Question for Larry and Rick

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RiskyB
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Question for Larry and Rick

Post by RiskyB » Tue Oct 07, 2008 7:36 am

I proposed the following question to a number of knowledgable investors. I was surprised by the response that overwhelmingly favored one of the two options.

Question:

Which of the following US Equity holdings do you believe will produce the highest after tax return if held in a taxable account over the coming 10 years, and why?

(a)
25% Vanguard Total Stock Market (VTI) ER: 0.07
20% iShares S&P 600 Small Cap Value (IJS) ER: 0.25%

(b)
45% DFA TA US Core Equity2 (DFTCX) ER 0.30%
(Assuming advisor fee of 0.25%)


Higher taxes and difficult times are on the horizon. I would appreciate opinions from Larry and Rick as well as other Bogleheads on the tax efficiency of the two proposals above. Given the change in circumstances over the past year I would also be interested in opinions on weather a SV tilt is less likely to offer an advantage going forward.

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Post by Rick Ferri » Tue Oct 07, 2008 8:41 am

Flip a coin.

The ETF solution as the advantage of lower expenses and greater tax efficiency within each fund. The disadvantage is the taxes that may develop during rebalancing between the two funds annually assuming you are doing annual rebalancing.

The DFA TA Core Equity 2 fund has the advantage of also being tax efficient, and being that it is one fund there may or may not be as large a tax consequence from retaining the value tilt within the fund (it is an unknown). The disadvantages are 1) additional access cost to DFA investors in the form of an advisor fee, which increases the total cost of the strategy, 2) DFA engineers a value and size tilt from the back end by leaving out many fine lrge cap growth stocks. I am not a fan of leaving out growth stocks to achieve a value tilt. The Fama/French three-factor model as designed by FF is based on a total stock market starting point and then over weights small and value stocks as desired.

In summary, both approaches are fine, but I prefer to use the ETF option because the overall costs are lower and the strategy is based on the pure form of the FF model.

Rick Ferri

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Post by RiskyB » Tue Oct 07, 2008 12:13 pm

Rick

Thanks for your response it was informative and appreciated. Others have also pointed out that the FF three-factor model was based on the idea of adding SV stocks to the total market not limiting exposure to large caps. Some say that eliminating large growth stocks is a big advantage. I have done some research on this but much of what I read by FF is over my head. Will you comment on exactly what might be lost by limiting the exposure to large stocks?

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Post by Rick Ferri » Tue Oct 07, 2008 2:04 pm

RiskyB wrote:Some say that eliminating large growth stocks is a big advantage. I have done some research on this but much of what I read by FF is over my head. Will you comment on exactly what might be lost by limiting the exposure to large stocks?
What is lost? You lose the return of the market!

Here is the bottom line. Advisors and money managers sometimes say and do things to help their own business when they do not believe that taking such action will be a long-term negative to investors. For example, you will never hear Fama or French (the academics) say that you should not have large cap growth stocks in your portfolio. On the other hand, DFA (the business) has a real incentive to manage money that way because eliminating large growth rather than adding small value provides their funds with near unlimited capacity to take on new assets. Remember that increasing assets under management is how DFA makes more money for the business partners.

Back to your question, theoretically it should not matter if a portfolio cuts out large growth stocks rather than overweight to small/value to reach a three factor solution. HOWEVER, there always seems to be some unknown risk lurking in those theoretical solutions that raises its ugly head when no one is paying attention. The black swan is out there.

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Post by SmallHi » Wed Oct 08, 2008 11:59 am

Risky,

Sadly, most of the advice Rick has given you is not very good. His best thought:
Flip a coin.
Beyond that, I am always amused at how Rick can be so dogmatic about the "equity" dimension of the Fama French 5 Factor model (equity, size, price, term, and credit), while completely bastardizing the rest of it (using emerging market bonds, junk, preferreds, etc). The reality is, unless you are using size/value tilted (or just market oriented) passive global equity strategies diluted with a short term, high quality fixed income that adjusts maturities based on the shape/slope of the yield curve, you really aren't investing according to the Fama/French research -- you are investing according to your interpretation of the research. Not to say that approach is right or wrong, just stating the facts. Read the dozen or so research papers on it from FF if you don't agree.

Also, the 5 Factor model is just a model. It guides investment choices. No where in the research does it say you must start with "the market". It does seem like a logical starting point, but I fail to see how its any more relevant than the S&P 500. The returns/risk of the two have been statistically identical for 80 years. Sure, TSM holds more stocks...but clearly it doesn't matter much if you are cap weighting them.

Furthermore, the TA (or taxable) Core funds don't leave out any stocks that pass DFAs liquidity/equity screens. As a matter of fact, if you want to get into a quabble about diversification, the Core fund is more diversified, as it holds almost 3,600 stocks vs. less than 3,500 for Vanguard Total Stock Index. Core simply underweights somewhat the largest, most growth oriented stocks, it doesn't avoid them. Only Vector funds avoid the largest 100 or so LG stocks, but still almost match the overall diversification by security of TSM funds.

Also. any supposed "black swan" from underweighting LG stocks applies equally to just overweighting the smallest value stocks. For example, what if the size premium manefests itself as much in mid cap as small cap? What if the value premium is as much in Large/medium as it is in small? Those occurances would have a very negative impact on a lumpy TSM/SV allocation. I don't think either is likely. But to assume one is plausable while another isn't is very nearsighted.

Bottom line, if you need an advisor, Core equity strategies are a nice option to have. If not, use the ETFs/Funds available.

sh

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Post by Rick Ferri » Wed Oct 08, 2008 1:12 pm

SmallHi wrote:I am always amused at how Rick can be so dogmatic about the "equity" dimension of the Fama French 5 Factor model (equity, size, price, term, and credit), while completely bastardizing the rest of it (using emerging market bonds, junk, preferreds, etc). The reality is, unless you are using size/value tilted (or just market oriented) passive global equity strategies diluted with a short term, high quality fixed income that adjusts maturities based on the shape/slope of the yield curve, you really aren't investing according to the Fama/French research
SH,

This conversation is not about investing using the FF 5-factor model. This is an equity only discussion. The DFA TA US Core Equity 2 and the ETF portfolios are based on the FF 3-factor model, and in that light I have provided correct answers.
Also. any supposed "black swan" from underweighting LG stocks applies equally to just overweighting the smallest value stocks.
That is not true. If it was, the R squared between the two portfolios would be 100%, and it is not. Leaving off MSFT, CSCO, GOOG and other large cap tech stocks is not that same as adding small cap value names. The two create different portfolios with different tracking.

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Post by RiskyB » Wed Oct 08, 2008 2:26 pm

SmallHi

Attempting to understand FF research regarding such things as adjusting maturities based on the shape/slope of the yield curve is precisely what had my head spinning in the first place.

The fact that Core2 holds more stocks than VTI is one reason I was attracted to the fund. Other reasons include the fact that patient trading can be used to purchase stocks at a lower price. Another reason is that the academic brainpower at DFA will always be working in the background to add stocks in response to changing market conditions or eliminate stocks that do not measure up. Also, that the fund will be automatically rebalanced by DFA without incurring the usual rebalancing costs. However, despite much effort I have not been able to determine how much value is actually added by all the above. Therefore I cannot measure them against the ongoing value of lower cost of the ETF portfolio.

To your final point. What if you need/want an advisor not for advice on complicated matters such as estate planning or managing a complicated portfolio but simply to achieve the highest after tax returns from a simple portfolio. Clearly every investor wants to earn the highest returns and keep as much as possible. Therefore If (b) is more likely to achieve this goal than (a) even after including a reasonable advisor fee, why not use an advisor.

