Swedroe: Index Fund Vs. Structured Funds

June 23, 2014

  • In 2009, VFINX returned 26.5 percent and VBR returned 30.3 percent. Since small value stocks outperformed, we should expect to see DFSVX outperform VISVX. It did, returning 33.6 percent.
  • In 2010, VFINX returned 14.9 percent and VBR returned 24.8 percent. Since small value outperformed again, we should expect to see a repeat performance. That's what happened, as DFSVX returned 30.9 percent.
  • In 2011, VFINX returned 2.0 percent and VBR returned -4.2 percent. Since small value underperformed, we should expect to see DFSVX underperform VBR. That's what happened, as DFSVX returned -7.6 percent.
  • In 2012, VFINX returned 15.8 percent and VBR returned 18.6 percent. Since small value outperformed, we should again expect to see DFSVX outperform VBR. That's what happened, as DFSVX returned 21.7 percent. Bridgeway's BOSVX returned 17.7 percent.
  • In 2013, VFINX returned 32.2 percent and VBR returned 36.4 percent. Since small value outperformed, we should again expect to see DFSVX outperform VBR. That's what happened, as DFSVX returned 42.4 percent. And BOSVX outperformed both, returning 44.6 percent, as we should have expected.

The only outlier in the data was the underperformance of BOSVX in 2012. The likely explanation is a random tracking error.

There are a couple of important takeaways. All three passively managed funds did their jobs well. The differences in performance were explained by the funds' structures—again, how they're designed—in what's known as Dunn's Law.

The law is that when an asset class does well, you should expect the fund with the most exposure to that class to have the highest return. And when an asset class does poorly, you should expect the fund with the most exposure to that class to underperform.

Choosing The Right Fund

Your choice of fund should be based on how much exposure you want to various risk factors and on the fund's expense ratio. Weigh both criteria. It might be that a fund with a higher expense ratio is a better choice, as it might have more exposure to the factors you desire. It's not just cost, but cost per unit of expected return (and risk) that matters.

For example, the Vanguard Small-Cap Value ETF (VBR | A-100) has an expense ratio of 0.09 percent, and DFSVX from DFA has an expense ratio of 0.52 percent. The higher costs of the DFA fund have been more than offset by the fund's greater exposure to certain factors and its focus on adding value by minimizing the negatives of pure indexing. For the 15-year period ending June 17, 2014, DFSVX returned 12.02 percent versus 10.19 percent for VBR and its mutual fund version VISVX.

BOSVX from Bridgeway meanwhile has an expense ratio of 0.60 percent, but its greater exposure to the size and value effects should allow it to produce the highest returns of the three funds.

When it comes to Total Stock Market (TSM) funds, there really are no negatives of any great significance. That said, there's one thing for advisors to consider: While a TSM fund owns lots of small and value stocks and thus is highly diversified across asset classes and by number of stocks, it has by definition no exposure at all to other factors (besides beta). So it's undiversified by factors, which may not be a concern.

The reason is that while a TSM fund is long small and value stocks, providing positive loadings on those factors, it also owns large and growth stocks, providing exactly offsetting negative loadings. That leaves investors with exposure to just the single factor of beta.

 


 

Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.


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