I've been getting a lot of questions lately about the passive mutual funds available through an advisor from Dimensional Fund Advisors (DFA), especially in comparison to the index funds available through Vanguard. There aren't a lot of “good guys” out there amongst the dozens of mutual funds companies on the planet. Bridgeway donates half of it's profits to charity. Charles Schwab, Fidelity, and Ishares offer a number of very low cost index funds and ETFs, although critics argue only because of the pressure from mutually-owned Vanguard. But two firms stand out amongst the others for their real commitment to passive investing, Vanguard and DFA. Most of you are familiar with Vanguard, a long-time champion for the do-it-yourself individual investor. You may not be as familiar with DFA, which although not as low-cost as Vanguard, and offered only through investment advisors, also offers a lot of great investment options which in many cases are better than Vanguard's offering.
What Does DFA Do That Vanguard Doesn't?
Index funds are great. Actually, they're not great, but they're so much better than actively managed funds due to their low costs and lack of underperformance that they look great in comparison. Like democracy and capitalism, they're the worst possible system, except everything else that's ever been tried. Indexing has its issues, and DFA has made a concerted effort to improve upon index funds without abandoning their most important aspects.
I had the opportunity to interview Weston Wellington, a vice president with DFA about the “DFA advantage.” Weston is a very reasonable and intelligent guy as evidenced by his careful phrasing and humility about what DFA does, and does not do. They do a lot of things very similarly to the indexers at Vanguard- i.e. invest passively (although he hates that phrase because it implies he isn't doing anything, preferring instead the word “equilibrium”) and keep costs low. But I'm going to focus on the differences.
The most significant thing that DFA and its network of authorized advisors do is to tilt portfolios toward small and value stocks. These higher risk stocks have higher expected returns. You can tilt a portfolio of non-DFA index funds to small and value easily enough, but many do-it-yourself indexers don't whereas very few users of DFA funds don't have a significant tilt to these risk factors. The research cited by DFA is that 96% of equity returns are explained by market, value, and small factors. The new “profitability” factor added on top of that is likely to add a small amount of additional value, although Mr. Wellington didn't want to be quoted about how big he thought that was likely to be. I asked him whether he felt the additional expected return with small, value, and profitable stocks was a “risk story” (i.e. small, value, and profitable stocks are riskier and thus carry higher expected returns) or a “free lunch” (i.e. diversification to additional risk factors actually makes the portfolio less risky). Weston was decidedly in the “risk” camp emphasizing that the future may very well not resemble the past and the risks of small, value, and profitable stocks may very well show up in the future and provide lower than market returns over a long time period.
Aside from tilting toward additional risk factors, DFA also does a number of “little things” that give their funds a bit of an edge over a comparable Vanguard fund. They like to divide these up into management, engineering, and trading. The management refers to designing an “equilibrium” (i.e. passive) portfolio so it is appropriately tilted to compensated risk factors. Engineering refers to applying their eligibility rules for a given fund. For example, they exclude REITs from their small cap value fund, arguing that they are essentially different beasts and a different asset class. Another eligibility rule they use is that they don't buy stocks unless that stock has at least 4 market makers. They also do not let an outside provider (such as a commercial index) dictate what stocks they should hold. Tracking error against an index doesn't bother these guys. Rather than reconstituting quarterly or yearly as many indexes and the funds that follow them do, they do it each day as stocks increase or decrease in value. DFA uses its “core funds” to further decrease turnover costs. Trading refers to their patient trading philosophy. They use buffer zones to so that they can trade smartly, minimizing trading costs. They try to be providers of liquidity rather than paying a liquidity premium. Along those same lines, they do security lending (lending securities to short sellers) to further boost returns.
DFA also tries to minimize turnover within the fund by forcing their investors to use some of the most highly-educated advisors out there. Many of them are CFAs, essentially the highest designation for an asset manager, and they have attended a number of seminars so they understand the academic research and exactly what DFA is trying to do. Their theory is that an investor guided by an advisor is less likely to be trying to time the market by jumping in and out of the funds and less likely to bail in a down market, minimizing costs and boosting performance for the fund. DFA actually started out investing only institutional money, but started bringing on individual investors only because of the guarantee from advisors that they wouldn't get “hot money.”
