Dimensional Fund Advisors

Dimensional Fund Advisors: A Deeper Look At The Performance

Dimensional Fund Advisors

As many of our readers know, we don't think highly of any form of active investing. In particular, we see more harm than good coming from investment products and strategies put forward by members of the actively managed funds industry.

Such fund companies specialize in trying to identify mispriced securities in relatively concentrated portfolios. These managers operate with a hope of trying to beat an underlying index. But a host of fact-based independent research by top-drawer academics -- ranging from Nobel Laureates Eugene Fama and Harry Markowitz to William Sharpe and Myron Scholes, to name just a few -- raise red flags about the wisdom of such an investment thesis.

Along with this growing body of independent third-party academic research, we've undertaken several studies of our own digging into the historical performances of active management. All of this evidence leads IFA's investment committee to a resounding conclusion: These active funds on the whole have failed to deliver on the value proposition they profess, which is to reliably outperform a risk-comparable benchmark.

As a result, our wealth advisors remain concerned that non-passive investors are being put in less-advantageous financial positions by trying their hands at active management. 

Although our portfolio management and research team has analyzed some of the largest active mutual fund families in the industry, it does beg the question: "What about Dimensional Fund Advisors, the family that IFA most frequently advises its clients to own?"

This is a good topic because it allows us to educate our investors about the basic philosophical differences between the approaches taken by the actively managed firms and Dimensional Fund Advisors (DFA).

Simply put, those differences can be summarized by stating that markets work, diversification reduces risk and certain company characteristics explain returns. Here are further explanations of these ideas:

Financial markets are efficient. Current market prices fully incorporate available information and forecasts. Future prices reflect random and unexpected new information. That process is borne out as a result of millions of traders engaged in "price discovery," e.g. the natural give-and-take of negotiations as provided by the very economic structure of how free markets work. In other words, an investor's best estimate of current pricing is the best estimate of the "fair" price, expressed for investment purposes as the price agreed upon between both sides of any exchange. From this fair pricing mechanism, investors are able to expect a fair return on average (and over risk-appropriate periods of time). Also worth noting: Any range of short-term returns relative to the average is commensurate with the risk of the investment.

Risk and return are inseparable. Although there is no such thing as return without risk, not all risks are equally rewarded. Long-term historical risk and return data informs the investment selection process, and index portfolios seek to capture the historical risk factors that have appropriately compensated investors for risks taken. These include market, size, value and profitability for equity as well as term and default for fixed-income.

Diversification is essential. Diversification within and among asset classes, and over extended periods of time, reduces risk in security selection and market timing errors, allowing investors to improve the probability of capturing the returns offered by global financial markets.

Structure explains performance. The returns of diversified portfolios can be explained by the exposure to the various risk factors. Therefore, investors can design diversified portfolios that target those risk factors and avoid the high costs, errors and risks of active management that have been harmful to investor's financial success.

Advisor Advantage. There are distinct measurable benefits to enlisting the services of a passively-oriented advisor, including investor behavior modification, appropriate asset allocation, disciplined rebalancing, tax loss harvesting, asset location and glide path risk reduction over time.

Fair Prices Equal Fair Returns. In competitive capital markets, investors should expect to pay a fair price for securities based on their risks, expected returns and the uncertainties of those returns. The more uncertainty of achieving that expected return, the lower the price buyers should be willing to pay. The future monthly returns on a diversified portfolio approximate a normal distribution or bell curve and our best estimation of that expected return is the very long-term historical average based on those fair prices that were obtained in publicly traded markets. In essence, when you are selecting an index portfolio of a certain risk level, you are accepting a future distribution of outcomes, which on a monthly basis approximate a bell curve.

Dimensional Fund Advisors accepts this basic premise that markets are fairly pricing securities based on the risks associated with them (i.e. markets work) and therefore accept market prices and market returns. Their active counterparts believe that free markets aren't most of the time performing the basic function of setting fair prices. As a result, active managers believe they can identify securities to buy at "undervalued" prices as well as time markets in order to avoid holding "overvalued" assets. As Rex Sinquefeld cleverly put it, "so who still believes market don't work? Apparently it is only the North Koreans, the Cubans and the active managers."

