DFA’s Dominance

A few weeks ago I pointed out the fact that Vanguard’s stock funds have had an enviable run of outperformance in relation to their benchmarks. I feel that the active fund industry can learn a lot from Vanguard’s process. In last weekend’s Barron’s there was a table that showed that 3 out of the top 4 active funds in terms of performance were from Vanguard.

A few people wrote in and urged me to point out another fund company with similar long-term principles and lower costs – Dimensional Fund Advisors (DFA). DFA has been in the fund business for over 30 years and has well over $300 billion in assets under management. DFA focuses most of their offerings on small cap and value funds based on the weight of historical evidence of the size and value premiums.

Here’s a list of some of the biggest DFA funds since their respective inception dates against their relevant benchmarks (all returns through year-end 2014):

U.S. Stocks
DFA US Large Value fund vs. Russell 1000 Value Index since 3/1993 = +10.5% vs +10.0%
DFA US Micro Cap fund vs. Russell Micro Cap Index since 7/2000 = +9.5% vs. +7.6%
DFA US Small Value fund vs. Russell 2000 Value Index since 4/1993 = +12.5% vs. +10.6%

International Stocks
DFA Int’l Value fund vs. MSCI EAFE Value Index since 3/1994 = +6.5% vs. +5.7%
DFA Int’l Small Cap fund vs. MSCI EAFE Small Cap Index since 1/1999 = +9.3% vs. +7.9%
DFA Int’l Small Value fund vs. MSCI EAFE Small Cap Value Index since 1/1995 = +7.6% vs. +7.0%

Emerging Markets Stocks
DFA Emerging Mkts Value fund vs. MSCI EM Value Index since 1/1999 = +12.7% vs. +10.6%
DFA Emerging Mkts Small Cap fund vs. MSCI EM Small Cap Index since 4/1998 = +12.1% vs. +7.5%

Bonds
DFA Five-Year Global Bond fund vs. Citigroup World Gov’t Bond Index 1-5YR since 12/1990 = +5.7% vs. +5.0%
DFA Intermediate Gov’t fund vs. Barclays Gov’t Bond Index since 11/1990 = +6.7% vs. 6.2%

You can see that these funds all have very long track records of outperformance. Many investors mistake passive investing with index investing but quantitative investing isn’t reserved for market performance. It’s surprising that DFA’s lower-cost hybrid passive/active fund process hasn’t been replicated by more fund companies. ETFs seem to be heading in the direction of creating a systematic process that’s based on historical evidence, but it’s taken quite a long time.

The unique aspect of DFA is that retail investors can only access their funds through DFA-approved financial advisors. To say their network of financial advisors is loyal would be an understatement. A recent piece in Investment News makes this clear:

Indeed, for many advisers, DFA’s investment philosophy is more than an approach to investing.

It is a religion.

“We are pretty passionate about it,” said Harold Evensky, president of Evensky & Katz Wealth Management, which allocates part of its equity portfolios to DFA Funds. “I joke about the “Kool-Aid,’ but I’ve drank it, and I believe in it.”

DFA goes to great lengths to ensure that their advisors think and act for the long-term when using their funds. Education and client coaching are important ways to reduce the behavior gap, so I think other fund firms could learn a thing or two from DFA’s approach.

No one knows for sure whether tilting to small caps or value funds will lead to similar outperformance in the future. It’s impossible to make that prediction with certainty. There will likely be long periods where these types of tilts don’t work over a number of years. Nothing works all the time. The reason most investment strategies work over the long-term is because they don’t always work over the short-term. But a disciplined process that focuses on longer time frames gives investors much higher odds for success, which really is the best you can hope for.

Sources:
Screening process at DFA inspires devotion, loyalty (Investment News)

*Hat tip to Eric Nelson at Servo Wealth Management for pointing me in the right direction on the most popular DFA fund options.

