Core Equity Funds

Dimensional Fund Advisors (DFA) introduced a series of "core equity" funds about a year ago. Since that time, we have been using these funds for many of our client portfolios. The following is an explanation of how these funds are constructed and why we consider them to be an attractive option for building client portfolios.

In order to capture higher returns for our clients, we construct broadly diversified equity portfolios with an emphasis on small company and value stocks, which have historically outperformed the overall market averages. In the past, we have relied mainly on DFA funds and exchange-traded funds to serve as building blocks for portfolio construction. The DFA core equity funds allow us to accomplish the same thing in a more efficient manner.

A core equity fund consists of all the stocks within a given asset class, with some overweighting of small company and value stocks. For example, the DFA U.S. Core Equity funds invest in the entire U.S. stock market with an increased exposure to small cap and value stocks. The DFA International Core Equity fund does the same thing for international stocks.

The main advantage of the core equity approach is that it reduces transaction costs while increasing tax efficiency. Transaction costs include both the commission and a more subtle expense referred to as the bid-ask spread. The "ask price" is the price at which you can buy a stock, while the "bid price" is the price at which you can sell it. At any given time, the ask price is always higher than the bid price. The difference between bid and ask prices (i.e., the bid-ask spread), is kept as a profit by the market maker or specialist handling the transaction. This expense reduces your returns every time you buy or sell a stock. The bid-ask spread can vary from a few pennies per share to 15% of the share price or more for illiquid securities. Large cap stocks generally have high trading volumes and excellent liquidity. Small cap and microcap stocks tend to have lower trading volumes and therefore significantly wider bid-ask spreads.

Before the core equity funds became available, we would build portfolios with a combination of large cap and small cap funds. For U.S. stocks, we would typically start with a broadly diversified fund, and then add small cap and microcap funds to achieve the desired emphasis on smaller companies. In any fund, some of its constituent stocks will go up in price resulting in a higher market cap. If a stock grows to a larger market cap than permitted by the fund guidelines, the fund manager is required to sell it. The resulting transaction cost is passed on to you, the investor. Imagine a situation in which a stock is being sold out of your small cap fund while simultaneously being bought by your large cap fund. In this scenario, you are paying two sets of transaction costs just to move the money from one pocket to another. In a core equity fund, a stock that is doing well is simply kept in the portfolio. Meanwhile, cash inflows into the fund can be used to maintain the appropriate small cap weighting. The core equity funds provide broad diversification with increased exposure to the small cap and value factors that have been shown to provide higher returns, all in an efficient package that reduces transaction costs and operating expenses.

Another advantage of the core equity funds is that they are inherently tax efficient. For taxable accounts, selling a security can lead to a capital gains tax that is distributed to investors at the end of the year. The core equity funds reduce capital gains taxes in two ways. First, by eliminating unnecessary stock trading, core equity funds minimize the capital gains distributed to their shareholders each year. Secondly, core equity funds allow portfolio rebalancing to be done in a more tax efficient manner. Under the old model, it was necessary to periodically sell shares in one fund while buying shares in another in order to keep a portfolio aligned with its target asset mix. If the shares were sold at a profit, the taxable investor was hit with a capital gains tax. In a core equity fund, portfolio rebalancing is done on a continual basis using cash inflows thereby avoiding unnecessary trading and reducing your investment-related tax liability.

Shearwater Capital is a fee-only investment advisor, which means that our only source of revenue comes from investment management fees. Unlike many advisors, we receive no incentives or payments from the companies whose funds we use for our client accounts. We sell no in-house investment products and avoid all soft-dollar relationships that might influence our advice. We are therefore free to choose the best investment products for our clients in a completely objective manner. Our goal is to provide maximum value by taking a scientific approach to investing. The DFA core equity funds help us to achieve that goal.

Please do not hesitate to contact me if you have any questions or comments.

Jeffrey J. Brown, MD MBA CFA
Shearwater Capital

Back to learning Center

Recommended Reading for Investors