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The story of dimensional fund advisors is unlike that of any other fund company. You can't just buy shares. Rather, you must first observe a courtship ritual and then hire an adviser. And if you're patient enough to listen and you agree with DFA that no one can beat the market, you'll be allowed to own DFA funds. As DFA's chief investment officer, Eduardo Repetto, puts it: "If we show you the data and you believe the data, then we are here to serve."
Just like Saab's claim that its cars are "born from jets," DFA funds are born of eggheads. Nobel prize-winning economist Myron Scholes sits on DFA's board, as does University of Chicago finance professor Eugene Fama -- considered a shoo-in for a future Nobel award. Chief executive David Booth and director Rex Sinquefield, who co-founded DFA in 1981, were Fama disciples in college. "When I walk into a board meeting," says Booth, "I don't have to worry about being the smartest person in the room."
The DFA philosophy boils down to the relationship between risk and return. History shows that some riskier stocks -- those of small companies and those considered undervalued -- produce higher returns on average over time than other types of stocks. "But on average doesn't mean every year," says Booth. DFA clients must be willing to endure periods of drought.
But over the long term, many DFA funds boast impressive results. DFA's marquee fund, U.S. Small Cap Value, for example, beats every relevant benchmark. The fund, which invests mainly in U.S. stocks with the lowest 10% of market capitalizations, returned an annualized 11% over the past ten years (all return data is to August 1). That beat both the Russell 2000 Value index, which measures undervalued small-company stocks, and the typical small-company value fund by an average of almost two percentage points per year. And it left the large-company Standard & Poor's 500-stock index in the dust by nearly eight percentage points a year.
DFA's small-company emerging-markets funds are also outstanding. But many DFA funds that stray from the firm's small-and-value credo are just average (see the table on page 40). So it's important to understand what this company does best.
Tweaking the rules
By all appearances, DFA funds are index funds -- but with some twists. Traditional index funds and the DFA products both seek to own certain types of securities -- such as U.S. small-company stocks or large-company international stocks -- without making judgment calls about a company's earnings, its executives' abilities and other such criteria that managers of traditional funds assess in making buy-and-sell decisions.
But the brains at DFA say they employ three tactics that help generate those precious extra percentage points of return. The first ingredient is DFA's flexible approach to indexing. For example, research by DFA and others has shown that real estate investment trusts don't provide the small-company performance premium. So out they go from DFA's roster of small-company funds. Also nixed are small companies that have only recently gone public -- in DFA's early years, says Robert Deere, a portfolio manager and trading strategist, its small-company funds "were getting slaughtered" because they held IPOs. Now, the hard-and-fast rule is that DFA won't own an IPO until it's been trading for at least six months.
As a result of these and other tweaks, the holdings of DFA U.S. Small Cap Value and the Russell 2000 Value index may overlap by only 30%. Says Deere: "We've learned a lot of these things the hard way. They don't hand out manuals on this stuff."
So DFA highly values pragmatism and hires a lot of engineers, some of whom are former rocket scientists. Deere worked with General Dynamics on space shuttle-related projects, and Repetto has a PhD from Cal Tech in aeronautical engineering.
When it comes to scary stocks, DFA can be very pragmatic. For example, just because a stock is the right size for a DFA small-company portfolio doesn't mean DFA will buy it. Deere recalls a company in U.S. Small Cap Value called Enron. As Enron's share price soared in the late 1990s, the fund unloaded the stock because it had grown well beyond the definition of small cap. When Enron's troubles became clear early this decade, the stock began to plummet and, says Deere, "One day the software said, 'Guess what? It's baaaaack.'" In the old days, DFA managers would have repurchased Enron shares (which eventually became worthless) because it again met DFA's definition of a small, undervalued company. But, says Deere, managers now have the latitude to consider that "they're carting people off in handcuffs and there are lawsuits everywhere."
Staying in motion
Another tactic DFA uses -- buying and selling stocks based on momentum -- makes finance profs grind their teeth. Most academics subscribe to the "random walk" theory, which says that prices of individual stocks move at random and can't be predicted. But DFA believes that a stock that's moving dramatically one way or the other tends to stay in motion for a while.
So when a stock spirals down into small-company territory, DFA managers will hold off buying it, even if the company isn't plagued by bad news. Likewise, managers won't immediately sell a stock that soars beyond small-capitalization boundaries. They may, in fact, hold on to it for months.
DFA managers don't rush to buy a full position, especially when it comes to so-called micro caps. Over time, micro caps, often defined as stocks with market values of less than $250 million, have beaten large-company stocks by a whopping four to five percentage points per year. But micro caps tend to be thinly traded, and buying them carelessly can erode much of their performance advantage.
So, again, rather than track an index to the letter, DFA takes a pragmatic approach. It buys stocks when it can get good prices and avoids the rest. By trading patiently, DFA officials say, the funds increase returns in micro-cap stocks. Head trader Henry Gray uses this example: Say sellers want $10.10 per share for a stock but buyers want to pay $10. "If you're an eager buyer, you're thrilled to pay $10.05, and you'll probably pay closer to $10.10. At Dimensional, we say, 'We'll sit at $10 and wait for sellers to come to us.'" (For a look at micro-cap funds that you can buy directly, see Tiny Companies, Huge Potential.)
POSTED BY: Teddy (September 11, 2008 02:05 PM)
Its funny, really, when advisors (correctly) convert to a passive and structured approach to investing in stocks and bonds. But then, when it comes to picking "this small value fund" or "that international value fund", they will claim some active ability to select a better index or structured fund vs. DFA's offering?
If your goal is to build a diversified, global equity portfolio that is tilted towards small cap and value stocks worldwide, there is absolutely no reason to use iShares, Vanguard, or anyone else. This is just another form of "advisor marketing", and the client is the only one who ultimately gets hurt.
Cracks me up, really. We have been building portfolios this way for over a decade. And this allows us to spend 99% of our time working with our clients, not spending useless time evaluating the 10 different small cap index options out there to try and show how smart we are.
Its a funny business, what can I say. Overall, a good article. Probably should have commented on DFAs new Core Equity funds which all but replace the older component asset class mutual funds, but, that is just my opinion.
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