A look at returns of an index fund versus competing structured funds tells an interesting tale.
This is the third in a series of articles about using structured portfolios to minimize the negatives and maximize the positives of indexing. You can find the first two articles here and here. A version of this article originally appeared on Advisor Perspectives here.
A well-designed structured portfolio maximizes the benefits of indexing while minimizing, or even eliminating, the negatives. In return for accepting tracking-error risk, structured portfolios can gain greater exposure to factors that have historically offered risk premiums. For example, a small-value fund could be structured to own smaller and higher-value stocks than a small-cap index fund might.
The following table, with data available from Morningstar as of June 17, 2014, illustrates various metrics for three small-value funds from three different fund families—the Vanguard Small-Cap Value ETF (VBR | A-100), a Dimensional Fund Advisors (DFA) structured fund and a Bridgeway structured fund.
The table shows the weighted average market capitalization to demonstrate a fund's relative exposure to the size premium. The table also shows four different value metrics—price-to-earnings, price-to-book, price-to-sales, price-to-cash flow—in order to demonstrate a fund's relative exposure to the significant premium that value stocks provide. (Full disclosure: My firm, Buckingham, recommends DFA and Bridgeway funds in constructing client portfolios.)
Unfortunately, Morningstar doesn't provide consistent data for each fund, so the data are for slightly different time periods. However, prices were relatively unchanged during the period. Thus, the differences in dates don't matter too much, especially since the differences in the metrics are so great, as you'll see. Vanguard's data is as of May 31, 2014, DFA's is as of March 31, 2014 and Bridgeway's is as of March 31, 2014.
|Vanguard Small Value (VISVX)||$2.8B||16.7||1.7||0.9||7.5|
|DFA Small Value (DFSVX)||$1.3B||16.8||1.3||0.7||5.6|
|Bridgeway Omni Small Value (BOSVX)||$.7B||14.1||1.2||0.6||4.5|
The Vanguard fund holds stocks that are more than twice as large as the stocks held by DFA, and Bridgeway's holdings are much smaller than DFA's (about half as large). Those differences are created by the structure of the funds; that is to say, the definitions they use to determine buy, hold and sell ranges.
The smaller the market cap, the greater the expected return over the long term. One should generally expect that when small stocks outperform large stocks, Bridgeway's fund will have the highest return and Vanguard's the lowest, with DFA in the middle. One should generally expect the reverse when large stocks outperform small stocks. This won't always be true, because DFA and Bridgeway both incur lots of tracking error to achieve their goals of having the highest long-term returns. And these are small-value funds, not small-cap funds.
In terms of value metrics, Vanguard's small-value fund owns stocks with relatively higher values in nearly all categories than either the DFA or Bridgeway funds. The exception is a similar price-to-earnings ratio between Vanguard and DFA. In some cases, such as when comparing the Vanguard fund and the Bridgeway fund, the differences in value metrics can be quite large.
Aside from only a small difference in price-to-book ratios, Bridgeway's fund owns stocks that have relatively lower values than DFA's fund. This shouldn't be a surprise, because the DFA small-value fund relies on the book-to-market ratio to screen stocks, while Bridgeway uses four metrics, with its own weighting scheme.
Bridgeway's fund, by design, has the most exposure to both the size and value premiums. Thus, when value stocks outperform growth stocks, one should expect Bridgeway's fund to have the highest returns and Vanguard's the lowest (depending on what the small premium is doing as well), and vice versa.
With the data and concepts in mind, let's now take a look at how the funds have performed in the past five calendar years, 2009 to 2013. For comparison, I'll also look at the returns of the Vanguard S&P 500 ETF (VOO | A-96).
Some notes: Bridgeway's fund has an inception date of Aug. 31, 2011, so we don't have much data for it. Also, when a fund is new and relatively small, the amount of tracking error it can experience is high, because it won't have as much diversification across the stocks in its asset class until it has more assets under management.
Also, Vanguard's value funds include real estate investment trusts (REITs), while DFA's and Bridgeway's funds do not, because DFA and Bridgeway treat REITs as a separate asset class. That can cause and explain some of the differences in performance that follow: