As you can see, the addition of either of the two small value funds improved both the returns and the risk-adjusted returns (Sharpe ratio) of our starting portfolio.
Portfolio B, using DFSVX, produced higher returns (8.0 percent versus 7.2 percent) than Portfolio C using VISVX. But it also experienced higher volatility (10.8 percent versus 9.6 percent), and it also experienced a greater worst-case loss (16.9 percent versus 15.5 percent).
Portfolio B delivered a slightly higher Sharpe ratio than Portfolio C (0.59 versus 0.57).
The most efficient portfolio of them all, however, was Portfolio D, which held the least amount of equity. Despite having an equity allocation of just 50 percent, it produced a higher return than either Portfolio A or C, and it did so with lower volatility than either.
It also experienced a much lower worse-case loss. Portfolio D's Sharpe ratio was 0.67 percent—72 percent higher than Portfolio A's Sharpe ratio, 21 percent higher than Portfolio C's Sharpe ratio, and 17 percent higher than Portfolio B's Sharpe ratio.
This example demonstrates that there are two ways an investor can benefit from adding exposure to factors such as size and value to their portfolios. You can use the higher expected returns and non-perfect correlations to increase expected returns without proportionally increasing risk, because of the diversification benefits. This is the way most investors have been shown to use the factor exposures.
Alternatively, you can use those higher expected returns and diversification benefits to lower the amount of equity needed in the portfolio to achieve the same expected return.
This second alternative is the strategy discussed in detail in a new book co-authored with my colleague Kevin Grogan, "Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns With Less Volatility." We believe this is an especially effective strategy for risk-averse investors—investors who have a relatively low marginal utility of wealth and are thus more concerned about wealth preservation than they are about wealth accumulation.
The bottom line is that even two "passively managed" funds in the same asset class can produce very different returns and different risks. It's important that each investor choose the fund that best meets his or her individual objectives.
That said, the greater the exposure of a fund to the factors of size and value (the smaller the market capitalization and the lower the prices to book value, earnings and cash flow), the less equity risk the investor will need to meet their objective, and the less tail risk there will be; that is, the smaller the worst-case drawn down will be.
An additional benefit of the strategy is that the lower equity allocation allows you to hold more safe bonds, and the costs of implementing the bond allocation are lower than they are for the equity portion. In fact, if you limit your holdings to Treasurys, government agencies, FDIC-insured CDs and AAA/AA-rated municipal bonds that are also general obligation bonds and essential services bonds (as we recommend), then you can build your own portfolio, eliminating the costs of a mutual fund, though you would lose some of the convenience benefits a fund offers.
In the end, passive investors today have many good options, beyond DFA and Vanguard, for investing in small value funds. Among them are Bridgeway funds and ETFs from Guggenheim, iShares, Stage Street Global Advisors and Wisdom Tree.
Larry Swedroe is a director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.