As our clients and many of our readers know, TAAG believes in a practical approach to investing, balancing the tradeoffs of risk and return to develop models based on each clients’ goals and tolerance to risk. We don’t believe in timing the market or anyone’s ability to pick one stock as superior to another. We prefer to own globally diversified portfolios at a very low cost and, for more than a decade, have found no better way to execute on this philosophy than through funds offered by Dimensional Fund Advisors (DFA).
Having such a disciplined approach can sometimes be perceived as a philosophy of hand sitting, star gazing and the like. In reality, the rigid academic process that helped form our approach is one that we’re constantly testing and challenging as are the heavily academic focused research staff at Dimensional.
In the past, we’ve seen from Dimensional’s research that both lower stock prices and a lower ratio of a company’s market value to it’s book value imply higher expected returns over time. This has led to the inclusion of value companies and small companies, both domestic and international, in our portfolios. Other factors, such as momentum and profitability are known to impact returns in meaningful ways, but measuring how and applying them successfully have been a challenge.
That doesn’t prevent Dimensional from continuously looking at ways to do so. When DFA looks at applying a new factor to the way it screens each asset class, it must pass three tests.
1) It must be sensible
2) The impact must be persistent, pervasive and robust across a wide spectrum of asset classes
3) It must allow for a cost-effective capture of the expected higher returns.
Recently, Dimensional announced that it has reached a breakthrough in its ability to test and include profitability as a measure of expected returns. They’ve done this by uncovering a way to widely measure profitability that helps point to a company’s future profitability.
So, let’s take a quick, 30,000 foot view at how this works using DFA’s own three tests as our means of examination.
1) Sensibility: It makes sense, and always has, that more profitable companies should have higher expected returns than less profitable companies.
2) Persistent, Pervasive, and Robust: Dimensional has used an overwhelming amount of historical data to show that applying profitability to portfolios as an added measure to enhance expected returns is both economically and statistically reliable over time. In fact, their research shows the impact to returns over time is similar to including value stocks in portfolios.
3) Cost-Effective: Because taking and applying this measure doesn’t involve a great deal of additional capital or time, the screen can be widely applied across their mutual funds to achieve higher expected returns without adding additional cost.
This is not a great departure for TAAG or Dimensional’s investment philosophy. The foundation of building low-cost, globally diversified portfolios to consistently reward investors with an appropriate return for the risk they take remains the cornerstone. Taking the profitability of companies into account as portfolios are built is simply the next natural step towards even smarter, more practical solutions than offered by the traditional investment model.