Sabela Capital Markets

Evidence-Based Investing

by Dimensional

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The Index Bogeyman

Over the last several years, index funds have received increased attention from investors and the financial media.

Some have even made claims that the increased usage of index funds may be distorting market prices. For many, this argument hinges on the premise that indexing reduces the efficacy of price discovery. If index funds are becoming increasingly popular and investors are “blindly” buying an index’s underlying holdings, sufficient price discovery may not be happening in the market. But should the rise of index funds be a cause of concern for investors? Using data and reasoning, we can examine this assertion and help investors understand that markets continue to work, and investors can still rely on market prices despite the increased prevalence of indexing.

MANY BUYERS AND SELLERS

While the popularity of indexing has been increasing over time, index fund investors still make up a relatively small percentage of overall investors. For example, data from the Investment Company Institute[1] shows that as of December 2017, 35% of total net assets in US mutual funds and ETFs were held by index funds, compared to 15% in December of 2007. Nevertheless, the majority of total fund assets (65%) were still managed by active mutual funds in 2017. As a percentage of total market value, index-based mutual funds and ETFs also remain relatively small. As shown in Exhibit 1, domestic index mutual funds and ETFs comprised only 13% of total US stock market capitalization in 2017.

Exhibit 1: Investor Breakdown in the US Stock Market as a Percentage of Total US Stock Market Capitalization

All totals may not equal 100% due to rounding. Sourced from the 2018 ICI Fact Book: ici.org/pdf/2018_factbook.pdf

In this context, it should also be noted that many investors use nominally passive vehicles, such as ETFs, to engage in traditionally active trading. For example, while both a value index ETF and growth index ETF may be classified as index investments, investors may actively trade between these funds based on short-term expectations, needs, circumstances, or for other reasons. In fact, several index ETFs regularly rank among the most actively traded securities in the market.

Beyond mutual funds, there are many other participants in financial markets, including individual security buyers and sellers, such as actively managed pension funds, hedge funds, and insurance companies, just to name a few. Security prices reflect the viewpoints of all these investors, not just the population of mutual funds.

As Professors Eugene Fama and Kenneth French point out in their blog post titled “Q&A: What if Everybody Indexed?”, the impact of an increase in indexed assets also depends to some extent on which market participants switch to indexing:

“If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.”[2]

WHAT’S THE VOLUME?

Trade volume data are another place to look for evidence of well-functioning markets. Exhibit 2 shows that despite the increased prevalence of index funds, annual equity market trading volumes have remained at similar levels over the past 10 years. This indicates that markets continue to facilitate price discovery at a large scale.

Exhibit 2: Annual Global Equity Market Trading Volume, 2007–2018

In US dollars. Source: Dimensional, using data from Bloomberg LP. Includes primary and secondary exchange trading volume globally for equities. ETFs and funds are excluded. Includes 2017 total returns for constituent securities in the S&P 500 Index as of December 31, 2016. Excludes securities that delisted or were acquired during the year. Source: S&P data ©2019 S&P Dow Jones Indices LLC, a division of S&P Global. For illustrative purposes only. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Besides secondary market trading, there are also other paths to price discovery through which new information can get incorporated into market prices. For example, companies themselves can impact prices by issuing stock and repurchasing shares. In 2018 alone, there were 1,633 initial public offerings, 3,492 seasoned equity offerings, and 4,148 buybacks around the world.3 The derivatives markets also help incorporate new information into market prices as the prices of those financial instruments are linked to the prices of underlying equities and bonds. On an average day in 2018, market participants traded over 1.5 million options contracts and $225 billion worth of equity futures.[3]

HYPOTHESIS IN PRACTICE

Even though the historical empirical evidence suggests that the rise of indexing is unlikely to distort market prices, let’s consider the counterargument that the rise of indexing does distort markets and in turn causes prices to become less reliable. In this scenario, wouldn’t one expect stock-picking managers attempting to capture mispricing to have an increased rate of success over time?

Exhibit 3 shows little evidence that this has been the case. This chart shows the percentage of active managers that survive and beat their benchmarks over rolling three-year periods. These data show that there is no strong evidence of a link between the percentage of equity mutual fund assets in index funds and the percentage of active funds outperforming benchmark indices.

