Christian Chensvold

DFA vs Vanguard

In politics, the winner isn't necessarily the best candidate, but the most well known. A similar case exists among mutual funds. Ask an investor who the index fund frontrunner is, and he'll likely tell you Vanguard. Ask why, and he'll probably say something about selection, low expense and a straightforward index style. But ignorance isn't bliss for an investor — it's doom.

Research shows that for a long-term investment strategy, Dimensional Fund Advisors (DFA) consistently delivers superior results to Vanguard. In a survey of between 1,100 and 2,000 investment advisors held three times between 1997-2002, Dalbar Research rated DFA best overall mutual fund company, sometimes well above Vanguard. Part of the misconception lies in the fact that DFA funds are mostly owned by institutions and are not easy for the average investor to buy. There is good reason for this.

In a recent Money Magazine survey about investing, the average investor scored a paltry 37 percent. DFA keeps these less-informed investors (who are also more likely to churn) out of its funds by only selling through a select network of independent investment advisors, such as Index Funds Advisors(IFA) in Irvine, California (www.ifa.com). These advisors are able to educate investors about the failings of active management and encourage them to take a buy-and-hold approach that keeps DFA's operating expenses low and benefits all shareholders. DFA has been called an investment club for the really smart investor.

Smart doesn't begin to describe the company's founders, scholars David Booth and Rex Sinquefield from the University of Chicago, global epicenter of Nobel Prize laureates in economics. DFA's investment strategy, designed primarily by Eugene Fama and Kenneth French, is backed by academic research and a historical perspective dating back to 1926.

It all starts with a DFA's indexes, which are quite different from Vanguard's. Vanguard does not create its own indexes, choosing to employ third-party ones, such as the MSCI and Wilshire indexes. The difference is that these and other indexes like them were designed for measurement, not as investment vehicles.

DFA has custom designed its indexes to capture the risk factors that explain 95% of stock market returns since 1929: company size (market capitalization) and value (based on the company's Book Value divided by its Market Capitalization, or Book to Market Ratio (BtM)). This is a significant difference, since returns correlate with risk factors like size and value.

In nearly all asset classes DFA is more heavily weighted toward small-company stocks than Vanguard. Historically, smaller-company stocks have outperformed larger-company stocks in the long haul. In addition, value stocks outperform the more popular growth stocks. DFA's greater orientation to value (namely the lower price-book ratio of its portfolio) makes it more likely to outperform funds that are more growth oriented. The scatter plot below illustrates the higher returns of small and value of the last 77 years.

Investors often assume that all index funds in a category like "small cap" are going to be the same. This is wrong.The average market cap of companies in Vanguard's Small Value index is about $1 billion. In DFA's same category the average market cap is $442 million. Over the past three years Vanguard's fund earned an average of 8.4% percent, DFA's 19.2 percent, or a total return difference of 42%, as of Jan 30, 2004.

Smaller company size equals greater risk, but historically that has translated into a vastly greater return. In the above example, Vanguard's Small Value fund had a return per unit of risk, or Sharpe ratio, of 0.4, while DFA's was 0.7. Basically, more gain per unit of pain, due to the application of financial science.

Index Funds Advisors' and Dimensional Fund Advisors' guiding principles are a no-forecasting investment strategy using the definition of an index fund as "a mutual fund with a clearly defined set of rules of ownership that are adhered to regardless of current market conditions."

Wise words from wise firms.