Why Style Investing is Active Management.

[Rick Ferri]

I stated in a previous article that passive investing does not exist; only lesser degrees of active management exist. Style investing is a greater form of active management than total stock fund investing. But it's OK to sit further away from the altar if you're style investing with index funds.

See my extended remarked here: Investing in Style with Index Funds

Rick Ferri

[larryswedroe]

One issue often missed by both investors and advisors alike relates to core vs component funds.

The benefit of a core fund vs the individual components is not only the reduction in trading costs as stocks migrate from one asset class to another, but a significant benefit comes from the core fund's ability to rebalance with other people's money while you have to rebalance with your own money if you use two funds. That can mean more selling of appreciated assets and thus more taxes, assuming they are held in taxable accounts. It surprises me how many miss this key benefit of a core strategy.

Vanguard helped when it combined emerging and developed international markets funds into one fund, it's the same idea when combining large and small and value into a core fund.

Best wishes
Larry

[EDN]

I stated in a previous article that passive investing does not exist; only lesser degrees of active management exist. Style investing is a greater form of active management than total stock fund investing. But it's OK to sit further away from the alter if you're style investing with index funds.

See my extended remarked here: Investing in Style with Index Funds

Rick Ferri

I disagree. It's generally accepted that portfolio returns are a function of 5 factors: stock/bond, within the stock market the relative large/small and value/growth orientation, and within fixed income the relative maturity and credit quality. Passive management entails developing an appropriate allocation based on personal circumstances with varying degrees of exposure to the aforementioned sources of expected returns. So long as those allocations are implemented in a static and strategic (fixed weights with changes only resulting from rebalancing or changes in personal circumstances) fashion, that's passive.

If you vary your portfolio allocation or underlying holdings based on valuations or perceived mispricings, or if you choose to allocate your portfolio in a way that is not consistent with generally accepted sources of return (let's say you over/underweight sectors), you have drifted into the active camp.

This whole "beta-centric", "only TSM is passive" argument simply is not in touch with reality. Not to say you have to target any particular expected return dimension, but to ignore or dismiss their existence is wrong. Any of the 5 dimensions could be positive or negative, but they still provide the most complete description of the behavior of prices.

Here's a quick example of the difference: investor A develops a 60/40 mix and decides to keep fixed income shorter and higher quality than the market (ST Bond Index), and that's their Policy. Investor B has the same stock/bond mix, but has recently sold TBM to buy ST Bond index because they are predicting rates will rise and they are trying to avoid price declines.

2 investors, same portfolio, both hold something other than Total Market indexes, but only investor B is "active"--making tactical shifts based on a perceived mispricing (that expected rate increases weren't already baked into prices via a steep yield curve). Investor "A" is investing passively based on their personal circumstances and preferences.

Eric

[rmelvey]

For me I am really only passive because I care about low costs and diversification. If someone has an "active" strategy with low costs and wide diversification than I won't stay away just because of a label.

[EDN]

This maybe the source of the misunderstanding:

One way to employ a value tilt in a portfolio is to use the Fama-French Three Factor Model. At the core of this portfolio is a low-cost, beta-seeking total stock market fund.

There's a lot wrong with these two sentences. I had to read them a few times to realize the issue. In reference to the FF3F model, it's most accurate to say:

"One way to develop a portfolio asset allocation is based on the findings of the FF3F model, which finds 3 unique sources of equity returns: market, size, and price. Per the model, investors may rationally choose to "tilt" their portfolios towards higher expected returning value stocks through a variety of different construction methods. One such method is to start with a Total Stock Index and add a small value component vehicle..."

You don't "use the FF model to employ a value tilt". The model simply outlines sources of expected return. You apply the model's findings to develop an allocation. And you use investment vehicles to employ the allocation. The model doesn't tell you: a) what the "right" allocation is, or the best way to target a particular allocation (although its implied that doing so passively is the preferred method, and FF have since clarified in their view the best way to build a portfolio that is tilted to size and value). It certainly says nothing about a particular portfolio where the market is the "core" holding. That is one application of the model's findings, and a market index is one vehicle that can be used to employ the allocation.

I don't mean to nitpick words, but they just aren't accurate or representative of the research in the way you use them.

Eric

[Rick Ferri]

If you vary your portfolio allocation or underlying holdings based on valuations or perceived mispricings, or if you choose to allocate your portfolio in a way that is not consistent with generally accepted sources of return (let's say you over/underweight sectors), you have drifted into the active camp.

This whole "beta-centric", "only TSM is passive" argument simply is not in touch with reality. Not to say you have to target any particular expected return dimension, but to ignore or dismiss their existence is wrong. Any of the 5 dimensions could be positive or negative, but they still provide the most complete description of the behavior of prices.

