Leader of the Pack: The DFA Funds

By Dagen McDowell
Senior Writer
TheStreet.com
7/8/99 12:02 PM ET

For those investors who haven't heard of DFA, think of Vanguard with a few potential Nobel laureates hanging around the soda machine. Unfortunately, it is very difficult for individuals to get their money into this firm's collection of low-cost, index-like funds.

DFA's approach starts with the oft-cited efficient-market theory, the same hypothesis that is the basis for all index investing. That is: An investor can't consistently outperform this relatively efficient, fairly priced market by picking stocks.

"The firm does not have a strategy of trying to beat the market," says Kenneth French, professor of finance at the MIT Sloan School of Management and a consultant to DFA.

It sounds like the same old mantra of passive investing. However, the funds you will find at this Santa Monica, Calif.-based firm don't track the more familiar, well-recognized indices. Yes, DFA does offer its U.S. Large Company fund, the obligatory S&P 500 index fund. But for other asset classes and styles, these folks shun the popular indices.

For example, the firm believes that with small-caps, you can lose a portion of your return by trying to replicate a recognizable benchmark like the Russell 2000. In an area with higher trading costs and poor liquidity, a manager is at the mercy of the market if forced to buy a known list of names on an index.

Instead, the firm takes a more academic approach to determining the benchmarks for its funds, most of which are small-cap- or value-oriented.

For its small-cap product line, DFA uses as benchmarks indices created by the Center for Research in Security Prices at the University of Chicago, usually referred to as CRSP or "crisp."

Look at the firm's first fund, U.S. 9-10 Small Company, launched in 1981. This fund invests in stocks with market capitalizations falling within the smallest 20% of companies on the New York Stock Exchange and also invests in stocks of companies with comparable market caps that trade on the Nasdaq and the American Stock Exchange.

DFA has deconstructed the market to come up with a list of building-block funds that can be used to construct a portfolio. Among the firm's 30-plus offerings, you'll find a selection of small-cap funds; a U.S. Large Cap Value fund; funds investing in the Far East, including a Pacific Rim Small Company fund; a variety of European portfolios, including a United Kingdom Small Company fund; an Emerging Markets Value fund; and several bond funds.

"Asset allocation is the entire ballgame," says Weston Wellington, vice president at DFA.

The firm's value strategies are rooted in the research of Eugene Fama, a famed University of Chicago finance professor, and MIT's French, who argued that value stocks (defined by low price-to-book ratios) tend to outperform growth stocks over time.

Fama and French are just two of the prominent names from academia who work closely with the firm, which was started in 1981 by David Booth and Rex Sinquefield, both University of Chicago business school alumni. Fama, often mentioned as Nobel candidate, is director of research and a board member. French acts as a consultant. Nobel-winning economists Merton Miller and Myron Scholes are fund directors.

Fortunately, the firm's expenses are a lot lower than the average IQ of its leaders. DFA goes to great lengths to minimize expenses shouldered by its investors. The cost of trading can obliterate gains in areas like small-cap stocks. Not surprisingly, DFA's trading operation is designed to minimize these costs, which include fees paid to brokers and the market impact. The firm can use its hefty size ($32.3 billion in assets, at last count) to negotiate favorable prices for stocks it is trying to buy and sell.

You also won't be seeing any multipage newspaper ads or trade show gift giveaways. "There is not a lot of marketing hoopla," says Robert Horowitz, a financial adviser at Stamford, Conn.-based New England Investment Management. The firm's plain-paper annual report from last year includes no nifty graphics or pie charts.

DFA funds' annual expense ratios, which include nontrading costs, such as operating expenses and the firm's management fee, also are very low. The Japanese Small Company fund carries an expense ratio of 0.74%, compared with 1.76% for the average Japanese fund tracked by Lipper. Expenses for the U.S. 9-10 Small Company fund are 0.59%, compared with 1.75% for the average micro-cap fund.

DFA funds' returns, in some cases, appear roughly comparable to those of Vanguard's index funds. Through June 30, the five-year average annual return for DFA's U.S. Large Company fund is 27.6%, compared with 27.8% for the Vanguard 500 Index fund, according to Lipper. DFA's Large Cap Value fund's annual 23.1% return over five years also slightly lags the 23.5% return of the Vanguard Value Index fund.

Returns stack up better for the U.S. 9-10 Small Company fund. Through June 30, it has delivered an average annual return of 12.9% over the past 10 years, making it the No. 1 micro-cap fund for that period.

The firm is picky about who can invest because it does not want fast, short-term money flowing in and out of the funds, which can push up transaction costs. "We have major institutions as clients, and they don't like to see high turnover and hot money," Wellington says. That's part of the reason the funds are not sold directly to individuals. Plus, limiting the number of individual investors helps keep administration costs to a minimum.

DFA only started allowing individual investors into the funds in 1990. The minimum investment is $2 million, according to Morningstar. But the only way someone like you or me can get in is through a selected group of financial advisers. Keep in mind, though, that many advisers won't take clients with less than $100,000 to invest.

The firm works with more than 100 advisers, who must go through a screening process ("We want to work with people who share our beliefs," says Wellington) before they can offer the funds to their clients. "These advisers have to behave like institutions," Wellington adds.

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