Why Our Firm Uses DFA Funds

by Dougal Williams, CFA, 2/25/14

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Dougal Williams

Research shows that 80% of active fund managers underperform their benchmarks.1 Index funds virtually eliminate this risk of underperformance. Dimensional Fund Advisors (DFA), however, has engineered an even better mutual fund. This article explains key tenets of DFA’s approach and why it has resulted in a sizeable return advantage over both active and index mutual funds.

Unconventional success

For 30 years, DFA has consistently acted against the investment industry’s conventional wisdom. The firm maintains no Wall Street office, dedicates zero resources to economic forecasting and doesn’t allow individual investors direct access to its funds. This unconventional approach has been critical to fueling the firm’s growth – DFA now manages over $300 billion in assets.

Why the success? Performance. Returns in DFA’s mutual funds have trumped not only a majority of active fund managers, but also comparable index benchmarks.2 The firm’s flagship U.S. Small Cap Value Fund has returned 13% annualized per year since its 1993 inception.3That beats the Russell 2000 Index of small-capitalization stocks by 3.4% per year. DFA’s other funds show similar results.

Remarkably, this performance does not come from DFA’s superior skill at forecasting the economic future or picking better stocks. Traditional stock picking and market timing efforts, DFA says, are a waste of time and money.

If the firm is not feverishly trying to outguess markets, what is DFA’s secret? The firm embraces a passive approach based on decades of academic research. (University of Chicago’s Eugene Fama and Yale’s Roger Ibbotson are board members, and Dartmouth’s Ken French is the firm’s head of investment policy.) The idea is that markets are correct more often than they are wrong. The sheer existence of many diverse investors ensures prices reflect most, if not all, available information. No one can reasonably expect to know more than the market as a whole knows. Market prices are fair, and when prices are fair, stock picking and market timing become futile.

If this line of reasoning sounds familiar, it should. The largest fund company on the planet, Vanguard, has popularized passive investing and enabled the masses to invest in index funds, those well-diversified baskets of stocks that mirror indexes such as the S&P 500. But don’t confuse DFA’s funds with traditional index funds.

Not your typical index fund

For starters, anyone can buy index funds. DFA, meanwhile, offers its funds exclusively through investment advisors. The firm figures a good advisor will help protect clients from cutting and running during bad times (or plowing into funds after a good run of performance). Active in-and-out moves increase trading and tax costs, dragging down returns for all fund shareholders.

Not just any advisor can offer DFA funds. Only “authorized” advisors who meet the firm’s strict criteria can gain access to the funds. To become approved, an advisor must pay to attend two days of lectures from academics at company headquarters. Whereas many fund companies bring in motivational sales gurus to speak at meetings, DFA turns to its brain trust of rocket scientists and Nobel laureates to dive into the finer points of multiple regression analysis, risk factor exposure and book-to-market ratios. (1997 laureate Robert Merton is DFA’s “resident scientist.”)

DFA funds differ from index funds in a few other important ways. These differences often lead to significant long-term performance advantages.

Asset class versus index

Rather than follow a commercial index such as the S&P 500, DFA managers target entire asset classes. They have a particular expertise in targeting certain types of stocks – namely small-company and distressed-value stocks – which history has shown to be riskier. Riskier stocks can be more rewarding over the long haul. DFA deliberately targets these risks across many asset classes, some of which index funds miss – microcap, international small-capitalization and emerging-market small-capitalization stocks. DFA’s goal, it says, is not to mimic a retail index but to harness the returns of the asset class.

Smaller small-caps

Relative to most mutual funds – both active and index – DFA funds favor smaller and more value-oriented stocks. As an example, the average stock held in the DFA International Small Cap Fund has a market capitalization of $389 million. That’s just half the size of the typical company in the international small-capitalization index. DFA’s commitment to smaller stocks provides significant benefits for fund shareholders.

Including stocks others don’t

Dimensional funds are broadly diversified. They hold most, if not all, securities within their respective asset class. By contrast, many index funds select only a representative sample of stocks in the index, rather than owning every single stock. Using such a sampling technique helps index funds keep an important lid on trading costs. Research shows, however, that a small handful of stocks typically deliver the bulk of an asset class’ return each period. For example, of the roughly 5,000 stocks composing the U.S. market, the top-performing 10% accounted for more than one-third of the market’s total return. Investors who failed to hold these stocks earned just 6.3% per year, while fully diversified investors earned 9.6% per year.4 By diversifying thoroughly – DFA’s International Small Cap Fund, for example, owns nearly twice as many stocks as the comparable index – DFA ensures its funds fully capture an asset class’ return. Over time, this has made an enormous difference.

1. Morningstar and Lipper. Through January 2008, the Vanguard S&P 500 Index Fund outperformed 78% of all U.S. large-capitalization stock mutual funds over the prior 15 years. In the same period, 80% of intermediate-term U.S. bond mutual funds underperformed the Barclays Capital U.S. Aggregate Bond Index. Of the 20 top-performing U.S. stock mutual funds from 1983 to 1993, 16 (80%) failed to match the market return in the subsequent decade.

2. See Tables 1 and 2 on pages 5 and 6, respectively, of this paper.

3. Dimensional Fund Advisors. Annualized returns of the DFA U.S. Small Cap Value Fund, S&P 500 Index and Russell 2000 Index from April 1, 1993 through Dec. 31, 2013 Past performance is not a guarantee of future results.

4. Dimensional Fund Advisors. Historical annualized return of the Center for Research into Securities Prices (CRSP) 1-10 Index from 1926 through 2012. The CRSP 1-10 index is widely used in academic research as a proxy for the U.S. market of all publicly listed stocks. Eliminating the top 10% (in terms of performance) of the CRSP 1-10 each year reduced the historical annualized return from 9.6% to 6.3%.