Barron’s published a recent article profiling Dimensional Fund Advisors (DFA) Emerging Markets Value Portfolio. They wanted to write the article to expose some keen insight that helped usher this fund to its stellar performance record. Most journalists find out quickly they’re barking up the wrong proverbial tree here.
They often get confused when they call DFA looking for a “scoop” about how their analysts or portfolio managers jaunted off to far-away locales to shake hands with local farmers or dig into a company’s supply chain process. The first awkward pause happens when DFA tells them they don’t know much about the companies held in the portfolios. The second one happens when DFA adds that it doesn’t matter. And finally, the real head scratching, or hopefully, “ah-ha” moment, happens when DFA explains how that seemingly ambivalent posture is what helps them achieve the impressive performance over time. Dimensional focuses on capturing the systematic performance of broad market dimensions rather than the random fluctuations of individual securities. After some consultation, this writer actually seemed to capture the spirit of DFAs approach.
DFA focuses on academically identified sources of risk and return. They capture a diversified and precise representation of risk factors while employing flexible and patient trading techniques. DFA is ever vigilant about reducing costs and taxes and quite simply, focuses on what matters and what can be controlled in portfolio design and delivery—and eschews the rest.
BARRON’S PROFILE: SATURDAY, AUGUST 14, 2010
Strictly By the Book By CRAIG MELLOW
Karen Umland, portfolio manager of the DFA Emerging Markets Value I Fund, relies on the discipline of efficient market theory.
EMERGING-MARKETS FUND MANAGERS are supposed to be swashbuckling types who restlessly circumnavigate the globe in search of market intelligence—grilling the finance minister of Malaysia one day, inspecting the output of a Brazilian paper mill the next. Not Karen Umland, who runs Dimensional Fund Advisors’ $9.4 billion Emerging Markets Value I fund. She seldom leaves DFA’s home base in Santa Monica if she can help it, takes no interest in the politics of any of the 17 countries where she invests, and completely ignores the quality or otherwise of company managements. She never plays market hunches. “We don’t think market timing works well,” she says flatly. “Emerging markets can move too quickly.”
Yet Umland and her six-member portfolio management team have proved to be just about the best in their business over time. Emerging Markets Value I (ticker: DFEVX) ranks third among 204 emerging-markets funds tracked by Morningstar in five-year returns, with an annualized rise of 16.42%. Nicking it for second, at 16.71% is its smaller sister fund, the $1.4 billion DFA Emerging Markets Small Cap I (DEMSX), which Umland also manages. That torrid performance compares to a 10.2% annualized return on the benchmark MSCI emerging-markets index over the past five years, and a depressing annual loss of 2.2% from the Standard & Poor’s 500.
Umland, a soft-spoken UCLA business school grad who has worked on the DFA emerging-markets funds since they were launched in 1998, achieves excellence by trusting in numbers, not perceptions. So do her colleagues at DFA, which oversees about $160 billion in total. The firm was founded in 1981, inspired by the work of University of Chicago economist Eugene Fama, who catalyzed the quant movement with his papers on efficient-market theory in the 1960s. Fama sits on DFA’s investment policy committee and hosts an online forum for its investors. And the ties run deeper. DFA’s chairman, David Booth, is a former student of Fama’s, and a donor of some $300 million to the business school, which was recently renamed for him.
DFA’s formula for emerging markets is simple in theory. The name on the fund says “value,” so Umland buys stocks that are relatively cheap and sells them when they get more expensive. The yardstick she uses is a company’s ratio of book value to share price. She says DFA chose book value because it reflects the underlying value of a company over time and is much more stable than the standard denominator, earnings. That means she has to shuffle the portfolio less often and economizes on trading costs, a major drain on performance in emerging markets. Emerging Markets Value fund turns over just one-quarter of its portfolio every year.
But applying the fund’s principle to an investment universe that includes any company with more than a $50 million free float (shares that can be publicly traded) is complex. The first step for Umland and her staff is identifying the cheapest 25% of stocks in every available market. Then come the exclusions. The fund stays away from locally traded shares in some major markets like China and Russia, only buying shares that are traded internationally as American or Global Depositary Receipts, considering local brokers too risky and expensive. Initial public offerings are too volatile. Umland won’t buy utilities and other companies with regulated profits, either. Occasionally, whole countries get tossed. This was the case with Argentina when it imposed onerous capital controls in 2001. Russia, by contrast, joined Umland’s world for the first time in 2008 as more companies could be traded through London.
All the companies that pass through the various screens are thrown into a huge global pot without country weightings per se . Umland says she cannot judge whether, say, Brazilian shares are a better buy than Indian stocks because accounting systems for determining the book value vary too widely. Instead, each eligible “bottom-25” company around the world gets a target weight based on the market value of its free float. So big companies and big markets naturally get larger allocations. The risk-control mechanism is diversity. The weighting formula spreads the fund around to nearly 2,000 different emerging-markets stocks. No single investment can account for more than 5% of total holdings at time of purchase, and no country more than 12.5%.
Umland’s country allocations tend to remain stable over time, as they are linked to market size. But by her formula, China has lately become a significantly better buy. The Chinese real economy may be powering the rest of the world’s fragile recovery, but its stocks have fallen 17% over the past year as measured by Shanghai’s benchmark SSE Composite Index. That means more value, and DFA’s China holdings have risen to the Emerging Markets Value fund’s 12.5% country limit. Other leading investment destinations: Taiwan, South Korea, Brazil and India. The top five account for about 60% of the fund.
The bigger shift in the Emerging Markets Value portfolio since the financial crisis has come in its sector weightings. Umland’s black box commanded her to pour into financial stocks around the world as their prices crashed after September 2008. Despite some bounce since, emerging-market bank shares remain a mathematical bargain. Financials now represent 29% of the fund’s investment, up from 20% two years ago. Not surprisingly, the fund’s top five individual holdings include Bank of China (3988.Hong Kong), one of the “Big Four” state banks, and India’s second-largest bank, ICICI (ICICIBC.India)—accounting for 1.5% and 1.4% of the portfolio, respectively. The single largest holding is Russia’s gas giant Gazprom (OGZPY), at 3.2%. Indian natural-gas producer Reliance Industries, (RIL.India) and Brazilian steel maker Usinas Siderugicas de Minais Gerais (USNZY), each with a 1.5% weighting, round out the top five.
Distrusting market timing on principle, Emerging Markets Value stays 100% invested. This hurt relative performance in the 2008-09 market crash, as many managers cut their losses by retreating into cash. Umland’s team lagged the MSCI emerging-markets index, losing a terrifying 69% of its value from the May 2008 peak to the March 2009 trough, compared to a 62% drop in the benchmark. The fund has roared back with the market, surging 179% in the past 17 months against 109% for the MSCI. Yet the wild ride has made DFA look again at the details of its methodology, Umland says, particularly whether price-to-book value is still the best criterion for finding cheap stocks in intangible-intensive areas like banking and retailing.
The bottom line: DFA has proved itself a superior choice if you’re bullish on emerging markets, and there are still compelling reasons to be bullish. The International Monetary Fund’s World Economic Outlook, one of the more optimistic prognoses out there, sees advanced economies growing by a halting 2.5% this year and next, while the developing world tears ahead at a 6.5% clip. That’s tough arithmetic for investors to argue with.