DFA believes markets are efficient... so do I!

Markets are efficient says the leaders of the 7th largest mutual fund company in the US

Barron’s did a cover story on Dimensional fund’s Gene Fama and David Booth a couple years back. If you don’t know already, DFA mutual funds are quite unique. While they’re passive in philosophy, they actively seek higher returns through what we call “smart beta” investing.

The simple way to describe DFA mutual funds is to refer to them as index funds. They are passive after all, as are index funds. The problem is they’re nothing like index funds for practical purposes.

 

The efficient market hypothesis

This entire post is predicated on the efficient market hypothesis. In simple terms, passive investors believe that all available information and expectations for the future are already built into the price of a security. If all available information and expectations are already built into the price, you cannot outsmart the markets with security selection or market timing.

There is so much liquidity in the capital markets – so many buyers and sellers – that prices are always fair! The best analogy I use is your house is worth what a buyer will pay for it on any given day. You may think it’s worth X, but unless you have a buyer with money it may not be worth X.

Now, there’s typically one or a handful of people looking at your house for sale. With the security markets there are millions upon millions.

Imagine if millions of people were interested in buying your house. The price would be perfectly accurate and reflect the thoughts and expectations of millions of people.

Those people know if you’re near a flood zone, and if there’s a chance they may put new parks and facilities near you. The collective wisdom of millions of investors will always accurately price a security, even in millisecond increments of the trading day.

In this day and age of technology and information, it’s implausible to me that markets are not efficient. I believe in fact – with the exception of insider information – that markets are truly efficient.

 

Passive investment management

Passive investment management was created out of the efficient market hypothesis. If one cannot possibly have information that others don’t, there is no “edge” or “advantage” one has. If having an edge is not possible, there’s no point in trying to pick and choose which securities and when to get in and out of. In this case, just buy all securities in an asset class.

Passive investing simply means you’re not trying to pick, choose, and trade individual securities. Whether stocks, bonds, or commodities, you just own them all.

Of course, there may be some limitations on “owning them all”. Regardless, passive investments own large quantities of securities.

Passive investors are security “agnostic”. By that I mean passive investors don’t believe in security selection. For example, passive investors may own a large quantity of large cap stocks with complete disregard as to which large companies they actually own.

Passive investment management also hinges on ignoring market movement. Passive investors do not try to time the markets. They don’t attempt to buy low and sell high, rather they just buy and hold securities until they need to liquidate for income purposes.

DFA mutual funds are passively managed. Index funds are also passively managed. Both are fully invested at all times, and both are security agnostic.

Contrary to passive management, many investors actively manage their investment portfolio.

 

Active investment management

Active investment management is based on the premise that markets are not efficient. Active managers believe it’s possible to outwit or outguess the capital markets. They think they know information – or have a “hunch” – which other investors do not.

Actively managed mutual funds are much more dynamic in style. Active management hinges on the philosophy that the portfolio manager can “outsmart” other investors.

For example, the manager of an actively managed large cap stock mutual fund may think Microsoft is going to beat earnings estimates. They may buy Microsoft stock in anticipation of their upcoming earnings report hoping for a rise in price after. Or an active manager may sell Apple stock expecting a new product launch to sell poorly.

Active management is human controlled. Passive management is model controlled. With active management you’re relying on a single person or small team of managers to pick and choose what to invest in and when to invest. Passive managers are always invested in the specific asset class they’re targeting.

 

Which is better? Passive management or active management?

You’ve probably heard of the Dow Jones company. They created an index of 30 of the largest companies in the United States.

You’re probably also familiar with the S&P 500. The S&P 500 is an index of 500 of the largest companies in the United States.

McGraw Hill Financial puts out what’s called a “SPIVA” scorecard each year. SPIVA stands for S&P Indices Versus Active. The report analyzes how actively managed mutual funds perform against indexes (which are passive).

