1. MARKET PERFORMANCE
“IT IS HARD TO CAPTURE A RETURN PREMIUM IF ONE IS NOT
I
EXPOSED TO THE FACTOR THAT GENERATES THAT PREMIUM.”
”
L
LARGE ORDERS OF NEEDED NAMES AND ASK
TRADERS TO ACT ON THEM WITH PATIENCE.”
US EQUITY
RESEARCH UPDATE
QUARTERLY INSTITUTIONAL REVIEW
“THE BOTTOM LINE IS THAT...DIMENSIONAL FOCUSES
T
ON THE OVERALL CHARACTERISTICS OF A STRATEGY.”
FIXED INCOME
E
INTERNATIONAL EQUITY
QUITY
FOURTH QUARTER 2007
THE COST OF IMMEDIACY
The inclusion of the ask-bid spread in
transaction costs can be understood
best by considering the neglected
problem of “immediacy” in supply and
demand analysis. Predictable immediacy
is a rarity in human actions, and to
approximate it requires that costs be
borne by persons who specialize in
standing ready and waiting to trade
with the incoming orders of those who
demand immediate servicing of their
orders. The ask-bid spread is the markup
that is paid for predictable immediacy of
exchange in organized markets.
Under competitive conditions the askbid spread, or markup, will measure
the cost of making transactions without
delay. A person who has just purchased
a security and who desires immediately
to resell it will, on the average, be
forced to suffer a markdown equal
to the spread found in the market
place. This markdown (plus brokerage
commissions) measures the cost of
an immediate round-trip exchange.
Under less competitive conditions, this
spread may somewhat exaggerate the
underlying cost to those who stand
ready and waiting of quick roundtrip transactions, but, for any given
degree of competition (since brokerage
commissions do not vary with the
time taken to complete a transaction),
differences in spread will indicate differences
in the cost of quick exchange.
—Harold Demsetz
“The Cost of Transacting.” Quarterly
Q
Journal of Economics 82, no. 1 (February
1968): 33-53.
Research Update
p. 2
Despite the magnitude and reliability of the value premium, there is evidence that
the average value mutual fund fails to capture and deliver that premium to investors.
Dimensional Fund Advisors, on the other hand, delivered the value premium in large
and small cap value strategies to its investors from April 1993, the first full month in
which Dimensional had large cap value and small cap value strategies in the US, to
December 2005. The present article describes in detail the investment process that allowed
Dimensional to succeed where so many others have failed.
What’s New at Dimensional
p. 11
The material in this publication is provided solely as background information for registered
investment advisors and institutional investors and is not intended for public use. It should not
be distributed to investors of products managed by Dimensional Fund Advisors or potential investors.
Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. Dimensional
Fund Advisors is an investment advisor registered with the Securities and Exchange Commission.
This article contains the opinions of the author but not necessarily the opinions of Dimensional.
All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot
be guaranteed. This article is distributed for educational purposes, and it is not to be construed as
a recommendation of any particular security, strategy, or investment product.

2. QUARTERLY INSTITUTIONAL REVIEW
RESEARCH UPDATE
DIMENSIONAL
INVESTORS DO CAPTURE
THE VALUE PREMIUM
Part II
The first part of this article, published in the third quarter
2007 issue of Dimensional’s Quarterly Institutional Review,1
showed that the average value mutual fund has failed to
capture a meaningful share of the value premium in stocks,
and thus has failed to reliably deliver excess returns relative
to the average growth mutual fund. On the other hand,
Dimensional’s US small and large cap value strategies captured
and delivered the value premium in stocks to investors from
April 1993, the first full month in which Dimensional had
large cap value and small cap value strategies in the US, to
December 2005. Additionally, the Dimensional US Large
Cap Value strategy outperformed the universe of large cap
value mutual funds by an average of 17 basis points per
month, while the Dimensional US Small Cap Value strategy
outperformed the universe of small cap value mutual funds
by an average of 30 basis points per month during that same
period.2
Dimensional’s ability to capture and deliver that premium
is not a random event,3 but rather the result of a skillful
investment process that combines scientific research into
the sources of financial risks and returns with rigorous
portfolio design and expert implementation of the strategies
through clever portfolio management and unique trading
techniques.
The second part of this article, published here, describes
that process. From the set of clearly defined philosophical
investment principles to the dynamic integration of
portfolio engineering, portfolio management, trading,
and the adoption of rules at every stage of the investment
process, every step of the investment process facilitates
that integration and, more importantly, contributes
to the delivery of value-added returns to investors.
Core Beliefs
At the core of Dimensional’s investment approach is the
proposition that public capital markets are informationally
efficient. Competition among different firms for investors’
capital and between buyers and sellers to find the most
attractive returns on their investments ensures that market
prices reflect most available information about fundamental
values. In these efficient and competitive public markets,
2
traded securities are fairly priced. For investors in search
of large expected returns, the key, then, is to identify the
dimensions of expected stock returns and to target those
dimensions that are compensated with higher expected
returns.
Dimensional’s approach does not require one to
determine which securities are mispriced today or to
forecast which of those securities will be fairly valued
tomorrow, or to have an ability to identify and profit from
any market inefficiencies that may or may not exist. It does
require, however, that once the dimensions of expected
stock returns have been identified, strategies be designed
and implemented to target those dimensions accurately,
continuously, and in a cost-effective manner. In addition,
Dimensional believes that there are opportunities to
provide value-added returns by managing around market
frictions such as momentum and by providing services
such as liquidity to other investors who want immediacy
in their trades and are willing to pay for that immediacy.
