DFA vs. Vanguard

Water Cooler Investing
#41

Manager risk is a very real risk. The 5.75% front end load isn’t the reason the industry is shifting away from A Shares. It’s because you had to use one fund company to hit your breakpoints and, in the process, expose yourself to manager risk. For example, when American Funds does poorly, all their funds tend to do poorly because they have centralized research and the same macro themes play out across all their funds. To hedge against this the industry moved to the fee-based model where using more than two managers in a given asset allocation model is fairly uncommon. Having 70% of your money with one firm is very rare. That’s the knock on DFA (hey! we came full circle).

The part about the single bond fund is a very real, but fairly new risk. In 2008, bond funds that were supposed to be safe and protect investors in times of crisis completely imploded. Many multi-sector bond funds were down well over 10%. Imagine the pain a person near retirement felt as they not only witnessed their equities getting cut in half, but their “safe” bond portfolio getting crushed by 20%. To make matters worse, the Barclays Aggregate Bond Index was up 6% in 2008 so it just goes to show how much risk these bond funds were taking and their clients (and advisors) had no idea. Dodge & Cox held up fine, only down about 60 bps, but that still sucks compared to the index being up 6%. Having a well diversified bond portfolio has been one of the key takeaways from the financial crisis.

You don’t need 40 funds to cover everything I listed. And, by the way, those asset classes I mentioned are the bare minimum for what’s considered a well diversified portfolio. You can reach all of them with 5 domestic funds, 2-3 international funds, 3 fixed income funds, and 1-2 alternative funds. 13 total funds isn’t so bad. Most models I see are between 12-18.

There most certainly is a benefit. This could be an entirely separate discussion…not even sure where to begin. We could talk about the benefits of using domestic and international funds vs global; why you always need some exposure to TIPS; why have about 10% in uncorrelated assets really makes sense…all this stuff is pretty straightforward. But the short answer is, no one manager can effectively allocate across all domestic equites (for example) and especially not on a global scale; nor do you (or me) offer the ability to make timely tactical shifts. You need exposure to the asset classes because it lowers risk without lowering your return. REITs, for example, are correlated to the S&P to the tune of about .6. So, it makes sense from a diversification standpoint to hold them. This is really portfolio construction 101. All this is really just scratching the surface though. There are tons of reasons to own a well diversified portfolio, and simply owning four funds that have a thousands securities does not guarantee diversification.

I don’t buy this at all. If your strategy could effectively gather assets guys would be all over it. Today’s advisors get paid on AUM and like to play golf. If there was a winning formula that could simplify their business while attracting clients they’d do it in a second. No one is going to pay you a fee, even a low one, to check their portfolio once a year. The major drawback of the fee-based model is investors expect their advisor to actually do something for their fee. If you want to buy something and forget it, go back to the A Share model.

#42

I think the flip side of this is also equally true–the major advantage of the fee-based model is that advisors get to absolutely nothing and still get paid.

In theory, I think a lot of advisors are “continually monitor your portfolio, and using the very latest cutting-edge research, we are constantly shifting into different sectors and asset classes which we expect to outperform while simultaneously reducing your systematic risk.”

In practice, I think a lot of advisors are playing golf and charging 1% of $100m per year.

#43

Enhanced, or _ optimized _?

#44

As I recall, enhanced just means that they’ll try to generate a little alpha but not if it results in more than just a tiny bit of tracking error. Presumably it is also optimized, but you can have optimized portfolios that are more than enhanced.

#45

Greenman why not go 100% passive with I shares? The way I see it your job isn’t to pick managers unless your running a fof, you’re really selling a service that’s trying to preserve capital more than anything else.

#46

^Certainly could, although (getting back to the original discussion) I’m not sure that using DFA funds wouldn’t be preferable to ETF’s that track a commercial index.

Of course, using iShares would be the ultimate in “capture beta not alpha”, but I do think there’s a little alpha to be generated by smart managers. That’s why I chose the funds that I did. Maybe I should rethink that strategy.

