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By Harry Milling | 06-21-2012 11:30 AM

2 Ways to Tame Trading Costs

DFA's Bob Deere describes how flexibility found with substituting highly correlated stocks and allowing more time for trades provides investors with better trading advantages.

Harry Milling: I'm Harry Milling, mutual fund analyst with Morningstar. And I'm here at the Morningstar Investment Conference with Bob Deere who is a senior portfolio manager with Dimensional Fund Advisors. Welcome, Bob.

DFA's investment approach is basically a passive one: It believes that small-cap and value stocks will outperform the broader market long term. Your firm has experienced terrific growth in the past decade. I'm just interested in what market trends have contributed to that growth?

Bob Deere: Well, thank you, Harry. The largest trend, of course, is this notion that I think what we've observed in the last eight years is there has been a tremendous, basically, elimination of the home bias in what I'll call U.S. plan-sponsored portfolios, whether they be at the individual level or at the institutional level. So, as short as eight years ago, it was very, very unusual for a plan to have 40% or 50% of their equity allocation overseas. And that's become more commonplace now for probably a couple of reasons.

Milling: Right. What about the trend of going away from active management to passive management? Has that benefited DFA at all, as well?

Deere: It has. I think our firm was founded 31 years ago. Our two main founders are arguably two people that started the first index fund at the institutional level. They are David Booth and Rex Sinquefield, both very sturdy names. And I think we've tried to extend that approach when Dimensional was founded as sort of that small-cap firm, while realizing, of course, that there were some issues that we'll have to confront.

Now having said that, while our approaches are mostly passive, I think the key to that is that our strategies have lots of names in them and lots of diversification. So to the extent that investors have learned over the years that maybe perhaps a conventional-type of management has not added as much value as they perhaps thought, I think the biggest thing I have noticed in my career is the proliferation of new indexes, which leads to new ways of measuring you. It's not good enough anymore just to say, 'Hey, I beat the S&P 500.'

Well, if small stocks beat the S&P 500, anybody in that space should have done it. So, we've become much sharper about how we measure a manager's performance, which has I think kept us all more on-guard.

Milling: So, you've talked about the success, but with success can sometimes come risk. What I mean by that is you've had heavy inflows over the years. And I'm wondering how is it that you're able to keep the integrity of your micro-cap and your small-cap strategies? Let's face it, I mean that's what really made DFA's name initially. How are you able to handle such inflows when they do come into those funds without sacrificing performance?

Deere: Well, one of the keys is that we didn't really allow anything but institutional inflows in the early years. When I started at Dimensional 21 years ago, there wasn't a lot of pressure at that time to open up our funds to a more retail investor because the performance at the time quite frankly wasn't that good on an absolute basis. But as the years went on, our performance became universally measured to be quite good. And there was pressure to add more avenues of assets, not so much from us internally because we were creating new products, but I think more and more people wanted to get in. So, our feeling was we want to make sure that the investors in our funds have more of a long-term track record. We don't want people getting in and getting out real quick because that generates real problems, especially when you consider the fact that our micro-cap portfolios and strategies are relatively illiquid compared with say their S&P 500 counterpart.

So that was a very important issue. And the funds were a lot larger by the time we did open our funds up [to retail investors]. We've never really opened them up completely to retail flow, but we have opened them up to channels that are more related to the individual investor.

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