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2 Ways to Tame Trading Costs

Harry Milling

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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Milling: So, basically you're controlling flows into these funds, and that's one of the ways in which you are maintaining the integrity of that strategy.

Deere: I can't say that we're specifically controlling flows because it's a mutual fund. People can take their money and add to it any time they want to.

Milling: You're controlling who invests?

Deere: We are certainly controlling to the extent that we can who invests.

Milling: I want to follow-up on that by saying part of the competitive advantage of DFA is the fact that it saves on trading costs. And I'm wondering if that is also relating to how you maintain the integrity of these micro-cap and small-cap names because you can trade when you want to. You don't have to buy a full position in that micro-cap, in that small-cap, which is a less liquid name. So, what do you guys do to create that trading cost advantage?

Deere: I'll rephrase trading cost advantage into the phase of our portfolio management that we call implementation, which means when do you trade, how do you trade, and implicitly, when don't you trade. And I think the key is when you're going after a group of stocks, whether they be less liquid or not, one thing that you can do to improve your trading costs for sure is to give your traders flexibility. Flexibility comes in two forms. It comes in a form of maybe substituting one stock for another that you believe are highly correlated or perhaps more importantly giving them time.

You do not have to finish this order today, even if it were an index fund. Most of our funds are not precise index funds, but we even have one that largely is. And even in that fund, we're able to say, "Look, when there is a new position that comes into that index, as long as we make sure that we don't try to add it whenever everybody else does, we will make money compared with the index, which of course goes into the return of the fund." And we've experienced that hands down. So, it's that flexibility that's important.

Milling: So, simply put, you can wait to get the best price?

Deere: True.

Milling: The best trading advantage. And as you were mentioning that you're not index funds. So, you don't have to be in any particular stock at any particular time.

Deere: With any particular holding, as well.

Milling: Exactly. We talked about that key competitive advantage for DFA is trading costs savings, but of course any investment philosophy has its risks. DFA's investment philosophy certainly does. Maybe you can mention one or two? I'm really thinking about volatility. Certainly some of your funds are more volatile than their peers. DFA Emerging Markets Value is one; DFA International Small-Cap Value is another. Clearly Europe is affecting that, as well. But what is it about DFA's funds that sometimes make them more volatile than their peers?

Deere: I'm not so sure that they are more volatile than their peers, particularly if the peers are broad-based funds. [They are] certainly not more volatile than an index fund. But I think what can make our funds more volatile is that we are willing to go into smaller-cap portions of the market than indexes typically travel in. We also typically construct our value strategies to have a sharper focus, and with that territory comes some more volatile stocks. But it's really not so much endemic to the way we trade. This really has more to do with the sectors of the market. Maybe sectors isn't the right word; it's the portions of the market in which we're willing to travel. And the issue there is that we know historically that the most micro-cap stocks have the highest returns. So, the trade-off is to what effort and expense do you want to consume to go after them in order to achieve what you believe to be a better result?

Milling: But it assumes a long-term investing horizon?

Deere: It critically assumes a long term investing horizon.

Milling: Right. So investors need to know that they are not going to be investing with DFA for six months, for a year, even three years, that it's going to be probably...

Deere: Well, that's our preference because we think that in the big picture, there is an equity premium. Stocks have higher expected returns than Treasury bills. That hasn’t been completely reliable lately; in fact it never is. But the other risk premia that we believe are out there, which is a small-cap premium and a value premium, these things often take time to come to fruition. And so we think that at the very minimum market cycle, my old boss Rex Sinquefield used to say 50 years on which everybody would laugh because it's a long time. But a market cycle of seven to 10 years is where you could pretty reliably expect to get paid these premia. It's not with certainty, but that's kind of the time horizon you need to have.

Milling: Good. We'll leave it there. Thanks very much.

Deere: Thank you, Harry. Pleasure being here.