Dimensions of Expected Stock and Bond Returns

Is there only one type of risk investors are considering? Acutally, there are multiple dimensions of risk associated with stock and bond markets. Academics have identified multiple factors including size, value, profitability, capital investment, default and term as the driving forces behind stock and bond returns.

Think of these factors as the components of the engine in your car. Like your car's ability to perform, the driving force behind stock and bond returns are these factors that are being considered by investors and are therefore (consciously or subconsciously) being embedded into stock and bond prices. 

This is extremely important to understand because it's going to explain the discrepancies that we see when examining performance of both actively managed mutual funds and even their passive counterparts. It also allows us to explain the outperformance of Dimensional's strategies against well-known index fund competitors such as Vanguard.

When comparing index funds to indexes, the analysis is more about the differences in indexes (factor exposures) rather than the existence of alpha (selecting stocks or bonds from within a benchmark). This is what makes Dimensional different -- its portfolio managers create their own Dimensional indexes that include different tilts to the dimensions of returns (such as size, value and profitability).

Then, they implement their indexes in their funds with rules that minimize market impact costs, minimize taxes in tax-managed funds, screen for social and sustainability factors and screen for float considerations and momentum.

So when we see positive (or negative) differences in real-time Dimensional fund returns, the next step is to look at the longer period index data on the factors that distinguish the index fund from the Morningstar assigned benchmark.

Once that takes place, longer-term data more frequently supports Dimensional's factor tilts, even though the shorter-term data might not show the premiums (i.e., excess returns of one factor as compared to another). This is where it becomes difficult for investors because they prefer to see the premiums on a consistent basis, where you might see 10- to 20-years where the premium wasn't available in the data.

That's why IFA's advisors warn that when comparing indexes, unfortunately, live fund data is rarely enough data to draw conclusions.

The chart below illustrates the difference among Russell Indexes and Dimensional Indexes over 40 years (1979 through 2018), which starts from the inception dates of some Russell indexes.

The scales on this chart are important to understand. On the y-axis you have a scale of company size, with 0 representing the average company size of a total market index fund, 1.0 representing a micro cap company and -0.4 representing a mega cap company. The x-axis scale represents a book to market ratio, which is a value quantification.  On the left side are growth companies and on the right side are value companies.

For investors in stock index funds, this might be one of the most important charts to understand. It explains that when an index is tilted towards small and value, the 40-year excess expected annualized return over the total market's gain was 1.12%. Meanwhile, on the opposite end of the size/value spectrum, such a comparison showed a large growth index had a negative expected annualized return of -0.20%. 

This type of an analysis using a popular benchmarking family is another piece of evidence giving IFA's investment committee confidence that an index with a smaller and more value tilted design is preferred to a larger and less-value tilted one. Data over an even longer period also supports that small and value tilts had higher returns in U.S. markets. But let's not stop there.

Not all indexes are the same. Digging even deeper, look at the Russell 2000 Value Index's excess expected annualized return versus the total market's return over such an extended period (1979 through 2018). This index tracks U.S. small-cap value stocks. So does the Dimensional U.S. Small Cap Value Index. But it produced 3.97% in expected excess annualized return over that of the total market as compared to the other index's 1.12%. (Note the example of how excess expected returns are calculated in the graphic below.)  

Based on our review of long-term data, there has been an excess return for exposure to these risk factors. These are referred to as: the U.S. Equity Premium (Risk of the Total Market Minus Risk Free 30 day T-Bill); the U.S. Value Premium (High Book to Market Minus Low Book to Market); and the U.S. Size Premium (Small Companies Minus Big Companies).

An important consideration for investors is the likelihood that these risk "premiums" are actually zero (i.e., there is no premium) despite a historical mean that is positive. The starting point is calculating a t-stat for each premium return series as outlined in the bar charts and data below. The blue bars indicate a positive excess return for the factor premium and the red bars indicate a negative factor premium. The t-stats, as shown in the bottom section of the chart, are all considered statistically significant (i.e., greater than 2), and we can almost be 99% sure that all three risk premiums are positive, with only the size premium (Small Cap minus Large Cap) t-stat being marginally lower than the required 2.6 for a 99% level of significance.

