Swedroe: Simple Factor Investing

September 10, 2018

As I have discussed many times, there is overwhelming evidence that simple indexing strategies outperform the vast majority of investors, be they individuals or institutions.

Perhaps the simplest strategy, as advocated in the new book by Taylor Larimore, “The Bogleheads’ Guide to the Three-Fund Portfolio: How a Simple Portfolio of Three Total Market Index Funds Outperforms Most Investors with Less Risk,” is to hold just three funds.

For equities, you can own the Vanguard Total Market Index Fund (VTSMX) and the Vanguard Total International Stock Index Fund (VGTSX). On the bond side, you can own the Vanguard Total Bond Market Index Fund (VBMFX). Had you owned such a portfolio over the past 20 years, chances are good you would have outperformed most investors. I fully agree that this approach is not only a very good one, but, as sure as the sun rises in the east, will likely continue to outperform a large majority of investors going forward.

That said, such an approach ignores the academic evidence demonstrating there are certain factors that have provided above-market returns to investors willing and able to accept their additional risks.

These factors have performed with persistence across long periods; pervasiveness across sectors, countries, regions and even asset classes; and robustness to various definitions. What’s more, they have intuitive risk-based or behavioral-based explanations for why they should persist and are implementable, meaning they survive transaction costs. The two factors with the longest history are size and value.

Dimensional’s Approach

Firms such as Dimensional Fund Advisors have been building portfolios based on academic findings regarding factors for decades. Therefore, investors have been able to build portfolios that accessed these factors.

Typically, investors constructed equity portfolios using the building blocks provided by Dimensional, which include U.S. large-cap, large-cap value, small-cap and small-cap value asset class funds, funds reflecting the same four asset classes for non-U.S. developed markets, and three emerging market asset class funds (large-cap, small-cap and value). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

To many investors, owning 11 funds was too complex. In 2005, Dimensional addressed that issue by creating what they call core funds, which provide exposure to all these asset classes. Core funds have the benefit of diversifying across factors/asset classes. In addition, they improve tax efficiency over an individual fund structure because they greatly reduce the turnover impact of stocks’ migration across asset classes. They also eliminate the need for investors to rebalance across asset classes, as the fund does it for them via cash flows and dividends.

Thus, today, investors can implement a factor-based equity strategy with just three Dimensional core funds: a core U.S. fund (DFQTX), a core international fund (DFIEX) and a core emerging markets fund (DFCEX). Alternatively, you could own Dimensional’s World ex-U.S. Targeted Value Fund (DWUSX), which combines international and emerging markets into a highly tilted (to the size and value factors) portfolio, or its world ex-U.S. Core Equity Fund (DFWIX). Either would allow you to own just two equity funds.

Dimensional Vs. Vanguard

With that knowledge, we can go back in time and see how an investor who was willing to accept these different risks, and the tracking error that can occur (factor-based funds will perform differently than total market funds), would have done.

While there are many possible combinations, the following analysis uses the Dimensional fund with the most exposure to the size and/or value factors for the U.S. (DFSVX), developed international (DISVX) and emerging (DFEVX) markets.

For comparison purposes, I’ll also show the returns of the Vanguard Emerging Markets Index Fund (VEIEX) and the Vanguard Developed Markets Index Fund (VTMNX), permitting you to look at a three-equity-fund portfolio versus the simpler, two-equity-fund portfolio. This allows for a more apples-to-apples comparison.

I’ll use the longest period for which we have data available (based on when all the funds were live). Thus, my start date is April 1998. Fund returns data comes from Portfolio Visualizer. Factor premiums are from Ken French’s website and run through July 2018 (one month less than our returns data, giving us a slightly different period than for the returns data).


During this period, and based on Ken French’s data series, the monthly U.S. size and value premiums were 0.25% and 0.12%, respectively. Those premiums help to explain the higher returns of DFSVX.

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