Cloning DFA

January 28, 2015


Increased concern about portfolio building fees and retainers is creating pressure for institutional and individual investors alike to re-evaluate managers, costs, risks and opportunities. In a perfect world, we’d like access to DFA mutual funds at Vanguard prices and—in this era of do-it-yourself portfolios—to put academic theory into practice on our own. It’s a pretty standard strategy: The Fama-French three-factor model is the root of Dimensional’s strategy, so it’s only natural to wonder if it’s possible to:

  1. Avoid the additional 1 percent or so charged by DFA-approved registered investment advisors
  2. Use broadly similar strategies to track the same asset classes at a reduced expense level

Furthermore, a portion of DFA’s previous outperformance may reflect its “indexation” of parts of the market that were previously unindexed and difficult to access. Under Sinquefield and Booth, DFA boomed by enabling investors to invest in the very smallest stocks and in “deep value” stocks that trade at the largest discount to book value. It was hard to find funds that had very high loadings on “small minus big” (SmB), say, above 0.7, so to a certain subset of passive investors, DFA funds used to be the only way to get “proper” exposure to small- and microcap stocks. DFA established its first fund in 1981, and at that time, Vanguard had no value or small value funds, so if you were going to slice and dice a portfolio, DFA was the best and cheapest carving knife.

However, low-cost funds, especially ETFs, now occupy every asset category offered by DFA. As new indexes have come to market, investors can get the unloved and unwanted part of the market for a lot less. Today DFA offerings are very close to what other major market benchmark providers deliver; the DFA U.S. Small Cap Value, for example, is not dissimilar from the iShares SmallCap 600 Value Index Fund (IJS|A-87). Where there’s not a perfect substitute, it’s rather easy to combine two less expensive funds and create an effective clone.

The Vanguard Alternative
DFA portfolios employ semi-passive strategies designed to capture the return behavior of an entire asset class, so as a core holding for replicating DFA, John Bogle’s behemoth Valley Forge, Pennsylvania-based Vanguard Group is a logical choice to start. It isn’t a requirement to use Vanguard as the base, but passive is a scale game, and Vanguard has always kept its expenses very, very low. As Andrew Tobias puts it, “In the investment race, that gives your horse the lightest jockey.”

There are some important differences between the two firms. A mistake that many make is to assume the Vanguard Small Cap Value is equivalent to DFA Small Cap value. That is not true. DFA has a twist: Compared with Vanguard, the firm is a much stronger advocate of the wisdom of using small-cap and value tilts within different equity asset classes. One needs a higher percentage of small-cap to get the numbers in the nine-box style grid to where they might mimic the DFA Small Cap Value portfolio (Figure 1).



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