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9. Explain the Fama and French three factor model, and the rational argument behind it. Is beta a useful measure under the Fama and French model? Why or why not? Why does DFA not utilize macroeconomic variables to explain risk and design investment products? (Why do you think? Make a convincing argument as a DFA representative.)
The Fama-French model was designed to help predict sources of systematic risk that affect stock returns. The factors chosen are variables that on past evidence seem to predict average returns well and therefore may be capturing risk premiums. In addition to the market index (so, yes, beta is important in this model as well), the model also incorporates a small minus big factor (i.e. small stocks may be more sensitive to changes in business conditions than large stocks) and a high minus low factor (i.e. high book to market value stocks are more likely to be in financial …show more content…
Over the five years (1994-1999), growth stocks outperformed value stocks. Should DFA have reconsidered its strategy in 2000? If you worked for DFA in 2000, how would you have explained the poor performance of the fund to your clients?
DFA recognized the sky-high valuations of growth stocks in 2000 and 2001 and that value stocks, being relatively cheaper, provided more tempting opportunities. Ultimately, DFA’s bet to stick with its overall small cap/value strategy, proved to be the right move. By sticking with that strategy during the tech run-up, the company was able to avoid the pain that tech and growth investors experienced in the subsequent downturn. DFA’s value funds had tremendous returns, justifying the faith of its long-term investors and solidifying DFA’s grip on the loyalty of its clients.
The poor performance could be explained by the excessive relative valuations placed on tech and growth stocks. Some companies, with multiples of 50x and greater placed on its earnings (and in some cases negative earnings for tech stocks) could be viewed as excessive and not reflecting true fundamentals of the company. It seemed like investors were not being “rational” when viewing these companies and were too involved in the
The Fama-French model was designed to help predict sources of systematic risk that affect stock returns. The factors chosen are variables that on past evidence seem to predict average returns well and therefore may be capturing risk premiums. In addition to the market index (so, yes, beta is important in this model as well), the model also incorporates a small minus big factor (i.e. small stocks may be more sensitive to changes in business conditions than large stocks) and a high minus low factor (i.e. high book to market value stocks are more likely to be in financial …show more content…
Over the five years (1994-1999), growth stocks outperformed value stocks. Should DFA have reconsidered its strategy in 2000? If you worked for DFA in 2000, how would you have explained the poor performance of the fund to your clients?
DFA recognized the sky-high valuations of growth stocks in 2000 and 2001 and that value stocks, being relatively cheaper, provided more tempting opportunities. Ultimately, DFA’s bet to stick with its overall small cap/value strategy, proved to be the right move. By sticking with that strategy during the tech run-up, the company was able to avoid the pain that tech and growth investors experienced in the subsequent downturn. DFA’s value funds had tremendous returns, justifying the faith of its long-term investors and solidifying DFA’s grip on the loyalty of its clients.
The poor performance could be explained by the excessive relative valuations placed on tech and growth stocks. Some companies, with multiples of 50x and greater placed on its earnings (and in some cases negative earnings for tech stocks) could be viewed as excessive and not reflecting true fundamentals of the company. It seemed like investors were not being “rational” when viewing these companies and were too involved in the