Why We Use Dimensional Fund AdvisorsMarcus A. Winbush, CFP®
Our November 2013 newsletter included an article titled “Portfolio Update” announcing that we had begun using Dimensional Fund Advisors (DFA) mutual funds in our portfolio allocations. I am very pleased with our experience using DFA funds, and I would like to explain a bit more about why we are moving in this direction with our asset management. In this article, we will consider what the DFA difference means and why I am convinced it is such a good fit for our firm and for our clients.
The DFA difference begins with their commitment to apply a scientific approach to investing based on the best available academic research. From its beginning in 1981, DFA has continued to collaborate with pioneers in finance science from the University of Chicago and other universities, including Nobel Laureates Merton Miller (1990), Myron Scholes (1997), and Gene Fama (2013). Working with some of the world’s leading financial economists, DFA has been able to bring the latest academic theories and research to practice. This includes a long list of innovations such as Fama’s market efficiency research and the Three-Factor Model of stock returns developed by Fama and Ken French of Dartmouth College. Over the years, they have translated financial research into real-world investment solutions. As an independent investment advisory firm, we are convinced that this symbiotic relationship between investment strategies and academia offers the innovative building blocks we need when assembling our client portfolios.
Clearly, we’re not the only ones taking note of the correlation between DFA’s allegiance to evidence-based investing and its solid performance results. The January 4, 2014 issue of Barron’s featured a cover article by Beverly Goodman, “A Different Dimension,” devoted to DFA and the ideas that guide it. This was not the first time that DFA and Gene Fama were featured prominently in a major business publication. As far back as 1998, DFA was the subject of a Fortune magazine cover story called, “How the Really Smart Money Invests: Nobel Prize winners entrust their nest eggs to DFA where investing is a science, not a spectator sport.” Goodman’s January 2014 article was so positive that it inspired John Rekenthaler, Vice President of Research for Morningstar, to offer his own appraisal of the company (“The DFA Model,” Morningstar, January 7, 2014).
The Force Be With YouAlthough this may seem like a lot of attention to lavish on a mutual fund company, a closer look shows why the headlines are justified. In her article, Goodman says that “Dimensional Fund Advisors is unusual,” and Rekenthaler declares that DFA “really is different.” You would naturally ask, “In what way is it unusual and different, and why should anyone care?” Goodman answers these questions this way (Barron’s, January 4, 2014, p.1):
its [DFA’s] overall performance is headline-worthy. More than 75% of its funds have beaten their category benchmarks over the past 15 years, and 80% over five years, according to Morningstar—remarkable for what some investors wrongly dismiss as index investing. Its process is simple and repeatable—and yet no other firm has tried emulating it. When asked why, co-founder, chairman, and co-CEO David Booth, 67, draws a surprising analogy to Star Wars and Luke Skywalker’s inability to harness the power of the Force until his devotion was deep and unwavering. ‘We are believers down to our toes,’ Booth says. (Beverly Goodman, “A Different Dimension,” Barron’s, January 4, 2014, p.1)The folks at DFA are believers, indeed—true believers in an evidence-based investing approach founded on the best that science has to offer. As Morningstar’s Rekenthaler put it, DFA “is the most self-consciously academic of fund companies.” He also goes on to point out that the company possesses a unique business philosophy with respect to how it chooses which funds to offer and who will be allowed to offer them—a point we will say more about later.
True Believers and Efficient Markets
The first tenet of the true believers at DFA is the proposition that markets are “efficient.” I hasten to note that the concept of “market efficiency” has nothing to do with markets always being right or never being volatile; indeed, even the slightest real world observation confirms that this not the case. Instead, market efficiency (or, more precisely, “the Efficient Market Hypothesis”) states that markets generally embed most of what can be known about a stock into their current price. It is, therefore, difficult or impossible for any individual analyst or stock picker to develop valuable information not already reflected in that price.
Prices move around, to be sure, sometimes drastically. However, those movements occur in response to new information arriving on the scene, not from old information having delayed impact. That is, prices do not move based on old information that might have been available to some careful and perceptive stock analyst. Since new information arrives “randomly,” stock prices will, in the short-run, move up and down randomly, not predictably. Fama puts it bluntly, “active management is a zero-sum game, and that’s before costs. That’s not opinion. That’s math.” By this, I do not mean to say there aren’t predictable sources of return that we can work to harness. The key is to understand the power of the Fama-French Three-Factor Model.
