Dimensional Fund Advisors Part XII

This article is one in a long series which I hope will help explain the ins and outs of DFA – Dimensional Fund Advisors. NOTE: This is my interpretation and explanation only. For the final word, please refer to the DFA Canada Website.

How Accepted Is The Three Factor Model?

The acceptance of the Three Factor Model is probably more widespread than people realize. While most investors have probably heard of the Capital Asset Pricing Model (CAPM), most have not heard of the Fama-French Three Factor Model. In fact, of all the textbooks I’ve had to study to become a financial advisor or attain new designations they all seem to have a refresher section on CAPM – but no mention of the Fama-French Three Factor Model (FFTFM).

So why then, would I say that the FFTFM is more widespread than people realize? One need only look at the following style box which might be very familiar:

These types of style boxes became popular in the mid 1990’s and have been used ever since to characterize the holdings of mutual funds and other portfolios. For the most part, investors and advisors learned to compare “like with like” – such that if you had a portfolio or fund that fell into the Large-Value box, then the straight performance comparison to a Small-Growth fund was considered an apples-to-oranges comparison (and not an apples-to-apples comparison). Today, everybody just “knows” that such a comparison isn’t fair.

If the only major determinant of portfolio performance was exposure to equities (as according to CAPM), then looking at these style boxes shouldn’t really give you any more information. That investors and advisors DO look at the fund’s size and value characteristics is a testament to the FFTFM and that the other major factors in determining portfolio peformance could indeed be Size and Value (and not just exposure to the market in general).

The Lipper Indices

The Lipper Database also converted to a multi-factor framework in 1999. Here are the Equity Indices as of March 9th, 1998:

  1. Capital Appreciation
  2. Growth Fund
  3. Small Cap Fund
  4. Growth & Income
  5. Equity Income Fund
  6. Science & Tech Fund
  7. International Fund
  8. Gold Fund
  9. Balanced Fund
  10. Emerging Markets

Here were the Equity Indices as of November 20th, 2000:

  1. Large-Cap Growth
  2. Large-Cap Core
  3. Large-Cap Value
  4. Multi-Cap Growth
  5. Multi-Cap Core
  6. Multi-Cap Value
  7. Mid-Cap Growth
  8. Mid-Cap Core
  9. Mid-Cap Value
  10. Small-Cap Growth
  11. Small-Cap Core
  12. Small-Cap Value
  13. Equity Income Fund
  14. Science & Tech Fund
  15. Gold Fund
  16. International Fund
  17. Emerging Markets
  18. Balanced

To Be Continued…

Well that’s all fine and dandy, but where this is really going to start getting interesting is when we start using a Three-Factor analysis instead of CAPM to measure mutual fund manager performance. I’ll spoil a bit of the surprise when I say that CAPM alpha does not usually translate into Multi-Factor alpha which isn’t good news for the few managers who have beaten their benchmarks. Stay tuned!

CLICK TO HERE TO GO TO PART XIII

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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