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DFA Funds had top rated Fixed Income performance last year

By: Investor Solutions

Our bond strategy is to accept very limited risk because the bond holdings are the portfolio’s “safe harbor”, and additional risk is not likely to be compensated. Given that every investor has a risk tolerance level, we believe that this risk should be “spent” in an area where it will be compensated. Having a very conservative bond portfolio allows us to tilt the portfolio towards small, value, foreign, real estate, and commodities where we expect higher returns while holding total portfolio risk within the investor’s tolerance level.

In the universe of the average investor bonds provide two important functions. They reduce the risk of the portfolio, and provide a store of value to fund future expenditures. Our strategy of holding short duration high quality fixed income securities performed extremely well in 2008 in a market where lower quality credit exposure was severely punished.

DFA utilizes a variable maturity strategy that can capitalize on a positive yield curve with relatively short term bonds (under approximately five years). When positive yield curves exist, the fund manager can capture both interest and incremental capital appreciation by purchasing bonds of longer duration and selling them as they approach maturity. However, positive yield curves are not always available. If yield curves are flat or inverted, the only rational strategy is to retreat to very short durations and wait for a positive yield curve to reappear.

Over the market cycle, this strategy has been able to add non trivial additional returns to the portfolio. And the return per unit of risk (Sharp Ratio) has been quite satisfactory. While we have every reason to believe that this strategy is prudent and close to optimum, it is not a zero risk strategy. Rather it is a low risk strategy designed to add value over the market cycle.

At the fund level, for the strategy to work reliably there must be lots of highly liquid bonds with very low transaction costs. So, for instance, it’s not possible to generate any additional benefits to a junk bond portfolio using this strategy because transaction costs would eat up any additional benefit.

Individuals who stretched for yield and credit risk last year might have seen their fixed income funds perform worse than their equity exposure. We have analyzed fixed income portfolio’s that were stocked with high yield, senior bank loan funds, preferred stock and convertibles that were supposed to be a safe harbor for investors that were down anywhere from 30% to 50%. DFA fixed income funds on the other hand performed exactly as we would have expected with positive performance and low volatility.

Investment News recently ranked top fund firms by average asset-weighted fixed-income returns. Dimensional Fund Advisors was ranked number one based off of one-year returns as of Sept. 30th. To see all firms and rankings, please click here.