A Dynamically Integrated Investment Process
Portfolio engineering, portfolio management, and portfolio
trading are the three main steps of the investment process. At
Dimensional, those three steps are dynamically integrated so
that decisions made at one level of the investment process
facilitate decisions made and tasks performed at the other
two levels. For instance, how an asset class is defined—a
decision made at the portfolio engineering level—will
impact the flexibility of portfolio managers to manage
around market frictions and to minimize turnover—a
portfolio management function—as well as how efficiently
trading can be implemented—issues related to the portfolio
trading function. Other money managers, on the other
hand, don’t necessarily take into account the impact that
decisions made at one step of the investment process have
on the other two steps, and they segregate their activities.
Portfolio Engineering
Portfolio engineering can be broadly divided into three
steps: (1) finding the dimensions that determine expected
returns; (2) designing strategies that target those dimensions;
and (3) defining asset classes along those dimensions in such
a way so as to (a) accurately capture the returns of those asset
classes and (b) set rules that minimize unnecessary turnover.
As shown in the first part of this article, US large cap
value stocks outperformed US large cap growth stocks by an
average of 4.4% per year from January 1928 to December
2006, while US small cap value stocks outperformed US
small cap growth stocks by an average of 6.1% per year. In

3. QUARTERLY INSTITUTIONAL REVIEW
international developed markets and in
throughout the whole period. Having hold
emerging markets, value stocks have also
ranges in time may make an index easier
“AFTER ALL, IT IS
historically outperformed growth stocks.
to track and reduce portfolio turnover, but
HARD TO CAPTURE A
Similarly, from January 1928 to
it does so at the expense of what matters:
RETURN PREMIUM IF
December 2006, US small cap stocks
continuous exposure to the asset class and
ONE IS NOT EXPOSED
outperformed US large cap stocks by an
the investment of cash flows in the desired
average of 4.6% per year. In international
asset class.
TO THE FACTOR THAT
developed markets and in emerging
Table 1 shows Russell indices’ average
GENERATES THAT
markets, small company stocks have also
allocation in June, just before their
PREMIUM.”
historically outperformed large company
reconstitution, to securities that leave the
stocks.
indices during the reconstitution process.
Those patterns in the behavior of stock
Between 1990 and 2006, an average of
returns are consistent with the Fama/French three-factor
35% of the Russell 2000 Growth Index was allocated in
model, which posits that, in equity markets, expected returns
June to securities that left that Index at reconstitution. For
are a function of an asset’s exposure to three common factors:
the Russell 2000 Value Index, that percentage was 29%. So,
a market factor, a size factor, and a relative price factor.
if one wanted to gain exposure to the small cap value asset
Thus, strategies that have higher expected returns are those
class by investing $100 in a fund indexed to the Russell 2000
that have more focused exposure to those factors. Investors
Value Index in June, on average, $29 of those $100 would be
that seek high expected returns—and are willing to accept
invested in securities that do not satisfy an updated definition
the corresponding multifactor risks—should tilt strategies
of the asset class.
toward small cap and value stocks.
To capture the return premiums associated with the
TABLE 1
factors that determine expected returns, strategies need to
AVERAGE ALLOCATION IN JUNE TO SECURITIES
LEAVING THE INDEX AT RECONSTITUTION
EA
be designed in such a way so as to be continually exposed
1990-2006
to those factors. After all, it is hard to capture a return
RUSSELL 3000
1.59%
premium if one is not exposed to the factor that generates
that premium. This may seem to be an obvious point—and,
RUSSELL 3000 VALUE
11.86%
perhaps, it is—but it is one that is often overlooked by many
RUSSELL 3000 GROWTH
12.69%
market participants, which may partially explain why the
RUSSELL 1000
2.18%
average value mutual fund fails to capture and deliver the
RUSSELL 1000 VALUE
12.00%
value premium. Achieving a continuous exposure to those
RUSSELL 1000 GROWTH
12.77%
factors has a cross-sectional component as well as a timeRUSSELL 2000
20.06%
series component.
RUSSELL 2000 VALUE
28.53%
First, value strategies need to be broadly diversified across
the universe of value stocks to maximize the reliability of
RUSSELL 2000 GROWTH
35.17%
the outcomes. As financial economists Eugene F. Fama and
Source: Compiled by Dimensional from Russell securities data. Indices are not available for direct
investment. Their performance does not reflect the expenses associated with the management of
Kenneth R. French have shown,4 the value premium largely
an actual portfolio.
comes from an unpredictable set of value companies that
dramatically outperform their peers and move from value
A look at the difference between the weighted average
toward growth. A value strategy that is not well diversified
market capitalization of the Russell 2000 Index and that of
may exclude from its holdings the very same companies that
the Dimensional US Small Cap Portfolio over time leads to
generate most of the value premium, which may prevent
a similar conclusion. On Chart 1, as we move further away
value investors from capturing that premium. The size
in time from reconstitution, the difference between the two
premium is the result of a similar process. These processes
weighted average market capitalizations gradually increases.
reinforce the need to have diversified portfolios to reliably
At reconstitution, the weighted average market capitalization
capture the factor premiums.
of the Index sharply drops and moves closer to that of the
Second, strategies need to maintain that broadly diversified
Dimensional US Small Cap Portfolio. That is an indication
exposure over time. To minimize turnover, many indices and
that, unlike the Dimensional strategy, the Index does not
money managers have hold ranges in time, whereby they
necessarily maintain a focused exposure to the small cap asset
hold a set of securities for a given period of time regardless
class throughout the year—only during the reconstitution
of whether those securities fit the definition of the asset class
period and soon thereafter.
