(Note: Most of this was written Friday night after the conference. Thoughts might be a little scattered but I wanted to get a lot down while it was fresh.)I’m sitting at LAX now with plenty of time on my hands thanks to a delayed flight. I just wrapped up a day and a half with Dimensional Funds in Santa Monica. I want to get down what I perceive to be the good and bad of what DFA is offering for investors and where they actually add value. First, if this all sounds foreign to you please start with this piece on my previous thoughts about DFA and other passive investment options.
First, the very good. DFA does the investment world a tremendous service by encouraging (and, in a roundabout way, funding) more academic research about the sources of equity and fixed income returns. The founders, staff and board of directors is littered with respected academics (including several Nobel winners) who are searching for answers to important questions about the investment markets. DFA then at times follows up on this research by evaluating methods to execute real-world investment strategy around their findings. This began with the small cap funds in the 1980s and over time has evolved to include the value premium and now profitability and (to a lesser extent) momentum factors. If nothing else, DFA is a laboratory where academic ideas are tested and proven.
Common refrains throughout the conference were:
“Trust markets,” “Evidence based,” “focus on what we can control: costs, taxes, diversification” and the concept that available information and the expectation of all market participants about a market or security is reflected in the price. These are good concepts and essentially all born out of the early work of Gene Fama and Ken French.
The basic construct for (nearly) all DFA stock funds is to exploit, to some degree, the small/value premium. From US large caps to emerging markets, DFA funds will be more tilted towards small cap stocks and value stocks than their “index” counterparts. I do not believe this is inherently good or bad, as excess returns from small and value come from higher risk historically. As a result, any attempt to benchmark DFA funds performance back to other passive options should correct for size and value factors to attempt to garner a true apples-to-apples comparison, which is difficult for most investors and their advisors. Additionally, DFA excludes REITs from both domestic and international stock portfolios, further skewing comparative results. (For example, any strategy that excluded REITs would have outperformed a market benchmark in 2013 and underperformed in 1Q 2014.)
I believe there is a generally misunderstanding about the “passive” nature of DFA. At a macro level, DFA argues for efficient markets and builds investment portfolios with an agnostic approach towards security selection. However, when it comes to the specific execution of these investment strategies, considerable leeway is given to both portfolio managers and fund traders as to the construction of the portfolio and timing and price of trade execution. In this regard, DFA’s strategy, while not active fundamental stock picking, is considerably more active than many people may believe. The difficulty is that without a benchmark to follow and without a market-weighted philosophy, DFA must make subjective decisions about 1) which securities to add/remove 2) when to add/remove them 3) at what price to add/remove them. At a governance level, DFA must walk a delicate balance between flexibility to execute the strategy and strict oversight of managers and traders. There is room for DFA to add value here, and also room for DFA to make mistakes here (as is the case with any more active strategy).
This more “active” nature of DFA’s execution is all the more true in their fixed income strategies, where portfolio managers are altering the term structure (maturity) and credit structure of the portfolios based on the shape of the yield curve and current yield spreads. This quasi-tactical approach to fixed income calls into question whether DFA truly believes markets are rationally efficient or if there are times and opportunities to earn higher risk-adjusted returns based on market conditions.
Ultimately I am going to be working with Dimensional in some capacity but I cannot stress enough that there is no investment cure-all, even from a company as storied as Dimensional (or, for that matter, Vanguard). Risk and return are inherently linked over the long term. Any deviation from the market portfolio must, by definition, experience periods of out-performance and under-performance. Investors (and their advisors) must decide if they are comfortable in deviating from a market-weight portfolio and consider the potential excess returns and excess risks in each situation.