This article is one in a long series which I hope will help explain the ins and outs of DFA – Dimensional Fund Advisors. NOTE: This is my interpretation and explanation only. For the final word, please refer to the DFA Canada Website.
Okay, so I know many people have been wondering about DFA (or Dimensional Fund Advisors). At the time of this writing, DFA’s Enhanced Index Funds are ONLY available to investors who use one of the less than 100 financial advisors in Canada who are authorized to offer DFA funds to their clients. To put this in perspective, it is estimated that there are over 100,000 financial advisors in Canada – so basically only 0.1% of advisors can provide DFA funds to clients.
That in and of itself doesn’t say much until you give it more context. I suppose a jaded person would just assume that advisors don’t like it, hence no one really offers it. However, this is about as far from the truth as one can get. In my humble opinion, it requires an incredible set of leaps in beliefs and behaviours from the current state of affairs of investing in general before you can truly appreciate DFA.
Leap The First
For financial advisors – who are bombarded with product presentations and red carpet treatment from mutual fund companies, structured product groups and other money managers – the first leap is to set aside the roar of the active money management community and open one’s mind to an alternative (passive investing). I suppose this ‘leap’ applies to investors as well, but they are more inclined to take this leap because there is no financial incentive for active investing over passive investing for investors (as there is with advisors). But DFA is not just a set of passive index products.
Leap The Second
For financial advisors and investors – the next leap is a commitment to education. On the surface, it would be very easy to dismiss DFA as simple indexing products like a benchmark tracking ETF or plain vanilla index mutual fund as mentioned before – but don’t make the mistake of doing this. If you are serious about investing, take the time to learn what makes DFA different. I will attempt to provide all the information imparted to me by DFA while I was attending their conference – but there is a lot of material to digest. You may decide that DFA is not a right fit for you in the end, but I can almost guarantee you will have a better perspective of the markets and investing in general from what teachings they have to offer.
Some Interesting Points Before We Get Started
One of the portfolio managers is literally a former rocket scientist, having worked for General Dynamics in space shuttle related projects. Another Vice President has a Ph.D. in aeronautics. In fact, the board of directors and executive management team is littered with Ph.D.s in everything from theoretical physics, to applied mathematics and economics.
There are two Nobel Prize winners in Economics sitting on the board (there was a third, Merton Miller, but he passed away in 2000). The two current laureates are Myron Scholes and Robert Merton. Most people believe that another board member, Eugene Fama will receive the Nobel Prize in the future.
More on Eugune Fama – He’s considered the father of Efficient Market Hypothesis. His work with Ken French is pretty much solely repsonsible for why you see the 3×3 Size and Style boxes on popular fund manager analytics like Morningstar and Globefund. (More on this later in the series.)
Two other members of the board of directors (David Booth and Rex Sinquefield) were among the first people to set up index funds (independently, although they knew each other) back the 1970’s. Both were students of Fama at the University of Chicago (pretty the much THE hotbed of finance academics).
Their oldest fund has beaten it’s benchmark by almost 2% on an after fee basis for the 25 years ending 2007. This means that after subtracting DFA’s managment fee of 0.52% on this fund (a micro cap fund), it has still beaten it’s benchmark (the Russell 2000). Note that normally there will be a 1.00% advisor fee added to this expense, but on the other hand to just replicate the Russell 2000 would require a small drag created by the plain vanilla index ETF as well.
DFA is the only fund company or investment product provider that interviews and assesses financial advisors based on their knowledge and business models (they only work with fee-based or fee-only advisors who they judge are able to understand what and how DFA funds work).
Even though there are very few advisors worldwide authorized to offer DFA funds, DFA has still managed to grow their assets under management to over $150 billion. The institutional clients include the largest pension funds in the world, banks, and many university endowment funds.
Timothy Middleton wrote a good article on DFA which you can read by clicking here, if you are eager to learn more right away. But again, there is more to this story and I will do my best to really get you the nitty gritty details that I don’t really see written anywhere. Stay tuned… it’s going to take a while! :)
Thanks for blogging this, Preet. This promises to be quite interesting!
I still can’t see the big mystery around dfa funds? If you have the capabilities to invest in etfs then what makes dfa funds so special?
I don’t mean to be rude but just because someone has a phd in math means nothing? Look what happened to Long term capital management with Mervyn Scholes etc. They had to be bailed out by the us govt–lol.
