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Special report

Dimensional implements profitability factor in equity strategies

Jed Fogdall
Jed Fogdall

At Dimensional Fund Advisors LP, “academic research is an important part of what we do,” said Jed Fogdall, vice president and co-head of portfolio management.

“A lot more research comes out than we would deem usable in a portfolio,” said Mr. Fogdall, who is based in Dimensional's Austin, Texas, main office. “So there is a certain set of criteria we look for in research” before Dimensional uses it in a portfolio.

“You want to … have a good reason to believe that these things are going to be usable in the future.

“How much data is being used to look at this particular effect? Can it be replicated outside that initial data set, whether it is different periods of time or different markets? And if those things are there, then you also want to think about how cost effective it is to implement in a portfolio.

“A lot of research fails on one or more of those things,” Mr. Fogdall said.

“Profitability research is probably the best example of a recent” application to portfolio management, he said.

“Because expected future profitability is not observable, one needs to come up with a systematic reliable proxy for expected profitability in order to make this research investible, implementable in real-world investment solutions,” said Savina Rizova, Santa Monica, Calif.-based vice president, research at Dimensional.

”Once we identified this measure we started thinking about … what would be the best way to implement (profitability) across” Dimensional's equity strategies “As of now, we are implementing (profitability) across most of our equity” strategies, Ms. Rizova said.

Because profitability is a different aspect of expected stock returns than the size or value premium, that additional information allows managers to focus on those differences in their portfolios and “improve the consistency of expected outperformance,” Ms. Rizova said.

“The motivation for the research on profitability comes from the basic valuation equation, which says simply that the value of a stock today depends on the expected future cash flows to shareholders and the discount rate applied to those cash flows to bring them to the present (value),” Ms. Rizova said.

Profitability is a fundamental factor of active managers as well.

“The main difference in the (profitability) approach (between) many active managers and (Dimensional) is that we always want (implementation) in a systematic, transparent, disciplined … way,” Ms. Rizova said. To implement it in that way, “required a systematic proxy for expected profitability,” which Dimensional developed.

Transparency is important in Dimensional's process, Mr. Fogdall said.

“It has to do with the fact we are managing portfolios for clients who would like to know what we are doing with their money,” Mr. Fogdall said. “If we can … explain … why we approach portfolio management the way we do” and clearly describe how the portfolios are built, clients can understand the process.