Exhibit 3: Active Manager Performance Has Not Improved
Percentage of Non-Index Equity Funds Outperforming for Three-Year Rolling Period, 2004–2018

Equity mutual fund outperformance percentages are shown for the three-year periods ending December 31 of each year, 2004–2018. Each sample includes equity funds available at the beginning of the three-year period. Outperformers are funds with return observations for every month of the three-year period whose cumulative net return over the period exceeded that of their respective Morningstar category index as of the start of the period. US-domiciled non-Dimensional mutual fund data is from Morningstar. Dimensional fund data provided by the fund accountant. Past performance is no guarantee of future results. For more methodology details, see the latest Mutual Fund Landscape brochure.

Lastly, in a world where index funds bias prices, we should expect to see evidence of such an impact across an index fund’s holdings. In other words, there should be more uniformity in the returns for securities within the same index as inflows drive prices up uniformly (and outflows drive prices down). Taking the S&P 500 Index as an example, however, we see that this has not been the case. The S&P 500 is a widely tracked index with over $9.9 trillion USD indexed or benchmarked to the index and with indexed assets comprising approximately $3.4 trillion USD of this total.[4] Exhibit 4 shows that in 2008, a year of large net outflows and an index return of –37.0%, the constituent returns ranged from 39% to –97%. This exhibit also shows that in 2017, a year of large net inflows and a positive index return of 21.8%, the constituent returns ranged from 133.7% to –50.3%. We would also expect that constituents with similar weighting in traditional market cap-weighted indices would have similar returns. In 2017, Amazon and General Electric returned 56.0% and –42.9%, respectively, despite each accounting for approximately 1.5% of the S&P 500 Index.

Exhibit 4: Range of S&P 500 Index Constituent Returns

Upper chart includes 2008 total returns for constituent securities in the S&P 500 Index as of December 31, 2007. Lower chart includes 2017 total returns for constituent securities in the S&P 500 Index as of December 31, 2016. Excludes securities that delisted or were acquired during the year. Source: S&P data ©2019 S&P Dow Jones Indices LLC, a division of S&P Global. For illustrative purposes only. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

CONCLUSION

Despite the increased popularity of index-based approaches, the data continue to support the idea that markets are working. Annual trading volume continues to be in line with prior years, indicating that market participant transactions are still driving price discovery. The majority of active mutual fund managers continue to underperform, suggesting that the rise of indexing has not made it easier to outguess market prices. Prices and returns of individual holdings within indices are not moving in lockstep with asset flows into index funds. Lastly, while naysayers will likely continue to point to indexing as a hidden danger in the market, it is important that investors keep in mind that index funds are still a small percentage of the diverse array of investor types. Investors can take comfort in knowing that markets are still functioning; willing buyers and sellers continue to meet and agree upon prices at which they desire to transact. It is also important to remember that while indexing has been a great financial innovation for many, it is only one solution in a large universe of different investment options.

GLOSSARY

Derivative: A financial instrument whose value is based on an underlying asset or security.

Options Contract: An options contract is an agreement between two parties to facilitate a potential transaction on an underlying security at a preset price.

Futures: A financial contract obligating the buyer to purchase an asset or a seller to sell an asset at a predetermined future time and price.


Source: Dimensional Fund Advisors LP.

Past performance is no guarantee of future results. There is no guarantee an investing strategy will be successful. Investing involves risks including possible loss of principal. Diversification does not eliminate the risk of market loss.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.

Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.

  1. ici.org/pdf/2018_factbook.pdf ↑
  2. famafrench.dimensional.com/questions-answers/qa-what-if-everybody-indexed.aspx ↑
  3. Options, futures, and corporate action data are from Bloomberg LP. Options contact volume is the sum of the 2018 daily average put and call volume of options on the S&P 500 Index, Russell 2000 Index, MSCI EAFE Index, and MSCI Emerging Markets Index. Equity futures volume is equal to total 2018 futures volume traded divided by 252, where annual volume traded is estimated as the sum of monthly volume times month-end contract value for S&P 500 Mini futures, Russell 2000 Mini futures, MSCI EAFE Mini futures, and MSCI Emerging Markets Mini futures. IPO, seasoned equity offering, and share repurchase data are based on Bloomberg corporate actions data and include countries that are eligible for Dimensional investment. ↑
  4. Source: S&P Dow Jones. ↑

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Perspective on Premiums

Investors may be tempted to extrapolate recent returns into the future, which can lead them to abandon their investment philosophy at potentially inopportune times. While negative outcomes are disappointing, investors should view them with the proper perspective and stay the course.

