Step 11: Risk Exposure

Analyze your five dimensions of risk exposure

11.3.6

Selecting Investments

As a fiduciary for its clients, IFA only receives compensation from its clients and is therefore unbiased in its choice of investments. So, how is the wheat sorted from the chaff by an independent investment advisor, like IFA, that receives no payments from any products that it advises clients to invest in?
Since index funds are the only funds that use risk and return data that deploy a constant set of rules of ownership, they are the first screen of the thousands of mutual funds in the Morningstar database.

This process of elimination limits the choices down to about 1,300 index funds and exchange traded funds (ETF’s). ETF’s are essentially index funds that trade like stocks, but like individual stocks, they usually have commissions and spreads between bids and asks. Most importantly, investors need to consider the net expected return of each index fund representing each set of rules of ownership. A sorting of index funds, loads, fees, and expenses will quickly eliminate all but Vanguard and DFA index funds. Then another problem arises.

DFA funds require a minimum trade amount of $2 million per fund purchase unless the purchase is made through a DFA approved fee-only advisor that has demonstrated to DFA that it understands the current status of financial science. Most advisors require minimum account sizes of around $250,000, while IFA's standard minimum is $100,000. However, in 2012, IFA launched the Emerging Affluent Program, enabling investors with $50,000 - $100,000 to be matched with a risk-appropriate portfolio. DFA limits access to their funds so that fund shareholders are shielded from excessive trading by short term speculators who increase costs, cash drag and capital gains distributions to long term shareholders. A Morningstar study documented this benefit to DFA fund shareholders and concluded that individual investors guided by a DFA approved advisor made very smart decisions that allowed them to capture an average of 109% of the DFA fund returns, while other indexers only captured 82% of other index fund returns, a whopping improvement of 27%. This study supports DFA's wise decision to only make their products available when investors are guided by a passive advisor.

The primary difference between DFA and Vanguard is that they use different indexes to design their index mutual funds. DFA custom designs its indexes to capture the risk factors that explain 96% of stock market returns. Those factors include company size (market capitalization) and value (book to market ratio or BtM).

There are smaller size and higher value oriented stocks in DFA indexes. Based on the higher long-term returns of these factors, there are higher expected returns for long-term investors with DFA index funds. However, past performance is not a guarantee of future performance.

Vanguard is now a fairly aggressive proponent of “tandem investing,” which is a post-Bogle slogan that encourages Vanguard investors to mix in some actively managed funds in their portfolios. It is as if the dark force has encroached on this champion of investor protection and low costs. There is no conceivable or logical reason for Vanguard to do this, other than it can make higher fees off uneducated and unsophisticated investors.

DFA, for its part, is the purest among all mutual fund companies in their application of the Efficient Market Theory and low-cost structure. They have an added benefit of providing substantial index data going as far back as 1926.

Firm Connections: How Dimensional Teams with Leading Financial Thinkers

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As evidence of DFA’s unique position in the investment product industry, Dalbar surveyed investment advisors four times between 1997 and 2004. The study was titled “The Professionals’ Pick.” Dalbar's survey rated DFA the best overall no-load mutual fund company in 1997, 2000, 2002, and number two in 2004. DFA rated highest in the “Investment Management” and “Current Use” categories in the 2004 survey. See Table 11-1. The DFA funds are low cost, style pure and well diversified.

Table 11-1

"Changing of the Guard" by David J. Drucker Research

In 2010, DFA ranked number one in Barron's annual ranking of best fund families. Click here to read the full article.

11.3.7

The Advantages of Investing in Dimensional Funds

1. Dimensional Adds Value Without Relying on Forecasts

Over time, a structured investment approach based on financial science and the efficacy of capital markets will add value with a higher reliability and confidence level than one based on instinct and prophesy. Prudent investing involves deciding how much risk to take, then choosing asset classes to match an investor's preferred risk-return tradeoff. Dimensional (DFA) helps build strategies to deliver precise risk dimensions. But they are not a traditional investment manager—and traditional labels do not fit them because they design their own indexes and have refined their trading methods to minimize friction and costs.