Fees & Expenses

Let's get into the actual data. We examined funds offered by Dimensional Fund Advisors that Index Fund Advisors recommends to its clients. There are many other funds from Dimensional that are either duplications of existing asset classes or funds that IFA does not think will add incremental value to a globally diversified portfolio.

The costs we examine include expense ratios, front end (A), deferred (B) and level (C) loads, and 12b-1 fees (there are no loads or 12b-1 fees in Dimensional's funds). These are considered the "hard" costs that investors incur. Prospectuses, however, do not reflect the trading costs associated with mutual funds. Commissions and market impact costs are real costs associated with implementing a particular investment strategy and can vary depending on the frequency and size of the trades taken by portfolio managers.

We can estimate the costs associated with an investment strategy by looking at its annual turnover ratio. For example, a turnover ratio of 100% means that the portfolio manager turns over the entire portfolio in one year. This is considered an active approach and investors holding these funds in taxable accounts will likely incur a higher exposure to tax liabilities such as short and long term capital gains distributions than those incurred by passively managed funds.

The table below details the hard costs, as well as the turnover ratios, for 28 mutual funds offered by Dimensional Fund Advisors that IFA utilizes in their IFA Index Portfolios. You can search this page for a symbol or name by using Control F in Windows or Command F on a Mac. Then click the link to see the Alpha Chart. Also remember that this is what is considered an in-sample test, the next level of analysis is to do an out-of-sample test.


Name Ticker Turnover Ratio % Prospectus Net Expense Ratio Asset Category
DFA International Social Cor Eq Instl DSCLX 8 0.33 International Equity
DFA Global Real Estate Securities Port DFGEX 3 0.24 Real Estate Equity
DFA Intl Sustainability Core 1 DFSPX 8 0.37 International Equity
DFA US Sustainability Core 1 DFSIX 4 0.25 U.S. Equity
DFA US Social Core Equity 2 Portfolio DFUEX 9 0.28 U.S. Equity
DFA CA Short-Term Municipal Bond I DFCMX 39 0.22 Muni Fixed Income
DFA Emerging Markets Social Core Port DFESX 11 0.53 International Equity
DFA International Core Equity I DFIEX 4 0.3 International Equity
DFA US Core Equity 2 I DFQTX 5 0.22 U.S. Equity
DFA Emerging Markets Core Equity I DFCEX 4 0.52 U.S. Equity
DFA Tax-Managed US Eq DTMEX 8 0.22 U.S. Equity
DFA US Targeted Value I DFFVX 23 0.37 U.S. Equity
DFA Tax-Managed International Value DTMIX 21 0.53 International Equity
DFA Tax-Managed US Small Cap DFTSX 11 0.47 U.S. Equity
DFA Tax-Managed US Marketwide Value DTMMX 7 0.37 U.S. Equity
DFA Tax-Managed US Targeted Value DTMVX 14 0.44 U.S. Equity
DFA Emerging Markets Value I DFEVX 21.16 0.54 International Equity
DFA Emerging Markets Small Cap I DEMSX 15 0.7 International Equity
DFA International Small Company I DFISX 22 0.53 International Equity
DFA Two-Year Global Fixed-Income I DFGFX 81 0.17 Global Fixed Income
DFA International Small Cap Value I DISVX 23 0.68 International Equity
DFA Emerging Markets I DFEMX 8 0.47 International Equity
DFA International Value I DFIVX 17 0.43 International Equity
DFA US Large Cap Value I DFLVX 15 0.27 U.S. Equity
DFA US Small Cap I DFSTX 13 0.37 U.S. Equity
DFA Five-Year Global Fixed-Income I DFGBX 67 0.27 Global Fixed Income
DFA Short-Term Government I DFFGX 34 0.19 U.S. Fixed Income
DFA One-Year Fixed-Income I DFIHX 68 0.17 U.S. Fixed Income

 

On average, an investor who utilized an equity strategy from Dimensional experienced a 0.41% expense ratio. Similarly, an investor who utilized a bond strategy from Dimensional experienced a 0.20% expense ratio. The average turnover ratios for equity and bond strategies from Dimensional were 11.92% and 57.80%, respectively. This implies an average holding period of about 20.76 months for bond funds and 8.39 years for equity funds. (The higher turnover associated with Dimensional's bond funds is due to the majority of them being short-term in nature with variable-terms and associated credit strategies employed.) 

