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DIMENSIONAL FUND ADVISORS

Lexo is the first and only online platform in the UK that offers solely DFA funds, Lexo offers exclusive access to investment strategies usually reserved for the private investor.

For more than 40 years, Dimensional Fund Advisors (DFA) have helped investors achieve higher expected returns through advanced portfolio design, management and trading. They manage $584bn (as at 31 Dec 2022) worldwide thanks to the work they have done – evidence of which you’ll see below.

DFA use a scientific and academic approach to investing that’s underpinned by Nobel Prize winning research. At Lexo, we aim to deliver an outstanding investment experience to every client based on this unrivalled research.

DIMENSIONAL, ACTIVE FUNDS AND INDEX FUNDS

DIVERSIFICATION ON AN UNRIVALLED SCALE

True diversification in a portfolio means investing in a vast number of different stocks and bonds that represent the underlying asset classes which the investor seeks exposure to.

INDEX FUNDS

Index funds typically hold:
500-600 stock

ACTIVE FUNDS

Active funds typically hold:
100-200 stocks

DIMENSIONAL FUNDS

Dimensional funds typically hold:
10,000+ stocks

Some investors try to achieve diversification by including dozens of different funds and/or fund managers in their portfolio. The problem for many investors that take this approach is that there is often a lot of overlap between the different funds and this can give a false sense of diversification.

Active funds typically invest in relatively few stocks or bonds which means that there is a concentration of risk; if one of the fund investments represents a large part of the total fund and that investment performs badly, then there will be a significant effect on the performance of the fund.

Recent research highlighted that active funds “regularly fail to outperform the benchmarks they follow”. And arguably one of the worlds’ greatest investors, billionaire Warren Buffet, has also warned about poor active fund performance.

An index fund will try to hold the same amount of stocks or bonds as the index that it is tracking follows. Typically up to 500-600 stocks, this will often provide more diversification than the typical active fund which can typically hold only 100-200 stocks.

Dimensional takes this to a whole new level, seeking to diversify as much as possible within each fund. As a result, a typical portfolio of Dimensional funds offered by Lexo will provide more than 10,000 individual stocks and bonds: this is true diversification.

There are a number of industry benchmarks that aim to represent each asset class. However, these benchmarks often have large differences from each other. Index investing managers choose one of these benchmarks and have no flexibility to deviate from it. The industry calls this deviation “tracking error”. Dimensional investing allows the flexibility to have tracking error from any chosen benchmark for each live fund, giving better potential returns.

THE THREE DIMENSIONS OF TRADING

When trading stocks (or anything else), there are three important factors: Time, Quantity, and Price.

You cannot control all three factors – there is always a compromise.

Controlling quantity and time means you have ‘urgency’. It seems logical that if you want a specific thing (quantity), now (time) – then you have urgency. If you have urgency, you cannot get the best price (think of any showroom as an example).

Active fund managers have urgency because they want a specific stock (quantity) and they want it immediately (time) because they believe that that stock is worth buying or selling quickly (price).

Index-tracking fund managers have urgency because they follow a specific index (quantity) and it rebalances at a very specific time.

Dimensional doesn’t have to pursue a specific stock (quantity) or trade at a specific time; so we can concentrate on getting the best price.

Being patient in the market means Dimensional is better placed to achieve a better price; other fund managers do not take the same approach as they have urgency, which affects the price.

This approach allows Dimensional Fund Advisors to minimise the costs of trading.

EQUITIES

Equities are a share ownership in a company, and their price can fluctuate over shorter time periods due to market sentiment and news. Dimensional investing provides focused exposure to these asset classes that it targets with each particular strategy/fund. This may cause the fluctuations to be slightly greater than index investing funds, which might not be as focused. However, over the longer-term, this focus and disciplined exposure rewards Dimensional investors for taking this approach.

We can see this by looking at the long-term performance of Dimensional investing strategies compared to the performance of the indices. This longer time frame allows us to see that the Dimensional Investing has generally outperformed the indices, although this is not guaranteed in the future.

SMALL COMPANIES, BIG RETURNS

In order to get the best possible equity market return, we focus clients’ exposure on dimensions of higher expected return that various Dimensional academics have identified, notably Professor Gene Fama, 2013 Nobel laureate in Economic Sciences, and Professor Ken French, of the Tuck School of Business, Dartmouth College.

Their research suggests that smaller companies and lower-priced companies (those whose book value of assets is high relative to their market price, also known as value shares) perform better than the market average over time.

Because risk and return are related, the higher expected return comes at a price and, as a consequence, investing in these companies is often more volatile than investing in the whole market. As with any investment, there are periods when these groups of shares underperform the market, but over time, academic research shows that these risk premiums are worth paying.

Smaller capitalisation stocks are considered riskier than larger capitalisation stocks, and value stocks are deemed riskier than growth stocks. These higher returns reflect compensation for bearing higher degree of risk.

Therefore Lexo’s portfolios tilt towards smaller and value companies to capitalise on these dimensions of returns.

This chart demonstrates the higher expected returns offered by small cap stocks and value stocks in the UK, Europe, US, and Emerging Markets, and how much these risk premiums have rewarded investors in comparison.