Further Reading:
Why aren’t there more value funds?
Why value investing works

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What's been said:

Discussions found on the web
  1. Paul Meloan commented on Jan 14

    Ben, I write this as a professional advisor who has utilized DFA in client portfolios for the past 16 years. The evidence behind it is clear and convincing, but it is only the type of case that can be made over years or perhaps decades. That makes it difficult for many to accept; investing remains this sort of “Lake Wobegon” where everyone believes they are above average. As far as the evidence goes, I argued back in 2013 that this makes DFA the opposite of religion (have to disagree with Harold here!) http://paulmeloan.com/2013/09/18/investing-without-faith/

    • Ben commented on Jan 14

      Great points. That’s probably why more fund firms don’t utilize their approach. Obviously their numbers didn’t look too great in 2000 after the large cap growth run of outperformance. Thanks for sharing. Makes sense.

  2. Steve commented on Jan 14

    Good points that DFA’s tilting may go many years with underperformance again. One other point is that their performance is further reduced by the management fee required. They are only sold through advisors. So is the net return really worth the risk of their reliance on small and value stocks? Some of the greats do not think so.

    • Ben commented on Jan 14

      That’s true, but pretty much the only way to get those small/value premiums is by being disciplined for the long-term. See Eric’s comments below on the value of an advisor’s services. I definitely think certain investors can do it on their own, but only if they can stay out of their own way. It’s a fairly small number that can do this in my mind, but it’s not impossible. Depends how much help you need in those other areas.

  3. John commented on Jan 14

    Can the DFA out performance not be replicated by using the Vanguard small cap value fund? Or the secret sauce for DFA is in the list of stocks which make up their small cap value fund and others do not have knowledge of the fund composition?

    • Ben commented on Jan 14

      Vanguard didn’t always use the CRSP data to break out small caps but in the past few years that’s changed. There are a few other minor tweaks DFA makes to their funds as far as excluding certain securities but I would imagine they’ll be fairly close going forward.

  4. eric commented on Jan 14

    Ben,

    Enjoyed the article. Good points on discipline and the need to stay the course. Whether it’s stocks vs bonds, small vs large, value vs growth, or domestic vs foreign, investors need to be prepared for their approach to “under perform” for long periods.

    One other point, on advisor fees, they typically go to pay for a wide variety of services: retirement planning, advice on estate planning and tax management, risk management, charitable giving and liquidity planning. Not to mention ongoing education, portfolio counseling and discipline as well as multi-generational continuity. If investors don’t think they need any of these services and aren’t suffering from over optimism in their abilities, then don’t pay an advisor. If all they want is a conduit to institutional-class funds (caveat emptor) the going rate is about 1k, a rounding error on a reasonable portfolio.

    • Ben commented on Jan 14

      Very true. A good advisor will be worth their fee for all of the reasons you listed. People can get small/value exposure on their own, but it really depends on how disciplined they are and whether or not they can do all of the other financial planning tasks you outlined. It’s a very small % in my opinion.

  5. Jim Haygood commented on Jan 14

    “I joke about the “Kool-Aid,’ but I’ve drank it.”

    I drunk it; you’ve drank it. Let’s english!

  6. BA commented on Jan 15

    Ben,
    I am a big fan of your musings. While I do appreciate the investment vehicles offered by Vanguard and DFA, I have often wondered what the actual “investor returns” are for the group that calls themselves “passive investors.” Perhaps the data is out there similar to what Dalbar provides regarding 401k data and what Morningstar tracks as “investor returns”, but I am not aware of it. When looked at individually for each fund, your point is well taken, however, a DIY investor or an advisor still must make a selection regarding allocation and stay the course and/or rebalance along the way throughout the entire market cycle.
    It is my experience as one who is long in the tooth and as any POW will tell you, everybody has their breaking point. Humans are still humans and markets are still markets and as you know, the two never mix very well! Passive investing used to be defined essentially as not being a stock picker. It now seems to be the holy grail whereby one can easily maximize returns for a given risk with minimal effort, all the while casting a spell over the investor preventing him/her from inevitable bad behavior. The investment equivalent of the furnace thermostat.
    Perhaps it is my grizzled cynicism, but after 6 years of straight up markets one has to wonder if this now popular approach will stick or is just the latest example of bull market populism.