So How Does DFA Do?
A number of smart individual investors have wondered whether it is worth it to hire a DFA authorized advisor just to get access to DFA funds. They've tried to do their best to compare apples to apples using a similar collection of non-DFA funds to DFA funds and tried to determine just how big the DFA advantage is, especially AFTER the cost of the advisor. Obviously for an investor who values the other services of the advisor, that may not be a fair comparison. I'm convinced that for some investors, they'd be better off paying an advisor 5% a year than doing it on their own. But for the intelligent investor with a reasonable demeanor, is it worth hiring an advisor JUST for access to the DFA funds? This question becomes more and more relevant as advisory fees drop, sometimes as low as $1000 a year from a firm like FPL Capital (one of my advertisers) or Rick Ferri's Portfolio Solutions (as low as 0.37% a year with a minimum of $3700 per year). More traditional firms tend to charge around 1% a year for assets under management.
For some asset classes, such as large US Stocks, DFA doesn't seem to make much of a difference. DFA's large company fund (DFUSX) is very similar to Vanguard's 500 fund (VFIAX), although it charges a slightly higher expense ratio (10 basis points vs 5 for the Vanguard fund). The performance difference? According to Morningstar, DFUSX has had an average annual return (arithmetic) of 7.96% per year for the last ten years, compared to 7.94% per year for the Vanguard fund. Am I going to pay 0.37%, much less 1% to get DFA access to that fund? No way. For other asset classes, however, the difference is larger.
Some of the Bogleheads and a number of DFA authorized advisors have tried to make comparisons between the two, but in the quest to compare apples to apples, the results tend to differ enough due to different methodology that it's hard to get an exact answer. Altruist Financial Advisors has a discussion of DFA vs Vanguard (and some recommendations for each asset class) on their site. FPL Advisors, one of my advertisers, has something similar on their site. Rick Ferri and Larry Swedroe, other well-known authors and DFA authorized advisors use both DFA funds and funds from other companies like Vanguard and Bridgeway in their portfolios. Tom Martin, at Larson Financial Advisors, gives clients a comparison sheet which can give you some idea of the size of the “DFA advantage”. This is my attempt at a comparison.
DFA Vs Vanguard
|10 Year Returns|
|Asset Class||Reasonable Index||DFA||DFA ER||Non-DFA||Non-DFA ER||DFA||DFA – 1% fee||Non DFA|
|US Large Stocks||S&P 500||DFUSX||0.10%||VFIAX||0.05%||7.96%||6.96%||7.94%|
|US Small Stocks||CRSP US Small Cap||DFSTX||0.37%||VSMAX||0.10%||11.42%||10.42%||11.73%|
|US SCV Stocks||CRSP US SCV||DFSVX||0.52%||VSIAX||0.10%||12.16%||11.16%||10.87%|
|Microcap Stocks||CRSP 9-10||DFSCX||0.52%||BRSIX||0.87%||10.87%||9.87%||9.59%|
|Intl Developed LC||FTSE Dev Ex-NA||DFALX||0.30%||VDMAX||0.10%||8.94%||7.94%||9.03%|
|Intl Small||FTSE Global SC Ex-US||DFISX||0.56%||VFSVX||0.45%||11.12%||10.12%||9.42%|
|Emerging Markets||FTSE Emerging Index||DFEMX||0.61%||VEMAX||0.18%||15.99%||14.99%||15.64%|
|US Real Estate||MSCI US REIT||DFREX||0.18%||VGSLX||0.10%||12.14%||11.14%||12.52%|
|TIPS||Barclays Series L TIPS||DIPSX||0.13%||VAIPX||0.10%||6.17%||5.17%||5.70%|
|Corporate Bonds||Barclays 5-10Y Credit||DFAPX||0.22%||VFICX||0.20%||2.92%||1.92%||5.58%|
|ST Federal||Barclays 1-5Y Gov||DFFGX||0.20%||VSGDX||0.10%||3.14%||2.14%||3.37%|
I tried to be as fair as I could with the data and compare apples to apples as much as possible. Ten year average annualized returns as reported on Morningstar on 5/15/13 were used wherever possible (Intl small used 3 years, corporates used 1 year). When looking at the asset classes where the DFA and non-DFA portfolios are very similar (US Large, Intl Small, EM, Real Estate, and TIPS), DFA won 2, non-DFA won 2, and we'll call US Large a tie. Subtract a 1% management fee, and the non-DFA funds handily win 4 out of 5.