 

Brad Steiman
Head of Canadian Financial Advisor Services, Director, Vice President,
Dimensional Fund Advisors

Wei Dai
Vice President, Research
Dimensional Fund Advisors 

 

March 2019

When you leave your server a tip, do you round it to a whole-dollar amount and often in multiples of $5? Does a 60th birthday seem more significant than a 59th? If you answer yes to these questions, you’re not alone. Most of us prefer round numbers.

This preference leads many investors to review results by calendar year and to consider 10-year periods when evaluating long-term returns. People tend to place greater emphasis on the latest period due to recency bias and to extrapolate recent results into the future. For these reasons, we should put recent performance into the proper perspective.

During the most recent 10 years, equity investors have generally fared well, with the MSCI All Country World Index (IMI) earning an annualized return of 10.32% through 2018. Within equities, small cap stocks and higher profitability stocks have generally delivered outperformance relative to the market, but the underperformance of value stocks has garnered a lot of attention. Value investors may feel somewhat disappointed, as the MSCI All Country World Value Index (IMI) underperformed the market, delivering an annualized 9.23% over the same period.

We expect positive market, size, value, and profitability premiums,1 but also recognize that realized premiums are volatile and can sometimes be negative. Although a negative premium can be disappointing, it is not unprecedented—and we can look at historical data to gauge how often each premium has been negative. For example, Exhibit 1 shows the frequency of experiencing a negative premium in the US over rolling 1-, 5-, and 10-year periods as far back as the data are available.

As you can see, negative premiums occur from time to time. While the odds of realizing a positive premium are never guaranteed, they are decidedly in your favor and increase the longer you stay invested.

This analysis looks at each premium individually. What if you integrate all four premiums in pursuit of higher expected returns? A different approach is to calculate the frequency that one, two, three, or all four of the premiums were negative over rolling 10-year periods from July 1963 to December 2018. As shown in Exhibit 2, periods when one of the four premiums was negative— like the most recent decade—occurred in almost half of the rolling 10-year periods. However, the premiums do not move in lockstep, so there were relatively few instances of two negative premiums and virtually no instances of three or four negative premiums.

Percentage of rolling 1-, 5-, and 10-year periods with negative premiums is calculated using monthly return data from June 1927 to December 2018 for market, size, and value, and from July 1963 to December 2018 for profitability. Market: Fama/French Total US Market Research Index minus the One-Month US Treasury Bill. Size: Dimensional US Small Cap Index minus the S&P 500 Index. Value: Fama/French US Value Research Index minus the Fama/French US Growth Research Index. Profitability: Dimensional US High Profitability Index minus the Dimensional US Low Profitability Index. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. One-Month US Treasury Bills is the IA SBBI US 30 Day TBill TR USD provided by Ibbotson Associates via Morningstar Direct. Dimensional indices use CRSP and Compustat data. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Fama/French indices provided by Ken French. Dimensional and Fama/French index definitions are available in the appendix. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global.

In all likelihood, any premium that doesn’t materialize will get called into question. Plenty of ink will be spilled over scrutinizing the one that had the bad draw, even if that’s all it was. The US value premium has been under the microscope lately, but the other premiums have had their turn historically.

From an empirical perspective, a negative 10-year premium is not so far outside the range of outcomes to suggest that the premium no longer exists. More importantly, we have a sensible framework for expecting positive size, value, and profitability premiums. That framework is valuation theory, which posits that a stock’s price reflects the company’s expected future cash flows discounted to present value. The discount rate equals an investor’s expected return. Therefore, as long as stocks have different expected returns, those with lower prices and higher expected cash flows should have higher expected returns. This framework holds regardless of whether realized premiums have been positive or negative in the recent past.

Exhibit 3 confirms that premiums have, on average, been positive after periods of underperformance, although the data show a wide range of outcomes. In this analysis, we identify the rolling 10-year periods when a premium was negative and then observe how the premium behaved over the following 10 years. Profitability is excluded because there are only two data points.

Number and percentage of rolling 10-year periods with one, two, three, and four negative premiums are calculated using monthly return data from July 1963 to December 2018. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. See Exhibit 1 for the definition of the premiums and data source.

Using monthly return data from June 1927 to December 2018, annualized premiums are calculated over the subsequent 10-year periods following a negative 10-year size, value, or profitability premium. The average, minimum, and maximum are calculated across all such 10-year periods for each premium. Excluded are 10-year periods that end after December 2018. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. See Exhibit 1 for the definition of the premiums and data source.

Despite compelling theoretical and empirical evidence supporting the premiums, investors may be tempted to extrapolate the recent past into the distant future, which can lead them to abandon their investment philosophy at potentially inopportune times. Maintaining discipline and sticking to the plan are vital. The performance of premiums in the recent past doesn’t tell you much about future premiums. So, if your goals haven’t changed, then your asset allocation likely doesn’t need to change.

Furthermore, premiums can materialize quickly, and you want to be properly positioned to capture the returns when they show up. The period leading up to and shortly after the start of the 21st century provides an extreme, albeit anecdotal, example. Exhibit 4 shows the performance of the Russell 1000 Growth and Value indices. Growth beat value over every trailing period from 1 to 20 years ending March 31, 2000. Consequently, many investors found themselves questioning a value strategy, meaning they wondered if expected returns were still related to the price paid for a stock in the so-called “new economy.”

Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

Investors who capitulated to this line of reasoning may have regretted their decision a mere 12 months later because the value index strongly outperformed the growth index, as illustrated in Exhibit 5, over every trailing period from 1 to 20 years, ending March 31, 2001.

The moral of the story? Negative outcomes are disappointing, but investors should view them with the proper perspective and stay the course!


APPENDIX

Fama/French Total US Market Research Index: The value-weighed US market index is constructed every month, using all issues listed on the NYSE, AMEX, or Nasdaq with available outstanding shares and valid prices for that month and the month before. Exclusions: American Depositary Receipts. Sources: CRSP for value-weighted US market return. Rebalancing: Monthly. Dividends: Reinvested in the paying company until the portfolio is rebalanced.

Fama/French US Value Research Index: Provided by Fama/French from CRSP securities data. Includes the lower 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973).

Fama/French US Growth Research Index: Provided by Fama/French from CRSP securities data. Includes the higher 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973).

Dimensional US Small Cap Index: Created by Dimensional in March 2007 and compiled by Dimensional. It represents a market capitalization-weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the eligible market. The eligible market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index also excludes companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 sub-indices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology for the Dimensional US Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.

Dimensional US High Profitability Index: Created by Dimensional in January 2014 and represents an index consisting of US companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three high-profitability subgroups. It is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat.

Dimensional US Low Profitability Index: Created by Dimensional in January 2014 and represents an index consisting of US companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three low-profitability subgroups. It is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat.

Profitability is defined as operating income before depreciation and amortization minus interest expense scaled by book. Relative Price refers to the share price (or market cap) of a firm’s stock, divided by a fundamental variable of the firm (e.g., earnings, cash earnings, dividends, net assets). One of the most widely used measures of relative price is the price-to-book ratio.

1. Market premium: The return difference between stocks and short-term bills. Size premium: The return difference between small capitalization stocks and large capitalization stocks. Value premium: The return difference between stocks with low relative prices (value) and stocks with high relative prices (growth). Profitability premium: The return difference between stocks of companies with high profitability over those with low profitability.

Past performance is not a guarantee of future results. There is no guarantee an investing strategy will be successful. All expressions of opinion are subject to change. This information is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. It should not be considered investment advice.

Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.

UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

CANADA: March 25, 2019.

These materials have been prepared by Dimensional Fund Advisors Canada ULC. Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Unless otherwise noted, any indicated total rates of return reflect the historical annual compounded total returns, including changes in share or unit value and reinvestment of all dividends or other distributions, and do not take into account sales, redemption, distribution, or optional charges or income taxes payable by any security holder that would have reduced returns. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.

MKT-2827 03/19 1621594

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Getting to the Point of a Point

A quick online search for “Dow rallies 500 points” yields a cascade of news stories with similar titles, as does a similar search for “Dow drops 500 points.”