3

4. QUARTERLY INSTITUTIONAL REVIEW
CHART 1
WEIGHTED AVERAGE MARKET CAPITALIZATION OF THE
RUSSELL 2000 INDEX – US SMALL CAP PORTFOLIO
300
250
200
150
100
50
1/2005
2006
2007 4/2007
Russell data copyright © Russell Investment Group 1995-2007, all rights reserved.
turnover will be higher and that portfolio trades will be more
exposed to downward and upward momentum—that is, the
tendency of losers (winners) to continue to perform worse
(better) than indicated by their exposures to the market, size,
and relative price factors.
Table 2 shows the annualized returns from 1977 to 2006
for various momentum factors around the world. These
factors are derived by ranking stocks on their cumulative
performance over the previous twelve months.5 For US small
cap stocks, the difference between the returns on a portfolio
of winning stocks and the returns on a portfolio of losing
stocks rebalanced on a monthly basis is 15% per year. For
large cap stocks in the United States and in international
developed markets, that difference is around 5.5%. Given
those magnitudes, the failure to take into account the effects
of momentum when evaluating the costs and benefits of
rebalancing a portfolio and the frequency of rebalancing can
have a large impact on returns.
The failure of many in the investment industry to rebalance
strategies on a continuous basis to ensure that exposure to
TABLE 2
an asset class is maintained throughout the year introduces
MOMENTUM RETURNS
1977-2006
unnecessary uncertainty into an investor’s asset allocation. In
the case of managers whose strategies are indexed to the Russell
UNITED STATES
ANNUALIZED RETURNS
indices—or, to any internally developed or commercially
US Large Caps
5.6%
available index—their rigid tracking of the indices ensures
US Small Caps
15.0%
that they do not have continuous exposure to the asset class
WORLD DEVELOPED EX US
they are targeting. The reason is that those indices allow their
Large Caps
5.4%
exposure to the asset classes they intend to represent to drift
WORLD DEVELOPED EX US, EX JAPAN
from one reconstitution period to the next, in some cases
Large Caps
7.3%
twelve months later. As they drift away from higher expected
return dimensions toward lower expected return dimensions,
Source: Kenneth R. French and Dimensional Fund Advisors.
the long-term performance of those indices and the strategies
indexed to them suffers. The effects of hold
Fortunately, those costs can be mitigated
ranges in time are even more pronounced
during the portfolio management process
“HAVING HOLD
when we analyze investors’ cash flows.
if portfolios are designed to give portfolio
RANGES IN TIME MAY
Because those flows are unexpected, they
managers and traders flexibility. In the
could come in on reconstitution day, in
absence of flexibility, a security may
MAKE AN INDEX EASIER
which case the manager would be buying
have to be purchased or sold at specific
TO TRACK AND REDUCE
the desired asset class on the perfect day
points in time, regardless of whether
PORTFOLIO TURNOVER,
(i.e., on the day on which the index most
that security is exposed to downward or
BUT IT DOES SO AT
closely approximates the targeted asset
upward momentum. With flexibility, the
THE EXPENSE OF
class); or those flows could come in on
negative impact of new value or small cap
WHAT MATTERS:
any other day, in which case the manager
companies with downward momentum
may be forced to buy what used to be the
characteristics can be mitigated by delaying
CONTINUOUS
desired asset class.
their purchase, while the positive impact
EXPOSURE TO THE
Having a continuous exposure to
of securities leaving the asset class with
ASSET CLASS AND THE
an asset class is not costless, however.
upward momentum characteristics can be
INVESTMENT OF CASH
Frequent rebalancing can continually
captured by delaying their sale. The idea is
FLOWS IN THE DESIRED
expose a strategy to the asset class whose
not to become a momentum trader and try
ASSET CLASS.”
returns it is targeting. However, frequent
to capture the returns of the momentum
rebalancing also means that portfolio
factor—which trading costs will prevent;
4

5. QUARTERLY INSTITUTIONAL REVIEW
rather, the idea is to deny liquidity for
The value added by rebalancing
momentum traders, which would ease this
monthly and applying both momentum
“DIMENSIONAL
market friction, and to avoid being hurt
filters—117 basis points in total for the
DESIGNS ITS
by downward momentum while enjoying
US large cap value strategy and 82 basis
STRATEGIES IN
the benefits of upward momentum in the
points in total for the international large
SUCH A WAY THAT
strategies.
cap value strategy—can be delivered for
PORTFOLIO MANAGERS
Table 3 shows the effects of having a
at least two reasons. First, Dimensional
AND TRADERS
continuous exposure to an asset class—in
designs its strategies in such a way that
this case, large cap value stocks in the US and
portfolio managers and traders have
HAVE ENOUGH
in international developed markets—while
enough flexibility to delay the purchase of
FLEXIBILITY TO DELAY
at the same time controlling for the impact
stocks affected by downward momentum
THE PURCHASE OF
of upward and downward momentum.
