Similar Fund Companies, Yet Still Different

While all squares are rectangles, not all rectangles are squares. Similarly, while all index funds are passively managed, not all passively managed funds are index funds. The trading strategies of Vanguard and DFA, two of the leading providers of passively managed mutual funds, provide a perfect illustration.

Vanguard's funds are index funds. DFA's funds are not index funds (with one exception -- the DFA US Large Company Portfolio (DFUSX), which is an S&P 500 Index fund). Instead, they're structured portfolios. The construction rules are based on academic definitions of asset classes (instead of popular indexes). And while indexes typically are reconstituted annually, DFA reconstitutes its portfolios on a daily basis. In addition, DFA attempts to add value in several other ways, including screening certain stocks -- such as very low priced stocks, companies in bankruptcy, IPOs and stocks exhibiting negative momentum. DFA also attempts to add value by what is called patient trading.

Index funds must trade when stocks enter or exit an index (though the indexes Vanguard tracks do have hold ranges). They must also hold the exact weighting of each security in the index (or they will be subject to tracking error). A fund with a goal of earning the return of the asset class and willing to live with tracking error can be more patient in its trading strategy, using market orders to reduce transactions costs. Patient trading strategies can improve returns by providing liquidity to actively managed funds that desire to quickly sell large blocks of stock.
Sunil Wahal, professor of finance at Arizona State University and a DFA vice president, examined all of DFAs U.S. trades from 2007 through 2009 -- more than 1.3 million transactions representing almost $89 billion of volume. The goal was to estimate the magnitude of the benefit of DFA's patient trading approach.

Wahil developed an algorithm that effectively asked the question: If traders were instructed to trade a given amount, at what price could they reasonably expect to deliver those shares? He then compared that price to the price at which DFA actually transacted. Here's what he found:

• For the full sample, DFA's patient trading strategy saved 80 basis points on buys and 73 basis points on sells.
• As you would expect, the greatest savings came on trades in the smallest stocks. For buys/sells, the savings for small-cap, mid-cap and large-cap stocks were 109/88, 66/77 and 46/42 basis points, respectively

For further reading, see my posts comparing Vanguard and DFA funds and discussing additional differences between the two companies.