This week we have been looking at one of the fastest growing companies in asset management – Dimensional Fund Advisors (DFA). Our Quote of the Week looked at the CEO’s key principal for successful investing, our Chart of the Week looked at DFA’s outperformance. Today we look and see how they do it.
DFA’s philosophy is that there are 3 criteria (or as they call them, “dimensions”) that have been found that lead to above market average investing returns:
Lets look at each of these a little closer:
Company Size – Small Cap Premium
Research from Fama and French find that there has been a historical difference in performance from small companies compared to large ones, typically referred to as the “small cap premium”.
If you really want to get into the research, here is their famous paper from 1993: “Common Risk Factors in the Returns on Stocks and Bonds“:
However, I don’t think anyone would say that means you should only invest in small cap stocks. The diversification benefits of large cap stocks are need. But it does mean that DFA funds are weighted slightly different than most low cost, passively managed index funds you see.
DFA doesn’t have “index” funds per say. They are not following the S&P 500 with their large cap mutual fund, or the U.S. completion index with their U.S. Equity Core fund.
But the holdings are similar:
DFA’s US Equity Core (DFEOX – 0.19% Expense Ratio, 2807 holdings)
Vanguard’s Total Stock Market Fund ( VTMSX – 0.17% expense ratio, 3814 holdings)
The differences are even more telling when you look at the median market cap weights for these two funds:
DFA is obviously overweighting small companies (and value companies – more on that below).
Now, to be clear, these funds do not claim to be the same thing. DFA doesn’t claim to follow the same index as Vanguard’s fund shown here (DFA doesn’t follow any index for their funds). This is to show how DFA’s funds differ from the typical indexes. This difference here is what has been boosting their performance.
So how do you recreate this for yourself? After all, unless your financial advisor is in with Dimensional Fund Advisors, you will not be able to access these funds.
You can “tilt” your portfolio by adding a small cap fund in addition to your normal stock holdings, effectively overweighting small cap companies in your portfolio.
However, to get to a median market cap down to around $1 billion, as DFA does with the fund above, you may have to add a microcap fund as most small cap fund have higher median market caps than $1 billion.
All fund companies are going to have a small cap fund, here are some of the bigger/most popular funds:
iShares Core S&P Small Cap ETF (Ticker: IJR) – 601 holdings, $1.5 billion median market cap, 0.12% expense ratio
SPDR S&P 600 Small Cap ETF (Ticker: SLY) – 544 holdings, $1.5 billion median market cap, 0.15% expense ratio
Schwab U.S. Small Cap ETF (Ticker: SCHA) – 1746 holdings, $2.5 billion median market cap, 0.08% expense ratio
Vanguard S&P Small Cap 600 ETF (Ticker: VIOO) 602 holdings, $1.6 billion median market cap, 0.15% expense ratio
Vanguard Small Cap ETF (Ticker: VB) 1487 holdings, $3.1 billion median market cap, 0.09% expense ratio
Getting into the microcap level gets a little more expensive. Be careful choosing a microcap fund if you choose to do so, as many funds have very little assets under management, trade very infrequently and are expensive.
One of the better and more popular micro cap ETFs is:
iShares MicroCap ETF (Ticker: IWC) 1416 holdings, $498 million median market cap, 0.60% expense ratio
But its performance of this microcap fund has not really showed any outperformance in the last 8 years or so, in fact it has seriously underperformed:
(click to enlarge)
Whether this underperformance is an anomaly or due to the difficulty indexing microcaps I don’t know. I will leave it up to the investor to decide if adding microcaps is worth the added expense or not.
This same small cap premium is present in foreign stocks as well, so if you are looking to tilt your portfolio toward smaller companies, consider some small cap international stocks as well.
Vanguard FTSE All World ex-US Small Cap ETF (Ticker: VSS) 3372 holdings, $1.6 billion median market cap, 0.19% expense ratio
iShares EAFE Small Cap ETF (Ticker: SCZ) 1459 holdings, $2.0 billion median market cap, 0.40% expense ratio
iShares Emerging Markets Small Cap ETF (Ticker: EEMS) 716 holdings, $1.1 billion median market cap, 0.67% expense ratio
SPDR Small Cap International ETF (Ticker: GWX) 2061 holdings, $1.0 billion median market cap, 0.40% expense ratio
Schwab International Small Cap ETF (Ticker SCHC) 1486 holdings, $1.7 billion median market cap, 0.18% expense ratio
These funds above are not all the same, some are emerging market based, others whole world. But no matter where you want to allocate your international investments, you can tilt towards small cap companies.
