Morningstar’s B-Musing Admiration of Dimensional Fund Advisors (DFA)
Did you ever have one of those teachers, who would return a paper you’d worked hard on with less than expected results? The theme of grading systems brings me to today’s point about Morningstar’s recent Dimensional Fund Advisors (DFA) analysis, “Discipline Gives Dimensional Its Edge.” (To read the report, you’ll need to register, for free, with Morningstar. I hope you do, because it’s worth your time.)
The analysis begins: “DFA has become one of the largest mutual fund companies after years of explosive growth, in part because of its low costs, strong performance, and the growing acceptance of passively managed strategies.” It goes on to extoll the company’s virtues: Its reliance on academic evidence; careful cost management; a patient, process-driven outlook; strong manager retention rate; and multi-disciplined collaboration among financial practitioners and academics. To quote that old pioneer song, seldom is heard a discouraging word.
And then it wraps: “DFA’s many positive traits plus a couple of reservations earn the firm a B for corporate culture.”
A typical reader might be confused by the seeming disconnect between the mostly glowing review and the “B” grade. As a former Morningstar analyst, I am in a better position than most to decipher the results. Here’s my take on it:
Well-managed costs are important, but not the lone determinant. There is overwhelming evidence from Morningstar and others that fees are among the most important metrics for predicting success. (And, my goodness, I can tell you they have looked at every data point under the sun.) But in arriving at a grade, fees are weighed along with other factors that can tilt the grade more than you might guess at a glance.
Corporate Culture. If you access the nitty-gritty details, you’ll find that Dimensional Fund Advisors received a Corporate Culture Grade of B, which may be related to the only minor concerns listed in the report about how the firm “handles its heft and responds to new sources of demand.” But as the report itself observes, DFA’s approach to fund management has little to do with having “star managers” (aka prima donnas) on board. Theirs is more of a structured, process-driven, quantitative approach, designed to handle such “heft.” Moreover, manager retention rate is quite strong, at around 95 percent for the past five years, which signals a strong corporate culture.
Manager Incentives. Morningstar’s stewardship scoring methodology is based in part on fund managers investing in their own funds, with the expectation that they put in at least $1 million of their own clams. I well remember discussions about the stewardship methodology during my tenure at Morningstar. The logic goes, if managers have to eat their own cooking, mutual fund and shareholder interests will better align. Dimensional Fund Advisors is likely getting penalized for its managers not having the full $1 million of manager buy-in. While this may be a valid point within the star-manager structure prevalent in many actively managed funds, Dimensional’s distinct approach makes it a bit of a square peg in this round methodology.
Combined, these three factors may have contributed to Morningstar’s conclusion:
“Yup, DFA works. But we’re stilling grading it a B.”