How DFA is Poised to Navigate Heightened Market Risks
Rising volatility in stocks is sending ripples to conservative investors who count on bonds for protection in times like these. One fixed income alternative that’s seeing a big jump in money flows so far this year are the strategies offered by Dimensional Fund Advisors.
Through January, DFA's bond fund assets under management have grown to $68.1 billion, according to Lipper. That's up 20% from a year ago and piggybacks just about a 2% increase from 2017’s total.
In the past five years and a month, DFA’s 29 different bond funds have garnered $32.4 billion in net inflow, says Lipper. Of the 365 bond fund families it tracks, such a total ranks as seventh-highest during that period.
In a time of growing popularity for low-cost investing, part of DFA's attraction is no doubt an average expense ratio for its fixed-income funds of 0.21%, says Tom Roseen, a Lipper analyst. He notes a typical bond mutual fund sold in the U.S. now averages nearly 0.88% in yearly management fees.
"With this year’s increased volatility on both the equities and fixed income side, people are looking for competitively priced and proven investment managers," Roseen says.
As market uncertainties rise in 2018, DFA’s more flexible "index-like" strategies should prove to be an appealing option for clients, suggests Chad Carlson, research director at suburban Chicago-based Balasa Dinverno Foltz, which manages about $4 billion.
"They’re basically creating unique indexes for each of their funds and then on a daily basis looking at all of the dynamics around yield curve fluctuations," he says. "The overall process is fairly static, but it offers a little more flexibility than a traditional index fund."
Indeed, Morningstar data show DFA produces relatively low turnover numbers over time compared to a typical competitor in key U.S. asset management categories. Of course, those groupings range across both active and index-based mutual funds.
The funds giant, which chiefly works through advisors and managed $577 billion heading into 2018, also fares relatively well over the longer-term in such risk-adjusted performance comparisons against active managers in terms of lower fee structures, Morningstar says.
But the proliferation of factor-based investing poses risks to DFA’s pioneering work in the field. A good example might be the $14.5 billion DFA Five-Year Global Fixed-Income Portfolio. Its institutional shares come with an expense ratio of 0.27%. That’s much cheaper than the average global bond fund’s 0.70% cost, Morningstar analyst Phillip Yoo points out.
"Most of this fund’s performance advantage over the years seems to have come from its lower-cost fee advantage," he says.
Such an edge faces increasing pressure as ETFs with bargain-basement prices keep entering the market, Yoo adds.
Also, he warns that since DFA’s process is based on "seminal" academic research first published decades ago, much of what makes their funds different is now "widely known" across the industry.
"Many asset managers are trying to replicate their process," Yoo observes, either through computer-driven quant funds or hybrid ETFs. "From a competitive standpoint DFA’s methodology has never been run as a black box," he adds.
Still, St. Louis-based advisor Kevin Grogan doubts rivals can duplicate a strategy that has been evolving over the past 35-plus years and includes plenty of "unique" nuances. In explaining such funds to clients, he lays out an investment "spectrum" ranging from passive to active management.
DFA falls somewhere in the middle, closer to indexing than active stock picking, says Grogan, director of investment strategies at Buckingham Strategic Wealth, which manages about $13 billion. He sees AQR, Vanguard, and BlackRock as some of its closest rivals.
"But DFA’s funds can wind up looking very different from any of its competitors," Grogan says. "They’re targeting an entire asset class and dynamically updating which securities are part of that group on a regular basis."
Different competitors can place a very different emphasis on factors driving long-term fund performance. Grogan notes AQR, for example, defines profitability differently than DFA and tends to build market momentum measures into its methodology to a greater degree.
DFA shines in "squeezing" value for investors by "messaging" trading in and out of positions when asset class boundaries fluctuate, advisor Carlson says. "They don’t feel a sense of urgency to drop or add a stock at the drop of a hat like a lot of managers do who must slavishly follow an index," he adds.
The funds shop focuses on capturing for investors exposure to key factors relating to size, value and profitability. Momentum is also a consideration on the edges of when to complete transactions, Carlson notes -- but not what stock or bond to actually trade.
On the bonds side, the wealth advisor relates several other distinctions to clients. For one, DFA usually features fixed income investment strategies with shorter durations, a measure of interest rate sensitivity. "In general, DFA’s bias is to guard against extra equity risks creeping into what’s supposed to be a client’s safer portfolio allocation," he says. "They see bonds as portfolio stabilizers."
Dave Plecha, global head of fixed income at DFA, notes that its Five-Year Global Fixed-Income fund at the end of 2016 was almost 100% invested in U.S. dollar-denominated bonds. The portfolio, which hedges currency risks back into the greenback, saw high-quality domestic issues commanding greater expected returns compared to bonds issued in a dozen other leading global currencies.
By mid-May 2017, five other currencies started to be added to the fund in varying yet significant degrees, according to DFA data. At the same time, the traditional Citi World Government Bond Index moved less than 2% of its constituents out of the U.S., Plecha notes.
"The weight of each security in the Citi index is dependent on the size of issuance in each market," he says. "By contrast, the DFA Global Bond fund is driven by expected premiums."
Calculating projected yield premiums isn’t an active securities picking process, Plecha notes. "We’re not trying to forecast changes in rates," he says. "We track current yield curves as they’re priced, then compare that information to all 12 currencies we consider for this fund."
That’s net of any hedging costs and related transactional expenses to take returns in local markets and convert them into the greenback. "Every day we’re looking at yield curves around the world, the costs of hedging and calculating those figures," Plecha says.
If fixed income markets keep moving towards a flatter yield curve where income spreads between longer-term and shorter-term notes compress, he finds that DFA’s strategy "wouldn’t be as willing to add more market risk by buying longer duration bonds." After all, he says, in such a situation "volatility could be higher with no real expected premium" for investors.