In order to ensure that all investment recommendations are unbiased, Index Fund Advisors doesn't offer any proprietary products. This means as a Registered Investment Advisor (RIA), our independent wealth management firm must make portfolio-related decisions based on the client's best interest, not the company's bottom line.

So, how does IFA put such an ideal into practice when selecting mutual funds and exchange-traded funds to use in client portfolios?

Methodology for Selecting Investments

The process starts with IFA's investment committee separating actively managed mutual funds and exchange-traded funds from those that are passively run. 

Along these lines, we've created an article ("A Blurring of the Lines: What Really is an Index Fund?") to explain how we sort the wheat from the chaff, so to speak, in an evolving U.S. funds marketplace. Also, IFA Founder and CEO Mark Hebner has created the video below to provide more details about our selection process.

Our process of elimination includes analyzing index funds as well as ETFs. Like mutual funds, ETFs are baskets of securities, sometimes holding thousands of different stocks and bonds. But unlike mutual funds, which are bought and sold once at day's end, ETFs can be traded during the day over stock exchanges like the NYSE and the Nasdaq — essentially, much like stocks.

The ability for investors to buy and sell on a daily basis means that IFA's portfolio management team remains aware of differences between what ETF traders initially offer and how much sellers are willing to accept. The resulting "bid-ask" spread on thinly traded ETFs can be wide. That's why our managers make sure IFA Index Portfolios are constructed using ETFs with sufficient liquidity. Also, they monitor when might be best to make trades in terms of keeping bid-ask spreads to a minimum. 

Screening & Managing ETFs  

Our clients should also be aware of another level of analysis applied to the selection and execution for each IFA Index Portfolio. This involves undertstanding how market-makers can influence ETF trading activity on a daily basis.

In order to help build volume and support liquidity for each ETF throughout the trading day, market-makers — big institutional investors and brokers — are given access to trade in large numbers with specific offerings.

Institutional support from such so-called authorized participants is a key factor in providing a large portion of the liquidity in ETFs. An ETF's Net Asset Value (NAV) fluctuates throughout the day based on the value of its underlying positions. By contrast, an open-end mutual fund is bought and sold based on its NAV after the close of each day's trading session. 

Likewise, ETFs can trade at a premium or discount to their NAVs. By premium, we're referring to the market price per share being greater than the NAV. At the same time, an open-end mutual fund trades at NAV at the end of the day. So, a mutual fund by its very structure doesn't trade at a premium or discount to its NAV. 

Performance Monitoring Reports

Whether we're reviewing ETFs or mutual funds, IFA's Performance Monitoring Report (PMR) scores each fund by objectively assigning points for different types of criteria.

Generally, PMRs give more weight to funds with less churning of holdings — as measured by lower turnover rates — and less 'style drift' between asset classes. Both are important factors in evaluating fund expenses, but aren't on the radar of a lot of investors since these can be seen as implicit rather than explicit costs of ownership. 

At the same time, our PMRs tend to de-emphasize raw return data in scoring funds. "IFA's decision to assign a lower weight to past performance," Hebner explains, "is based on the requirement that we have a large enough sample size (i.e., number of years) to determine the presence of skill with statistical significance."

Such an evaluation process leans heavily on Sharpe ratios, which measure returns against a relatively risk-free investment like a one-month U.S. Treasury bill. IFA's systematic review also makes sure to compare a fund's gains to standard deviation, a statistical metric that can be used to quantify portfolio volatility. 

PMR scores are heavily weighted to mutual fund and ETF holding characteristics such as market-cap sizes and book valuations. In particular, we've found these risk factors to be key drivers in a fund's ability to capture expected returns. Also, IFA's PMR places a high degree of emphasis on diversification, weighting inputs such as the percentage of total assets represented by a fund's top 10 holdings. All of this leads us to employ a select group of index mutual funds and ETFs in designing and implementing IFA's passively managed and globally diversified stock and bond portfolios.

Portfolio Design & Execution

Such an investment selection process can generally lead us to a number of different fund providers. These can include portfolios that utilize mutual funds and ETFs from the likes of Vanguard, Schwab, BlackRock, State Street Global Advisors, Invesco and Avantis. Typically, however, our portfolio implementations predominantly feature mutual funds and ETFs from Dimensional Fund Advisors (DFA).

Although Vanguard is ranked by Morningstar as the biggest player in the index funds industry by assets managed, our use of DFA is based on the way its managers construct and maintain large baskets of securities.

Given Vanguard's brand recognition, we're most frequently asked why our investment committee prefers DFA to Vanguard. 

Led by Founder John Bogle, Vanguard developed in 1976 the first index mutual fund for mass consumption. Like dozens of others that followed over the next several years, it was designed to primarily capture a single dimension of return — what's known as the market risk premium. That's measured by the excess return of a broad equity market portfolio relative to a risk-free rate.

The groundwork for defining market risk was established in the 1960s through empirical work by the Center for Research in Security Prices (CRSP) and development of the Compustat database for collection of stock-related information. This led to formulation of the Capital Asset Pricing Model (CAPM) as a theory of how expected returns should be determined. 