These two paragraphs appear to directly contradict each other. The first one says that "if you vary your portfolio based on valuations" or sectors then you have drifted into the active camp, and the second implies that TSM "is not out of touch", and that investors should overweight a portfolio using risk factors such as book-to-market. Overweighting a portfolio for any reason is active management. You can't have it both ways.

To say the TSM is "out of touch" is absurd. What's out of touch is how people try to describe the TSM. This fund represents the opportunity set for all equity investors net of fees. It is "the market" net of trading costs and management expense. It is a benchmark for all active mangers to try to beat.

It an investor decides try to beat the market, then they will 1) have higher turnover of securities, 2) have higher fund fees, 3) have more risk. A value titled strategy has all three of these characteristics; higher turnover, higher cost, and higher total risk.

Conclusion: ALL value investment strategies are active management.

One issue often missed by both investors and advisors alike relates to core vs component funds.

The benefit of a core fund vs the individual components is not only the reduction in trading costs as stocks migrate from one asset class to another, but a significant benefit comes from the core fund's ability to rebalance with other people's money while you have to rebalance with your own money if you use two funds. Larry

That is a benefit, albeit at higher cost than the two fund portfolio. Vanguard TSM ETF (VTI) is only 0.06% and iShares 600 Value (IJS) is 0.25%. A 75-25 split on these two funds is only 0.11%. The DFA US Core Equity 2 Portfolio has a 0.22% fee (US Core Equity 1 Portfolio is 0.19%).

Not major difference in cost, but an investors still paying about double for one DFA fund than two ETFs. So, an investor in DFA has to be convinced that net of the extra cost paid to DFA that their fund will generate a higher return given the same risk exposures. Perhaps they will, or perhaps not. Truth be told, it's period specific. It depends on what type of value investing is winning at the time. See Value Stocks are in the Eye of the Beholder.

Rick Ferri

[EDN]

If you vary your portfolio allocation or underlying holdings based on valuations or perceived mispricings, or if you choose to allocate your portfolio in a way that is not consistent with generally accepted sources of return (let's say you over/underweight sectors), you have drifted into the active camp.

This whole "beta-centric", "only TSM is passive" argument simply is not in touch with reality. Not to say you have to target any particular expected return dimension, but to ignore or dismiss their existence is wrong. Any of the 5 dimensions could be positive or negative, but they still provide the most complete description of the behavior of prices.

These two paragraphs appear to directly contradict each other. The first one says that "if you vary your portfolio based on valuations" or sectors then you have drifted into the active camp, and the second implies that TSM "is not out of touch", and that investors should overweight a portfolio using risk factors such as book-to-market. Overweighting a portfolio for any reason is active management. You can't have it both ways.

To say the TSM is not "out of touch" is absurd. What's out of touch is how people try to describe the TSM. This fund represents the opportunity set for all equity investors net of fees. It is "the market" net of trading costs and management expense. It is a benchmark for all active mangers to try to beat.

It an investor decides try to beat the market, then they will 1) have higher turnover of securities, 2) have higher fund fees, 3) have more risk. A value titled strategy has all three of these characteristics; higher turnover, higher cost, and higher total risk.

Conclusion: ALL value investment strategies are active management.

Your conclusion is wrong, as is how you interpreted my comment. A portfolio that is tilted to value does not "vary it's allocation based on valuations", it maintains the same allocation all the time--one that is lower priced than the cap weighted market portfolio. And because "price" is an expected return dimension liked to higher associated risks (see cost of capital), the decision to allocate this way is purely passive. Now, using a "fundamental index" like RAFI that trades back and forth between value/growth? That's active despite its index label.

And the cap weighted market isn't the only passive portfolio. That went out with the death of CAPM. As long as your portfolio is allocated according to generally recognized sources of expected return (even if your decision is to minimize or avoid some dimensions), you are firmly in the passive camp. But once you start making decisions with your indexes because things are "undervalued" or "overvalued ", you are active.

It just so happens TSM is heavily weighted towards successful large companies. Nothing wrong with that, but investors may have very rational reasons for wanting a different risk/return profile. That's not active, that's a preference.

Eric

[EDN]

One issue often missed by both investors and advisors alike relates to core vs component funds.

The benefit of a core fund vs the individual components is not only the reduction in trading costs as stocks migrate from one asset class to another, but a significant benefit comes from the core fund's ability to rebalance with other people's money while you have to rebalance with your own money if you use two funds. Larry

That is a benefit, albeit at higher cost than the two fund portfolio. Vanguard TSM ETF (VTI) is only 0.6% and iShares 600 Value (IJS) is 0.25%. A 75-25 split on these two funds is only 0.11%. The DFA US Core Equity 2 Portfolio has a 0.22% fee (US Core Equity 1 Portfolio is 0.19%).