A Non-Traditional Approach

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2. Investment Philosophy Is Grounded in Robust Academic Research

The Three Factor Model has replaced the Capital Asset Pricing Model in the work of financial economists. DFA's equity strategies capture the insights of the model, which has withstood rigorous open review by academics all over the world. Dimensional has forged working relationships with some of the world's leading financial economists to bring their latest theories and research to practice. Though bound to a rigorous scientific process, they also have an instinct for knowing what works with investors. DFA's founder, David Booth, provided the largest gift to any business college in the history of such gifts. He donated $300 Million to the University of Chicago, which then named the school The University of Chicago Booth School of Business.

Linking Science to Practice

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3. Diversification and Minimal Style Drift

Diversification is the most essential tool available to investors. It enables them to capture broad market forces while reducing the excess, uncompensated risk arising in individual stocks. DFA's strategies draw upon this power in numbers. Successful investing means not only capturing risks that generate expected return but reducing risks that do not. Avoidable risks include holding too few securities, betting on countries or industries, following market predictions, and speculating on "information" from rating services. To all these, diversification is the antidote. It washes away the random fortunes of individual stocks and positions your portfolio to capture the returns of broad economic forces.

Power in Numbers

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They also adhere to specific rules of ownership to maintain reliable asset class exposures. Their portfolio managers have no discretion to purchase stocks that do not meet these rules, and no financial incentive exists for them to deviate from the very specific disciplines.

Implementing the Science

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4. Smart Trading Increases Returns

Careful trading can reduce or even reverse the costs borne by traditional managers. Because Dimensional focuses on capturing the systematic performance of broad market dimensions rather than the random fluctuations of individual securities, they can keep costs low, patiently and expertly. They concentrate on favorable price execution that neutralizes the effects of momentum and index reconstitution and they maintain portfolio-specific hold ranges that reduce turnover and trading costs. This video explains DFA's trading advantage in their own words.

Our Trading Advantage

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5. Low Cost

In line with DFA's structured, scientific approach to investing, their investment management fees are positioned well below those of typical, traditional active managers and inline with other passive managers. Their patient and price-conscious buy-and-hold approach to trading is designed to minimize costs.

6. DFA is the Pioneer of Risk Factor Based Management Using the Three Factor Model for Equities

Dimensional has pioneered many strategies now taken for granted in the industry. The firm was originally founded in 1981 to provide institutional investors access to US small and micro cap stocks, underrepresented at the time in most portfolios. Dimensional later introduced its first value strategies based on the Fama and French Three Factor Model. In 2004, they launched core strategies that efficiently target risk factors across regional stock markets like the US and emerging markets. Financial science has demonstrated that investors are rewarded in proportion to the risk they take. Framing decisions around compensated risk factors in the equity and bond markets positions investors to market forces that create opportunities to build wealth over time.

Risk Means Opportunity

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The Three Factor Model offers a logical and useful framework for portfolio design, analysis, and investment discipline. It brings order and clarity to the investment process, isolating and explaining the market forces that drive returns in a portfolio.

Figure 11-5

A Unifying Model

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Dimensional's research has shown that the Three Factor Model on average explains about 96% of the variation of equity returns among fully diversified portfolios. Therefore, investing largely consists of deciding the extent to which your portfolio will participate in each of the equity market dimensions: small/large and value/growth. The greater the risk exposure, the greater the expected return.

Figure 11-6

7. Broad Line of Strategies for a Complete Total Portfolio

Dimensional's broad array of investment strategies offers calibrated exposures to the full spectrum of key asset classes across dimensions of size, value, and geography. The goal is to provide investors with global investment solutions that, at the total portfolio level, maximize returns at an investor's level of risk capacity.

The Strategy of Structure

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8. Clear and Accessible Philosophy and Approach

Dimensional strives to keep its process clear and transparent so that investors can easily understand it. Concepts such as the fact that market prices reflect the vast, complex network of information, expectations, and human behavior. These market forces drive prices to fair value, incorporating the global news, risk and expected returns appropriate for the investment. This simple yet powerful view of market equilibrium has profound investment implications that change the focus from short term speculation to long term investing.

Markets, Information, And Price

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9. Combination of Theory and Practice

By acting as a conduit between scientists and practicing investors, Dimensional has pioneered many strategies and consulting technologies now taken for granted in the industry. This feedback loop serves as an idea growth engine, positioning DFA to impliment these ideas into investment products. Dimensional has developed working relationships with some of the world's leading financial economists to bring their latest theories and research to practice. Though bound to a rigorous scientific process, they also have an instinct for knowing what works with investors. Financial science leads the way in understanding risk and return in securities markets. By maintaining a continuous feedback loop between the academic community, practitioners, and clients, Dimensional appears to be ahead of other firms at bringing academic research to investors.

