I got my driving license when I was 16 years old. It was my ticket to freedom. I could ask a girl to the movies and pick her up from her home. I no longer had to beg my dad for a ride. The license listed my height, weight and eye and hair color. But imagine if this were printed on the back:
“This driver is qualified to independently operate every brand of car with the exception of a Mazda. If he or she chooses to drive a Mazda, he or she must be accompanied by a professional Mazda-approved driver.”
If that were the case, Mazdas would have been mythic. Robert B. Cialdini wrote the bestselling book, Influence: The Psychology of Persuasion. He says that when we can’t have something (or it’s tough to get) we often want it badly. Cialdini calls this the scarcity effect. It would have driven many of us mad for Mazdas. Dimensional Fund Advisors’ mutual funds are a lot like that. Retail investors can’t buy them directly. They can only acquire them through a DFA approved financial advisor.
DFA’s funds have performed well. But their scarcity might have given them cult-like status. Between 2008 and 2012, investors pulled $535.7 billion from U.S. mutual funds. But Dimensional bucked the trend. During that same time period, investors added $34.4 billion to DFA’s funds.
DFA’s exclusivity might be a marketing ploy. But its Big Brother effect might also boost returns. Let me explain.
During the ten-year period ending December 31, 2015, the typical index fund investor beat the average investor in actively managed funds by 2.39 percent per year. Actively managed funds charge higher fees than low-cost index funds. That’s one reason investors in index funds did better.
But there’s one other reason that added to the difference. Morningstar says that investors in actively managed funds buy and sell a lot. They hope to beat the market. Many believe they can find the next hot hand. When a hand they’re invested in suddenly turns cold they seek something warmer. Unfortunately, this causes many people to buy high and sell low. They buy funds after they have had a strong winning streak. They sell funds that lag. But fortunes often reverse after they’ve made those trades.
Most index fund investors don’t jump from fund to fund. Most admit that they can’t forecast winning funds or predict where stocks are headed. That’s why they do far less trading and market timing. Sometimes they even beat the posted performances of their index funds.
For example, Vanguard’s Total Stock Market Index (VTSMX) averaged a compound annual return of 7.12 percent during the ten years that ended January 31, 2017. Its investors did even better. According to Morningstar, they averaged a compound annual return of 8.12 percent per year. More of them must have dollar-cost averaged. That means they invested the same amount every month. This allowed them to add fewer units when the fund price rose and more units when it fell.
It was a similar story with Vanguard’s International Stock Market Index (VGTSX). It averaged a compound annual return of 1.17 percent. But its investors averaged 1.75 percent per year.
However, factor-based funds, such as those offered by Dimensional Fund Advisors, aren’t like broad market index funds. A factor-based index is made up of specific types of stocks. For example, a small cap index contains only small stocks. A value stock index contains only cheap stocks. A growth stock index only contains stocks whose business earnings are soaring.
I wondered how investors in factor-based index funds perform. Do they jump around like investors in actively managed funds? Or do they mostly stay put, like disciplined broad market index fund investors.
I suspected that they behaved more like active fund investors. After all, most of them likely chose factor-based funds because they wanted to beat the market.
Morningstar doesn’t provide 10-year investors’ performance data for many of DFA’s funds. But I found such data for Vanguard’s factor-based indexes. Retail investors can buy these funds directly.
Vanguard’s U.S. Value Index (VIVAX) earned a compound annual return of 5.81 percent during the ten-year period that ended January 31, 2017. Perhaps a Big Brother advisor might have helped a lot. The typical investor in this fund averaged a compound annual return of just 1.81 percent during the same time period.
Growth stocks beat value stocks for the decade. But they didn’t win every year. Investors’ ten-year returns in Vanguard’s Growth Stock Index (VIGRX) reveal that plenty jumped ship when they should have stayed on board. The fund averaged a compound annual return of 8.09 percent. Its investors averaged a compound annual return of just 5.33 percent.
Investors in Vanguard’s Small Cap Value Index (VISVX) didn’t behave much better. The fund averaged a compound annual return of 7.49 percent per year to January 31, 2017. But its average investor only earned a compound annual return of 4.18 percent.
Investors in Vanguard’s Small Cap Growth Index (VISGX) behaved a bit better. The fund earned a ten-year compound annual return of 8.09 percent. Its investors averaged a compound annual return of 7.53 percent.
This brings us back to Dimensional Fund Advisors. These funds are also factor-based. Most of DFA’s investors hope to beat the market. But they won’t win every year. Investors in actively managed funds jump around a lot. Investors in Vanguard’s factor-based funds appear to do the same. Perhaps that’s why DFA puts Big Brother in the captain’s chair. They promote a buy-and-hold approach instead of speculation.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.