The Evolution of Index Investing

Studies in the 1980s uncovered patterns in the cross-section of stock returns that were even more far-reaching in scope. In particular, research by two leading professors — Eugene Fama and Kenneth French — led to an even greater degree of precision in managing investment risk.

The pair, who were both working at the University of Chicago at the time, released a series of papers in the early 1990s that led to the so-called Fama/French Three-Factor Model. In 1992, their research piece "The Cross-Section of Expected Stock Returns" won the prestigious Smith Breeden prize for best paper published in the Journal of Finance that year. Fama went on to become a Nobel laureate in 2013.

While including market risk, Fama and French found expected returns to also be significantly tied to a diversified stock portfolio's sensitivity (i.e., exposure) to two other common risk factors: 

• Market capitalization size, as measured by the difference in returns of a portfolio of small-cap stocks as opposed to a portfolio of large-cap stocks.
• A value factor, which is commonly calculated by comparing returns of a portfolio of high book-to-market (value) stocks to a portfolio of low book-to-market (growth) stocks. The ratio (BtM) is influenced by a company's growth prospects, shareholder risk and cash-flow generation. 

The Fama/French Three-Factor Model heightened development of multi-factor funds. A pioneer in this field has been Dimensional, which tilts to small-cap and value stocks. Not only did Fama and French join the fund provider's board of directors, but DFA Co-Founder David Booth — who studied and worked under Fama as a graduate student — was involved with the creation of the first index fund (for an institutional client) at Wells Fargo in the early '70s. 

Under IFA's Microscope: The Financial Sciences

How big of a difference has such an evolution in the financial sciences made for those who invest with IFA? Building a diversified stock portfolio using CAPM as a model is credited with explaining about 70% of expected returns. By contrast, statistical reviews of IFA Index Portfolios using regression analysis show more than 90% of our investors' return expectations can be tied to the Three-Factor Model.

For example, a regression analysis of the IFA Index Portfolio 100 (which is 100% invested in equities) found that nearly 99% of its domestic returns during an extended period could be explained by the portfolio's exposure to risk factors relating to market, size and value. By some estimates, however, more than 300 different "factors" have been "discovered" by market researchers over the years. This has driven a wave of product launches, particularly in the ETF space.

As fiduciaries to our clients, we've made sure to maintain a healthy sense of caution when considering adopting different types of funds into our investment selection process.  In fact, we've found DFA's disciplined approach to introducing new funds — not to mention its rigor in investigating different dimensions of stock and bond returns — to be quite refreshing. At the same time, we've been struck by Dimensional's ability to innovate without catering to the latest investment fads and "hot" fund strategies. 

The proof is in the pudding, though. To help illustrate such a point, see the chart below. It compares how IFA Index Portfolios have performed over time on a risk-adjusted basis using Vanguard's index funds as opposed to DFA's lineup. 

As Hebner points out in his book chronicling the evolution of fund investing, DFA's researchers keep advancing innovations in portfolio management. (See "Index Funds: The 12-Step Recovery Program for Active Investors.") They continue to supply us with extensive research and a database of benchmark risk-and-return metrics to help keep our portfolio management team apprised of developments across world markets. 

Of particular note, Dimensional's managers concluded in 2012 their researchers had discovered persuasive enough evidence to start including the profitability factor into the company's investment strategies. This gave our clients even greater insight into expected returns over time for their portfolios.

In 2019, Dimensional started implementing a new so-called investment premium in managing its funds. As Savina Rizova, head of research at DFA, explained to us at the time: 

"In plain terms, what our research shows is a company that must invest heavily to sustain its profits should have lower cash flows to investors than a company with similar profits but lower investment. So, if both companies trade at the same price today, this implies that the company with higher investment and lower cash flows has a lower expected return." 

Sticking to an Independent Fiduciary Standard

IFA maintains no financial ties to Dimensional or its executives, and we continue to monitor new research and fund developments across different market segments. In short, we stand ready to build portfolios using the best funds available to meet each client's own specific risk capacity and financial goals. It's a fundamental tenet mandated by our Founder in serving as a true fiduciary. 

Simply put, we find that DFA's academic rigor and systematic investment process continues to provide our clients with consistent and effective access to key asset classes and market factors. Our research shows that DFA's tilt to verifiable drivers of returns provides us with the best risk-adjusted opportunities over time to maximize an IFA Index Portfolio's expected return. 

While Dimensional's methodology continues to impress us as the most thorough and well-executed in the funds industry, we emphasize to our clients there isn't any magic involved here. After all, decades of leading academic studies tell us that higher expected returns court greater portfolio risk. That's why our wealth management team remains mindful of the trade-off between higher expected returns and exposing investors to greater market risk.

Even with our efforts to refine and improve IFA's investment selection process, we can't emphasize enough that gaining an understanding of how we pick funds should be considered as supplemental knowledge to engaging in an ongoing conversation with our wealth advisors. After all, a number of studies — including a series by Vanguard — tells us that investing is a journey that's best undertaken together, not alone. 

---

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.