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Fund Spy

An Attractive Small-Cap Option

DFA US Small Cap sidesteps the most expensive and least profitable small-cap stocks.

The following is our latest Fund Analyst Report for DFA US Small Cap (DFSTX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days. 

DFA US Small Cap is an attractive choice in the small-blend Morningstar Category. This fund systematically removes stocks with characteristics that have been associated with lower expected returns over the long run. It packages the remaining stocks in an efficient market-cap-weighted portfolio that seeks to keep trading costs down. The fund's reasonable fee adds to its sustainable edge over peers. These attributes support its Morningstar Analyst Rating of Gold.

The fund starts with the smallest 10% of U.S. stocks (excluding REITs) ranked by market capitalization and removes the least profitable and most expensive names. Academic research suggests that these stocks have lower relative expected returns. This is a modest exclusion, only stripping out 6% to 10% of the eligible universe. The portfolio managers market-cap-weight stocks that pass their screening criteria.

DFA's portfolio managers use a flexible trading approach to further reduce transaction costs. The managers can substitute any one stock for a similar alternative and avoid trading when it does not significantly affect the fund’s style characteristics. The firm often acts as a liquidity provider in thinly traded stocks, allowing them to secure more favorable prices. This practice is especially effective among small-cap names that may be less liquid than their larger counterparts. Over the past decade, the fund’s average annual turnover has measured less than a fourth of the average fund in the category.

The portfolio's average market cap is in line with the Russell 2000 Index's. Because DFA screens out REITs from its holdings, this fund's real estate sector exposure is much lower than the category average. Conversely, its industrials and financials sector weightings top those of the Russell 2000 Index.

This fund should reward investors who can weather its higher category-relative risk over the long run. During the past decade through June 2018, the fund outpaced the small-cap category average by 3.0 percentage points annually. But it has underperformed during market downturns and may lag for long periods.

Process Pillar: Positive | Adam McCullough, CFA 07/23/2018
The fund’s broad market-cap-weighted portfolio, exclusion of expensive stocks with poor profitability, and flexible trading contribute to its Positive Process Pillar rating.

The fund invests in stocks representing the smallest 10% of the U.S. stock market, with a few adjustments. It excludes REITs, recent IPOs, acquisition targets, and stocks below $10 million in market cap. Next, it removes the most expensive (based on price/book) and least profitable stocks. DFA measures profitability as operating income before depreciation and amortization minus interest expense, over book value. The managers remove these names because academic research suggests these characteristics have been associated with lower expected returns over the long run. The portfolio managers market-cap-weight stocks that pass their screening criteria, leading to a broadly diversified, low turnover portfolio.

DFA enhances the cost efficiency of its market-cap-weighted portfolio by giving its traders the flexibility to substitute stocks with similar characteristics and patiently work into and out of positions. The managers may also refrain from buying stocks with strong negative momentum and hold on to some of its winners as they move pass its market-cap threshold.

Although this fund invests in the smallest 10% of U.S. stocks and can buy stocks with market cap as low as $10 million, the portfolio’s average market cap is in line with the Russell 2000 Index. The portfolio is well diversified, including over 1,900 stocks. Its top 10 holdings represent about 3% of the portfolio. Removing the least profitable stocks generates a portfolio with a higher return on invested capital than the Russell 2000 Index, but it measures near the category average. On average, its holdings trade at a price/book ratio that is nearly 50 percentage points lower than the category index.

Because the portfolio excludes REITs (which DFA considers a separate asset class), its sector weightings differ from the Russell 2000 Index. It has greater exposure to the industrials and financial services sectors than the category index, and less exposure to the healthcare sector. The latter owes to its underweighting of small-cap biotech firms, many of which are unprofitable. The fund’s broad, market-cap-weighted portfolio and flexible trading approach have kept turnover low. During the past 10 years through 2017, its turnover has averaged less than fourth that of the average fund in the category.

The fund is always fully invested. Its low cash drag will pay off during bull markets but detract from performance during market downturns.

