DFA Fund Family: An Alternative to Smart Beta?
Smart beta may be all the rage right now, but there’s another fund family that’s quietly but exponentially growing using a similar investment approach. I’m referring to Dimensional Fund Advisors, which has been around for 34 years — long before the fundamental indexing approach often branded as smart beta was invented.
According to Morningstar, DFA is now the 10th-largest fund family with $295 billion in assets, as of May 31. During the past five years ended Dec. 31, 2014, all of DFA funds’ cash inflows have been greater than inflows to all of Vanguard’s fund offerings, when measured as a percentage of growth over asset base. Since DFA funds can, for the most part, only be purchased by individual investors through an advisor, this growth rate is even more astounding.
FAVORING SMALL CAPS
DFA funds are low cost, passive (but not indexed) portfolios that often allow advisors to tilt portfolios toward similar factors as used by smart beta, such as size, value, and profitability. The firm was founded in 1981 using research that demonstrated that small cap stocks outperformed large cap issues. Then, in 1992, when Eugene Fama and Ken French published research on what’s become known as the Fama-French Three Factor Model, DFA launched funds based on this framework as well. John Rekenthaler, Morningstar vice president of research, credits DFA for indirectly influencing the creation of the Morningstar style box, which uses these same dimensions to classify equity funds.
Both Fama and French have long been involved with DFA and — along with Nobel laureate Myron Scholes and Yale professor Roger Ibbotson — are members of its board of directors. Other DFA funds use other benchmarks, such as credit and term premiums for fixed income, and profitability measures for stocks. The fund family is now owned by employees, board members and outside investors.
Advisors using DFA funds have looked pretty good to their clients. Morningstar gives them high historic performance ratings, with (by my calculations) a weighted average performance across all categories of 3.5 out of five stars. According to Morningstar, DFA fund performance is especially strong in equities, which represent the lion share of their assets. Per David Butler, head of DFA Global Financial Advisor Services, about 55% of current assets are derived through the advisor channel while the rest comes from institutional investors. Newer distribution channels in retirement accounts such as 401(k) and college 529 plans are currently small but growing.
DFA funds are low cost and passive, but not indexed. DFA will let portfolios drift from their slated benchmarks in order to minimize trading costs and maximize tax-efficiency. For example, the DFA U.S. Small Cap Value (DFSVX) fund does not have to immediately sell a particular stock when it no longer meets the criteria for small cap or value. It can wait and sell it later in a more efficient manner. By comparison, a small cap value index fund would need to sell if that stock were no longer in the index it follows.
WORKING WITH DFA
DFA works with 1,500 to 2,000 advisory firms that, according to its website, comprise about $200 billion in assets. But advisors can’t just buy DFA funds for their clients; first they must be approved by DFA, which entails several steps.
First, the advisor must attend a conference that reviews the DFA philosophy and academic research in support of it.
If the advisor sees a fit, a DFA regional director visits the advisor to discuss the advisor’s support for the firm’s investment philosophy that markets are efficient, and that both low costs and high tax-efficiency are important. If there is a meeting of the minds, it can take several months to be approved, though Butler notes there is no specific time-frame.
Once approved, the advisor can now purchase DFA funds for his or her clients, but isn’t restricted to only purchasing DFA funds.
At this point, Butler says it’s important for the DFA regional directors get to know the advisor in order to better support them in building their practice. This includes providing them with data from DFA’s benchmarking surveys, which allows the advisor to compare their practice with others.
DFA also offers ongoing seminars to help advisors better understand the academic research behind the funds and how to design portfolios based on that research. Advisors can receive continuing education credits and are not charged to attend, although advisors must pay their own travel and lodging costs.
Other than retirement plans ‒ 401(k)s and 403(b)s and 529 college plans ‒ DFA has no intention of bypassing the advisor channel and offering its funds directly to retail investors. “We think advisors help keep investors disciplined,” Butler says.
The strategy appears to be working. According to the 2014 annual Advisor Brandscape report from Cogent Reports, DFA is the fund family far and away most often cited by advisors as their primary fund provider.
Rick Ferri, founder and managing partner of Portfolio Solutions, has been using DFA for the past 16 years and has $100 million of $1.4 billion assets under management in DFA funds.
