Among the Best for Small-Cap Exposure

The following is our latest Fund Analyst Report for DFA U.S. Micro Cap DFSCX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

DFA U.S. Micro Cap is among the best funds available for exposure to the smallest U.S. stocks. The fund systematically avoids the most-expensive and least-profitable micro-cap firms while maintaining broad diversification. It augments its efficient market-cap-weighted construction by patiently trading to minimize transaction costs, which is especially important in this illiquid market size segment. These features provide the fund a leg up over its peers and support its Morningstar Analyst Rating of Gold.

The fund targets stocks that make up the smallest 5% of U.S. stocks by market capitalization, including those with market caps as low as $10 million. It removes the most-expensive and least-profitable stocks from its portfolio because these attributes have been associated with lower expected returns over the long run. But this exclusion is modest and only removes 6%-10% of the eligible universe, so the fund stays well-diversified. The portfolio’s average market cap of $1 billion is about half that of the average fund in the small-cap blend Morningstar Category.

Dimensional’s flexible trading approach gives this strategy a sustainable edge. It’s more expensive to trade micro-cap stocks than it is to trade larger stocks. The fund’s managers avoid trading between names when it does not significantly affect the fund’s style characteristics. They have the flexibility to substitute one stock for a similar alternative and often act as liquidity providers in thinly traded stocks, allowing them to secure more-favorable prices. Over the past decade through 2017, the fund’s average annual turnover has measured about a fourth of the category average’s.

During the past 15 years through April 2018, the fund outpaced the category average return and the Russell 2000 Index by 1.7 and 0.7 percentage points annually, respectively. But long periods of underperformance can occur, and the fund tends to be more sensitive to market cycles. This fund should reward investors who can tolerate its high risk over the long run.

Process Pillar: Positive | Adam McCullough, CFA 05/30/2018 A time-tested approach, efficient market-cap-weighted construction, and flexible trading support the fund's Positive Process Pillar rating.

The fund invests in stocks representing the smallest 5% of the U.S. stock market but excludes REITs, recent IPOs, acquisition targets, and stocks with market caps of less than $10 million. It also excludes the most-expensive (based on price/book) and least-profitable stocks that meet its small size criterion. This last exclusion is motivated by research suggesting that the least-profitable stocks generate subpar returns over the long run. Dimensional incorporated the profitability screen into the strategy at the end of 2013. DFA measures profitability as operating income before depreciation and amortization minus interest expense, over book value.

DFA’s flexible trading approach balances tilting the portfolio toward its desired characteristics with minimizing trading costs. Traders have the flexibility to substitute stocks with similar characteristics and to patiently work into and out of positions. And the portfolio managers will often delay buying and selling stocks with negative and positive momentum, respectively. Because micro-cap stocks are less liquid than their larger counterparts, flexible trading techniques can generate transaction cost savings that accrue over time.

This fund owns stocks with market caps as low as $10 million. And because it invests in stocks representing the smallest 5% of the U.S. market, the portfolio’s weighted average market cap measures half that of its average peer. The portfolio is well-diversified and holds more than 1,550 stocks. Its top 10 holdings make up 10% of the portfolio. Owing to its smaller market-cap orientation and exclusion of the most-expensive and least-profitable stocks, the fund’s holdings trade at a lower price/book ratio and have a higher return on assets than the category average.

The portfolio’s sector weightings differ from the category average, largely because it excludes REITs. The fund has greater exposure to the financial services and industrials sectors than the category average, and smaller allocations to healthcare and technology stocks. The latter owes to its underweighting of unprofitable, micro-cap biotech firms.

The fund’s broad, market-cap-weighted portfolio and flexible trading approach have kept turnover low. Its turnover averaged only 13% over the past decade through 2017, just a fourth of the small-cap category average’s. The fund remains fully invested. Its 10-year average cash balance through April 2018 is a fraction of its category peers. Lower cash drag will pay off during bull markets but detract from performance during market downturns.

