We utilize no-load passively managed institutional class mutual funds from Dimensional Fund Advisors (DFA) in building our portfolios. DFA funds are constructed to control exposure to the key sources of stock and bond returns. There are five key factors that determine relative investment performance, three for
stocks and two for bonds:
Stocks (Three Factor Model)
- Exposure to Markets. There is no reward without risk. Stocks are more risky than bonds and therefore have a higher expected return as compensation for the additional risk incurred.
- Company Size. Another determinant of stock performance is company size. Empirical data shows that smaller companies outperform larger companies over time. This data supports the intuitive notion that smaller companies are riskier and therefore investing in them should have greater potential reward.
- Value. A third determinant of stock performance is company value, measured as a function of book (accounting) value, versus market price. High book to market (“value”) stocks outperform low book to market (“growth”) stocks over time. Here, too, the empirical data supports the intuitive notion that companies whose market values are depressed relative to book value are riskier than companies with higher relative market values, increasing the expected return for value stocks.
Bonds (Two-Factor Model)
- Term. The longer a bond’s maturity the more sensitive it is to changes in interest rates. Prices for bonds have an inverse relationship to interest rates, falling when rates increase and rising when rates drop. Prices for longer maturity bonds, therefore, vary more than those for shorter term bonds given the same change in interest rates. Empirical data shows that there is a pattern of diminishing returns versus risk for bonds once maturities reach approximately five years.
- Default. The second risk factor for bonds is the risk of default, also known as credit risk. Bonds with lower credit ratings are more at risk of default hence the yield paid to investors as compensation for holding these bonds is greater than the yields paid for higher credit bonds of comparable maturity.
DFA equity funds overweigh exposure to small and value stocks in light of their higher expected return. DFA bond funds traditionally invest in shorter-term, high investment grade debt given the relative lack of reward to investors for investing in riskier bonds. All DFA funds employ a passive strategy designed to capture the behavior of an asset class in a highly cost effective and tax efficient manner. DFA funds are not index funds and therefore do not track popular benchmarks. This allows for more targeted exposure to specific asset classes and lower trading costs since mechanical tracking of an index is not required.
Articles On DFA:
Institutional Investor on David Booth
A Conversation With DFA’s David Booth
In Vanguard’s Shadow
Where the Smart Money is Headed
The DFA Model: Daring to Be Different
Dimensional’s Passive Course Pays Off