Performance Pillar: Positive | Adam McCullough, CFA 07/23/2018
The fund deserves a Positive Performance rating.

During the past decade through June 2018, the fund’s return topped the small-blend category average and Russell 2000 Index by 3.0 and 1.3 percentage points per year, respectively. Favorable stock exposure in the consumer cyclical sector contributed the most to this outperformance. Although the fund takes slightly more risk than the average fund in the category, it has been a consistent outperformer. Its rolling three-year performance falls in the top half of the category 86% of the time over the trailing 15 years through June 2018.

Despite its attractive long-term performance, this fund has been slightly more volatile than its category peers and has lagged in market downturns. During the bear market from October 2007 through March 2009, it fell 60.3% and the category average lost 57.9%. Unfavorable financials, materials, and tech sector stock exposures detracted the most from performance. But the fund has rebounded nicely, outpacing the average fund in the category by 2.0% annually from March 2009 through June 2018.

Although this fund has low turnover, it has distributed small capital gains in six of the trailing 10 years through 2017, the largest of which measured 5.9% of the fund’s NAV in 2012. Despite these distributions, the fund’s aftertax 10-year return still lands in the top decile of its category.

People Pillar: Positive | Adam McCullough, CFA 07/23/2018
An experienced and well-supported team underpins the fund’s Positive People rating.

Joseph Chi and Jed Fogdall have been listed as comanagers of the fund since February 2012. Chi and Fogdall co-lead the firm's equity portfolio management team and have served as portfolio managers at the firm since 2004 and 2005, respectively. Chi also serves as chairman of the investment committee. Joseph Schneider rejoined the fund as a named portfolio manager in February 2017. These named managers lead a broader team of portfolio managers who assist with the fund’s day-to-day operations. Chi and Fogdall sit on Dimensional’s investment committee, which provides additional oversight.

Recent changes in the manager lineup aren’t a cause for concern. Henry Gray left DFA in May 2017 to pursue opportunities in academia. Gray had served as head of global equity trading and as a portfolio manager on the fund. Schneider replaced Gray as a portfolio manager on the fund. DFA removed Bhanu Singh and Stephen Clark as named managers on the fund in February and July 2015, respectively. Clark is now in charge of DFA's North American institutional group and is not a portfolio manager. Singh transferred to the Sydney office to head the Asia-Pacific portfolio management team.

According to regulatory filings, the listed portfolio managers are not currently invested in this fund.

Parent Pillar: Positive | 06/07/2018 
Dimensional Fund Advisors continues to be an outstanding steward of its shareholders' capital and maintains its Positive Parent Pillar rating. The firm is under new management following turnover at both co-CEO positions in 2017. David Butler and Gerard O'Reilly now share responsibilities for guiding the organization. But Dimensional's culture remains strong, and it continues to follow a singular investment philosophy that is rooted in market efficiency and transaction cost management.

All of Dimensional's investment strategies are subjected to a rigorous vetting process that is overseen by some of the top academics in the industry. Modifications to existing processes and the introduction of new strategies are few and far between. Proposed changes must meet a strict set of criteria and be exploitable in a well-diversified, low-turnover, cost-effective manner. Manager retention at the firm is high, and several managers are employed to watch over each fund. This team-oriented approach maintains continuity and minimizes any potential issues when turnover occurs.

Dimensional requires that investors access their funds through an approved investment advisor or platform. Limited access acts like a barrier that protects funds from short-term trading, which can increase transaction costs and harm the interests of long-term shareholders.

Price Pillar: Positive | Adam McCullough, CFA 07/23/2018
Although there are cheaper small-cap index funds available, this fund charges an annual expense ratio of 0.37%, well below the median small-blend category fee of 1.03%. Dimensional’s flexible trading approach and low turnover also help to reduce transaction costs, which can be meaningful in the small-cap arena. The fund uses securities-lending revenue to offset its expenses, which further benefits fundholders. Like all Dimensional funds, this offering is available to individual investors only through a qualified financial advisor or select platform such as a 401(k).

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Adam McCullough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.