Loring Ward advisors learned that a 'breakthrough' dimension related to profitability will be mixed into all funds by year's end

June 6, 2013 — 6:53 AM UTC by Brooke Southall

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Brooke’s Note: Dimensional Fund Advisors is a company that continues to experience stunning success — but not because it does anything exciting per se. DFA is a boring company, basically selling index funds with a layer of intelligence baked in. But it sells a tremendous amount of those funds and its steady nature is part of its charm and why it is so trusted. That dare-to-be-dull bearing of the Austin, Texas-based company with about $300 billion of managed assets helps explain why the company sent no less than its co-CEO to California to explain that, in effect, a couple lines of code are being changed in a tome of algorithms. Eduardo Repetto employed a combination of humor, numbers and deft use of an Argentinian accent to get his point across that 'profitability’ as a DFA additive to portfolios is a good thing and a 'big deal’.

Dimensional Fund Advisors LP is making profitability a separate and distinct attribute that it seeks out in a company before it buys its stock.

The company, which has about 450 employees at its Austin, Texas, headquarters and about 100 in Santa Monica, Calif., already has introduced the sparky little additive to some of its separately managed accounts. But the “breakthrough” advancement will be added across the board to all of its fund products, which have $300 billion of combined assets, according to a one-hour speech its co-chief executive, Eduardo Repetto, delivered yesterday at Loring Ward national conference in Monterey, Calif. Personal financial advisors globally account for $164 billion of DFA’s assets. See: Loring Ward tells a focus group to let loose on advisors — and it does.

All that is holding back the change at this stage is that such a change is not easy to explain and so the company is determined to do so carefully. Not only do advisors need to understand exactly how profitability comes into play but they need to be able to grasp what’s happening well enough to explain it to clients, he added.

DFA is measuring profitability not in terms of profits per se but profits divided by book value, as a good indication of a company’s potential for strong future profits.

How big?

Asked to characterize how big a deal it is— on a scale of watershed event, big deal or tweak — that DFA is messing with a formula that many advisors speak of with the same reverence as aficionados of Coca-Cola Classic (keep out that corn syrup!), Repetto paused, and then chose his words carefully.

“From a theoretical point of view, it’s a big deal,” he said. “But the marginal contribution is smaller and smaller and smaller — not like when value [as an approach to investing] came.”

When Alex Potts, CEO of Loring Ward, which has about $8.8 billion of TAMP assets came on stage after the speech, he stated that the change should certainly not be viewed as a watershed event by any means.

When I ran into Chip Roame, managing principal of Tiburon Strategic Advisors LLC, in the hallway after the speech, he said he believed that the change could be viewed as, hydrology aside, a watershed. He said he viewed it in the same way as DFA’s introduction of momentum investing a number of years ago as part of its formula — a watershed event of sorts for a company religious about passive investing.

20 years in the making

Repetto mentioned that DFA did not have growth portfolios before because we could not find a significant source of value added, but with profitability applied to growth stocks he found that source of value added so his firm could launched growth portfolios” See: Dimensional Fund Advisors still has low RIA acceptance rate and stunning growth.

Repetto added that there could be times when profitability hurts the portfoilio. One example he gave was the 2000-era technology bubble when companies with no profits were being accorded astronomical valuations.

To demonstrate just how grudgingly his company made the addition of the profitability screen, Repetto said his company had been waiting to get and crunch what it considered a critical mass of data. “Twenty years ago there was 20 years less data,” he said.

Still, Repetto made clear that the idea has been kicking around DFA for quite a while, pointing out that his company put out an article that was “going in that direction” in 2006.

One thing that is certainly pointing in the right direction for DFA is its asset growth. It had $213 billion of AUM as of Dec. 31, 2011, $262 billion as of Dec. 31, 2012, and $283 billion as of March 31. See: Eduardo Repetto tips Dimensional Fund Advisors’ hand on long-term succession — which likely involves an IPO.

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Mentioned in this article:

Tiburon Strategic Advisors
Consulting Firm
Top Executive: Charles Roame



Share your thoughts and opinions with the author or other readers.

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Elmer Rich III said:

June 6, 2013 — 6:49 PM UTC

DFA is a remarkably successful marketing firm and one of the first to utilize evidence-based, scientific and academic studies. The immense contribution by Booth to U of Chicago, my alma mater, is a small indicator of the profitability of their approach.

It is, however, very hard to judge any investment approach based on evidence using current academic and commercial approaches. Economics and finance as bodies of knowledge seem far too new to even start to address this challenges. Back-testing has well known weaknesses. Another factor is implementation. Say effective algorithms are created through experimentation, other than just back testing, then the actual implementation of products would need to be assessed, etc.

Certainly, DFA has the money to support deep and rich, non-proprietary research. For economics and the industry to move beyond back-testing and into true double-blind, control group experimentation and testing will likely take some generational shifts.

Finally, there is always the proverbial wise client’s, very tough question of the industry and investment approaches: If they were so good and productive, no company would need any client money to invest.

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Craig Morningstar said:

June 6, 2013 — 8:48 PM UTC

As a support organization for Advisors and RIA firms investing with DFA, even though we appreciate and like the 3 dimensions (3 factors), it is a pleasure to see the 4 dimension added. It will be a pleasure training our every increasing Advisor base about the 4 dimensions.
From Dynamic Wealth Advisors to Dimensional Fund Advisors, CONGRATUALATION.

