Quant Giant of Texas Confronts an Industry Crisis of Confidence

(Bloomberg) -- The quants at $609 billion Dimensional Fund Advisors are here to set the record straight: Value investing isn’t broken.

Sure, the strategy of buying apparently cheap stocks just tumbled to a fresh two-decade low versus one of chasing growth shares. Rivals are exploring fixes for the brand of systematic trading that dissects stocks by factors like how depressed their valuations look and how fast they’ve risen.

Even the finance legends who helped birth the investing style -- Eugene Fama and Kenneth French -- are harboring doubts about whether it’s still got juice.

But for all that, the quant giant of Texas is unbowed.

“Certainly the last 10 to 15 years have been a very painful experience for being exposed to or pursuing the value premium,” Savina Rizova, Dimensional’s research chief said in an interview in London. “Premiums can turn around quickly.”

To the Austin-based firm, even an epic stretch of underperformance is no reason to doubt what their academic research still shows: As long as there are material differences in market valuation, cheaper stocks will eventually win out.

The money manager -- one of the largest of its kind -- helped bring rules-based value to the investing masses and continues to pitch the style across its huge network of financial advisers.

Its unwavering belief in tried-and-tested academic models feels increasingly old school, as billions flee this corner of quantland and competitors toy with artificial intelligence and alternative data.

Traditional factors have delivered diminishing returns in the post-crisis era. Dimensional’s $30 billion U.S. core equity fund, which invests based on the value, size and profitability factors, has lagged its capitalization-weighted benchmark, the Russell 3000, on a one-, three-, five- and 10-year basis.

It’s not clear what the fix is, or if any is needed at all. Rizova pours cold water on a popular new approach to revamp value. Research Affiliates has found that capitalizing intangible assets on company balance sheets would have nearly doubled the strategy’s annual return from the 1990s onward. The argument is that ignoring research and development makes stocks look pricier than they really are.

“Do we see a different spread in returns when you adjust for intangibles versus when you don’t? The answer is, historically, the spread is almost the same,” she says, citing preliminary internal research that looks at data going back to 1963.

It’s an academic point that has real-world consequences. A large chunk of Dimensional’s giant asset pool is in stock products guided by its factor models, which means even small tweaks to how it classifies shares can reverberate through markets. It also oversees fixed-income, real-estate and target-date funds.

It’s not just equities where Dimensional’s orthodox streak shines through. Rizova is skeptical of the factors quants are mining in the bond market now that systematic traders are turning to other asset classes.

The firm argues in a paper published last week that most popular fixed-income factors -- such as distance to default, bond momentum and corporate profitability -- aren’t worth the hype after taking into account a security’s forward rate. That supports Dimensional’s view that forward rates, or the expected return projected by the yield curve for similarly-rated bonds, are the best guide to future returns, with the issuer’s short-term equity performance also a key indicator.

But for all its staunch adherence to time-tested models, Dimensional also tweaks them occasionally, after extensive research.

The firm has discovered that recent profit growth can predict outperformance in U.S. stocks, even after controlling for current profitability. Dimensional is looking to add that insight to the model, after determining whether it applies across global markets, Rizova says.

It might look like the firm is playing a game of catch-up, but the deliberative stance is Dimensional’s brand. The money manager started using the investment factor -- part of the Fama-French model -- in its portfolios only last year, after first exploring it around 2012.

“A separate standalone factor is unlikely to come out, but it doesn’t mean we’re not doing additional work on long-term drivers of returns,” Rizova says, referring to the Fama-French framework. “You want to see it is a robust pattern before you incorporate it in your investment process -- at least, we do.”

To contact the reporter on this story: Justina Lee in London at jlee1489@bloomberg.net

To contact the editors responsible for this story: Sam Potter at spotter33@bloomberg.net, Yakob Peterseil, Sid Verma

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