Also, (and I don’t spend all my time reading Barron’s or Morningstar, or else I would probably know more,) I don’t know if there are “global” ETF’s. That is, I used the example of the D&C Global fund earlier to gain exposure to all large caps, foreign and domestic. If there is no such thing as a “global” ETF, then I’d have to abandon my “four-fund” rule, which actually might not be a bad idea, after listening to Sys and STL.

#47

^Yes, but is your job to “capture alpha”?

#48

Not really. Your job is to invest client assets according to their needs and wants. Capturing alpha isn’t part of it. But if you knew you could get a positive alpha with a lower stdev, you’d be a fool not to grab it. I think a few (emphasis on the “few”) managers are able to do that.

Do you disagree? I’m not sure what your point is.

#49

If you’re trying to capture beta of US stocks, why can’t you just put your entire investment in SPY? I understand the need for different asset classes (bonds, real estate) but trying to capture beta by allocating between US growth/value, momentum/defense–does that really work?

#50

IMHO, no. Some others would say that you need “systematic exposure to growth and value in order to achieve the desired asset diversification…” I think that’s baloney. There’s an ongoing debate about whether value or growth will win, and there’s no way to tell what will work in the future.

Yes, investing 100% into an S&P 500 index fund or ETF would be the ultimate in “capture beta”, and would also be the ultimate in simplicity. But that’s a little too simplistic, even for a simple guy like me. While I don’t think you necessarily need exposure to every single asset class in the world (like emerging market floating rate collared debt), just having one asset class is surely a recipe for disaster.

#51

Fuark Sweep, we’re making negative progress in this thread…

#52

The whole debate on passive versus active never gets old…and I suspect it is because of all the vested interests. Keep in mind I am in the active management part of the industry as I say this – I have never understood how the search for an extra 50bps per year keeps an entire portion of the industry afloat, teeming with researchers, analysts and PMs. It seems to me that you pay some lowly people to construct an index, and that does a pretty good job at capturing a large chunk of the return stream flowing to assets (i.e., the beta) – why go crazy with selection and complex schemes to piece together something that can add, maybe, (a volatile) 50-75bps per year?

Now I realize that this will open me up to criticism by some, but again, keep in mind, my own livelihood is in the belief of active management. I’m simply pointing out that if you have a blended portfolio delivering 7-8% per annum on average, the additional uncertainty introduced in seeking the advantage of an additional few basis points a year, I wonder sometimes, is it worth it? We’re not talking about a magnitude of alterning your return stream by a factor of 2x or 3x here, we’re talking about a very low percent of your total return that is involved in the active management differential.

As an analog, imagine that 99% of the resources of the agricultural industry were focused on extracting the last 1% of the crop yield…we wouldn’t think twice about criticizing this and suggesting that these resources be deployed elsewhere in society to achieve a greater benefit.

#53

Greenman, go mess around etfdb.com. You can find a lot of ETFs in there, and it’s easy to navigate. I think you may change your preferences that way. There are cheap MSCI World ETFs, for instance: http://etfdb.com/index/msci-world-index/. They even have some portfolio suggestions (I really don’t like those, but reading them may help you think about what you can do with ETFs)

ETFs are not a guaranteed best bet for stocks (tracking error, transaction costs and stuff), but they do OK. For other classes you must know what you’re doing. For instance, contango will eat you up in many commodity ETFs.

The hardest part to do with low fees/low AUM is to get a good grip of different/smart/exotic betas. HF replication funds may have very little in common with the real risk factors that may affect HFs. You’ll also hardly have access to top managers when trying to get exposure to some Alternative Investments.

Also, always remember you will be dealing with people. If your portfolio falls too hard, even on a single year, they’ll fire you.

STL has been hitting the nail on the head. On an intuitive level, I think the best way to look at diversification is to get away from any single risk crushing your portfolio. If you’re all above equities and HY, for instance, you may get badly burned if your optimistic way to look at things does badly.