and to delay the sale of stocks affected
STOCKS AFFECTED
Moving from a large cap strategy to a large
by upward momentum, even if doing
BY DOWNWARD
cap value strategy increases the annual
so temporarily increases tracking error
MOMENTUM AND TO
return by 3% in the United States and by
relative to some target portfolio. That
4% in international developed markets.
flexibility limits the negative impact that
DELAY THE SALE OF
Adding a momentum filter to avoid buying
momentum can have on the strategies. It
STOCKS AFFECTED BY
companies that are exposed to downward
also denies momentum traders the liquidity
UPWARD MOMENTUM.”
momentum mitigates the negative impact
that they need to lower their trading
of downward momentum and adds an
costs and perhaps make a momentumadditional 44 basis points per year to the
based strategy profitable. Second, the
international large cap value strategy and 89 basis points per
momentum screens that Dimensional has implemented
year to the US large cap value strategy. Because there is more
have enabled portfolio managers to incorporate momentumrebalancing and trading in value and small cap strategies,
related information when deciding potential trades.
momentum effects become more important for those types
The final step in the portfolio engineering process is to
of strategies. For that reason, the monthly rebalanced strategy
define an asset class in a way that accurately captures the
controls for both upward and downward momentum. These
returns of that asset class and makes implementation of asset
monthly rebalanced strategies add 38 basis points to the
class strategies less costly.
international large cap value strategy and 28 basis points to
Value stocks are often defined as stocks with a low market
the US large cap value strategy.
price relative to fundamentals such as book value, cash
flows, earnings, dividends, or sales. That definition, while
appropriate in most cases, is not appropriate in all cases.
TABLE 3
PROVIDING A CONTINUOUS EXPOSURE AND CONTROLLING FOR
Recognizing those cases in which it is not appropriate can
MOMENTUM INDEX RETURNS (NO COSTS)
help us capture more accurately the returns of the asset class.
1976-2006
Let’s instead define value stocks as stocks with high expected
WORLD DEVELOPED EX US
LARGE CAP LARGE CAP VALUE
returns. This definition allows us to exclude from a value
REBALANCING FREQUENCY
ANNUAL ANNUAL MONTHLY
portfolio stocks such as real estate investment trusts and
regulated utilities that are often considered to be value stocks
DOWNWARD MOMENTUM FILTER
YES
YES
but are fundamentally different from value stocks.6
UPWARD MOMENTUM FILTER
YES
Table 4 shows monthly average returns and three-factor
AVERAGE ANNUAL TOTAL RETURN (%)
13.08 17.28
17.72
18.10
regression coefficients for REITs, utilities, and several
UNITED STATES
MARKETWIDE MARKETWIDE VALUE
indices. From 1979 to 2006, the monthly average return for
REBALANCING FREQUENCY
ANNUAL ANNUAL MONTHLY
the REIT portfolio was 1.28%, while the monthly return
for the Dimensional US Small Cap Value Index was 1.58%.
DOWNWARD MOMENTUM FILTER
Looking at the factor exposures to the market, size, and relative
UPWARD MOMENTUM FILTER
price factors—as measured by the b, s, and h coefficients,
AVERAGE ANNUAL TOTAL RETURN (%)
13.43 16.54
17.43
17.71
respectively—for REITs and small cap value stocks, we
Source: Data simulated by Dimensional Fund Advisors. Simulated returns do not represent
can see that 27 basis points, or 90%, of the performance
trading in actual accounts, and the performance results do not represent the impact that material
economic and market factors might have on the decision-making process of a prospective investor
differential between REITs and the Dimensional US Small
if the assets had been actually invested during that period. Simulated performance may differ from
Cap Value Index can be attributed to their different exposure
actual performance because simulations are built through the retroactive application of a strategy
designed with the benefit of hindsight.
to the market factor.7 REITs and small cap value stocks had
5

6. QUARTERLY INSTITUTIONAL REVIEW
a similar exposure to the value factor (0.64 for REITs vs. 0.69
for small cap value stocks), so they both capture a comparable
fraction of the value premium.
TABLE 4
ASSET CLASS RETURNS
1979-2006
MONTHLY
AVERAGE RETURN
E
Utilities
1.12%
Dow Jones Wilshire REIT Index
1.28%
Russell 3000 Index
1.15%
S&P 500 Index
1.15%
US Large Cap Value Index
Inde
1.38%
US Small Cap Value Index
1.58%
AVERAGE MONTHLY PREMIUM
MKT – T-BILLS
0.65%
b
0.66
0.66
1.01
1.00
1.11
1.07
s
-0.16
0.45
-0.08
-0.22
-0.06
0.81
SMB
0.17%
h
0.61
0.64
0.02
0.01
0.60
0.69
HML
0.42%
Sources: Utilities data provided by Fama/French. Dow Jones Wilshire data provided by Dow
Jones Indexes. Russell data copyright © Russell Investment Group 1995-2008, all rights reserved.
The S&P data are provided by Standard and Poor’s Index Services Group. US value indices are
compiled by Dimensional from CRSP and Compustat securities data. Indices are not available for
direct investment. Their performance does not reflect the expenses associated with the management
of an actual portfolio.
