DFAX ETF: A Bet On A Changing Global Economic Dynamic (NYSEARCA:DFAX)

One of the advantages of investing in the U.S. capital markets is the kind of transparency and visibility you get. Of course, I’m not putting down the market regulators of other countries, but the SEC has done a fairly good job of ensuring that public securities operate with the most amount of transparency for investors that you can expect. Together with more stringent reporting standards, this gives investors a lot of confidence when they invest in U.S. securities.

The reason I’m using that preamble is that today’s discussion is around the Dimensional World ex U.S. Core Equity 2 ETF (NYSEARCA:DFAX). Dimensional has a pretty big lineup of ETFs for both equity and fixed-income investors, and this is one of the lesser known funds on Seeking Alpha, with only about 150 followers for the ticker. I also don’t see any focused coverage of this ETF on SA, but that’s very likely due to the fact that there are just too many ETFs out there for analysts to be able to track and report on each and every one of them. So, how big is the ETF market in the United States? This is what I was able to find from the Investment Company Institute.

As of December 2023, the total number of index-based and actively managed ETFs, including commodity ETFs, domiciled in the United States stood at 3,108. Total net assets of these ETFs were $8.1 trillion and accounted for 24 percent of assets managed by investment companies at year-end 2023.

There’s a simple answer for why ETFs are becoming so popular – there are more retail investors today than ever before. Data from Forbes shows that:

… between 2019 and 2022, direct stock ownership grew from 15% to 21%, the largest change on record. These investors can move markets, and both public and private companies are taking note.

More than companies, however, investment managers are taking note, and packaging a bucket of stocks and other securities enables them to cater to a wide range of retail investors – everyone from those looking for a secure fixed-income source to those willing to take risks on more volatile equities.

DFAX, I believe, is one of these myriad ETFs that caters to a very specific niche – investors looking to gain exposure to outside markets without having to directly invest in those countries.

Holdings and Other Characteristics of DFAX

DFAX holds a very broad basket of about 9700 stocks of companies from both developed and emerging markets. Primary developed markets are Japan, with its securities making up more than 15% of the fund’s portfolio, followed by the UK, Canada, and France, all below 8% each. China, India, and Taiwan securities all constitute more than 6% each, with sub-4% invested in Korea and Brazil.

Investors need to see this mix in perspective, because much of the world is struggling with high interest rates and trying to fend off respective recessions in their market. Some haven’t been so lucky and have already gone into technical recessions, such as Japan and the UK, which are two of the top ten largest economies by GDP. There are nearly 20 countries at risk right now.

In such a scenario, is it wise to invest overseas? Well, there’s a case to be made here based on a couple of key points.

A Macro Case for Emerging Markets

First, while the near-term outlook might not be as rosy for emerging markets, there’s evidence that these markets might bounce back stronger once geopolitical and general financial stress in their markets start to ease up. The key point is that the currently-high interest rates will give these markets the levers they need to start easing their respective economies much faster than most developed markets, including the United States. Not that they’ll be in a hurry to do so, however, as I discuss further down the article.

One of the reasons cited for this is that monetary policies between developed and developing or emerging markets have seen a divergence since COVID first struck. Indeed, an IMF report from earlier this year states that:

Emerging market economies, however, saw much milder rate moves. We take a longer-term perspective on this in our latest Global Financial Stability Report, demonstrating that the average sensitivity to US interest rates of 10-year sovereign yield of Latin American and Asian emerging markets declined by two-thirds and two-fifths, respectively, during the current monetary policy tightening cycle compared with the taper tantrum in 2013.

… major emerging markets have been more insulated from global interest rate volatility than would be expected based on historical experience, especially in Asia.

In fact, you can see that smaller emerging markets outside Asia are already bringing down their respective policy rates over the past few months, so these economies have the levers to effect more aggressive rate cuts in the coming months and into next year. Again, note that they may not immediately begin to do so once the U.S. makes a QE move.

My second point for the case is that the U.S. dollar’s strength seems quite volatile over the past couple of years. After what many economists still consider to be peak USD in 2022, there was some weakness in 2023 as the dollar gave back some of its earlier gains against the euro. 2024 marked a resurgence of the dollar’s strength, and it now rests firmly on the head of the Fed and how it navigates its own interest rate maze in relation to European and other economies. While the recent rate cuts in Europe could further boost the dollar, the Fed has to start cutting its own policy rates at some point. Many expect that to be later this year. If and when that happens, yields of U.S.-denominated securities are likely to drop alongside it, and that could, in turn, weaken the dollar against other global currencies.

For emerging markets, that’s a boon, because U.S. securities and their now-high yields will no longer be as attractive to foreign investors, and we should ideally see a reversal of fund flows back into those local economies. Now, that might play out very differently in reality, especially with the elevated level of global conflict we’re still seeing and the fact that the U.S. presidential elections are mere months away.

