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A Scientific Approach

Shearwater Capital was founded 14 years ago on a simple premise: offer an investment approach based on the best available evidence from academic research at a reasonable price. Although our initial idea was to build tax-efficient portfolios comprising individual stocks, we soon began using funds from Dimensional Fund Advisors (DFA) as the primary building blocks of our client portfolios. We gravitated to DFA because of their scientific approach and unique collaboration with some of the world’s leading financial economists.

Many of the most important advances in portfolio management have come from scientific research. Academic evidence regarding market efficiency led to the introduction of index funds in the 1970s. While index funds have been very successful, accounting for almost 30% of mutual fund assets, they have remained largely unchanged in structure since their inception. Meanwhile, academic research has marched on spawning new ideas that have allowed DFA funds to evolve beyond simple index funds. DFA’s first product, launched in 1981, was the U.S. Microcap Portfolio, inspired by research at the University of Chicago showing that, in the long run, small companies have higher expected returns than large companies.

The next step in the evolution of DFA funds was based on research by two leading financial economists, Eugene Fama(1) and Kenneth French. The Fama/French model demonstrated that stock returns are influenced not only by a company’s size, but also by its relative value, as measured by its price-to-book ratio. This led to several new DFA funds that overweight small cap and value stocks in order to capture the higher returns associated with these asset classes over long time periods.

Further academic research has documented a momentum effect in stock prices, in which stocks that have outperformed their peers tend to continue outperforming for a while, and vice versa. This effect is small and difficult to exploit in a cost efficient manner, however, by implementing a sophisticated momentum trading algorithm, DFA has been able to capture increased returns from the momentum effect.

The latest enhancement to DFA funds is based on company profitability. Academic research has identified profitability as an independent factor that can influence stock returns. Companies with high profitability, as measured by their gross operating margins, tend to provide higher returns over time than low profitability companies. DFA has therefore incorporated a profitability screen into many of its existing funds in order to harness this effect and boost returns.

DFA follows a careful vetting process before adopting new investment strategies. When a potential new dimension of stock returns is identified, DFA tests the effect to see if it is persistent across many historical time periods and pervasive across various domestic and international markets. Only when the effect has been shown to be robust based on extensive empirical research is it implemented as a strategy for increasing returns.

The DFA approach to investing reveals a willingness to modify one’s beliefs based on new academic data and the rigorous observation of markets over time. This philosophy embodies the scientific approach followed by DFA since its inception and it is why we continue to use their funds to implement our clients’ asset allocation strategies.

Jeffrey J. Brown, MD CFA Principal, Shearwater Capital

(1) Awarded the 2013 Nobel Prize in economic sciences

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