In 2009, VFINX, the S&P 500 fund, returned 26.5 percent, and VISVX, the Vanguard small-cap value fund, 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 VISVX returned 24.8 percent. Since small value outperformed, 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 VISVX returned -4.2 percent. Since small value underperformed, we should expect to see DFSVX underperform VISVX. And that’s what happened, as DFSVX returned -7.6 percent.
In 2012, VFINX returned 15.8 percent and VISVX returned 18.6 percent. Since small value outperformed, we should again expect to see DFSVX outperform VISVX. Again, that’s what happened, as DFSVX returned 21.7 percent. Bridgeway’s BOSVX returned 17.7 percent. Given the fund’s greater exposure to the size and value factors, we should have expected BOSVX to outperform.
An Anomaly Uncovered
However, remember that issue with tracking error and new funds? That said, BOSXV’s performance is our first “anomaly.” We didn’t get what we expected.
In 2013, VFINX returned 32.2 percent and VISVX returned 36.4 percent. Since small value outperformed, we should expect to see DFSVX outperform VISVX. That’s what happened, as DFSVX returned 42.4 percent. BOSVX outperformed both, returning 44.6 percent, just what we should have expected. As we mentioned earlier, VISVX’s performance was negatively impacted in 2013 by the 2.3 percent return on REITs.
In 2014, VFINX returned 13.5 percent and VISVX returned 10.4 percent, aided by the 30.1 percent return on REITs as measured by the performance of VGSIX. Since small value underperformed, and REITs dramatically outperformed, we would expect to see DFSVX underperform VISVX. Once again, the expected happened. DFSVX returned 3.5 percent. And Bridgeway, with even more exposure to the underperforming factors of size and value, returned just 0.8 percent.
A Single Outlier
Looking at six years of data, we find only a single outlier within the data—the underperformance of BOSVX in 2012. As explained, there’s a likely explanation in random tracking error.
We see the same type of results if we examined the performance of the iShares Russell 2000 Value ETF (IWN | A-79). Using Morningstar data as of March 18 for IWN, the fund, while having a similar average market cap to DFA’s fund, is much less “valuey.” Its prices-to-earnings ratio (17.8 versus 14.8), price-to-book ratio (1.4 versus 1.2), price-to-sales ratio (1.0 versus 0.6) and price-to-cash flow ratio (8.3 versus 6.1) are all higher than DFA’s valuations.
And in every single year in which small value outperformed the S&P 500 Index, DFSVX outperformed IWN, and vice versa.
There are two important takeaways. The first is that all three passively managed funds were doing their jobs well. The differences in performance weren’t explained by good or bad management. Instead, they’re explained by the fund’s structure—how they are designed.
The second is that asset pricing models (such as the Fama-French three-factor model) work very well. They are able to explain the differences in the performance of diversified portfolios to a very high degree.
When an asset class does well, you should expect the fund with the greatest exposure to whatever factors explain that asset class’ outperformance to have the highest return. And when an asset class does poorly, you should expect the fund with the most exposure to those factors will underperform.
Making The Right Choice
The lesson I hope you walk away with is that you don’t want to be like investors in actively managed funds, chasing returns. Instead, the choice of the fund you use should be based on other considerations, including how much exposure you want to certain factors, the design of the fund and, of course, a fund’s expense ratio.
When making the decision, you want to be sure you weigh all factors. It might be that the fund with a higher expense ratio is the better choice. It might, for instance, have more exposure to the factors that determine returns and carry premiums. In other words, it’s not just cost, but cost per unit of expected return (and risk) that matters.
Let’s use an example.
While VISVX has an expense ratio of 0.24 percent (the Admiral shares version costs just 0.10 percent) and DFSVX has an expense ratio of 0.52 percent, the higher cost of the DFA fund has been more than offset by its greater exposure to the factors and its focus on adding value by minimizing the negatives of pure indexing.
For the 15-year period ending March 19, DFSVX returned 11.00 percent versus 10.56 percent for VISVX. Lastly, BOSVX has an expense ratio of 0.6 percent, but its greater exposure to the size and value effects should allow it to produce the highest returns of the three funds.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.