How do you build a winning portfolio? Investment managers use techniques such as fundamental analysis, technical analysis, even social media analysis. They work hard to identify the "best" securities and to diversify by sector, capitalization and country. But under the rigors of academic research and analysis, those strategies have historically failed to live up to expectations.
The closest anyone has come thus far to catching the performance genie in a bottle has been factor analysis, which uses academic research to quantify the components of "alpha" (an asset's outperformance compared to the market overall) and turn it into an objective, repeatable model of security selection.
Since the 1960s, the traditional asset pricing model has been CAPM (the capital asset pricing model), which uses a single variable — an asset's beta, or correlation to the broad market — as a predictor of its expected future performance relative to some risk-free rate (cash or government bonds).
Then, in 1980, Rolf Banz, a former student of Eugene Fama, published a study finding that small-cap stocks had systematically outperformed large-cap stocks over time, research that resulted in the founding of Dimensional Fund Advisors (DFA) and the 1981 launch of its pioneering DFA 9-10 fund, which focused on small- and micro-cap stocks.