Looking to Research

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10. Low Professional Turnover Strengthens the Team Process

IFA has known the DFA leadership since 1999 and they have remained committed to fostering a culture of learning, teamwork, innovation, and dedication to always doing what’s right for investors. To this end, the firm’s leadership brings a valuable perspective to their work and deep resources to enhance their offering. They have had very few departures among the portfolio managers and key personnel. The hiring of investment managers at Dimensional is the antithesis of the "Morningstar Star" system of managers that is the rule at most firms. DFA’s board members and consultants include some of the world’s most distinguished academic theorists: Eugene Fama, Kenneth French, Roger Ibbotson, Donald Keim, and Nobel laureates Myron Scholes and Robert Merton.

Dimensional's People

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11. Successful and Independent

Dimensional is one of the largest independently owned investment management firms in the world, with over $250 Billion in assets under management as of September 30, 2012. In the opinion of IFA, the firm has operated its business in a true fiduciary manner, keeping the the best interest of its investors in their business practices.

A New Way to Invest

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12. Excellent Service Provided to IFA

Dimensional appears eager to continue building relationships with institutional clients, financial advisors, and consultants through development of customized investment programs and an interchange of investment research and ideas. Dimensional serves a distinguished group of institutional and advisor clients. They structure support teams to connect with firms like IFA, to learn from them, to inform them of the key research and practical work that will shape current and future investment strategies.

A regional director services Index Funds Advisors. This approach keeps IFA fully informed of current research and developments while quickly addressing any questions we may have.

Dimensional also provides IFA with a wide range of communications resulting from internal and sponsored research. These range from investment research reports commissioned from leading academic centers to Dimensional's seminars providing general discussions on issues facing plan sponsors and advisors. Their direct links to the academic community provide a large body of original research supporting existing investment strategies and creating the foundation for new investment approaches. This is one of the many reasons we advise clients to invest in Dimensional funds.

Serving Clients - And Learning From Them

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13. DFA versus Vanguard

We are sometimes asked what the difference is between Vanguard, ETFs and DFA Index Funds. The short answer is they use different indexes. DFA has custom designed their indexes to capture the risk factors that explain 96% of stock market returns, going back to 1929. Those factors include company size (market capitalization) and value (based on the company's Book Value divided by its Market Capitalization, or Book to Market Ratio (BtM)). [also see DFA vs Vanguard]

IFA's concern with Vanguard: Vanguard investment plans 50% active funds? Say it ain't so...
- Here is an actual proposal with active funds! Where is Jack? What have they done to his song, Ma? And now they are offering a Hedge Fund (12/15/07)! "When asked about this departure from low-cost indexes, Ms. Chain pointed out that Vanguard actually manages more active assets ($680 billion) than passive ($600 billion). “We serve many clients beyond the investor who holds the 500 fund in an IRA,” she said.

In this presentation from Vanguard, Daniel Wallick speaks about the choice of active managers in portfolio construction. The data in Steps 3 and 5 of the IFA 12-Step program conclude that there should be no actively managed funds in portfolios.

Here are a few charts explaining why IFA prefers to advise clients to invest in DFA funds.

Figure 11-7

These differences in fund returns are explained by the difference in small and value tilts of the funds. When we assemble diversified portfolios and scatter plot the data, the chart below shows the combined impact of these fund differences based on risk and return.

Figure 11-8

The Vanguard Target Retirement Funds have not been around very long, but over this period, it clearly would have been better to be in the IFA constructed index portfolios. This is a short period, but the small value tilt is less in the Vanguard Funds than it is in the DFA funds.

Figure 11-10

14. IFA's concern with iShares

"To generate more revenue, Barclays has worked in recent years to build up its actively managed funds like hedge funds. About 21% of BGI's assets are actively managed, some in hedge funds. A recent report by Sanford C. Bernstein & Co. says BGI has been successful in subtly shifting to the higher fee, actively managed funds." WSJ 08/13/07. iShares are now owned by Blackrock, of which Merrill Lynch owns about 30% of the shares. Enough said.

