Cloning DFA

January 28, 2015

 

MakingEquityIndexesRelevantForLocalInvestors

Sometimes only a quarter of the returns come from a particular tilt, and there is variability in that tilt because Fama-French factors are not stationary over time. The important thing to note is that DFA and the indexes that we use as building blocks experience factor drift in the same direction from period to period (Figure 9).

MakingEquityIndexesRelevantForLocalInvestors

The coefficient drift isn’t coming from DFA putting less weight on “value” or more weight on “small cap”; it’s coming from the market. DFA’s emphasis on the factors is relatively constant, so the clone and DFA will rise and fall with the tide together. The factor control is illustrated in Figure 10.

MakingEquityIndexesRelevantForLocalInvestors

The Successful Clone
We have to address what it means to successfully clone something. A successful “clone” will “act the same,” i.e., have a pattern of returns that mimics the DFA portfolio as closely as possible. Statistically, this can mean many things: beta and correlation both close to 1, a minimum of tracking error, etc. However, each rule—on a stand-alone basis—suffers from some weakness.

 

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