A Fundamental/DFA Comparison

December 11, 2007

Today we look at the ICI/IRS cartel as well as outline just how alike FTSE/RAFI and DFA really are.

I have a few thoughts on the ETN story as that continues to unfold. First, wow. I still can't believe the sweeping finality of the first IRS ruling on ETNs. Like Matt, I'm not altogether sure I have not just been bamboozled by an ICI/IRS cartel, but THANK YOU for some clarity.

That's really all we've been screaming for over the last few months in ETFR and on this site. And we've got that now for Currency, and soon it looks like we'll have it for commodities and funky equity products as well. Otherwise, for now, I'm all blogged out on ETNs.

But I just can't get enough of fundamental indexing lately. All this recent jabbering inspired me to go back into a huge old DFA post on the site and pontificate:

Larry—I can't help jumping back into this discussion. Because we've been talking a lot about Rob Arnott (who actually posted my blog today on our home page).

But the truth is that Arnott and DFA are birds of a feather, though Rob denies it and DFA seems insulted by the comparison (see our Fama French interview in Journal of Indexes here).

And Larry, I remember fighting this total market vs. slice-and-dice argument with you years and years ago. And really, slicing up the market and allocating on that basis instead of by capitalization weighting is really not all that different from weighting on other factors, including factors based on a company's "economic footprint," as Arnott likes to say.

The effect is that you get a tilt toward small and value, riskier asset classes with historically higher returns.

As far as whether this is "active," "passive," "enhanced" or something in between, I repeat that you've GOT to say that it's SOME kind of active. The asset class is the index by its cap-weighting ... period. You go against that and you are making a tilt against "the market," and that is essentially an active decision.

And if you want to call FTSE RAFI "active" but call DFA "passive," good luck making that argument with the kind of weighting schemes and turnover that DFA runs. It is a very, very good quant shop that understands illiquid asset classes, trading and correlation. But an indexer it is not.

BTW, there was this very intriguing ad-on to my DB post if you missed it, by someone with the moniker "Trustee":

I was a DFA guy way back in the very early nineties. They are a good crew, pushing a standard, Markowitz-based, Graham and Dodd, quant-based modernized hybrid academic bent that tells a good and valid story. The most "bang for the buck" based on time horizon assessment and other forms of risk such as liquidity sells easy as it sells itself. I've been there, and done many things since. Consistent investment policy (avoiding portfolio drift) with divergent correlating composition based on asset class/sector (to some) bent foci with an eye towards taxation and expenses while rebalancing and in consideration of the TYPE of account (one can do wonders with ETFs and persistent margin ratios thrown into the equation) can spell a very assertive yet liquid and conservative balance. The proof is in the pudding. The proof can be seen with correlation and how it illustrates with the smoothness and steepness of the yield curve. As a former RIA, and registered securities principal (as well as CEO of various businesses) I respect DFA, worked with them (they would prefer "for them"), learned from them (sort of like a "practicum" with my former practice), and consider that experience a far more reaching education than my MBA in Finance, and all of the other dressing behind my name. This said, they are not "all that" as we as individuals are alone "all that." Come on fellas! Think about the globe. Look at the macro picture. Look at comparative advantage, currencies and more.... Look at all of that inefficiency with infrastructure, natural resources, energy, trade disparity. I can speak volumes but shall simply chill to hear more.

Looks like he may be with Hougan on the Commodities project...

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