Last Updated Apr 28, 2010 9:51 AM EDT
Analyzing the Data A week ago, Allan Roth cited a study that showed DFA funds had underperformed Vanguard funds from 1983-1995 and then outperformed. Thus, which fund family is better is dependent on the time period studied. Let me offer another explanation.
DFA introduced its first equity fund -- the DFA Micro Cap Portfolio (DFSCX) -- in late 1981. That was its only equity fund until late 1990, when it introduced its Large Cap Portfolio (DFLCX). DFA added a small-cap fund in 1992 and value funds in 1993. So prior to 1993, there really wasn't much to compare except for small-cap funds. And here's the important point.
For the period that Vanguard funds outperformed, the size premium was -1.6 percent. Thus, we should expect that the Vanguard fund with less exposure to the risk factor would outperform in such a period, though not over the long term. However, from 1996 through August 2009 (when the study found that the DFA funds had outperformed), the size and value premiums were positive at 2.2 percent and 3.7 percent, respectively. Note that both fund families were accomplishing their objectives of providing exposure to risk factors. The funds just offer different exposures. Thus, different outcomes should be expected, depending on whether the risk premiums are positive or negative.
Need to See the Whole Picture*
One mistake investors make is to only focus on expense ratios when comparing funds. However, there's more to the story. For example, DFA has historically been able to generate higher earnings from securities lending. Security lending revenue enhances net returns just as any expenses penalize returns. (You should examine all sources of income and expenses before concluding which vehicle appears to be the most advantageous.) In addition, DFA has been able to add value by implementing certain screens and patient block trading strategies.
Other Factors to Consider Another important issue to consider is that DFA offers core funds that combine various asset classes into one fund. The "core" strategy is designed to reduce turnover expenses and improve tax efficiency. Another benefit is the reduced need for rebalancing between funds. The strategy is the same as the one used to combine developed and emerging markets into one fund.
Another consideration is that DFA offers funds in some asset classes that Vanguard doesn't -- asset classes that are good diversifiers of U.S. equity risks and also carry risk premiums. Among these are emerging markets small-cap and value and international small-cap and small-cap value.
Summary When considering two passively managed funds from the same asset class, there's more to consider than the expense ratio. Among the many other considerations are securities lending revenue, weighted average book-to-market, weighted average market capitalization, number of securities held (more is generally better), how often the fund reconstitutes its index (more frequent is better), other portfolio construction rules and block trading strategies. And if the fund requires the use of an advisor, one should not only consider the advisor's fee, but also the value added (if any) by the advisor.
For more information on this topic, see my article on Indexing vs. Passive Asset Class Investing on my company's Web site.
*I edited the paragraph under the "Need to See the Whole Picture" section for clarity after some comments from a colleague. It originally read "For example, DFA has historically been able to generate higher earnings from securities lending, revenues that first go to offsetting a fund's expense ratio."