Not major difference in cost, but an investors still paying about double for one DFA fund than two ETFs. So, an investor in DFA has to be convinced that net of the extra cost paid to DFA that their fund will generate a higher return given the same risk exposures. Perhaps they will, or perhaps not. Truth be told, it's period specific. It depends on what type of value investing is winning at the time. See Value Stocks are in the Eye of the Beholder.

Rick Ferri

Rick, you aren't implying that expense ratios are the only cost consideration, are you?

What about securities lending? That matters, or iShares wouldn't be in a lawsuit right now over their practice of pocketing most of their fund revenue to boost company profits.

What about fund turnover and the cost of that turnover? Market on close reconstitution has to be more expensive than trading patiently and providing liquidity.

What about the portfolio rebalancing costs and taxes associated with maintaining separate vehicles and the unwanted asset class drift that results?

And, finally, what about the issue of risk, as "tilting" by loading up on a 400 stock portfolio (600 Value) compared to holding just 1.5 to 3 times the market weight of about 2500 companies that are either smaller or more value oriented (or both) is not advisable if you can help it. Anything less than maximum diversification carries its own costs.

I don't care what your opinion is on these, just don't pretend they aren't considerations and portfolio decisions should come down to .08% differences in expense ratios. That's like buying a car because you like the color.

Eric

[EDN]

One more comment. You seem to be trying to devise some rules-based criteria for what constitutes "active" investing here:

It an investor decides try to beat the market, then they will 1) have higher turnover of securities, 2) have higher fund fees, 3) have more risk. A value titled strategy has all three of these characteristics; higher turnover, higher cost, and higher total risk.

But I think each has issues.

First, you don't know that someone who "tilts to value" is trying to best the market. Maybe they wish to get the market expected return but with less than 100% stock (adding some bonds). So we start with a blanket characteristic that may not apply.

It is not necessarily true that portfolios that are tilted to value have higher turnover. For example, DFA Core 1 and 2 both have lower turnover than the iShares Russell 3000 Index. And lots of active funds have less turnover than the 80% rate of TBM. Turnover by itself doesn't always indicate active or passive. Why you are selling/buying does.

On fees, yes, TSM portfolios are the lowest. But that's just because they are the most commoditized, not because they are the only viable passive vehicle.

On risk, I'd say "different" risks, as value =/= market. But we should only be concerned with the portfolio risk profile, and again, we cannot say how a tilted allocation is being used. 80% DFA US Core 2, 20% TBM contains more exposure to value risk than 100% TSM, but you'll have a hard time finding anyone who believes that is a riskier mix.

I make these points only because I think your idea of what constitutes active is flawed. The market isn't the only passive approach, it's just one of the passive approaches.

Eric

[larryswedroe]

That is a benefit, albeit at higher cost than the two fund portfolio. Vanguard TSM ETF (VTI) is only 0.6% and iShares 600 Value (IJS) is 0.25%. A 75-25 split on these two funds is only 0.11%. The DFA US Core Equity 2 Portfolio has a 0.22% fee (US Core Equity 1 Portfolio is 0.19%).

Not major difference in cost, but an investors still paying about double for one DFA fund than two ETFs. So, an investor in DFA has to be convinced that net of the extra cost paid to DFA that their fund will generate a higher return given the same risk exposures. Perhaps they will, or perhaps not. Truth be told, it's period specific. It depends on what type of value investing is winning at the time. See Value Stocks are in the Eye of the Beholder.

Thought I would address these points. As I have pointed out many times, while expenses matter, it's clearly an error to make that the sole criteria.
For example, it's estimated that the reduction in transactions costs for the CORE funds due to minimizing migration of stocks across asset classes is worth about 12-15bp per year. Then DFA generally creates more securities lending revenue than Vanguard. Those savings should be added back in as they are negative expenses. But the largest benefit for taxable accounts likely comes from being able to rebalance with OPM, something I note almost no one seems to consider. Finally, I'll note you have a tendency to use words like "double" the expenses. Well double can be 1bp or 10bp or 1 or 2%, that makes a big difference. As you note here it's only 8bp, which is more than made up for by the estimated savings in transactions costs, securities lending revenue and also savings from rebalancing. Then DFA adds value through screens, patient trading, including momentum screens and so on.

Best wishes
Larry

[supertreat]

That is a benefit, albeit at higher cost than the two fund portfolio. Vanguard TSM ETF (VTI) is only 0.6% and iShares 600 Value (IJS) is 0.25%. A 75-25 split on these two funds is only 0.11%. The DFA US Core Equity 2 Portfolio has a 0.22% fee (US Core Equity 1 Portfolio is 0.19%).

Not major difference in cost, but an investors still paying about double for one DFA fund than two ETFs. So, an investor in DFA has to be convinced that net of the extra cost paid to DFA that their fund will generate a higher return given the same risk exposures. Perhaps they will, or perhaps not. Truth be told, it's period specific. It depends on what type of value investing is winning at the time. See Value Stocks are in the Eye of the Beholder.

