DFA history of economics

Innovations in financial markets research over the last fifty years are the keystone of a belief system that guides Dimensional's approach to investing. Today, the investment industry takes for granted the calculation of rates of return and the availability of comparative universes for professionally managed funds. But before the mid 1960s, there was neither a generally accepted way to calculate a total return nor a way to compare the returns of different funds. This all changed with the advent of computers and the collection of data for mutual funds as well as for individual stocks and bonds.

Rigorous testing by financial economists of that seminal era led to the development of asset pricing models to evaluate the risk/return characteristics of securities and portfolios, and also led to a theory of market efficiency that suggested excess returns were only achievable by taking on above-market risk. Studies documenting the failure of active managers to outperform market indexes gave rise in the early 1970s to passively managed index funds that relied on capital markets as the source of investment returns.

Further research and data compilation over several decades led to the identification of the multiple asset classes and sources of higher expected returns that form the basis of Dimensional's strategies.

The History of Economics

1950 Conventional Wisdom circa 1950 "Once you attain competency, diversification is undesirable. One or two, or at most three or four, securities should be bought. Competent investors will never be satisfied beating the averages by a few small percentage points." Gerald M. Loeb The Battle for Investment Survival, 1935 Analyze securities one by one. Focus on picking winners. Concentrate holdings to maximize returns. Broad diversification is considered undesirable. 1958 The Role of Stocks James Tobin Nobel Prize in Economics, 1981 Separation Theorem: 1. Form portfolio of risky assets. 2. Temper risk by lending and borrowing. Shifts focus from security selection to portfolio structure. "Liquidity Preference as Behavior Toward Risk," Review of Economic Studies, February 1958.

1950

1952 Diversification and Portfolio Risk Harry Markowitz Nobel Prize in Economics, 1990 Diversification reduces risk. Assets evaluated not by individual characteristics but by their effect on a portfolio. An optimal portfolio can be constructed to maximize return for a given standard deviation.

1961 Investments and Capital Structure Merton Miller and Franco Modigliani Nobel Prizes in Economics, 1985 and 1990 Theorem relating corporate finance to returns. A firm's value is unrelated to its dividend policy. Dividend policy is an unreliable guide for stock selection. 1965 Behavior of Securities Prices Paul Samuelson, MIT Nobel Prize in Economics, 1970 Market prices are the best estimates of value. Price changes follow random patterns. Future share prices are unpredictable. "Proof that Properly Anticipated Prices Fluctuate Randomly," Industrial Management Review, Spring 1965 1968 First Major Study of Manager Performance Michael Jensen, 1965; A.G. Becker Corporation, 1968 First studies of mutual funds (Jensen) and of institutional plans (A.G. Becker Corp.) indicate active managers underperform indexes. Becker Corp. gives rise to consulting industry with creation of "Green Book" performance tables comparing results to benchmarks.

1960

1964 Single-Factor Asset Pricing Risk/Return Model William Sharpe Nobel Prize in Economics, 1990 Capital Asset Pricing Model: Theoretical model defines risk as volatility relative to market. A stock's cost of capital (the investor's expected return) is proportional to the stock's risk relative to the entire stock universe. Theoretical model for evaluating the risk and expected return of securities and portfolios. 1966 Efficient Markets Hypothesis Eugene F. Fama, University of Chicago Extensive research on stock price patterns. Develops Efficient Markets Hypothesis, which asserts that prices reflect values and information accurately and quickly. It is difficult if not impossible to capture returns in excess of market returns without taking greater than market levels of risk. Investors cannot identify superior stocks using fundamental information or price patterns.

1971 The Birth of Index Funds John McQuown, Wells Fargo Bank, 1971; Rex Sinquefield, American National Bank, 1973 Banks develop the first passive S&P 500 Index funds. Years later, Sinquefield co-chairs Dimensional, and McQuown sits on its Board. 1975 A Major Plan First Commits to Indexing New York Telephone Company invests $40 million in an S&P 500 Index fund. The first major plan to index. Helps launch the era of indexed investing. "Fund spokesmen are quick to point out you can't buy the market averages. It's time the public could." Burton G. Malkiel, A Random Walk Down Wall Street, 1973 ed. 1977 Term Structure Models Oldrich Vasicek, Wells Fargo Bank Lays the academic groundwork for bond pricing and yield curve models. 1977 Asset Returns and Inflation Eugene Fama, University of Chicago; William Schwert, University of Rochester Study the inflation hedging properties of different assets and finds short-term government fixed income to be an effective inflation hedge.