Apples and Oranges?
Some of the portfolios are fairly different, for example the average stock in the DFA Small Cap fund is half the size of the one in the Vanguard fund. Likewise, the average stock in the DFA Micro Cap fund is over 3 times the size of the one in the Bridgeway fund and the Bridgeway fund is far more valuey. Vanguard's SCV fund is nearly as valuey as the DFA fund, but not nearly as small. The DFA international developed fund includes Canada, but the Vanguard one does not. This makes the comparison difficult.
I asked Mr. Wellington about quantifying the DFA advantage. He points out that over the last 31 years DFA's small cap fund has outperformed the Russell 2000 by 165 basis points (1.65%) a year but he is careful to note that may not persist. He admits the advantage may be much lower in other asset classes. As noted above, much of that 1.65% may be explained simply by the fact that the DFA fund holds much smaller stocks than the Russell 2000.
What about the entire portfolio? If I made two portfolios using these asset classes, one composed of the DFA funds and one composed of the non-DFA funds, I could figure out what the “DFA advantage” really would be. A priori (just like I chose the asset classes above), I decided my asset allocation would be 15% US Large, 5% US Small, 5% US Small cap value, 5% microcap, 10% international developed, 5% international small, 7.5% emerging markets, 7.5% real estate, 15% TIPS, 10% corporates, and 15% Federal bonds, for a 60/40 portfolio where 37.5% of the equity is international. I then calculated the DFA advantage. I calculated it out to be a MINUS 0.04%, or essentially a tie. That was before any advisory fee, but any advisory fee you add on is going to make the DFA portfolio look even worse.
There's No DFA Advantage?
Well there could be. If your portfolio was more heavily tilted toward those asset classes where DFA seems to do very well, like small cap value, international small, EM, and TIPS, then there would be. Your advisor may also choose to use non-DFA funds where they appear to be superior. But certainly any reasonable interpretation of the data would not justify a statement that DFA funds were dramatically better than the alternatives, and certainly not sufficiently superior to justify the hiring of an otherwise unvalued investment advisor. However, if I were going to hire an investment advisor anyway (I'm not of course), I would definitely make sure said advisor had access to DFA funds. Not only would that give me access to those funds, but it would also ensure my advisor was reasonably well-educated with regards to the academic investing literature and knew the importance of developing a good plan and staying the course with it.
I asked Mr. Wellington directly whether a disciplined, educated do-it-yourself investor should hire a DFA-authorized advisor just to get access to the funds and his answer was an emphatic no. He based his argument on philosophical factors, however. He felt that if the only reason you were hiring an advisor was to boost performance by access to better funds, and didn't value the other things the advisor brought to the table, like portfolio design, maintenance, and what diehard do-it-yourselfers like to refer to as handholding, then every time you met the focus would be on “performance, performance, performance” and that the relationship wouldn't be very satisfying to either of you, especially when the inevitable, hopefully temporary, underperformance versus a do-it-yourself portfolio occurs.
I also asked if they'd ever consider allowing individual investors direct access to the funds. He noted they weren't staffed to service individual investors directly and also that he felt the number of individual investors out there who had the knowledge and temperament to manage their own portfolio were so few that it wasn't worth it, pointing out that “even Tiger Woods has a golf coach. Most investors just can't sit still and get market returns.”
So in the end, if you are an educated and disciplined investor, don't go out and hire an advisor just to get DFA funds. There is probably an advantage there, especially in certain asset classes, but it isn't large enough to pay for the advisory fees by itself. But before you decide to do it on your own, you'd better be sure you're sufficiently educated and disciplined to implement and maintain an intelligent portfolio over the long run.
What do you think? If DFA funds were available without any advisory relationship which ones would you use? Have you considered hiring an advisor to get access to DFA funds? Comment below!