Fama-French Three-Factor Model and Stock ReturnsIn 1993, Gene Fama and Ken French developed the Three-Factor Model to better measure market returns. Through research, they found that the return for any stock (or portfolio of stocks) was best explained by a combination of (1) its sensitivity to the stock market as a whole, (2) how big (or small) the stock was, and (3) how expensive (or cheap) it was—that is, how high or low it is priced relative to its assets or earnings. In terms of what an investor most cares about, the Fama-French Three-Factor Model tells us this:
|Small company stocks have higher returns than large company stocks||Low-priced (value) stocks have higher returns than high-priced (growth) stocks|
Rekenthaler notes that, with its focus on size and value factors, DFA indirectly “influenced the development of the Morningstar Style Box, which sorts funds according to the same two criteria of value-growth and size.” At True North, we’ve taken Morningstar’s two-dimensional style box and converted it into a three-dimensional graph that we believe more vividly illustrates a portfolio’s mix of large and small, value and growth stocks.
It’s not enough, however, to know that choosing to invest in small company and value stocks will impact the returns you earn. The strategy for how your advisor allocates those investments matters tremendously. This is one more way that DFA distinguishes its approach from that of the average index fund. As Goodman writes in the Barron’s article (January 4, 2014, p. 4):
Dimensional’s funds aim to capture the returns of an asset class—be it small or large companies, developed or emerging markets—without slavishly adhering to an index. And they do. For example, take the Vanguard Small Cap Value index fund (VISVX), which is based on the S&P 600 Small Cap Value index and is the counterpart to Dimensional’s DFA US Small Cap Value (DFSVX). The DFA fund has a much smaller tilt—its average market value is $1.1 billion, versus Vanguard’s $2.7 billion—and on all measures is much more value-oriented. So the Dimensional fund better captures the market-beating advantage of small and value stocks. In fact, a lot better: The DFA fund returned 42% in 2013, beating 88% of its peers in Morningstar’s small-cap value category, versus the Vanguard fund’s 36% return, which beat just 53%. Over 15 years, which includes periods that were less favorable to small and/or value stocks, DFA’s fund returned an average of 12% a year, beating 80% of peers. The Vanguard fund returned 10% on average, beating just 37% of peers. (Beverly Goodman, “A Different Dimension,” Barron’s, January 4, 2014, p. 4)
The bottom line is that these DFA-identified return boosters (i.e., stocks that are small cap and value-oriented) increase in return the more a portfolio is overweighted toward increasingly smaller cap stocks and increasingly deeper value stocks. That is to say, the tendency of small company stocks to have higher returns becomes more pronounced as the size of the companies gets smaller. Likewise, the tendency for low-priced “value” stocks to produce higher returns also becomes more pronounced as the price becomes ever lower relative to a company’s earnings or assets. DFA tends to overweight more toward small-cap stocks and stocks that are of deeper value than your average index fund.
And because they are not an index fund, the folks at DFA can also be much more patient when buying or selling stocks that qualify for inclusion in one of their portfolios. Thus, if a company’s shares suddenly qualify for one of DFA’s value portfolios because of a spate of bad news, the managers don’t have to buy right away but can wait for the bad news to be more fully reflected in the stock price. As Rekenthaler puts it, “DFA is leery of trying to catch a falling knife.”
Morningstar’s Rekenthaler also makes some interesting points about DFA’s business philosophy. He points out that, like Vanguard and American Funds, DFA is “… strategic in temperament rather than tactical. They launch relatively few funds, with those funds that they do create being part of a long-term plan rather than a response to current marketplace demands.” Rekenthaler also notes that all three companies tend to “keep their fund expense ratios low and their senior management in place.” Strong execution of this philosophy has led Dimensional to become the eighth largest fund company in assets, and they are continuing to grow. The obvious question then is this: Why don’t more fund companies follow DFA’s example? Rekenthaler adds the following observation (“The DFA Model,” Morningstar, January 7, 2014, p. 3):
You’d think that more fund companies would decide that having a unique strategic plan, one that makes the company look like no other, is better than being a commodity supplier by giving the marketplace what it desires. You would think. I doubt that DFA’s success will have much effect, however, just as American Funds’ and Vanguard’s have not. Bypassing a dollar today for more dollars tomorrow does not seem to come naturally to many fund-company executives. (John Rekenthaler, “The DFA Model,” Morningstar, January 7, 2014, p. 3)
The True North-DFA Connection
DFA’s strategies are only available to individual investors through a select group of independent, fee-based advisors. Before investment advisory firms like ours can work with DFA, they must undergo screening and training. Essentially, DFA looks for advisors who are committed to educating clients on the financial science that drives their investment philosophy, offering guidance and expertise to construct properly diversified portfolios, and encouraging the discipline essential to long-term investment success.
All these aspects are consistent with the investment philosophy we have held for 25+ years. At True North Capital Alliance, we believe in developing strategies that are grounded in the best scientific evidence the academic world can supply and then applying those strategies in a consistent and disciplined fashion. This is what led us to make DFA a significant part of our portfolio construction process, contributing, as it does, many important building blocks to nearly all of our clients’ portfolios. DFA has a very successful business model; we think it’s an example of a company doing well by doing good.