Pre-reading: Explaining portfolio returns using stock market models
If you’ve read my posts on our portfolio construction and Dimensional Fund retail equivalents, you may have noticed that we invest our funds with Dimensional Fund Advisors (DFA). This makes us a little different to the majority of the personal finance community which prefers to use companies such as Vanguard and Blackrock. In this post I wanted to give a brief introduction to factor investing and why we use DFA.
What is factor investing?
In my previous post I talked about how asset pricing models such as the CAPM and the Fama and French 3 factor model are used to explain differences in portfolio returns. Factor investing can be thought of as the practical application of the research that gave rise to such models. To perform this strategy an investor/fund manager will choose stocks with the intent of tilting a portfolio towards specific risk factors that are known drivers of returns. This is different to index investing where an investor is seeking to obtain the same return (minus the management fee) as a particular index through exposure to a single risk factor – the systematic risk of the market.
Is factor investing passive?
Wait, I thought you said stock picking was really hard and the odds are stacked against active managers? Hahaha yes, I did say those things and rest assured that I still stand by those opinions. Factor investing is not active management because it does not seek to beat the market by generating alpha. Portfolios more heavily exposed (tilted) towards known risk factors have a tendency to outperform their respective benchmarks over time because they are riskier than standard index portfolios, not because of fund manager skill. Hence the differences in returns are completely explained by asset pricing models.
In addition to this, managers using factor invested techniques do not attempt to time the market by shifting into, and out of equities, to protect against downward price movements. They simply aim to capture the risk that comes with certain factors that drive portfolio returns.
Who are Dimensional Fund Advisors?
Dimensional Fund Advisors was founded in 1981 by David Booth and Rex Sinquefield and bases its investment approach on economic theory and empirical research. They seek to apply financial research from academics such as Eugene Fama (2013 Nobel laureate) and Kenneth French. DFA is a sizeable investment manager with $879B (AUD equivalent) in funds under management and their equity funds have a tendency to tilt towards known risk factors such as small and value stocks.
So, why do we use Dimensional Funds?
DFA as a company represents the application of financial research into the field of funds management. Their philosophy of investing consistently over the long-term using diversified portfolios aligns with our investment requirements. We also believe that their slightly riskier factor tilted portfolios will result in outperformance in the long run (net of fees) when compared to standard indexed portfolios. As a result, DFA is a rational choice for us and provides a slightly better fit than standard indexed fund alternatives.
Comparison between the index funds and Dimensional Funds
Table 1, shown below, shows a side-to-side comparison between the fund make up for the Dimensional Global Core Equity Trust; the Vanguard International Shares Index Fund; and the MSCI World Ex Australia.
| Dimensional Global Core Equity Trust (unhedged) | Vanguard International Shares Index Fund | MSCI World Ex Australia Index | |
| Benchmark | MSCI World Ex Australia | MSCI World Ex Australia | – |
| Price-to-book | 2.66 | 3.1 | 3.1 |
| % in top ten holdings | 13.50% | 17.56% | 17.87% |
| Number of holdings | 6114 | 1505 | 1499 |
Sector Allocations | |||
| Information Technology | 18.72% | 22.5% | 22.5% |
| Industrials | 14.41% | 10.7% | 10.7% |
| Financials | 13.61% | 13.1% | 13.1% |
| Consumer discretionary | 12.28% | 12.1% | 12.1% |
| Health care | 10.95% | 12.6% | 12.6% |
| Communication Services | 7.99% | 9.3% | 9.3% |
| Consumer staples | 6.61% | 7.1% | 7.1% |
| Materials | 5.72% | 4.1% | 4.1% |
| Energy | 3.21% | 3.1% | 3.1% |
| Utilities | 2.81% | 2.8% | 2.8% |
| REITs | 2.71% | 0% (note 1) | 0% (note 1) |
| Real Estate | 0.98% | 2.6% | 2.6% |
The first notable difference is that the DFA Global Core Equity Trust has a significantly higher number of holdings when compared to the Vanguard International Shares Index Fund (6114 vs 1505). The average price-to-book (2.66 vs 3.1) and percentage of allocation in the top ten holdings (13.50% vs 17.56%) are both lower for the DFA fund when compared to its Vanguard counterpart which indicates that it is tilted towards value and small stocks. Hence the increased exposure to the size and value factors.
