Dimensional’s investment solutions seek to add value by using up-to-date information embedded in the latest market prices to identify reliable differences in expected returns across securities in equity and fixed income markets. By doing so, we can avoid the rigidities of indexing as well as the unreliability of forecasting.
We believe such an approach is critical to building a robust asset allocation and better positions investors for success.
Valuation theory provides a framework about the drivers of expected stock returns, linking expectations about a firm’s future cash flows to its current value through a discount rate (or, equivalently, the expected return on the stock). Using the valuation framework, we can expect small cap stocks to outperform large cap stocks, low relative price stocks to outperform high relative price stocks, and stocks with higher profitability3 to outperform low profitability stocks.
Consistent with valuation theory, the existence of these premiums has been documented in studies covering over 40 countries and nine decades of stock data.4
Dimensional’s core equity strategies seek to efficiently target the size, value, and profitability premiums through a total market solution. These solutions systematically overweight stocks with higher expected returns (those with lower market capitalizations, lower relative prices, and higher profitability) relative to their market weights and underweight stocks with lower expected returns (those with higher market capitalizations, higher relative prices, and lower profitability) across the entire market in each eligible country.5
Realized returns vary across the premiums as well as across regions, countries, and sectors. Research, however, has not found evidence that these differences are reliable over the long term.6 As a result, we believe that an integrated and balanced focus on all three reliable long-term drivers of expected returns along with broad diversification across geographies and regions provide investors with the best chance of outperforming the market.
Additionally, research has found little evidence that short-term performance differences across premiums, regions, countries, or sectors can be consistently predicted.7 Based on these findings, we do not make short-term allocation shifts across premiums, regions, countries, or sectors. A strategy that attempts to time these differences may increase return volatility and incur higher turnover and trading costs relative to a consistent approach, increasing the performance hurdle required to make such a strategy worth pursuing.8 A disciplined asset allocation that maintains broad diversification and a consistent focus on the long-term drivers of expected returns is, in our view, a more reliable way to pursue higher expected returns.
We also believe that designing asset allocations using a thoughtful framework based on financial science is advantageous vs. employing optimization techniques. An approach to asset allocation that uses ex post investment outcomes as ex ante return assumptions in a complex, opaque model may result in poorly understood or misleading conclusions for investors. For more on this, see Lee (2013) and Davis (2008).9
As with equities, we use current market prices to identify systematic differences in expected returns among fixed income securities. Across bonds, expected returns vary by duration, credit quality, and currency of issuance. We also use information in current market prices to monitor and manage risks and eliminate unnecessary trading costs. Portfolio implementation—which includes research, portfolio design, and portfolio management and trading—integrates those functions with the goal of increasing overall returns or meeting investors’ goals efficiently.10
Emphasis on Known Drivers of Higher Expected Returns
The degree to which an investor emphasizes equity and fixed income premiums in their asset allocation should depend, in part, on their goals as well as their overall portfolio.
In portfolios with higher equity allocations, taking on more term and credit exposure (by focusing on bonds with longer durations or lower credit quality, respectively) can supplement the higher expected return goal of such asset allocations without materially impacting the overall volatility of the portfolio since this volatility is dominated by the equity component. In portfolios with higher fixed income allocations, the goal is to preserve capital and minimize losses in consumption power, so such allocations would benefit from fixed income investments that emphasize short duration, high credit quality, and inflation protection.