The battle lines were clear. On one side, stood Vanguard founder John Bogle. Burton Malkiel, author of A Random Walk Down Wall Street stood next to him. Warren Buffett backed them both. A force of Nobel Prize winners in Economics also lent their weight. Actively managed mutual funds, they said, cost too much. Investors are better off with index funds.
The other side’s army had treasure to protect. They fed their cache with high mutual fund fees. Today, skirmishes continue. But the war is practically over. Nobody, it seems, can consistently find actively managed market-beating funds without a Back to the Future time machine.
That doesn't mean, however, that index fund supporters all hold hands and sing “Kumbaya.” Some believe in different kinds of index funds: those that claim to capture the return of an identified factor, such as small cap, small cap value or large cap value.. Dimensional Fund Advisors was the first of these firms. They built funds with a tilt towards smaller cap and value stocks. They also built them by the characteristics of each stock rather than duplicating an index that roughly identified a characteristic. These funds cost more than traditional index funds, but their back-tested studies said the cost would be worth it.
Vanguard’s S&P 500 Index Admiral (VFIAX) charges just 0.05 percent per year. DFA’s U.S. Core Equity 1 Portfolio Institutional Class (DFEOX) costs 0.19 percent. Yet, in spite of trailing the S&P 500 Index over the last one, three and five year periods ending 12/31/15, the DFA fund beat the index by an annualized 0.06 percent over the preceding 10 years. And it beat the Vanguard fund by an additional 0.01 percent.
Vanguard founder, John Bogle, says the higher cost funds won’t beat the market.
In 2013, Jeff Sommer quoted John Bogle in the New York Times. Bogle said, “Over the long run, I doubt very much that they [DFA’s funds] can really beat the market.” As a practical matter, it’s important to make sure any comparison is as close to apples to apples, as possible. So we may have to get more precise.
I asked Burton Malkiel what he thought. The Princeton economics professor and A Random Walk Down Wall Street author said, “I generally prefer minimum cost plain vanilla broad-based index funds. But if an investor does want to add one of the ‘smart beta type’ offerings, DFA funds are among the best available.”
DFA’s funds have beaten the broad U.S. market. But that’s to be expected because DFA tilts its funds towards value and small cap stocks. The S&P 500 gained a total of 122 percent from January 1, 1999 to December 31, 2015. U.S. value stocks gained 167 percent. U.S. small cap stocks gained 318 percent.
S&P 500 vs. Value Stocks and Small Cap Stocks
January 1, 1999-December 31, 2015
- S&P 500
- Value Stocks
- Small Value Stocks
DFA, however, says they have a few other advantages over traditional index funds. For example, when a new stock enters an index, a traditional index fund has to add it all at once. This can push the price up before the purchase is completed. DFA, by comparison, is working to characteristics, not names. So they build their portfolios differently. By doing so, they avoid the cost bumps of stock list-following index funds.
But are the DFA funds worth their extra fees? Duke University professor Edward Tower and PhD student, Cheng-Ying Yang say yes. In 2008, they published their findings in the Journal of Investing. In an 8 year period that ended in 2006, they found that DFA funds beat similar style Vanguard funds by 1 to 3.81 percent per year.
In other words, they didn’t compare DFA’s funds to a Vanguard S&P 500 Index. They compared funds that represented similar asset classes. That study ended in 2006.
But that was then? Has the advantage persisted? Apparently not. I found six equity categories to compare over the past ten years. Vanguard had the advantage with three funds, DFA had the advantage with two funds and it was a virtual dead heat with a sixth, a difference of only one basis point.
DFA versus Vanguard Compound Annual Returns
January 1, 2006 to December 31, 2015
|U.S. Small Cap Value||DFSVX |
|U.S. Small Cap||DFSTX |
|U.S. Large Cap Value||DFLVX |
|U.S. Large Blend||DFUSX |
|International Large Cap Value||DFIVX |
|Emerging Markets Large Blend||DFEMX |
|Growth of $60,000 split equally into each fund||$106,353||$107,586|
|Average Compound Annual Return||5.89%||6.01%|
Results were very close. But Vanguard had the edge. We can expect the debate will continue.
Most investors, however, underperform the funds they buy. In the ten years ending October 31, 2014, the average Vanguard investor underperformed their funds by 0.81 percent per year. That’s far more than the performance difference between comparable Vanguard and DFA funds. You can read about why, here and here.
Investors can’t buy DFA’s funds directly. They need an advisory firm that’s approved by DFA. Those firms charge fees to create and manage investor portfolios. But if they do a good job, and their investors keep cool, those with DFA’s funds will likely end up winners.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas