Starting in mid-January, we began to implement one of the most significant changes to our Dynamic Contrarian Portfolio Strategy (DYCOPS) since we launched it back in mid-1998. We began to include mutual funds from Dimensional Funds Advisors as our baseline picks in some of our asset classes. We think this change represents a potentially significant enhancement for our clients’ portfolios. Let me share some of the thinking, study and research that led us to this new capability.
We monitor the performance of our portfolios over multiple time periods using multiple metrics. Of course, we start by examining our absolute and relative performance. Did our clients make or lose money in absolute terms? (Were they up or down?) How did each client perform compared to relevant benchmarks? (Did we add value?) How much risk did we take per unit of return? How broad a dispersion between clients with the same risk profiles? (Did some do better than others? Why?)
We also look deeper, to examine the drivers of performance, through a process called attribution analysis. Here, we are trying to determine which of our choices worked and did not work, with focus on two factors:
♦ Did we make the right asset allocation decisions? (For example, choosing whether to own more stocks or bonds, or choosing value stocks over growth stocks, or foreign stocks over U. S. stocks.) In other words, did we put the right number of dollars in the right buckets?
♦ Did we choose the best buckets to receive the money? This comes down to a choice between active and passive managers, in other words between intentionally-selected portfolios and indexes. If we are using active managers, are we sure they are adding value (alpha) on a risk-adjusted basis?
We’ve determined that we’ve added value at the asset allocation level, subtracted a little bit at the manager selection level, and subtracted quite a bit with peripheral non-core asset classes without durable economic returns. (For example, commodities, which we are eliminating from our portfolios.)
Our performance history matches our key insight: the most powerful investment advantages can be found at the asset allocation level, not at the security selection level. It is more important to decide whether to own dividend-paying value stocks or high-risk tech stocks (an asset class decision) than it is to know whether to own Google or Apple (a security selection decision).
Over time, we have become more skeptical about the value-add from active management, especially in large-cap stocks, but believe that it is vital to be sure each of our mutual fund or ETF picks accurately represents the underlying asset class we are targeting.
Enter Dimensional Funds. Founded in 1981 by David G. Booth and Rex Sinquefield, both University of Chicago graduates, Dimensional Funds has, from the beginning, sought to make investment decisions based on the most compelling academic research. They call this process “evidence-based investing.” Their first fund was a micro-capitalization fund, seeking to capture the higher expected returns of smaller-cap stocks over larger-cap stocks. (They call these advantages “dimensions,” hence the company’s name.)
Over time, Dimensional has grown to over 100 mutual funds managing over $380 billion, and has also added a fourth dimension of advantage, profitability.
Last spring, we identified a concern with our baseline pick in the emerging markets space, the Vanguard Emerging Markets ETF, due to its pledge to increase exposure to China. We researched the universe of emerging markets stock funds and determined that the Dimensional Emerging Markets fund had our desired combination of lower China exposure, low cost, and consistent portfolio style.
End of story, right? Actually not. We believed that this particular Dimensional fund would advantage our clients, but we could not access the fund without clearance from Dimensional Fund Advisors (DFA). Unlike other mutual fund companies, who typically advertise heavily and seek to capitalize on past performance to attract new money to “hot” funds, DFA works only through carefully screened investment advisors. They wish to be sure each advisor understands Dimensional’s philosophy, and that the advisor’s own investment approach is compatible.
Since last summer, we attended a DFA-organized investment conference and collaborated with them to evaluate our existing equity and fixed-income portfolios decisions. Internally, we have included DFA funds in our proprietary mutual fund screens. Early this year, we reached a mutual decision to make DFA funds available to our clients.
We see several key advantages for our clients in replacing certain of our prior choices with DFA funds:
♦ Lower cost. In most cases, DFA funds have lower expense ratios than most actively-managed funds.
♦ Higher tax efficiency. The nature of DFA’s style leads to lower turnover and hence fewer distributed short- and long-term capital gains. In one case, we’ve selected a tax-managed fund, for even greater tax advantage.
♦ More reliable investment style. Because they are not chasing specific “superior” investment ideas, Dimensional is extremely consistent in style. Their value funds don’t gradually morph into growth funds. If we are interpreting the data correctly, and value out-performs growth in the coming years, we can be very confident the DFA Tax-Managed Marketwide Value Fund will fully reflect value’s potential advantage.
There is more to the DFA story, which I’ll share over time. Right now, we want our clients to understand that, as always, we are exercising great care in selecting the firms that help us to manage your investments, and that even more than in the past, the success or failure of our investment strategy will be driven by the analytic power of our relative-price model.
By James S. Hemphill, CFP®, CIMA®, CPWA®/ Managing Director & Chief Investment Strategist
Jim has been a CERTIFIED FINANCIAL PLANNER™ professional since 1982. Jim specializes in complex wealth transfer and retirement transition strategies and coordinates TGS Financial’s investment research initiatives.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by TGS Financial Advisors), or any non-investment related content, made reference to directly or indirectly in this article will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. It is not possible to invest directly in any investment index, and no representation is made that any client will earn returns consistent with the returns of any investment index. The historical performance results of any index do not reflect the deduction of fees, the incurrence of which would have the effect of decreasing indicated historical performance results. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from TGS Financial Advisors. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. TGS Financial Advisors is neither a law firm nor a certified public accounting firm and no portion of this article’s content should be construed as legal or accounting advice. A copy of the TGS Financial Advisors’ current written disclosure statement discussing our advisory services and fees is available upon request.