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11.3.6 Selecting Index Funds

How is the wheat sorted from the chaff? Since index funds are the only funds that use risk and return data that deploy a constant set of rules of ownership, they are the first level to screen over 17,000 existing mutual funds in the Morningstar database.

This process of elimination limits the choices down to about 600 index funds and exchange traded funds (ETF’s). ETF’s are essentially index funds that trade like stocks, but like individual stocks, they usually have commissions and spreads between bids and asks. Most importantly, investors need to consider the net expected return of each index fund representing each set of rules of ownership. A sorting of index funds, loads, fees, and expenses will quickly eliminate all but Vanguard and DFA index funds. Then another problem arises.

DFA funds require a minimum trade amount of $2 million per fund purchase unless the purchase is made through a DFA approved fee-only advisor. Most advisors require minimum account sizes of around $250,000. However, Index Funds Advisors’ (IFA) minimum account size is $100,000. The primary difference between DFA and Vanguard is that they use different indexes to design their index mutual funds. DFA custom designs its indexes to capture the risk factors that explain 95% of stock market returns. Those factors include company size (market capitalization) and value (book to market ratio or BtM).

There are smaller size and higher value oriented stocks in DFA indexes. Based on the higher long-term returns of these factors, there are higher expected returns for long-term investors with DFA index funds. However, past performance is not a guarantee of future performance. Vanguard is now a fairly aggressive proponent of “tandem investing,” which is a post-Bogle slogan that encourages Vanguard investors to mix in some actively managed funds in their portfolios.

It is as if the dark force has encroached on this champion of investor protection and low costs. There is no conceivable or logical reason for Vanguard to do this, other than it can make higher fees off uneducated and unsophisticated investors.

DFA, for its part, is the purest among all mutual fund companies in their application of the Efficient Market Theory and low-cost structure. They have an added benefit of providing substantial index data going as far back as 1926.

As proof of DFA’s unique position in the investment product industry, Dalbar surveyed investment advisors four times between 1997 and 2004. The study was titled “The Professionals’ Pick.” Dalbar rated DFA the best overall no-load mutual fund company in 1997, 2000, 2002, and number two in 2004. DFA rated highest in the “Investment Management” and “Current Use” categories in the 2004 survey. See Table 11-1. These funds are low cost, style pure and well diversified.

Table 11-1

 

One unique advantage of DFA is their innovative execution of small capitalization stock trades. Because of the low liquidity in these stocks, the trading cost can be very high. DFA’s board members and consultants include some of the world’s most distinguished academic theorists: Eugene Fama, Kenneth French, Roger Ibbotson, Donald Keim, and Nobel laureates Myron Scholes and Robert Merton.


Kenneth French explains the DFA Advantage

 

 

DFA versus Vanguard: (source: MSN Money)
Large Value - Small Value - Small Caps - -
Int'l Value - Emerging Markets - TM-Int'l
TM-Small Cap.


DFA Prospectus for DFA Funds

DFA states their advantages this way:

We Add Value without Relying on Forecasts or Intuition
We believe that, over time, a structured investment approach based on financial science and the efficacy of capital markets will add value with a higher reliability and confidence level than one based on instinct and prophesy.

Investment Philosophy Is Grounded in Robust Academic Research
The Three-Factor Model has replaced the Capital Asset Pricing Model in the work of financial economists. Our equity strategies capture the insights of the model, which has withstood rigorous open review.

Minimal Style Drift
We adhere strictly to specific parameters to maintain reliable asset class exposures. Our portfolio managers have no discretion to purchase stocks that do not meet these parameters, and no financial incentive exists for them to deviate from our very specific disciplines.

Smart Trading Increases Returns
Careful trading can reduce or even reverse the costs borne by traditional managers. Because Dimensional focuses on capturing the systematic performance of broad market dimensions rather than the random fluctuations of individual securities, we can keep costs low, patiently and expertly. We concentrate on favorable price execution that neutralizes the effects of momentum and index reconstitution and we maintain portfolio-specific hold ranges that reduce turnover and trading costs.

Low Cost
In line with our structured, scientific approach to investing, Dimensional's investment management fees are positioned well below those of typical, traditional active managers. Our patient and price-conscious buy-and-hold approach to trading is designed to minimize costs.

Pioneers of Risk-Factor-Based Management
Dimensional has pioneered many strategies now taken for granted in the industry. The firm was originally founded to provide institutional investors access to US small cap stocks, underrepresented at the time in most portfolios. Dimensional later introduced its first value strategies based on the Three-Factor Model. In 2004, we launched core strategies that efficiently target risk factors across the total stock market.

Broad Line of Strategies for a Complete Total Portfolio
Dimensional's broad array of investment strategies offers calibrated exposures to the full spectrum of key asset classes across dimensions of size, value, and geography. Our goal is to provide investors with global investment solutions that, at the total portfolio level, maximize returns for a desired risk level.