Diversification is a good thing. Dalio’s All Weather approach has some interesting insights, and CFA’s curriculum L3 IPS section is pretty standard and it tends to work well. I mention the IPS stuff because I think it’s more important to first thing qualitatively about risk factors and client’s needs before throwing a lot of assumptions into Monte Carlo simulations and the like.

As DoW above has wisely shown, playing defense may be much more rewarding than reaching for more bps (that gets clear when things go bad).

Any type of concentration, like buying only equity or trusting on just a few managers, is better for things that represent part of somebody’s portfolio. In your case, maybe the best idea would be to have a Strategic Asset Allocation based on Time Horizon, Liquidity Needs, yadda yadda (textbook L3) + some minor tactical shifts so your clients will have stuff to talk about at parties.

In my opinion, you may have an easy time beating a fewPrivate Wealth shops because some of them seem more interested in selling sucky structured notes to naïve clients or getting rebates from high-fee funds than actually helping people. If you build a low fee diversified portfolio you can probably deliver better results without unnecessary risk.

#54

I think both clients and practitioners think or want to think they are not only above average, but way above average. In the some way entrepreneurs like to think they may be be building the next Google, investors like to think they may be investing with the next Buffet, or buying the next MSFT. And some will succeed, so hope is always around.

#55

The efficency of markets/suitability of passive investing relies heavily on how much active management/research is out there. If everyone stopped research and just indexed, security prices would be complete nonsense. I’ve always found the debate interesting as someone largely outside of of the asset management industry… “security prices reflect all known public information.” Well yes, because some analyst did the work and made that info known.

If there was less research, there would be more to gain by doing research. It’s an equillibrium sort of thing, no?

Passive investors are really just freeloaders on the active side, getting a free lunch.

#56

^Charles Ellis suggested the same thing in “Winning the Loser’s Game”. He says that the reason that active managers can’t beat the market is because they’re so good at research. The only way that active management will ever beat passive management is if enough analysts drop out of ER that it actually becomes profitable to do ER again.

Anyway, thanks for the suggestion, Crazyman. Never heard of that site.

@DoW - can you point to any empirical evidence that suggests that my “four-fund rule” is right on? Or is there some that shows that it is bunk? (BTW–saying “all the advisors do it this way, so it must be the right way” is not what I would consider empirical evidence. That might be a commercial for limiting liability or marketing yourself, though.)

#57

How do you know your clients even want alpha? The 35 yo self made millionaire may not care about alpha, but may be more interested in tax avoidance, a 65 yo retired doctor might be more concerned with charitable giving etc. The way I see it, you’re performing a service of “I’m looking after your investments so you don’t have to”, and your primary goal is “don’t lose money”. From time to time, some investors may be interested in alpha and you can invest in certain assets based on that, but not as a general business plan. But this is solely my opinion.

#58

^That’s a good point. And your other points are well taken too.

That’s where I think the real synergy of tax accountant + investment advisor will reall really come into play. Being both, there’s nothing “lost in translation” between the tax advisor and the wealth advisor.

And IMHO, too many tax practicioners focus on “We need to reduce your income taxes right now. Today. That is the only value we add.” And too many investment advisors are focused on “We need to increase your investable assets right now. Today. That is the only value we add.” Unfortunately, neither one is working with the other, and neither one is asking all the right questions.

#59

Here in KC we have one of the largest RIAs in the country, Creative Planning, that does what (I think) you’re getting at. They only use ETFs…won’t even take calls from guys like me. They’re one of the best - if not the best in the country - at what they do. Check out their site and the services they offer. Keep in mind, the reason they can do all this and charge less than your average mutual fund, is because they have extremely high minimums and they reached scale a long time ago. Having nearly $10B in AUM allows you to do nice things.

#60

^Took a look at it, and yes, that’s extremely similar to what I want to do, except that I’m not an attorney (which they have on staff), and they don’t seem to do business taxes–only personal. (It’s hard to be a CPA firm and not do business taxes.)

And of course, I’d be doing it on a much smaller scale. $100m AUM is a good goal. If I ever got to $250, I’d feel like the king of the world.