(a)
25% Vanguard Total Stock Market (VTI) ER: 0.07
20% iShares S&P 600 Small Cap Value (IJS) ER: 0.25%

(b)
45% DFA TA US Core Equity2 (DFTCX) ER 0.30%
(Assuming advisor fee of 0.25%)

Finally, I am not sure where it was but I remember reading something in the FF papers supporting the notion that the total market should always be the starting point for a portfolio.

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Post by SmallHi » Wed Oct 08, 2008 5:26 pm

Rick,
SH,

This conversation is not about investing using the FF 5-factor model. This is an equity only discussion. The DFA TA US Core Equity 2 and the ETF portfolios are based on the FF 3-factor model, and in that light I have provided correct answers.
I really cannot argue with that statement.

Overall, such strict adherence to one side of the factor model with almost complete disregard for the other raises flags, but I'll let it go.
That is not true. If it was, the R squared between the two portfolios would be 100%, and it is not. Leaving off MSFT, CSCO, GOOG and other large cap tech stocks is not that same as adding small cap value names. The two create different portfolios with different tracking.
You have lost me here. I don't think the TSM/SV portfolio tracks TSM less closely than Core? Actually, it tracks it closer.

The Core fund does not leave off MSFT, CSCO, or GOOG, it just doesn't hold as much of them (only 0.25% to 0.75% of the portfolio).

Just how is underweighting some of the largest growth stocks detrimental for Core, while holding more than 2X the allocation of the smallest value stocks (relative to Core) not detrimental for TSM/SV? Still don't see how this isn't a two way "black swan"?

The TSM/SV portfolio holds twice the weight of "small value" stocks as the Core fund does, as well as twice the weight of "large growth stocks". The Core fund spreads the LG stock "savings" <ie. from the underweight position> more evenly across the market cap spectrum, so LV, Mid Blend, Mid Value, and Small are all modestly overweighted relative to TSM/SV. Moderation vs. excess, if you will.

Am I missing something?

sh
Last edited by SmallHi on Wed Oct 08, 2008 6:26 pm, edited 3 times in total.

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Post by SmallHi » Wed Oct 08, 2008 5:51 pm

Attempting to understand FF research regarding such things as adjusting maturities based on the shape/slope of the yield curve is precisely what had my head spinning in the first place.
Oh, don't take that comment I said literally, I was just trying to make a point about Rick's comment. If we want to follow the research, lets follow it! I didn't say we have to, but lets not pretend or cherry pick what we like/dislike. That would be like John Bogle saying "I like the 3 Factor model -- but just the "Equity" part".
The fact that Core2 holds more stocks than VTI is one reason I was attracted to the fund.
Again, that is statistically meaningless. Rick mischaracterized how the Core fund worked (saying they excluded LG stocks), so I just wanted to make that point.
Other reasons include the fact that patient trading can be used to purchase stocks at a lower price. Another reason is that the academic brainpower at DFA will always be working in the background to add stocks in response to changing market conditions or eliminate stocks that do not measure up.


All good stuff.
Also, that the fund will be automatically rebalanced by DFA without incurring the usual rebalancing costs. However, despite much effort I have not been able to determine how much value is actually added by all the above. Therefore I cannot measure them against the ongoing value of lower cost of the ETF portfolio.


enough to cover the advisor fee, IMO.
To your final point. What if you need/want an advisor not for advice on complicated matters such as estate planning or managing a complicated portfolio but simply to achieve the highest after tax returns from a simple portfolio. Clearly every investor wants to earn the highest returns and keep as much as possible.
Well, the advantages of better structured funds is a matter of basis points. Someone who can provide the discipline to get through the rough times if you are unable to on your own (as most aren't), thats worth percentages.
Finally, I am not sure where it was but I remember reading something in the FF papers supporting the notion that the total market should always be the starting point for a portfolio.
I'd love to read it, and would stand corrected.

sh

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Post by RiskyB » Thu Oct 09, 2008 11:21 am

SmallHi & Rick

Thanks for your thoughts but I am still hoping for a more direct answer to my original question: Which of the following US Equity holdings do you believe will produce the highest after tax return if held in a taxable account over the coming 10 years, and why?

(a)
25% Vanguard Total Stock Market (VTI) ER: 0.07
20% iShares S&P 600 Small Cap Value (IJS) ER: 0.25%

(b)
45% DFA TA US Core Equity2 (DFTCX) ER 0.30%
(Assuming advisor fee of 0.25%)


Rick said flip a coin, SmallHi said the advantages of better structured funds is a matter of basis points. From your comments here and in past posts it appears that if Rick were investing his own money in a taxable account and had only (a) & (b) to choose from he would choose (a). SmallHi in the same situation would choose (b). However, it appears that you both believe that the outcome after 10+ years, even with higher taxes is not likely to be much different. Please let me know if my interpretation is correct.

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Post by SmallHi » Thu Oct 09, 2008 11:46 am

RiskyB wrote:SmallHi & Rick

Thanks for your thoughts but I am still hoping for a more direct answer to my original question: Which of the following US Equity holdings do you believe will produce the highest after tax return if held in a taxable account over the coming 10 years, and why?

(a)
25% Vanguard Total Stock Market (VTI) ER: 0.07
20% iShares S&P 600 Small Cap Value (IJS) ER: 0.25%

(b)
45% DFA TA US Core Equity2 (DFTCX) ER 0.30%
(Assuming advisor fee of 0.25%)


Rick said flip a coin, SmallHi said the advantages of better structured funds is a matter of basis points. From your comments here and in past posts it appears that if Rick were investing his own money in a taxable account and had only (a) & (b) to choose from he would choose (a). SmallHi in the same situation would choose (b). However, it appears that you both believe that the outcome after 10+ years, even with higher taxes is not likely to be much different. Please let me know if my interpretation is correct.
For me, there are enough "pros" to vote confidently in favor of (b).

sh

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Post by Rick Ferri » Thu Oct 09, 2008 12:00 pm

SmallHi wrote:Just how is underweighting some of the largest growth stocks detrimental for Core, while holding more than 2X the allocation of the smallest value stocks (relative to Core) not detrimental for TSM/SV? Still don't see how this isn't a two way "black swan"?
I don't know. There is just something about it, and I don't quite have my finger on it yet.

To me, getting to a three factor solution by directly reducing the percentage in large growth is different enough than keeping the TSM and increasing the percentage in small value. Granted, intuitively the methods should be close. But there always seems to be something negative about model manipulation that is not realized until it happens.

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Question for Larry and Rick

Post by YDNAL » Thu Oct 09, 2008 12:04 pm

RiskyB wrote:Question for Larry and Rick
RiskyB,

I didn't respond since you were looking for Larry and Rick's input. Can't help myself, though, since it is so much fun to listen to the theoretical guys/gals!

Here's my take from the trenches... it doesn't matter whether is A) or B) and we will know in 20 years. Ask a Japanese investor who accumulated up to 1989 if using a 5-factor model (based on historical data) meant anything to them over the past 20 years.

Look at the link and tell me that you don't get lost (like I do) after the first little square box in fig 8-19. :wink:
http://www.ifa.com/12steps/step8/step8page4.asp

Regards,
Landy
Landy | Be yourself, everyone else is already taken -- Oscar Wilde

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Post by richard » Thu Oct 09, 2008 12:16 pm

SmallHi wrote:The reality is, unless you are using size/value tilted (or just market oriented) passive global equity strategies diluted with a short term, high quality fixed income that adjusts maturities based on the shape/slope of the yield curve, you really aren't investing according to the Fama/French research -- you are investing according to your interpretation of the research. Not to say that approach is right or wrong, just stating the facts. Read the dozen or so research papers on it from FF if you don't agree.
FF equity research, as I interpret it, concludes that exposure to three risk factors (market, size, value) are the primary determinants of returns. Increasing exposure to risk factors increases expected returns at the cost of higher risk. It's more explanatory than prescriptive.

Do you disagree?

