Swedroe: Not A Stock Picker’s Market. Again.

January 22, 2016

At the end of 2014, Tom Lee, co-founder and head of research at Fundstrat Global Advisors, explained why only about one out of five actively managed funds were able to outperform their benchmark index that year, and why he believed that 2015 could be huge for stock pickers. In fact, “2015 should be a very good year for active managers,” he predicted.

As sure as the sun rises in the east, you’re going to hear statements like Lee’s from active managers. They’re always predicting that next year will be different; that it will be one in which stockpickers will shine. And with almost the same certainty that the sun will set in the west, the results will show otherwise.

Last year provided yet another demonstration that active management is the loser’s game. It’s not that the game is impossible to win; it’s just that the odds of doing so are so poor that it’s not prudent to try.

The table below presents the Morningstar percentile rankings—a ranking of 1 represents the best performance, a ranking of 100 represents the worst performance—for two of the largest providers of passively managed funds, Vanguard (index funds) and Dimensional Fund Advisors (structured asset class funds) over the latest one-, three-, five-, 10- and 15-year periods. (In the interest of full disclosure, my firm, Buckingham, recommends DFA funds in constructing client portfolios.)

Morningstar Percentile Ranking

Vanguard 500 Index (VFINX) 23 20 16 23 37
DFA U.S. Large (DFUSX) 21 18 14 20 34
Vanguard Value Index (VIVAX) 17 10 15 32 61
DFA U.S. Large Value III (DFUVX) 44 7 7 22 3
Vanguard Small Cap Index (NAESX) 38 30 24 15 40
DFA U.S. Small (DFSTX) 31 22 19 14 22
DFA U.S. Micro Cap (DFSCX) 35 21 19 14 22
Vanguard Small Cap Value Index (VISVX) 38 7 6 21 56
DFA U.S. Small Value (DFSVX) 71 41 29 43 15
Vanguard REIT Index (VGSIX) 65 37 34 30 36
DFA Real Estate (DFREX) 42 26 22 40 34
Average Domestic Ranking 39 22 19 25 33
Vanguard Developed Markets (VTMGX) 37 29 28 33 40
DFA International Large (DFALX) 72 57 50 38 42
DFA International Value III (DFVIX) 77 59 77 26 6
DFA International Small (DFISX) 43 41 64 27 40
DFA International Small Value (DISVX) 44 26 31 10 1
Vanguard Emerging Markets Index (VEIEX) 62 54 56 52 48
DFA Emerging Markets II (DFEMX) 64 56 46 32 42
DFA Emerging Markets Value (DFEVX) 86 88 92 37 11
DFA Emerging Markets Small (DEMSX) 16 16 16 1 1
Average International Ranking 56 47 51 28 26
Average Vanguard Ranking 40 27 26 29 45
Average DFA Ranking 50 41 37 25 21

As you review this data, there are three important issues to keep in mind. The first is known as the “law of style purity,” sometimes referred to as Dunn’s Law (after the Southern California attorney who provided the insights).

Dunn’s Law

Dunn’s Law states that when an asset class does well, index funds will tend to perform relatively better because they have the “purest” (greatest) exposure to the stocks in that asset class. Active managers, however, tend to style-drift. For example, large-cap funds often own mid- and small-cap stocks, small-cap funds often own mid- and large-caps, and growth funds often own value stocks. Thus, active managers tend to lose some of their exposure to both the “winning” and “losing” asset classes.

On the other hand, when an asset class does poorly, index funds will tend to perform relatively worse because they have the “purest” (greatest) exposure to the stocks in that asset class, and the style drifting of actively managed funds gives them less exposure.

In 2015, the best-performing domestic asset class was large-cap stocks, and the worst-performing domestic asset class was small value stocks. Thus, the relatively strongest rankings for the Vanguard and DFA funds are in U.S. large stocks and their worst rankings come in U.S. small value stocks. The relatively poor performance of international equities also helps explain the worse percentile rankings for the Vanguard and DFA funds in those asset classes in 2015, and for the recent one-, three- and five-year periods.

Another point to keep in mind is that the DFA funds tend to have more exposure to the small and value factors than the similar Vanguard funds. Thus, when those asset classes have relatively poor returns, the Vanguard funds will tend to outperform the DFA funds, and vice versa.


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