Factor Gap

Remember those driving factors of stock and bond returns that we mentioned above? Discrepancies between passively managed fund returns and a benchmark can be attributed to differences in "factor exposures." As a result, we have identified these discrepancies in the charts below as Factor Gaps.

We have included below Alpha charts for 28 Dimensional funds that are utilized in various implementations of IFA Index Portfolios. (See below after this report's conclusion.)

Dimensional's equity funds are smaller and more value oriented, so underperformance relative to their benchmark is due to these factor premiums not being positive for the time period examined. The size, value, or profitability premiums are not positive for all time periods. This is because there is risk associated with these premiums. If they were always positive, the price would reflect that and then there wouldn't be any risk and the premiums would become zero.

Dimensional's fixed income funds were created to complement DFA's equity funds. When looking at the Factor Gap (i.e., Alpha) between DFA's fixed income funds and their Morningstar-assigned benchmarks, underperformance can be attributed to Dimensional's bond portfolios tending to hold higher credit-quality and lower duration bonds than their assigned benchmarks.  

Not All Index Funds Are Created Equal

When investors finally embrace a passive approach to investing they often falsely believe that all passive investing is the same and that the lowest fee will result in the highest return.

Dimensional's ability to better target the driving forces behind stock returns allows them to have outperformed other index funds. This can also be displayed in a comparison of Dimensional's performance against a similar fund offered by Vanguard. The chart below shows you historical performance of Dimensional versus Vanguard. The time period is limited by the inception dates of the funds.

As you can see, in almost every asset class Dimensional has outperformed Vanguard, even with higher expense ratios. Why?

In the table attached to the above bar chart ("Vanguard vs Dimensional Fund Advisors - Select Mutual Fund Comparisons"), there are five different categories that include: Book-to-Market (a value metric); Weighted Average; Market Capitalization and Standard Deviation.

The higher the Book-to-Market ratio, the more the fund is exposed to the value factor. Weighted Average Market Capitalization is a measure of exposure to the size factor. The smaller this number, the greater the exposure to the size factor (small and micro cap stocks).

You can see that Dimensional consistently had a higher Book-to-Market Ratio and a smaller Weighted Average Market Capitalization. In other words, they have been better at targeting the known dimensions of expected stock returns. This has led to their outperformance against Vanguard while still maintaining robust diversification (# of holdings).

Conclusion

When investors ask us about Dimensional's "alpha," it presents a great opportunity to educate investors on the fact that Dimensional doesn't try to generate an "alpha" in the traditional sense of security selection. This is in contrast to the entire active investment community, which is seeking alpha by selecting the "best stocks or bonds."

In our analyses of actively managed mutual fund firms, we find that virtually all active funds, (when considering statistical significance of the alphas), have not been able to reliably deliver alpha and have falsely attributed their positive alphas as a repeatable skill, as opposed to chance outcomes. In our opinion, Dimensional shows us a keen sensitivity to this lack or absence of alpha, as well as a heightened understanding of important strides being made in academic research on risk factors. Together, these attributes provide our investors with return patterns that are different over time than we've been able to find elsewhere.

This, among many other reasons, is why Index Fund Advisors advises clients to invest in Dimensional funds. 


Another point worth keeping in mind is depicted in the figure below. It shows the formula to determine the t-stat for a fund. Our investment committee warns investors against trusting or relying on data relating to alpha or averge returns without t-stat calculations. 

Below is a figure showing the formula used to calculate the number of years needed for a t-stat of 2. We first determine the excess return over a benchmark (the alpha), then determine the regularity of the excess returns by calculating the standard deviation of those returns. Based on these two numbers, we can then calculate how many years we need (sample size) to support the manager's claim of skill.


This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey (www.ifa.com/survey) to determine which portfolio captures the right mix of stock and bond funds best suited to you. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.