Screening process at DFA inspires devotion, loyalty

Jun 17, 2012 @ 12:01 am

By Jason Kephart

Over his 20-year career as a financial adviser, Dave Hutchinson heard all the jokes about Dimensional Fund Advisors LP — the ones about its being a cult and how advisers selling its funds had to “drink a lot of Kool-Aid.”

He probably even made some of those jokes himself, he said.

Still, this month, Mr. Hutchinson found himself spending two days in a classroom at DFA's headquarters in Austin, Texas, listening to executives extol the virtues of the company's investment philosophy, which combines elements of both passive and active management.

Mr. Hutchinson, a senior vice president at Hewins Financial Advisors LLC, was joined by 59 other advisers who made the pilgrimage to DFA's über-chic offices — on their own dime, no less — as part of the educational process that DFA requires advisers to complete in order to invest in its mutual funds.

FINE SCREEN

In many ways, the care and attention that DFA puts into screening advisers is as much a part of its success as its investing strategy. The process, which is intended to weed out advisers unlikely to embrace the firm's buy-and-hold mantra, has helped foster an almost cultlike devotion to DFA among advisers picked to sell its funds.

For the past two years, DFA has topped Cogent Research LLC's adviser loyalty rankings, which also measure advisers' anticipated future investments with their partners.

“They're more of a niche player, but among investors who use them, they really are the go-to,” said Meredith Rice, senior project director at Cogent. “Their philosophy is one of the main things that differentiate them from other firms.”

Indeed, for many advisers, DFA's investment philosophy is more than an approach to investing.

It is a religion.

“We are pretty passionate about it,” said Harold Evensky, president of Evensky & Katz Wealth Management, which allocates part of its equity portfolios to DFA Funds. “I joke about the "Kool-Aid,' but I've drank it, and I believe in it.”

DFA's investment strategy is based on the research of academics Eugene Fama and Kenneth French, which found that individual stocks are basically unpredictable and that over a long time period (think 20 years), small-caps and value stocks have the best risk-return ratios.

“All our funds are basically variations on the same idea,” said David Booth, who founded DFA in 1981 in an apartment in Brooklyn, N.Y.

However, because the funds are largely passive, they rise and fall with the general markets. The DFA U.S. Core Equity 1 Fund (DFEOX), for example, plummeted 36.5% in 2008, while the S&P 500 was down 37%.

“It's not a free lunch,” said Weston Wellington, a member of DFA's in-house research team.

“We don't know when the style is going out of favor or when it's going to come back,” he said. “Our best guess over any time period, a day, a week, a year, is that small is going to outperform large, and value is going to outperform growth.”

SOME DOUBTS

To be sure, the notion of sitting tight through market storms leaves some advisers uneasy.

That was especially true after the 2008-09 stock market meltdown, which left many advisers in the unfortunate position of having to explain to clients why buy-and-hold investing left them poorer.

“I have to be more responsive to my investors than to a theory,” said Lee Munson, chief investment officer at Portfolio LLC.

Mr. Munson, who doesn't use DFA funds, is a strong proponent of passive, long-term investing. But that didn't stop him from moving clients to 30% cash amid last summer's bout of volatility.

If DFA finds an adviser moving in and out of funds too frequently, it blocks the adviser from purchasing additional shares. That is why, before advisers can even get to the two-day educational conference, they have to pass an intensive screening process.

“If the adviser's value-add is to try and time the markets, we're not the right fit for them,” Mr. Booth said.

Even though the firm celebrated its 30th anniversary last year, there are only about 1,600 advisers selling its funds. The number has been growing at the rate of about 80 to 100 a year.

ASSET GROWTH

DFA's mutual fund assets, meanwhile, have grown to $160 billion, from $110 billion in 2008, according to Lipper Inc. Over the 12-month period ended April 30, DFA had more than $14 billion of net inflows, the fourth-best total in the industry, behind The Vanguard Group Inc., Pacific Investment Management Co. LLC and J.P. Morgan Asset Management.

For his part, Mr. Booth attributes his firm's success to the fact that the advisers who sell DFA's funds are committed to buy-and-hold investing.

“People aren't going to go through the grief we give them if they don't believe in our philosophy,” he said.

The grief he refers to is the multi-step screening process advisers have to pass in order to use DFA's funds.

“It can be quite intrusive,” said Harry Milling, a mutual fund analyst at Morningstar Inc.

It begins the first time an adviser calls.

One of the representatives will take down the adviser's basic information, such as asset size, location, and whether they consider themselves wealth managers. The last point is the key.

“We want to find advisers who are client-focused,” said David Butler, head of global adviser services.

Once the initial screening is complete, DFA sends out one of its 32 regional directors for a face-to-face meeting that digs a little deeper.

The director asks questions about asset allocation and the role of fixed income in a portfolio.

The meetings can be a little stressful.

“Every time I was talking to them, it was like sitting for the oral exam for my master's,” said Rick Kahler, founder of Kahler Financial Group Inc., who went through the DFA process last year.

He currently allocates about 60% of client portfolios to DFA funds.

If the face-to-face meetings go smoothly, advisers are invited to one of DFA's introductory conferences, such as the one that Mr. Hutchinson attended. DFA holds eight introductory conferences a year, alternating between its headquarters and its offices in Santa Monica, Calif.

The conferences cover all facets of DFA, from math-heavy analyses of why the strategies work, to how to market and communicate, to clients' using materials on the DFA website, to a panel on “investment porn,” poking fun at the financial press' touting of hot firms or strategies.

Mr. Hutchinson came away from the conference “pleasantly surprised” by the DFA approach.

“I was expecting there to be a lot more computers running the show,” he said.

“When you think of passive investing, you think of this black-box approach, but at DFA, it's really about the people. Once you learn about their approach, I find it hard to see how you could go a different way,” Mr. Hutchinson said.

jkephart@investmentnews.com

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