These types of headlines may make little sense to some investors, given that a “point” for the Dow and what it means to an individual’s portfolio may be unclear. The potential for misunderstanding also exists among even experienced market participants, given that index levels have risen over time and potential emotional anchors, such as a 500-point move, do not have the same impact on performance as they used to. With this in mind, we examine what a point move in the Dow means and the impact it may have on an investment portfolio.

IMPACT OF INDEX CONSTRUCTION

The Dow Jones Industrial Average was first calculated in 1896 and currently consists of 30 large cap US stocks. The Dow is a price-weighted index, which is different than more common market capitalization-weighted indices.[1]

An example may help put this difference in weighting methodology in perspective. Consider two companies that have a total market capitalization of $1,000. Company A has 1,000 shares outstanding that trade at $1 each, and Company B has 100 shares outstanding that trade at $10 each. In a market capitalization-weighted index, both companies would have the same weight since their total market caps are the same. However, in a price-weighted index, Company B would have a larger weight due to its higher stock price. This means that changes in Company B’s stock would be more impactful to a price-weighted index than they would be to a market cap-weighted index.

The relative advantages and disadvantages of these methodologies are interesting topics themselves, but the main purpose of discussing the differences in this context is to point out that design choices can have an impact on index performance. Investors should be aware of this impact when comparing their own portfolios’ performance to that of an index.

HEADLINES VS. REALITY

Movements in the Dow are often communicated in units known as points, which signify the change in the index level. Investors should be cautious when interpreting headlines that reference point movements, as a move of, say, 500 points in either direction is less meaningful now than in the past largely because the overall index level is higher today than it was many years ago.

Exhibit 1 plots what a decline of this magnitude has meant in percentage terms over time. A 500-point drop in January 1985, when the Dow was near 1,300, equated to a nearly 39% loss. A 500-point drop in December 2003, when the Dow was near 10,000, meant a much smaller 5% decline in value. And a 500-point drop in early December 2018, when the Dow hovered near 25,000, resulted in a 2% loss.

EXHIBIT 1: Hypothetical 500-Point Decline of the Dow Measured in Percentage Terms

Dow Jones and S&P 500 data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. The chart illustrates what a 500-point drop would have been in percentage terms for the Dow Jones Industrial Average on a daily basis. It assumes a 500-point loss took place each trading day from January 1, 1985, to February 1, 2019, and uses daily historical closing values of the Dow Jones Industrial Average to compute the percentage change. Percentage change does not indicate the actual change in the Dow during the period shown. Actual results may vary.

HOW DOES THE DOW RELATE TO YOUR PORTFOLIO?

While the Dow and other indices are frequently interpreted as indicators of broader stock market performance, the stocks composing these indices may not be representative of an investor’s total portfolio.

For context, the MSCI All Country World Investable Market Index (MSCI ACWI IMI) covers just over 8,700 large, mid, and small cap stocks in 23 developed and 24 emerging markets countries with a combined market cap of more than $50 trillion. The S&P 500 includes 505 large cap US stocks with approximately $23.8 trillion in combined market cap.[2] The Dow is a collection of 30 large cap US stocks with a combined market cap of approximately $6.8 trillion.[3]

Even though the MSCI ACWI IMI, S&P 500, and Dow are all stock market indices, each one tracks different segments of the market, so their performance can differ significantly over time, as shown in Exhibit 2. Since 1995, the Dow has outperformed the S&P 500 and MSCI ACWI IMI by an average of 0.5% and 3.3%, respectively (based on calendar year returns). However, relative performance in individual years can be much different. For example, in 1997, the Dow underperformed the S&P 500 by 8.4% but outperformed the MSCI ACWI IMI by 13.9%.

EXHIBIT 2: Performance of MSCI ACWI IMI, S&P 500, and Dow by Calendar Year

Dow Jones and S&P 500 data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data © MSCI 2019, all rights reserved. MSCI ACWI IMI is the MSCI All Country World Investable Market Index (net dividends). Their performance does not reflect fees and expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

It is also important to note that some investors may be concerned about other asset classes besides stocks. Depending on investor needs, a diversified portfolio may include a mix of global stocks, bonds, commodities, and any number of other assets not represented in a stock index. A portfolio’s performance should always be evaluated within the context of an investor’s specific goals. Understanding how a personal portfolio compares to broadly published indices like the Dow can give investors context about how headlines apply to their own situation.

