Mays or Mantle? Manning or Brady? Batman or Superman? Sometimes it’s not easy to decide who really is the best. A similar argument rages among index mutual fund investors. Is Vanguard the best index mutual fund family, or has Dimensional Fund Advisors (DFA) taken the throne? What is Indexing?
While both fund families offer low-cost, no-load mutual funds, they are distinctly different in one very important way: Vanguard’s index funds are tied directly to indexes, while DFA funds are not. The is no DFA fund that owns all the stocks in the Standard & Poor’s 500, for example. Instead, DFA invests in asset classes, which are similar indexes with some crucial differences. These critical distinctions gives DFA an important advantage over Vanguard. For example, DFA doesn’t have to buy and sell the stocks of the index as they are added and subtracted. Being required to make these purchases and sales can lead to imperfect pricing, as prices rise unreasonably for stocks about to be added and fall similarly for those being dropped.
Dimensional calls their own shots, buying and selling gradually as stocks move in and out of asset classes. This gives them trading advantages over Vanguard, which can add a small amount t your return.
The Bigger They are, the Harder They Fall
Now let’s talk about DFA’s size advantage. Because of its passive asset management approach, DFA is able to own more small company stocks than Vanguard.
Most investors have too much of their money tied up in big companies. That’s understandable, because most of the financial industry feels the need to offer more immediately large capitalization oriented stock funds. In addition, most index funds are “market capitalization weighted.” Which means that most of the portfolios are made up of the biggest companies. Yet, smaller stocks have offered investors better returns.
Let’s look back 81 years. From 1928 through 2009, large companies made 9.33% a year. Not bad except for the fact that small companies returned 10.33% a year. Thanks to the power of compounding, one dollar invested in large companies in 1928 would have grown to $1,497 by the end of 2009. But that same one dollar invested in small companies became whopping $4,269. Advantage: DFA.
What Made Warren Famous?
DFA also has a clear advantage over Vanguard is the type of companies it owns.
How did Warren Buffet become the “world’s greatest investor?” How was it possible for Jim Miller to beat the Standard & Poor’s 500, year after year?
It’s not really that complicated: they owned companies that were out-of-favor with the bulk of investors. These, typically temporarily, unloved firms are known as value stocks. Value investing has historically displayed generous advantage over growth investing.
Let’s go back in time, again. Large U.S. firms that are considered to be value companies (according to a formula that compares market price to a firm’s “book” value) returned 10.18% a year from 1928-2009, while large growth firms, during that same time frame, returned just 8.73% per annum. That meant that a single dollar invested in value stocks grew to $2,842. Over that same 81 year period growth stocks would have made you only $955. Again, advantage: DFA.
There are a couple of other items worth mentioning. The first is turnover, that is the amount of buying and selling done inside your mutual fund. This is a critical area for mutual fund owners that is long ignored, and costly. It’s hard to precisely quantify the cost but every purchase or sale of a stock in a mutual fund creates an transaction fee as well as the difference between the bid and ask of that security. Dimensional’s funds have lower turnover than Vanguard, saving their investors money. DFA wins this battle.
The Big D
Finally, Dimensional’s funds average more than 1,600 stocks each. So, when a Washington Mutual goes out of business, a GM heads south, or a Microsoft loses half of its value, you have literally hundreds (or thousands - when you build a globally diversified portfolio) of stocks to keep the portfolio afloat. Vanguard, on the other hand, averages about 600 stocks in each of its funds. While that is still more than the vast majority of stock mutual funds DFA has a clear edge in protecting its investors against individual company risk. Better diversification: DFA.
Sounds Bad for Vanguard, but...
Vanguard is still one of the finest mutual fund companies in the business. (and we use some of their fixed income funds when we manage money for our clients). For do-it-yourself investors, they are one of the best fund groups available. However, DFA, with its tilt toward smaller firms, academically based emphasis on value companies, lower turnover, and greater diversification, make it a better choice for investors.
After adding up all of DFA’s advantages we believe they will provide a better return for investors.