As an investor, you can choose between active and passive investment management. Active management is an attempt to beat the market averages through stock selection and/or market timing. Reams of academic data have shown that this is very difficult to achieve over the long run, but that doesn’t stop people from trying. With passive management, the goal is simply to capture market returns, usually through the use of low-cost index funds. The funds from Dimensional Fund Advisors (DFA), which we use as the primary building blocks of our client portfolios, do not use stock selection or market timing, and therefore cannot be classified as actively managed; however, they incorporate multiple little strategies for adding value, all grounded in sound financial principles.
DFA funds invest in broadly defined asset classes, unlike traditional index funds, which are required to mechanically replicate a commercial index, such as the S&P 500. The DFA approach is more flexible, allowing their funds to hold securities that a comparable index fund may be forced to sell. This flexibility reduces turnover and can lead to higher returns. It also allows DFA to incorporate a momentum algorithm into some of their funds. There is evidence of a short-term momentum effect in stock returns, in which stocks that have recently gone up tend to continue to go up for a while, and vice versa. DFA’s flexible approach allows them to capture some of these small incremental gains.
DFA also adds value by functioning as a market maker for small-cap and micro-cap stocks. This allows them to extract discounted prices from sellers seeking rapid execution on large blocks of stock. Historically, DFA's average block purchase price is significantly below the next day's closing price, which translates into higher returns.
Empirical research has shown that, over the long run, small cap and value stocks outperform large cap and growth stocks, respectively. Many DFA funds are designed to capture these higher returns by providing more concentrated exposure to small cap and value factors than traditional small cap or value index funds. This has led to increased returns over the long run, although it can also result in lagging short term returns, since the performance of small cap and value stocks varies from year to year.
Securities lending is the practice of lending stocks within a fund to another party, usually to facilitate settlement of a trade or support a short sale. This practice, which generates revenue for the lending party, is widely practiced in securities markets throughout the world. While most mutual fund companies engage in securities lending, DFA is unusual in that all the proceeds are returned to the fund, thereby enhancing returns. The increase in returns varies depending on the supply and demand for the available stocks, ranging from about 0.01% to 0.40% annually for each DFA fund.
These strategies, when considered individually, have a relatively small influence on overall returns, but the net effect over many years is significant. In comparing the returns of DFA funds with index funds that cover similar asset classes, the DFA funds have consistently come out on top. Although results vary from year to year, in the long run, DFA’s little strategies have historically added an average of 1-3% in annual returns compared to analogous index funds.(1)
Jeffrey J. Brown, MD CFA Principal, Shearwater Capital
(1) Past performance is no guarantee of future results. Investment return and the principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost.