Few subjects bring more reader response and dispute than index investing. My recent column about a small Dallas firm, JWA Financial Group, was no exception.

The firm constructs "Market Return" portfolios using institutional funds from Dimensional Fund Advisors in Santa Monica CA. These funds are different from conventional (and simple) index funds in that they are not designed to reproduce the performance of an index like the S&P 500. Instead, they are designed to ferret out high return asset classes based on the respected Fama/French research on company size and book value. Think of this approach as sophisticated indexing.

Several advisors wrote with confidence. They were certain they could assemble portfolios that did better than any kind of index fund.   Analysis, they assured me, would always find superior funds. It would always do better than funds that could beat "only"   70 percent of their competitors.

To these folks I suggest two things. First, review your Statistics and Probability 101. Alternatively: Show me the money.

Two investors wrote asking me to compare Dimensional's funds with index fund performance. One, a man who had recently inherited $1 million, wanted to know whether it would be better to invest the money in a collection of index funds or with his accountant. The accountant would manage the money in Dimensional funds for 75 basis points a year (that's 0.75 percent).

Many others simply wanted more complete information on how to build a portfolio with index funds.

Let's start with building an index fund portfolio. The Diversified Index Portfolio that James Whiddon cited was a traditional balanced portfolio with a small international equity component. Specifically, it was 40 percent Lehman Brothers Intermediate Government index (fixed income), 20 percent S&P 500 Index (large cap), 20 percent Russell 2000 Index (small cap), and 20 percent MSCI EAFE Index (international).

Government employees in the federal Thrift Savings Plan can virtually duplicate this with ease by investing 40 percent in their F Fund (Lehman Aggregate Bond Index), 20 percent in their C Fund (S&P 500 Index), 20 percent in their S Fund (Invests in the 4500 stocks not included in the S&P 500 Index), and 20 percent in their I Fund (Invests in the Morgan Stanley EAFE index of foreign stocks). This will be done at a cost of about 0.06 percent.

Many non-government employees can get close by investing in exchange traded funds, or mutual funds from Vanguard and a handful of other firms active in indexing. Barclays iShares, for instance, offer the Lehman Aggregate Bond Index, (ticker: AGG, expense ratio: 0.20 percent); the S&P 500 Index (IVV, 0.09 percent); the Russell 2000 Index (IWM, 0.20 percent); and the MSCI EAFE Index, (EFA, 0.35 percent). That's an average cost of about 21 basis points or 0.21 percent.

The diversification of this portfolio can be increased by adding a REIT investment such as iShares Cohen and Steers Realty Majors Index Fund, (ICF,   0.35 percent), emerging markets such as iShares MSCI Emerging Markets Index Fund (EEM,   0.75 percent), or a variety of   indexes that lean to value or high dividend yields.

Want more index portfolios from different firms? Check out http://www.fundadvice.com/, Paul Merriman's website and its collection of "buy and hold" portfolios.

Significantly, Morningstar considers only one of Dimensional's 48 funds as a true index fund. A comparison of the Dimensional small cap value fund and the Vanguard small cap value fund indicates that Dimensional may have the superior tool. While it trailed the Vanguard fund over the last 12 months, it did significantly better over the last 3 and 5 year periods. Here are the figures:

  

Vanguard vs. Dimensional Funds' Small Cap Value

This table shows returns for both funds over different time periods. The Vanguard fund has not been available for the 10 year period. (* ) Expense ratio for the institutional fund. The retail fund has a higher expense ratio.
Fund 12 months 3 years 5 years 10 years Exp. Ratio
Dimensional-DFSVX

12.64%

18.00%

18.09%

16.21%

0.56%

Vanguard-VSIIX

16.38

12.01

14.47

NA

0.08*

Source: Morningstar Principia, data for period ending 6/30/2005
  

Is the additional cost of management by a Dimensional Funds registered advisor worth it?   It all depends on the fee charged.

Newsletter publisher and investment manager Paul Merriman says he has seen fees that range from 25 basis points (one-fourth of 1 percent) to 2   percent a year. I think 2   percent a year will do more harm than good and 1 percent a year is a lot to charge for asset allocation.

On the web:

Paul Merriman on "The Ultimate Buy and Hold Strategy" and Dimensional Funds

Sunday, July 31, 2005:   If the house wins, so can you