The Wrong Time to Fire a Fund

Many Ways to Fail There are many sound reasons to sell a fund. Its sponsoring company might be embroiled in a scandal. Its senior management might have fled. The fund might have violated its prospectus, or made several abnormally poor investment decisions. Or, perhaps, the fund was one that should not have been bought in the first place (high expenses, indifferent track record), and its poor showing provides the excuse to correct one's initial mistake.

None of those would seem to apply to

The First Look Doesn't Flatter There's no denying that the fund's returns have disappointed. DFA International Value has appreciated by a mere 1.03% per year over the trailing decade (through July 31). Over the past three years, it has landed slightly in the red. Investors would have been better off owning pretty much any Treasury fund.

Of course, that comparison is second-guessing. All risky investments sometimes lag Treasuries. (Aside from Bernie Madoff's funds, that is, which demonstrated that portfolio volatility is but one flavor of risk, and not the worst flavor at that.) If DFA International Value held an unlucky asset class but fought valiantly against a headwind, then the fund's performance would be vindicated.

However, that is not what happened.

When compared with its peers, other foreign large-value funds, DFA International Value shows average 10-year returns, modestly below-average three- and five-year returns, and risk above the norm. That combination makes for a Morningstar Rating of 2 stars--generated by comparing the fund's risk/return profile against other funds in its category--which places the fund in the lower third of its competitive group. The fund also trailed the wordy MSCI ACWI ex USA Index, which tracks the performance of non-U.S. equities.

The initial picture, therefore, is rather dim. The fund has competed against two rivals, its category peers and the foreign-stock benchmark, on the two fronts of return and risk. It failed in all four cases, over each of the three trailing time periods. That would seem to constitute a pattern--and be sufficient evidence for termination.

The Second Glance Does But there's more to be said. To start, while that MSCI index is good for measuring general foreign-stock funds, it's an imperfect match for funds that follow a value strategy. The better comparison for DFA International Value comes from the MSCI ACWI ex USA Value Index, which holds only lower-cost equities. When the value index is selected, the fund's apparent underperformance disappears. Over each of the trailing three-, five-, and 10-year periods, the fund's returns and volatility almost exactly match those of the benchmark.

There remains the source of the 2-star rating: the fund's shortfall when compared against the average for its category. While persistent, that gap hasn't been very large, and it can pretty much be explained away by how the fund differs from the category norm. The fund is a pure embodiment of its investment style. It remains fully invested in non-U.S. stocks at all times, even as other funds sometimes hold either U.S. equities or fixed-income securities.

In addition, the fund follows among the "deepest" of the category's value strategies. The average weighted price/book ratio of the companies in its portfolio, at 0.86, is the lowest figure of any foreign large-value fund. The portfolio's price/earnings ratio is also very near the bottom. Unlike many competing funds, DFA International Value doesn't truck with mid-priced stocks; it holds only the cheapest.

Faithful readers of this column have probably anticipated the punch line: The fund has suffered for its purity. In recent years, U.S. stocks have outstepped their foreign rivals; bonds (if dollar-denominated) have beaten foreign equities; and blend/growth style stocks have outgained value stocks. Most competing funds dabbled in one or more of those areas. DFA International Value did not, and was therefore left behind.

Thus, the fund will likely post relatively strong returns when the fortunes of non-U.S. value stocks improve. Just as it led its group on the way down, it will probably lead on the way up.

Same as It Ever Was In short, if DFA International Value was selected to provide pure, consistent exposure to foreign value stocks, with the possibility that the fund might trail when such securities fare poorly, then nothing has changed. The fund continues to fulfill that role. Its peripheral attributes are excellent, too. Its parent DFA is highly reputable, earning the top Morningstar Stewardship Grade of A. And the fund carries an unusually low expense ratio of just 0.43%.

I could defend dismissing DFA International Value from an employer retirement plan if that move was part of a larger overhaul, with the goal of making the plan simpler. Most investors, at most companies, do not benefit from being given a set of bricks and then asked to construct a custom house. They need solutions, not raw materials and tools. If the retirement plan eliminated specialized funds entirely, so that it only offered target-date funds, a general stock fund or two, and a general bond fund, that would be fine with me.

But that, I am told, is not what this plan did. It did not revamp its structure. Instead, it made an adjustment, apparently for performance reasons. That strikes me as buying high, selling low. That is rarely a successful investment precept.

John Rekenthaler 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.