Fama himself has said in a few interviews that he'd start with the market portfolio, which would be a fine holding. If you want to try for higher returns at the cost of higher risk, add S and V to taste.

Do you disagree that Fama has said this? Do you disagree with with the statement?

In which paper did Fama recommend using short term, high quality fixed income that adjusts maturities based on the shape/slope of the yield curve? (Not just analysis of fixed income markets)

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Post by SmallHi » Thu Oct 09, 2008 12:28 pm

FF equity research, as I interpret it, concludes that exposure to three risk factors (market, size, value) are the primary determinants of returns. Increasing exposure to risk factors increases expected returns at the cost of higher risk. It's more explanatory than prescriptive.
I'm fine with that. As I said -- the model drives investment choices.
Fama himself has said in a few interviews that he'd start with the market portfolio, which would be a fine holding. If you want to try for higher returns at the cost of higher risk, add S and V to taste.

Do you disagree that Fama has said this? Do you disagree with with the statement?
Sure, he's said thats one way to skin the cat. Not the only way, however. And he's certainly never said that starting with an S&P 500 fund or a Core Equity fund is less efficient.

If anything, if you want to isolate the size premium, as calculated by FF, you have to use a Large Cap fund (CRSP 1-5 or S&P 500/Russell 1000) and add a Small Cap fund (CRSP 6-10/Small Cap Index). The size premium is not calcuated as Small Cap minus TSM. Nor is the Value premium calcuated as Value minus TSM.

There is a huge flaw in arguing that you must start with a TSM portfolio and add tilts to it. That is just one way to do it.
In which paper did Fama recommend using short term, high quality fixed income that adjusts maturities based on the shape/slope of the yield curve? (Not just analysis of fixed income markets)
Check out his 2003 paper: Update of the Research Underlying Dimensional's Bond Strategies, in which he starts:
Dimensional's bond products are based on research I did in the 1980s.
sh

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Re: Question for Larry and Rick

Post by Rick Ferri » Thu Oct 09, 2008 12:30 pm

YDNAL wrote:Look at the link and tell me that you don't get lost (like I do) after the first little square box in fig 8-19. :wink:
http://www.ifa.com/12steps/step8/step8page4.asp
Not difficult. Briefly, the FF 5-factor model attempts to explain MOST of the risk and return of broadly diversified portfolios using 5 risk factors.

1) The overall market exposure (beta or market risk)
2) Over or under exposure to small stocks (size risk)
3) Over or under exposure to value stocks (price or quality risk)
4) Where the bond portfolio is invested on the yield curve (term risk)
5) The types of bonds you invest in (credit risk)

Those factors were shown to explain 95% (?) of the long-term returns of very broadly diversified portfolios. All you have to do is decide how much risk you want to take overall, and how you want to allocate that risk.

It is a decent model, although not the only one out there. Academics and investment institutions have created many, many factor models to explain portfolio return. Some of these models have a few factors and others have 10 or more factors. The FF model happens to have 5 factors. If you think about it, Morningstar style boxes for equity and fixed income illistrate those same risks.

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Post by SmallHi » Thu Oct 09, 2008 12:38 pm

Rick Ferri wrote:
SmallHi wrote:Just how is underweighting some of the largest growth stocks detrimental for Core, while holding more than 2X the allocation of the smallest value stocks (relative to Core) not detrimental for TSM/SV? Still don't see how this isn't a two way "black swan"?
I don't know. There is just something about it, and I don't quite have my finger on it yet.

To me, getting to a three factor solution by directly reducing the percentage in large growth is different enough than keeping the TSM and increasing the percentage in small value. Granted, intuitively the methods should be close. But there always seems to be something negative about model manipulation that is not realized until it happens.

Rick Ferri
I will tell you, in all fairness, and almost anyone familiar with the FF research should acknowledge this, there is something about getting all of your size/value tilts in a relatively concentrated SV Index fund. If I had to worry about anything, thats what I'd be trying to place my finger on. (I don't worry about either, to be fair)

By definition, as of 6/30, over 1,800 stocks could be classified as more value oriented than the market (across large/medium/small capitalizations), and over 3,200 can be classified as smaller than the market (750 mid caps, almost 2,500 small/micro caps). Just how is it that we decide overweighting just 460 of these (through IJS) is ample? Seems more like an arbitrary, active decision to me.

Sure, there is a concentration of distress and liquidity risks (and expected premiums) in these tiny companies, just as their is a lack of one in the largest, highest priced growth stocks (as well as a lack of return). But how one decides that a portfolio that overweights these 460 stocks by a factor of 6 (as TSM/SV portfolios do), relative to a 2 or 3X increase for all 3200 stocks considered smaller/more value oriented than the market (as the Core fund does) is not riskier, or at least as subject to black swans, is beyond me?

Wouldn't be the first thing I missed, however :lol:

sh

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Post by RiskyB » Thu Oct 09, 2008 1:34 pm

Talk about unintended consequences, I didn’t mean to start a factor fight.

In trying to calculate the annual cost of maintaining portfolios (a) compared to (b) (based on 100K invested) including the 0.25% advisor fee I came across the following language on the DFA website.

Dimensional has contractually agreed to waive certain fees and assume expenses for a one-year period set to terminate on April 1 unless renewed. Dimensional may seek reimbursement for amounts previously waived under the conditions outlined in the prospectus.

Any thoughts on the possibility that fees and expenses will be increased or that DFA will seek reimbursement?

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Post by Rick Ferri » Thu Oct 09, 2008 2:02 pm

RiskyB wrote:Talk about unintended consequences, I didn’t mean to start a factor fight.

In trying to calculate the annual cost of maintaining portfolios (a) compared to (b) (based on 100K invested) including the 0.25% advisor fee I came across the following language on the DFA website.

Dimensional has contractually agreed to waive certain fees and assume expenses for a one-year period set to terminate on April 1 unless renewed. Dimensional may seek reimbursement for amounts previously waived under the conditions outlined in the prospectus.

Any thoughts on the possibility that fees and expenses will be increased or that DFA will seek reimbursement?
That is up to DFA. Who knows.

I will point out that in this passage the "advisor fee" is DFA's management fee, NOT the separate advisor's fee (RIA fee) that investors must also pay for access. I hope that is clear.

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Post by richard » Thu Oct 09, 2008 2:36 pm

SmallHi wrote:There is a huge flaw in arguing that you must start with a TSM portfolio and add tilts to it. That is just one way to do it.
Agreed. I'd also apply "just one way to do it" to:
The reality is, unless you are using size/value tilted (or just market oriented) passive global equity strategies diluted with a short term, high quality fixed income that adjusts maturities based on the shape/slope of the yield curve, you really aren't investing according to the Fama/French research
SmallHi wrote:
In which paper did Fama recommend using short term, high quality fixed income that adjusts maturities based on the shape/slope of the yield curve? (Not just analysis of fixed income markets)
Check out his 2003 paper: Update of the Research Underlying Dimensional's Bond Strategies, in which he starts:
Dimensional's bond products are based on research I did in the 1980s.
I regard this paper as descriptive rather than prescriptive. "Based on" does not mean that it is the only way to invest consistent with the research. The paper is at http://www.dfaus.com/library/articles/update_research/

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Post by RiskyB » Thu Oct 09, 2008 2:47 pm

Rick

Understood, it’s the expense ratio that DFA may increase from 0.30 to 0.60. Do you know if they ever exercised the option to increase fees/expenses on any of there funds? Seems unlikely at a time when Vanguard, Fidelity and others are moving in the opposite direction to stay competitive but it is an important consideration.

With the strong possibility of higher taxes I think the biggest advantage offered by the Core funds is the ability to continuously rebalance without tax consequences. I am not clear as to why you do not find this a significant benefit for a taxable account. I realize the Core concept is new and perhaps unproven but ETFs are often criticized for the same reason.

