Discipline Gives DFA Its Edge

Morningstar recently issued a new Stewardship Grade for DFA. The firm's overall grade--which considers corporate culture, fund board quality, fund manager incentives, fees, and regulatory history--is a B. What follows is Morningstar's analysis of the firm's corporate culture, for which DFA receives a B. This text, as well as analytical text on the other four Stewardship Grade criteria, is available to subscribers of Morningstar's software for advisors and institutions: Morningstar Advisor Workstation(SM), Morningstar Office(SM), and Morningstar Direct(SM).

DFA has become one of the largest mutual fund companies after years of explosive growth, in part because of its low costs, strong performance, and the growing acceptance of passively managed strategies. Its singularity of purpose, discipline both in managing its funds and in qualifying the financial advisors who use those funds, and low-cost structure have contributed to a clear identity--both inside and outside the firm.

Market efficiency is the foundation of DFA's investment philosophy. The firm believes that the only way to consistently earn higher returns than the market over the long run is to accept greater risk. It is not in the business of forecasting and individual security selection. Rather, it harnesses what it views as risk factors, or characteristics that historically have been associated with higher expected returns, in an attempt to beat the market. Each strategy the firm adopts must be economically sound and backed by substantial empirical evidence that it has consistently worked across different markets and time periods. DFA draws heavily on academic research to develop its strategies. It even maintains consulting relationships with several prominent finance professors, including two Nobel laureates, to stay on the cutting edge of financial research. In order to bridge the gap between theory and implementation, DFA maintains an in-house research team, which focuses on applying academic research and improving the implementation of its existing strategies.

In fact, academic research has primarily guided the evolution of DFA's funds throughout its history. DFA started out specializing in small-cap and micro-cap funds, based on research suggesting that small-cap stocks outperform their larger-cap counterparts. The firm launched its first value strategies in 1993, a year after renowned finance professors Eugene Fama and Kenneth French published their seminal three-factor asset-pricing model, which indicated that value stocks, as indicated by book value/market price ratios, offer an additional return premium. Most recently, the firm has started to incorporate a profitability factor into its equity funds, based on new research suggesting that profitability can help predict returns. It will take some time to determine whether or not this change has a significant impact on the funds' portfolios or performance, but it's a material change to the firm's proven investment approach. There is also a small risk that this adjustment could cause the funds to deviate from their original mandates.

Transaction-cost management is also an essential tenet of DFA's value proposition. It avoids high-turnover strategies and incorporates transaction costs into its portfolio construction framework. Because its funds do not track an index, DFA's managers are not forced to trade when doing so would not be cost-effective. For example, if a security is near the cusp of a fund's targeted style zone, but trading it would significantly move prices against the fund, it may defer or avoid trading it. The firm's traders can substitute one stock for another with the strategies' desired characteristics, and trade those that are offering the best terms. DFA often leverages this flexibility to provide liquidity--buying stocks when the herd is selling or selling stocks to satisfy investor demand. This flexibility distinguishes the firm's strategies from those of traditional index fund shops and should help reduce trading costs. To further reduce costs and retain full control of its orders, DFA has increasingly shifted to an automated direct-market-access trading model, which it now uses to place nearly all of its trades. As of September 2013, DFA employed 24 traders with an average of 12 years of experience. 

In order to ensure that its funds follow their mandates, DFA has a standing investment committee that meets twice a month to provide oversight and approve implementation changes. The committee includes the firm's senior executives and portfolio managers. DFA also has a separate investment policy committee that meets to recommend new strategies and enhancements to its existing strategies. In their consultancy roles to DFA, Fama and French sit on that committee, along with many of the firm's senior executives. 

Because of its unifying academic framework, many of DFA's equity funds incorporate similar small-cap value tilts. There is also substantial overlap among its portfolios, which gives investors more flexibility to choose between funds with moderate to significant style tilts but also creates some redundancy in the lineup or could create some confusion (even though DFA goes to great lengths to explain its funds to its customers). DFA is methodical about launching new strategies. However, it is willing to work with clients to develop products that address their investment needs. For example, it introduced a series of core equity funds in response to client demand for a broad-market portfolio with systematic small-cap and value tilts. It also offers some socially responsible versions of its funds. 

Although it has launched more than 20 funds during the past five years, DFA usually doesn't chase trendy investment themes. For example, the firm didn't abandon its stoic value framework during the tech boom in the 1990s. Rather, it takes its cues from the academic community and goes where the research leads. There must be a preponderance of evidence before DFA will consider adopting a new strategy. That being said, DFA's willingness to work with clients to create new solutions may tempt it to compromise its research integrity in order to grow. This becomes a bigger risk as the firm extends its reach. Even when the evidence is solid, the strategy must be consistent with the firm's low-turnover philosophy. For instance, despite the strong empirical evidence that shows the near-term persistence of stock-price momentum, DFA does not attempt to trade on it, though it will use it as a reason to delay a trade. As a result of DFA's deliberate approach to launching new funds, it rarely liquidates or merges its funds. In fact, in the United States, DFA has only ever merged or liquidated two funds, according to Morningstar data. While DFA offers both fixed-income and equity funds, its equity funds represented about 75% of its assets as of the end of September 2013.

DFA has grown substantively during the past decade, now ranking among the top 10 mutual fund companies with more than 8 times the assets it had 10 years ago, but it hasn't done so through advertisement or traditional fund-company marketing. Like most fund families, DFA has institutional clients, representing roughly 40% of assets. However, its practice in the financial-advisor channel, which today represents close to 60% of assets, distinguishes it from others. Specifically, in order to reduce potential misuse of its products, DFA screens each advisor to ensure that he or she understands the firm's investment approach and shares a similar investment philosophy.

DFA also tries to understand how each advisor plans to use its funds before starting a relationship. These advisors help educate their end clients about DFA's approach and help keep them invested with DFA through rough patches. In 2008, when investors were leaving equity funds in droves, DFA bucked the trend and enjoyed net inflows to its equity funds. But even this responsible approach to selling has its limits. Like many fund families', DFA's dollar-weighted investor returns, which approximate how average investors have done in individual funds, are generally subpar to its time-weighted total returns over the past five years and 10 years through Dec. 31, 2013.

Because DFA's funds are so process-driven and based on academic research and quantitative models, it may seem that portfolio-manager retention would be less important than at other firms, where a star manager departure would have a meaningful, detrimental impact. To be sure, DFA does not have a star-manager culture, but manager retention can still send investors some signals. DFA's manager-retention rate is quite strong compared with large mutual fund companies, at close to 95% during the past five years. The asset-weighted tenure of the firm's longest-tenured managers is near 10 years. This retention rate could indicate that DFA has hired good cultural fits for its unique approach (though a small group of managers is named on multiple funds). The firm's private ownership structure may also contribute to its low turnover. Current and former employees own most of the firm, including co-founder David Booth, who owns between 25% and 50% of the company.

While DFA has developed a strong corporate culture, it is necessary to monitor how the firm handles its heft and responds to new sources of demand. DFA's many positive traits plus a couple of reservations earn the firm a B for corporate culture. 

This article is the Corporate Culture portion of the Morningstar Stewardship Grade for Funds for this fund family. Click here to see Morningstar's Stewardship Grade methodology.