A similar story emerges when we look at regulated utilities
and compare them to large cap value stocks. From 1979 to
2006, the monthly average return for the utilities portfolio
was 1.12%, while the monthly average return for the US
Large Cap Value Index was 1.38%. Again, most of the
performance differential between utilities and large cap value
stocks can be attributed to their different exposures to the
market factor. The differences in exposure between utilities
and large cap value stocks to the size and value factors are
trivial, as is the impact on the performance of utilities relative
to large cap value stocks that arises from those differences.
In contrast, Russell and other fund managers do not
exclude these lower expected return securities from their
value indices and strategies, which drives down their expected
returns by not capturing a fraction of the largest of the three
factor premiums, the market premium (see Table 5).
TABLE 5
REITS AND UTILITIES ALLOCATION WITHIN RUSSELL INDICES
AS OF DECEMBER 31, 2006
RUSSELL
1000
RUSSELL RUSSELL
RUSSELL RUSSELL
1000
1000 RUSSELL
2000
2000
VALUE GROWTH
2000 VALUE GROWTH
UTILITIES
3.9%
6.5%
1.4%
3.0%
0.1%
5.6%
REITS
2.2%
3.5%
0.8%
7.5%
11.8%
2.9%
Source: Russell data copyright © Russell Investment Group 1995-2008, all rights reserved.
Finally, we look at how an asset class is defined, as that
6
can have a considerable impact on portfolio turnover and, by
extension, trading costs. For instance, let’s focus our attention
on an example that is easy to explain, the international small
cap asset class. There are at least three ways of establishing
the breakpoints that separate small cap stocks from large
cap stocks. First, size breakpoints can be determined using
a market percentile approach, in which a fixed percentage
of the market (e.g., the bottom 12.5% of the total market
capitalization of a country or group of countries) is targeted.
Under this approach, each country or group of countries
has a weight in the strategy that is proportional to the size
of its market and, additionally, each country’s weight is
identical across all size segments (e.g., all countries have
the bottom 12.5% of the total market capitalization in the
small cap universe and the top 87.5% of the total market
capitalization in the large cap universe). However, the market
percentile approach has two well-known problems. First, it
does not have size integrity across markets. For instance, the
company at market capitalization percentile 87.5 in New
Zealand has a market capitalization of approximately $370
million. In Switzerland, the company at that same percentile
has a market capitalization of approximately $8.5 billion.
Second, the value of the market percentile breakpoint that
divides large caps and small caps in a market is driven by
the performance of the mega cap companies in that market.
That performance induces large turnover in small caps
due to breakpoint movements and not due to companies
outgrowing their size range. Mega cap companies tend to
represent a large fraction of the market capitalization in each
country; so, given that the breakpoint is a function of the
market capitalization (e.g., 12.5% of a country’s total market
capitalization), differences in performance—and volatility—
between those large companies and the rest of the market
affect the breakpoint between large and small companies and
generate unnecessary turnover.
A second way of defining size breakpoints is to use a fixed
market capitalization level measured in USD or some other
international currency (e.g., small cap companies are defined
as those companies with a market capitalization of $3.2
billion or less). The main advantage of this approach is that
it achieves perfect size integrity across markets. The main
disadvantage of this approach is that the percentage of the
market that falls under a size segment can vary widely across
countries. For instance, using a $3-$3.5 billion breakpoint,
the small cap universe would cover as much as 47% of the
total market capitalization in New Zealand and as little as 4%
of the total market capitalization in Switzerland. In addition,
a hard-dollar ceiling does not reflect market movements,
which can lead to an inaccurate definition of an asset class and
unnecessary turnover. This breakpoint methodology may also
trigger higher turnover due to currency volatility, which is an

7. QUARTERLY INSTITUTIONAL REVIEW
external factor. In the particular case of a USD breakpoint in
portfolio management can be expressed by the Fama/French
a world ex US portfolio, it is not natural to have a breakpoint
three-factor model as shown in the following equation:
denominated in a currency that is not the currency of any
of the countries in the portfolio. A large appreciation or
R – Rtarget = a + (b – btarget) (Mkt – Tbills) +
depreciation of the US dollar relative to the currencies of
(s – starget) SmB + (h – htarget) HmL + e (1)
the countries in the portfolio could trigger large—as well as
costly and unnecessary—rebalancing events.
Equation 1 gives us an indication of how close an actual
The third approach to defining size breakpoints, the
portfolio is to the target portfolio. It is the responsibility
approach that Dimensional developed more than five years
of portfolio managers to move the actual portfolio in the
ago, is to use a fixed number of names to define size segments
direction of the target portfolio. Pure indexers and other
within each market. This approach avoids the turnover
rigid portfolio managers intend to have zero tracking error
generated by the performance of mega cap companies in
with respect to some target portfolio, which means that those
a country or group of countries and the turnover due to
portfolio managers need to closely match the target weights
currency volatility. It also provides good
of every security in their portfolio at every
asset class stability because changes in
point in time. In the case of pure indexers,
“THE MOMENT A
the value of the breakpoint are correlated
those weights are determined by the
PORTFOLIO MANAGER
with the performance of small caps,
behavior and composition of the index; in
and turnover is generally a function of
the case of active managers, those weights
WANTS TO HAVE
companies outgrowing the asset class,
are a function of their real or perceived
ZERO TRACKING
not the result of breakpoint volatility. To
ability to identify mispriced securities that
ERROR WITH RESPECT
maintain a consistent market capitalization
will be fairly valued at some time in the
TO SOME TARGET
representation and size integrity across
future. Zero tracking error also means that
PORTFOLIO, HE
markets, the number of names can be
the difference between the actual and the
CHANGES THE NATURE
chosen so that (a) it represents a similar
target exposures to the market, size, and
fraction of the total market capitalization
value factors is always equal to zero (i.e.,
OF HIS TRADES IN A
of each country or group of countries and
b = btarget, s = starget, and h = htarget), as is the
WAY THAT IS HARMFUL
(b) the market capitalization value of the
error term, e, in Equation 1.
