Category: Investment Decisions

DFA Mutual Funds Explained

Dimensional Fund Advisors, is an investment management company that takes a unique approach to the mutual fund investment strategy.

As with traditional mutual funds, DFA allows investors the opportunity to pool their funds with other investors to buy blocks of securities, but the strategy behind selecting assets for a DFA mutual funds differs significantly.

The techniques used to select assets are guided through academic research that follows the science of investing rather than simply making predictions based on past market performance or the success or failure of certain companies.

Dimensional Investment Philosophy: Utilizing Academic Research and Empirical Evidence

Dimensional Fund Advisors (DFA) was founded by David G. Booth and Rex Sinquefield in 1981. David Booth, a professor at the University of Chicago’s Booth School of Business, played a significant role in developing DFA’s investment philosophy.

DFA’s investment philosophy is data-driven and relies on empirical evidence rather than speculation. This is influenced by groundbreaking research in finance, including the efficient market hypothesis and studies on factor-based investing such as the three-factor model developed by Eugene Fama and Kenneth French.

DFA takes the emotion out of the equation to deliver reliable results. It has shown over time that it is possible to seek higher expected market returns through the use of science without having to outguess the market.

Over the past several decades this data-driven philosophy has proven successful and has become a preferred mutual fund strategy for investors who share in the belief that success is not arbitrary.

How DFA Mutual Funds are Different

DFA follows a philosophy that uses empirical evidence to arrive at carefully determined “premiums,” or factors, to guide the investment strategy.

Rather than simply looking at past performance and market trends, they take into account these select premium attributes which include relative price, company size, and profitability, all of which aim to have an impact on the fund’s end results and the investor’s bottom line.

DFA’s Factor-Based Approach: Targeting the “Premiums”

1. Company Size: The size factor refers to the historical evidence that smaller companies tend to outperform larger companies over the long term.

In practice, a factor-based strategy might involve overweighting or investing in small-cap stocks compared to their market capitalization weights. This approach aims to capture the potential excess returns associated with the size factor.

2. Relative Price (Value): Stocks with lower valuation metrics, such as low price-to-earnings (P/E) or price-to-book (P/B) ratios, tend to outperform stocks with higher valuations.

Implementing the value factor could involve constructing a portfolio that emphasizes stocks with attractive value metrics relative to their peers.

3. Profitability: Companies with higher profitability, as measured by metrics like return on equity (ROE) or operating margins, tend to deliver better long-term performance.

A factor-based strategy might involve directing the portfolio towards stocks with strong profitability characteristics.

DFA’s investment strategy revolves around carefully selecting securities that demonstrate these factors, aiming to capture systematic sources of risk and long-term market returns within a modern investment framework.

How Dimensional Mutual Funds Differ from Index Mutual Funds

DFA mutual funds and index mutual funds share the same purpose of building wealth with pooled investments, but there are some key differences in their approach:

Dimensional Funds	Index Funds
Accessible through authorized advisors	Direct access for individual investors
Managed by individuals who meet DFA’s high standards	No specific requirements for advisors
Philosophy based on following the science of investing	Reflects current market trends and past performance
Favors small-sized companies with long-term outperformance potential	No specific bias towards company size
Considers value in comparison to growth	No specific focus on value or growth
Emphasizes profitability as a determinant of long-term performance	No specific emphasis on profitability

Benefits of Investing in DFA Mutual Funds

1. Lower costs and fees

1. DFA does not pay advisors commissions to recommend their funds to investors. This practice tends to deter fee-based advisors who may trade fund assets based on emotions, trends, and performance markets, passing those trade fees along to the client.
2. It attracts advisors who embrace a passive investment strategy and value their role of educating and providing guidance for their clients.
3. DFA employs disciplined trading practices, such as patient trading and minimizing market impact. This approach aims to reduce transaction costs and prevent negative impacts on portfolio performance.

2. Diversification and risk management

DFA’s mutual fund strategy employs several market strategies to emphasize diversification across different market segments, providing investors with a robust risk management mechanism.

