A Unique Approach to Small Value

In June 1992, Eugene Fama and Kenneth French published their seminal paper, "The Cross-Section of Expected Stock Returns," which showed that small-cap and value stocks consistently generated higher returns than their large-cap and growth counterparts. Less than a year later, Dimensional Fund Advisors launched  DFA US Small Cap Value (DFSVX), which targets the cheapest quartile of the U.S. small-cap market. This fund's simple approach has worked remarkably well. Over the past 20 years, it outpaced the Russell 2000 Value Index by nearly 2% annualized, net of fees. However, the fund's deep-value and micro-cap tilts may cause it to overweight distressed companies and make it one of the small-value category's more volatile options. Its younger sibling,  DFA US Targeted Value (DFFVX), offers investors similar exposure with slightly less volatility and a lower expense ratio.

This lower volatility owes to the wider net cast by DFA US Targeted Value Fund relative to DFA US Small Cap Value. It targets the cheapest fifth of the mid-cap market segment based on book value/price, and the cheaper half of the small-cap segment, which sweeps in a large helping of small-blend stocks. While in theory these mid-cap value and small-blend stocks should create a slight drag on the fund's returns relative to the pure small-value portfolio, it hasn't hurt much over the past decade (through April 2013). During that span, the targeted value fund posted an impressive 12.4% annualized return, slightly better than the small value's 12.3%, with less volatility (their standard deviations were 21.3% and 22.1%, respectively).

Although the targeted value fund employs passive market cap and book/price screens, its flexibility sets it apart from most value index funds. Because it does not track a specific index, the fund's managers have the flexibility to substitute one stock for another based upon trading costs and liquidity. This flexibility allows the firm's traders to negotiate from a position of strength. They often act as liquidity providers in thinly traded stocks, which allows them to obtain better prices that can enhance the fund's return.

The fund's managers also have discretion to balance a stock's momentum against its value characteristics. Consequently, they may refrain from purchasing stocks with strong negative momentum, which can help reduce the fund's exposure to value traps, cheap stocks that are quickly becoming cheaper. Additionally, they may hold on to some winners as they move out of the value zone in order to benefit from positive momentum. This approach may actually help reduce turnover because the fund is not forced to mechanically sell when a good run pushes a stock out of the targeted value zone.

How Does the Fund Stack Up?
While DFA Targeted Value extends its reach further up the market-cap ladder than do many of its small-value peers, it also ventures deeper into micro-cap territory. In fact, micro-cap stocks soak up nearly 29% of the fund's assets, nearly twice the category average. As a result, its assets are spread across more than 1,500 holdings. That breadth is prudent because many of its holdings carry relatively high business risk. For instance, over the past year the fund's holdings generated a meager 3.7% average return on invested capital. In contrast, the corresponding figure for the small-value category average is 14.6%. However, small-cap blend stocks help anchor the portfolio and reduce the fund's exposure to distressed stocks.

In contrast to most of its peers, the fund excludes highly regulated utilities and real estate investment trusts, which tends to give it a lower dividend yield. DFA believes that REITs are a separate asset class that do not behave like most small-cap value stocks, and that utilities are not consistent with the fund's high-risk, high-reward strategy.

The fund's turnover is consistently lower than most of its peers'. This is partially because its book/price selection criterion is more stable than most other valuation metrics. The fund's flexibility also helps because it is not forced to trade when doing so would only marginally improve style purity, or concentrate its trades around an index reconstitution date.

So far, DFA US Targeted Value's approach has served investors well. Over the trailing 10 years through April 2013, the fund outpaced the Russell 2000 and Russell 2000 Value indexes by 1.9% and 2.1%, respectively. It also outperformed more than 90% of its peers in the small-value category during that period. However, those superior returns came with greater risk. The fund exhibited greater volatility than most of its peers over the past decade (though less than DFA US Small Value), and it has tended to lag during market downturns. That may be partially due to its deeper value tilt, large micro-cap stake, and exclusion of highly regulated utilities. Consequently, the fund took a bigger hit than its peers did during the credit crisis in 2007 and 2008. Yet, it will likely continue to reward patient investors with a high risk tolerance. Low fees (0.38% expense ratio), coupled with DFA's structural trading advantages, give the fund a sizable and ongoing edge against most of its competitors.

Oversight
Stephen Clark has served as one of the fund's portfolio managers since 2008. In addition to his portfolio-management responsibilities, Clark is also in charge of DFA's North American Institutional group. In this capacity he develops and markets new products, which may limit the amount of time he can devote to the fund. However, Clark has good support. Joseph Chi, Jed Fogdall, and Henry Gray joined Clark as comanagers of the fund in February 2012. While these managers are new to the fund, they are all seasoned DFA veterans. Chi and Fogdall have served as portfolio managers at the firm since 2004 and 2005, respectively. Gray, who oversees DFA's global equity trading operations, helps monitor and minimize the fund's transaction costs.

DFA fosters a collaborative approach that allows the fund's management team to receive support from any of the firm's other equity fund managers and traders. The fund's named managers provide biweekly reports to DFA's investment committee, which includes several of the firm's most senior managers. The investment committee provides oversight to ensure that the management team is executing the fund's strategy properly. Chi replaced Clark as the head of that committee after Clark took over institutional client services for North America.

Fees
Where DFA US Small Cap Value charges a 0.52% expense ratio, DFA US Targeted Value offers similar exposure for 0.38%. While this fee is low relative to the price tags the fund's actively managed peers carry, there are cheaper index alternatives, such as  Vanguard Small Cap Value ETF (VBR) (0.10% expense ratio). However, DFA makes up for this difference by leveraging its structural advantages to secure better trading prices than many of its peers. DFA engages in securities lending, the practice of lending out the fund's underlying holdings in exchange for a fee. This ancillary revenue partially offsets the fund's expenses.

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