Are DFA's Funds Active or Passive?

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Larry Swedroe’s recent critique of Graham and Dodd value investing mischaracterized DFA’s value funds as “passive.” Beyond that, he misread James Montier’s discussion of “perfect” value investors, made unfair comparisons among funds and didn’t measure risk properly.

Introduction

Swedroe defended passive investing against Graham and Dodd value investing. He did this by commenting on a 2006 paper written by GMO analyst James Montier, who was then at Dresdner Kleinwort Wasserstein.

In that paper, Montier quoted Sequoia Fund SEQUX manager Bob Goldfarb, citing nine value funds that he thought “perfectly” embodied the Graham and Dodd style of investing. Montier tossed in a tenth fund, the Tweedy Browne Global Value TBGVX (which Swedroe omitted). That gave Montier’s list two funds from Tweedy Browne, including Tweedy Browne Value TWEBX, the shop that began its life brokering many of Ben Graham’s trades in what we now call micro-cap stocks.

Swedroe’s critique found the funds that Montier listed wanting in terms of their nine-year performance (2006-2014), against both the DFA U.S. Large Cap Value Fund III DFUVX and the S&P 500 Index.

Low price-book investing is not a passive strategy

Unfortunately, the premise of Swedroe’s argument is incorrect because the DFA U.S Value III Fund isn’t a passive investment vehicle.

DFA’s value funds have a low price-book value (or as the firm puts it, high “book-to-market” or “BtM”) tilt to them. If this doesn’t sound like a passive strategy, it shouldn’t because it isn’t.

It is, however, a big yawn for anyone who’s read the original 1934 edition of Graham and Dodd’s Security Analysis. Buying low price-book value stocks or tilting a portfolio to them is a value investing strategy that’s been out for 80 years at this point.

In other words, DFA U.S. Large Cap Value III is an actively managed value fund, not a passive index fund. It might be a mechanically arranged portfolio or a portfolio organized around prearranged valuation rules, but it’s a value fund nevertheless. And Graham, especially later in life, was a big fan of mechanical value strategies.

DFA deserves kudos for employing one of the simplest and most basic value strategies so well, as the fund’s nine-year returns show. But DFA doesn’t represent passive investing any more than Ben Graham combing through an S&P stock manual for low price-book value stocks would.

Interestingly, Joel Greenblatt calls his mechanical value formula of choosing stocks with the best combination of high EBIT/EV and high ROIC metrics “value-weighted indexing.” That seems like an honest attempt to arrive at a precise characterization of a mechanical value strategy rather than calling it simply “passive.”

For a long time now, DFA and its admirers have called that shop’s funds’ strategies “passive,” and that appellation simply isn’t accurate.

Comparing apples to oranges

Among the 10 funds Montier mentioned, three invest significantly overseas: Mutual Beacon TEBIX, Tweedy Browne Global Value (which Swedroe omitted from his analysis) and First Eagle Global SGENX (which Swedroe confuses first with First Eagle Gold SGGDX and then with First Eagle U.S. Value FEVAX). Comparing funds that venture overseas with the DFA U.S. Large Cap Value III Fund is not a reasonable comparison.

Montier indeed mentioned that three funds on his list venture overseas, but he did not specify which. For two of them, First Eagle Global and Tweedy Browne Global Value, it’s obvious from their names. One might understandably mischaracterize Mutual Beacon, which, according to Morningstar, currently has 31% of its portfolio in foreign stocks. (Incidentally, the Clipper Fund CFIMX has 13% of its portfolio in foreign stock currently, according to Morningstar’s data.)

The First Eagle issue

For a moment, let’s put aside Swedroe’s use of the wrong First Eagle fund. Let’s re-examine how First Eagle U.S. Value -- the one Swedroe chose -- did over the nine-year period compared to DFA U.S. Value III.

First Eagle U.S. Value lagged behind DFA U.S. Large Cap Value III by 3 basis points annualized (7.98% versus 8.01%), but managed that return with a standard deviation of returns of 11 versus 22 for DFA. Is that really victory for DFA?

Volatility may not be a true measure of risk, but when it’s high it can prevent an investor from holding an investment for the long haul. So is experiencing double the volatility to achieve three basis points more per year worth it? No mathematical formula can determine that. But it does seem reasonable to call the First Eagle U.S. Value fund a success – even a raging success -- for basically matching the return of the DFA U.S. Value III Fund with strikingly less volatility.

First Eagle is a notorious user of cash, and Swedroe argued that value funds’ use of cash can distort investors’ asset allocations. But in the brutal market of 2008, First Eagle U.S. Value dropped 23%. This was 14 percentage points less than the S&P 500 Index and 17 percentage points less than the DFA U.S. Large Cap Value III Fund. No doubt, the Frist Eagle fund’s downside protection during the crisis was due to its cash and gold positions.

Can one look at the First Eagle fund’s returns in comparison to the DFA’s fund’s returns over the nine-year period under consideration and in 2008, and reasonably conclude that its managers don’t know how to use cash?

So at this point, let’s say two of the nine funds – First Eagle U.S. Value (despite it being the wrong First Eagle fund) and Oakmark Select OAKLX (for simply outpacing DFA U.S. Value III over the nine-year period) met Goldfarb’s expectations. That’s still a poor showing, but it’s better than what Swedroe would have readers believe.

And if we throw away the other global fund (Mutual Beacon) for being an unfair comparison, we’re at two out of eight.

Cash and measuring risk

Montier pointed out that many of the funds he identified have underperformed over seven-year periods in the past. Value fund underperformance is typically associated with holding cash in raging bull markets (such as the one we’ve had for the past six years.)

But Swedroe did not address Montier’s seven-year time horizon. Investors in value funds deserve to be forewarned that seven- or even nine-year periods of underperformance can be the price to pay for longer term outperformance.

Finally, Swedroe doesn’t consider that First Eagle delivered the goods not only with less volatility, but also with much less exposure to potentially permanent impairment. First Eagle’s virtue is that it held cash when securities got expensive and protected its investors from permanent loss.

Avoiding permanent loss is much harder to measure mathematically than volatility or standard deviation, which are the metrics typically relied on by fund analysts and advisors.

Conclusion

The issue of cash is particularly important because many value investors have elevated exposure to it. That includes First Eagle whose stellar record of using cash might give pause to anyone fully invested currently.

First Eagle U.S. Value and First Eagle Global hold well over 20% in cash and gold, according to Morningstar. (Tweedy Browne Value and Tweedy Browne Global Value are holding 12% and 19% cash, respectively, at the moment, according to Morningstar.)

The DFA fund looks great compared to most -- but not all -- of the other value competition for the past nine years, as Swedroe argued. But who wants to invest fresh cash in it over the First Eagle Fund or even the Tweedy Browne funds now?

John Coumarianos is a freelance writer. He has worked as a branch representative at Fidelity Investments, a mutual fund and equity analyst at Morningstar, and a writer at Capital Group. He also runs the website/blog Institutional Imperative.