CONCLUSION

News headlines are often written to grab attention. A headline publicizing a 500-point move in the Dow may trigger an emotional response and, depending on the direction, sound either exciting or ominous enough to warrant reading the article. However, after digging further, we can see that the insights such headlines offer may be limited, especially if investors hold portfolios designed and managed daily to meet their individual goals, needs, and preferences in a broadly diversified and cost-effective manner.

Source: Dimensional Fund Advisors LP. Also available at us.dimensional.com/perspectives/getting-to-the-point-of-a-point

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.

    1. Market capitalization is the product of price and shares outstanding. ↑
    2. 500 companies are included in the S&P 500 Index. However, because some of these companies have multiple classes of stock that meet the requirements for inclusion, the total number of stocks tracked by the index is 505. ↑
    3. Market cap data as of January 31, 2019. ↑

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Here’s the Prescription

As much as I value the unfettered access to information the internet provides, I recognize the potential harm that too much information can cause.

By David Jones
Head of Financial Advisor Services, EMEA and Vice President
Dimensional Fund Advisors Ltd.

December 2018

Take, for example, a friend of mine, who was experiencing some troubling medical symptoms. Typing her symptoms into a search engine led to an evening of research and mounting consternation. By the end of the night, the vast quantity of unfiltered information led her to conclude that something was seriously wrong.

One of the key characteristics that distinguishes an expert is their ability to filter information and make increasingly refined distinctions about the situation at hand. For example, you might describe your troubling symptoms to a doctor simply as a pain in the chest, but a trained physician will be able to ask questions and test several hypotheses before reaching the conclusion that rather than having the cardiac arrest you suspected, you have something completely different. While many of us may have the capacity to elevate our understanding to a high level within a chosen field, reaching this point takes time, dedication, and experience.

My friend, having convinced herself that something was seriously wrong, booked an appointment with a physician. The doctor asked several pertinent questions, performed some straightforward tests, and recommended the following treatment plan: reassurance and education.

Not surgery. Not drugs. But an understanding of why and how she had experienced her condition.

The consultative nature of a relationship with a trusted professional—both when a situation arises and as we progress through life—is one of the key benefits that an expert can provide.

There are striking parallels with the work of a professional financial advisor. The first responsibility of the doctor or advisor is to understand the person they’re serving so that they can fully assess their situation. Once the plan is underway, the role of the professional is to monitor the person’s situation, evaluate if the course of action remains appropriate, and help to maintain the discipline required for the plan to work as intended.

Like my friend’s doctor, advisors may have experienced conversations with clients that are triggered by news reports or informed by unqualified sources. In some cases, all that is required to help put the client’s mind at ease is a reminder to focus on what is in their control as well as providing reassurance and (re)education that they have a financial plan in place that is helping them move toward their objectives. The benefits of working with the right advisor are demonstrated through the ability to both help clients pursue their financial goals and to help them have a positive experience along the way.

Exhibit 1: Reacting Can Hurt Performance
Performance of the S&P 500 Index, 1990–2017

In US dollars. For illustrative purposes. The missed best day(s) examples assume that the hypothetical portfolio fully divested its holdings at the end of the day before the missed best day(s), held cash for the missed best day(s), and reinvested the entire portfolio in the S&P 500 at the end of the missed best day(s). Annualized returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero.

S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. “One-Month US T-Bills” is the IA SBBI US 30 Day TBill TR USD, provided by Ibbotson Associates via Morningstar Direct. Data is calculated off rounded daily index values. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

Trouble might arise when we confuse simple and complex conditions. Probably no harm is done when a person, recognizing the onset of a common cold, takes cold medicine, drinks plenty of fluids, and rests. But had my self-diagnosing friend not made an appointment with a specialist, and instead moved from self-diagnosis to self-medication, she may have caused herself real harm. Similarly, thinking that all aspects of your own financial situation can be handled through a basic internet search or casual conversation with a friend might result in a less than optimal financial outcome.

Without the guidance of an advisor, the self-medicating investor might overreact to short-term market volatility by selling some of their investments. In doing so, they risk missing out on some of the best days since there is no reliable way to predict when positive returns in equity markets will occur.1 One might think that missing a few days of strong returns would not make much difference over the long term. But, as illustrated in Exhibit 1, had an investor missed the 25 single best days in the world’s biggest equity market, the US, between 1990 and the end of 2017, their annualized return would have dropped from 9.81% to 4.53%. Such an outcome can have a major impact on an investor’s financial “treatment” plan.