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Post by clay » Thu Oct 09, 2008 3:09 pm

Rick Ferri wrote: Here is the bottom line. Advisors and money managers sometimes say and do things to help their own business when they do not believe that taking such action will be a long-term negative to investors.
Also, in far too many cases, when they do believe it.

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Post by Rick Ferri » Thu Oct 09, 2008 3:13 pm

RiskyB wrote:With the strong possibility of higher taxes I think the biggest advantage offered by the Core funds is the ability to continuously rebalance without tax consequences. I am not clear as to why you do not find this a significant benefit for a taxable account. I realize the Core concept is new and perhaps unproven but ETFs are often criticized for the same reason.
The DFA core fund still has to eventually sell stocks to keep on target allocation with FF model. And you will have to sell some fund shares to keep pace with your US/international and stock/bond allocations.

Also, with the TSM ETF and small value ETF, you have the advantage of tax-swapping TSM or small value independently depending on the market. For example, you can swap VTI into IVV, or IJS into IWN, hold for 31 days and swap back.

So, while there may be a small potential short-term benefit of "continuously rebalance without tax consequence", I do not see that as a meaningful long-term advantage if it actually does become a realized advantage at all. But these are minor issue. Both ETFs and DFA are good options.

Rick Ferri

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Post by PiperWarrior » Thu Oct 09, 2008 4:40 pm

SmallHi wrote:By definition, as of 6/30, over 1,800 stocks could be classified as more value oriented than the market (across large/medium/small capitalizations), and over 3,200 can be classified as smaller than the market (750 mid caps, almost 2,500 small/micro caps). Just how is it that we decide overweighting just 460 of these (through IJS) is ample? Seems more like an arbitrary, active decision to me.
Have you come across a study about the number of stocks and the distribution of tracking errors (preferably in small cap value)? I've seen several topics in this area with qualitative discussions on this forum, but I have never seen numbers. The reason why a telephone poll doesn't have to call everybody in the U.S. is because calling 1,000 people (or whatever appropriate number) is good enough to drive the sampling error very low. Sure, diversification among small-cap value stocks is good, and a black swan is bad, but I am not sure to what extent diversification matters. (By "not sure", I mean I simply don't know.)

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Post by SmallHi » Thu Oct 09, 2008 5:22 pm

RiskyB wrote:Rick

Understood, it’s the expense ratio that DFA may increase from 0.30 to 0.60. Do you know if they ever exercised the option to increase fees/expenses on any of there funds? Seems unlikely at a time when Vanguard, Fidelity and others are moving in the opposite direction to stay competitive but it is an important consideration.

With the strong possibility of higher taxes I think the biggest advantage offered by the Core funds is the ability to continuously rebalance without tax consequences. I am not clear as to why you do not find this a significant benefit for a taxable account. I realize the Core concept is new and perhaps unproven but ETFs are often criticized for the same reason.
There is almost no chance the fee will go up. It will likely be down to 0.25% or so in a few years, if the path of taxable Core 2 is any guide.
The DFA core fund still has to eventually sell stocks to keep on target allocation with FF model. And you will have to sell some fund shares to keep pace with your US/international and stock/bond allocations.
Yes, but those can be offset with losses. And all portfolios (except World Index Funds) have to rebalance between regions. Thats a wash -- except if you choose to rebalance between Europe and Asia, at which point the tax consequences will be higher.
Also, with the TSM ETF and small value ETF, you have the advantage of tax-swapping TSM or small value independently depending on the market. For example, you can swap VTI into IVV, or IJS into IWN, hold for 31 days and swap back.
Thats true, although, normally, you will see adverse performance in the Core fund if either TSM or SV are losing value -- which normally happens together. 1998 and 2001 are not the rule, they are the exception. And this is only a benefit in the first few years anyway (assuming historical returns). You certainly can swap TA Core for Core I would imagine and not loose a step from that perspective. Heck, there's even a Social Core fund now with similar size/value exposure.

I've never felt like a lot of the critiques I read above are very legit, to be honest.

sh

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Post by RiskyB » Fri Oct 10, 2008 2:14 am

Rick

Can you give some examples of the large cap stocks that were eliminated by Core2?

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Post by RiskyB » Fri Oct 10, 2008 9:20 am

Another thought:

What about the possibility that permanent changes in the financial industry resulting from the economic crisis keep small companies with limited access to financing at a long-term disadvantage. If so you may want to reduce exposure to small stocks and this would not be possible with the Core Funds.

How would William J. Bernstein choose between portfolio (a) and (b) I am inclined to think he would choose the DFA Core2 portfolio but he advocated keeping costs low so who knows.

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Post by Rick Ferri » Fri Oct 10, 2008 9:24 am

RiskyB wrote:Rick

Can you give some examples of the large cap stocks that were eliminated by Core2?
HERE is the list of the top 25 names in the DFA TM Core 2 portfolio. Compare that HERE to the top 25 holding of the Vanguard Total Stock Market ETF.

Among the missing from the DFA fund are Microsoft, Apple, Cisco, Google, Intel, and Oracle. These companies may have a small weighting in the DFA TM Core 2 fund, but it is a small fraction of their market weighting.

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Post by RiskyB » Fri Oct 10, 2008 9:59 am

Rick

I see what you mean; Wall-Mart was not there either. Do you know why the academics at DFA chose to underweight these companies?

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Post by Rick Ferri » Fri Oct 10, 2008 10:05 am

RiskyB wrote:Rick

I see what you mean; Wall-Mart was not there either. Do you know why the academics at DFA chose to underweight these companies?
I not sure it is the academics at DFA that decided this, rather the investment committee. This is DFA's new method for employing the Fama / French 3-factor model to gain asset capacity in their funds. Rather than leave the TSM as is and overweight small and value stocks, DFA is underweighting/eliminating some large growth stocks. I assume they chose these stocks based on book-to-market value (which is basically the inverse of price-to-book). Stocks that don't have a lot of book value compared to market value are cut back. Earnings and earnings growth are not a consideration.

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Post by Blue » Fri Oct 10, 2008 10:08 am

RiskyB wrote:In trying to calculate the annual cost of maintaining portfolios (a) compared to (b) (based on 100K invested) including the 0.25% advisor fee I came across the following language on the DFA website.
RiskyB --- where can you get DFA access for 25 bp with only $100k? I always thought minimums would have to be much higher to get that kind of advisor fee?

Thanks,
Blue

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Post by RiskyB » Fri Oct 10, 2008 10:09 am

Rick

That sounds like a good thing, what am I missing? Are you saying that the Core funds are designed primarily to benefit DFA not because the academics developed a superior technology?
Last edited by RiskyB on Fri Oct 10, 2008 10:48 am, edited 1 time in total.

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Post by RiskyB » Fri Oct 10, 2008 10:22 am

Blue

I believe you’re right, minimums would have to be higher. I was only using 100K for example purposes.

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Post by btenny » Fri Oct 10, 2008 12:43 pm

Rick, How can they say the DFA Core is representative of the overall stock market when it contains so many energy stocks versus other things? Or is 6 of 25 companies the right ratio in market value analysis?

Bill

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Clarification on Rick's opinions

Post by SmallHi » Fri Oct 10, 2008 1:39 pm

Some clairification:
This is DFA's new method for employing the Fama / French 3-factor model to gain asset capacity in their funds.


This is Rick's opinion. Plain and simple. He is entitled to his opinion, but thats all it is. Truman Clark has said something different:

With reduced trading costs, the Core Equity funds strive to provide higher net returns than standard tilted portfolios of comparable risk.
Rather than leave the TSM as is and overweight small and value stocks, DFA is underweighting/eliminating some large growth stocks. I assume they chose these stocks based on book-to-market value (which is basically the inverse of price-to-book). Stocks that don't have a lot of book value compared to market value are cut back. Earnings and earnings growth are not a consideration.
Again, from Truman's perspective:

The traditional way to build tilted portfolios is by combining an S&P 500 or other large cap index fund with one or more asset class funds.
and...
The Core Equity funds are designed to reduce the costs of maintaining tilted portfolios. Unlike asset class funds, Core Equity funds target all eligible stocks, and trading is aimed at preserving portfolio balance.