Thought I would address these points. As I have pointed out many times, while expenses matter, it's clearly an error to make that the sole criteria.
For example, it's estimated that the reduction in transactions costs for the CORE funds due to minimizing migration of stocks across asset classes is worth about 12-15bp per year. Then DFA generally creates more securities lending revenue than Vanguard. Those savings should be added back in as they are negative expenses. But the largest benefit for taxable accounts likely comes from being able to rebalance with OPM, something I note almost no one seems to consider. Finally, I'll note you have a tendency to use words like "double" the expenses. Well double can be 1bp or 10bp or 1 or 2%, that makes a big difference. As you note here it's only 8bp, which is more than made up for by the estimated savings in transactions costs, securities lending revenue and also savings from rebalancing. Then DFA adds value through screens, patient trading, including momentum screens and so on.

Best wishes
Larry

I'm just wondering if you know Larry. Why can't Vanguard compete with DFA when it comes to these value adding activities? Why is DFA so much better at securities lending and various trading strategies to add value for it's customers than Vanguard? Are there any other fund companies that are roughly in the same league as DFA when it comes to these types of activities?

[stevewolfe]

I'm also curious as to the transparency of the estimates above regarding items like income from securities lending, etc - how does an average investor gain access to this information?

[stlutz]

Securities lending revenue is reported in the Statement of Operations in the fund's annual report. Since I happen to have the report for the VG Total International Index fund handy, I'll look and see: Securities Lending revenue of 66,683,000 which compares to total expenses of 116,489,000.

Edit: VG has a whitepaper on the subject, BTW: https://institutional.vanguard.com/iam/pdf/ICRSL.pdf

[Rick Ferri]

It just so happens TSM is heavily weighted towards successful large companies. Nothing wrong with that, but investors may have very rational reasons for wanting a different risk/return profile. That's not active, that's a preference.

Eric

I have to disagree with you, Eric. "The market" is not heavy toward anything. It IS the market. How you slice and dice the market may make it seem that the TSM is growth heavy. But this decision is based only after slicing and dicing the markets into growth and value styles. The process of doing slice and dice is an active process. Style investing didn't exist until the 1980s when it was possible to do this analysis using computers.

That being said, I agree that investors may decide that the market portfolio is not the best risk/return profile for them, and that make an active decision to not be the market is rational for them. There's nothing wrong with this choice but you cannot get around the fact that is an active management decision.

I've said this 100 times and will continue to say it to my grave, there is one Boglehead philosophy but there are countless strategies for employing it. We all believe in low-cost, low-turnover, select an allocation, stay the course, et all. That's the Boglehead philosophy. How we employ a portfolio strategy differs from investor to investor; some will use TIPS, some will not; some will use TSM and some will slice and dice.

As long as the philosophy is there, it really doesn't matter which strategy is used. In the end, there is risk, there is return, there is cost, and all else is marketing.

Rick Ferri

[EDN]

It just so happens TSM is heavily weighted towards successful large companies. Nothing wrong with that, but investors may have very rational reasons for wanting a different risk/return profile. That's not active, that's a preference.

Eric

I have to disagree with you, Eric. "The market" is not heavy toward anything. It IS the market. How you slice and dice the market may make it seem that the TSM is growth heavy. But this decision is based only after slicing and dicing the markets into growth and value styles. The process of doing slice and dice is an active process. Style investing didn't exist until the 1980s when it was possible to do this analysis using computers.

That being said, I agree that investors may decide that the market portfolio is not the best risk/return profile for them, and that make an active decision to not be the market is rational for them. There's nothing wrong with this choice but you cannot get around the fact that is an active management decision.

Rick Ferri

Rick,

First, if you look at the average market cap of something like the Vanguard Total Stock Index or Russell 3000, you see about 70% in large and mega cap companies, 20% in mid cap, and 10% in small cap. If you don't think that is heavily weighted towards big companies, I'm not sure what is. That is like saying TBM, which is 70% treasury and agency/mortgage debt isn't heavily invested in government bonds. Of course it is, and no one would bother arguing otherwise.

And you just aren't right about your definition of "active decisions". Here is a perfect example: is an investor who chooses to hold TSM and TISM in non-market cap percentages making an active decision? How about holding stocks and bonds in something other than their global cap weighted proportions? Of course not. To say so completely eliminates any meaning of the term active, and then you have no distinction between someone who holds a heavier TSM vs. TISM portfolio and someone who day-trades. See the problem?

Ultimately, as I said some time back, these are all just labels without exact definitions, but of course we can spot terms being applied incorrectly, like in this case. Why make it more difficult than saying "active" is trying to outguess markets, "passive" is to accept the risk/return of markets across all dimensions? Now, 40 years ago, it wasn't necessary to add across all dimensions, because we didn't know there was more than a stock/bond consideration. But markets don't price all securities within stock or bond market with the same expected risk and returns, so we can no longer confine our definition of "markets" to just the equity/fixed distinction.