Performance Pillar: Positive | Adam McCullough, CFA 05/30/2018 The fund earns a Positive Performance Pillar Rating because it has generated attractive long-term returns compared with its category peers.

During the past 15 years through April 2018, this fund’s return bested the small-blend category average and the Russell 2000 Index by 1.7 and 0.7 percentage points annually, respectively. Favorable stock exposure across sectors contributed the most to this outperformance.

The strategy can underperform for long periods of time. During the financial crisis from October 2007 through March 2009, the fund lost 62.3% and the category average lost 57.9%. Unfavorable financial and technology stock exposures detracted the most from the fund. Its underperformance during the financial crisis likely stems from higher-risk micro-cap focus. But the fund has rebounded nicely. From October 2007 through April 2018, it returned 8.2 percentage points annually versus an average annual return of 7.4 percentage points for the category. The fund benefitted the most from favorable stock exposure within the consumer cyclical, financial services, and materials sectors.

Although the fund has low turnover, it has distributed capital gains in six of the past 10 years, the largest of which measured 6.2% of the fund’s NAV in 2013. Despite these distributions, the fund’s aftertax 15-year return still lands in the top quintile of the category.

People Pillar: Positive | Adam McCullough, CFA 05/30/2018 This well-supported and experienced team supports the fund's Positive People Pillar rating.

Joseph Chi and Jed Fogdall have been listed as comanagers of the fund since February 2012. Chi and Fogdall co-lead the firm's portfolio management team and have served as portfolio managers at the firm since 2004 and 2005, respectively. Chi also serves as chairman of the investment committee. Joel Schneider rejoined the fund in July 2015. Schneider has served as a portfolio manager at DFA since 2015. These named managers lead a broader team of portfolio managers who assist with the fund’s day-to-day operations. Chi and Fogdall sit on Dimensional’s investment committee, which provides additional fund oversight.

Recent changes in the manager lineup aren’t a cause for concern. Henry Gray left DFA in May 2017 to pursue opportunities in academia. Gray had served as head of global equity trading and as a portfolio manager here. DFA removed Bhanu Singh and Stephen Clark as named managers on the fund in February and July 2015, respectively. Clark is now in charge of DFA's North American institutional group and not a portfolio manager. Singh transferred to the Sydney office to head the Asia-Pacific portfolio management team.

According to regulatory documents, none of the listed portfolio managers are currently invested in this fund.

Parent Pillar: Positive | 01/18/2017 Dimensional Fund Advisors is one of the industry's best stewards, so it earns a Positive Parent Pillar rating. All its strategies are grounded in an unwavering belief in market efficiency and transaction cost management. They attempt to profit from the types of risk that the market compensates by emphasizing securities with characteristics that historically have been associated with higher returns.

The firm generally has been disciplined about launching new strategies in each of the markets where it operates. Each strategy must be economically sound, consistent with its philosophy, and backed by empirical evidence. That said, the firm has adapted some of its strategies to meet client demand in all markets. This behavior bears watching, but for the most part the firm has maintained strong research integrity. It is also selective about the clients it works with. Individual investors can gain access to the firm’s funds only through an intermediary or financial advisor that the firm has screened to mitigate short-term trading that can hurt long-term investors.

Manager retention here is high. The firm’s team- and rules-based approach to portfolio management mitigates the impact of departures when they do occur. An investment committee provides additional oversight and continuity. Dimensional is organized as a private partnership, with significant employee ownership.

Price Pillar: Positive | Adam McCullough, CFA 05/30/2018 Although there are cheaper small-cap index alternatives, this fund is among the least-expensive micro-cap-focused funds in the small-blend category. It earns a Positive Price rating.

The fund charges an expense ratio of 0.52%, almost half the small-blend category median fee of 1.01%. Dimensional’s flexible trading approach and low turnover helps reduce transaction costs, which add up quickly in the micro-cap arena. The fund uses securities-lending revenue to offset its expenses, which further benefits fundholders. Like all Dimensional funds, this offering is available to individual investors only through a qualified financial advisor or select platform such as a 401(k).