For those interested, hop over to the dfaus.com website, click on an associated Core fund, pull up the holdings spreadsheet, and "search" for any stock you can find. As you'll see (contrary to what has been said), it'll be there. The larger/growthier it is, the lower % it will have relative to the market. Vice versa for smaller/more valuey stocks.

When the "debate" moves away from the details of each strategy, and instead towards the motiviations of each strategy, we are no longer dealing with facts, but conspiracy theories. I would not make investment decisions on conspiracy theory -- that is not a sound investment principal.

sh
Last edited by SmallHi on Fri Oct 10, 2008 1:42 pm, edited 1 time in total.

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Further clarification

Post by SmallHi » Fri Oct 10, 2008 1:41 pm

btenny wrote:Rick, How can they say the DFA Core is representative of the overall stock market when it contains so many energy stocks versus other things? Or is 6 of 25 companies the right ratio in market value analysis?

Bill
At recent glance, DFA US Core 2's energy weighting was within 0.4% of the Russell 3000.

sh

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Re: Further clarification

Post by Rick Ferri » Fri Oct 10, 2008 7:46 pm

btenny wrote:Rick, How can they say the DFA Core is representative of the overall stock market when it contains so many energy stocks versus other things? Bill
Bill,

It was not me who said that. I am in agreement with you. Please reread my posts.

Rick Ferri

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Rick please elaborate on your statement

Post by Edor » Sat Jan 17, 2009 11:12 pm

Rick Ferri wrote:
Here is the bottom line. Advisors and money managers sometimes say and do things to help their own business when they do not believe that taking such action will be a long-term negative to investors....
On the other hand, DFA (the business) has a real incentive to manage money that way because eliminating large growth rather than adding small value provides their funds with near unlimited capacity to take on new assets. Remember that increasing assets under management is how DFA makes more money for the business partners.

Rick Ferri
I have read this thread with interest. Rick could you elaborate on the part of your post that I have underlined. I don't know enough about DFA to understand how the shift in proportions that you mention above makes it easier for DFA to have nearly unlimited capacity to add assets.

If you can substantiate this, while it does not raise a red flag for me, it does indicate that the motivation of DFA the business may not be as closely aligned with me as a potential investor. If that was the case, then I'd want to determine even more closely whether the first part of your statement holds true for this particular fund (whether indeed it will turn out NOT to be a long term negative).

Thanks, Edward

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Post by Rick Ferri » Sun Jan 18, 2009 11:31 am

This is an old thread, but I will elaborate.

The only way a fund company can grow profits is to increase assets under management. When a fund company faces capacity constraints, they have only two choices; 1) stop taking in new assets 2) change the way accounts are managed to increase capacity. Like every company, DFA's private investors expect a return on their capital.

Since DFA is a private company with investors who expect earnings growth, the board of directors really had no choice in the matter. They chose #2. Given who they are, what they do, and who owns the company, I believe that was the right business decision for the company. People who owned the old funds could stay in them, and new investors went into the new funds.

The way DFA was managing money 10 years ago had capacity limits. For example, there is only so much money they could efficiently manage in a micro-cap fund before they broke SEC limits on the amount of each company the fund could own (no more than 10% of voting shares outstanding). Once capacity was reached, DFA would not be able to take in any new money in those funds because they could not invest it.

About 6 years ago (?), DFA expanded the size range of what they considered to be microcap. Basically, the pushed up the range into small cap, and changed their performance benchmark from the CRSP 9-10 (mirocap) index to the Russell 2000 small cap index. That gave DFA breathing room, but only for a little while.

A surging micro-cap and small value market in the early 2000s kept money poring in from a growing number of investment advisors who were given access to the funds. Consequently, it was not long before DFA was up against capacity issues again. That brought about a complete restructuring of DFA fund offerings so that capacity would no longer be an issue. The micro cap and small value funds were closed, and new fund 'target' and 'vector' funds were created that added mid-cap stocks.

DFA had long been sour on midcap stocks in thier research and their lectures to advisors. But, to expand their business, they needed mid-cap stock exposure. So they redid their research and 'discovered' that adding mid-caps did not harm a portfolio. That justified owning mid-caps and that enabled them create new funds that had nearly unlimited asset capacity.

So, back to my 2008 comments, "Advisors and money managers sometimes say and do things to help their own business when they do not believe that taking such action will be a long-term negative to investors".

You can make what you will out of this post. I will not say anything negative about DFA or their business model. They are an independent fund company who can manager money any way they wish and charge whatever they want for those services.

I will, however, speak negatively of the many independent advisors who hard-sell DFA as 'the answer to investors prayers.' That is a marketing pitch. A true advisor will look at all the product available from ETFs to Vanguard funds and DFA funds, and make unbiased decisions for the benefit of their clients.

Rick Ferri

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Post by SmallHi » Sun Jan 18, 2009 1:11 pm

Edor, you are in serious need of some straight talk.

My advice to you is to not treat Rick's elaboration as fact, but merely his opinion of events that have transpired. Let me explain:
The only way a fund company can grow profits is to increase assets under management. When a fund company faces capacity constraints, they have only two choices; 1) stop taking in new assets 2) change the way accounts are managed to increase capacity.


Of course this is false. Growing existing assets through capital appreciation is another, primary mode of company profitability. DFA has been doing that as well as any firm in existence for 25 years. If they were to stop working an innovating towards better solutions tomorrow, the firm and all investors would suffer.
The way DFA was managing money 10 years ago had capacity limits. For example, there is only so much money they could efficiently manage in a micro-cap fund before they broke SEC limits on the amount of each company the fund could own (no more than 10% of voting shares outstanding). Once capacity was reached, DFA would not be able to take in any new money in those funds because they could not invest it.
The way DFA was investing 10 years ago has not changed materially relative to its approach today. But you have to understand what DFA is trying to do, and how that differs from one advisor's opinion of what DFAs intensions are. Straight from the horses mouth:

The mission of Dimensional Fund Advisors is to deliver the performance of capital markets and increase returns through state-of-the-art portfolio design and trading.

and,

...structure strategies based on scientific evidence rather than on speculation or commercial indexes. Small cap strategies target smaller stocks more consistently. Value strategies target value returns with greater focus. As a result, investors achieve more consistent portfolio structure.

As you can see, nowhere is it said that the goal of DFA is to hold the smallest stocks of any firm in the industry, or the most value oriented. Their products are designed to target size and value dimensions purely and consistently and in an investor friendly manner (keeping fees, turnover, and taxes low).

Why are there strategies designed the way they are? Again, per DFA:

...investors accept the idea of small cap stock risk more readily than the idea of value risk. They might be hesitant to invest large portions of their portfolio in a value strategy. Dimensional's value strategies are more focused. And investor can commit half the dollars he commits to a typical value strategy and achieve the same increase to his plan's expected return.
About 6 years ago (?), DFA expanded the size range of what they considered to be microcap. Basically, the pushed up the range into small cap, and changed their performance benchmark from the CRSP 9-10 (mirocap) index to the Russell 2000 small cap index. That gave DFA breathing room, but only for a little while.
Not even close. In 2000, consistent with their belief in not blindly tracking indexes, they migrated away from the CRSP definition of market capitalization, and towards a much more investable "% of market capitalization" definition. So instead of micro cap stocks being represented by the CRSP 9-10, or CRSP 10, or Russell Micro Cap Index, or whatever arbitrary index you use, they decided to go with "smallest 4% of the marketplace". Small Cap went from CRSP 6-10 to "smallest 8% of the marketplace. It is a much more consistent, investable approach to investing in different market capitalizations. Sometimes, CRSP was buying as small as the bottom 2% of the market, other times as big as the biggest 8% of the market.

