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