Life is filled with great dilemmas: boxers or briefs? Short skirt or long? Habs or Leafs? Man-U or Arsenal? Tokyo or Osaka? Aussie Rules, League, or Union? French or Italian food? And, of course, index mutual funds from Vanguard or Dimensional Fund Advisors?
Along with State Street Global Advisors and Barclays Global Investors, Vanguard and DFA are two of the world's leading managers of index investment products. Compared to the other three firms, DFA is in some ways unique. It has the strongest emphasis on indexed products, and perhaps the strongest association with very well-known academics, including Rex Sinquefield, Gene Fama, and Ken French. Moreover, there is a certain mystique about its retail mutual funds, which are only available through a select group of financial advisers. But is there anything to this, besides great marketing (which, of course, is nothing to sneeze at)? We've lost count of the number of times we've been asked this question. And that's why we've done the analysis in this article -- to see if we can settle the question once and for all. Our main approach will be an asset class by asset class comparison of the mutual fund products offered by DFA and Vanguard. We have deliberately left ETFs (and their main sponsors, BGI and SSGA) out of this analysis, because we wanted to do a mutual fund to mutual fund, apples to apples comparison.
We should also say up front that what we are doing, in essence, is comparing one all-star to another. Both DFA and Vanguard have well earned reputations for holding down their fund expenses, and for using their size and skill to limit their trading costs (in a recent survey of asset management firms with the lowest average transaction costs, both DFA and Vanguard ranked in the top ten). Moreover, at the margin, both firms also take actions to slightly enhance returns, including lending shares and departing occasionally from the underlying index weightings. As DFA notes in its prospectus, "rather than replicate an index in mechanical fashion, we allow slight variations from precise market weightings. This flexibility allows us to take advantage of favorable trading costs." On the other hand, there are also some important differences between the two firms. Compared to Vanguard, DFA is a much stronger advocate of the wisdom of using small cap and value tilts within different equity asset classes (e.g., domestic, foreign, and emerging market). We have written before about the wisdom of taking these tilts (our articles on these subjects can be easily accessed via the home page of our website). To briefly sum them up, there are three issues: (1) Does the small size and/or value premium exist? (2) If it does, what has caused it in the past? And (3) will that cause persist in the future? With respect to the size premium, we have noted our doubts about its existence, except in the case of microcap stocks (generally, stocks included in the bottom 2% or so of total market capitalization). With respect to the value premium, while the evidence for its existence seems compelling, its underlying cause remains unclear.
One school of thought (and DFA is in this camp), believes that the value premium reflects an efficient market delivering higher returns for bearing higher risk than is found in the broad equity market index. Unfortunately, different academics have yet to reach agreement on the nature of this additional risk. In contrast, the other school of thought believes that the value premium is a behavioral phenomenon that results from defects in the way investors process information. As such, they believe that by taking a value tilt it may be possible to earn higher returns than the broad market index, while taking on less risk. However, the validity of this argument necessarily depends on the existence of what are called "barriers to arbitrage." Theoretically, not all investors in the market should act irrationally. Hence, some smart investors should recognize the mistake that the irrational ones are making, and bid up the price of value stocks to the point that the expected additional return premium disappears. If you believe that the value premium is likely to persist into the future, you also have to believe in the continued existence of some very powerful barriers to arbitrage. Unfortunately, advocates of the "behavioral explanation" for the value premium have yet to make a convincing case to support this second argument.
It is interesting to note that DFA states that while its definition of value stocks is primarily based on the book/market ratio (consistent with Fama and French's research), it also notes that it may use other screening criteria, including price/cash flow and price/earnings, "as well as economic conditions and developments in the issuer's industry." Moreover, DFA's "criteria for assessing value are subject to change from time to time." In comparison, Vanguard uses indexes from Morgan Stanley Capital International (MSCI) in many of its funds. MSCI uses three criteria (book/market, price/earnings, and dividend/price to identify value stocks).
Over the long-term, we come down on the efficient market side of the argument, while recognizing that some investors can and do occasionally act irrationally. However, we find it hard to believe in a free lunch that lasts forever. In short, while taking a value tilt will, over the long-term, probably produce higher returns than the broad market index, it will also expose an investor to more risk, of one kind or another.
In talking about DFA's domestic equity funds, one of the terms you occasionally hear is the "CRSP Index. Before getting into our fund comparison, it will help to explain this index a bit more. As we have noted in other articles, when it comes to constructing an equity index, there are two basic approaches one can take. Either one include a fixed number of companies in the index, and vary the percentage of total market capitalization it covers, or one can take the opposite approach, targeting coverage of a fixed percentage of market cap, and letting the number of companies vary to achieve it. Indexes that start with a fixed number of companies (ranked by market capitalization) include those from Russell (e.g., the Russell 3000 Index), Standard and Poor's (e.g., the Standard and Poor's 500 Index), and Morgan Stanley Capital International (e.g., the MSCI Prime Market 750 Index). Indexes that start with a fixed percentage of market capitalization include those from Wilshire (e.g., the Wilshire 5,000, which covers 100% of market capitalization), Dow Jones (e.g., the Dow Jones Total Market Index covers 95% of market capitalization) and Morningstar (whose broad index covers 97% of market capitalization).
To put it charitably, the CRSP (which stands for the Center for Research in Securities Prices) takes a hybrid approach. It starts with the companies listed on the New York Stock Exchange, ranked by market capitalization, and divides them into ten equal groups (e.g., 178 companies in each group). Next it determines the market cap "breakpoints" for each group (that is, the high and low market capitalizations that define each group's boundaries). Using these breakpoints, it then assigns companies from the American Stock Exchange and National Association of Securities Dealers Automated Quote System (the NASDAQ) to different groups, which it calls "deciles." Stocks in deciles 1 and 2 are often called "large caps", those in deciles 3 to 5, "mid-caps", those in deciles "6 to 8, "small-caps", and those in declies 9 and 10, "micro-caps." Unfortunately, this can easily create confusion, because the "deciles" contain neither equal percentages of total market capitalization, nor equal numbers of companies. The 1996 example shown on the CRSP website shows that the top decile contained 203 companies that accounted for 58.6% of total market capitalization, while the tenth decile contained 2,426 companies that accounted for 1.3% of total market capitalization. Confusing, no?
Also confusing (though "interesting" might be a better word) is DFA's description of its approach to market capitalization weighting in its small company, real estate, and international funds: "Market capitalization weighting means each security is generally purchased based on the issuer's relative market capitalization. Market capitalization will be adjusted by [DFA] for a variety of factors. [DFA] may consider factors such as free float, trading strategies, liquidity management and other factors determined to be appropriate by [DFA] given market conditions. [DFA] may exclude the stock of a company that meets applicable market capitalization criteria if [DFA] determines, in its best judgment, that the purchase of such stock is inappropriate in light of other conditions. These adjustments will result in a deviation from traditional market capitalization weighting." As a result, DFA notes that "the weightings of certain countries…may vary from their weightings in international indices, such as those published by …Morgan Stanley Capital International." In other words, it appears as though there might be a little bit of active management going on at DFA to improve some of its funds’ performance.
One other issue that we need to address before going to the fund comparisons is financial adviser fees. As we noted, the only way an individual can invest in DFA funds is through a financial adviser. Vanguard funds can be directly purchased by individuals without having to go through a financial adviser. A survey done for DFA (available on its website) showed that "91.2% of DFA advisers charge clients a 1% annual fee on accounts up to $1 million, as opposed to a flat fee." Given this, we have decided to present DFA fund results in three different ways: before fund expenses, after fund expenses only, and after fund expenses plus a 1% adviser fee.
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