What no one will bother to tell you is (or they don't know), both approaches have led to identical simulated returns. The % of mkt cap approach is simply easier for DFA to manage, and targets a certain amount of small exposure more consistently across time.

Only in prospectuses does DFA use the Russell indexes. That point is completely irrelevant to this discussion. As Rick knows, that is commonplace in the industry, adopting one or two leading commercial industry benchmarks to report performance comparison for year end legal accounting.
A surging micro-cap and small value market in the early 2000s kept money poring in from a growing number of investment advisors who were given access to the funds. Consequently, it was not long before DFA was up against capacity issues again. That brought about a complete restructuring of DFA fund offerings so that capacity would no longer be an issue. The micro cap and small value funds were closed, and new fund 'target' and 'vector' funds were created that added mid-cap stocks.
There was no restructuring, DFA simply developed complimentary investment strategies to offer an alternative approach to targeting smaller cap and more value oriented stocks. US Micro has not changed, US Small Value has not changed. US Small xMicro Cap Value (which was just a $100M niche product) changed to the US Targeted Value fund with more universal appeal (a slightly less value oriented, slightly less small cap oriented smaller value strategy -- with a tilt of about 0.6/0.6 vs. 0.8/0.7 for SV). US Vector was developed as an alternative "tilting vehicle" to traditional component based funds for those looking for increased multifactor exposure in a total market package to compliment the Core strategies. Its success has spawned the International version.

Again, the evolution towards Core strategies offers an alternative way to tilt to size and value without some of the traditional costs/drag of maintaining component portfolios. No one has lost anything with the closing (to new investors) of Micro/Small. You can still achieve even extreme size/value tilts via US Small Cap and US Targeted Value.

Code: Select all

Lets say you have TSM as a core, but want a huge small target (0.75 tilt to small).  2 ways to do this based on simulated regression analysis:

10% Russell 3000; 90% DFA Small Index (79-07 = +13.98%)
22% Russell 3000; 78% DFA Micro Index (79-07 = +13.69%)
or

Code: Select all

Lets say you have TSM as a core, but want a huge value target (0.50 tilt to value and small).  2 ways to do this based on simulated regression analysis:

20% Russell 3000; 80% DFA Targeted Value (79-07 = +16.48%)
35% Russell 3000; 65% DFA Small Value (79-07 = +16.14%)
or,

Code: Select all

Suppose you want a modest size/value tilt (0.4/0.4), but want an alternative to your TSM/SV portfolio.  Again, based on historical simulations:

42% Russell 3000; 58% DFA Small Value (79-07 = +15.84%)
100% DFA US Vector (79-07 = +15.78%)
All of DFAs funds have the same multifactor principals (designed around size and book-to-market), use the same screens, block trading, and securities lending principals. Their evolution is about offering alternative strategies to capture various dimensions (advisors still use component funds as well as new core funds).

Ongoing technology has made this evolution possible. It was not based on capacity. Its likely that US Targeted Value could house $50B (1/2 the size of DFA) before it ran out of room. Really a silly notion.
DFA had long been sour on midcap stocks in thier research and their lectures to advisors. But, to expand their business, they needed mid-cap stock exposure. So they redid their research and 'discovered' that adding mid-caps did not harm a portfolio. That justified owning mid-caps and that enabled them create new funds that had nearly unlimited asset capacity.
Again, lets set the truth straight. DFA has said that adding a seperate mid cap strategy to a component portfolio of Large/Small/Value/Blend would be rendundant because:

a) some mid caps are already held in Large Cap, and received a full weighting in the Marketwide portfolios (US Marketwide Value, US Equity, and EM Value) dating back to 2000, the way DFA defines it
b) the increased portfolio turnover to rebalance back to Large/Medium/Small would not be compensated by higher expected returns

Again, straight from the horses mouth:

Mid-cap stocks, popular as they are, are not primary components. By definition, they're neither large nor small, but fall midway in the size risk spectrum. Their exposure can be achieved with combinations of large cap and small cap asset classes

So why the inclusion of mid cap stocks in some of DFAs recent strategies (ie. Core, Vector, and Targeted Value)? Well, for the first two, they attack small cap and value investing within a total market framework -- they own almost every stock in the market, choosing to hold higher than market percentages of smaller and lower priced names. Under this approach, it doesn't make sense to exclude any stocks that match the portfolio's definition. Excluding mid cap stocks (which have small dose of size exposure and can offer strong value exposure) would increase the costs of these strategies through increased turnover. In this case, because these portfolios are designed to offer only mild to modest tilts towards small and value, a total market mandate (instead of the smallest 4% or 8% of the market) makes the most sense from an investability perspective.

The Core funds, in most cases, replace the need for a TSM or S&P 500 "Core fund", so that the base of the portfolio is now structured with Large/Medium/and Small stocks in a seamless fashion without the usual costs of maintaining 3 seperate portfolios. To these strategies, more severe component size/value funds (or Vector) can be added to customize the plan.

What about Targeted Value? Well, this strategy is based directly from the research work of Fama/French in their study Migration. In it, the findings are that the migratory patters of SV stocks from SV to SB and SV to Mid Value explain almost all of the turnover and return behavior of the asset class, and a deep size/value tilted portfolio. So the construction rules are such that it is allowed to hold SV stocks a bit longer as momentum carries them to the boundaries of SB or MV. It does result in lower exposure to small cap and value, and as my example showed, you need more of it to achieve your target allocation -- but to the extent it creates a more investment friendly strategy, it may produce higher total returns for the investment portfolio.

Clearly, no capacity issues here. Its called evolution, and no settling for yesterday's processes and success, but instead trying to pioneer for tomorrows accomplishments. DFA never said "mid caps are bad", just that they were redundant and superflous in a traditional Large/Small component portfolio, and already held once in many existing funds.
So, back to my 2008 comments, "Advisors and money managers sometimes say and do things to help their own business when they do not believe that taking such action will be a long-term negative to investors".

You can make what you will out of this post. I will not say anything negative about DFA or their business model. They are an independent fund company who can manager money any way they wish and charge whatever they want for those services.

I will, however, speak negatively of the many independent advisors who hard-sell DFA as 'the answer to investors prayers.' That is a marketing pitch. A true advisor will look at all the product available from ETFs to Vanguard funds and DFA funds, and make unbiased decisions for the benefit of their clients.
And that includes a "marketing approach" that puts products ahead of process and results. The reality is, there is a lot of DFA angst, and adopting an anti-DFA mentality no doubt appeals to some investors. Hiding behind a commoditized product approach like "index funds"/"etfs" because they have become popular is another way to stand out. Investing "passively" through index funds or asset class funds, but then claiming to actively choose the single best strategy for each category smacks of contradiction.

But, unfortunately for investors, that is what the marketplace looks like today.

Its a free market, and I wish all the best to everyone involved. But when part of that attempt at success is to miscategorize or misrepresent the facts of another investment management firm that challenges the index fund status quo, I have to take exception.

Hope this helps. I have a tremendous amount of respect for Rick, I just don't approve of any of his views on DFA.

sh

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Whoops, wrote my post before seeing/reading SmallHi

Post by Edor » Sun Jan 18, 2009 1:29 pm

1) Thanks for response to "old thread"; I'm new here thought it preferable to keep things in same area rather than proliferate threads. Anyway your history lesson about DFA is helpful to my education and I certainly agree/understand that early DFA funds were trapped by a ceiling to assets in micro or small cap area. But I do not see how what you wrote is germane to the OP situation which is about US TA Core 2 USA as one of your very early posts says:
"On the other hand, DFA (the business) has a real incentive to manage money that way because eliminating large growth rather than adding small value provides their funds with near unlimited capacity to take on new assets. My emphasis, not Rick's."

