DFA
Vs Vanguard By Christian Chensvold January 1, 2004
In politics, the winner isn't necessarily the best candidate,
but the most well known. A similar case exists among mutual funds.
Ask an investor who the index fund frontrunner is, and he'll likely
tell you Vanguard. Ask why, and he'll probably say something about
selection, low expense and a straightforward index style. But
ignorance isn't bliss for an investor — it's doom.
Research shows that for a long-term investment strategy, Dimensional
Fund Advisors (DFA) consistently delivers superior results to
Vanguard. In a survey of between 1,100 and 2,000 investment advisors
held three times between 1997-2002, Dalbar Research rated DFA
best overall mutual fund company, sometimes well above Vanguard.
Part of the misconception lies in the fact that DFA funds are
mostly owned by institutions and are not easy for the average
investor to buy. There is good reason for this.
In a recent Money Magazine survey about investing, the average
investor scored a paltry 37 percent. DFA keeps these less-informed
investors (who are also more likely to churn) out of its funds
by only selling through a select network of independent investment
advisors, such as Index Funds Advisors(IFA) in Irvine, California
(www.ifa.com). These advisors are able to educate investors about
the failings of active management and encourage them to take a
buy-and-hold approach that keeps DFA's operating expenses low
and benefits all shareholders. DFA has been called an investment
club for the really smart investor.
Smart doesn't begin to describe the company's founders, scholars
David Booth and Rex Sinquefield from the University of Chicago,
global epicenter of Nobel Prize laureates in economics. DFA's
investment strategy, designed primarily by Eugene Fama and Kenneth
French, is backed by academic research and a historical perspective
dating back to 1926.
It all starts with a DFA's indexes, which are quite different
from Vanguard's. Vanguard does not create its own indexes, choosing
to employ third-party ones, such as the MSCI and Wilshire indexes.
The difference is that these and other indexes like them were
designed for measurement, not as investment vehicles.
DFA has custom designed its indexes to capture the risk factors
that explain 95% of stock market returns since 1929: company size
(market capitalization) and value (based on the company's Book
Value divided by its Market Capitalization, or Book to Market
Ratio (BtM)). This is a significant difference, since returns
correlate with risk factors like size and value.
In nearly all asset classes DFA is more heavily weighted toward
small-company stocks than Vanguard. Historically, smaller-company
stocks have outperformed larger-company stocks in the long haul.
In addition, value stocks outperform the more popular growth stocks.
DFA's greater orientation to value (namely the lower price-book
ratio of its portfolio) makes it more likely to outperform funds
that are more growth oriented. The scatter plot below illustrates
the higher returns of small and value of the last 77 years.
Investors often assume that all index funds in a category like
"small cap" are going to be the same. This is wrong.The
average market cap of companies in Vanguard's Small Value index
is about $1 billion. In DFA's same category the average market
cap is $442 million. Over the past three years Vanguard's fund
earned an average of 8.4% percent, DFA's 19.2 percent, or a total
return difference of 42%, as of Jan 30, 2004.
Smaller company size equals greater risk, but historically that
has translated into a vastly greater return. In the above example,
Vanguard's Small Value fund had a return per unit of risk, or
Sharpe ratio, of 0.4, while DFA's was 0.7. Basically, more gain
per unit of pain, due to the application of financial science.
Index Funds Advisors' and Dimensional Fund Advisors' guiding
principles are a no-forecasting investment strategy using the
definition of an index fund as "a mutual fund with a clearly
defined set of rules of ownership that are adhered to regardless
of current market conditions."
