Dimensional Fund Advisors DFA
James Sweeney No Comments

Would you like to know how winners of the Nobel Prize in Economics invest? Look no further than Dimensional Fund Advisors (DFA). DFA has been implementing the great ideas in academic finance since it was founded in 1981. Nobel Laureates Eugene Fama and Myron Scholes sit on the firm’s Board of Directors, as well as several other notable academics.

By harnessing the greatest minds in the field and following a disciplined and rigorous implementation process, DFA has built an impressive track record of outperforming both benchmarks and peers. Dimensional now manages more than $600 Billion, making it one of the largest (and fastest growing) mutual fund companies in the country.

And yet, they are still unknown to some investors. Why?

  1. Only available through select advisors. DFA funds are not available to the general public in retail investment accounts. Instead, they are sold only through select financial advisors who have gone through a lengthy approval process.
  2. No Revenue Sharing. In order to keep the cost of their funds as low as possible, DFA doesn’t pay commissions or kickbacks to the advisors who recommend their funds. Lower costs mean higher returns for investors, but a lack of commissions acts as a deterrent to commission-based advisors.
  3. No Advertising. Because DFA only sells its funds through a select group of advisors, they have no need to advertise to the public. You won’t see commercials, magazine ads, or radio spots from DFA. Instead, they grow solely by attracting advisors who embrace their investment philosophy.

If you aren’t familiar with DFA, here are five reasons you should get to know them:

  1. Their strategies are developed using academic research
  2. They have a thoughtful implementation process that adds value to investors
  3. Their fund have some of the lowest expenses in the industry
  4. They only work with advisors who understand the research and have a disciplined approach
  5. Their funds have a long track record of outperforming

 

1. DFA’s Academic Approach

 

“People at Dimensional care much more about getting the right answer than defending their answer.”

KENNETH FRENCH – Professor, Dartmouth College. Dimensional Director, Consultant, and Co-Chair of the Investment Research Committee

 

Dimensional’s approach to investing is based on decades of academic research. This dedication to research creates a culture of seeking for truth and basing strategies on scientific evidence.

I can tell you in my years of working in this industry, this is a unique approach. Many fund companies take the opposite approach – letting the marketability of a strategy inform the investment decision.

What does the academic literature tell us about investing?

  1. Markets work. Capital-based economies thrive because markets work. The market is an effective information-processing machine and incorporates all available information on a company and its future prospects into securities prices. Intense competition drives stock and bond prices to “fair” value. This concept, known as modern portfolio theory, revolutionized the field of finance, and earned Eugene Fama a Nobel Prize.DFA Market Prices

Fortunately, throughout history, markets have rewarded disciplined investors for providing capital.DFA Growth of a Dollar

In US dollars. US Small Cap is the CRSP 6–10 Index. US Large Cap is the S&P 500 Index. Long-Term Government Bonds is the IA SBBI US LT Govt TR USD. Treasury Bills is the IA SBBI US 30 Day TBill TR USD. US Inflation is measured as changes in the US Consumer Price Index. CRSP data is provided by the Center for Research in Security Prices, University of Chicago. S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Long-term government bonds and Treasury bills data provided by Ibbotson Associates via Morningstar Direct. US Consumer Price Index data is provided by the US Department of Labor Bureau of Labor Statistics. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.
  1. Risk factors drive returns. Investors demand compensation for taking risk. As such, risk and reward are related – higher risk assets have higher expected returns. The return of a portfolio is largely driven by its exposure to various risk factors – or “dimensions” of return. The primary drivers of returns in the stock and bond markets are:DFA Dimensions of Expected Return
  2. Stock picking & market timing have low odds of success. Back in 1965, Michael Jensen did the first study of mutual fund manager performance. His research indicated that the vast majority of highly skilled and talented managers fail to beat their benchmarks. In fact, the number of managers who did outperform the benchmarks was no different then we would expect by simple random chance. Many studies have been performed since, with similar results. Over time, managers who attempt to pick stocks just can’t consistently pick them well enough to overcome the associated costs.

DFA US Mutual Fund Survivors and Winners

The sample includes funds at the beginning of the 15-year period ending December 31, 2017. Each fund is evaluated relative to the Morningstar index assigned to the fund’s category at the start of the evaluation period.  There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results.

 

2.    DFA’s Implementation Process

 

“It’s 10% having a good idea and 90% implementing that idea and making it work. Dimensional has been making it work for decades.”

ROBERT MERTON – Nobel laureate, 1997. Professor, MIT. Dimensional Resident Scientist.

 

Dimensional combines it’s deep knowledge of how markets work with a disciplined process that puts the odds in your favor.

Portfolio Design – Dimensional’s portfolios are designed to capture the risk factors that drive returns. For example, since the research shows that small company stocks outperform large company stocks, DFA’s portfolios will overweight the small stocks in order to capture this return premium.

DFA Portfolio Tilts

Patient trading – Most mutual fund managers are compelled to pay a premium when they trade due to the urgency of their investment decisions. However, DFA is different. They maintain flexibility in their trading, which reduces costs and improves returns.

