Dimensional Fund Advisors (DFA) has been one of the fastest-growing fund families, and one that’s been typically available only through hiring an advisor approved by DFA.
But things have changed: Asset flows have turned quite negative recently, and the firm entered the ETF space. These are two things I thought I’d never see, and wouldn’t have predicted either. With ETFs, anyone can buy DFA without an advisor.
Investors Pulling Money
According to Morningstar, DFA saw investors pull $37.0 billion, or 8.3%, of the total assets from the fund family in 2020. The negative flows have continued so far this year, though it appears the trend has slowed.
DFA market share peaked in 2017 at 2.76%, declining to 2.37% at the end of 2020. From the chart below, you can see how fast they were growing and gaining share through 2017.
What has changed is quite simple: Advisors and investors chase past returns.
DFA is a fund family originally based on the Fama-French Three Factor Model. This means tilting the portfolio toward small cap and value stocks. I consider DFA the original smart beta fund family even before the term “smart beta” was introduced. Small cap and value badly underperformed large cap growth as the Morningstar chart below with annualized returns over the five years ending Dec. 31, 2020 shows.
Markets aren’t predictable, but investors are predictably irrational.
DFA Enters The ETF Space
Late last year, DFA entered the ETF space with a U.S. core equity ETF (DFAU), an international core ETF (DFAI) and an emerging market ETF (DFAE).
These are active ETFs that have low turnover. They also don’t have same level of factor tilting that DFA is known for and, presumably, would have performed better than DFA’s factor tilted funds over the past five years had they been in existence. Marlena Lee, head of investment solutions at DFA, told me, “These are marketwide portfolios, with light tilts to size, value and profitability, relative to market cap weighting.”
Now, DFA plans to convert six of its existing mutual funds to ETFs. DFA says the funds represent roughly $26 billion of the current $448 billion under management shown by Morningstar. These funds are mostly the tax-managed funds; and some do have a value and small cap tilt. They will also be lowering the fees significantly.
What’s Going On?
I asked Lee whether the entry into ETFs (which can now be bought by anyone with a brokerage account without an advisor) was intended to stem the tide of the asset outflows. “Absolutely not,” was her response.
According to her, the firm is “committed to our advisors” and, she notes, that many advisors requested the ETF wrapper, as they are more tax efficient, which is consistent with the mandate of a tax-managed fund.
As she put it, it was advisors who were asking DFA for ETF wrappers for more tax efficiency. They also wanted them because ETFs can now be traded without commissions at most large brokerage firms. Remember that DFA has been subadvising ETFs for several years with Hancock ETFs.
”Premiums have had disappointing performance, but the majority of our clients have stayed invested and are now reaping the rewards,” Lee said.
The total return of the Russell 3000 (a surrogate for the total U.S. stock market) returned about 63% for the 12 months ending Mach 31, 2021 versus the Russell 2000 value index (small cap value) returning a far higher 97%, Lee added.
So, I had to ask Lee if this was the beginning of DFA’s converting all of their mutual funds to the ETF wrapper. She replied that DFA definitely won’t convert all of its funds—only the funds with a tax mandate.
Lee explained all DFA funds try to be tax efficient and, unlike an index fund, won’t immediately trade when a stock style no longer matches the fund, waiting for a more favorable trade.
But what about factors? Is factor tilting a free lunch rather than compensation for taking on more risk? Lee’s response: “Markets should be treated as if they are efficient.” I couldn’t agree more.
My Take
DFA is a great fund family with discipline and low costs. The new ETFs will have even lower costs and more tax efficiency. I expect DFA will again be gaining assets and market share as riskier small cap value stocks begin to perform as well or better than the overall market for a more sustained period.
Every time I have asked DFA if factor tilting is a free lunch, they have said no. Yet many advisors have told their clients it was, and I suspect it is those advisors who are moving client money away from DFA, possibly to the hot ARK ETFs. Just a theory, but there it is.
DFA prides itself on educating advisors on discipline, but I have noted before that funds poured into the DFA emerging markets fund while it was hot, and stopped after performance cooled.
I experimented with DFA roughly 18 years ago, buying a few funds to supplement my cap-weighted Vanguard index funds. I found them less tax efficient than lower-cost total cap-weighted index funds, and reached the conclusion that a slightly more aggressive cap-weighted index fund could have approximately the equivalent risk of a DFA-tilted portfolio. And as an advisor, I didn’t have to pay myself an advisory fee to get DFA access.
Today I have three remaining DFA funds that represent a small portion of my portfolio with the vast majority of my stock assets in boring old broad cap-weighted funds.
I applaud DFA for not chasing the hundreds of so-called smart beta factors based on past performance. While I don’t personally use the Fama-French three- or five-factor models for my investing, moving back and forth based on what has been hot is practically a sure recipe for underperformance.
This article originally appeared on ETF.
