Swedroe: Index Fund Vs. Structured Funds

June 23, 2014

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.

Fund Weighted Average
Market Cap
P/E P/B P/S P/CF
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:

 

  • 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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