1970

1972 Options Pricing Model Fischer Black, University of Chicago; Myron Scholes University of Chicago; Robert Merton Harvard University; Nobel Prize in Economics, 1997 The development of the Options Pricing Model allows new ways to segment, quantify, and manage risk. The model spurs the development of a market for alternative investments. 1975–1982 Market Efficiency, Interest Rates, and Inflation Eugene Fama, University of Chicago Extends empirical tests to fixed income markets and finds evidence of market efficiency. Finds that nominal interest rates incorporate information on future inflation expectations and that greater inflation uncertainty is positively related to risk premia. Examines the relationship between real interest rates and inflation and shows they are negatively correlated. 1977 Database of Securities Prices since 1926 Roger Ibbotson and Rex Sinquefield,  Stocks, Bonds, Bills, and Inflation An extensive returns database for multiple asset classes is first developed and will become one of the most widely used investment databases. The first extensive, empirical basis for making asset allocation decisions changes the way investors build portfolios.

1981 The Size Effect Rolf Banz, University of Chicago Analyzed NYSE stocks, 1926-1975. Finds that, in the long term, small companies have higher expected returns than large companies and behave differently. Dimensional Fund Advisors is founded in 1981 and launches the US Micro Cap Portfolio. 1982 Interest Rates and Inflation Eugene Fama, University of Chicago; Michael Gibbons, Stanford University Show that real interest rates are negatively correlated with inflation. "Inflation, Real Returns and Capital Investment," Journal of Monetary Economics (9) 297-323. 1983 Variable Maturity Strategy Implemented Dimensional Fund Advisors One-Year Fixed Income Strategy With no prediction of interest rates, Eugene Fama develops a method of shifting maturities that identifies optimal positions on the fixed income yield curve. 1986 International Size Effect Dimensional Fund Advisors International Small Cap Strategies Dimensional Investing vs. Indexing: With no index, Dimensional creates international small cap strategies modeled after the US research. Dimensional's live returns become the index used in Ibbotson Associates' database. Dimensional investing is based on a rational return source, and does not slavishly follow indexes or investing conventions.

1980

1981–1984 Interest Rate Parity Eugene Fama, University of Chicago; John Bilson, University of Chicago; Richard Meese, University of California at Berkeley; Kenneth Rogoff, Board of Governors of the Federal Reserve System A forward rate is shown to be the sum of a risk premium and expected future spot rate. Most of the variation in forward rates is due to variations in premiums. Empirical evidence reveals the failure of uncovered interest rate parity, which means that forward rates do not predict short-term currency movements. 1984 Information in the Term Structure Eugene Fama, University of Chicago Finds that risk premiums are an important factor when evaluating forward interest rates. Finds that forward rates implied by the treasury yield curve provide information on the term structure of expected returns. 1989 Business Cycle Patterns in Stock and Bond Returns Eugene Fama and Kenneth French, University of Chicago Offer evidence that the expected excess returns on stocks and bonds are typically higher than normal during recessions and lower than normal at business peaks.

1990 Nobel Prize Recognizes Modern Finance Economists who shaped the way we invest are recognized, emphasizing the role of science in finance. William Sharpe for the Capital Asset Pricing Model. Harry Markowitz for portfolio theory. Merton Miller for work on the effect of firms' capital structure and dividend policy on their prices. 1993 Bond Mutual Fund Performance Christopher Blake, Fordham University; Edwin Elton, New York University; Martin Gruber, New York University Conduct what's believed to be the first comprehensive study of bond mutual fund returns. They conclude that, on average, bond funds underperform relevant indexes after expenses. They also find no evidence of predictability using past performance to predict future performance. 1999 Tax Management Dimensional tax-managed strategies implemented which seek to maximize after-tax returns by offsetting gains and minimizing dividends. Based on Fama/French research and Dimensional's "portfolio decision system" trading technology.

1990

1992 Multifactor Asset Pricing Model and Value Effect Eugene Fama and Kenneth French, University of Chicago Improve on the single-factor asset pricing model (CAPM). Identify market, size, and "value" factors in returns. Develop the three-factor asset pricing model, an invaluable asset allocation and portfolio analysis tool. Establish term and default factors for fixed income returns. Dimensional introduces value strategies based on the research. Lends to similar findings internationally. 1997 Inflation-Protected Bonds The Treasury conducts the first auction of Treasury Inflation-Protected Securities (TIPS), thus allowing US investors to invest for long periods with minimal default risk and inflation risk.

2002 Improved Bond Market Transparency National Association of Securities Dealers (NASD) introduces Trade Reporting and Compliance Engine (TRACE), which requires the reporting of US corporate bond trades. This data allows researchers to study trading costs and inequality in the US corporate bond market.

2000

2004 Applied Core Equity Dimensional portfolio construction methodology weights securities by size and value characteristics instead of market capitalization. Total market strategies launched which seek to provide efficient, diversified exposure to the sources of higher expected returns while limiting turnover and transaction costs. Core equity portfolios move beyond traditional, component-based asset allocation via vast diversification and cost-efficient market coverage.