Making Cash Flows Count
This article discusses the systematic and important ways in which Dimensional Fund Advisors manages cash flows in and out of mutual funds held by New Capital’s clients.
KEY TAKEAWAYS
Dimensional makes buy and sell decisions every day based on numerous inputs.
This process allows us to use available proceeds on a targeted subset of portfolio holdings.
Our approach may increase expected returns and manage risk more reliably than deploying cash flows pro rata across portfolios.
When you go grocery shopping, do you typically purchase every single item consumed in your household, regardless of your current supply? Or does your shopping list tend to focus just on items you need to replenish? If you fall in the latter camp, you a) are less likely to have five jars of mayo in your refrigerator and b) can probably appreciate Dimensional’s approach to deploying cash flows, which seeks to add value by targeting specific securities rather than spending pro rata across the entire portfolio.
Whittling Down the List
Dimensional’s equity portfolios are broadly diversified, typically comprising hundreds or even thousands of stocks. But on any given day, we may only trade in a subset of the portfolios’ holdings. Our daily investment process takes into account numerous inputs when determining what we want to buy and sell (see Exhibit 1). A portfolio’s intended exposures to the size, value, and profitability premiums help generate an initial list of rebalancing candidates—securities we may want to increase or decrease our weight in based on their market capitalization, relative price, and profitability characteristics.
From there, we further refine the candidate list based on shorter-term signals. For example, downward momentum or high borrowing fees detract from a stock’s expected returns in the near term. These signals influence the timing of our trades—for instance, we may delay trading in a stock with adverse short-term considerations.
“A targeted approach to rebalancing, while potentially better from an expected returns perspective, is inconsistent with the objective of a typical index fund.”
Expected trading costs play an additional role in sizing orders and isolating the day’s trade candidates. Our goal is to avoid impacting security prices when we trade. By using smaller order quantities every day, we can minimize our influence in the market on a given day. Furthermore, if there is not sufficient liquidity to transact in a stock that day, we can wait to trade on another day when available volumes permit better trade execution.
Exhibit 1: Consider This
The intent of our order-generation process is to identify rebalancing candidates that increase expected returns and manage risk (see Exhibit 2). Not every stock will meet those objectives every day. Trading the portfolios in pro rata slices, meaning trading all holdings at their current weights, may be a less efficient way to spend cash flows. A flexible process with daily implementation can put those cash flows to better use by targeting a meaningful set of trades each day.
Exhibit 2: Targeting Meaningful Trades
This stands in contrast to the way indexed strategies are typically managed. Their goal is to minimize tracking error with respect to the index. Applying available cash flows pro rata across all holdings is an efficient way to do that. A more targeted approach to rebalancing, while potentially better from an expected returns perspective, is inconsistent with an index fund’s objective and the constraints it imposes.
In addition to sacrificing the balance between long-term and short-term stock characteristics, index pro rata trading may exacerbate style drift from infrequent index reconstitutions. For example, let’s say a small cap value index fund holds a stock that fit the asset class several months ago but has grown in price to become a large cap growth stock. Until the next reconstitution event, cash flows to the index fund will continue adding to this ill-fitting stock’s position.
Spending That Makes Sense
Assessing what’s already in your portfolio is like perusing your pantry before heading to the grocery store—it can lead to more-informed buying decisions. And if you go to the grocery store every day,1 spreading out your shopping efforts into smaller quantities, you may end up with more consistently fresh ingredients than buying in bulk. Similarly, a daily approach to rebalancing with the flexibility to use more targeted trades can help strategies stay more consistently focused on higher expected returns. And, if your idea of higher returns is accumulating vats of mayo, flexibility can help you expedite that as well.