How Are DFA Funds Different From Index Funds?

Index funds are good, we believe Dimensional funds are better.Here's why.

We make no apologies for being advocates of the investment funds from Dimensional Fund Advisors (DFA).The firm’s investment philosophy is grounded in rigorous academic research and they follow the data wherever it leads. DFA has demonstrated a remarkable ability to take the pure science of academic research and combine that with the applied science of beautiful execution to deliver superior long-term returns for clients.

 For those unfamiliar with DFA, we often get the question, “How are DFA funds different from index funds?” Let’s briefly address the main differences:

1. DFA is not compelled to buy or sell a security. 

The evidence is clear, being forced to buy or sell has a cost. I recently saw this phenomenon in real life while vacationing at the coast. It was nearly 100 degrees as an ice cream vendor hawked Sno-cones, Push-ups and Dilly bars up and down the beach with no alternatives or competition anywhere to be found. If you are the father of two young children on the beach, demanding immediacy has a cost. 

 Index funds are handcuffed by tracking error. When a stock enters or exits the index they are told when and how much to buy or sell, with no regard for price. 

 2. Do you trust committees or markets?

The S&P 500 index is designed to be a surrogate for US large cap stocks. The stocks to include in the index are made by a committee at Standard & Poors. 

DFA prefers to let the market determine which stocks best represent US large cap. They look at all publicly traded US stocks and focus on the top decile by market cap. 

3. DFA counts cards. 

In blackjack card counters bend the odds in their favor using data. That doesn’t mean a card counter wins every hand, but over the long term it enhances the odds of success. 

Nearly 100 years of market data tell us there are clear drivers of higher expected returns, namely profitability, size and value. By tilting portfolios towards stocks with these attributes and underweighting stocks that don’t, DFA puts the odds of success in their favor. 

 4. DFA is a nimble trader. 

Index funds have very strict and confining reconstitution and rebalancing rules. This leads to style drift and holding stocks with negative momentum. DFA can rebalance and trade daily which has the benefit of providing investors with an investment that more accurately captures the asset class. In addition, DFA uses momentum (both positive and negative) as a trading barometer. Applying the robust academic research on momentum helps create a sort of tailwind. 

When we find something supported by evidence and intuition, we're inclined to pay attention. This is why we advocate for using DFA versus index funds.   

By Mike Palmer- Managing Principal