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DFA’s Disciplined Approach Earns It a Top Mark

Reprinted by permission of Morningstar, Oct. 26, 2016 • PM270965

The firm puts theory into practice with a focus on investors.

Fund Spy | 06-09-15 | by Alex Bryan

Morningstar recently issued a new Stewardship Grade for DFA. The
firm’s overall grade–which considers corporate culture, fund board
quality, fund manager incentives, fees, and regulatory history–is an A.
What follows is Morningstar’s analysis of the firm’s corporate culture,
for which DFA receives an A. This text, as well as analytical text on
the other four Stewardship Grade criteria, is available to subscribers
of Morningstar’s software for advisors and institutions: Morningstar
Advisor Workstation(SM), Morningstar Office(SM), and Morningstar
Direct(SM).

Dimensional Fund Advisors has forged a strong and distinctive culture
that has served investors well. The firm’s low-cost structure and
disciplined approach to investing, launching new strategies, and
qualifying the financial advisors who use its funds help set it apart. It
reflects a consistent, industry-leading focus on fundholders, and thus, we
are raising its Corporate Culture grade to an A from a B.

Dimensional’s investment philosophy is based on the idea that market
prices reflect all publicly available information–commonly known as
market efficiency. Therefore, it is not in the business of forecasting and
individual security selection. But that does not consign it to a broad
market-cap-weighted approach. The firm offers strategies that attempt
to beat the market by targeting exposures to what it views as the types
of risks that the market compensates. These are characteristics that
historically have been associated with higher expected returns, such as
credit, duration, value, small market capitalization, and profitability.
Each strategy the firm adopts must be economically sound and backed
by substantial empirical evidence that it has consistently delivered
attractive returns across different markets and time periods. DFA draws
heavily on academic research to develop its strategies. For example,
it maintains consulting relationships with several finance professors,
including two Nobel laureates, to stay on the cutting edge of financial
research. To bridge the gap between theory and implementation, DFA
maintains an in-house research team, which focuses on vetting and
applying academic research, testing new ideas, and improving the
implementation of its existing strategies.

Academic research has guided the evolution of DFA’s funds throughout
its history. DFA started out specializing in small-cap and micro-cap
funds, based on research suggesting that small-cap stocks outperform
their larger-cap counterparts. The firm launched its first value strategies
in 1993, a year after professors Eugene Fama and Kenneth French
published their seminal three-factor asset-pricing model, which indicated
that value stocks offer an additional return premium. Most recently, the
firm has incorporated a profitability tilt into its equity funds, based on
new research suggesting that profitability can help predict long-term
returns. These changes refined the strategies but did not fundamentally
alter them. This research paved the way for DFA to launch its first growth
funds, which target stocks with strong profitability.

Transaction-cost management is an essential tenet of DFA’s value
proposition. It avoids high-turnover strategies and incorporates
transaction costs into its portfolio construction framework. Because its
funds do not track an index, DFA’s managers are not forced to trade
when doing so would not be cost-effective. For example, if a security
is near the cusp of a fund’s targeted style zone but trading it would
significantly move prices against the fund, the fund may defer or avoid
trading it. The firm’s traders are rarely required to trade any specific
stock. They can substitute one stock for another that would be cheaper
to trade as long as it has the desired characteristics for the strategy.

DFA often leverages this flexibility to provide liquidity–responding to sell
orders with purchase orders or selling stocks to satisfy investor demand.
This flexibility distinguishes the firm and should help reduce transaction
costs. To further reduce costs and retain full control of its orders, DFA
has adopted an automated direct-market-access trading model, which it
now uses to place nearly all of its stock trades. As of March 2015, DFA
employed 23 traders with an average of 14 years of experience.

An investment committee meets twice a month to provide oversight for
the strategies and approve implementation changes. The committee
includes the firm’s senior executives and portfolio managers. DFA also
has a separate investment policy committee that meets to recommend
new strategies and enhancements to its existing strategies. Professors Fama and French sit on that committee, in a consultancy role, along with many of the firm’s senior executives.

While it has a large lineup of funds, DFA only targets a handful of drivers
of expected return. There is substantial overlap among its portfolios,
which gives investors the option to choose from funds with moderate
to more-exaggerated style tilts, but it also creates some redundancy in
the lineup. This overlap is a result of the firm’s willingness to adapt its
strategies to meet client demand. For example, it introduced a series
of core equity funds in response to client demand for a broad-market
portfolio with systematic small-cap and value tilts. It also offers some
socially responsible versions of its funds.

However, client whims don’t sway DFA from its methodical approach
to launching new strategies. It requires a heavy burden of supporting
empirical evidence before it will consider adopting a new strategy.
Even when the evidence is solid, the strategy must be consistent with
the firm’s low-turnover philosophy. For instance, despite the strong
empirical evidence that shows the near-term persistence of stock-price
momentum, DFA does not attempt to trade on it, though it may use
momentum as a reason to delay a trade. Although it has launched 22
funds during the past five years, most of these target the same sources
of expected return as its longer-standing funds.

Dimensional usually doesn’t chase trendy investment themes. Rather, it
takes its cues from the academic community. For example, the firm didn’t
abandon its stoic value framework during the tech boom in the 1990s.
Similarly, it hasn’t rushed to offer a low-volatility strategy because it
believes investors can achieve the same results more efficiently by
allocating a greater portion of their portfolios to fixed income and value
equity funds. As a result of its deliberate approach to its fund lineup,
DFA rarely liquidates or merges funds. In the United States, DFA has
merged or liquidated just three funds, according to Morningstar data. As
of March 2015, equity funds represented about 74% of the firm’s assets,
while fixed-income funds accounted for most of the remainder.

DFA has grown substantively during the past decade, now ranking
among the top 10 mutual fund companies with more than 6 times the
assets it had 10 years ago. It was able to accomplish that feat without
traditional advertising. Rather, it devotes considerable resources to
investor education, which is a major area of focus for the marketing
team.

Unlike most mutual fund shops, Dimensional does not make its funds
available directly to individual investors. Instead, the funds are only available through an intermediary, such as a 401(k) platform, or a financial advisor that DFA has approved. Before qualifying advisors
to use its funds, Dimensional educates candidates on its investment
approach and attempts to filter out those who are likely to hold the funds
for the short term, a practice that could harm the strategies’ long-term
investors. The firm does not compensate or receive compensation
from advisors who use its funds. Investments from financial advisors
represent about 55% of Dimensional’s assets, while the remaining 45%
comes from institutional clients.

The firm’s client-education effort appears to be effective. In 2008, when
investors were leaving equity funds in droves, DFA bucked the trend
and enjoyed net inflows to its equity funds. But even this responsible
approach to selling has its limits. Like many fund families’, DFA’s dollarweighted
investor returns, which approximate how average investors
have done in individual funds, are generally subpar to its time-weighted
total returns over the past five and 10 years through April 2015.
Because DFA’s funds are so process-driven and its approach is
team-oriented, it may seem that portfolio-manager retention would be
less important than at other firms, where a star manager’s departure
would have a meaningful, detrimental impact. But manager retention is
still important because it is indicative of the firm’s ability to attract and
retain talent. Dimensional hires many of its portfolio managers straight
out of MBA programs. But the team has no shortage of seasoned
professionals. As of March 2015, the 45 members of the portfolio
management team had an average of 14 years of experience.

During the past five years, Dimensional has retained close to 92%
of its managers, which is strong compared with large mutual fund
companies. However, this figure is only based on the senior portfolio
managers that DFA lists in its regulatory filings with the Securities and
Exchange Commission. Dimensional has provided additional information
to Morningstar that indicates the retention rate for the broader portfolio
management team was above 90% in each year since 2009. This
suggests that its managers are well-suited to the firm’s distinctive
investment approach. The firm’s private ownership structure may also
contribute to its low turnover. Current and former employees own most
of the firm.

Alex Bryan, CFA, is director of passive strategies research,
North America for Morningstar.

Reprinted by permission of Morningstar, Oct. 26, 2016 • PM270965
Fund Spy | 06-09-15 | by Alex Bryan

Morningstar produces Stewardship Grades for asset management firms
and Stewardship Reports on the US fund industry’s 20 largest firms by
assets, which together manage more than two-thirds of open-end mutual
fund assets.

For those assigned a Stewardship Grade, Morningstar publishes letter
grades—A, B, C, D, or F—for each of the five components as well
as an overall letter grade. For firms that are assigned a Parent rating,
Morningstar gives them a Positive, Neutral, or Negative overall rating.
There is a direct relationship between a firm’s Stewardship Grade and its
Parent rating; firms with a Stewardship Grade of A or B receive a Positive
Parent rating, those with a C receive a Neutral Parent rating, and those
with a D or F receive a Negative Parent rating. The grades are based on
analyses by Morningstar’s fund researchers, Morningstar’s proprietary
data, and information compiled from public regulatory filings.

Morningstar analysts evaluate and assign grades from A (the best grade)
to F (the worst grade) to each of these areas, and they combine the
component grades to arrive at an overall Stewardship Grade for a family
of funds. A local committee of Morningstar fund analysts, which actively
studies industry stewardship practices in its market and beyond, reviews
the grades to ensure that the methodology is fairly and consistently
implemented. All fund firms are graded on an absolute basis.

Past performance is no guarantee of future results. There is no guarantee
strategies will be successful. Mutual fund investment risks include loss of
principal and fluctuating value. Small cap securities are subject to greater
volatility than those in other asset categories. Fixed income securities
are subject to increased loss of principal during periods of rising interest
rates. Fixed income investments are subject to various other risks,
including changes in credit quality, liquidity, prepayments, and other
factors.

Eugene Fama and Ken French are members of the Board of Directors
for and provide consulting services to Dimensional Fund Advisors LP.

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October 24, 2016
This article contains the opinions of the author but not necessarily of
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