FOR THE PORTFOLIO.
breakpoint in any country is within a
But there are no clear benefits to that
HE NOW REQUIRES
given range of the market capitalization
type of rigid management style. The
IMMEDIACY IN HIS
breakpoints of all the other countries. These
expected return on the error term is equal
TRADES.”
two goals can be enforced with bounds
to zero, so making the error term equal zero
to minimize turnover and guarantee the
produces no net benefits (i.e., it does not
appropriate asset class exposure.
increase the expected return of a portfolio)
We have attempted to describe some of the steps of the
beyond the reduction of tracking error relative to an arbitrary
portfolio engineering process. In the next two sections, we
benchmark. What is worse, zero tracking error with respect
explain how those steps and rules in portfolio engineering
to some target portfolio is likely to have a negative impact
facilitate the task of portfolio managers and traders.
on performance because it leads to higher trading costs as a
result of trading specific securities at specific points in time.
Portfolio Management
The moment a portfolio manager wants to have zero tracking
error with respect to some target portfolio, he changes the
Because trading does not occur in a vacuum, portfolio
nature of his trades in a way that is harmful for the portfolio.
managers must balance the benefits of implementing
He now requires immediacy in his trades, which forces him
portfolios that achieve the desired asset class exposure versus
to conduct those trades as a liquidity seeker, not as a liquidity
the costs of achieving that exposure. How portfolio rules are
provider, and pay a cost for that immediacy.
implemented can have a significant impact on (a) whether
At Dimensional, on the other hand, actual portfolios are
the actual portfolio achieves what it set out to do (i.e., deliver
close but not exact approximations of the target portfolios.
the returns of the asset class); and (b) at what cost. The rules
How close of an approximation will depend on transactions
also give portfolio managers enough flexibility to deal with
costs and, in some cases, taxes. But, clearly, in a world where
events that cannot easily and efficiently be codified into rules,
trading is not frictionless, continuous rebalancing to achieve
such as cash flows from clients, for instance.
the exact target portfolio weights at all times is not a sensible
The interaction between portfolio engineering and
strategy.
7

8. QUARTERLY INSTITUTIONAL REVIEW
Therefore, accepting some tracking
limits, indifferent as to stock A or stock
error with respect to a target portfolio
B, than if he has to hold X shares of stock
“IF THERE IS NO NEED
gives portfolio managers and traders a
A and Y shares of stock B at all times, or
FOR IMMEDIACY IN
lot of flexibility. For instance, a portfolio
if he has to buy X shares of stock A and
ANY GIVEN NAME,
manager expecting cash inflows or outflows
Y shares of stock B at a specific point in
PORTFOLIO MANAGERS
in the near future can use those flows to
time. And this is what allows portfolio
CAN CREATE LARGE
rebalance portfolios closer to their target
managers to manage portfolios around
ORDERS OF NEEDED
weights by buying securities that belong
market frictions such as momentum
to the asset class or by selling securities
using substitution and a patient trading
NAMES AND ASK
in the portfolio that no longer meet the
approach. To be sure, flexible trading can
TRADERS TO ACT ON
definition of the asset class. Although
generate biases in the portfolio, but it is
THEM WITH PATIENCE,
the portfolio engineer obviously does not
the responsibility of portfolio managers to
BUYING WHEN
have information about cash flows when
control those biases over time without the
LIQUIDITY SEEKERS
designing the portfolios, the portfolios
need to pay for immediacy. Like herding
ARE WILLING TO PAY
are designed in such a way that portfolio
cows, you do not waste resources imposing
managers can use that information in a
the right position to each cow; you just get
FOR THEIR IMMEDIACY
valuable way.
all of them moving in the right direction.
NEEDS.”
This flexibility allows portfolio
managers to substitute, for instance,
securities that are not currently affected by momentum for
otherwise similar securities that are affected by momentum.
Portfolio Trading
It also allows portfolio managers to create flexibility when
trading. If there is no need for immediacy in any given name,
The final element of the investment process is trading.
portfolio managers can create large orders of needed names
Since its inception in 1981, Dimensional Fund Advisors has
and ask traders to act on them with patience, buying when
sought to enhance net returns by keeping trading costs low,
liquidity seekers are willing to pay for their immediacy needs.
avoiding trades that greatly impact market prices, trading
The ability to substitute names and the interaction between
patiently and with flexibility, and trying to provide liquidity
traders and portfolio managers create unique opportunities
to the market. Dimensional supplies liquidity to index and
to capture value. For example, using fictitious numbers, a
active managers in search of immediacy. The bid/ask spread is
portfolio manager can give traders $100 million in orders to
a very simple measure of the cost of immediacy for a nominal
trade the best $50 million, the $50 million worth of trades in
amount of shares.8 Liquidity providers earn the spread, while
which he can trade as a liquidity provider and earn a premium
liquidity seekers pay for it. Table 6 shows bid/ask spreads for
for doing so. In contrast, a non-flexible portfolio manager
stocks in international developed markets in different market
must give $50 million in orders to trade $50 million, and
capitalization segments. The spread increases from 20 basis
these $50 million must be allocated to
points for the largest stocks to 189 basis
a specific number of shares for specific
points for the smallest stocks.