Other notable differences are that the index fund is more heavily weighted towards IT stocks but has a lower weighting of industrials. This is likely due to DFA targeting stocks with lower price-to-book ratios and market capitalization vs the index which is comprised of the approximately 1500 largest companies.
Table 2 shows a side-to-side comparison between the fund make up for the Dimensional Australian Core Equity Trust; the Vanguard Australian Shares Index Fund; and the S&P/ASX300 (Total Return) Index.
| Dimensional Australian Core Equity trust (unhedged) | Vanguard Australian Shares Index Fund | S&P/ASX300 (Total Return) Index | |
| Benchmark | S&P/ASX300 | S&P/ASX300 | – |
| Price-to-book | 2.21 | 2.4 | 2.4 |
| % in top ten holdings | 30.03% | 45.59% | 45.59% |
| Number of holdings | 526 | 306 | 298 |
Sector Allocations | |||
| Materials | 24.52% | 20.3% | 20.3% |
| Financials | 21.99% | 29.3% | 29.3% |
| Consumer discretionary | 11.22% | 8.3% | 8.3% |
| Industrials | 8.14% | 6.7% | 6.7% |
| Health care | 7.86% | 10.1% | 10.1% |
| REITs | 6.45% | 0% (note 1) | 0% (note 1) |
| Communication Services | 5.02% | 4.2% | 4.2% |
| Consumer staples | 4.89% | 5.1% | 5.1% |
| Energy | 4.33% | 3.1% | 3.1% |
| Information Technology | 3.63% | 4.4% | 4.4% |
| Utilities | 1.53% | 1.5% | 1.4% |
| Real estate | 0.68% | 7.0% | 7.0% |
For the DFA Australian Core Equity Trust the average price-to-book ratio is again lower (2.21 vs 2.4) and the number of holdings within the fund is also higher (526 vs 306). The top ten holdings in the DFA fund are responsible for driving a smaller proportion of fund returns when compared to the Vanguard fund and the index (30.03% vs 45.59%). As a side note, I find it interesting how 10 companies make up a little under half of the market capitalization of largest 300 companies on the Australian stock market.
The biggest differences in sector weightings between DFA and the Vanguard Australian index fund comes from the materials and financials sectors. Where DFA has a higher allocation towards materials stocks (24.52% vs 20.3%) and a lower allocation towards financials (21.99% vs 29.3%).
Concluding thoughts
I believe that for most people, investing consistently using diversified index investment strategies produces the best outcomes in the long run. Hence, I’m a supporter of any fund manager that can provide these options at a reasonable cost. However, I’m also aware of the extensive research behind which factors are responsible for driving portfolio returns and believe that increased exposure to such factors will yield higher returns in the long run. Seeing that our DFA funds provide exposure to such factors but do not deviate too significantly from standard indexing investing portfolios, this represent additional risk that we are willing take for the possibility of higher returns.
Notes
1. REITs are counted as part of the Real Estate sector in the Vanguard funds and benchmark indices
References
Dimensional 2021, Global Core Equity Trust Unhedged Class, Dimensional Fund Advisors, available from: <https://au.dimensional.com/funds/global-core-equity-trust-unhedged-class>
Vanguard, 2021, Vanguard International Shares Index Fund, Vanguard, available from: <https://www.vanguard.com.au/personal/products/en/detail/8116/portfolio>
Dimensional 2021, Australian Core Equity Trust, Dimensional Fund Advisors, available from: <https://au.dimensional.com/funds/australian-core-equity-trust>
Vanguard, 2021, Vanguard Australian Shares Index Fund, Vanguard, available from: <https://www.vanguard.com.au/personal/products/en/detail/8100/portfolio>