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Selecting Investments Part 1

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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? In this video, we further explore this subject.

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. 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.

In IFA's opinion, DFA 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 going back to 1928. The video below includes DFA CEO David Booth interviewing 2013 Nobel Laureate in Economics, Eugene Fama, Kenneth French and 1997 Nobel Laureate in Economics Robert Merton. 

 

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. Cogent Research LLC has conducted three surveys of investment advisors since 2010 where they asked how likely the advisors were to increase or decrease assets with twenty-four different mutual fund families, and DFA ranked at the top all three times. See the table below. The DFA funds are low cost, style pure and well diversified.

On January 4, 2014, Dimensional was the cover story and the subject of a detailed profile article. In 2010, DFA ranked number one in Barron's annual ranking of best fund families.

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.

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.

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.

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.

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.

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.

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.

 

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.

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.

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.

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.

Continue to Part 2 »