Eric

[Bradley]

DFA generally creates more securities lending revenue than Vanguard. Those savings should be added back in as they are negative expenses.

Best wishes
Larry

Larry,

1. Does DFA return all revenue from securities lending to the shareholders? As the referenced article below reveals Vanguard returns 100% of the revenue to shareholders while many other product providers put up to 50% of that revenue in their own pockets.

2. Can you provided the data for your claim that “DFA generally creates more securities
lending revenue than Vanguard”? Vanguard is what? 6, 7, 8 times the size of DFA but
“generally” creates less lending revenue? Are you sure?


https://advisors.vanguard.com/VGApp/iip ... SecLending

“Recent headlines have put a spotlight on the practice of securities lending by investment firms. At Vanguard, it's another example of how we always put shareholders first.

Many other firms may take up to 50% of the lending revenues for themselves or their management companies. In contrast, Vanguard returns all the proceeds (net of the costs of administering the program) back to the funds, ultimately benefiting fund shareholders.

"If fund investors are taking on 100% of the risk, they should get 100% of the return," Vanguard Principal Joel Dickson said”



Bradley

[EDN]

DFA generally creates more securities lending revenue than Vanguard. Those savings should be added back in as they are negative expenses.

Best wishes
Larry

Larry,

1. Does DFA return all revenue from securities lending to the shareholders? As the referenced article below reveals Vanguard returns 100% of the revenue to shareholders while many other product providers put up to 50% of that revenue in their own pockets.

2. Can you provided the data for your claim that “DFA generally creates more securities
lending revenue than Vanguard”? Vanguard is what? 6, 7, 8 times the size of DFA but
“generally” creates less lending revenue? Are you sure?


https://advisors.vanguard.com/VGApp/iip ... SecLending

“Recent headlines have put a spotlight on the practice of securities lending by investment firms. At Vanguard, it's another example of how we always put shareholders first.

Many other firms may take up to 50% of the lending revenues for themselves or their management companies. In contrast, Vanguard returns all the proceeds (net of the costs of administering the program) back to the funds, ultimately benefiting fund shareholders.

"If fund investors are taking on 100% of the risk, they should get 100% of the return," Vanguard Principal Joel Dickson said”



Bradley

Bradley,

Yes, DFA returns all revenue to shareholders, as does Vanguard. iShares is currently being sued over their practice to return less than 1/2 of it if memory serves.

As for the amount of securities lending revenue, remember, it is a percentage of fund assets. So a fund that is 5X smaller could have less total lending revenue, but a higher amount as a percentage of that fund's assets. That is the case with DFA.

For example, a quick glance at Statement of Operations for Vanguard shows 0.03% for TSM and 0.04% for SV in the last 12 months. DFA US Core 2, for example, earned 0.09%. Int'l Core earned 0.22% and EM Core earned 0.27%. I point this out just to add that "fund costs" are more than just top line expense ratios, including all the considerations I listed above.

Why does DFA earn more revenue? Two reasons: because the DFA holds more stocks than Vanguard, especially in the small cap asset class, and in greater percentages, where lending opportunities are greatest. For example, DFA US Small Cap earned 0.22% last year, about 8X the amount of DFA US Large Cap. In some respects, DFA is the largest small cap manager in the world, so they become a primary destination for those looking to borrow securities, especially non-US stocks. The DFA Continental Europe Small Cap Fund (part of Int'l Small) earned a whopping 0.5% last year. The second reason is they are more aggressive in seeking lending opportunities (finding borrowers).

I am in complete agreement with the Vanguard/Dickson quote you provided. It's why I only use Vanguard and DFA funds, no iShares or SSGA or other ETFs. I think the issue raised about iShares securities lending revenues (clients take risk, Barclays gets the reward) should be seriously considered by fiduciaries.

Eric

[Rick Ferri]

, if you look at the average market cap of something like the Vanguard Total Stock Index or Russell 3000, you see about 70% in large and mega cap companies, 20% in mid cap, and 10% in small cap. If you don't think that is heavily weighted towards big companies, I'm not sure what is.

You said it again, YOU are deciding to slice and dice the market among large, mid, and small (and between value and growth). and then YOU are deciding to change your portfolio allocation away from the market based on YOUR analysis of expected risk and return. That is an active management decision. It is based on analysis and a reallocation of assets for what you perceive to be a higher risk-adjusted return than holding all stocks in their market cap weighting.

How an investor does a slice and dice strategy can be through over-weighing style index funds, DFA funds, RAFI based ETFs, or any of a growing number of packaged products designed for this purpose.

