As 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 30 years, Dimensional Fund Advisors (DFA) have helped investors achieve higher expected returns through advanced portfolio design, management and trading. They manage $445bn (as at 31 Dec 2016) 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-winning research. At Lexo, we aim to deliver an outstanding investment experience to every client based on this unrivalled research.
DFA, 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.
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 from Which? 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 holds. At typically up to 500-600 stocks, this will often provide more diversification than the typical active fund which can 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 DFA investing portfolio 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 are risky assets and their performance can fluctuate over shorter time periods. Dimensional investing provides focused exposure to these risky 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 risk.
We can see this by looking at the long-term performance of DFA investing strategies compared to the performance of the indexes. In the UK, the strategies have not all been available for a long time period but we can see that the same strategies in the US have been available for longer. This longer time frame allows us to see that the Dimensional Investing has generally outperformed the indexes, although this is not guaranteed in the 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 DFA academics have identified, notably Professor Gene Fama, of the University of Chicago Booth School of Business, and Professor Ken French, of the Tuck School of Business, Dartmouth College.
Their research suggests that smaller companies and low-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 riskier 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.
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.
Small cap stocks are considered riskier than large cap stocks, and value stocks are deemed riskier than growth stocks. These higher returns reflect compensation for bearing higher risk.
We therefore tilt Lexo’s portfolios towards small and value companies to capitalise on these dimensions of returns.