Dimensional Fund Advisors is a private investment company with $609 billion in assets under management. David Booth and Rex Sinquefield founded DFA in 1981. These three based the investment philosophy of the funds around studies by Eugene Fama and Kenneth French and their efficient market hypothesis as well as three factor asset pricing model.
Table of Contents
- What are DFA Funds?
- 3 Main Ideas of DFA Funds
- Breakdown of 3 Main Ideas
- Who Can Invest in DFA Funds?
What are DFA Funds?
Dimensional Fund Advisors started with David Booth in 1981 and was based on the idea of creating a low-cost passive fund diversified in small cap public companies. This is because of the long run historical premium returns that small cap companies, as well as value companies earn above the returns of large cap and growth companies.
In simple terms, DFA Funds are passive low-cost mutual funds that invest a lot of their money around the world (global diversification) as well as into small companies and value companies.
3 Main Ideas Behind DFA Funds Investing
The combination of these three investing ideas is what the DFA funds consider their differentiator that allows them to achieve strong passive returns based on their level of risk. DFA funds look to take on the extra risk and volatility that comes with international, small cap, and value companies because over the long run, it ends up returning higher.
International diversification means that DFA looks to invest money all over the world to make sure to earn possible returns wherever money is needed for investing. By spreading out the fund between the U.S., developed countries, and emerging markets, the fund has a strong balance that captures returns globally.
Small Cap Companies
Small cap companies are publicly traded companies with a total value (or market capitalization) between $300 million and $2 billion. Small cap companies are typically riskier (than large cap companies) and because of this risk, usually pay a higher return in the long run.
Value companies are seen by investors to being traded currently at a discount or on sale to what they should really be worth. These companies are compared with growth companies or ones that are priced high because investors expect them to continue to grow and expand quickly. Value companies are typically riskier than growth companies, so they too usually pay a higher return in the long run.
Breaking Down the 3 Main Ideas
Diversification is one of the most important ideas behind all types of investing. There are different types of diversification as well that promote spreading out your investments by different sectors, assets, and locations. The two focused on in this article are diversification by sector and diversification by location.
Diversification by Sector
This diversification will enable investors to limit the amount of risk associated with one type of sector or industry underperforming. Put simply, if a pandemic happens, the travel industry will most likely take a big hit. If an investor only had their money in travel companies, airlines, and cruise ships, then they would lose a lot of their money.
By having money spread out among many different sectors such as having some in financial companies, some in agriculture, some in entertainment, etc. this type of diversified portfolio in different sectors would not take as large of a loss.
Diversification by Location
Every country in the world has different types of challenges that are risks politically, economically, and even geographically. These sort of risks that differ by country can be limited by spreading money around the world investing in many different countries.
If one country is negatively impacted by something political (like a military coup), something economic (like a central bank failure), or something geographical (like a terrible hurricane) then that country and the businesses within it that people invest their money into will suffer large losses. The best way to limit this risk is by international diversification.
Although it can be more expensive to invest money internationally, funds like DFA that can do it relatively cheaper compared to other funds will provide good opportunities to realize good returns while limiting single-country risk.
Small Cap Companies
Smaller companies do not have the large size and deep pockets that their larger competitors have. Less money and less access to funding can create risks for smaller companies. These financial risks cause smaller companies to be more susceptible to market downturns or other external risks.
Small cap companies also tend to be analyzed and looked at less often than their larger counterparts. Less total coverage by financial analysts leads to more uncertainty with future outlooks on smaller companies.
More Uncertainty –> Greater Risk
These risks faced by the small cap companies come with the possibility for greater returns as well. Typically, small cap companies have experienced historically higher returns than large cap companies.
The important valuation metric used by Fama and French in their three factor asset pricing model is the book to market ratio.
Book to Market Ratio is the Intrinsic value of a company (seen from their financial statements) divided by their market priced value. So a higher book to market ratio means that the market sees a company worth less than its actual value whereas a low book to market value means the market sees a company as being worth way more than it currently is worth on paper.
Value companies are companies that have a high book to market ratio (being undervalued by the market.) Growth companies are companies that have a low book to market ratio (being overvalued by the market.)
The DFA funds put extra weight into value companies because they have experienced historically higher returns than growth companies.
Who Can Invest in DFA Funds?
These are not available to invest in for anybody that wants to invest, even if you are considered financially fit. These funds can only be accessed by investing in them through an institutional investor or a DFA approved financial advisor.
Institutional investors include organizations or companies that hold lots of money given to them by individuals or groups to invest their money for them. This money is typically managed professionally and therefore is given more room to invest with less strict regulations than an average retail investor (normal person.)
DFA Approved Financial Advisor
Financial advisors can also access these funds for their clients if they have been approved by Dimensional Funds. This approval process includes obstacles such as taking classes and listening to seminars to learn and understand the philosophy these funds follows:
Low cost passive investing in small cap value companies in a globally diversified portfolio.
This approval process is an important factor that maintains DFA funds as an exclusive style investment fund. The exclusivity is something that advisors can use as well when promoting services to clients. Having a financial advisor can provide normal people (retail investors) access to well managed exclusive funds such as DFA.
DFA Funds FAQS
DFA Funds are a good investment for investors that can gain access to these types of funds. For investors looking for a low cost passive investment fund that is professionally managed, DFA funds will be a good choice. Although many other mutual funds and ETFs may be lower cost and can sometimes outperform, they are often not fully comparable to the DFA funds. DFA strictly targets small cap value companies with a globally diversified allocation.
Investors are able to buy DFA funds through Schwab if their Schwab account is accessing these funds through an institutional investor platform or through a DFA approved financial advisor and his/her platform. A normal person (retail investor) that opens a Schwab account without access to a platform that DFA has approved will not be able to purchase DFA funds through Schwab.
DFA funds are not actively managed. DFA funds are a passively managed fund. Looking to earn high risk adjusted returns by earning the premiums from small cap and value companies, DFA funds invest in these companies passively to keep their costs lower relative to the average mutual fund.