If active investment management outperformed indexes, it would show in this report. Unfortunately for active managers, the results are in and they’re not good. Take a look at a snapshot from page five of the report:

Actively managed funds simply can't beat their benchmark index consistently.

Across the board, roughly 3/4 of all active funds CANNOT beat their benchmark index.

As you can see the news isn’t good for actively managed mutual funds. By far the majority of actively managed mutual funds cannot beat their benchmark index. The longer the timeframe, the less likely they are to beat their benchmark.

Granted, some actively managed mutual funds do beat their benchmark index. Someone must win the lottery too right? Statistically however, your odds of using active management to beat the benchmark are quite small.

 

So you’re telling me I have a chance – YEAH!

Active managers – and active investors – remind me of “Dumb and Dumber“. There’s an exchange between the hopelessly dorky Lloyd (played by Jim Carrey) and the beautiful Mary (played by Lauren Holly).

 

Lloyd desperately wants a shot with Mary, but clearly he doesn’t have one. He asks Mary if he has a 1 in 100 chance with her. She replies “more like one in a million”.

Lloyd is so painfully oblivious he says “so you’re telling me I have a chance… YEAH!” His happy-go-lucky outlook prompts him to think his one in a million shot is pretty awesome!

Dear active investor, stop being a Lloyd! Your odds of beating the simple benchmark are pretty slim. They’re negligible the longer you go. Negligible to the point where if you really think your manager – or you – can outsmart the market, you’d be better off hitting the roulette wheel.

 

Enter “smart beta”

I started this post pointing out Barron’s cover story on DFA mutual funds. DFA – Dimensional Fund Advisors – believes markets are efficient.

They believe they cannot outsmart the markets. They believe no person can! As such, DFA mutual funds do not seek to time market swings or pick outperforming securities.

What DFA mutual funds does do is tweak – or overweight – their portfolios based on factors which have proven to outperform over time. Those factors at the most basic level are:

  1. Stocks outperform bonds over time (I bet you got that one!)
  2. Small stocks outperform big stocks (again, you probably figured that)
  3. Value stocks outperform growth stocks
  4. More profitable stocks outperform less profitable stocks

“Beta” is the risk of the market as a whole. Just by investing in say the S&P 500 you have risk. “Smart Beta” refers to accepting the risk of the market overall, but “tweaking” or “tilting” your exposure to securities in an asset class with higher expected returns over long periods of time.

Dimensional Funds is THE pioneer in smart beta – or “factor” investing as they would call it. That’s why their the 7th largest fund company in the states. They’ve been so incredibly successful that the firm has experienced amazing growth over time.

It’s important to note that these factors of higher performance do not appear through all time periods. They do however appear through most time periods and have shown outperformance over long periods.

 

Oh, and Happy Birthday index funds!

While not the original pioneers of indexing, DFA mutual funds have long been noted in any academic discussion of index investing. Originally created by John Bogle of Vanguard, index funds turned 40 years old last month.

They didn’t start of with a bang however. The first index fund was so undersubscribed that the underwriters wanted to cancel the deal and send investors their money back.

Index funds didn’t hit their stride until about 10 years later in 1985. From then through the mid 90’s they grew 55 billion in assets. By 2005 there was 868 billion in index funds.

 

DFA mutual funds in summary

dfa-mutual-funds-performanceWe know active managers can’t beat their benchmark index consistently or predictably. There is no secret sauce to beating the markets.

It’s painfully obvious the higher your investment fees the lower your returns will be. Keeping fees and taxes as low as possible should be a focus for every investor.

We also know that there are segments of the capital markets which have illustrated outperformance relative to their peers over time. Enter the Dimensional Funds story: by tilting your investments towards those dimensions of higher expected returns you improve your results and your chances for financial success!

DFA mutual funds are incredibly low cost, generally highly tax efficient, and have the performance to prove it! They’re impressive on many levels (ultra-low costs, tax efficiency, etc.), and every investor should explore whether or not DFA mutual funds have a place in their portfolio.