Financial Economics Corner: Dimensional Funds versus Vanguard
In a previous post about financial economics, I mentioned Dimensional Funds (“DFA”) as alternative to a purely passive indexing strategy.
Dimensional funds are “enhanced” index funds. What this means is that philosophically Dimensional funds subscribes tot he notion that it is very difficult to beat the market. Thus, their main strategy is still based on indexing, or in other words, holding a large basket of stocks that are picked according to some rule. For instance, the most basic Index fund is one that invests in all of the stocks in the S&P 500. However, Dimensional funds are enhanced in the sense that they do engage in some stock picking. It is still rules based, but their choices deviate to some extent from simply holding all of the stocks in an index. Why do they do this? Because the two main economists behind Dimensional funds, Ken French and Eugene Fama have discovered some interesting things about stock returns. Specifically, they’ve found that over the long term, small-cap stocks out perform large cap stocks, value stocks outperform growth stocks, and that to some extent stocks have “momentum.” Or as Fama explains:
“There’s evidence that if you rank stocks every month based on their last year of returns, the very extreme winners tend to win for a few more months and the losers tend to lose for a few more months.”
Now because of transaction costs, it is extremely difficult for an individual investor to take advantage of these effects. But by pooling assets DFA seeks to allow the individual investor to make extra returns beyond those available to those who invest in pure index funds. The question is, does there approach work?
Well, according to two financial economists, the answer is an impressive yes.
Tower and Yang find that overall Dimensional Funds, out-perform the purely passive index funds offered by Vanguard.
"We conclude that DFA’s performance relative to Vanguard’s, before advisor fees are subtracted, has been impressive. Specifically, during the period encompassing 1999 through 2006, before advisor fees: a. Before style adjustment DFA outperformed Vanguard by 8.9 percent per year. b. The DFA portfolio outperformed Vanguard’s style-mimicking portfolio by 2.57 percent per year. This reflects the quality of DFA funds relative to Vanguard’s as well as the choices that DFA advisors and their clients make. It, like the rest of our calculations, assumes that Vanguard’s portfolios are rebalanced every month. c. The DFA portfolio outperformed Vanguard’s Fama-French load-mimicking portfolio by 1.4 or 3.0 percentage points per year, depending on the method of analysis. d. The DFA constant-style portfolio over the entire 8 year period (using beginning period weights) outperformed the style-mimicking Vanguard portfolio by 2.7 percent per year. This reflects the quality of the DFA funds relative to Vanguard’s. e. Using end-period weights DFA’s performance is higher (11.5%/year as opposed to 10.8%/year for start period weights). This illustrates the general principle that using later period weights, as Barron’s does in their annual studies of mutual fund families, overstates portfolio performance, because the proportion of the market portfolio rises in funds that have appreciated, although in Barron’s defence, Barron’s publishes only rankings, not absolute performance, but this makes its studies less worthwhile. f. The DFA portfolio outreturned the DFA portfolio using portfolio weights that are a year old by 0.23 percent per year, with a higher standard deviation of real return of 0.41 percent per year. Thus, DFA clients and their advisors outreturned what they would have done if they had selected their portfolios as the portfolios that DFA investors used a year ago. g. DFA outperformed by 1.44%/year the style-mimicking Vanguard portfolio in a simulation which assumed that value under-returned growth and small under-14 returned large by 2% per year. The positive sign occurred in spite of DFA’s orientation toward small and value stocks. h. Breaking the portfolios into a domestic and a foreign component improves the margin by which DFA beats Vanguard. Over the 8 year period, the DFA portfolio of domestic funds beat the style adjusted portfolio of Vanguard domestic funds by 2.61 %/year continuously compounded. The corresponding differential for the international funds was 3.59 %/year continuously compounded."
This evidence is pretty impressive. Now as I mentioned earlier,
DFA only allows people to invest through private wealth managers or 401k plans. For those looking to invest outside of a 401k, this means that in general you will need to invest $100,000 or more to gain access. Why do they do this? Because they keep costs down by only letting investment managers who believe in a strict buy-and-hold strategy to provide access to the fund so as to keep trading costs down. Now for those of us who like me don’t have that sort of money sitting around, your company can provide access to DFA in your 401k plan. Show your bosses this evidence, and maybe they’ll put DFA on your menu.
PS to those of you working at Navigant Economics, my old company, your 401 k plan allows access to DFA’s emerging markets value portfolio. I maintain an investment in that fund. In fact its the only 401 k asset I haven’t converted to an IRA.