Table 11-4 shows the simulated annual returns for 20 of the 100 IFA Index Portfolios going back to 1928.
Investing in index
funds assures a higher return with less risk than the average active
fund. According to the tenets of Modern Portfolio Theory, indexing
is inherently less risky than active investing. Because an index fund
holds all of the investments that comprise a discrete asset class,
it maximally reduces risk within that asset class. Although it’s
not possible to entirely rid diversifiable risk from investment portfolios,
index portfolios come very close. An indexer therefore incurs virtually
no diversifiable risk.
While it’s true that most risk is eliminated with a portfolio of 100 stocks, this is not always the case. The amount of risk not eliminated is what active money managers “leave on the table” as seemingly small amounts of diversifiable risk. Yet this risk can have a substantially negative impact on investment performance over the long run. Even the expected return of an active portfolio containing as many as 200 stocks can diverge one percentage point on either side of the market’s expected return. Although this differential is certainly not substantial in any one year, it can represent enormous differences in accumulated wealth when compounded over extended periods of time.
In short, the diversification advantage offered by indexing can’t be matched by any actively managed portfolio, whether it holds mutual funds or individual stocks and or bonds or some combination thereof.
has created index mutual funds to capture all important risk factors, and their
funds are hands down the best, most efficient index mutual funds available.
Members of the DFA team talk about engineering mutual funds that capture many dimensions of risk and returns.
The mutual funds based on the equities from the United States use certain Exclusion Rules as a part of the fund design. These rules address several areas of concern.
1. Asset Class Concerns: exclusion of foreign stocks, ADRs, REITs, closed-end investment companies and regulated utilities in the value strategies.
2. Pricing Concerns: exclusion of recent IPOs, firms in financial difficulty, bankruptcy, merger/tender offers, or corporate actions.
3. Trading Concerns: exclusion of firms with listing requirement problems or limited operating histories.
4. Other Concerns: exclusion of limited partnerships, firms that are still under consideration, or firms with inadequate data.
Unlike index funds that follow commercial benchmarks like the Russell 2000 Value, Dimensional defines asset classes based on a security's market capitalization and book-to-market (BtM) ratio and actively applies our own eligibility rules. To gain the purest representation possible, they exclude securities that do not exhibit the general characteristics of the defined asset class. They also eliminate securities that lack sufficient liquidity for cost-effective trading.
The graphic below illustrates the portfolio construction engineering process for the small-cap value asset class.
Engineering portfolios around broadly defined risk factors regularly generates opportunities for Dimensional traders to add value. Rather than replicate an index in mechanical fashion, their sophisticated rules of construction permit deviations from market cap weightings and allow for the integration of stocks among asset classes. This flexibility also allows DFA to reduce transaction costs caused by counterproductive trading. For asset classes defined by size, a slightly higher hold or "buffer" range allows DFA to hold securities that commercial indexes are forced to sell, which reduces turnover and can increase returns.
DFA’s objective is to capture real estate market returns. This
strategy is based on rigorously back-tested research and uses a disciplined
approach designed to achieve its objective. DFA’s real estate securities
strategy has the advantage of providing market-based pricing and daily
The portfolio is market-cap weighted and diversified. Investments are made in all eligible publicly traded REITs. The portfolio consists of shares of equity and hybrid real estate investment trusts (to the extent that at least 75% of the REITs’ assets are equity investments). The fund does not currently purchase shares of health care or prison REITs. The stocks in the portfolio represent more than $123 billion in market capitalization and pro rate ownership of several thousand properties. On at least a semi-annual basis, DFA reviews all eligible companies to assure that their principal line of business is real estate related.
IFA has replaced U.S. REITS in its IFA Index Portfolios with Global REITs. Global REITs are a combination of U.S. REITs and International REITs, and they have had roughly the same annualized return as US REITs. After adjusting for risk, however, their returns have been superior to U.S. REITs. The data that we have on them goes back to 1989.
July 1989 to June 2008
Citigroup Global REIT Index
Dow Jones US REIT Index
Source: DFA Returns Program
If we limit the time period to when we have live data for U.S. REITs, the numbers look very favorable for Global REITs.
February 1993 to June 2008
Citigroup Global REIT Index
DFA US REIT Portfolio
Source: DFA Returns Program
Even though it is shorter, this period may be considered more reliable
because the global index includes more countries that became investable
after the first few years.
In addition to REITS in developed countries, the Global REIT fund will be allowed to purchase REITs in emerging markets, which may add additional risk and return.
2) Therefore, adding international REITs to IFA’s portfolios is expected to increase their reward-to-risk ratio over the long-term.
