Swedroe: 3 Fine Passive Funds Compared

March 27, 2015

 

Different-Size Companies

What you should note here is that the Vanguard fund holds stocks that tend to be much larger than the stocks held by the DFA fund. And the Bridgeway fund holds stocks that tend to be much smaller than the stocks held by the DFA fund.

 

Those differences are created by the structure of the funds—the definitions they use to determine buy, hold and sell ranges. And as the size premium tells us, the smaller the market cap, the greater the expected return over the long term.

 

In addition, we should generally expect to see that when small stocks outperform large stocks, Bridgeway’s fund will have the highest return and Vanguard’s the lowest, with DFA’s fund in the middle.

 

It’s not that Bridgeway is a better-run fund; it has the most exposure to the size premium. Conversely, we should expect the opposite when large stocks outperform small stocks. This won’t always be true because DFA and Bridgeway both incur lots of random tracking error in order to achieve their goal of obtaining the highest long-term returns. Also, these are not small-cap funds, but small value funds.

 

Measuring Value

You can further observe that, in the case of the four value metrics, Vanguard’s small value fund owns stocks with relatively higher prices than either DFA or Bridgeway. And in some cases, the differences are quite large. With the exception of a small difference in the price-to-book ratio, the Bridgeway fund owns stocks with relatively lower prices than the DFA fund.

 

This shouldn’t be a surprise, because DFA’s small value fund uses a single book-to-market screen, while Bridgeway uses four metrics and its own weighting scheme.

 

Bridgeway’s fund has the most exposure to the value premium. Again, that’s by design. As a result, when value stocks outperform growth stocks, we should expect the Bridgeway fund to have the highest returns and Vanguard’s fund the lowest (depending of course on what the size premium is doing at the time) and vice versa.

 

The Thing About REITs

There’s one other important factor to consider. While the Vanguard fund includes exposure to REITs (about 10 percent), the DFA and Bridgeway funds don’t. There are a number of good reasons for excluding REITs:

  1. First, REITs are highly tax inefficient. Thus, in general, they should only be held in tax-advantaged accounts.
  2. Second, REITs have significantly lower expected returns than small value stocks. From 1978 through 2014, the Dow Jones Select REIT Index returned 12.7 percent on an annualized basis versus 15.2 percent for the Fama-French U.S. Small Value (ex-utilities) Index.
  3. Third, if investors want exposure to REITs, they can own them directly through a REIT fund, such as Vanguard’s. That way, an investor can specifically target how much exposure they have to REITs. The differences in exposure to REITs can have a significant impact on the returns of the fund.

 

Comparing REIT Returns

For example, in 2013, Vanguard’s VISVX returned 36.4 percent. The performance of the fund was negatively impacted by the performance of REITs that year. Vanguard’s REIT Index Fund (VGSIX), in fact, returned just 2.3 percent that year. The DFA and Bridgeway funds weren’t negatively impacted because they excluded REITs.

 

The reverse was true in 2014. VISVX returned 10.4 percent, and its performance was positively impacted by the return on REITS. Last year, VGSIX, the Vanguard REIT fund, returned 30.1 percent.

 

With the data and theory in mind, let’s now take a look at how the funds have performed.

Did we get what we expected?

 

We’ll examine the funds’ returns for the last six calendar years (2009-2014). To measure the results against our expectations, we’ll also examine the returns of Vanguard’s S&P 500 Index Fund (VFINX). Note the Bridgeway fund has an inception date of Aug. 31, 2011. We will include it in the analysis beginning in 2012. Also note that, when a fund is new and relatively small, the amount of tracking error it may experience can be quite high. This occurs because it won’t have as much diversification across the stocks in its asset class until it has larger assets under management.

 

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