Clear and Accessible Philosophy and Approach
Dimensional strives to keep its process transparent so that clients can easily understand it.

Combination of Theory and Practice
By acting as a conduit between scientists and practicing investors, Dimensional has pioneered many strategies and consulting technologies now taken for granted in the industry. This feedback loop serves as an idea growth engine, positioning us to research tomorrow's solutions today.

Low Professional Turnover Strengthens Our Team Process
Longevity characterizes the nucleus of our investment and research team. We have had very few departures among our portfolio managers and we hire in advance of future growth. The decision-making approach for strategies at Dimensional is the antithesis of the "star" system.

Successful and Independent
Dimensional is one of the largest independently owned institutional investment management firms in the world. The firm is dedicated to managing investments on behalf of clients and to operating its business in the best interests of clients.

Exceptional Client Service
We are eager to continue building relationships with institutional clients, financial advisors, and consultants through development of customized investment programs and an interchange of investment research and ideas.

We recommend that you purchase primarily DFA funds for your portfolio. Short articles on DFA can be found here, 1 - 2 - 3 - 4 - 5 - 6 . Some key advantages of DFA can be found HERE.

DFA originally designed their funds for large institutional clients. These funds are low cost, style pure, and well diversified. If you become our client, you will have the opportunity to invest alongside some of the world's largest institutional funds.
For a list of institutional clients of DFA, click here.

One unique advantage of DFA is their innovative execution of small capitalization stock trades. Because of the low liquidity in these stock, the trading costs can be very high. To see how DFA addresses this issue, click here.

DFA versus Vanguard:

Not all indexes are the same, see these comparisons of similar funds from DFA and Vanguard: Large Value - Small Caps - Int'l Value - Emerging Markets - TM-Int'l - TM-Small Cap. (source: MSN Money.) Vanguard has changed their indexes to the MSCI indexes. For a Three Factor Model comparsion of these indexes (S&P vs MSCI) and the DFA indexes, see HERE.

We are sometimes asked what the difference is between Vanguard, ETFs and DFA Index Funds. The short answer is they use different indexes. DFA has custom designed their indexes to capture the risk factors that explain 95% of stock market returns, going back to 1929. Those factors include company size (market capitalization) and value (based on the company's Book Value divided by its Market Capitalization, or Book to Market Ratio (BtM))
. [also see DFA vs Vanguard]

IFA's concern with Vanguard: Vanguard investment plans 50% active funds? Say it ain't so...
- Here is an actual proposal with active funds! Where is Jack? What have they done to his song, Ma? And now they are offering a Hedge Fund(12/15/07)! "When asked about this departure from low-cost indexes, Ms. Chain pointed out that Vanguard actually manages more active assets ($680 billion) than passive ($600 billion). “We serve many clients beyond the investor who holds the 500 fund in an IRA,” she said.

The only pure passive play is DFA. DFA is the only fund company that adheres to a non-forecasting, efficient markets strategy for all of their funds.

IFA's concern with iShares: "To generate more revenue, Barclays has worked in recent years to build up its actively managed funds like hedge funds. About 21% of BGI's assets are actively managed, some of in hedge funds. A recent report by Sanford C. Bernstein & Co. says BGI has been successful in subtly shifting to the higher fee, actively managed funds." WSJ 08/13/07

The grid below illustrates the differences between the indexes used by D
FA and Vanguard mutual funds. As you can see, they are very different. Because returns have correlated with risk factors like size and value, this is an important distinction to make.

You get smaller size and higher value oriented stocks with DFA indexes. Based on the higher long-term returns of these factors, there would be higher expected returns for long-term investors with the DFA index funds.
However, we must caution you that past performance is not a guarantee of future performance.

Below is a chart that plots factor loadings of various indexes. Factor loadings are a comparison of indexes and mutual funds. As you see, the 0,0 point is the total market.


For loading factors on entire portfolios, see below:


For more detail on DFA and CRSP, see here.
Here are two tables that illustrate some of the differences in the indexes. They use a Three Factor Regression Model to compare funds to the Total Market.

Value

Index Fund

Book to Market Ratio (Value)
relative to the Total Market

Vanguard Large Growth Index

-0.31

Total Market

0.00

Vanguard Small Value

0.20

Vanguard Large Value

0.38

DFA Small Value (CRSP 6-10)

0.59

DFA Large Value (CRSP 1-5)

0.65



Size

Index Fund

Market Size Relative
Total Market

Vanguard Large Growth Index

-0.32

S & P Index

-0.17

Total Market

0.00

Vanguard Extended Market*

0.52

Vanguard Small Value

0.83

DFA Small Value

0.96

DFA Small (6-10)

1.02

DFA Small (9-10)

1.11

*total market, without the S&P 500

Because higher returns have been achieved with smaller and value type stocks, DFA has created indexes that are focused more on those factors.