How Does This Impact DFAX?

Since DFAX is directly invested in these emerging economies as well as developed markets outside the U.S., any weakness in America’s economy is likely to have a booster effect on their respective economies, and that includes any weakness in the dollar relative to other currencies.

That’s also one of the reasons the Fed can’t afford to act in haste and start cutting interest rates willy-nilly. This must necessarily be a very carefully cadenced rate cut schedule, but that also poses the problem of the Fed being too slow to cut its rates. Rates being kept too high for too long tends to “distort financial markets”, according to chief global strategist at J.P. Morgan Asset Management, David Kelly, and we’re clearly seeing that with the Magnificent 7 skewing the market over the past year or more. Here’s an excerpt from a February report from Forbes:

The magnificent seven’s combined market capitalization of $13.2 trillion accounts for some 29.2% of the S&P 500’s total market cap of about $45 trillion, skewing the results of the market cap-weighted S&P significantly.

Another data point to think about (as of Feb 2024):

Click to enlarge

The point I’m making here is that whenever the U.S. does begin its journey of interest rate cuts, emerging markets will receive a temporary boost – unless their own rate cut cadences are more aggressive than the U.S. Fed’s, which is unlikely in my view. The longer they keep their interest rates high, the more of an advantage they’ll have when the Fed starts its rate cuts.

Indeed, JP Morgan’s Global FX Strategist, Meera Chandan, is quoted as saying:

Strength in U.S. activity has been a mainstay of our long-dollar bias, and the persistence of U.S. exceptionalism is a major FX theme. But this has always been in the context of high market conviction that the Fed would invariably begin its easing cycle this year. This is now being challenged, and the corresponding de-pricing of Fed cuts has taken the dollar to new year-to-date highs.

Such a rate cut by the largest economy in the world would also impact its currency, which is likely to depreciate against other global currencies, as described above, but the question is whether this will happen sooner rather than later. My bet is that the U.S. will delay rate cuts as long as it’s practically possible, and that practical aspect is because even though the economy looks resilient with its sticky inflation, America’s population of consumers is feeling the heat. Senior U.S. economist Troy Ludtka of SMBC Nikko Securities America has this to say:

… interest rates are simply crushing particularly low-income-earning Americans. That is a big portion of the population.

That has significant political implications as well, and this is an important phenomenon to be aware of because it impacts the bulk of DFAX’s holdings.

Not today and maybe not even this year, but that dynamic is bound to play out at some point in the next year to two years. It might not be good for those invested heavily in U.S. securities, but funds like DFAX, with significant exposure to emerging and ex-U.S. developed markets are very likely to see greater inflows as the balance between the U.S. economy or even the USD against global economies and currencies achieves a more sustainable equilibrium.

Naturally, greater investor interest has the effect of pushing the fund’s market price higher, which is kind of an ancillary benefit of the underlying companies themselves benefitting from a U.S. rate cut. The relationship is somewhat convoluted, because lower interest rates in the U.S. and a weaker dollar are not necessarily that great for foreign companies generating revenues from the United States, but it does entice domestic investors in those countries to invest in locally domiciled businesses, thereby increasing their market value on domestic bourses, which in turn translates to higher ADR/ADS prices in the U.S. As a side note, to my knowledge, Dimensional doesn’t invest directly in these markets but only through depository shares, but I could definitely be wrong. If I’m right, then there are also risks associated with a fund that holds only depository shares with no voting rights and no key obligations for the issuer to provide timely information about the companies’ performance.

That essentially rounds out my bull case thesis for DFAX, and because the fund has a broad basket of stocks across multiple industries, there’s a much lower concentration risk here than in a fund that weighted more heavily toward specific sectors. This way, DFAX should benefit from a boost in practically any global sector, including financials, industrials, consumer discretionary, information technology, energy, and materials. The fund is underweighted sectors like Utilities and Real Estate, but these aren’t likely to significantly move global markets, so I think the holdings have the right amounts of concentration in the right sectors so it can benefit from major movements in any of those sectors overseas.

For now, price and total returns seem marginal, and the fund clearly underperformed the broader U.S. equities market on several timelines. However, the whole thesis of this article rests on that dynamic changing in the medium to long term.

As such, I’m comfortable recommending a long-term buy and hold strategy for funds like DFAX. The expense ratio is quite low at 0.28%, and while emerging markets have largely underperformed developed economies over the decade since the GFC, their time will eventually come. Essentially, this investment is a bet on that belief, and my Buy recommendation is contingent on that being the case for you. Of course, if you think emerging markets have a long way to go before they catch up to more mature markets, then it’s best to stay away from this fund. However, it can also act as an effective hedge against your core U.S. securities, offsetting any potential losses in the event that the U.S. economy and the dollar weaken considerably against their global counterparts.