Process / 
Multifactor

We believe that the multifactor model offers an elegant framework for portfolio design, analysis, and investment discipline. It assists us in bringing order and clarity to the investment process, isolating and explaining the forces that drive returns in equity and fixed income portfolios.

Dimensional started with a single micro cap portfolio that helped pioneer small cap investing. In fixed income, the firm started with a high-quality short-term portfolio developed from Eugene Fama's research on changes in the yield curve and differences in expected returns among bonds with varying durations. Since then, the fund family has grown to meet a broad range of client needs worldwide.

This would seem to be a perplexing number of choices were it not for the consulting technology and investment philosophy that evolved alongside the strategy line. Dimensional's strategies are coordinated by robust models of risk and return, inspired by academic research, and applied in actual portfolios.

Dimensional's research has shown that the three-factor model on average explains about 96% of the variation of equity returns among fully diversified professional investment plans. Equity investing therefore largely consists of deciding the extent to which your portfolio will participate in each of the equity market dimensions: small/large and value/growth. The greater the risk exposure, the greater the expected return.

Financial economists have identified two factors that determine the expected returns of fixed income securities: credit and term. The credit (default) factor is a proxy for changes in economic conditions that change the likelihood of default, while the term factor is a proxy for unexpected changes in interest rates. Together, those two factors explain much of the common variation in the cross-section of bond returns.

The five sources of expected return—equity market, equity size, equity price, fixed income term, and fixed income credit—can be used to create a five-factor model that explains much of the variation of a balanced equity/fixed income portfolio. This in turn provides a multifactor framework for strategy design, asset allocation, returns analysis, and investment discipline.

Strategy Design

The model suggests that to control risk and best capture expected return, equity portfolios should be sorted along size and price dimensions, and fixed income portfolios along term and credit dimensions. The model helps set the criteria for weighting the component portfolio sorted this way in the investor's total portfolio.

Asset Allocation

The model defines risk exposures and serves as a framework to help investors structure portfolios that accurately capture the expected returns of each underlying asset class.

Analysis

The model is indispensable for measuring portfolio "style" and past performance. It also produces expected return calculations that, though not predictive, help us manage assets with scientific rigor.

Discipline

The model helps bring purpose and focus to an otherwise chaotic investment process. It offers a frame of reference that helps investors navigate tough market conditions, set and maintain expectations, apply logic, and maintain discipline. The multifactor model helps us separate investing from speculating.