DFA Is Paying the Price for Its Conviction

The Middle Lane Fund investors tend to be attracted to portfolio managers who profess conviction in their beliefs. Portfolio managers indulge that desire. Attend any investment conference, and you will hear managers relate stories about securities that were once unloved by the rest of the marketplace but which brought their funds profits because the managers maintained their faith.

Those tales are mostly fantasy. In reality, investors quickly become spooked by below-average results. They might hold their losing fund rather than sell it, thereby convincing themselves that they did not make a mistake (a mindset called the disposition effect), but they won't send that investment manager additional assets. Conviction is appealing in theory but painful in practice.

This precept applies to relative rather than absolute performance. Many fund companies gained business after the 2008 financial crisis because their stock funds lost 30% while their competitors' offerings dropped 35% or 40%. Conversely, making 5% when other funds are gaining 10% is a recipe for business failure. Mr. Smith does not wish to trail Mr. Jones.

Most successful fund companies recognize that investors wish to hug the middle, and they manage their assets accordingly. Consider the five biggest U.S. fund managers: Vanguard, Fidelity, American Funds, BlackRock BLK, and State Street STT. Three of those five organizations are mainly indexers, Fidelity's once-idiosyncratic stock funds have become staid, and American Funds' offerings are famously diversified. None of those businesses need worry about sinking on the rock of conviction.

The Lone Star Not so for Dimensional Fund Advisors, the Texas-based organization that currently ranks as the nation's 11th-largest fund company. From the beginning, DFA has promised to "beat the market, not outguess it" by creating funds that diverge sharply from the norm. Although the company now offers conventional funds, so that its shareholders may assemble complete portfolios, it historically has favored small, cheap stocks that frequently behave very differently than do those in the major index funds.

For example, the average weighted investment in what historically was DFA's biggest fund, US Small Cap Value DFSVX, currently has a market capitalization of $1.6 billion and a price/book ratio of 0.90. In contrast, Vanguard 500 Index VFINX features a market capitalization of $155 billion and a weighted price/book ratio of 3.4. The two funds can barely be said to participate in the same equity market.

Net Outflows This year has highlighted DFA's willingness to be different. While the S&P 500 is currently up 14% for the year to date (take that, pandemic!), DFA US Small Cap Value is slightly in the red. As this column recently noted, the S&P 500's 10 largest stocks now account for one third of that index's assets. None of those issues appear in DFA US Small Cap Value--nor, for that matter, in most other DFA funds.

Unfortunately for DFA, the woes of value and small-company stocks began well before 2020 began. Over the past five years, only four DFA funds that invest in U.S. equities have been able to outgain the S&P 500. The median DFA fund that holds domestic stocks has risen by an annualized 7.2% over that time period, while the S&P 500 has appreciated by 11.6%. Cumulatively, that translates to a 42% gain for DFA's median fund, as opposed to 73% for the benchmark index.

Unsurprisingly, DFA's shareholders have started to head for the exits. Through October, Morningstar estimates that DFA suffered net 2020 redemptions of $30 billion, which was the largest outflow among the top 15 fund companies. What's more, these losses occurred across DFA's product line: U.S. stock funds, international equities, taxable bonds, and even the group's small muni-bond lineup.

The Bright Side Less predictably--indeed, I had not realized that was the case until writing this column--this is the first year since Morningstar began calculating such data in 1993 that DFA has not enjoyed net sales. When Internet stocks crumbled during the early 2000s, DFA's small-value orientation boosted its funds' performances, leading the organization to pick up new investors. The company's funds did not weather 2008 as smoothly, but shareholders nonetheless remained steadfast, rewarding DFA with net sales both during that year and during 2009's aftermath.

They stayed loyal for two reasons. First, although DFA funds over the past few years have trailed the major stock indexes, their previous relative results were outstanding. Even through their recent woes, every DFA U.S. equity fund that existed when the new millennium began has since outgained the S&P 500. That is a record unmatched by any rival fund company.

Second, DFA has built unusually strong investor relationships. The company has taken its own distribution path, selling exclusively through financial advisors who have attended one of DFA's in-person training seminars. In addition, although almost every financial advisor in the early 1980s accepted commissions, DFA's funds have never carried front-end loads. Advisors who wished to work with DFA had to adopt to the company's business model, rather than vice versa.

In short, DFA made its advisors jump through its hoops, instead of following the usual fund company approach of begging for business, however those sales may come. The result has been an advisor force that regards itself as the investment version of the Marines: the few, the proud. (The company's critics prefer the term "cult.") By and large, DFA advisors regard themselves as being among the elite--and they have passed that mindset along to the shareholders whom they serve.

The upshot: No fund company can overcome weak relative performance forever. At some point, its shareholders will lose faith. However, thanks to its funds' previously high returns and to its strong investor communications, DFA has done well at delaying the inevitable. Should small/value stocks soon recover, which seems probable given their long journey through the wilderness, DFA will have no trouble surviving this dry spell. That is very much to its credit, given the challenges facing fund companies that dare to be different.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.