets work, setting prices fairly for all practical purposes, are there nevertheless ways to do better as investors?
Risk and Return
Dimensional takes this question as its guiding one, setting it apart from all other mutual fund companies. Some of its most important innovations grow out of another simple observation: no one will take more risk rather than less without thinking there is a good reason for doing so.
As investors, this means we will own riskier assets only if we expect better returns from them. There is no guarantee we will earn better returns – if there were, we wouldn't really be risking anything. But we expect better returns. So if we own a 100% stock portfolio, we know we are taking more risk than if we own a 60% stock and 40% low-risk bond portfolio. If we own the former rather than the latter, we do so expecting better returns over time but knowing that the portfolio is riskier, more volatile, subject to sharper declines and deeper losses.
These observations about risk and return give rise to further questions. For example, are there parts of the stock market that are riskier and have higher expected returns than other parts of the stock market? If so, are there effective ways to design and manage portfolios to target these parts of the market? We can ask similar questions about the bond market.
Dimensional answers these questions "yes," drawing on the extraordinary past fifty-five years of capital markets research and on its own extraordinary past thirty-five years of designing and managing state of the art asset class portfolios.
Regarding risks worth taking, financial economists at the forefront of capital markets research have observed, confirmed, and reconfirmed in a series of seminal studies five important risk factors that are the sources of higher expected returns.
Equity Risk Factors
Fixed Income Risk Factors
Informed by this research, Dimensional designs its signature stock portfolios to capture the return premiums associated with small company and value stocks. On the bond side, Dimensional designs portfolios primarily to be risk reducers for combined stock and bond portfolios, providing a range of ways to invest in especially shorter-term, higher quality bonds.
Dimensional's freedom from the limitations of traditional management is on display in the design of its asset class portfolios, but also in how it manages these portfolios.
One of the firm's first great challenges was to show that it could manage its original fund efficiently despite the high costs of trading the micro cap stocks that it targeted. Its early innovations in this regard set the tone for how it manages its entire range of funds.
Put briefly: don't use commercial benchmarks indexes for your target portfolios; once you design the benchmark targets for your portfolios, don't trade foolishly with a view to tracking precisely these targets; trade instead with an eye above all to capturing the return premiums associated with the targeted asset classes; always trade with a keen eye to costs.
Dimensional offers a broad, seemingly bewildering array of mutual funds. Yet in designing and managing its funds, it follows the principles of design and guidelines for management I have just outlined. The result: the Dimensional fund family is remarkably coherent, making it possible to structure complete investment strategies with measurable and consistent exposures to the risk factors that drive returns.
So, why Dimensional? I consider the understanding of risk and return that informs Dimensional's approach to investing to be the best framework for structuring investment strategies for my clients. And I consider Dimensional's asset class portfolios to be the best tools for implementing these strategies.