One Vanguard, Many DFAs (Part 1)

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

John Rekenthaler 21.04.2016
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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, available in the U.S.), 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, available in the U.S.) and Vanguard European Stock Index (VEURX, available in the U.S.) to, a few years later, the even-broader  Vanguard Total International Stock Index (VGTSX, available in the U.S.).

(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, available in the U.S), 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.)

 

In part 2 of this article, we will explore the business logic of these two indexing leaders.

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John Rekenthaler  is vice president of research for Morningstar.

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