(Full disclosure: I am DFA-approved advisor. I would invite readers to also see my thoughts after my trip to a DFA conference: After the Dimensional Fund Advisors Conference)
Fans of index investing know that there are two powerhouses in the traditional mutual fund space: Vanguard and Dimensional Fund Advisors (DFA). Both companies have rabid, foaming-at-the-mouth fans who would happily club each other to death over 0.02% in risk-adjusted returns. Both companies have changed the face of investing from chummy stock brokers taking commissions for their clueless recommendations to a focus on what actually works: broad diversification, low costs and risk-adjusted returns.
Vanguard was a pioneer in index investing, offering the first publicly available S&P 500 index fund and today is a leader in low cost index funds. DFA was founded by academics from the Booth School of Business out of Chicago using the research of (today’s Nobel Prize winner) Eugene Fama and Ken French on risk-adjusted portfolio returns. DFA in particular has done an amazing job of growing a cult following of advisors and investors. They’ve done this by controlling access to the funds, creating an air of exclusivity. Most investors can only access DFA through advisors who have completed onsite visits at DFA and drank the kool-aid of DFA’s philosophy. A large piece of the philosophy is Fama & French’s research that small cap stocks and value stocks will outperform cap-weighted indexes over time, as compensation for additional risk in those asset classes. Many simple performance comparisons you can find online do not account for the additional risk that comes with a heavy small cap/value weighting associated with DFA funds.
DFA claims a few advantages over traditional index fund providers: superior trading strategies, fund construction and securities lending.
1) Trading strategies. Because DFA does not rely on outside index providers such as Russell or S&P, they are not forced to make changes in their portfolios when there is a change in the benchmark. This is a real problem and investors should avoid owning narrow benchmarks with high turnover. In a time when an index investor’s only option was the S&P 500, DFA’s offerings had an advantage. However, Vanguard’s index funds have moved to broader, more inclusive benchmarks. Earlier this year Vanguard changed the benchmarks on most index funds to Center for Research on Securities Prices (CRSP) benchmarks which are broader targets that will reduce unnecessary portfolio turnover.
2) Fund construction. Since DFA does not rely on outside benchmarks, they are creating their own definitions of “large cap,” “small cap,” “growth” and “value.” As a result, the funds tend to have a much higher tilt towards small caps and value stocks than any other benchmarks. I would argue this is not truly an advantage, simply a choice to build portfolios with higher expectations of return and risk. The lack of an outside benchmark also gives DFA portfolio managers great flexibility in choosing which stocks to add to a portfolio and when (something that at times sounds a lot like active management).
3) Securities lending. Virtually all portfolio managers engage is securities lending. When a fund manager owns a stock, s/he can earn a small (very small) profit by lending the stock to a short seller, who pays a fee as with any other loan. Securities lending can provide real returns to the fund company or the fund itself. Often revenue from securities lending is split between profit for the firm and excess return for investors. DFA is a very aggressive securities lender, as Larry Swedroe noted in this column, DFA generates significantly more revenue from securities lending than most other firms (including Vanguard). There is some evidence that securities lending is not without risk (as with any other loan, you take on counter party risk). Additionally, DFA is under no obligation to share this revenue back with investors. Blackrock was recently sued (and had the case dismissed) for retaining too large of a share of securities lending revenues. Because of Vanguard’s mutual ownership structure, all net securities lending revenue eventually finds its way back to fund investors.
Narrow institutional advantages aside, it’s important to remember that there is still no free lunch in investing. Additional return comes with additional risk, no matter how you slice it. There are some terrible comparisons of DFA and Vanguard floating around out there, generally designed to show that over very long time periods, DFA funds outperform – OF COURSE they should, as compensation for additional risk! The results of a true apples-to-apples comparison of Vanguard and DFA are likely to be inconclusive at best.
Bason Asset Management 