Below, we reprint our latest BFI profile, "Diversity Key at Dimensional: Discussion w/Dave Plecha".... This month, Bond Fund Intelligence interviews Dave Plecha, Global Head of Fixed Income at Dimensional Fund Advisors and manager of the DFA One-Year Fixed Income Portfolio. We ask Dave about Dimensional's history, strategies and presence in the ultra-short, and overall, bond market. We also discussed Dimensional's views about timing the market, ultra-short funds benefiting from money fund reforms and more. Our Q&A follows.(Contact us if you'd like to see the latest Bond Fund Intelligence.)
BFI: Give us a little bit of your history. Plecha: Dimensional was founded in 1981. We launched our first fixed income strategy in 1983 -- an ultra-short bond fund with a maximum average maturity of one year. So we've had 33 years of experience investing in short term fixed income. I joined the firm in 1989 and was involved in the One-Year Fixed Income Portfolio from my start, so it has been 27 years for me.
We have a large, experienced team of portfolio managers and traders. Our fixed income teams are in Santa Monica, Austin, and Charlotte in the US, as well as in London, Sydney, and Tokyo. The One-Year Fixed Income Portfolio team is based in the US. We employ a team-based approach, which we like because it helps establish clear responsibility and multiple levels of accountability without too much reliance on any one person. This helps ensure continuity for our investment process.
BFI: Is One-Year Fixed Income Portfolio Dimensional's biggest bond fund? Plecha: The fund was the largest for a number of years, and today it is still one of our biggest fixed income funds and is used widely by our clients. But we manage a lot of fixed income, almost $90 billion across strategies with different maturity and credit quality constraints, including European based UCITS and Australian based trusts for investors in those regions. What was appealing to our investors in 1983 is still appealing to investors today.
BFI: Talk about that fund's position relative to the other funds in the lineup. Plecha: In the US we have two funds that I would categorize as ultra-short bond funds. The One-Year is focused on U.S. dollar-denominated, short term and high quality bonds, and the average maturity is no more than one year. The fund can buy individual bonds with up to two years maturity, which has basically been the structure of the portfolio since inception. In 1996, we launched a global version, which is fully currency hedged and invests in high quality global bonds, as well as bonds with up to two years maturity. Dimensional has other U.S. and global taxable and non-taxable portfolios that seek higher expected returns while investing in a broader set of credit qualities and maturities.
BFI: What was the original impetus? Plecha: The strategy was designed to offer investors a premium over cash, while maintaining capital preservation. If you care about capital preservation then you probably want to focus on short duration, high quality issues, and you want to be diversified -- that lines up with how we position the portfolio. But within that universe, we can still pursue higher expected returns. So for investors who might otherwise still be in cash, the strategy offered them the ability to have a portfolio that extended duration and the premium that comes with taking that approach.
BFI: What are your biggest challenges? Plecha: We have no challenge finding the securities we want to execute our strategy. Today, we are in a low yield environment and some investors are tempted to reach for yield and extend duration in an attempt to get a bit more yield. But yield is not the only component of expected returns. Our approach of finding portions of the yield curve with higher expected capital appreciation, and our willingness to roll bonds instead of holding to maturity, adds an expected capital appreciation component of returns to the yield. As with any strategy, we believe it is critical to set the proper expectations with our clients -- in a low rate environment and otherwise -- to help them understand there are no free lunches and the importance of remaining disciplined.
BFI: What can and can't you do in the fund? Plecha: At Dimensional, we believe you can't time the market -- that markets are very difficult to outguess consistently. We believe in market prices and that new information is quickly reflected in prices. We believe we provide value to our investors by having a deep understanding of the relationship between the current term structure, the current yield curve, and expected return premiums. This is where we focus.
BFI: Do you adhere to pretty tight maturity guidelines? Plecha: We have a one-year maximum (for our average security). Our maturity guidelines are essentially a function of the shape of the yield curve and the term structure. When yield curves are upwardly sloped, on average we expect larger premiums for moving out towards the one-year limit. When yield curves are flat or inverted, we don't expect the same premium. The Fama research shows that there is a positive relationship between forward rates and term premiums. When yield curves are upwardly sloped, expected premiums are positive. So while our average maturity will vary between zero and one year, it will be near the upward limit in upwardly sloped curves and near the lower limit in flat or inverted curves.
BFI: What about quality guidelines? Plecha: In our opinion, one of the most important attributes of an ultra-short strategy with an objective of capital preservation is liquidity, and we take that very seriously. We stay broadly diversified on the very high end of the credit spectrum, investing primarily in double- and triple-A government and corporate securities.
BFI: What about diversification limits? Plecha: We put a lot of emphasis on diversification, not only to reduce volatility or minimize the risk of losses but also to enhance liquidity. We have tighter maximum allocation limits per issuer than what is allowed for credit issuers in money market regulations. So within a portfolio of very high quality issuers, triple-A and double-A issuers, we are highly diversified. We fix limits by issuer, by guarantor and by industry. Even though we are investing in U.S. dollar-denominated bonds, there are issuers from all over the world that come into the U.S. corporate bond market to issue debt. So we look at the country of issuer and put limits on that. We believe that diversification is important in all of the portfolios we manage -- fixed income and equity.
BFI: How about sectors in general? Plecha: We buy commercial paper which is a big market with new issues every single day. We also have floating rate notes in the portfolio which we often buy on new issue, as two-year issues of FRNs are not uncommon. We do not invest in mortgage-backed securities in the portfolio.
BFI: Do you have relatively stable cash flows? Plecha: Our client base is made up of institutional investors and financial advisors. We've been fortunate to see pretty steady inflows across our fixed income offering as more clients recognize the benefits of our approach. That being said, for the One-Year Fixed Income Portfolio we are talking about a highly liquid strategy -- stable cash flows are not a requirement for the strategy to be successful.
BFI: How about expenses? Plecha: There are a couple of aspects to think about when thinking about costs. Obviously the expense ratio of the strategy is important, but also important are the costs of executing the strategy, which some people forget about. The expense ratio for this portfolio is 17 basis points. We care a lot about the costs of executing the strategy, as anything we can do to reduce them can be passed along as higher returns for clients.
BFI: What about the regulatory environment? Plecha: As you know, the recent focus has been on money market fund reform. Money market funds have an opportunity cost due to the regulatory constraints in the way they need to be managed. Historically, they were able to provide stable NAVs as a benefit to investors. The reform in October and the switch to floating NAVs for prime money market funds take away that "main attraction" if you will. Without this benefit, I would expect that many investors who were or are in 2a-7 funds may be considering ultra-short portfolios.
BFI: Do you have an outlook on the Fed? Plecha: The whole market has an outlook on the Fed, and that outlook, together with all other information, is embedded in the term structure of interest rates. Rather than forecasting in the traditional sense, we use the broader information provided by the yield curve to assess difference in expected returns among different maturities when implementing our strategy, and we do this every day.
BFI: Any thoughts on the future? Plecha: We have 33 years of live history, and I think the One-Year Fixed Income Portfolio and its successful track record is a great example of our investment process at work. At all points during the last 33 years there have been investors who have found a favorable tradeoff to take some extra duration out of cash. And there's nothing that indicates that over the next 33 years, or the 33 years after, will be any different.