Rick Ferri

[EDN]

, if you look at the average market cap of something like the Vanguard Total Stock Index or Russell 3000, you see about 70% in large and mega cap companies, 20% in mid cap, and 10% in small cap. If you don't think that is heavily weighted towards big companies, I'm not sure what is.

You said it again, YOU are deciding what is large, what is mid, what is small (and what is value and what is growth). and then YOU are deciding to change your portfolio allocation away from the market based on YOUR analysis of market segment composition and expected return. That is active management decision.

Rick Ferri

Rick,

You are grasping at straws. There are generally agreed upon breaks for sizes of companies that are very similar between M*, Russell, MSCI, DFA, pension funds, etc. And I am not changing my portfolio away from the cap weighted market position based on a personal view of mispricing, instead based on a generally accepted view based on academic research that the market has set the prices and risk/return for the value/growth dimension differently than the overall market or small/large. As long as I hold a greater than cap weighted market allocation to lower priced stocks in a static fashion and with maximal diversification (I don't think 400 stocks meets this criteria, so you maybe tilting to small and value actively via S&P 600 Value), that is completely passive.

For your definition of active management to hold, you would have to admit that two investors with TSM and TISM in different percentages are making active decisions, or two investors that hold TSM and TBM in different percentages based on their personal circumstances are making active decisions. Are you saying these are active management decisions?

Eric

[Bradley]

Bradley,


As for the amount of securities lending revenue, remember, it is a percentage of fund assets. So a fund that is 5X smaller could have less total lending revenue, but a higher amount as a percentage of that fund's assets. That is the case with DFA.

For example, a quick glance at Statement of Operations for Vanguard shows 0.03% for TSM and 0.04% for SV in the last 12 months. DFA US Core 2, for example, earned 0.09%. Int'l Core earned 0.22% and EM Core earned 0.27%. I point this out just to add that "fund costs" are more than just top line expense ratios, including all the considerations I listed above.




Eric

Ok, so we agree DFA does not generally create more securities lending revenue than Vanguard. They do however have some funds that have a higher percentage of lending revenue when compared to that of similar products at other firms. Your example above is comparing apples to oranges. From a recent Barron's article, "VANGUARD SMALL-CAP INDEX FUND (NAESX), for instance, returned an average of 0.17% of assets to the fund annually for six years."

Bradley

[stevewolfe]

Securities lending revenue is reported in the Statement of Operations in the fund's annual report. Since I happen to have the report for the VG Total International Index fund handy, I'll look and see: Securities Lending revenue of 66,683,000 which compares to total expenses of 116,489,000.

Edit: VG has a whitepaper on the subject, BTW: https://institutional.vanguard.com/iam/pdf/ICRSL.pdf

Thanks, I'll give that whitepaper a read, appreciate the response.

[EDN]

Bradley,


As for the amount of securities lending revenue, remember, it is a percentage of fund assets. So a fund that is 5X smaller could have less total lending revenue, but a higher amount as a percentage of that fund's assets. That is the case with DFA.

For example, a quick glance at Statement of Operations for Vanguard shows 0.03% for TSM and 0.04% for SV in the last 12 months. DFA US Core 2, for example, earned 0.09%. Int'l Core earned 0.22% and EM Core earned 0.27%. I point this out just to add that "fund costs" are more than just top line expense ratios, including all the considerations I listed above.




Eric

Ok, so we agree DFA does not generally create more securities lending revenue than Vanguard. They do however have some funds that have a higher percentage of lending revenue when compared to that of similar products at other firms. Your example above is comparing apples to oranges. From a recent Barron's article, "VANGUARD SMALL-CAP INDEX FUND (NAESX), for instance, returned an average of 0.17% of assets to the fund annually for six years."

Bradley

Who cares about total lending revenue? Lending revenue offsets expenses, and expenses are a percentage of assets, so you only care about the amount of revenue as a percentage of fund assets. If you have more assets, then of course your gross lending revenue will be higher, but so will your gross expenses, which is why you look at net as a percentage of fund assets. That's why it is always expressed as a percentage of fund assets.

Yes, I saw the Barrons article last year (didn't mention DFA). I don't have multi-year figures, just what current prospectuses quote. There was a WSJ article from 2007 "Barclays Puts ETF to Good Use" that found 2006 lending revenues of 0.11% for NAESX, 0.10% for IWM, 0.07% for VISVX, 0.22% for DFA US Small Cap and 0.35% for DFA US Micro Cap. So DFA produced double and triple the Vanguard and iShares result.

Eric

[stlutz]

Post-2008, VG seemed to become more conservative with securities lending. I remember the income percentages being higher then than they are now.

[larryswedroe]

'm just wondering if you know Larry. Why can't Vanguard compete with DFA when it comes to these value adding activities? Why is DFA so much better at securities lending and various trading strategies to add value for it's customers than Vanguard? Are there any other fund companies that are roughly in the same league as DFA when it comes to these types of activities?

