November 4, 2013

Deconstructing DFA’s Secret Sauce

The exclusive funds beat both index funds and ETFs in several asset classes, according to one recent scorecard

DFA diehards tend to be proud and protective of their relationship with the exclusive fund family — Dimensional Fund Advisors works with fewer than 2,000 advisors — known for its deep value orientation and emphasis on empirical financial research.

As befits the financial sophistication for which the firm is known, the latest paean to the fund firm’s superiority is a three-factor regression analysis that DFA advisor Eric Nelson of Servo Wealth Management has undertaken with a view toward understanding which factors account for DFA’s excess returns.

Writing on his blog, the Oklahoma City-based advisor seeks to show that DFA’s superior returns derive not merely from fund design characteristics — factors that lead some investors to favor ETFs over mutual funds or index funds over actively managed funds, for example; rather it is superior fund management that makes DFA funds advantageous.

To demonstrate this point, Nelson compares DFA funds over the past 15-plus years in two broad categories for which multiple index fund and ETF alternatives exist: large value funds and small value funds.

He looks at how the DFA fund compared with two iShares ETFs and a Vanguard index fund in each category, then isolates how much did each fund’s value orientation, small-cap bias and management alpha contribute to performance.

The analysis seems to show that DFA is a different sort of creature than these other value products.

For example, in the large-value category, DFA’s annualized return of 7.2% far exceeded the 4.9%, 5.8% and 5.2% returns of the iShares S&P 500 value index, iShares Russell 1000 and Vanguard Value Index Fund.

Part of the reason for that, Nelson explains, is the fund’s 0.6 value coefficient compared to value exposure in the other funds ranging from 0.3 to 0.4.

That means that when value beats growth, the DFA fund will capture 60% of the outperformance compared with its peers’ 30% to 40%. And DFA gets this deeper value orientation by buying low price-to-book ratio stocks in the bottom quartile rather than the bottom half as is common with index funds, resulting in a deeper value bias.

The more diluted stock selection of DFA’s peers “results in watered-down and stale portfolios with much lower returns,” Nelson writes.

The DFA fund also outperformed its exposure to small-cap and value stocks by 0.1% through alpha (compared to its peers’ -0.1 to -1%), meaning through portfolio management emphasizing patient trading and lending of securities for added portfolio income.

“We can conclude that between 20% and 50% of DFA’s outperformance in large value stocks, a sizable sum, has nothing to do with their increased value exposure,” Nelson writes.

In the small-cap value comparison, Nelson found that management expertise had an even greater impact, accounting from between 40% and 70% of DFA’s advantage over its peers — beyond its deeper value orientation and more pronounced tilt toward smaller stocks.

What’s more, while DFA was consistently adding value in value exposure, size exposure and alpha, its peers evinced no such consistency:

“The best non-DFA index in the large value asset class, the Russell 1000 Value, was also the worst non-DFA index in the small value asset class, the Russell 2000 Value,” Nelson finds.

The Oklahoma City-based RIA concludes that fund management and fund design equally drive DFA’s performance edge:

“We find how DFA manages their portfolios (trading patiently, screening out non-asset class holdings, and generating securities lending revenue) on an ongoing basis is as important as how the portfolios are designed (greater orientation to small-cap stocks, deeper orientation to value stocks),” Nelson writes.

Despite these advantages, Nelson insists it is the advisor and not the fund company that makes the key difference in investor outcomes.

“Access to DFA is nice and they do a better job than other options, but the value we provide in developing an appropriate asset allocation and ensuring our clients stick with it through thick and thin is where the greatest value lies,” he tells ThinkAdvisor.

That said, Nelson is currently using DFA funds exclusively (though that is not a requirement that DFA imposes) for new clients — “not because…we are a ‘DFA advisor,’" he says, "but instead because in each asset class we use in a balanced portfolio (U.S. large growth, large-value, small-value, international large value, small value, emerging markets value, and global short-term bonds), we simply cannot find an ETF, Vanguard fund, or other passive strategy that is as diversified and captures the returns of the asset class as robustly and consistently as DFA does.”

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Check out Your Move, Bogleheads: Advisor Finds DFA’s Returns Trump Vanguard’s on ThinkAdvisor.

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