NEW YORK ( TheStreet ) -- In a year when many equity mutual funds suffered withdrawals, investors have been pouring into DFA funds. According to Morningstar, the company recorded inflows of $18.3 billion, a sizable figure for a company with total assets of $208 billion. The only competitor that attracted more money was Vanguard, which drew $60 billion and has a total of $1.8 trillion in assets.
Strong returns have put DFA on the radar screen. Funds that topped more than 75% of peers during the past 10 years include DFA Emerging Markets Small Cap (DEMSX), DFA US Small Cap (DFSTX - Get Report), and DFA U.S. Large Cap Value (DFLVX - Get Report). The company has proved especially attractive because it offers a version of low-cost passive investing at a time when investors have been abandoning active management.
Relying on academic research, DFA aims to deliver superior results by tweaking standard indexing approaches. The strategy is based heavily on research by Eugene Fama of the University of Chicago and Kenneth French of Dartmouth. The researchers found that over long periods small stocks outperformed large ones and low-cost value shares outdid more expensive growth names. Based on the findings, DFA funds tilt to small and value stocks.
During the past decade, the tilting has helped to boost results. "The small-cap emphasis has been driving the strong performance," says Alex Bryan, an analyst for Morningstar.
To appreciate why DFA has excelled, consider DFA U.S. Large Cap Value. While conventional value funds take the cheapest half of the market, DFA only takes the cheapest 20% and tilts to smaller stocks. The portfolio holdings of DFA U.S. Large Cap Value have an average market capitalization of $10.5 billion, compared to $69.7 billion for Vanguard Value Index (VIVAX - Get Report), a conventional large value index. During the past 10 years, it paid to emphasize smaller stocks. For the decade, small value stocks returned 9.2% annually, while large value returned 7.0%. During the period, DFA U.S. Large Cap Value returned 9.0% annually, compared to 7.4% for the Vanguard competitor.
The DFA approach tends to work best during bull markets. At such times, investors grow more confident and bid up prices of smaller shaky stocks. But when markets panic, small stocks often sink. During the turmoil of 2008, the DFA large value fund lost 40.8% and trailed its Vanguard competitor by 4 percentage points. Then as stocks rebounded in 2009, DFA soared, outdoing Vanguard by 10 percentage points.
Will DFA outperform in the next decade? Maybe not. If large growth stocks lead the market, then DFA would face headwinds. Large stocks could easily outperform in the next 10 years. After rallying in recent years, small stocks are now at unusually high multiples. Many analysts argue that large stocks are undervalued compared to small stocks.
Besides tilting the portfolio to small stocks, DFA uses a variety of strategies to reduce trading costs and boost returns. Say a stock becomes too large to remain in a small-cap fund. A conventional index fund must sell the stock and buy a replacement. That results in costs, and portfolio managers may be forced to make purchases during periods when many competitors are trying to accomplish the same trades. With the crowd rushing in, stocks prices can be excessively rich. To limit expenses, DFA does not have to make the trade right away. Instead portfolio managers can wait until opportune moments to buy. By systematically buying when others are selling, DFA can boost returns slightly. "DFA cares a lot about controlling turnover to limit costs," says Bryan.
Buying a DFA fund takes some doing. You can only make purchases through financial advisors who have been certified to sell the brand. DFA wants to deal with advisors who are committed to long-term investing and the DFA approach. The aim is to avoid the plight of hot fund companies that can be overwhelmed with floods of unsophisticated investors. Such undisciplined shareholders often sell at market troughs. That could make life difficult for DFA portfolio managers and hurt long-term returns.
At the time of publication the author held no positions in any of the stocks mentioned.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.