Relative Price – Value Premium
That same study above also finds a long term outperformance by “value” stocks, which is based on the company’s low price to book ratio (P/B) , or as Fama and French refer to it, a high book to market ratio (BtM).
Here is another reference on Dimensional Fund Advisor’s webpage that cities some research:
https://us.dimensional.com/library/articles/is-there-still-value-in-the-book-to-market-ratio.aspx:
“Several other accounting-based variables have been suggested as alternatives to BtM for identifying value stocks. Earnings to price (E/P), cash flow to price (CF/P), and sales to price (S/P) have received the most attention in empirical studies. The general conclusion is that these variables, along with BtM, are all highly correlated with one another, and they produce similar dispersion in average returns. The variable that has had the most success in producing dispersion in average returns over an extended period of time is BtM, but all four of these ranking variables tend to produce similar portfolios.”
If you are unfamiliar with the concept of Book Value, check out our definition page on Book Value and Shareholder Equity here:
Here Fama and French are simply screening companies that have a low Price to Book ratio, or a High Book to Market ratio.
Just for example, a company with a book value of $1 billion, with a market cap of $2 billion would have a Price to Book ratio of 2, or a Book to Market ratio of 0.5.
You can see how DFA has over weighted these value stocks by the low price to book ratio compared to the “total market” above.
How do you add Value to your portfolio? The explosion in the number of ETFs outstanding makes this easy today. Most fund companies have value tilted funds already, just for example here are a few:
Vanguard:
Vanguard Value ETF (Ticker: VTV) – 0.09% expense ratio, large cap fund, 315 holdings
Vanguard Mid Cap Value ETF (Ticker: VOE) – 0.09% expense ratio, $10.5 billion median market cap, 209 holdings.
Vanguard Small Cap Value ETF (Ticker: VBR) – 0.09% expense ratio, $3.3 billion median market cap, 825 holdings.
And just like small cap, now fund companies even offer value ETFs for international stocks. Here is just a few:
Vanguard does not offer an international value ETF, but they do offer an international value mutual fund:
Vanguard World Value (Ticker: VTRIX) 155 holdings, 1.7x price to book ratio, 0.44% expense ratio.
iShares offers a couple international value ETFs for both developed international countries and emerging markets:
iShares MSCI EAFE [Europe, Asian, Far East] Value ETF (Ticker: EFV) 463 holdings, 1.3x Price to Book ratio, 0.40% expense ratio.
iShares MSCI Emerging Markets Value ETF (Ticker: EVAL) 442 holdings, 1.2x Price to Book ratio, 0.68% expense ratio.
Profitability –Profitability Premium
Recently, DFA has added a new “dimension” to their funds – Profitability.
The big research paper on the topic is 2012 Novy-Marx paper, found here:
http://rnm.simon.rochester.edu/research/OSoV.pdf
In it they find:
“ Profitable firms generate significantly higher average returns than unprofitable firms despite having, on average, lower book-to-markets and higher market capitalizations.”
They also find
“Mixed profitability-Value strategy has never had a losing 5 year period over July 1963-December 2010.”
Not bad!
But what determines how “profitable” a company is? Novy and Marx use a company’s gross profits divided by its total assets.
Fama and French have since done a study on the added performance of highly profitable companies here:
But they define profitability a little different, they also subtract out interest expense from gross profit, and divide that number by Equity.
So they say profitability = gross income – interest expense / Equity
Who is right? Both can be. I’m not smart enough to figure out how the differences in those definitions change the results. Use either one and keep it consistent.
This is also a little harder of a metric for individual investors to add to their portfolio. As of this writing there is no “profitability” ETF or mutual fund in existence.
If you want to weight profitable companies in your portfolio, right now you are going to have to go out and do it on your own with individual stocks. (or using something with Motif Investing might be cool! I’ll have to work on that…)
You do the hard labor yourself, by looking at each company’s financial statements, but that is going to be a pain in the arse for screening out thousands of stocks.
If you are willing to pony up a small amount of money, a “cheap” stock screener like AAII Stock Investor Pro can screen for these highly profitable companies.
Here are the results I get, sorted highest (“most profitable”) to lowest (“least profitable”) – (Using the Novy-Marx definition of profitability):
I think this topic deserves another article and possibly a new motif created…stay tuned for future articles where we will go into easier ways to add a profitability tilt to your portfolio.
Conclusion
So there are the 3 major factors in stock performance over the last 50 years. Obviously the risk is that there is no way to tell if this outperformance will continue on into the future, or was this just a product of data mining (a coincidence) and it actually means nothing?
As they always say “Past performance is no guarantee for future returns”.
But if you want to invest like DFA – here is your road map. Tilt your portfolio towards small caps, Value stocks and highly profitable companies.