Actual Weighted Average Market Capitalizations and Weighted Average Book To Market Ratios
For Small and Large Indexes as of Dec. 31, 2000





More Index Data

Russell Indexes
Wilshire Indexes
Dow Jones Indexes
Barra Indexes
Bloomberg Index Data
S&P Indexes
MSCI Indexes
Morningstar Indexes
Compare International Funds

Compare Small Cap Fund
Compare Large Value
Compare Emerging Markets
Dimensional Fund Advisors strives to deliver the performance of capital markets and add value through portfolio design and trading. The firm departs from the rules and rigidity of traditional index funds and avoids the cost-generating activity of stock picking and market timing. Instead DFA focuses on the dimensions of capital markets that reward investors and they deliver them as intelligently and effectively as possible. Financial science has documented that, over the long term, small cap stocks outperform large cap stocks and value stocks outperform growth stocks. These returns seem to be compensation for risk. In fixed income, risk is well described by bond maturity and credit quality. Dimensional's investment strategies deliberately target specific risk factors. They are highly diversified and painstakingly designed to work together in a total index portfolio.

IFA has advised clients to invest in DFA funds since March, 1999. IFA receives no compensation from any product or service they advise their clients to use. IFA only receives fees from their clients, other advisors who license their software and book sales. The best strategy for investors is to invest in a globally diversified portfolio of index funds and rebalance as needed. As Louis Pasteur said, "Chance favors the prepared mind."

Symbol
[Click to compare DFA and Vanguard]
2007
Return
IFA Indexes 50 yrs 1958-2007 [source]
5.44%
10.84%
-5.76%
13.33%
-3.06%
12.77%
-8.19%
15.79%
-18.67%
12.79%
10.24%
12.91%
5.66%
16.27%
2.95%
17.57%
36.02%
18.62%
45.64%
19.88%
38.02%
19.04%

It is normal for investors to be suspicious when an author or advisor leans so heavily toward one mutual fund company. Indeed, it is wise to be cautious of loads or 12b-1 fees that may be kicked back to the advisor. This is not the case with DFA. DFA has no loads or tailing fees for advisors and they provide the absolute best education of any fund company, including monthly updates on risk and return data and a software package to analyze the data. Simply put, they are the best in the business.


11.4
Solution

11.4.1 Twenty Index Portfolios

The answer to the investor’s dilemma is to design the most efficient portfolios of available investable indexes. (See Table 11-2 and Appendix A for a listing of the portfolios and data concerning them.) Input into efficient analysis must be based on at least 20 years of risk and return data. But there are now 80 years of reasonably good index simulations.

Table 11-2

CLICK ON THE IMAGE FOR A LARGER VIEW

 

  The Flash Graph below show the risk and reward plots for all 20 portfolios and the component indexes for 20, 35, 50, and 80 year periods.

We have assembled a continuum of risk exposures as summarized in histograms below. They are depictions of both the risk and return of all 20 index portfolios. They are numbered and color coded to denote their risk level beginning with Portfolio 100 — Bright Red at the highest risk, down to Portfolio 5 — Ivory at the lowest risk. The charts show a histogram of 780 months of returns data on the left and the growth of one dollar on the right. The risk capacity painting is also included to give an idea of the age appropriateness of each portfolio.


The 20 Index Portfolios and S&P 500 Returns (Table 11-3) show the risks and simulated returns of all 20 portfolios. An investor’s actual returns will vary from these asset class allocations due to differences in asset allocations, timing of withdrawals and contributions, index tracking errors, rebalancing strategies and costs, fees, and other factors.

Table 11-3 - Risk Return Table
Twenty Index Portfolios and S&P 500
Simulated Returns, Growth of a Dollar and Risks (Standard Deviations)
Jan 1927 to Current Month

Note: An investor's actual returns will vary from these index portfolios due to differences in index allocations, timing of withdrawals and contributions, index tracking errors, rebalancing strategies, costs, fees, tax related strategies, and other factors. According to the Financial Economists Roundtable, index portfolios are the best estimates of the principal risk factors that are likely to influence fund risks and returns in the future. The annualized returns shown below are after an advisor fee of 0.90%/year (your fee may be lower) and after a DFA mutual fund fees for the entire period, including simulated data periods. Returns data includes an annual rebalancing of indexes. The DFA US Large Company Fund (which tracks the S&P 500) is shown with no IFA advisor fee deducted and is similiar. For monthly and YTD returns, the percentage return corresponds to the total period. Index returns DO NOT represent actual mutual fund performance and are for illustration and comparison purposes only. For individual Mutual Fund performances, see the appropriate DFA Fund prospectus. Past performance does not guarantee future performance. In fact, the Risk - SD or Standard Deviation number shown below quatitfies the uncertainty of expected returns. The higher the historical Standard Deviation number, the higher the risk or uncertainty, and the wider the range of future probable outcomes. To visualize and compare these risks, click: . For a complete portfolio analysis, take a ride in the Portfolio Simulator.
 

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