The Efficient-Market Hypothesis & DFA: The Building Blocks for Our Investment Philosophy Since 1991

By on July 10, 2019
Categories: MARKET NEWS

The United States economy has now been growing for over a decade, making this the longest economic expansion on record. At least for now, the stock market is not being held back by imposed and threatened tariffs, political uncertainty surrounding next year’s presidential election, or fears of a coming recession. Perhaps the market’s resilience stems from more optimistic investors detecting counteracting, less well-publicized, positive forces at work such as relatively strong corporate earnings, muted inflation, low unemployment, and still historically low interest rates. In fact, the 10-year Treasury bond yield, a benchmark for longer-term interest rates, has fallen from 2.6% at the beginning of the year to less than 2.0% at quarter’s end, dropping mortgage rates back to 2017 levels.

In contrast to the volatile end of 2018, when we were net buyers of stocks in client portfolios, we are now net sellers of stocks to rebalance portfolios to their target allocations of stocks versus bonds. We are also using the runup in equity prices to help clients with gifting of appreciated securities to further their charitable and estate planning goals.

Asset class returns for the quarter and year-to-date were as follows:

asset class returns for second quarter 2019


For over 28 years, Dowling & Yahnke has invested client assets as fiduciaries. Our firm is independent with respect to the investment vehicles we use, freeing us to design portfolios we believe will best meet client objectives. We continuously scrutinize our investment philosophy and the tools we use, challenging our thinking and experience to ensure our clients receive the best experience possible based on their financial objectives, risk appetite, and tax situation. In this quarter’s newsletter, we will explore our longstanding relationship with Dimensional Fund Advisors (DFA). While DFA mutual funds represent a minority portion of the assets we use in building portfolios, many of the philosophical and practical concepts underpinning DFA’s approach also permeate our thinking.

Dowling & Yahnke has used DFA mutual funds in client portfolios for more than 28 years. While relatively unknown when our co-founder Mark Dowling identified DFA as an industry thought leader, DFA is now a household name in professional investment circles with over $575 billion in assets under management. We continue to work closely with DFA to bring innovative ideas and cutting edge thinking to our management of client assets.

The foundation of DFA’s investment approach is the efficient-market hypothesis (EMH). Pioneered in part by Eugene Fama, a professor at the University of Chicago Booth School of Business and 2013 winner of the Nobel Prize in Economics, the EMH asserts that market prices reflect the collective knowledge and expectations of all investors based on all publicly available information at any given time. The EMH assumes that information from new developments is quickly reflected in stock prices. As a result, the EMH concludes that such an “efficient market” is extremely difficult for an investor to consistently outperform through forecasting strategies or market timing. It is therefore wasted energy to seek out undervalued stocks or to forecast short-term market movements. Not surprisingly, the EMH has been hotly debated since its introduction in the 1970s, largely because so many market participants earn a living attempting what Fama and others say is so difficult to do – trying to beat the stock market.

The practical implications of EMH are relatively simple. If beating the market is unrealistic, an investor is better off owning the overall market at a low cost and focusing on other more controllable factors (risk, taxes, diversification, etc.). DFA’s mutual fund lineup allows investors to do just that. While DFA’s original fund focused on small company stocks, the firm now offers a broad range of funds covering many areas of the global equity and fixed income markets. But the original premise remains intact: own nearly all the stocks (or bonds) in a particular area of the market and focus on reducing trading costs, keeping fees low, and minimizing tax impacts. In addition, the academic research performed by DFA has shown that the long-term returns on stock portfolios can be explained by certain factors: small company stocks have outperformed large company stocks, and returns on value stocks have exceeded those of growth stocks over long periods. The reasons cited above make DFA funds valuable foundational building blocks for our client portfolios.

One might be tempted to characterize DFA’s funds as index funds, given that they attempt to cover large swaths of the market. However, one of DFA’s stated goals is for their strategies to outperform their benchmark indices after fees, over long periods of time. But how can this be explained in the context of the efficient-market hypothesis? There are three sources of additional value added by DFA.

First, unlike true index fund providers, DFA does not emphasize adherence to arbitrary indexes, like the S&P 500 or Russell 2000, giving it much greater flexibility. Instead, DFA develops its own criteria for investment characteristics that provide added expected return (small cap, value, sustained high profitability, etc.), and then seeks to own nearly all the stocks that fit those characteristics. It also does not immediately dispose of a stock that no longer fits its definition (or immediately obtain a stock that does), in contrast to index funds that must sell a certain stock as soon as an index committee decides that it no longer belongs. This approach results in DFA funds having less turnover, lower transaction costs, and greater trading flexibility relative to index funds.

Another source of DFA’s edge over traditional index funds is the firm’s market position as a buyer of large blocks of small company stock. Because motivated sellers of large blocks of less liquid stock do not usually have many options for selling their shares quickly (without driving down the price of the shares significantly), DFA is occasionally able to purchase these blocks at discounts to the prevailing market price, creating a win-win for both parties of the transaction. DFA’s research shows that this advantageous, opportunistic trading position has allowed it to net additional returns on block trades, something an index fund cannot do.

DFA is also distinguished by the firm’s strong ties to renowned finance and investment researchers at leading educational institutions such as University of Chicago, Harvard, University of Pennsylvania, and Yale. These academics play an ongoing role in identifying new sources of risk and return, oftentimes in advance of the broader financial services industry. Based on this academic research, DFA implements new investment strategies and then brings feedback to the academics for further research, testing, and enhancement. The result is that economic research becomes more relevant to practical investing, and practical investing is backed by solid theory and rigorous academic research.

In the modern world of real-time, continuous communication, we believe the concepts underpinning the efficient-market hypothesis continue to be highly applicable, particularly in the large, liquid stock markets around the world. We also believe that the underlying principles supporting the premiums offered by investing in small cap stocks (vs. large cap) and value stocks (vs. growth stocks) over the long term continue to be valid, although sometimes they are not apparent for extended periods of time. We continue to seek out innovative ideas, technologies, and partnerships to improve our client experience. The drive to provide a great client experience that led us to identify DFA as a strategic partner 28 years ago remains as strong as ever. As always, we remain focused on the primary factors under our control when investing client assets: managing risk, minimizing costs and taxes whenever possible, diversification, and disciplined rebalancing to each client’s target asset allocation as market conditions change.

The “SECURE” Act of 2019

We are closely watching the newest round of retirement plan and tax proposals moving through Congress. One of the recent proposals is the SECURE Act, which, if passed in its current form, would implement the following changes:

  • Increase the Required Minimum Distribution (RMD) age from 70½ to 72;
  • Expand the withdrawal provisions of Section 529 plans; and
  • Change the “Stretch IRA” rules, forcing certain beneficiaries to withdraw inherited IRA money over a shorter time period.

These provisions, among others, are still in the early stages and have not been passed into law. We will continue to monitor these important financial planning changes as they continue to evolve.

We thank our clients and fellow business professionals for their continued trust and support. We hope your summer is off to a great start and we encourage you to contact our team with any questions or concerns regarding your finances.


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