Figure 11-11

15. Comparisons of Various Alternative Portfolios

IFA recommends that its clients invest primarily DFA funds when implementing a risk exposure. We also have a Diversified Index Manager implementation that we mostly recommend for large institutional investors. Short articles on DFA can be found at these links, 1 - 2 - 3 - 4 - 5 .

DFA originally designed their funds for large institutional clients. If you become our client, you will have the opportunity to invest alongside some of the world's largest institutional funds. For a list of institutional clients of DFA, click here.

Here are several portfolios constructed based on portfolios based on Vanguard Funds or iShares, portfolios recommended in various books or in target date funds. They are compared on the basis of risk and return. As you can see in every case, the portfolios based on IFA Indexes, using DFA indexes and DFA funds stitched together provide a more optimal solution. This is why we advise clients to invest in DFA funds. In a 2010 contest of 25 various passive portfolios, IFA's Index Portfolio 100 took top prize, beating the number two portfolio by an absolute 4.5%.

Figure 11-12

Figure 11-13

Figure 11-14

Figure 11-15

To compare DFA funds, based on DFA Indexes to the closestthird party indexes, see the table below. Youcan see the positive difference over the last 10 years and since inception.

Figure 11-16

It is often said that DFA funds are not "index funds." But as you can see below, the returns of portfolios of DFA funds closely tracks a same allocation of indexes of similar names, mostly from DFA. If you add back the 0.41% annual expense ratios of Portfolio 100, the 10 year, 6 month return is almost exactly the same as the same allocation of indexes.

Figure 11-16a

16. The Only Pure Passive Play is DFA

DFA is the only fund company that adheres to a non-forecasting, efficient markets strategy for all of their funds. All other firms that offer passive funds, also offer active funds and the active funds are more profitable for the firm.

It is normal for investors to be suspicious when an author or advisor leans so heavily toward one mutual fund company. Indeed, it is wise to be cautious of loads or 12b-1 fees that may be kicked back to the advisor. This is not the case with IFA and DFA. DFA has no loads or tailing fees for advisors and they provide the absolute best education of any fund company, including monthly updates on risk and return data and a software package to analyze the data. Simply put, they are the best in the business.

For reference, here are links to other index providers: Russell Indexes- Wilshire Indexes - Dow Jones Indexes - MSCI Barra Indexes - S&P Indexes. DFA does not publish its indexes, but IFA has modified them with fees and stiched together index and live fund data and presented them as the IFA Indexes.

11.4

Solution

11.4.1

One Hundred Index Portfolios

The answer to the investor’s dilemma is to design the most efficient set of portfolios. IFA has created 100 Index Portfolios, providing a solution that is individualized and indexed.

The graph below shows the risk and reward scatter plot for 20 of the 100 Index Portfolios and the component indexes for 2007, 2008, 2009, and 10, 20, 30, 40, 50, and 82 year periods.

Figure 11-17

We have assembled a continuum of risk exposures as summarized in histograms below. They are depictions of both the risk and return of 20 Index Portfolios. They are numbered and color coded to denote their risk level beginning with Portfolio 5 — Ivory at the lowest risk and up to Portfolio 100 — Bright Red at the highest risk. The charts show a histogram of monthly returns data going back to January 1928 on the left side and the growth of one dollar over the specified period on the right side. The risk capacity painting is also included to give an idea of the age appropriateness of each portfolio.

Figure 11-18

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Risk Capacity Surveys

One Hundred IFA Index Portfolios:

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IFA Index Portfolio 10

IFA Index Portfolio 20

IFA Index Portfolio 30

IFA Index Portfolio 40

IFA Index Portfolio 50

IFA Index Portfolio 60

IFA Index Portfolio 70

IFA Index Portfolio 80

IFA Index Portfolio 90

IFA Index Portfolio 100

Disclosures for Backtested Performance

Index Funds Advisors, Inc. — 19200 Von Karman Ave., Suite 150 — Irvine, CA 92612
Call Toll Free: 888-643-3133 — Local Phone: 949-502-0050 — Fax: 949-502-0048 — Email:
For several other offices and representative locations, see About Us.

Step 1: Active Investors

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Problems

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Step 2: Nobel Laureates

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Step 3: Stock Pickers

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Step 4: Time Pickers

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Step 5: Manager Pickers

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Step 6: Style Drifters

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Step 7: Silent Partners

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Step 8: Riskese

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Step 9: History

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Step 10: Risk Capacity

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