“DFA is all about evidence-based investing,” Ferri says, noting that the firm’s conferences are second to none in the industry. “Where else can you go listen to Nobel laureate Eugene Fama talk about his latest research and ask any question you want?”
The firm’s benchmarking studies are extremely helpful in understanding how other advisors are constructing their portfolios and running their practices, Ferri adds. Asked if he’d like to see anything change at DFA, the advisor responds that he’d like to see the firm launch ETFs as a new share class in addition to its existing funds. The redemption process for ETFs, he notes, could add to the tax-efficiency of DFA’s existing funds.
Another advisor, Alex Potts, president and CEO of Loring Ward, says that his firm has roughly $12.3 billion of the $13 billion it manages in DFA funds. Potts notes DFA funds are a better performing vehicle and the best way his firm has found to capture the return of an asset class. “DFA provides a sense of community and helps advisors understand their practice,” Potts says.
COMPARING DFA TO SMART BETA
According to Research Affiliates, roughly $360 billion in assets are now in ETFs that use non-market cap weighting indexes. RAFI builds smart beta indexes by weighting individual stocks based on sales, cash flow, book value, dividends and other factors. Like DFA portfolios, this construction methodology also over-weights smaller cap and value companies.
Though they both harness similar factors, Bahnu Singh, a portfolio manager at DFA, says DFA factors in market cap when constructing a portfolio, while smart beta ignores price and constructs a portfolio based solely on non-market cap rules. But price contains information and ignoring it leaves that useful information on the table, Singh says.
He also notes that DFA updates its portfolios continuously, while smart beta portfolios aren’t updated until the underlying index is reconstituted periodically. Also, DFA has a three decade-plus track record, while smart beta funds are relatively new.
Both DFA and smart beta small- and value-tilted portfolios have clearly outperformed market cap-weighted portfolios over the past decade. Many who make use of these approaches believe the tilting leads to additional return without additional risk.
Singh is not so inclined. Because the factors used by these funds have been known for so long, he attributes the additional compensation to additional risk, although he acknowledges that risk is hard to measure and involves more than just looking at historic standard deviations.
COMPARING DFA TO VANGUARD
DFA equity funds have also outperformed Vanguard’s “dumb beta” market cap funds. Perhaps this is true even accounting for the more extreme tilting used by DFA. Morningstar assigns 4.0 stars to both families’ domestic equity funds, but gives the edge to DFA with a 3.3 rating versus an average 3.0 rating for Vanguard for international equities.
Vanguard, however, holds a clear lead in fixed income, although this asset class represents a much smaller portion of DFA assets.
But do investors get better returns? I tested Butler’s claim that DFA advisors help keep investors disciplined by asking Morningstar to compare the performance gap between the two fund families. The performance gap is the difference between investor returns (dollar weighted) and fund returns (geometric).
Over the 10 years ending Dec. 31, 2014, the DFA annualized performance gap stood at 1.28% versus only 0.22% for Vanguard. When I showed these figures to Butler, he responded, “It’s hard to make an argument about the discipline of advisors based on these figures.”
Was this the result of performance chasing? In a discussion with Russel Kinnel, Morningstar’s director of fund research, he suggested I look at the fund flows into DFA’s largest fund, the DFA Emerging Markets Value I (DFEVX).
Flows slowed significantly in the second half of 2011, when emerging market stocks declined, and outflows occurred in 2014 after the fund incurred losses in 2013 and 2014. For the 10-year period ending June 30, 2015, Morningstar showed a 6.21 annualized performance gap. In other words, investor and advisor discipline clearly has its limits.
Even so, are DFA funds right for your clients?
Low-cost products are gaining market share, be they cap-weighted indices, smart beta or DFA passive, driven by clients’ push to pay less. DFA has a long history of working with advisors and, of the three, is the only solution marketed primarily through the advisor channel. Also, DFA advisors strongly believe in the funds and receive great educational support.
“When you view the cash flow numbers,” Butler says, “it suggests that clients have been well-served by their association with advisors and Dimensional.”
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for The Wall Street Journal and AARP the Magazine and has taught investing at three universities. Follow him on Twitter at @Dull_Investing.