3) The higher book-to-market ratio and lower average size of adding international REITs over US REITs is attractive. In fact, the average international REIT is currently selling below tangible book value. In addition, the number of REIT holdings is 281, an increase in diversification.
4) The international allocation of your whole index portfolio will be more in line with global allocation of equities.
If you wish to discuss this further, please contact your IFA advisor.
As in DFA’s other international strategies, DFA gains exposure to companies in emerging markets mainly by investing in the local market in ordinary common equity. Where advantageous, it may also invest in American Depository Receipts (ADRs) traded in the United States to gain exposure to an emerging markets country. For example, DFA purchases ADR’s in Chile because they provide broad coverage of the stock market and allows U.S. investors to avoid repatriation restrictions. In emerging markets, individual countries are characterized by a high degree of volatility and a low degree of cross-correlation among countries. DFA weights the countries in its emerging markets portfolios equally, maximizing diversification and minimizing overall portfolio volatility. DFA believes that a diversified portfolio of emerging markets’ equities complements a well-structured asset allocation.
This variable maturity strategy shifts the maturities of the portfolio as yield-curve changes create the possibility for lower risk with higher expected return outcomes. In recognizing the bond market as being highly efficient, the variable maturity approach does not anticipate changes in the yield curve; rather it seeks to maximize the risk-adjusted returns present in the current curve. Investors can further expand their opportunity set by also considering global bonds. If currency exposure is fully hedged, globally managed fixed income portfolios can provide higher expected returns and lower standard deviations.
Some investors believe that buying individual bonds and holding them to maturity is preferable to buying a low-cost, passively managed bond mutual fund. One commonly used approach is to create a bond ladder where consecutively maturing bonds are held and then re-invested at the top of the ladder as they mature. One problem with this approach is that it is not always in the investor's best interest to hold bonds to maturity. The other problem is that individual investors who buy bonds (particularly corporate and municipal bonds) pay high transaction costs. The chart below shows how the transaction cost decreases as the size of the transaction increases.
DFA's trading expertise serves their bond fund investors well. As the chart below shows, DFA's bond buys are substantially lower than prices paid by other bond buyers and their bond sells are higher than prices received by other bond sellers.
Several papers authored by Eugene Fama and Ken French, separately and together, are available for download through Social Science Electronic Publishing. Among them are seminal titles such as "Market Efficiency, Long-Term Returns and Behavioral Finance", "Value Versus Growth: The International Evidence", and their latest "The Equity Premium".
The names of these clients of DFA are indicated, with their consent, for information only.
|Health Care Service Corporation||California Institute of Technology|
|City of San Diego||PepsiCo, Inc.|
|Blue Cross of California||Stanford University|
|McKesson Corp. Foundation||Sprint Corporation|
|Boeing Corporation||Owens-Illinois, Inc.|
|Citibank Savings Incentive Plan||St. John's Hospital and Health Center|
|Credit Union National Association||Boise Cascade Corporation|
|Carnegie Mellon University||Salvation Army|
|Furniture Brands||Marin County Employee's Retirement|
|New Haven Community Foundation||Verizon Communications, Inc.|
|State of Maryland||WellPoint Health Networks|
|Sara Lee Corporation||Unocal|
|Cornell College||BellSouth Corporation|
|Lubrizol Corporation||State of Utah|
|People's Energy Corporation||Chicago Community Foundation|
|National Electric Benefit Fund||Nebraska Investment Council|
|PPG Industries, Inc.||San Francisco Foundation|
|Kellog & Company||City of Seattle|
|New Have Community Foundation||Premera Blue Cross|
|City and County of San Francisco||AT&T Corporation|
|Tribune Company||James S. McDonnell Foundation|
|County of Kalamazoo||Danforth Foundation|
|Los Angeles City Employee's Retirement System||The Missouri State Employee's Retirement System|
|County of San Diego||Public Policy Institute of California|
|Jewish Community Foundation||United Way Of Palm Beach County|
|Sandia Corporation||California Wellness Foundation|
Hopefully you understand our logic in selecting DFA. Let us reassure you that we are not paid anything by DFA and can invest our clients' assets in any mutual fund available in the U.S.
Listen to financial economist Kenneth French on the lack of value of commodites in your portfolio. In short, "it's just crazy." So is this a once-in-a-lifetime opportunity to climb about the commodities train, as many burned advisors are now saying? No, says Kenneth French, professor of finance at Dartmouth's Tuck School and the director of investment strategy at Dimensional Fund Advisors. There's no reason for most investors to own commodities. Contrary to popular belief, they aren't a good inflation hedge, and they don't provide a long-term real return that investors aren't already exposed to through normal stock ownership.
