Fortunes change for mutual funds, even the best ones. That’s true for funds that seem to be alike. Subtle differences, however, can spell a noteworthy divergence in performance. A case in point is the contrast between good funds from Dimensional Fund Advisors and Vanguard Investments.
Recently, the difference in historical performance between DFA U.S. Small Value (DFSVX) and Vanguard Small Cap Value (VISVX) has narrowed. For example, for the 10-year period ending December 2014, the compound annual return of DFSVX was 7.9%, while VISVX earned 8.3%. Comparatively, for the 10 years ending December 2012, returns were 11.3% for DFSVX and 9.6% for VISVX.
What explains this reversal? It’s not so much their costs. The DFA fund is slightly more expensive to run than the Vanguard offering (charging investors 0.53% of assets yearly, versus 0.23%), but the difference isn’t very wide and both are relatively cheap. What separates them is their asset allocation.
From January 2003 through December 2012, an analysis shows the two funds had roughly comparable concentrations in value stocks, which trade at a lower price than their fundamentals warrant. But DFSVX had markedly higher exposure to market risk – meaning its holdings were more vulnerable to volatility – and owned much smaller companies.
Both the equity market and small-cap stocks did exceedingly well during the earlier timespan, with an average annual equity risk premium – stocks’ extra performance over risk-free Treasury bonds – of 8 percentage points and a 4.3 percentage point size premium, which is how much small stocks exceed large. So it’s not surprising to see that DFA Small Value had substantially higher performance than Vanguard Small Value for the 2012-ending period.
From January 2005 through December 2014, an analysis shows exactly what we found in the earlier period: DFSVX had markedly higher exposure to market risk and small-cap risk than VISVX. Both the market premium and size premium were positive over this period, albeit the average annual size premium was just 1.0 percentage point. What explains the slightly lower returns of DFSVX compared with VISVX?
First, it’s worth noting that the average annual returns of DFSVX were slightly higher than VISVX, but the compound returns were lower due to the higher volatility of DFSVX (24.2% volatility). That’s in contrast to VISVX’s 20.5%.
The primary explanation for the performance differential was that the higher volatility of DFSVX compared with VISVX more than offset the incremental return benefit of having more exposure to market risk and small-cap risk. In periods such as 2003–2012 when the size premium was closer to its historical average, the additional volatility does not tend to offset the higher average annual returns.
Second, DFA Small Value excludes both real estate investment trusts, which are pools of properties or mortgages that trade like stocks, and highly regulated utilities, while Vanguard Small Value does not.
Over this later 10-year period, both REITs (using the Dow Jones U.S. Select REIT Index) and utilities (using economist Ken French’s utilities industry series) had higher returns than Vanguard Small Value itself, indicating that this is likely another explanatory factor.
The higher returns of these two sectors, which are frequently a substantial portion of VISVX’s portfolio, likely pulled VISVX’s returns up relative to what they would have been had Vanguard followed the same sector-exclusion methodology as DFA.
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Jared Kizer is the director of investment strategy for the BAM ALLIANCE, a community of more than 140 independent wealth management firms located throughout the United States. See its disclosures page for more information. Follow him on Twitter at twitter.com/JaredKizer. A St. Louis resident, Jared co-authored the book The Only Guide to Alternative Investments You’ll Ever Need in 2008 with financial author Larry Swedroe. To learn more about the BAM Alliance or to find an independent member firm, please visit www.TheBAMAlliance.com.
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