DFA aims to provide investors with exposure to a wide range of market segments, including domestic and international equities, fixed income securities, and alternative asset classes. A few notable strategies include:

1. Broad Market Exposure
2. Factor-Based Investing
3. Structured Portfolios
4. Efficient Trading

3. Focus on long-term investing

DFA encourages investors to adopt a long-term perspective and resist short-term market timing or reacting to market fluctuations. This patient approach allows investors to benefit from the long-term performance of the market segments they are invested in.

4. Strong performance track record

The company’s commitment to rigorous research, data-driven methodologies, and a long-term investment perspective has contributed to its strong performance track record.

It’s important to note that past performance is not indicative of future results, and investing involves risks. Factors such as economic conditions, market volatility, and specific company or industry risks can impact investment outcomes.

Therefore, it’s crucial for individuals to conduct a thorough assessment of their financial goals, risk tolerance, and time horizon before making any investment decisions.

Consulting with financial professionals, such as fiduciary advisors or certified financial planners CFP^®, can help assess risk profiles, develop appropriate investment strategies, and provide ongoing monitoring and adjustments as needed.

How to Invest in DFA Mutual Funds

Unlike index mutual funds, DFA mutual funds are not readily available to the general public. Investors can only access them through select financial advisors who have undergone a rigorous and lengthy selection process.

This ensures that those advisors managing investor accounts understand and respect DFA’s philosophy of investing based on academic research and the science of investing.

1. Selecting an Approved Financial Advisor

1. When you are ready to invest in DFA mutual funds, start by selecting a financial advisor that has been approved to offer DFA mutual funds to their clients.
2. They are not likely to make drastic changes to the assets held within a mutual fund on a whim or for their own benefit, thus potentially affecting the portfolios of investors in a negative way.
3. Not only are they well-versed in selecting the funds that will provide optimal results based on size, value, and profitability, but these advisors work to educate and provide sound, reliable advice rather than chase trends and try to predict market outcomes.
4. Fiduciary advisors working with Dimensional Funds (DFA) are ideal resources due to their obligation to act in clients’ best interests and their expertise in DFA’s unique investment strategies, providing access to well-diversified portfolios and ongoing guidance.

2. Building Your Portfolio

1. Once you have selected an approved DFA fund advisor, open a brokerage account to fund your investment.
2. By opening a brokerage account, clients gain access to a range of investment options, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and other securities.
3. The brokerage account facilitates transparency and accountability, as clients can view their portfolio holdings, track performance, and receive regular statements and reports detailing their investment activity and account balances.
4. The next step is selecting the appropriate mutual funds that meet your investment goals.
5. Fiduciary approved mutual fund advisors are the ideal resource to help with this step of building your portfolio.

3. Managing Advisor Fees

1. DFA does not pay commissions to approved financial advisors.
2. Fees based on service rather than account size result in a rewarding advisor-investor relationship that is fair to both parties. Learn more about fee-only advisors.

DFA & Ferguson-Johnson Wealth Management.

Ferguson-Johnson Wealth Management collaborates with DFA by providing expertise and guidance to clients interested in investing in DFA funds.

As a fee-only fiduciary with more than 40 years of experience, our firm is well-versed in various investment styles, including those aligned with DFA’s philosophy of investing based on academic research and the science of investing.

We work closely with clients to understand their investment goals and leverage our knowledge of DFA funds to build diversified portfolios that align with their objectives.

By incorporating DFA funds into our tailored investment strategies, we aim to maximize profitability and provide our clients with the benefits of DFA’s approach to investing.

My clients always ask me how I invest my own money as if it’s a secret that I keep to myself. The thing about money management is that people often feel like no matter how much they learn about the latest techniques and trends, they’re never quite doing it right, that there’s always some better way to save or invest. 

Well, as a CERTIFIED FINANCIAL PLANNER™ professional who works with wealth management strategies every day, I’m here to tell you that the way I manage my own money is not all that different from how I manage my clients’ money. The first step is to start with the basics.

Basic Money Management &  Personal Investment Tips

Before developing and implementing an investment plan, it’s crucial to make sure all your other financial bases have been covered. Here are three tips to consider before we dive into my personal investment process.

