A Portfolio Makeover

Last September, I wrote a piece for Canadian MoneySaver called An ETF Portfolio With Added Dimension. The article looked at the strategies used by Dimensional Fund Advisors, “the best money management firm that most people have never heard of.” The portfolio I put together for that article became the Über-Tuber — as in “the ultimate Couch Potato” — which you’ll find on my page of Model Portfolios.

If you’re not familiar with Dimensional Fund Advisors, that’s not surprising: the firm keeps a low profile, and its funds are offered only through a select group of advisors who must first undergo extensive training. DFA’s investing strategies are based on the academic work of Eugene Fama and Kenneth French, whose research demonstrated that value stocks and small-cap stocks have historically delivered higher returns than the overall market. (For more details, see the DFA website and my own post, Where Do Returns Come From?) The point of my article was to suggest a way for do-it-yourself investors to use Dimensional’s passive strategies with ETFs.

I later learned that the article made the rounds among DFA advisors, who gave it a mostly positive review, though with some criticisms. I recently spoke about this with Justin Bender, an advisor with PWL Capital in Toronto who uses both DFA funds and ETFs with his clients. Using Morningstar’s PALTtrak research tool, Justin drilled into the Über-Tuber to compare its asset class exposure to what you would get in an actual Dimensional portfolio like this one:

Then he made a number of suggestions to bring the ETF portfolio much closer to being a DFA clone. Here’s what he came up with:

Peeling back the Potato

Justin provided some commentary to explain the changes:

• “The original Über -Tuber had 40% of its Canadian equity allocation in small cap stocks, but the DFA Canadian Core Equity Fund has just 15% to 20% in small cap stocks. I reduced the small-cap allocation to reduce risk in the portfolio. The original portfolio also had an underweight in energy and materials stocks and an overweight to financial stocks. I reduced exposure to CRQ and added XIC to better mimic the DFA fund and also to lower the overall MER.”

• “I found that 11% PRF combined with 5% VXF [a fund of US mid- and small-cap stocks] gave the appropriate small-cap and value tilts relative to the DFA US Core Equity Fund.”

• “The original Über -Tuber had too much international large cap and not a sufficient amount of small cap, relative to the DFA International Core Equity Fund. I replaced the Vanguard All World ex-US Small-Cap (VSS) with PDN to gain more value exposure while also increasing the exposure to mid and small-cap companies. I replaced the iShares MSCI EAFE Value (EFV) with VEA, which helped reduce costs as well as remove the overallocation to large value and spread it more evenly across the other size and style categories. The sector allocations also aligned more closely to the DFA fund after these changes.”

• “Using equal amounts of the two DFA fixed-income funds results in an allocation of approximately 25% to US bonds (with currency hedging). We can get a similar exposure by allocating 10%  to XIG and the other 30% to XSB. The approximate maturities, as well as the mix of government and corporate bonds, also mirror the DFA model portfolio more accurately than a single position in XSB.”

Too many moving parts?

The Über-Tuber started off as an intellectual exercise more than anything else. As a couple of DFA advisors have told me, it has a lot of moving parts, which will make it difficult and potentially expensive to maintain: the original was already a behemoth with 11 ETFs, and the above version uses an even dozen. Is it too unwieldy?

If you’re going to build a portfolio like this, a low-cost brokerage is a must. Your account would have to be quite large before you even consider it: $100,000 is the bare minimum, and unless you’re investing at least $300,000 or so there is probably no meaningful benefit over the Complete Couch Potato. Rebalancing could be something of a nightmare — I would suggest doing so only when the allocations are way out whack.

In fact, the more I speak with experienced advisors who understand investor behaviour, the more I have come to value simplicity. The urge to tinker with a complex portfolio is just too great. I’m not going to make any changes to the Über-Tuber on the Model Portfolios page for now, and I’ll be giving some thought to how it might be streamlined without losing too much of its small-cap and value tilt.

In the meantime, I’d love to hear from readers who are currently using the Über–Tuber or something like it — I know you’re out there. How are you managing?