How do DFA funds work?

 

That brings us to the third approach that is used by Dimensional Fund Advisors (DFA).  Unlike the index funds, Dimensional Fund Advisors do NOT rely on a commercial index.  Instead, the folks at DFA have leveraged the Nobel Prize-winning work of Eugene Fama and Kenneth French to take a slightly different approach to investing. As mentioned before, they focus on capturing the key “dimensions” that have been identified as existing in the marketplace.  These dimensions include:

 

• The equity premium – Stocks perform better than bonds over the long term
• The size premium – Small companies outperform large companies over the long term
• The value premium – Value companies outperform growth companies over the long term
• The profitability premium – More profitable companies outperform less profitable companies over the long term

 

Based on Fama and French’s academic work, DFA has implemented a systematic approach to identify each of these premiums and has utilized this approach to construct their investment funds.  The fact that DFA uses a data-driven approach that exploits persistent and pervasive dimensions is the primary reason that I prefer this approach.  However, there is one additional reason that I prefer this approach:

 

• It passes the “sniff test.” By the sniff test, I refer to whether or not something makes sense to me.

 

Each of the above premiums makes sense intuitively:

 

• I would expect owners (stocks) of companies to outperform lenders (bonds) to companies.
• I would expect small companies to have a better prospect of performing over the long term than big companies (yeah I love Apple, but how big can it get?)
• I would expect value companies to outperform growth companies (sure Facebook did great, but once upon a time there was this thing called MySpace. . .)
• I would expect well run companies (more profitable) to outperform poorly run (less profitable) companies

 

Personally, when I find something that has its foundation in the facts AND it makes sense intuitively, I am inclined to pay attention.

 

DFA and dimensional investing also differ from index funds in the implementation strategy.  Again, the index fund is targeted at mirroring the underlying index.  Stability and consistency are critical to success; however, rigid adherence to principles is often sub-optimal.  DFA has the flexibility to deviate from a rigid index.  As a result, there are several techniques used in the actual implementation of their funds.  These include:

 

• Maintaining Asset Class Consistency – On a daily basis, each holding is evaluated to ensure that it continues to match with the underlying asset class that the fund is targeting.
• Managing Momentum – Stocks do exhibit momentum in the short term. As a result, a small delay in selling when positive momentum exists and buying when down momentum exists has the potential to add value.
• Managing Trading Costs – By focusing on explicit costs (commissions, custody fees, and exchange fees) and implicit costs (bid/ask spread and market impact) trading costs can be minimized.
• Integrated Portfolio Implementation – By balancing the expected premium of the dimension with the expenses associated with turnover, implementation costs are minimized.
• Securities Lending – As the owner of a large amount of securities, DFA takes advantage of this position to “lend” securities to others in the market.

Finally, DFA funds are different than index funds in that they require investors to work with an advisor versus having direct access to the funds.  There are two reasons for this:

 

By going through advisors, DFA is able to minimize the impact on the flow of funds in and out of their funds. This helps DFA to avoid having to sell or buy at the wrong times.

 

DFA believes that most investors are better served by working with a financial advisor.

 

No doubt some folks reading this will find these last two points to be self-serving as I am a comprehensive, fee-only advisor.  Fair enough.  I would offer that for those individuals who (i) have spent the time to understand the financial planning process, (ii) fully understand the theory and mechanics behind portfolio construction, (iii) have the discipline to develop and implement an IPS, (iv) have the time to devote to their financial plan, and (v) have the ability to avoid poor behaviors associated with their emotions, the services of a financial planner may not add any value.  However, as a rule, a great number of individuals will benefit from using an advisor to help them with their investment decisions The Behavior Gap (click here to see what WSJ has to say on the topic).

Hopefully, you have taken away a few ideas after reading about the differences in these three approaches to investing.  Furthermore, hopefully, you will use the information provided to evaluate your approach to investing and make the necessary changes.  Finally, if you have any questions about the topics covered in this article, feel free to reach out to me at any point in time.  I enjoy working with entrepreneurs, corporate executives, and families to define their goals and make sure they have plans in place they are executing to achieve those goals.