Tuesday, January 17, 2012

Examining DFA Funds: Are the Right Measures Being Utilized?

An article appearing on CBSMoneyWatch on Jan. 17th, "Should You Invest in DFA Funds," located at http://www.cbsnews.com/8301-505123_162-57357831/should-you-invest-in-dfa-funds, led me to make this comment.  (I encourage you to read the article first, before reading my comment thereon.)

This article makes me question whether "risk-adjusted performance" as applied to individual stock mutual funds is a valid measurement criteria.  It depends on the use of the fund, of course, in connection with an overall portfolio.

Risk-adjusted performance seems more appropriate to apply to an entire portfolio, rather than to particular funds.  Especially if such higher-volatility funds are utilized to form a portfolio which has less volatility.  This could be done, for example, by including Dimensional's funds for their higher probability of long-term (15 years or greater) out-performance in the portfolio's allocation to equities(due to the value and small cap effects, and the ability of these funds to capture such effect).  Then, the investment adviser could lower the overall allocation to equities in the individual client's investment portfolio by 10% to 15%.  This would likely achieve a similar long-term return, but with far less PORTFOLIO-LEVEL volatility than a portfolio which has a "balanced" equities portfolio - especially during most stock market downturns.

I would note that Modigliani risk-adjusted performance (M2 or RAP) is a measure of the risk-adjusted returns of investment portfolios. It measures the returns of the portfolio, adjusted for the deviation of the portfolio (typically referred to as the risk), relative to that of some benchmark (e.g., the market).

I would also question the implied conclusion that holding cash in a mutual fund portfolio is a bad thing.  Holding cash represents an opportunity cost to investors.  I always perceived large cash holdings in stock mutual funds as a negative for individual investors, who should be "fully invested" in my view in equities, fixed income investments, or other asset classes.  Settling for funds which often hold 6% to 12% (or more) in money market funds, and settling for the drag on returns resulting from such holdings, seems problematic - or at the minimum a factor which must be taken into account when forming an asset allocation for the overall portfolio.  (If this was done, then a greater allocation to equity mutual funds would be undertaken - if those equity funds had high cash holdings.  Again, this means the individual funds may have lower risk-adjusted returns, but to compensate for the cash holdings within the funds the overall portfolio could have greater exposure to equities - and hence the same - or higher - risk-adjusted returns at the portfolio level.)

There are some very low-cost (web-based) advisors who provide access to DFA funds.  Some charge a very low percentage fee, or even a flat annual fee.  Other advisors charge higher fees, but usually throw in a lot of additional services (financial planning, wealth management) for such higher fees and personal service.

I look forward to Thursday's column.  However, and regardless of whether the result you ascertain is a positive or negative for Dimensional's funds, I would caution that taking a "snapshot" of returns of funds at any one point of time often comes up with incorrect results.  If funds have been around for 20 or more years, why not measure them over rolling 10-year time periods, or rolling 15-year time periods, or over the entire time period?  Since funds and indices rarely have the same exposures to book-to-market and market cap-driven factors, "starting points" and "ending points" over any 5-year or 10-year period can lead to poor analyses.  For example, did a significant overvaluation or undervaluation of large cap stocks vis-a-vis small cap stocks, or value stocks vis-a-vis growth stocks - exist at either the beginning or the end of the period chosen to be viewed?  This could really skew results over a discrete time period - even 10 years.

Since some sector indices have been around for 30+ years (i.e., Russell), comparing long-term returns of a fund (which has been around a long time) relative to indices may be a better indication of the fund's performance.  Yet, rolling 10-year time periods for a fund which has been around a long time can be useful.  It can be helpful as a means to weed out funds which may have possessed exceptional performance as a small starter fund, for example, but only mediocre performance thereafter.

Lastly, I would note that even Morningstar has admitted that fees and costs are a more significant factor in predicting future returns than its own ratings.  Since Dimensional's funds - especially its micro-cap and "core equity" funds - either have very low internal transaction costs, or add to returns through block purchases of (small-cap, mid-cap) stocks at discounts, or add to returns through securities lending practices (possible for a passive and diversified fund), these positive cost/fee attributes should show up in the long-term performance data.

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