Keystone Financial Planning uses passively managed mutual funds to create low cost, low risk, tax-efficient portfolios that are globally diversified. The universe of passively managed mutual funds consists of two different types—index funds and passively structured funds. While our investment philosophy uses some index funds (from companies like The Vanguard Group  ), we primarily use passively structured funds, which are only available through a firm called Dimensional Fund Advisors (DFA).

 

 

Index fund managers construct portfolios to mirror the performance of well-known market benchmarks, such as the Standard & Poor's (S&P) 500 Composite Index, the Russell 2000 Index, or the Morgan Stanley Capital International EAFE index. Index managers make no attempt to forecast the stock market or the economy, and they do not try to distinguish between "attractive" and "unattractive" securities. Instead, an index manager will just buy every security in the index, resulting in a portfolio with hundreds of stocks. Portfolio adjustments are made only in response to changes in the underlying universe or index.

 

 

Similar to indexing, passively structured investment strategies share a common belief in "efficient markets"—the concept that market prices are the best estimate of value. Hence, neither strategy attempts to "beat the market" through superior security selection. The difference between the two strategies is that passively structured mutual funds are not designed to match the performance of well-known indexes. Indexes for equity or fixed income securities were often developed as simple signposts of financial performance and were not intended to serve as blueprints for actual investment strategies.

 

Rather than mirror an index, passively structured funds are designed to capture specific risk factors in the market. Academic research has focused on identifying the risk factors investors appear to care about in determining security prices. Bearing risk is what investors get paid for—the more clearly we can define risk, the better we can predict the expected returns that come with it. Passively structured funds may not necessarily match familiar equity or fixed income indexes, but they often represent a more scientific approach to designing the asset class "building blocks" used to develop a total portfolio. An asset class is defined as a group of securities that share a common risk factor. By starting with a clean sheet of paper, a passively structured approach can take into account characteristics unique to a particular asset class that make an indexed strategy less appealing.

 

For example, small cap stock strategies are best served by a passively structured approach because they are difficult to index without bearing costs that swamp their higher expected returns. Indexing a portfolio of several thousand small company stocks may not be the optimal approach, since both turnover and transaction costs are sharply higher for small companies than they are for large companies. Alternatively, a passively structured approach places priority on minimizing trading costs rather than "tracking" (replicating) the index. Stock weightings are relaxed relative to an index, allowing moderate overweighting or underweighting in specific securities. Stocks are purchased when they become available at attractive prices, avoiding the problem of "paying up" for certain stocks simply to match a theoretical index. Therefore, a passively structured mutual fund can add to investment returns by lowering transaction costs.

 

 

Most investors who believe in using index funds are completely unaware of the important distinctions between Vanguard and DFA. First, Vanguard funds are available to all advisors and retail investors; whereas, DFA offers its mutual funds only to institutions (such as corporate pension funds) and a select group of fee-only financial advisors. Since DFA funds are not available to most advisors and retail investors who might engage in "market timing," these funds provide protection against "hot money," which causes numerous problems for retail funds. This is just one example of how DFA funds provide institutional benefits that are generally available only to large institutional investors, such as pension plans, charitable foundations, etc.

 

Second, while Vanguard and DFA both offer low-cost passively managed funds, Vanguard offers primarily index funds; whereas, DFA offers passively structured funds designed to capture the returns of academically defined asset classes around the world. Since most of the Vanguard index funds are not designed to capture the risks of these academically defined asset classes, it is very difficult for any investor to build a globally diversified portfolio with Vanguard funds alone. The following table shows that while most asset classes are available at DFA, several of the U.S. equity asset classes at Vanguard are "sub-optimal" and many of international equity asset classes are simply not available at Vanguard.

 

Availability of Various Assets Classes at DFA & Vanguard

Type of Asset Class	Name of Asset Class	DFA	Vanguard
Fixed Income	Short-Term Bonds	X	X
Fixed Income	Inflation-Adjusted Bonds	Not available	X
Equity	U.S. Large	X	X
Equity	U.S. Large Value	X	Sub-optimal
Equity	U.S. Small	X	Sub-optimal
Equity	U.S. Small Value	X	Sub-optimal
Equity	Real Estate Investment Trusts	X	X
Equity	International Large	X	X
Equity	International Large Value	X	Not available
Equity	International Small	X	Not available
Equity	International Small Value	X	Not available
Equity	Emerging Markets	X	X
Equity	Emerging Markets Value	X	Not available
Equity	Emerging Markets Small	X	Not available

 

Third, DFA offers a "tax-managed" family of passively structured mutual funds that should be used in taxable accounts. These tax-efficient funds provide extremely valuable tax benefits that cannot be easily duplicated by Vanguard index funds.

 

Keystone Financial Planning believes that access to DFA funds is necessary for building globally diversified portfolios that provide exposure to targeted asset classes. For this reason and many others, we strongly believe that most investors should seriously consider hiring a professional advisor, such as Keystone Financial Planning, that is approved to work with DFA mutual funds.

 

 

•        Visit the DFA website  

 

•        Read the Fortune article How the Really Smart Money Invests: Nobel Prize winners entrust their next eggs to DFA, where investing is a science, not a spectator sport
 

•        Read the article Leader of the Pack: The DFA Funds  

 

•        Read DFA's brochure Global Investment Solutions  (244k)

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