DFA funds are missing the boat by making themselves so exclusive. Just my opinion. Preet, I hope that your next articles on dfa can convince me otherwise. Best regards—Joe
DFA funds seem to be more trouble than they are worth.
@ Joe – you may find very well determine that plain vanilla index tracking ETFs are good enough for you – and I don’t think anyone would dispute that you will do better than most investors by doing just that. My goal is not to convince you that you must invest in DFA funds, but rather to educate people on them so that they can understand them better. Some people will choose to use them, others will not. I will discuss the differences between DFA funds and index ETFs in more detail later in the series.
So Preet,
I take it you’re one of those elite 100 Financial Planners in Canada that can sell DFA funds?
@Billy Paradise – I’m in the bottom of the ninth inning in the process of being vetted. It’s quite a process at that. First someone from DFA has to interview you over the phone to see if their is a philosophical alignment to begin with. They then send over a bunch of academic materials along with advisor-focused materials. An in-person meeting is then conducted, followed by access to their secure advisor site (which I wish readers could see) for self-research. Next, they have to arrange with the advisor’s firm to see if an invitation can be extended to the advisor, at which point an official invitation is presented to attend a two day conference at the world headquarters in Santa Monica. After being immersed in the theory and history, the advisors must then present a business plan or business case which is partly a knowledge test as well. After review by DFA, the approval is granted (or not). I am just waiting for the official green-light at this stage (or red-light!).
Preet, I really don’t mean too be rude. What extra fees do advisors make from selling dfa funds? These dfa rules IMHO are downright insane. I am usually very tolerant with regards to investing styles.
I respect everybody. If one investor chooses only to buy individual stocks —fine. Same goes for etfs, mutual funds etc.
IMHO, DFA funds seem very similar to the Rob Arnott school of investing—namely fundamental indexation. If I’m not mistaken this is the basis for the Claymore etfs in Canada. the Claymore etfs in Canada have so far been a big disappointment volume wise.
Preet, as I said earlier —I love your site—but Imho DFA funds are suspect at best. Best regards—–Joe
@Joe – You are certainly entitled to your opinion, and you are more than welcome to speak your mind on this blog – so don’t worry about offending me – I encourage people to contribute.
I will point out that while there are similarities between Arnott’s FTSE RAFI and DFA, there are probably more differences. These will become more apparent later in the series.
You are correct in that FTSE RAFI is behind some of Claymore’s ETFs. However, according to one of their VP’s whom I met with just yesterday (because I asked him about volume as well) – it is actually a non-issue. Market makers will fill the bid and asks and provide liquidity since the true liquidity is actually based on the liquidity of the underlying stocks (which are very liquid). Arbitrageurs will prevent the ETF and the underlying stocks from getting out of whack pricing wise. You still need to use limit orders to prevent whipsawing from the investors out there looking to catch someone out – but according to the VP if you place your limit order (which is reflective of the underlying stocks’ market prices) it will get filled by the makers. Specifically, we discussed that if the daily volume was 1000 shares for the last 5 days, I could place an order for 100,000 shares and it won’t impact the price due to liquidity constraints, and it would get filled that day. For even larger orders they have a block trading protocol too. So in the end, the volume is a non-issue.
To answer your fee question: In Canada, there are two classes of DFA funds available: A class and F class shares. The A class has a trailer fee of 1.00%. The F class has no trailer fee, and is designed for fee-based accounts, where the fee is determined by the broker and firm (I believe the norm is still 1.00% – but at least it is potentially tax-deductible for non-registered accounts).
Preet, I like your attitude. If more financial advisors were as upfront and honest as yourself than that would be a good thing. Thanks for letting me express my opinions.
All the best——–Joe
Preet, slightly off-topic. How can Claymore etfs continue to stay in business in Canada with such low share volumes? Investors also get killed by the spread between bid and ask prices on these etfs.
IMHO, Investors are not understanding Rob Arnott’s “fundamental indexation” and therefore what Claymore is trying to accomplish.
Could Claymore be exiting Canada very soon?
@Joe – I just did a quick calculation and they have roughly $115,000,000 under management in their FTSE RAFI ETFs, which at a 0.65% management fee means they are pulling in roughly $750,000 in revenues from those ETFs alone. Considering that they have many other ETFs, I would say they are in good shape on that front. They have closed out some ETFs in the past due to low assets, but that is not really going to affect investors since if a fund was closed down it didn’t have much time to build up any sizable gains to hurt too much on the tax front (from the forced disposition).