There are several reasons for this

A) Vanguard is indexer. While indexing has positives (low cost, relatively low turnover, relatively high tax efficiency) a passive fund that doesn't have to track the index can improve on those, maximizing the benefits, and also eliminate or minimize the negatives (forced turnover, intentionally taking ST gains, inclusion of all securities even where evidence shows it's best to exclude them). Indexer's goal is to track the index. That sacrifices some benefits that could be obtained by not simply adhering to an index. So cannot be patient trader if pure indexer or would have tracking error.

B) DFA has more securities lending mostly because it owns smaller cap stocks and the smaller stocks own larger lending revenues--those wanting to short pay more for them as they are hard to borrow.

There are other fund families that play the game like DFA including Bridgeway and new fund family Vericymetry. I would add AQR to that list as well.

Hope that helps

Larry

[larryswedroe]

'm just wondering if you know Larry. Why can't Vanguard compete with DFA when it comes to these value adding activities? Why is DFA so much better at securities lending and various trading strategies to add value for it's customers than Vanguard? Are there any other fund companies that are roughly in the same league as DFA when it comes to these types of activities?

There are several reasons for this

A) Vanguard is indexer. While indexing has positives (low cost, relatively low turnover, relatively high tax efficiency) a passive fund that doesn't have to track the index can improve on those, maximizing the benefits, and also eliminate or minimize the negatives (forced turnover, intentionally taking ST gains, inclusion of all securities even where evidence shows it's best to exclude them). Indexer's goal is to track the index. That sacrifices some benefits that could be obtained by not simply adhering to an index. So cannot be patient trader if pure indexer or would have tracking error.

B) DFA has more securities lending mostly because it owns smaller cap stocks and the smaller stocks own larger lending revenues--those wanting to short pay more for them as they are hard to borrow.

There are other fund families that play the game like DFA including Bridgeway and new fund family Vericymetry. I would add AQR to that list as well.

Hope that helps

Larry

[larryswedroe]

'm just wondering if you know Larry. Why can't Vanguard compete with DFA when it comes to these value adding activities? Why is DFA so much better at securities lending and various trading strategies to add value for it's customers than Vanguard? Are there any other fund companies that are roughly in the same league as DFA when it comes to these types of activities?

There are several reasons for this

A) Vanguard is indexer. While indexing has positives (low cost, relatively low turnover, relatively high tax efficiency) a passive fund that doesn't have to track the index can improve on those, maximizing the benefits, and also eliminate or minimize the negatives (forced turnover, intentionally taking ST gains, inclusion of all securities even where evidence shows it's best to exclude them). Indexer's goal is to track the index. That sacrifices some benefits that could be obtained by not simply adhering to an index. So cannot be patient trader if pure indexer or would have tracking error.

B) DFA has more securities lending mostly because it owns smaller cap stocks and the smaller stocks own larger lending revenues--those wanting to short pay more for them as they are hard to borrow.

There are other fund families that play the game like DFA including Bridgeway and new fund family Vericymetry. I would add AQR to that list as well.

Hope that helps

Larry

[larryswedroe]

'm just wondering if you know Larry. Why can't Vanguard compete with DFA when it comes to these value adding activities? Why is DFA so much better at securities lending and various trading strategies to add value for it's customers than Vanguard? Are there any other fund companies that are roughly in the same league as DFA when it comes to these types of activities?

There are several reasons for this

A) Vanguard is indexer. While indexing has positives (low cost, relatively low turnover, relatively high tax efficiency) a passive fund that doesn't have to track the index can improve on those, maximizing the benefits, and also eliminate or minimize the negatives (forced turnover, intentionally taking ST gains, inclusion of all securities even where evidence shows it's best to exclude them). Indexer's goal is to track the index. That sacrifices some benefits that could be obtained by not simply adhering to an index. So cannot be patient trader if pure indexer or would have tracking error.

B) DFA has more securities lending mostly because it owns smaller cap stocks and the smaller stocks own larger lending revenues--those wanting to short pay more for them as they are hard to borrow.

There are other fund families that play the game like DFA including Bridgeway and new fund family Vericymetry. I would add AQR to that list as well.

Hope that helps

Larry

[larryswedroe]

'm just wondering if you know Larry. Why can't Vanguard compete with DFA when it comes to these value adding activities? Why is DFA so much better at securities lending and various trading strategies to add value for it's customers than Vanguard? Are there any other fund companies that are roughly in the same league as DFA when it comes to these types of activities?

There are several reasons for this

A) Vanguard is indexer. While indexing has positives (low cost, relatively low turnover, relatively high tax efficiency) a passive fund that doesn't have to track the index can improve on those, maximizing the benefits, and also eliminate or minimize the negatives (forced turnover, intentionally taking ST gains, inclusion of all securities even where evidence shows it's best to exclude them). Indexer's goal is to track the index. That sacrifices some benefits that could be obtained by not simply adhering to an index. So cannot be patient trader if pure indexer or would have tracking error.