DFA Patient Trading

Tax-efficiency – DFA funds are very tax efficient. Mutual funds incur taxes in the same way individual investors do – by selling stocks at a gain. The IRS requires mutual funds to pay out those capital gains on an annual basis, hitting investors with a tax bill. The way DFA minimizes these taxes is by avoiding selling. In other words, they buy and hold for a long run. These tax savings can add up significantly over time.

 

3.    DFA’s Low Costs

 

“The grim irony of investing is that we investors as a group not only don’t get what we pay for, we get precisely what we don’t pay for.”

JOHN C. BOGLE – Founder, The Vanguard Group

 

In investing, costs matter. Just a 1% difference in fees can add up to 100’s of thousands of dollars over your lifetime.

Affect of fees on growth

As discussed earlier, most stock pickers fail to outperform their benchmarks. Why pay a high price for something you have very low odds of actually getting?

Nearly all of DFA’s mutual funds’ fees are in the lowest 10% of funds in their respective categories. And many are in the lowest 2-3%.

 

4.    DFA’s Advisor Approval Process

 

“The important thing about an investment philosophy is that you have one you can stick with.”

DAVID BOOTH – Founder and Executive Chairman of Dimensional Fund Advisors

 

Dimensional’s approach to investing and their distribution strategy go hand in hand. As I mentioned earlier, DFA funds are not available to retail investors.

Why?

  1. Investor experience – Investing is an emotional experience. Markets go up and down and it can be difficult to maintain discipline when your investment strategy doesn’t seem to be working. There have been a number of studies done that show that investor’s returns tend to be significantly lower than the return of the funds they invest in. This happens because investors chase performance (they buy funds that have recently done well) and they flee danger (selling funds that have recently done poorly). While this instinct has served us well in some areas of life, is it a recipe for disaster in investing. Having an advisor who has a deep understanding of investing and who follows a disciplined approach can go a long ways in helping investors capture the returns that markets generate.
  2. Protect existing shareholders – finicky investors who are constantly buying and selling create a problem for existing investors. When investors add or take away money, portfolio managers have to put that money to work, buying and selling stocks. This increases costs for existing shareholders. It also can create tax problems if managers have to sell stocks with capital gains. For this reason, DFA prefers to have disciplined, buy and hold investors invest in their funds. By utilizing advisors who share their long-term perspective, they are able to protect their current shareholders and keep costs low.

This advisor approval process isn’t just a charade. DFA’s philosophy has served them and their investors well. For example, in 2008, when most mutual fund companies saw huge outflows – investors selling and running for the hills – DFA investors actually stayed disciplined and continued investing during this time.

DFA Investor Discipline

In USD. Dimensional estimated net flow data provided by Morningstar based on Dimensional’s US-domiciled equity mutual funds. Industry net new cash flow data provided by Investment Company Institute© based on the approximately 4,600 US-domiciled equity (domestic and international) mutual funds reported on an aggregate level to the Investment Company Institute©. This includes information on Dimensional’s US-domiciled funds during this period. For illustrative purposes only.

 

5.    DFA’s Track Record

 

“Our long-term results match the long‑term research.”1

DAVID BOOTH – Founder and Executive Chairman of Dimensional Fund Advisors. Dimensional Fund Advisors, 35 Quotations on a Better Way to Invest (July 2016).

 

DFA’s performance speaks for itself. Across time, markets and regions, Dimensional’s investment strategies have delivered outstanding performance relative to their respective benchmarks (see below) and peers.

DFA Track Record

Returns are annualized from the first full month and reflect compound returns and assume reinvestment of dividends and other earnings. Benchmark information available in the appendix. Returns in USD. Portfolios shown are a representative sample of product offerings considered to be early examples and flagship strategies with more than 15 years of performance. Performance for the portfolios is reported net of all advisory fees and includes reinvestment of dividends and other earnings. Performance data shown represents past performance and is no guarantee of future results. Current performance may be higher or lower than the performance shown. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. To obtain the most current month-end performance data, visit us.dimensional.com.

 

Switchpoint and DFA

As a fee-only fiduciary, Switchpoint’s only loyalty is to its clients. We have no sales relationship or duty to Dimensional Fund Advisors. We have used and will continue to use other mutual funds where we believe they have an advantage over a comparable DFA fund or in a category where DFA doesn’t currently operate.

However, we are an approved advisor with DFA and we do utilize their funds in our clients’ (as well as our own) portfolios. We choose to construct portfolios using primarily DFA funds for all the reasons described above. We believe that their funds offer our clients the best combination of a robust, research-based investment strategy, cost-effectiveness, tax efficiency, trading acumen and consistency of strategy implementation.

 

DFA Offers Peace of Mind

Finally, we believe Dimensional offers us and our clients peace of mind. Having an investment philosophy that is fully transparent and backed by decades of research helps us sleep at night. We don’t have to wonder about a star manager losing his touch or a new fad idea not panning out.

Instead, we can focus on activities that truly add value to our clients lives, like retirement planning and tax planning. We can spend more time understanding our clients needs and goals and then liberate them to enjoy the life that they desire.

If this is approach to investing appeals to you, schedule a complimentary, no-obligation introduction here.

You can also visit my website at switchpointfinancial.com, email me at james@switchpointfinancial.com or call 801-753-8538.