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Cloning DFA | ETF.com

Cloning DFA

January 28, 2015

RiskBudgetIndexesWhen the craving is strong, it’s not uncommon for regular folks to want to figure out how to make the Colonel’s original, finger-licking Kentucky Fried Chicken at home. The trick is figuring out the Colonel’s secret recipe. The term for the copycat process is “deformulation” or “reverse engineering”; and—from a chemistry standpoint—it can be very difficult to do. Fortunately, regular investors have a much easier task if they want to home-brew DFA or their favorite “smart beta” ETF.

The original in the “alternative index” or “superior passive” space was Dimensional Fund Advisors, which was co-founded by Rex Sinquefield, whose pioneering work on long-term performance statistics roughly 40 years ago—when matched with Eugene Fama’s development of the efficient markets hypothesis—helped establish the bedrock of passive investing. In fact, the epic shift out of bonds and into stocks that financial analysts associate with best-selling and influential books like Jeremy Siegel’s, “Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies” can trace its roots to Sinquefield’s original research with Roger Ibbotson in the early 1970s on the long-term risk premiums: “Stocks, Bonds, Bills, and Inflation.”

Why DFA?
DFA was founded to apply academic research on capital market behavior to the practical world of managing investment portfolios, and its success has been epic. According to Morningstar, 75 percent of its funds have beaten their respective category benchmarks for the past 15 years. Today trillions of dollars worldwide are invested in passive portfolios, and DFA—with its uniquely close ties to academic financial research—is an index-fund icon, even though the funds don’t actually track indexes. The booming 600-person firm manages more than $378 billion in equity, fixed income and other strategies, and is partially owned by a blue-ribbon board of directors that has included Nobel laureates Myron Scholes and the late Merton Miller, as well as distinguished academic theorists Eugene Fama, Donald Keim, Kenneth French and Roger Ibbotson. The firm serves more than 200 corporate, government, college endowment, charitable and Taft-Hartley clients, and has drawn such a passionate following that enthusiastic clients have been known to sing a DFA fight song at company events, leading some wags to refer to it as a religion or, more dismissively, a cult.

That’s the good news; the bad news is that the firm’s mutual funds are not offered directly to the public. One of the dimensional focuses of DFA—hence the name “Dimensional Funds”—is to deliver low-cost exposure to the market, but DFA funds are only available through approved fee-only registered investment advisors who often have minimums of $200,000 or more, and generally levy additional “wrap fees” of up to 1 percent on top of DFA’s underlying management expense ratios. This quirky, difficult-to-buy distribution feature means DFA is a different kind of passive vehicle; DFA investors have made the decision to take advantage of indexing’s low-fee structure, but they potentially—and paradoxically—give away a significant portion of indexing’s cost advantage when the additional fees required to gain access to the funds are tacked on.

Investment advice is a big business, and the big money is in advising people how to invest, not actually investing. Your garden-variety index fund charges a management fee that commonly ranges between 0.04 percent and 0.17 percent; DFA’s funds, however, array between 0.38 and 0.70 percent, and average about 35 basis points, which is higher than most of the biggest index funds, but far lower than most actively managed mutual funds. DFA’s charges are very competitive, but not so low that some observers haven’t commented on the inconsistency between preaching the merits of passive investing and then charging quasi-active fees somewhere between a true index fund and an active management fee. The genius here is selling index funds with near-active management fees, which explains how co-founder and co-CEO David Booth annually makes the Forbes list of the richest Americans with a personal net worth that is reportedly in excess of $5 billion—a not-so-subtle reminder that low-cost money management can pay off big-time.

Something both strikingly obvious and often ignored is the fact that DFA’s headline-worthy performance and the thought engine behind it are well-established both in academia and the real world. Because DFA’s approach is quantitatively driven by computer models, there are no star managers. All DFA funds operate on the same principles; it’s all math, and Rex Sinquefield, Eugene Fama and the rest literally “wrote the book” on investing. All self-investors interested in these academically inspired approaches need to do is read the book(s).

It also used to be said that DFA took additional actions to slightly enhance returns and serve as the market maker of last resort, but that’s no longer the case: 95 percent of their trades today are black pool versus block trades. Nowadays trades are brought to the market in smaller pieces; DFA uses an automated direct-market-access trading model to place nearly all of its trades. The trading component is no longer there; it’s not part of the value added, so we may be paying for a brand of indexing when we probably shouldn’t be. Today they’re not costing you anything on trading, but they’re not gaining you anything either. More than ever before, if the style attributes are mirrored in a Fama-French context, investors can expect to capture the largest return drivers of DFA.

 

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