“THE BOTTOM LINE
names, regardless of liquidity constraints
To get an idea of the benefits of being
or other market conditions.
able to trade as a liquidity provider instead
IS THAT, UNLIKE
The bottom line is that, unlike indexing
of a liquidity seeker, we conduct a simple
INDEXING AND ACTIVE
and active management, which focus on
experiment. We take the Russell 1000
MANAGEMENT, WHICH
exact numbers of shares for each individual
Value Index, the Russell 2000 Index,
FOCUS ON EXACT
stock, Dimensional focuses on the overall
and the Russell 2000 Value Index and
NUMBERS OF SHARES
characteristics of a strategy. This allows
reconstitute them at the end of September,
FOR EACH INDIVIDUAL
portfolio managers to treat stocks that
approximately three months after the
have similar characteristics and belong
official reconstitution date, for every year
STOCK, DIMENSIONAL
to the same asset class as close substitutes
between 1990 and 2006. We then look
FOCUSES ON
for one another, which facilitates trading.
at the monthly average returns for the
THE OVERALL
In other words, a trader will have more
actual indices and for the lagged indices
CHARACTERISTICS OF A
chances to trade opportunistically and take
from July to June, from October to June,
STRATEGY.”
advantage of favorable trading conditions
and from July to September. The lagged
if he is, within certain diversification
indices outperform the actual indices
8

9. QUARTERLY INSTITUTIONAL REVIEW
by an average of 3, 15, and 18 basis points per month,
respectively, from July to June (see Table 7). In the case of the
Russell 2000 Index and the Russell 2000 Value Index, those
performance differentials are statistically reliable.
From October to June, when the actual and the lagged
indices are the same, there are no differences in performance
between the two sets of indices. But from July to September,
when the actual indices and the lagged indices have different
components, the differences in performance between the two
sets of indices are huge: 13 basis points per month in the case
of the Russell 1000 Value Index, 59 basis points per month
in the case of the Russell 2000 Index, and 70 basis points per
month in the case of the Russell 2000 Value Index.
TABLE 7
THE COSTS OF IMMEDIACY
MMEDIAC
LIQUIDITY SEEKERS VS. LIQUIDITY PROVIDERS
JANUARY 1990-DECEMBER 2006
INDEX
(%)
LAGGED
INDEX (%)
DIFFERENCE (%)
S.E.
(%)
T-STAT
RUSSELL 1000 VALUE
1.05
1.08
-0.03
0.02
-1.79
RUSSELL 2000
1.03
1.19
-0.15
0.04
-4.32
RUSSELL 2000 VALUE
1.20
1.38
-0.18
0.04
-4.31
RUSSELL 1000 VALUE
1.45
1.45
0.01
0.01
0.95
RUSSELL 2000
1.59
1.60
-0.01
0.01
-1.87
RUSSELL 2000 VALUE
1.73
1.74
-0.01
0.00
-0.01
JULY-JUNE
OCTOBER-JUNE
TABLE 6
TRADING COSTS
MARKET CAP
($ MILLIONS) NAMES
> 5,000
1,500-5,000
677
842
PERCENT OF
BID/ASK TRADING VOLUME
MARKET CAP SPREAD (%)
PER ISSUE ($)
79.3
0.31
0.20
0.31
111,044,603
14,558,882
500-1,500
1,128
5.3
0.56
3,542,329
200-500
1,150
2.0
0.86
965,087
25-200
1,848
1.0
1.89
312,924
Source: Bloomberg (accessed Nov. 10, 2006). The bid/ask spread is generally regarded as an
indication of the cost of liquidity. The twenty-two developed markets are those in Dimensional’s
eligible universe (Canada, Europe, Japan, Asia Pacific, UK).
Having flexibility allows portfolio managers to avoid the
costs of immediacy in the execution of trades, and traders
may participate in the market anonymously with the intent
to capture liquidity in different ways and in different trading
venues. The cumulative performance drag created by
trading as a liquidity seeker instead of a liquidity provider,
as quantified in our simple experiment, ranges from 40
basis points for the Russell 1000 Value Index to 211 basis
points for the Russell 2000 Value Index over the threemonth period following reconstitution. The behavior of pure
indexers around reconstitution time, when they give priority
to immediacy of execution of trades to minimize tracking
error over cost of execution, tends to depress index returns.
The prices of stocks that enter the indices are pushed up
around reconstitution and then gradually come down, while
the prices of stocks leaving the indices are pushed down at
reconstitution and then gradually increase.
Although we cannot predict the future costs of immediacy
and careless trading, for as long as those costs remain positive
there will be market participants, Dimensional included, who
will try to take advantage of situations in which providing
liquidity earns some premium.
JULY-SEPTEMBER
INDEX
LAGGED
S.E.
(%) INDEX (%) DIFFERENCE (%) (%)
T-STAT
CUMULATIVE
RETURN DIFF.
OVER THREE
MONTHS
RUSSELL 1000 VALUE
-0.15
-0.02
-0.13 0.06
-2.34
-0.40
RUSSELL 2000
-0.63
-0.05
-0.59 0.12
-4.69
-1.76
RUSSELL 2000 VALUE
-0.40
0.31
-0.70 0.15
-4.82
-2.11
Source: Russell data copyright © Russell Investment Group 1995-2008, all rights reserved.
Note: The lagged indices are reconstituted at the end of September, three months after the official
reconstitution date for the Russell indices. Indices are not available for direct investment; their
performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is not a guarantee of future results.
Conclusion
At the end of the first part of this article, we stated
that Dimensional’s delivery of the value premium is not a
random event, but rather the result of a skillfully designed
and implemented investment process. This process,
schematically described here, has been successfully
tested in real markets for more than twenty-five years.
As markets evolve and our understanding of the sources
of financial risks and returns continues to improve,
Dimensional’s dynamically integrated investment process
will remain focused on the issues that matter: providing a
diversified and continuous exposure to the dimensions of
expected stock returns, balancing the different premiums
and costs related to the factors that determine expected
returns, and giving portfolio managers and traders the
flexibility to trade patiently as a liquidity provider and
using substitution to efficiently capture the desired
premiums. Together, all these ingredients form the basis
of Dimensional’s value-added proposition.
— Eduardo A. Repetto and L. Jacobo Rodríguez
9

10. QUARTERLY INSTITUTIONAL REVIEW
R
REFERENCES
1. See Eduardo A. Repetto and L. Jacobo Rodríguez, “Dimensional Investors Do Capture the Value Premium: Part I,” Quarterly Institutional
Review (Dimensional Fund Advisors), third quarter 2007: 2-7.
2. The data presented do not reflect recent market conditions, values, or returns. Past performance is no guarantee of future results and
current performance may be higher or lower than the performance shown. To obtain performance data current to the most recent month end,
access our website at www.dimensional.com/strategies.
3. From July 1927 to June 2007, the value premium, the difference between the average returns on a portfolio of value stocks and the average
returns on a portfolio of growth stocks, was about 5.6% per year on average. Despite the magnitude of the value premium in the United States
in the eighty years for which data are available, there is a risk that the premium will not be positive in any given period of time. If the premium
is compensation for common, non-diversifiable risks associated with the ratio of book-to-market equity or with any other measure of relative
prices, investors must be exposed to the risks that produce the value premium if they seek to capture it.
4. See Eugene F. Fama and Kenneth R. French, “Migration,” Financial Analysts Journal 63, no. 3 (May/June 2007): 48-58. Fama is a director
and consultant and French is a director, consultant and head of investment policy at Dimensional Fund Advisors.
5. For more information on how these momentum measures are constructed, please see http://mba.tuck.dartmouth.edu/pages/faculty/ken
.french/Data_Library/det_mom_factor.html.
6. For more information on REITs, see L. Jacobo Rodríguez, “Real Estate Investment Trusts,” Quarterly Institutional Review (Dimensional
Fund Advisors), fourth quarter 2006: 2-8.
7. The monthly market premium (0.65%) times the b coefficient for REITs (0.66) gives us the contribution to the return of REITs from
exposure to the market factor (0.43%). Similarly, the market premium times the b coefficient for the US Small Cap Value Index gives us the
contribution to the return of small cap value stocks from their exposure to the market factor (0.65% × 1.07 = 0.70%).
8. See Harold Demsetz, “The Cost of Transacting,” Quarterly Journal of Economics 82, no. 1 (February 1968): 33-53.
10

11. QUARTERLY INSTITUTIONAL REVIEW
WHAT’S NEW AT DIMENSIONAL
• New Products Launched
Dimensional Fund Advisors launched a US Social Core Equity 2 strategy in October. This strategy targets the same
universe of companies as the US Core Equity 2 strategy—that is, marketwide coverage of US stocks with increased
exposure to small cap and value stocks—but excludes certain companies and industries that do not pass the social
screens set up by an independent third-party provider of social issue exclusions. These screens do not necessarily
reflect the beliefs held by or causes supported by Dimensional.
Dimensional also launched a TA US Core Equity 2 strategy in October. This strategy targets the same universe of
companies as the US Core Equity 2 strategy and employs a tax-advantaged investment approach to minimize the
federal income tax implications of investment decisions.
For more information about these new strategies or any other Dimensional products, please contact your regional
director.
• Quarterly Institutional Review Wins Spotlight Award
Dimensional Fund Advisors’ Quarterly Institutional Review was honored with a Spotlight Award by the League
of American Communications Professionals. The Spotlight Awards recognize excellence in print, video, and web
communications. The Quarterly Institutional Review won a platinum award for being ranked first in its class—
magazine/newsletter for companies with $100 million to $1 billion in annual revenue—and number 72 overall out
of more than 900 entries from industries and organizations in seven countries. In its class, the Quarterly Institutional
Review edged out publications from ESPN and Wells Fargo Institutional Services, among others. All of us involved
in the production of this newsletter would like to thank the League of American Communications Professionals for
their recognition of our work.
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