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Anatomy of a Low-cost Mutual Fund
In recent years index mutual funds, which mirror the
movements of indices like the S&P 500, have become
very popular. The cost of investing in such funds can be
quite high, however, if they are pegged to indices of so-called
small-cap stocks. Generally defined as stocks with a
market capitalization of $750 million or less, small-cap
stocks are often illiquid. As a result, trading stocks contained
in small-cap index funds can be pricey: one-way
costs of trading are typically as high as 2 per cent of the
value of the transaction for these illiquid stocks.
One small-cap mutual fund, however, is an exception.
The 9-10 Fund designed by Dimensional Fund Advisors, a
money manager in Santa Monica, Calif., has trading costs
that are not just low — they are sometimes negative. The
fund gets its name from the fact that it is based on an index
composed of small-cap stocks in the ninth and tenth (smallest)
deciles of New York Stock Exchange market capitalization.
Another factor that makes Dimensional Fund
Advisors unusual is that its strategies are based on academic
research. The firm’s board includes Nobel laureates like
Myron Scholes of Stanford University and Merton Miller of
the University of Chicago, as well as potential Nobel
prizewinner Eugene Fama of Chicago.
So how does the 9-10 Fund achieve its contrarian success?
In a fascinating case study, Donald B. Keim, professor of
finance, explains that the fund’s performance is the result of
its unusual design. “The DFA fund does not exactly mirror
the performance of the small-cap universe,” he says. “It just
tries to approximate it.” The approximation is due to an
innovative trading strategy. In addition to trading patiently
by waiting for favorable prices, fund managers also effectively
act as market-makers for illiquid stocks. This allows them to
buy stocks at discounted rather than at premium prices. Says
Keim: “DFA simply aims for a high correlation between the
9-10 Fund and its performance benchmark. Thus, the 9-10
Fund does not precisely mirror the underlying index, but the
tradeoff is that it saves investors money on transaction costs,
improving the fund’s performance.”
Donald B. Keim; An Analysis of Mutual Fund Design: The Case
of Investing in Small-Cap Stocks
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