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Vanguard vs. Dimensional: Getting Exposure to the Biggest Companies in the U.S.

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As we all know, when it comes to implementing a passive investment strategy, costs really matter. While most people focus on the more tangible costs such as expense ratios, loads, or 12b-1 fees, it really goes deeper into the more obscure costs that are involved in trading. We have written extensively about these costs (you can find an example here), and although they are not itemized for investors to see, they will manifest themselves in the net returns that investors get at the end of the day.

As a fiduciary, it is our duty to take all costs into account and weigh them against the intended benefit that we are trying to seek within our portfolios. In one particular example, our investment committee has determined that having exposure to the largest companies within the United States is very important for our clients. The decision to be made is how we decide to gain our exposure to that particular segment of the market. Because we subscribe to passively investing with index funds, our options basically come down to mainly Vanguard and Dimensional Fund Advisors (DFA).

We have written previous articles about the value that DFA brings to our clients (you can find an example here). They bring tremendous value to their strategies through custom benchmark constructions that tilt towards the dimensions of expected return and mitigating frictions when transacting in the marketplace. But, many of our clients wonder if these value-adds apply when tracking the largest companies within the United States since both are simply trying to track the S&P 500 as closely as possible.

We will focus primarily on the asset allocation for our non-taxable accounts. Getting exposure to the US Large Blend segment of the market can be done with either the Vanguard 500 Index Fund Admiral Shares (VFIAX) or DFA US Large Company (DFUSX). Let’s start with some basic characteristics as of the latest fact sheet produced by both investment companies (as of 06/30/2015).

As we can see, these two funds are very similar. Although DFA is just slightly more value oriented (lower price-to-book ratio), Vanguard is 0.03% cheaper than DFA. Without getting too egregious in splitting hairs, let’s take a look at historical performance.

The bar chart below depicts the annual net returns of VFIAX and DFUSX from 2000 to 2014 as well as some summary statistics about the performance.

Over the entire period, VFIAX delivered a net return of 4.22% and DFUSX delivered a net return of 4.19%. The difference between the growth of $1,000 between these two funds over the last 15 years is about $8. Now, based on these simple analytics, our investment committee may want to look into adopting VFIAX and replace DFUSX. But there is more to the story.

If we were to break up the entire 15-year period into two sub-periods (2000-2004 and 2005-2014), we find two different trends in terms of performance differences between DFA and Vanguard. From 2000-2004, the performance of DFUSX lagged VFIAX by 0.09% per year even though the difference between the two funds’ expense ratios was again only 0.03% at that time. More interestingly, that 0.09% outperformance had a very high t-statistic (5.95) meaning that there was something operationally wrong with how DFA was trying to track the S&P 500. See table below.

When we asked DFA what could the potential issues have been in those early years of the fund’s life (Inception Date is 09/23/1999), they mentioned the following:

  • Before 2005, DFA tried to buy stocks as cash flows allowed. Because cash flows are never consistent day-to-day, this led to certain positions being overweight in the index and certain position being underweight in the index since DFA could never buy a perfect slice of the S&P 500 everyday.
  • Since 2005, they have added enhancements to the fund through the use of futures and delayed constitution. By purchasing S&P 500 futures contracts with the cash flows coming into the fund, the fund managers were able to buy perfect slices of the S&P 500 at any given time. Once they had enough cash, they could exchange the futures contracts for the physical stocks that underlie the futures contract. This way investors could have a more consistent day-to-day exposure to the S&P 500.
  • Other enhancements are their delayed reconstitution or slowly rebalancing the fund as certain securities are added or dropped from the index, as well as securities lending.

Since 2005, the difference in net return between VFIAX and DFUSX has been essentially 0.00%. In fact, DFA came out slightly ahead, but difference in returns is not statistically significant (0.14). There have been certain years where DFA has outperformed (2008) and there have been years when Vanguard has outperformed (2012), but nonetheless the performance of the funds has been almost identical over the 10-year period ending 2014.

Although Vanguard has consistently provided a more cost-effective solution in terms of their S&P 500 Index Fund, this has not translated into outperformance over the last 10 years. In fact, the more expensive solution (DFUSX) has been able to deliver a slightly higher return. We believe that DFA has a superior process to mitigating the frictions involved in managing portfolios, which has translated into higher performance figures for almost all of their strategies across all asset classes, even for something as simple as tracking the S&P 500 Index.