1. Emergency Fund

One of the most important money management tips is to make sure you have an adequate emergency fund before investing. An emergency fund should consist of cash as well as access to capital and lines of credit.

It is used to cover unexpected expenses or disruptions in cash flow, so that you won’t have to steal from your investment portfolio in the event of an emergency. 

If you haven’t already, start saving a portion of your income in highly liquid investments (savings accounts, money market accounts, certificates of deposit, etc.). Ideally, you should have 3-6 months’ worth of non-discretionary expenses saved before moving onto investment goals.

2. Net Cash Flow

After you’ve built an adequate emergency fund, it’s time to look at your net cash flow (income minus expenses). Since investments are just one component of a larger financial plan, this step is very important. It is your net cash flow that will act as the funding mechanism for your investment plan.

For instance, if you are consistently spending more than you earn (deficit), there will be no extra funds to contribute to your portfolio. Consistent negative cash flows actually indicate a larger issue that will need to be addressed before a successful investment plan can be established. 

Similarly, a net cash flow of zero (spending as much as you earn) doesn’t allow for any leftover funds to be contributed to investments. It may not indicate systemic issues like a negative cash flow, but it does indicate that spending will need to be adjusted to meet investment goals.

A positive cash flow (surplus) is ideal when assessing how to fund an investment plan. To generate a surplus cash flow, you must spend less money than you earn. This can be accomplished through techniques such as budgeting and tracking expenses.

3. Don’t Time the Markets

Avoiding market timing is a money management technique that can improve your returns over time. You may have heard the saying “buy low, sell high,” but the fact of the matter is that trying to determine when an asset has reached its high or low is like trying to guess the winning lottery numbers: more often than not, it doesn’t work. 

There is no way to predict short-term fluctuations with enough accuracy that you can consistently make the right decision about when to buy and when to sell. Staying in the market, even through volatile times, is a much better choice when trying to build long-term wealth.

Historically, although it has had many ups and downs, the market has always rebounded over time. That’s why it’s so important to trust the market and avoid temptations to time it, instead letting time be your ally when growing your investments. 

Personal Investment Policy

As a duty-bound fiduciary to my clients, I strive to handle their money as if it were my own, which is why the steps I take in my personal management and investment process mirror those I take with my clients. My personal investment policy involves several key points, including:

Active vs. Passive Investing

One of the most important aspects of my personal investment plan is the distinction between active and passive investing. At Ferguson Johnson Wealth Management, we focus on passive investing.

Though there is no guarantee that one strategy will outperform another, passive management techniques have generally outperformed active management over the long term. 

Passive investing utilizes strategies like buy-and-hold or indexing, while active investing involves single-stock investing and frequent buying and selling in an attempt to beat the average returns of the market.

As expected, active management comes with added expenses and no guarantees that the returns will be any better than a passively invested portfolio. In fact, active investing often results in worse returns when the increased costs are factored in. 

Trying to pick and choose individual stocks has proven to be a losing game many times, and it’s something I try to avoid in both my own portfolio as well as my clients’.

Diversification

Next, diversification is a critical piece of any investment plan. It can be achieved through an asset allocation strategy that considers which components of your plan can move together and which can act as a hedge against downside risk.

Diversification can’t guarantee a minimum level of return, but it will at least act as a buffer against the inherent volatility of the market. By investing across and within several different asset classes, you can reduce your overall exposure to risk. 

While it can be tempting to chase performance and overload a portfolio with the hottest asset class, I prefer to take a more balanced (and diversified) approach when investing my own money. This mindset aligns with how we manage our clients’ funds at Ferguson Johnson Wealth Management. Our portfolio options include diversified allocations in:

1. Large-cap growth
2. Large-cap value
3. Mid-cap 
4. Small-cap
5. Diversified international
6. Emerging market
7. Fixed income
8. Real estate through low-cost index funds

This provides broad exposure to several different industries, sectors, and asset classes across the market, ensuring that no single investment can drastically alter the returns of the whole portfolio. I personally focus on exchange-traded funds (ETFs) and mutual funds as a convenient way to increase diversification in my investment portfolio.

