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Why my money is in passively managed funds

By Sam Instone - May 25, 2018

Last week one blog I published caused a flurry of questions to my inbox.

It caused confusion.

Sparked curiosity.

And a little anger.

The greatest reaction stemmed from one sentence:

“My own money is in firms such as DFA moving forwards.”

In this blog you’ll find out who exactly DFA is, where they came from, and why I am confident in using them myself going forwards. 

So, who is DFA?

Helping me answer this is Jason Zweig, columnist for the Wall Street Journal, and his article, Making Billions With One Belief: The Markets Can’t Be Beat

Dimensional Fund Advisors is the fastest-growing major mutual-fund company in the U.S.

It isn’t strictly an active or passive investor. 

Download: Active vs passive investing 

It’s both.

It’s drawing nearly $2 billion in net assets per month at a time when investors are fleeing many other firms.

Its founders and advisers include leading purveyors of efficient-market theory, and it’s built on the bedrock belief that active management practiced by traditional stock pickers is futile, if not an absurdity.

Investment Advice Evolving

DFA’s founders are pioneers of a passion of mine, index funds.

But they believe even better returns can be achieved, than plain index funds deliver.

“We think indexing is too mechanical,”

...co-founder David Booth (who has the University of Chicago Booth School of Business named after him) said in a recent interview.

“A little bit of judgment can make a difference.”

Last week I also referred to them as

“the best fund manager in the world that you have never heard of.”

This is because DFA remains all but unknown to the general public, since its funds are available exclusively through financial advisers or to big institutions.

Nevertheless, it’s the 6th largest manager in the world.

Here’s Zweig’s description of how DFA invests.

“It designs its own indexes, often of small-capitalisation stocks, then waits—for weeks, if necessary—until an eager seller is willing to unload shares at below the prevailing asking price in the market.

Such tactics can minimize (and in some cases) even erase transaction costs, providing a small but meaningful boost to returns.

The firm often emphasizes cheap, small-cap stocks that are cumbersome for active managers to buy, whether because they are too tiny to make a difference for a portfolio or are costly to trade.”

And now for my favourite bit.

His evidence.

Research by Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College (finance professors who also advise DFA and serve as directors there) has shown that stocks with smaller market capitalisations, as well as those trading at low prices relative to their asset values and those with above-average profitability, outperform in the long run.

Since its launch in late 1981, DFA’s flagship fund has returned an average of 11.8% annually.

Two-thirds of the firm’s approximately 50 stock funds have beaten their benchmark since inception.

DFA was the first investment manager to create an index fund of small-cap stocks after academic research conducted in the late 1970s showed that such companies had outperformed the overall market by roughly two to four percentage points annually.

So, what’s the cost?

Fees, on average about a third of a percentage point, are higher than generic index funds and low compared with traditional active funds, though individuals with access generally will already be paying a financial adviser.

But with small caps, there were those big brokerage costs - often 2% or higher.

So DFA created a type of index that it would follow closely - but not exactly.

“We don’t try to do magic,” says Professor French.

“We’re doing engineering.”

Much of DFA’s growth came after 1988, when a financial adviser named Dan Wheeler approached the firm, which then offered its portfolios exclusively to big institutional investors.

A former stockbroker, Mr. Wheeler had often seen purportedly market-beating investments generate big commissions for brokers but losses for clients

Brokers Vending Products

Mr. Wheeler recalled recently he could find other “advisers with a conscience” and get them to offer DFA funds to their clients.

So the directors took a chance on the idea of selling funds through advisers who wouldn’t charge commissions.

There exists still a daunting steeplechase that advisers must hurdle before they can market the funds.

Perhaps the most important hurdle?

They probe for any disqualifying signs of performance-chasing behaviour.

There must also be a like-mindedness when it comes to values.

Something we also live by.

So why is more of my money in DFA going forwards?

  1. I share their philosophy on on why active management, and other attempts to beat the market, fail
  2. I am busy. I have 3 children, 3 businesses and a lot of complexity in my life.  DIY investing for myself can prove costly because of behavioural bias and worse still, misses the far more important aspects around planning.  I want safety, security and a sound investment proposition that buys me time to live the life I want with the people and activities I love.  I therefore choose to go with a DFA adviser for the very reason that I must have the right type of adviser and of the peace of mind and freedom it brings.

Today, DFA faces three major challenges according to competitors, clients and former employees.

Can it continue to grow without losing its edge?

Can it maintain its prestigious reputation?

And can it fend off new competitors whose funds are often cheaper?

Everyone with an interest seems to slice the data according to their own self-interest.

Like technology, investment changes

Is DFA like Andriod as Vanguard is to Apple?

I am not sure. 

But yesterday’s solutions likely aren’t best for today and today’s thinking may not work for tomorrow.

I am happy with this solution for my own money and I guess only time will tell…