2023-05-24 13:11:57 ET
Summary
- DFAT is actively managed by Dimensional Fund Advisors, offering exposure to a high-quality group of small/mid-cap stocks for a low 0.28% expense ratio.
- DFAT recently converted to an ETF, so its listing history is short. However, it launched in December 1998, and its track record compared to well-established passive ETFs is solid.
- One reason is because managers consider profitability when designing the portfolio. It achieves high profitability and a low valuation, even when sticking to an approximate $4 billion market cap.
- The drawback is low growth, and likely a reason why DFAT lagged its peers in 2009 and 2020. Given strong recent earnings surprises, growth-oriented funds like IWM and PRFZ might do better.
- This article also introduces DSMC, a free-cash-flow-focused small/mid-cap ETF that complements DFAT well.
Investment Thesis
The Dimensional U.S. Targeted Value ETF ( DFAT ) converted from a mutual fund to an ETF on June 14, 2021, bringing a 20+ year track record that may be compelling to investors wanting active management in the small/mid-cap segment. DFAT's ETF listing history is short, but this article compares its long-term performance against some established passive alternatives like the iShares Russell 2000 Value ETF ( IWN ) and the Invesco FTSE RAFI US 1500 Small-Mid Portfolio ETF ( PRFZ ). It concludes with a comparative fundamental analysis of five ETFs, nicely illustrating DFAT's strength as a value play but potential overreliance on the risky Regional Banking industry. I look forward to discussing this exciting fund in more detail below.
DFAT Overview
DFAT follows a proprietary strategy, but its stated investment objective is "to achieve long-term capital appreciation while minimizing federal income taxes on returns," according to its fact sheet . The fact sheet references its "daily flexible process," a synonym for active management, and how it can deliver consistent, value-added exposure to small/mid-cap value stocks for a reasonable 0.28% net expense ratio. Curiously, the fact sheet states that "DFAT uses reliable information in prices to target higher expected return securities within value stocks." That sounds like technical analysis but with a longer view. DFAT's latest turnover rate was only 8%, so Dimensional managers have high conviction in their selections. I suggest prospective investors take a similar long-term view and avoid getting caught up in short-term price fluctuations.
The Dimensional website lists several risks to the fund, many of which are standard, like market and operational risks. However, the two most relevant for me are Value Investment Risk and Small and Mid-Cap Company Risk, defined by Dimensional as follows:
Dimensional Fund Advisors
A crucial point is how value stocks can underperform the market for long periods. Again, prospective investors should prepare for the possibility that DFAT will lag other blend/growth funds, and impatience could cause them to question the strategy altogether. In addition, small- and mid-cap stocks are less liquid, and DFAT holds stocks with market capitalizations as low as $20 million. This feature sometimes makes it challenging to buy and sell at a fair price. However, the premium/discount to NAV is consistently under ten basis points, and the median bid-ask spread over the last 30 days is 0.14%. These figures aren't unusual for the small/mid-cap segment, so I think it's a well-run ETF. Instead, I believe the higher volatility small/mid-cap stocks present could be problematic for defensive value investors.
Finally, I mentioned how DFAT recently converted from a mutual fund to an ETF. The ETF has a listing date of June 14, 2021, so that is why most third-party websites show only a limited history. However, its inception date was December 11, 1998, meaning DFAT has nearly a 25-year track record. Over that period, the fund has accumulated $7.5 billion in net assets. Its stated benchmark is the Russell 2000 Value Index, and today, I will assess its long-term performance against that Index and several other passive alternatives for you to consider.
Dimensional Fund Advisors
DFAT Performance Analysis
I identified four small/mid-cap ETF alternatives for you to consider alongside DFAT. I've listed them in the table below.
Morningstar
According to Morningstar, IWN matches up well with DFAT, as both have a "Small Value" Equity Style. However, PRFZ has a similar $4 billion weighted average market capitalization and makes selections based on four fundamental factors: book value, cash flow, sales and dividends. Meanwhile, the iShares Russell 2000 ETF ( IWM ) and the Vanguard Extended Market Index ETF ( VXF ) are plain-vanilla market-cap-weighted ETFs in the small- and mid-cap blend categories, respectively.
I selected these comparators because of their extensive track records. Let's see how DFAT has matched up each year since 2007, PRFZ's first full year.
The Sunday Investor
DFAT's average annual ranking is 2.88/5, meaning its average annual returns were slightly better than this peer group. The other four ranked as follows, from worst to best:
- IWN: 3.88/5
- PRFZ: 3.00/5
- IWM: 2.94/5
- VXF: 2.29/5
Unfortunately, Portfolio Visualizer doesn't include historical returns pre-dating DFAT's ETF listing. However, it's noteworthy how PRFZ has the best annualized return since January 2007 (8.11%) against IWN, IWM, and VXF.
Portfolio Visualizer
The reason is PRFZ's consistency. It was the worst performer in just three years: 2008, 2011, and 2019, but it rarely substantially lagged the top performer (10.35%, 2.37%, and 6.21%, respectively). In contrast, when VXF misses, it misses big. In 2016, 2021, and 2022, it lagged the top performer by 15.78%, 23.16%, and 20.28%. DFAT was the top performer in 2021-2022, so it was quite the fortunate timing to convert to an ETF.
