With arguably the most diversified Canadian stock portfolio of any fund in its category (nearly 500 holdings), the DFA Canadian Vector Equity Fund is an ideal choice for those investors seeking the higher expected returns of value and small cap companies. The price is also reasonable, with a management expense ratio (MER) of just 0.45%.
I Gotta Have More Value
Whenever I hear the term “value company”, I picture the scene from Rudolph where he stumbles across The Island of Misfit Toys. In the classic animated TV special, a group of unwanted and defective toys go to live there until the island’s ruler, King Moonracer, can find a suitable home for them.
In the media, RIM’s BlackBerry appears to be the misfit toy of the day, tossed aside for Apple’s sexier iPhone. Value companies are believed to have a financial distress premium built into their price, resulting in higher expected returns.
DFA accepts these out-of-favour companies in the same way that King Moonracer accepted the mutant toys. They currently hold over twice as much RIM than their more discriminating predecessor, the S&P/TSX Composite Index (“The Index”).
I Wish I Were Small
Who didn’t drink RC Cola as a kid?! My cost-conscious father was always stocking the fridge full of cheap alternatives to “The Real Thing”. RC Cola is a division of Cott Corporation, a smaller and relatively unknown beverage company with locations throughout the world. Smaller companies are generally considered riskier than bigger, more established companies (and we should therefore expect a higher return for investing in them). DFA’s fund has over three times the allocation to Cott Corporation relative to the index.
Higher Expected Returns and Higher Risk
If we assume that value and small cap companies will each return 2% more than their growth and large cap counterparts, how much would the DFA fund be expected to outperform the index by (before fees)?
In order to venture a guess, we could first run a 3-factor regression on the historical monthly returns of the Dimensional Canadian Vector Equity Index (this index performance is a back-test of the vector strategy and is available in the Dimensional Returns 2.0 software).
The model is a fairly good fit, explaining 98% of the fund’s monthly returns (indicated by an adjusted R2 of 0.98). The beta (β) of the fund is 1.00, which indicates market risk similar to the index (this comes as no surprise, as broadly diversified equity funds normally have a beta of close to 1.00). The large and significant positive small cap (s) and value (h) coefficients indicate that this fund has substantial small cap and value tilts (0.39 and 0.24 respectively). In comparison, the index would be expected to have small and value coefficients equal to 0.
SMB = 2%
HML = 2%
s = 0.39
h = 0.24
Expected Outperformance = (s × SMB) + (h × HML)
= (0.39 × 2%) + (0.24 × 2%)
In other words, if the Index returned 7% over the long term, and the small cap and value premiums were each 2%, the DFA Canadian Vector Equity Fund would be expected to return 8.26% (assuming DFA was successful at capturing the premiums). Keep in mind that if the small cap and value premiums turn out to be negative in the future, DFA’s vector strategy will also be expected to underperform the index.
Although tilting towards value and small cap companies is not for everyone, the strategy has historically resulted in higher returns (and higher risk), relative to a simple Couch Potato strategy. For investors who are obsessed with maintaining a tight tracking error relative to the index, this fund is not for you.
* Methodology for Construction of Canadian Regression Factors:
Mkt-TBill= MSCI Canada IMI Index – DEX 30 Day T-Bill Index
HML = ½(MSCI Canada Small Cap Value Index + MSCI Canada Value Index) – ½(MSCI Canada Small Cap Growth Index + MSCI Canada Growth Index)
SMB = ⅓(MSCI Canada Small Cap Value Index + MSCI Canada Small Cap Index + MSCI Canada Small Cap Growth Index) - ⅓(MSCI Canada Value Index + MSCI Canada Index + MSCI Canada Growth Index)