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Rekenthaler Report

One Vanguard, Many DFAs

The mutual fund industry’s two indexing leaders have left different legacies.

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The Genesis
The history of U.S. mutual fund indexing is Vanguard versus Dimensional Fund Advisors. In 1976, Vanguard introduced what was then called First Index Investment Trust, a fund that replicated the S&P 500. Five years later, DFA launched its U.S. 9-10 Small Company Fund. Every mutual fund indexing entrant since that time has been a historical footnote.

The companies are not only today’s two biggest mutual fund indexers (with Vanguard being substantially larger, of course) but also neatly encapsulate a key debate of indexing: Should indexers own the entire marketplace, on the theory that the wisest man is the man who realizes that he knows nothing and who therefore will not attempt what must surely fail? Or should they use academic research to shape their funds so that they hold some market segments but not others?

Broad and Narrow
Vanguard took the first path. Its initial fund covered about 80% of the U.S. stock market, by capitalization. In 1992, the company launched  Vanguard Total Stock Market Index (VTSMX), which expanded the exposure to U.S. stock market assets to something near 100% (practical constraints preventing the ideal from being achieved). Similarly, the company’s international-stock indexes progressed from the broad debut funds of  Vanguard Pacific Stock Index (VPACX) and  Vanguard European Stock Index (VEURX) to, a few years later, the even-broader  Vanguard Total International Stock Index (VGTSX).

(Eventually, I figure, Vanguard will offer Vanguard Total World Marketplace--a fund that indexes all of the globe's securities. Such is the logical ending place for the agnostic indexer. Don’t favor one individual security over another, or a region, or an industry, or an asset class. Just hold what the world holds. Stocks, bonds, warrants, convertibles, partnerships, whatever. It can all be done through a single fund.)

DFA begged to differ. Its first fund, later renamed  DFA U.S. Micro Cap (DFSCX), offered exposure to only a tiny corner of the U.S. stock market. It reflected the company’s belief that the smallest companies in the market offered higher returns that their larger competitors. Rather than be neutral, as Vanguard instructed index investors, DFA taught its advisors--and thus ultimately, those advisors’ clients--to  implement a viewpoint. Don’t own the market’s entire beta, to use the modern lingo. Own only the smart betas.

(Henceforth, I will use Morningstar’s preferred phrase of “strategic beta" instead of smart beta to eliminate the suggestion that those so-called betas--for example, the exposure to securities that carry certain attributes, such as a small stock market capitalization or a low price/book ratio--are favorable. They may prove so or may not. Fund marketers will express certainty that their betas are the smart ones, but fund owners should be warier.)

DFA did not--and has not--used the language of strategic beta to describe its approach, but that is what it does. In DFA's words, academic research has identified “dimensions of higher expected returns in the global capital markets. Portfolios can be structured around those dimensions, which are sensible, backed by data, and cost-effective to capture.” Whether these additional returns from exposure to these factors (or betas) are fully paid by the price of additional risk is unclear. The main point is that DFA--as with fund companies that talk about the intelligence of their betas--promises that, by neglecting portions of the marketplace, its funds will outperform the naive, broad indexing strategy.

For Vanguard, this notion sounds suspiciously like those espoused by active managers. Strategic-beta investors think they can identify a pool of higher-returning stocks. So do active managers. Strategic-beta investors also believe that, no matter how cheaply a broad-index fund is priced, they can outgain that fund by applying insight. So, too, do active managers.

Indeed, writes Vanguard in a white paper on the subject, strategic-beta funds may be structured as indexes, but they are not passive investments. They are instead “active strategies, because their rules-based methodologies tend to generate meaningful security-level deviations, or tracking error, versus a broad market-cap index.” The paper finishes with a stiletto. “The debate regarding the long-term performance of active versus indexed strategies continues, but Vanguard believes that reweighting traditional market-cap-based indexes represents neither a ‘new paradigm’ of index investing nor a ‘smarter’ way to invest.”

Business Logic
The investment merits of each side continue to be debated. From a business perspective, the outcome of the broad versus narrow tussle was inevitable.

The market only needs one broad indexer. The 15th flavor of an S&P 500 fund won’t taste any different from the other flavors, assuming that the fund provider keeps costs low and has competent management. Vanguard got there first, pressed its first-mover advantage with aggressive cost controls, and rolled the field. The invention of exchange-traded funds did open a door for BlackRock and State Street, but Vanguard is catching up there, as well.

In contrast, there are many possible interpretations of strategic beta. A marketer can’t credibly make the proposition “Buy my market-capitalization fund because it is different from and better than Vanguard’s.” But it certainly can claim to have different strategic-beta funds from DFA. There are other betas to discover and new definitions of existing betas (for example, defining “value” in a manner other than a low price/book ratio), or fresh combinations thereof. The landscape has been wide open for companies that wish to follow in DFA’s footsteps.

And follow they have. It took until the ETF-age for strategic-beta providers to emerge in earnest, because accepting the lower fees associated with that approach was not an easy step for asset managers. (It feels a lot better to them to raise prices than to lower them.) But now they are legion, coming from all corners of the investment-manager industry, including hedge fund company AQR.

One Vanguard, many DFAs. (Note: This comment applies to the investment debate only. For its entire business, DFA, like Vanguard, has a wide protective moat, thanks to its unique distribution strategy of selling through relatively few financial advisors, who pledge unusual loyalty to the company and who use only asset-based fees [as opposed to load charges].) It took a while, but it was bound to happen.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.