There are many ways to interpret these performance results. However, my three takeaways are:
1. Don't buy IWN. It consistently produces below-par returns, which I've written about several times in other articles. It also makes it an easy benchmark to beat.
2. IWM, DFAT, and PRFZ a more suitable "core" holdings for longer-term investors. However, DFAT produced the least consistent results of the three. DFAT lagged the top performer by 30% in 2009 and 2020, years when market sentiment was extremely positive.
3. VXF is more hit-and-miss, performing at the top of the peer group (2007, 2011, 2014, 2015, 2017, 2018, 2019, 2020, 2023) and the bottom (2016, 2021, 2022). It's also more of a mid-cap fund since it's market-cap-weighted. VXF holds seven stocks with market capitalizations above $50 billion, so it's not a fair comparator.
DFAT Fundamental Analysis
The following table highlights selected fundamental metrics for DFAT's top 25 industries, totaling 61% of the portfolio. In the final rows, I also included summary metrics for IWN, IWM, VXF, and PRFZ.
The Sunday Investor
A few observations:
1. DFAT's 13.86% exposure to Regional Banks gives me some pause. IWM, VXF, and PRFZ have 7.35%, 4.79%, and 6.98% exposure to this industry, while IWN's is 14.56%. Remember that DFAT is actively managed, so its managers purposely chose these allocations, in contrast to the others, which rebalance on schedule according to a set of rules. At first, I thought DFAT's managers were engaging in some closet indexing, which is when managers don't deviate too much from a benchmark for fear of underperforming. However, upon closer analysis, DFAT's managers are willing to vary from IWN. For example, it underweights Biotechnology by 5.28% and avoids nearly all REITs, which is 13% of IWN. Therefore, I'm confident investors are getting a truly unique portfolio with DFAT.
2. DFAT's 6.15/10 profitability score is relatively strong. Dimensional values this factor, as they track the ETF's profitability score on its website. The 0.27 weighted average profitability score is the adjusted operating income scaled by book value. While it's just one measure, Seeking Alpha's Factor Grades are more thorough, giving me added confidence DFAT's managers value high-quality stocks.
Dimensional Fund Advisors
3. DFAT differentiates itself with a low growth profile, which explains its poor relative returns in 2009 and 2020. It trades at 12.77x forward earnings and 1.53x trailing sales, a few points less than IWN and well below IWM, VXF, and PRFZ. However, estimated sales and earnings growth rates are relatively weak at 6.89% and 5.80%. IWM, VXF, and PRFZ are more suitable for high-growth environments. Furthermore, market sentiment potentially reached an inflection point this quarter. Small- and mid-cap stocks delivered 11.9% and 13.7% aggregate earnings surprises for Q1 2023, a nice change from the low-single-digit figures over the prior few quarters.
Yardeni Research
As strong as DFAT is fundamentally, that might matter less in an optimistic market. We're seeing some early evidence of that based on YTD returns.
Seeking Alpha
DSMC: A Complementary ETF
After reviewing the Pacer US Small Cap Cash Cows 100 ETF ( CALF ), a reader requested I evaluate the Distillate Small/Mid Cash Flow ETF ( DSMC ). DSMC only launched in October 2022, but it is similar to DFAT in that it is highly profitable with a similar $4.2 billion weighted average market capitalization. I've highlighted the fundamentals for its top 25 industries below.
The Sunday Investor
Notice the absence of Regional Banks. DSMC screens for companies with a positive expected free cash flow yield. However, regional and diversified banks often have negative operating cash flows due to increased lending. Instead, DSMC's Financial holdings total 7.06% and include companies in the Asset Management, Transaction & Payment Processing Services, and Financial Exchanges industries. DSMC and DFAT only have an 18% overlap by weight, so consider them complimentary funds.
Like CALF, I like the free cash flow screen as it's applied to the small/mid-cap segment. These stocks need a good profitability screen, whereas large-cap stocks are already quite profitable, so it's less of a differentiator. DSMC's 7.67/10 profitability score easily tops DFAT's and doesn't "cheat" by simply including large-cap stocks. However, the key negative is that DSMC's growth profile is even lower than DFAT's. It's also more volatile, as indicated by its 1.38 five-year beta. As mentioned earlier, defensive value investors may wish to avoid this feature.
Investment Recommendation
DFAT is a solid small/mid-cap value fund with a nearly 25-year track record and $7.5 billion in assets under management. Its 0.28% expense ratio is cheap for an actively managed ETF, and my performance analysis revealed how DFAT was an above-average performer based on returns from 2007 to 2023. Dimensional asks that its shareholders take a long-term approach and not get caught up in short-term price swings, and the evidence supports an argument that its managers can deliver alpha. One likely reason is how DFAT combines relatively high profitability with a consistently low valuation. My research into the segment suggests profitability is vital. Few passive ETFs do this well, so there's a gap to fill in the small/mid-cap segment, and it's nice to see alternatives like DFAT enter the space.
I'm not convinced that DFAT is superior to PRFZ, the fundamentals-based passive alternative with a higher growth profile. Furthermore, recent quarterly earnings surprises indicate PRFZ should outperform, so I'm limiting my rating on DFAT to a hold today. Still, I look forward to providing regular updates as market conditions change. Thank you for reading.
For further details see:
DFAT: A Recent Mutual Fund Convert, This Active Small/Mid-Cap ETF Looks Interesting