Here is the question and answer from the Fama French Forum.
"There seems to be some confusion about your opinion on the role of commodities in a portfolio, based on a conference presentation for financial advisors in 2004. Have your views changed since then?
Ken French: No, my views have not changed—at least on this topic. Here's the thrust of my 2004 presentation. The claims that, going forward, commodity funds (i) will have the same Sharpe ratio as the stock market, (ii) will be negatively correlated with the returns on stocks and bonds, and (iii) will be a good hedge against inflation can't all be true. Who would want the other side of this trade? The high volatility of commodity prices makes it impossible to accurately estimate the expected returns, volatilities, and covariances of commodity funds, but theory suggests that if commodity returns are negatively correlated with the rest of the market, the expected risk premium on commodities is small, perhaps negative. Finally, commodity funds are poor inflation hedges. Most of the variation in commodity prices is unrelated to inflation. In fact, commodity indices are typically 10 to 15 times more volatile than inflation. As a result, investors who use commodity funds to hedge inflation almost certainly increase the risk of their portfolios. Six years after my presentation, I still think these points are correct. Commodity funds are probably a good investment for some investors, but not for the reasons many of their advocates suggest."
Here is what Warren Buffett said about gold. (see another article here)
times, commodity futures can turn out a strong performance. When they
do, they seem to make a very appealing addition to an investment portfolio.
But is the addition of an investment in a commodity futures index really
such a great idea?
Proponents of commodity futures assert that the investment vehicles offer a positive average excess return. Additionally, it has been asserted that the addition of commodity futures to a conventional equity and fixed income portfolio can significantly reduce portfolio risk with added diversification, and deliver a great hedge against inflation.
If, through an investment in commodity futures, an investor can increase returns, lower risk and hedge against inflation, why wouldn’t
we all buy them? And to further that point, why would anyone ever sell
them? Both of these questions can be answered in a study conducted by
Truman Clark, former professor of finance at University of Southern California. Clark’s analysis of commodities futures investments is titled “Commodity
Futures in Portfolios” and was published for limited distribution to institutional investors and financial advisors in 2004.
Clark’s in-depth study of commodity futures includes experiments using the Goldman Sachs Commodity Index (GSCI), the industry benchmark. He stated that not one of the claims regarding excess returns, reduced risk or hedge against inflation was strongly supported by the empirical evidence.
Clark concluded the following:
First, the average excess return of the GSCI over T-Bills was indistinguishable from zero. The average expected return of fully collateralized commodity futures may not be any greater that the Treasury bill return.
Second, an investor who added the GSCI to his/her equity and fixed income portfolio had very limited potential to reduce standard deviation to achieve a constant level of average return and dampen volatility. “Commodity futures do not appear to be “good diversifiers” for stock and bond portfolios,” Clark concluded.
Third, despite the GSCI’s positive correlation with inflation, adding the GSCI futures to a portfolio of conventional assets produces negligible reductions in the standard deviation of real returns and no appreciable hedge against inflation was identified.
Clark’s summary statement on the promise of commodity futures likely answers the questions of why don’t we all buy them? He states, “The evidence indicates that the purported benefits of commodity futures are exaggerated... Investors acquiring commodity futures in expectations of higher returns, lower risk, and improved inflation protection are making bets. Current evidence indicates that the odds are against them.”
Here is what John Bogle said about investing in commodities at a Morningstar Conference on May 28, 2009.
"I for one, have no conviction that commodities belong in anybody's portfolio, at any time, under any circumstances. Did I make that clear?
Don Phillips: [laughs] You're still hedging. I don't know.
Bogle: I say that for a very particular reason. I don't think it came up in the commodities session today; I wasn't able to hear all of it. But stocks and bonds are investments. What does that mean? That means they generate an internal rate of return. In bonds, it happens to be the current coupon on the bonds. And in stocks, it's the discounted cash flow on the investments. Let's look at the stock market in total. Or put in a more easily familiar way, the dividend yield at the time you buy, I guess a little bit to the earning's yield when you buy in, to the interest rate yield when you buy in. And the subsequent earnings growth. That's the internal rate of return on an investment.
Now the speculative return, whether people are paying 40 times earnings or 10 times earnings can change that, but that's the internal return.
What is the internal return on a commodity? It is zero. A commodity is therefore a total speculation. That doesn't mean that if you want to speculate in it you can't make money, but somebody else is going to lose the money. In the long run, just look at gold over a couple of hundred years. With no internal rate of return, there is no way it could possibly match even a Treasury bill, and it doesn't.
