Using DFA (Dimensional Fund Advisors) funds allows us specific advantages over other index funds. Early on, investors used indexes to track managers’ performance on a risk-adjusted basis. Years later, many indexes have been licensed to fund providers allowing investors to gain diversified exposure to an asset class. However, if the index fund is not a precise representation of the asset class, it may not be worth the cost required to track them. Unfortunately, the huge inflows into index funds have changed the dynamics of indexes. Remember that indexes are now investment vehicles, not simply a long list of stocks to reference relative performance. There are three major issues that the growth of index funds has created.
First, there are potentially higher costs in reconstitution of index funds. Since a commercial index rebalances once or twice per year, an index fund manager must buy and sell securities at a specific time. When a stock is dropped from an index it tends to have selling pressure, and stocks added to an index see price increases. So, the manager must buy and sell stocks on a particular date that everyone else on the planet knows about ahead of time. Needless to say, this is disadvantageous. Our goal is to gain exposure to a particular asset class, not mimic a commercial index that holds a stale allocation.
Second, style drift occurs between the reconstitution dates. Since prices change constantly, we want a fund provider that will update and keep the basket of stocks consistent with the objective. Remember our objective is to gain exposure to an asset class, not an arbitrary list of stocks that changes infrequently. By constraining the ability to keep the list of stocks fresh and reflective of the asset class, an index fund manager may reduce the expected return relative to the intended asset class. For example, if we hold a long list of value stocks and one company increases in price it may have a lower expected return. By having stale and infrequent reconstitution, the index fund may hold stocks that don’t match the intended asset class.
Third, concentration risk can derail an otherwise solid plan. Commercial index fund managers may be susceptible to concentration risk when one sector dominates the market capitalization of an asset class. For example, during the dot.com boom big tech stocks bubbled to huge valuations. If you were an index manager charged with tracking the market capitalization on an index, you could be forced to concentrate the portfolio in very few names in one sector. We seek to have a strategy that considers the risk of single securities, sectors and countries relative to the market. This addresses unnecessary concentration risk.
The bottom line is our objective to obtain exposure to specific asset classes while remaining diversified and keeping costs down. Avoiding the costs of reconstitution on specific dates, style drift that occurs in between distant reconstitution dates, and reducing concentration risks by implementing risk management rules will help us achieve our two objectives.