    • Ben commented on Jan 15

      Valid points. This could be something I look into for a future post. I’ll take a look at the Morningstar behavior gap numbers. Thanks for the idea. Stay tuned…

      • eric commented on Jan 15

        Generally both Vanguard and DFA have very sticky, long-term oriented assets. The M* behavior gap calculations don’t always illustrate this but that’s more a function of the conflict between IRR calculations and a growing asset base into funds with volatile returns.

        And, clearly, “passive” investing has become more popular during the 6-year bull market for stocks. But I’m not sure a bear market will dent that popularity any. First – there isn’t a lot of evidence that active managers are good at avoiding bad stocks and only holding the winners. I don’t recall stalwarts Longleaf or Dodge & Cox having 2008 returns worth mentioning. Those that save a few % in downside typically do by holding ~10% or more in cash for redemptions or whatever.
        Second – “passive” investors who hold some high-quality bonds tend to cushion the blow pretty well without resorting to stock picking or market timing tactics. It’s asset allocation that drives risk/return, not security selection.

        As to whether an investor will stick with a passive vs active portfolio more reliably during a bear market, I think most investors have their trembling fingers on the sell button regardless of which approach they favor.

    • AmericanFool commented on Jan 16

      I imagine passive investors have a wide range of results, but people often take a while to get the passive religion. Reasoning from an example of one(!), I can tell you that I have 20 years of fairly passive investing (can’t claim to be consistent the entire 20 years, but i didn’t buy high and sell low at any point, if you get my drift). Over 20 years the arithmetic avg of my portfolio returns is 10.4%, geometric 9.6%, and weighted by amount invested each year it’s 8.0% (that’s my own invented version of ‘what have you done for me lately’.) I think people tend to be either/or – either like me: never buy or sell out of fear (but i may shift my portfolio a bit sometimes if I have a thesis), or like my dad: a really smart guy but a really bad market timer.

  7. Steve Adams commented on Jan 15

    Ben,

    Thanks for the article. While DFA had a run in the 90s (after a disastrous first 15 years), it’s merely and index hugger now (before fees, including the advisor fee layer).

    https://dfavsvanguard.wordpress.com/

    • Ben commented on Jan 16

      Well that’s just one fund offering. And the only reason DFA had a “disastrous” first 15 years is because that was one of the worst periods ever for small/value. Every value manager got crushed on a relative basis. The fact that they stayed true to their small/value roots is actually commendable in my book. More here:

      http://finance.yahoo.com/news/dfa-model-140000638.html

      • Eric commented on Jan 24

        Ben, spot on. Many individual investors have a very narrow and short-term focus which is why such a large behavioral gap exists between fund returns and investor returns.

        Incidentially, the DFA US Vector fund is designed to capture about 50% of the returns on small value stocks above/below the US market. From inception in 2006, it’s earned +200%, compared to +204% for Vanguard Total Stock Index and +197% for DFA US Small Value. Exactly what you’d expect, even if it isn’t what you planned on (a premium for holding small/value stocks over the market).

        We see different results for the DFA Int’l Vector fund (same goal as US version) and EM Core funds since 8/2008 (inception of Int’l Vector) through 12/2014:

        Vanguard Developed Markets Index = +17%
        DFA Int’l Vector fund = +31%
        DFA Int’l Small Value fund = +45%
        ————————————
        Vanguard Emerging Markets Index = +13%
        DFA EM Core fund = +27%

        So when there IS a small/value premium, DFA’s market-wide Core/Vector funds will capture their fair share of it without the need to hold multiple market/small/value strategies and incur the added trading/rebalancing/tax costs. When there isn’t (see US Vector since 2006), they won’t.

        There has been a strong size/value premium in the US since the recovery began in 3/2009, and we see this play out in US fund results (through 12/2014):
        Vanguard Total Stock Index = +325%
        DFA US Vector fund = +357%
        DFA US Small Value fund = +387%

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