Improving someone’s financial health is a lot like improving their physical health. The challenges associated with pursuing a better financial outcome include diagnosis of the current situation, development of the appropriate course of action, and sticking with the treatment plan. Many advisors are trained on the intricacies of complex financial situations and work to understand how their clients feel about money and how their clients might react to future events.

By providing the prescription of reassurance and education over time, we believe the right advisor can play a vital and irreplaceable role in investors’ lives.

1. The 2018 Mutual Fund Landscape report compiled by Dimensional showed that for the 15-year period through 2017, only 14% of US equity mutual funds and 13% of US fixed income mutual funds survived and outperformed their benchmark after costs. Refer to https://us.dimensional.com/perspectives/mutual-fund-landscape-2018 for more information.


Dimensional makes no representation as to the suitability of any advisor, and we do not endorse, recommend, or guarantee the services of any advisor, including those in the Find an Advisor portion of our website. Investors should carefully and thoroughly evaluate any advisor whom they consider hiring or working with.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. Results for other time periods, including shorter time periods, may include losses.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

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A Question of Equilibrium

“Sellers were out in force on the market today after negative news on the economy.” It’s a common line in TV finance reports. But have you ever wondered who is buying if so many people are selling?

By Jim Parker
Vice President
DFA Australia Limited, a subsidiary of Dimensional Fund Advisors LP

October 2018

The notion that sellers can outnumber buyers on down days doesn’t make sense. What the newscasters should say, of course, is that prices adjusted lower because would-be buyers weren’t prepared to pay the former price.

What happens in such a case is either the would-be sellers sit on their shares or prices quickly adjust to the point where supply and demand come into balance and transactions occur at a price that both buyers and sellers find mutually beneficial. Economists refer to this as equilibrium.

But the price at which equilibrium is reached can change. That’s because new information is coming into the marketplace continually, forcing would-be sellers and would-be buyers to constantly adjust their expectations.

That new information might be company-specific news on earnings. It might be news that has implications for specific industries—like a spike in oil prices. Or it might be an economic development that affects the entire market, like a change in the unemployment rate. Given this constant flux in the flow of news and information and the changing expectations of participants, it can be reassuring to remember that for everyone selling shares there must also be buyers of those shares—or the trade will never take place. And whenever information changes, prices may change and quickly reach a new level of equilibrium.

Recent trading activity by market participants in shares of a US-based health care provider offers a clear example of how quickly prices adjust to new information. It was reported in late July 2018 that a large private equity firm was in talks to purchase the health care firm at a price valuing the company at $65 per share. Prior to the announcement, shares of the firm were trading around $48. As we see in Exhibit 1, when the announcement broke, the market price for the stock adjusted overnight to just below $65. In other words, after news of the impending sale hit the market, the supply and demand for the stock met at a new equilibrium price.

Given that security prices rise and fall based on a multiplicity of influences, how should investors interpret and act on these signals? We believe that trying to untangle all these influences and profit from perceived mispricing is not possible in a systematic and scalable manner.


In USD. For illustrative purposes only. Stock price data as shown are official NASDAQ closing prices. Data provided by Bloomberg L.P. See end disclosures for additional important information.

An alternative approach is to start by accepting that prices are fair and reflect the collective expectations of market participants. While information frequently changes, this is quickly built into prices. Competition among buyers and sellers is such that it’s not possible to consistently outguess the market.

The second step is to see that fairly priced securities can have different expected returns. And we can use market prices and security characteristics to identify those securities that offer higher expected returns.

The third step is to build highly diversified portfolios around these broad drivers of return, while implementing efficiently and managing the cost of buying and selling securities.

The final step is to apply discipline and rebalance your portfolio to either stay within your chosen risk parameters or to adjust for changes in circumstances.

Ultimately, the market is like a giant information processing machine. All the influences mentioned above are constantly being assessed by millions of participants, and prices adjust based on those collective expectations.

The returns we expect from investing do not necessarily show up every day, every week, every month, or even every year. But the longer we stay invested, the more likely we are to capture them. So, rest assured that even when prices are falling, people are still buying. The market is doing its job, and we believe the rewards will be there if you remain disciplined.