Not All Bonds Are Created Equal

Another important investment consideration is understanding the current bond environment and how to avoid exposing yourself to too much risk. Clients often don’t realize that traditional “safe” investments like bonds no longer provide the guarantees they used to 40 years ago.

In 1982, you could achieve an average yield of 13.01% with a relatively low-risk investment in long-term bonds, but that is no longer the case. As of July 7, 2022, the yield on a 10-year bond is only about 3.01%! 

Given the interest-rate environment we find ourselves in, not all bonds are created equal. The Federal Reserve has already raised interest rates three times and they are very likely to continue raising rates throughout the rest of 2022.

Because of this, we believe that short-term bond funds are a much better choice for the fixed-income portion of an investment portfolio as opposed to longer-term bonds. 

This is because interest rates are inversely related to bond prices, and the longer the bond’s maturity, the more intense this relationship is. So longer-term bonds will likely lose their value much more quickly and intensely as interest rates continue to rise.

Paying attention to the duration of a fixed-income investment has never been more important than it is in today’s investment environment. As a firm, we have targeted shorter-duration bonds over the last 8-10 years in order to alleviate this issue.

How We Can Help

Successful money management and investing don’t have to be shrouded in mystery. Our goal at Ferguson Johnson Wealth Management is to give our clients the tools and resources to feel confident in their financial plans. If you’d like to learn more about our investment philosophy and how it applies to your portfolio, reach out to us at 301-670-0994 or by email.

Albert Einstein was said to have described compound interest as “the eighth wonder of the world” and that it is “the most powerful force in the universe”. High praise from one of history’s greatest scientists about an elementary-level concept of finance.

I mean, he’s right. Warren Buffet, widely regarded as one of the greatest investors ever, openly admits that most of his wealth is attributable to simple compounding.

Let’s talk about bonds for a minute. Occasionally, we get asked about what the future prospects are for bond investors. Sometimes with the implication being: “Should I be invested in bonds at all?” For the past decade, we’ve lived in a very low interest rate environment, relative to historical averages. (Click charts below to enlarge)

Bitcoin is has been in the news a lot recently. As of August 24^th, the price of ‘physical’ Bitcoin had increased by 336%, year-to-date. Of course, as anyone who has looked into purchasing direct Bitcoin already knows, the process of “investing” in Bitcoin is rather complicated and poses a litany of unique risks.

I had an interesting conversation with someone who was asking about the mutual funds we employ. Specifically, he asked if we use “Five-star mutual funds”.

I probably shouldn’t have been surprised, based on how ubiquitous Morningstar is for investment research, but I had never been asked about Morningstar Star Ratings before.

In the world of detailed analytics and minutiae, Morningstar star ratings are a throw-away metric. It is a crude approximation of a narrow slice of a mutual fund’s story.

I often come across interesting images or thought-provoking data that I want to share with our community, but may not dictate 1,000+ words on the subject. Today, I want to launch a new series that explores these fun-facts in more bite-sized pieces. Click the image above for an expanded view.

Rules of thumb are common in the investment world. There’s the “rule of 72”, which gives us an idea of how often money will double. The safe retirement withdrawal rate lets us know how much we can “safely” draw from retirement portfolios without significant risk of long-term depletion.

Finally, there is the your age in bonds rule, telling us how much of an investment account should be in fixed income at a given time.

According to Gallup poll conducted in late 2015, most people are financially illiterate. The majority of us received no formal education in personal finance during school. We were just expected to figure it out once we entered the real world.

Today, many schools are beginning to include personal finance classes as a part of the curriculum. However, as I will illustrate below, the benefits of classroom financial education are largely ineffective.

As a parent, you may ask yourself, what can I do help my child? Today we’ll begin a recurring series in an effort to equip parents with the knowledge and tools they’ll need to educate their children about money.

Since this is going to be a big subject, we’ll just tackle one piece at a time. Today the focus will be on teaching kids how to invest.