MacKenzie D. An engine, not a camera.. How financial ... - TiERA

Tests, Anomalies, and Monsters 101aged academics to work on subjects of interest to the firm by giving any professora share of profits from investment strategies derived from his or herideas” (Cohen 2002, p. 1).There is, however, more to Dimensional Fund Advisors than the exploitationof efficient-market research. Especially in its most distinctive domain—small-capitalization stocks—Dimensional’s traders also have to be economicsociologists, so to speak: that is, for example, why its initial products were notquite small-stock index funds. Small stocks are notoriously illiquid, which isone possible reason their prices were low enough to offer such attractiveaverage returns. A buyer such as an index-tracking fund who had to buy suchstocks faced having to pay what could be a considerable premium. A sellerwho had to sell (for example, because a firm’s market capitalization had grownto such an extent that it was no longer small enough to fall within the fund’sremit) might likewise have to offer a substantial discount.In consequence, Dimensional avoided an exact index-tracking strategy thatwould have left it little or no discretion over the content and timing of salesand purchases. Instead of being a customer, paying in order to trade, it successfullypositioned itself as in effect a market maker, making money out oftrading (Keim 1999; Cohen 2002). It encouraged other participants in themarket for small stocks to offer it blocks of stock that they wanted to sell, sothat it was able to buy at a discount rather than paying a premium.Encouraging others to sell to Dimensional had obvious potential disadvantages:a seller might have negative information about a stock’s prospects thatDimensional did not have, or a seller might go on immediately to sell furtherblocks of the same stock, depressing the price. To reduce the risk of beingexploited by those with whom it traded, Dimensional cultivated relationshipsof trust. “Preferred sellers were firms (and individuals within those firms) thatconsistently made full disclosure to [Dimensional] of everything they knewabout the stock,” including plans they had for further sales (Cohen 2002,p. 7).Dimensional’s traders operated a “penalty box” in the form of “a largeboard visible from any spot on [Dimensional’s] trading floor,” into which wereplaced the names of those who Dimensional’s traders reckoned had shownthemselves not to be trustworthy. “Depending on the severity of the infraction,a broker-dealer could stay in the penalty box for months or even longer.”(Cohen 2002, p. 7) Simultaneously, the firm was careful itself to act in a trustworthyway—for example, by not exploiting information about planned salesby selling ahead of them.As an increasingly significant presence in the market for small stocks,Dimensional affected that market by adding to its liquidity. If the circumstances