Are DFA’s Funds Active or Passive?
March 3, 2015
by John Coumarianos
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Gates Capital Management's Excess Cash Flow (ECF) Value Funds have returned 14.5% net over the past 25 years, and in 2021, the fund manager continued to outperform. Due to an "absence of large mistakes" during the year, coupled with an "attractive environment for corporate events," the group's flagship ECF Value Fund, L.P returned 32.7% last Read More
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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.
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.
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