By "forcing the fund" to use less of the large cap stocks, does it not create more of a capacity ceiling rather than less of one? That is my point.

2) My emphasis added; that sounds like the researchers might have been motivated to have the data support what was good for the business. If true, it is a bit troubling to potential clients via advisors.
Rick Ferri wrote:This is an old thread, but I will elaborate.

DFA had long been sour on midcap stocks in thier research and their lectures to advisors. But, to expand their business, they needed mid-cap stock exposure. So they redid their research and 'discovered' that adding mid-caps did not harm a portfolio. That justified owning mid-caps and that enabled them create new funds that had nearly unlimited asset capacity.Rick Ferri
3) I agree with all of this and particularly value an advisor who is not married to DFA but chooses them as an implementation vehicle when it is the best choice for the client. With regard to the OP ? and comparison, my read of the evidence presented is that both alternatives have their pros and cons; both are good and perhaps it is a coin toss. Nonetheless, the DFA fund has additional stock positions and more diversification and for some would "make more sense". Again thanks for taking the time to reply.
Edward
Rick Ferri wrote: You can make what you will out of this post. I will not say anything negative about DFA or their business model. They are an independent fund company who can manager money any way they wish and charge whatever they want for those services.

I will, however, speak negatively of the many independent advisors who hard-sell DFA as 'the answer to investors prayers.' That is a marketing pitch. A true advisor will look at all the product available from ETFs to Vanguard funds and DFA funds, and make unbiased decisions for the benefit of their clients.
Rick Ferri
Reason for edit minutes later: I had not seen SmallHi post before I wrote mine and will read it now. I usually find his posts to be clear and well supported by data. Changed subject from blank to what is there.

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Thank you

Post by Edor » Sun Jan 18, 2009 1:48 pm

Thanks to both SmallHi and to Rick for continuing this respectful dialogue. Your most recent post SmallHi was extremely helpful to me personally, thank you again.

Edward

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Post by SmallHi » Sun Jan 18, 2009 1:51 pm

Edward,

Because Rick is "uncomfortable" with a particular process of achieving multifactor exposure does not make it any less acceptable or relevant. Has Rick discovered something that Eduardo Repetto and Eugene Fama Sr. (both worked to create the Core process) don't already know? I have my doubts.

Here are the monthly 3F alphas on the following DFA Core Indexes, CRSP 1-10 Index, and the component based US Targeted Value indexes back to 1928:

Code: Select all

CRSP 1-10 = +0.01% (r^2 of 0.99)
US Core 2 = -0.01% (r^2 of 0.99)
US Vector = -0.02% (r^2 of 0.98)
US Targeted Value = -0.01% (r^2 of 0.98)

t-stats are miniscule, indicating no statistical significance to positive or negative alphas

Clearly, after controlling for market, size, and value exposure, there is more than 1 way to target small cap and value risks. One is to create a "lumpy" allocation of Large/Mega Cap growth (via TSM) + Small Cap Value (Targeted Value), the other way is to create a small cap/value weighted portfolio that underweights LG and overweights Mid/small/value relative to market cap weighting, but in a total market package.

As long as fees are low, taxes are managed, and turnover is controlled...and the normal process is unchanged (screens, block trades, avoiding reconstitution, managing momentum, securities lending), both should be viable. Per my quote above, DFA believes the later is a superior approach.

sh

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Post by Roy » Sun Jan 18, 2009 2:17 pm

SmallHi wrote:Clearly, after controlling for market, size, and value exposure, there is more than 1 way to target small cap and value risks.
sh
Smallhi,

In your view, is there a place for small growth (or small blend), in addition to SV, by way of having greater diversification? I see many portfolio samples (from books and online advisors) that include within them a quartile-like, S/D approach but most people seem to focus on SV a lot more.

Also do you think there is a place for REITS --some research shows it as a separate asset class--or does SV already include enough REITS and whatever risks you'd be taking with REITS?

Thanks,

Roy

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Post by SmallHi » Sun Jan 18, 2009 3:01 pm

Roy,

I don't think SB or SG adds much to a component allocation. The fact that DFA holds some SG and MG stocks in their Core funds is OK for the tilt they are aiming for, but when you are using building blocks, I'd be a bit more picky. At Vanguard, some combination of S&P 500, Mid Value, and Small Value will likely allow you to target the tilt most appropriate for you.

As for REITS, if you own Vanguard MV or SV, you have plenty for the portfolio already. If you have the supercharged value strategies from DFA, you should probably take a pass, for the following reasons:

a) REITS have lower expected returns than LV or SV, but subject a portfolio to similar tracking error concerns. If you are going to move away from the market, increasing risk and reducing how you behave relative to the market, best to do so with diversified value funds and not a REIT strategy

<Some might say you lower standard deviation a bit with REITS in an equity portfolio, but so does small doses of ST bonds, and when coupled with SV stocks, the portfolio doesn't suffer. ST bonds, unlike REITS, introduce a favorable element of liquidity into the portfolio. As we've seen with all bond strategies outside of high quality sT bonds and treasuries, liquidity disappears when you need it most, as does the favorable pricing...and that extends to other "diversifiers" such as CCFs, gold, or other alternative assets. Liquidity is a function of price and ability to execute trades. If either of those elements is uncertain (through unexpected economic outcomes, changes in interest rates, inflation, or military or other external risks), then you are lacking liquidity.>

b) REITS crowd ST bonds from IRA accounts due to their tax inefficiency, forcing some to opt for munis in taxable instead, lowering the expected returns of the portfolio beyond that of just simple expected returns

c) portfolios should be structured around the FF 5 Factor model, because its the clearest, most robust asset pricing model available. Using this as a framework allows you to exclude holdings that aren't explained by the model, which introduces uncertainty. Without the aid of FF 5F, there is a neartherworld of hybrid investments (and portfolio management behavior!) that could be considered an asset classes, but often carry the risk/uncertainty of sectors.

sh

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Post by Rick Ferri » Sun Jan 18, 2009 3:12 pm

SmallHi wrote:Edor, you are in serious need of some straight talk. My advice to you is to not treat Rick's elaboration as fact, but merely his opinion of events that have transpired.
It is your opinion that my facts are opinions.
The only way a fund company can grow profits is to increase assets under management. When a fund company faces capacity constraints, they have only two choices; 1) stop taking in new assets 2) change the way accounts are managed to increase capacity.


Of course this is false. Growing existing assets through capital appreciation is another, primary mode of company profitability.


Obviously money managers make more when the markets appreciate, but that does not change the fact that the primary driver of profit is through new assets. I do know that for a fact because I own a money management company.
The way DFA was managing money 10 years ago had capacity limits. For example, there is only so much money they could efficiently manage in a micro-cap fund before they broke SEC limits on the amount of each company the fund could own (no more than 10% of voting shares outstanding). Once capacity was reached, DFA would not be able to take in any new money in those funds because they could not invest it.
The way DFA was investing 10 years ago has not changed materially relative to its approach today. But you have to understand what DFA is trying to do, and how that differs from one advisor's opinion of what DFAs intentions are. Straight from the horses mouth:

The mission of Dimensional Fund Advisors is to deliver the performance of capital markets and increase returns through state-of-the-art portfolio design and trading.