So if you think you can spot highs and lows, if you think the demand from the underdeveloped countries is going to push the price of wheat and those kinds of things, or copper or whatever it might be--each of which has had their own crisis--speculate in the commodity. I wouldn't tell you not to do that. I wouldn't do it myself, and I wouldn't consider it an investment. It's a gamble." (Source: morningstar.com video reports)
On May 27, 2010, Brett Arends of the Wall Street Journal wrote an article titled, "Why I Don't Trust Gold." You could summarized the article with this quote, "At some levels, gold, as an investment, is absolutely ridiculous." Arends goes on to state:
1. Warren Buffet put it well, "Gold gets dug out of the ground in Africa, or someplace," he said. "Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."
2. Gold is volatile. It's hard to value. It generates no income.
3. It's a currency "substitute," but it's useless. In prison, at least, they use cigarettes: If all else fails, they can smoke them. Imagine a bunch of health nuts in a nonsmoking "facility" still trying to settle their debts with cigarettes. That's gold. It doesn't make sense.
4. As for being a "store of value," anyone who bought gold in the late 1970s and held on lost nearly all their purchasing power over the next 20 years
5. What if the price goes back to where it was just a few years ago, at $500 or $600 an ounce? Will you buy more? Sell?
6. Everyone knows the price has risen about fivefold in the past decade. But this is not due to some mystical truth or magical act of levitation. It is simply because there have been more buyers than sellers.
7. Gold’s supply (mostly through mining) has consistently exceeded demand. Thus price is rising merely due to hoarding.
8. Lots of people have been buying gold in the hope it would rise. But the only way it can rise is if still more people buy it, hoping it will rise still further. And so on. What do we call an investment scheme where current members' returns depend entirely on new money brought in by new members?...A Ponzi scheme.
Note where oil, gas and gold sit on this risk reward chart below. You can see how they would have detracted from the returns and increased the risk (a bad combination) over this 35 year period.
The process of prudent investing is the intelligent management of risk. At the most fundamental level, this process matches each investor’s capacity to expose his assets to risk. The measurement of capacity, is both an event and a process because this capacity slowly erodes as an investor closes in on the need to withdraw money from the account. Investors should revisit the Risk Capacity Survey at least once a year. Since knowledge of investing is an important component of risk capacity, investors should allocate some time to read about Modern Portfolio Theory.
There is only one
risk exposure question that needs to be posed. What mix of indexes provides
the highest expected return at each level of risk? Getting to that answer
involves concepts discovered by academics who methodically applied the
scientific method to this problem. See the list below for examples of
1. Obtain data with acceptable confidence levels. This requires at least 20 years of risk and return characteristics of indexes.
2. Select several indexes that best capture the three factors that explain 95% of stock market returns. Those include indexes from the United States, international, and emerging markets. Within each area, select indexes that focus on total market, small cap, and value stocks.
3. Assemble those indexes in such a manner that you obtain global diversification, tax management where applicable, and high expected returns at each level of risk.
4. Considering the taxable status of each account, allocate the index mutual funds that best match the indexes. In taxable accounts, use tax-managed index funds. In tax deferred accounts, use standard index funds.
1. What is
the minimum number of years of risk and return data of an index needed
to design an efficient portfolio?
Fund Advisors (DFA) and Vanguard both offer a broad selection of index
funds. Why does DFA consistently rank higher?
a. Vanguard promotes actively managed funds in addition to index funds
b. DFA has indexes that are more concentrated in small and value stocks
c. DFA provides high-level education and data to its advisors
d. DFA restricts “hot” money investors by channeling through approved passive advisors
e. All of the above
a. have very high distributions of short-term capital gains
b. include a loss harvesting strategy
c. minimize the dividend paying stocks in the tracked index
d. are used in tax-deferred accounts
e. b and c
4. The 100
a. allow investors to match their risk capacity score to a risk exposure
b. were designed based on five years of risk and return data
c. include companies that are only located in the United States
d. have fixed income added to some portfolios to increase the risk exposure
e. include small growth and large growth indexes
5. The long-term
expected return of a portfolio can best be estimated by:
a. the track record of the stock pickers
b. the track record of the time pickers or market timers
c. the track record of the advisor selecting other money managers
d. the selection of indexes used in asset allocation
e. the track record of a manager using style or sector timing
Index Fund Advisors, Inc. — 19200 Von Karman Ave., Suite 150 — Irvine, CA 92612
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