The big brains at Dimensional Fund Advisors may have some explaining to do.

The firm, which specializes in passive, index-style management, raised some eyebrows by recently announcing a relatively steep, 9% taxable distribution for one of its better-known funds.

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The size of the distribution is especially striking for DFA, an exclusive money management shop known for reducing fund management costs through sophisticated quantitative techniques.

It also goes to show that, despite their reputation to the contrary, passively managed funds aren't always tax-efficient.

The $1.2 billion ( DFLVX) DFA U.S. Large Cap Value fund said that its estimated distribution would equal $1.87 a share, or about 9.4% of its net asset value as of last Friday ($0.483 is dividends; the remainder is long-term capital gains).

Generally, a distribution of 15% or more for an actively managed fund is considered excessive. But for an index-type fund like this one, a distribution that's pushing double-digits seems extreme. DFA's oldest fund, ( DFSCX) U.S. 9-10 Small Company fund, is also expected to make a distribution of close to 10% of its NAV.

Santa Monica, Calif.-based DFA sells index-investing with a twist.

The firm, which manages $31 billion in assets, takes an academic approach to passive money management. Its value strategies are based on the research of famed finance professors Eugene Fama and Kenneth French, who argue that value stocks (defined by low price-to-book ratios) tend to outperform growth stocks over time. Nobel-winning economists Merton Miller and Myron Scholes are also linked to the firm.

Further enhancing its highbrow image, DFA only sells its funds to individuals through a select group of financial advisers.

DFA's funds don't always track the well-known indices. For example, rather than track the Russell 2000, DFA's small-cap funds follow benchmarks created by the Center for Research in Security Prices at the University of Chicago.

This large-cap value fund invests in U.S. stocks whose market capitalizations are among the largest 50% of companies on the New York Stock Exchange and whose book-to-market ratios are within the highest 30% of those companies. (A high book-to-market ratio suggests that a stock price may not reflect a company's fundamental value.) The fund may also buy comparable companies on the Nasdaq and the American Stock Exchange.

Did something go awry in this ivory tower?

Weston Wellington, a vice president at DFA, says absolutely not.

Wellington points out that indexing is not inherently tax-efficient in areas like value or small cap. "The arguments that apply to indexing the S&P 500 or the whole market don't necessarily apply to subsector portfolios," he says.

Indeed, the DFA distribution demonstrates the potential downside of buying more specific index funds.

"Value indexes are going to be less tax-efficient because they are generally higher-dividend paying companies," says Bryan Olson, director of research at Charles Schwab's Center for Investment Research. "One of the measures of value is a higher dividend yield." Mutual funds are required to distribute net realized gains to shareholders each year.

Also, a style- or capitalization-specific index fund will be forced to sell stocks as they appreciate or leave the underlying index. Therefore, highly specific index funds can be forced to unload stocks that have experienced great price appreciation, which can mean realizing capital gains. Think about it: A great small-cap stock will become a mid-cap stock and a great value stock will become a growth stock.

In fact, it was price appreciation that forced DFA to sell some longstanding positions, realizing capital gains, Wellington says. "The strategies themselves calls for selling securities that have appreciated as they get larger," Wellington says. "That's exactly why we came out with tax-managed flavors of these."

In fact, only index funds that track the S&P 500 or the Wilshire 5000 are truly tax-efficient. A total stock market fund, which tracks the broad Wilshire index, follows the whole market. "It can move anywhere and you're still fine," Olson says.

Of course, heavy shareholder redemptions could propel almost any fund to sell and realize capital gains in a portfolio.

The ( OAKMX) Oakmark fund made a distribution that was 15% of its NAV following a year of heavy investor redemptions. During the first six months of this year alone, this actively managed fund lost $2 billion in net assets.

As for distributions among value index funds, DFA is not alone this year.

The ( VIVAX) Vanguard Value Index fund is expected to make a distribution of $1.24 share on Jan. 3, which represents approximately 5.3% of its NAV. Compare that to the ( VFINX) Vanguard 500 Index fund, which expects to make a distribution that's 0.4% of its NAV.

DFA's funds are hard to compare to others because they track some less-recognizable benchmarks, but the firm's shareholders certainly aren't the only index investors who will be receiving considerable distributions this year.

At least they've got their advisers to badger if they're displeased.

Q Tips

With the Nasdaq 100 rejiggering its lineup today, investors who've poured more than $5 billion into the index's tracking stock ( QQQ) are surely wondering about the impact of these changes.

With the removal of 15 stocks and the addition of 15 new ones, the index's technology weighting is slightly heavier. Before the shuffle, the tech weighting was 72.4%. Afterward, it will be 72.9%, according to data provided by Diane Garnick, equity derivatives strategist at Merrill Lynch.

The tax effects also are negligible.

Th 15 departing stocks are leaving the index based on their size alone. The Nasdaq 100, after all, consists of the 100 largest nonfinancial companies that trade on that exchange.

"The stocks that are leaving probably decreased in value," Garnick says. Therefore, when the stocks are sold out of the underlying trust, few if any capital gains will be realized.


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