and,

...structure strategies based on scientific evidence rather than on speculation or commercial indexes. Small cap strategies target smaller stocks more consistently. Value strategies target value returns with greater focus. As a result, investors achieve more consistent portfolio structure.
Yes, I am well aware of the spin.
As you can see, nowhere is it said that the goal of DFA is to hold the smallest stocks of any firm in the industry, or the most value oriented. Their products are designed to target size and value dimensions purely and consistently and in an investor friendly manner (keeping fees, turnover, and taxes low).
Yes, that is what the advisors are told to believe, and many do.
Why are there strategies designed the way they are? Again, per DFA: ...investors accept the idea of small cap stock risk more readily than the idea of value risk. They might be hesitant to invest large portions of their portfolio in a value strategy. Dimensional value strategies are more focused. And investor can commit half the dollars he commits to a typical value strategy and achieve the same increase to his plan's expected return.
Yeap. Good marketing there also.
About 6 years ago (?), DFA expanded the size range of what they considered to be microcap. Basically, the pushed up the range into small cap, and changed their performance benchmark from the CRSP 9-10 (mirocap) index to the Russell 2000 small cap index. That gave DFA breathing room, but only for a little while.
Not even close. In 2000, consistent with their belief in not blindly tracking indexes, they migrated away from the CRSP definition of market capitalization, and towards a much more investable "% of market capitalization" definition. So instead of micro cap stocks being represented by the CRSP 9-10, or CRSP 10, or Russell Micro Cap Index, or whatever arbitrary index you use, they decided to go with "smallest 4% of the marketplace". Small Cap went from CRSP 6-10 to "smallest 8% of the marketplace. It is a much more consistent, investable approach to investing in different market capitalization. Sometimes, CRSP was buying as small as the bottom 2% of the market, other times as big as the biggest 8% of the market.
That is nonsense. Never bought that excuse and still don't. The SIZE of the 9-10 micro cap market DID NOT SHRINK in absolute $ value. It was all about percentages, not money. Large caps stocks more than doubled in value verses small cap in the late 1990s, and that cause the percentage of the total market in micro cap to go down. It was not the size of the micro cap market in dollar value that changed. Think about it.
What no one will bother to tell you is (or they don't know), both approaches have led to identical simulated returns. The % of mkt cap approach is simply easier for DFA to manage, and targets a certain amount of small exposure more consistently across time.

Only in prospectuses does DFA use the Russell indexes. That point is completely irrelevant to this discussion. As Rick knows, that is commonplace in the industry, adopting one or two leading commercial industry benchmarks to report performance comparison for year end legal accounting.
Using the Russell 2000 Index is NOT irrelevant, especially considering that Russell has a micro-cap index! There are many micro-cap indexes out there, and have been for many years. So, why go to a small-cap index? I have asked many times and the only answer I received was the 'advisors are familiar with that index', whatever than is supposed to mean.

BTW, DFA also uses the EAFE fund as a benchmark for their large international value fund when the EAFE Value index is a much better benchmark. Why does DFA use the EAFE rather than the EAFE Value? The answer I got, "Advisors are familiar with that index". They might have well have said, "Advisors are stupid. Whatever we say, they'll believe."
A surging micro-cap and small value market in the early 2000s kept money poring in from a growing number of investment advisors who were given access to the funds. Consequently, it was not long before DFA was up against capacity issues again. That brought about a complete restructuring of DFA fund offerings so that capacity would no longer be an issue. The micro cap and small value funds were closed, and new fund 'target' and 'vector' funds were created that added mid-cap stocks.
There was no restructuring, DFA simply developed complimentary investment strategies to offer an alternative approach to targeting smaller cap and more value oriented stocks....Again, the evolution towards Core strategies offers an alternative way to tilt to size and value without some of the traditional costs/drag of maintaining component portfolios. No one has lost anything with the closing (to new investors) of Micro/Small. You can still achieve even extreme size/value tilts via US Small Cap and US Targeted Value.
Call it what you will. The microcap and small value funds are closed because they were capacity issues. For a company to grow, they need product to sell. DFA reengineered their product line to provide capacity for their growth. Nothing wrong with that, as I have said many time. It was a good business decision that any for profit mutual fund company would do.
DFA had long been sour on midcap stocks in their research and their lectures to advisors. But, to expand their business, they needed mid-cap stock exposure. So they redid their research and 'discovered' that adding mid-caps did not harm a portfolio. That justified owning mid-caps and that enabled them create new funds that had nearly unlimited asset capacity.
Again, lets set the truth straight. DFA has said that adding a separate mid cap strategy to a component portfolio of Large/Small/Value/Blend would be redundant because:

a) some mid caps are already held in Large Cap, and received a full weighting in the Marketwide portfolios (US Marketwide Value, US Equity, and EM Value) dating back to 2000, the way DFA defines it
b) the increased portfolio turnover to rebalance back to Large/Medium/Small would not be compensated by higher expected returns.

Again, straight from the horses mouth:

Mid-cap stocks, popular as they are, are not primary components. By definition, they're neither large nor small, but fall midway in the size risk spectrum. Their exposure can be achieved with combinations of large cap and small cap asset classes
(bold added) Nothing has changed there.

Here is the bottom line, a capacity issue in DFA'drove the decision to change direction. That had to happen if DFA was to continue to expand.

That said, I am not going to discuss the benefits and disadvantages of the new direction verses just using the old way of using Vanguard Total Stock market and adding the old DFA micro cap and small value. I will only say that we are staying with the old method.

To be straight on this, it is not wise for me to speak out against DFA on any topic. We want to continue to use a few DFA funds when and where appropriate in client's accounts, and I know very well the danger of speaking out against DFAs strategy. Not from DFA directly (they could not care less), but from a few advisors who frequent this board regularly and like to 'report' to DFA what I said, mostly out of context I might add. Then I get a call from my DFA rep because he got a call from his co-worker who had to listen to the idiot advisor, blah, blah, blah.

Rick Ferri

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Post by SmallHi » Sun Jan 18, 2009 3:54 pm

Rick,

I cannot go on and on with you. You cannot hide behind "marketing excuses" when a fund family isn't even offered to the general public? Your choice to nit pick what index a family chooses to place in the prospectus is bizarre, but superficial. Your critique of an "index change" that didn't harm simulated returns, but improves investability and consistency is head-scratching.

Certainly DFA has to consider capacity in every decision they make. They are one of the most successful firms on the planet. But their movements in recent years have been about evolution and improving existing processes. Investability is better, choices are better, diversification is better, opportunity is improved, costs are lower, tax efficiency is enhanced, and consistency is superior.

The entire DFA equity product line globally is a series of portfolios with unique sorts of market capitalization and book-to-market (except the US/Int'l LC funds). Thats it. No indexes (commercial or CRSP or otherwise). It is an incredibly consistent, transparent pool of global strategies. You may not like their choices, but they were structured this way for simplicity, consistency, and transparency. How anyone can view this as a negative is unbelievable. Just look at the hodgpodge of random strategies Wisdomtree has come up with in the last 3 years if you want to see the risks of inconsistent investment methodologies. Pure chaos. But DFA should keep old, outdated asset class definitions that don't mix with the rest of the product line because one advisor finds that easier and more managable? C'mon.

Thats all I have on the topic, I'll leave you with your conspiracy theories and "active" indexing.

sh

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Post by Rick Ferri » Sun Jan 18, 2009 7:05 pm

Small-Hi,

You have me all wrong. Every company reinvents itself now and then for various business reasons. DFA did it by realigning their fund lineup. I did not say DFA's new strategy was not good, nor did I say that I disliked the funds. Their just a different way to skin a cat.

As far as DFA being 'one of the most successful firms on the planet', well that might be a little far fetched, although David Booth did donate $300 million to the University of Chicago and $16 million to University of Texas business school. So, the owners of the company must be doing well. They are also building a new headquarters in Austin and no doubt their name will go on the buildings. That is a sign of business success, I suppose.

What I have learned over the years is that anything I say about DFA that that might be taken as remotely negative will be to my own detriment. First, there will be an onslaught of disciples who just do not want to hear it and will snow under my post with data that has nothing to do with the point I am making. Then, there will be the calls to DFA to report me as non- conforming, and I will have to deal with that. I have been there, more than once. So, I am no longer interested in commenting about the company or their policies or their funds. Believe what you want.

Rick Ferri

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