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Elmer Rich III said:

June 6, 2013 — 9:03 PM UTC

Is there academic support fot he 4th dimension?

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Elmer Rich III said:

June 6, 2013 — 9:59 PM UTC

Interestingly we just came across a couple of articles relevant to this topic.

For the first time in history, individuals are responsible for investing their life savings and to do so for decades during and after their work lives. We have to admit honestly that the state of knowledge about how to invest is very rudimentary.

A couple of recent articles about how the “best and brightest” Noble prize winners invest their own money is sobering if not concerning. They have direct access to the best thinking and knowledge on investing and they are as confused as everyone else.

For example:
“Readers might take comfort in learning that even some of the world’s great mathematical minds have admitted to wrestling with the same issues they do: How do I invest my 401(k)? Should I take some risk? How about international stocks?”

“If the creme de la creme of the economics profession and American academia can’t get these sorts of things right, why should we expect everyone else to?”

“Retirement is not like buying a cup of coffee,” said Joseph E. Stiglitz, a 2001 Nobel Prize winner, former Clinton administration economist and Columbia professor. “It’s not something you get to do over and over again and learn from your mistakes.”

Recent research suggests that people, by nature, often make poor economic decisions.

Analysts examining the actual behavior of individuals — as opposed to what most economists’ theories predict — find that it rarely conforms to standard notions of what’s rational. Instead, it often involves systematic mistakes that end up producing the very opposite of what people say they intend.”

We are digesting two articles on this study for our blog and will post a link.

Now, maybe DFA and other firms have a “secret sauce” that is not known or studied in the academic sciences of finance and investing but if there is any evidence-based approach that can work – now is the time to make it public to firms, individuals, institutional investors and even governments.

Developing experimentally proven, fact-based investment strategies is an urgent global need.

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Ira Artman said:

June 11, 2013 — 2:13 PM UTC

re: Academic sources for additional factors

See Professor Robert Novy-Marx’s recent works:

1. The Quality Dimension of Value Investing, December 2012

2. The Other Side of Value: The Gross Profitability Premium, June 2012

Both are available at his site at the University of Rochester:

http://rnm.simon.rochester.edu/

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Ira Artman said:

June 11, 2013 — 2:22 PM UTC

More popular/accesible recap of Professor Novy-Marx’s work may be found here:

Swedroe: Look At Value, Quality And Momentum
By Larry Swedroe | June 04, 2013
Looking beyond the three-factor Fama-French may be just what your portfolio needs.

http://www.indexuniverse.com/sections/guest-blogs/18884-swedroe-look-at-value-quality-and-momentum.html

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Elmer Rich III said:

June 11, 2013 — 3:32 PM UTC

Thanks for citation. Ah, so this is not an academic work but just another promotional article by a money manager based, supposedly – since we have no access to the data cited, on back testing.

So if this was presented to a client or advisor, what kind of evidence and proof would this be called? If it hasn’t been independently validated is it anything more than opinion?

What kind of proof and evidence should clients and advisors require before implementing any professional service?

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Ira Artman said:

June 11, 2013 — 4:00 PM UTC

See earlier post [below], with reference to Professor Robert Novy-Marx, or google his name. Easy to find.

Ira Artman added: (Tuesday 6.11.13 7:13a.m. PST)
re: Academic sources for additional factors… etc.

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Elmer Rich III said:

June 11, 2013 — 4:40 PM UTC

We will study the quality dimension paper. The only method is back testing, we assume. Have critiques been issued. All good ideas need to be disprovable and falsifiable. How would these be and have that been undertaken?

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Elmer Rich III said:

June 11, 2013 — 5:02 PM UTC

OK, so let’s unpack the claims.

The Proposition: “Novy-Marx (2013) finds that a simpler quality measure, gross profitability (revenues minus cost of goods sold, scaled by assets), has as much power predicting stock returns as traditional value metrics.”

So this a clear empirical question, it is factually correct in the future or not.

- This approach is not new -“BlackRock, the earliest adopter (when still BGI) of Sloan’s (1996) accruals-based measure of earnings quality”. So we have then data to test this approach since ’96. – May not work with all asset class: “Quality driven performance improvements are more elusive, however, in the large cap universe.” “Elusive” is an interesting choice of words. Does that mean it doesn’t work?
More – “This suggests that large cap investors trading on value and profitability have little to gain by incorporating other measures of quality.” This is sounding like less of a “breakthrough” after all. – To get the real promised returns however, it requires trading strategies – “Investors trading on value and profitability can, however, realize significant improvements by also incorporating momentum signals into their trading strategy. This is really confusing. So we have a 2 major independent variable – trading strategy. How is this operationalized, tested, defined? Are the contributions of the quality approach lost if some kind of, pretty much ad hoc trading behavior is included. BTW, there are “strategies” (what is said should be done) and actual trading behavior (what is actually programmed and executed).

There is more but let’s stop here, for now.

Bottom line – where are funds using this strategy, as defined in this paper where we can see the audited results? How will different funds apply the same ideas? Is there anyway to know that the calculations used in this paper will be applied uniformly or accurately? How is one to assess trading strategies.

As a marketer, I appreciate the public claims and promises of all this being special. But also as a marketer in a highly regulated industry it seems basic truth in advertising is at play here as well.

Looking forward to an energetic exchange on this.


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