Dimensional (DFA) vs. Vanguard

Summary

This video compares Vanguard and Dimensional Fund Advisors (DFA), two investment companies with roots in the index fund revolution. Vanguard is renowned for its low-cost market index funds, while DFA applies academic finance theories to build funds aimed at beating the market. The video explores the history, philosophies, and performance of both companies, with DFA using systematic strategies to capture market premiums like small-cap and value stocks. The analysis shows that DFA’s funds, while volatile, have outperformed similar Vanguard funds over time, offering an interesting perspective on risk premiums and evidence-based investing.

Takeaways

• 😀 Vanguard is well-known for its low-cost funds that track market indexes, while Dimensional Fund Advisors (DFA) applies academic theory to design funds aimed at beating the market.
• 😀 Dimensional and Vanguard share a history rooted in the early days of index investing, with both companies relying on academic research to shape their strategies.
• 😀 Vanguard's index funds follow a market capitalization-weighted approach, while Dimensional funds target additional market premiums like small cap, value, and profitability.
• 😀 Dimensional Fund Advisors is known for applying evidence-based finance theories to portfolio design and is seen as a pioneer in using academic insights to outperform traditional index funds.
• 😀 Both Vanguard and Dimensional have a focus on minimizing costs, but Dimensional's strategy goes a step further by actively tilting portfolios toward factors that have historically outperformed the market, like small-cap and value stocks.
• 😀 Dimensional’s performance tends to outperform Vanguard in certain sectors, such as small-cap value stocks, but Vanguard still holds the edge in broader market indexes like the S&P 500.
• 😀 Over the long term, Dimensional's factor-based approach has added value, but there are periods when tilting toward factors like small-cap or value can result in significant underperformance, such as in the last 10 years in the U.S. market.
• 😀 Dimensional’s ties to academic finance and its use of the five-factor asset pricing model have helped explain systematic premiums in asset returns beyond simple market risk.
• 😀 Dimensional and Vanguard both benefit from the theory that capturing market premiums, rather than trying to pick stocks or time the market, is the key to achieving better returns.
• 😀 The DFA funds are not suitable for all investors, especially those who cannot tolerate short-term underperformance or those who don’t have access to financial advisors who use these funds. However, Dimensional’s approach can provide higher returns in specific market conditions, especially outside of the U.S.

Q & A

What is the main difference between Vanguard and Dimensional Fund Advisors?

The main difference is that Vanguard primarily focuses on low-cost market-capitalization weighted index funds that track market indexes, whereas Dimensional Fund Advisors (DFA) applies academic finance theory to construct portfolios that aim to beat the market by targeting factors like small-cap stocks, value stocks, and profitability premiums.

What were the foundational ideas behind Vanguard's creation of index funds?

Vanguard's index funds were based on the premise that active management often doesn't outperform the market. Instead, capturing market returns through low-cost, market-capitalization-weighted funds makes more sense, as active managers tend to underperform after accounting for costs and risks.

What is the significance of Dimensional Fund Advisors' (DFA) approach to portfolio construction?

DFA's approach is rooted in academic research, incorporating factors like small-cap stocks, value stocks, and high profitability to enhance expected returns. They go beyond traditional index funds by targeting these systematic risk premiums, which are theoretically expected to lead to higher returns over the long term.

How did Dimensional Fund Advisors (DFA) differ from Vanguard in the early years?

Dimensional was founded with the idea of constructing flexible portfolios that captured premiums from small-cap, value, and profitable stocks, while Vanguard focused on market-capitalization-weighted index funds. DFA's funds weren't strict index funds, but instead aimed to outperform by targeting certain factors and applying academic finance insights.

What is the concept of 'small-cap premium' discussed in the video?

The small-cap premium refers to the observation that small-cap stocks tend to deliver higher returns than large-cap stocks on average, which can be explained by their exposure to greater market risks. This concept was part of the research that influenced Dimensional’s investment strategies.

What are the five factors identified by Eugene Fama and Kenneth French that explain most differences in returns?

The five factors are: 1) Market risk, 2) Small-cap premium (small stocks tend to outperform large ones), 3) Value premium (stocks with low price-to-book ratios tend to outperform), 4) Profitability premium (stocks with strong profitability tend to outperform), and 5) Investment premium (stocks with low investment rates tend to outperform). These factors form the foundation of DFA's investment strategies.

What is the difference between Dimensional Fund Advisors' funds and traditional index funds?

While traditional index funds simply track market-capitalization-weighted indexes, Dimensional's funds are designed to tilt towards factors like small-cap, value, and profitability stocks. This strategy aims to deliver higher returns by capturing systematic premiums beyond just market risk.

How has Dimensional Fund Advisors' performance compared to Vanguard over time?

Dimensional's performance has generally outperformed Vanguard's market-capitalization-weighted index funds in various categories, such as small-cap, value, and international markets. However, Dimensional's funds have experienced periods of underperformance, particularly in the U.S. market in recent years, due to the dominance of large-cap growth stocks.

What are the risks associated with investing in Dimensional's funds?

The main risk of Dimensional's funds is that they can underperform the market in certain periods, particularly when the factors they target (small-cap, value, profitability) are out of favor. For example, the DFA Small Cap Value portfolio has underperformed the Vanguard 500 Index Fund during certain periods, such as the last decade.

How do Dimensional and Vanguard differ in terms of product availability?

Vanguard's funds, especially its index funds, are widely available to individual investors, while Dimensional's funds were originally only available to institutional clients or through financial advisors. However, Dimensional started offering ETFs in the U.S. market in 2020, making their strategies more accessible to retail investors.