Advisor Blog

I'm not quite sure how I missed this.  It was really cold in Texas last week, but I hadn't realized that hell had, indeed, frozen over!  Suffice it to say that I don't read Barron's.  But, at DFA's Dallas study group meeting yesterday, a lot of the participants found this to be rather amusing.  It's a lot like CNN choosing Glenn Beck as man of the year or Fox News choosing George Soros for some honor.  Nevertheless, it did actually happen.  Here are some excerpts from the article:

Dimensional Fund Advisors, whose quant[itative] funds operate almost like indexes, was in precisely the right markets and watched its pennies.-

Of course, it’s impossible to time stock- and bond-market changes and the strategy that’s paid off for the best big fund families – as well as investors – is a diversified one. Our No. 1, DFA, is a global asset manager that oversees $206.5 billion in all and owns a mind-boggling 13,000 stocks, or about 70% of the world’s publicly listed equities. Because DFA’s investment process is purely quantitative, it doesn’t have the option of succumbing to fear in the face of adversity. It certainly helped that DFA focuses much of its attention on some of last year’s highest-performing equity areas – value, small-cap and emerging markets.-

The privately held firm (Arnold Schwarzenegger is an investor) also is known for keeping a lid on costs that can rob shareholders of performance points, steering clear of some foreign markets where it doesn’t believe funds can get a fair shake on prices.

Weston Wellington, a Vice President at DFA, once said "Fama doesn't read Barron's and readers of Barron's don't read Fama."  That may still be true, but the Barron's readers might at least now know who he is.

David Booth, Chairman and Co-Chief Executive Officer of Dimensional Fund Advisors interviews Eugene Fama, Ken French, and Robert Merton and explains the importance of Dimensional's relationships with leading thinkers in the field of modern finance. 

• Eugene Fama is the Robert R. McCormick Distinguished Service Professor of Finance at The University of Chicago and is widely recognized as the "father of modern finance." 
• Ken French is the Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business at Dartmouth College.
• Robert Merton is a Nobel Laureate and finance professor at Massachusetts Institute of Technology.

View the video here.

It seems that if something can be "dumbed down", it will be.  This is particularly true when it comes to mutual fund selection and the results are disturbing.

In an article titled "Stargazing: Five-Star Investors Revisited", Tom McGuigan and Tim Courtney examined 248 mutual funds that were five-star rated by Morningstar as of December 31, 1999.  The findings are very interesting.  As of December 31, 2009, exactly ten years later:

• Only four of the original 248 funds were still five-star rated.
• Of the 248 funds, 87 had ceased to exist.
• Of those still in existence, all had been downgraded to an average of just under three stars.

Not a single small cap value fund was rated five stars in 1999.  Yet, over the next ten years, this asset class proved to be the best performer.  The average return for five-star funds over the ten-year period was worse than the average return for all funds in every category except international stocks.  Even then, the five-star international stocks only beat the average by about a tenth of a percent per year.

Beyond all this, the study found that investors in five-star funds achieved lower rates of return than those that invested in the average fund.  Why?  Probably because they bought them in 1999 and dumped them at a loss when the market turned down over the next few years.

You might find this surprising, but we don't.  We know that fund rating services cannot identify, in advance, funds that will outperform.  We also know that investor behavior is the most important determinant of portfolio performance.

Scott Maxwell recently attended a conference where an insurance firm's investment arm offered advice to their sales force on how to win investment business from prospective clients.  The advice was to comb through the prospect's portfolio and look for funds that had one or two-star ratings.  Then, ask the prospect why he or she would do business with an advisor who obviously can't count stars.  When Scott pointed out that the ratings had no correlation with future performance, he was pointedly reminded that this was about winning business and not about what's best for the client. 

The selection of a fund should be based on the fund's statistical contribution to the portfolio.  In his recent article, "Stars or Straws", DFA's Jim Parker discusses the foundation for choosing one fund over another.  "Leading academics Gene Fama and Ken French, in a recent study of mutual fund performance, showed how hard it is for investors to distinguish skill from pure chance in analysing the returns of individual funds.

So what should an investor and his or her advisor weigh up in making a decision? The key here is to focus on items within their control, such as:

• Are the risks being taken related to return?
• Are those risks targeted in a reliable, consistent way?
• How diversified is the fund?
• Does it make promises it can't keep?
• What is more important - individual judgement or clear processes?
• Are the underlying strategies driven by forecasts?
• Does the fund take account of costs and taxes in its decisions?
• Does the fund manager communicate in a clear and consistent way?

While many of these attributes can lead to good outcomes for investors, they are no guarantee of positive returns every year. Anyone who makes those sorts of promises risks disillusioning those who put their faith in them.

But the above characteristics can give investors comfort that their money is being invested in a consistent, transparent way and that ensures that when the targeted premiums kick in, they are positioned to receive them."