So to answer your question, I think they will be around for quite some time, but I agree – people do not understand fundamental indexing and the theory very well.
I am using a fee-only advisor since 2006 that sells Dimensional Funds enhanced ETFs. At the time he did provide literature that consistently backed the claim that the funds beat the realted indices.
But a recent literature I see that fund performances for 5 years and more clearly indicating underperformace to the Russell 1000 and 3000, MSCI EAFE Indices.
Clearly what I saw in 2006 was the US fund performance and the more recent was Canadian fund performance.
This is somewhat disappointing as I would have better returns for a lower cost in managing indices on my own.
I am glad you are utilizing a fee-only advisor using Dimensional Fund Advisors. The funds are not ETFs, they are mutual funds.
Most likely your investment horizon is not 5 years, therefore any 5 year data is futile. 5-year performance is a drop of water in the bucket. You should be more inclined to focus on the long-term out-performance of DFA funds over the respected indices. DFA does this through years of experience, utilizing unique trading techniques enabled by their flexibility.
I suspect your return over 10 years would not be greater if you were using Vanguard or iShares funds. First, you would have to maintain discipline. Secondly, you would not have as great of a small/value tilt as you would have through DFA. Research by Duke examines the value of using a DFA advisor: http://econ.duke.edu/Papers/PDF/Vanguard_Versus_DFA_30%20july_2007.pdf They find that it is worth it to hire an advisor. To see the value of an advisor vs. DIY, check this out: http://ariannacapital.blogspot.com/2010/09/advisors-really-can-help.html
@Hockeynomad: Dimensional Fund Advisors and their enhanced index funds (not ETFs) are constructed so that an advisor/investor may tilt towards the various factors that make up market returns over time. There are three factors: 1. The market factor (which is exposure to the market as a whole), 2. The small stock factor (small stocks have historically outperformed large stocks) and 3. The value factor (value stocks have historically outperformed growth stocks).
By tilting towards having more small/value stocks in your portfolio you would be expected to have an outperformance over a long period of time. A few years is not enough time for these factors to play out.
You either have to review what you are trying to accomplish with these funds and ask your advisor to provide material for you to understand how they work, or switch to managing your own portfolio. But don’t necessarily fall into the trap of assuming that it didn’t work or didn’t do what it’s supposed to, because it is. You just weren’t given the proper expectations.
Good luck in whichever route you take! :)
My observation was based on the respective DFA Dec 31, 2008 management reports of Fund performance for the different ETFs.
All DFA’s funds fall below the corresponding index benchmarks as the MSCI EAFE, Russell 3000, and Russell 1000 for each of the Class A, F and I funds. I have the Class F funds.
The annual compound returns compared were 5 years and over.
I believe your response was directed at my portfolio’s actual actual asset allocation compared to the indices I’ve indicated but that was not the means of my comparison.
So I believe the benchmarks I was provided in 2006 related to the US funds and not the more recently started Canadian dimensional funds.
Perhaps with the similarity of the other indices I would have minimized my costs and maximize my returns in the future by purchasing those on my own.
Well it seems I am a slow learner. It took me too many years to realize the insanity of the typical mutual fund, you were paying top dollar for lesser returns 80% of the time.
Better to go with the higher odds.
@Hockeynomad – no, my response was directed to the funds irrespective of the overall asset allocation. The Canadian fund lineup uses core funds (the US fund lineup is vastly larger). The core funds are tilted towards small stocks and value stocks. If they weren’t, then you would have performance similar to the TSX composite. They are tilted because they want to beat the index (over time) by exposing the fund to these two factors that have been shown to generate more return (because they are riskier – remember DFA is all about the risk and return relationship). In the recent past, the risk has manifested itself on the downside – hence the underperformance.
Having said all that, as long as you can stick to your ETFs managed yourself, you are going to have less costs than by using an advisor. BUT most people tend to change their minds over and over again. So be careful. I’m not saying stick with DFA and I’m not saying switch to doing it yourself – the choice is yours. But from what I am reading your understanding is not 100% of what makes DFA “DFA”. Having said that, if you have a better time understanding ETFs and doing it yourself, then perhaps that is all that matters and that route may be best for you.
Good luck in whatever you decide to do.