Index Portfolio Implementation

Once investors identify the asset allocation that matches their risk capacity, they have a choice to make as to how to best implement that asset allocation. A handful of passively managed fund providers offer asset class indexes, namely Vanguard and Dimensional Fund Advisors (Dimensional). In 2013, these two firms had the most cash inflows of all mutual fund families1. The index portfolios referenced in this book are usually implemented with funds from Dimensional, a highly regarded fund company which provides indexes and funds based on the Fama/French Five-Factor Model, purposefully isolating risk factors to efficiently capture higher expected returns. They have recently added a sixth factor known as Direct Profitability (to be further detailed in future editions of this book).

Figure 11-3 illustrates a 16-year comparison between 20 index portfolios implemented with funds from Dimensional and Vanguard, and with the same stock/bond allocations. The time period shown reflects the longest time period for which we have live mutual fund data. All portfolio results are net of fund fees as well as a 0.9% advisor fee. The chart shows that the implementation of the index portfolios utilizing Dimensional funds had a higher annualized return than the portfolios utilizing Vanguard funds.

Figure 11-3

Figure 11-4 is a similar chart that shows a 14-year comparison between the same 20 index portfolios implemented with Dimensional funds and iShares exchange-traded funds (ETFs). The beginning date is two years later (due to the limited availability of live ETF data), but the results are similar. The size of the Dimensional advantage is directly proportional to the risk level of the portfolio. Although several brokerage firms offer a "free-trades" promotion with select ETFs, investors should proceed cautiously with their trades, staying cognizant of the bid/ask spread, and the possible divergence between market price and net asset value. Investors who do not understand what this means should refrain from trading ETFs altogether.  Finally, lessons from Steps 4 and 6 show why investors must avoid the temptation to use ETFs as market-timing tools and tactical asset allocation.

Figure 11-4

Dimensional funds are available through a select group of fiduciary registered investment advisors to whom the company provides comprehensive data from CRSP on numerous indexes dating all the way back to 1926. This allows for analysis of data that is usually only available to academic researchers.

Dimensional's emphasis on educating advisors, who in turn, educate investors, is intended to improve the investor experience for the clients of fiduciary advisors.

Dalbar surveyed investment advisors four times between 1997 and 2004. In a study titled, "The Professionals' Pick." advisors rated Dimensional the best overall no-load mutual fund company in 1997, 2000, 2002, and number two in 2004. Dimensional was also ranked number one for Advisor Commitment in 2010 and 2011 by Cogent Research and #1 by Barron's in 2010. In 2014, Dimensional was the focus of a feature article, with Nobel Prize winner Eugene Fama and Dimensional CEO and founder David Booth gracing the cover of the publication. See Figure 11-5 for a summary of their accolades.

Figure 11-5

Step 11Risk Exposure