B) DFA has more securities lending mostly because it owns smaller cap stocks and the smaller stocks own larger lending revenues--those wanting to short pay more for them as they are hard to borrow.

There are other fund families that play the game like DFA including Bridgeway and new fund family Vericymetry. I would add AQR to that list as well.

Hope that helps

Larry

[larryswedroe]

'm just wondering if you know Larry. Why can't Vanguard compete with DFA when it comes to these value adding activities? Why is DFA so much better at securities lending and various trading strategies to add value for it's customers than Vanguard? Are there any other fund companies that are roughly in the same league as DFA when it comes to these types of activities?

There are several reasons for this

A) Vanguard is indexer. While indexing has positives (low cost, relatively low turnover, relatively high tax efficiency) a passive fund that doesn't have to track the index can improve on those, maximizing the benefits, and also eliminate or minimize the negatives (forced turnover, intentionally taking ST gains, inclusion of all securities even where evidence shows it's best to exclude them). Indexer's goal is to track the index. That sacrifices some benefits that could be obtained by not simply adhering to an index. So cannot be patient trader if pure indexer or would have tracking error.

B) DFA has more securities lending mostly because it owns smaller cap stocks and the smaller stocks own larger lending revenues--those wanting to short pay more for them as they are hard to borrow.

There are other fund families that play the game like DFA including Bridgeway and new fund family Vericymetry. I would add AQR to that list as well.

Hope that helps

Larry

[larryswedroe]

FWIW


Deciding on TSM is just as much an active decision as is any other asset allocation. It's how you implement the AA that determines whether one is passive or active, that's all that matters.
Larry

[Rick Ferri]

For your definition of active management to hold, you would have to admit that two investors with TSM and TISM in different percentages are making active decisions, or two investors that hold TSM and TBM in different percentages based on their personal circumstances are making active decisions. Are you saying these are active management decisions?

Eric

A case can easily be made that these are both active decisions. Rebalancing can also called an active decision. Does it matter?

As I said in my first article, there is no such thing as "completely passive" investment strategy as you put it. There are only varying degrees of active management. But who cares about definitions. As David Booth said, if you want to call DFA active, call them active. If you want to call them passive, call them passive. Don't make a decision on someone else's definition of passive and active. We make our own decision on where to draw the line and move forward.

There is a difference between am investment strategy and a benchmark. TSM is a benchmark first and an investment strategy second. Slice and dice is only a strategy. It's purpose is to outperform the benchmark on a risk adjusted basis, which is the definition of active management BTW.


Rick Ferri

[Bradley]

DFA is a great company that provides very good products.

Vanguard is a great company that provides very good products.

Speaking of small caps, it may be fun to market DFA's strategies/methods/practices, but can either of you two DFA fanatics(Larry/Eric) explain how DFA's Small Cap (DFSTX) returned only $32,332 on $10,000 over ten years while Vanguard's VSMAX returned $32,538 considering they(DFA) have the advantages of increased lending revenue, not having to conform to an index etc? Size does matter. Expenses do matter. Vanguard is bigger and it is cheaper.

Bradley

[Rick Ferri]

Here is the important question; on a net, net basis, does slice and dice outperform? It always cost more than the TSM benchmark, always has higher turnover and higher taxes, always requires more oversight (perhaps an adviser. which is another fee). So, is TSM the efficient investment strategy that most people should use?

I can argue that it is, specifically when the average extra cost to do slice and dice with an adviser using DFA funds exceeds 1.0%. At that extra fee level, it seems that all the "alpha" from slice and dice goes to managers and advisers.

Rick Ferri

[larryswedroe]

The argument of DFA with an advisor vs Vanguard, which is often made is the wrong argument for the simple reason it assumes that the advisor adds no value. Once you have decided to hire an advisor then the question is which are the superior funds to choose.

As to Bradley's comments about fanatics,Eric and I only use DFA funds, and in my case the funds of Bridgeway as well, because they are superior choices for our clients. That's the only reason. Now if you care to show why that is not the case, feel free to make it. Or show why anything that Eric or I said is incorrect. And if I was a DFA "fanatic" then why would I recommend/use Bridgeway's funds? It's all about the engineering and management of the portfolio and nothing to do about some cult. Should be more careful about the words you choose.

As to that period, why did you not look at the 15 year period? DFA fund 8.1 vs 7.3 for Vanguard. For that 10 year period DFA Micro underperformed DFA Small which is not what one would expect (10.4 vs 10.8) over the long term. Because DFA's fund is smaller than Vanguard's that could easily explain the ten year data.

Best wishes
Larry

[EDN]

DFA is a great company that provides very good products.

Vanguard is a great company that provides very good products.

Speaking of small caps, it may be fun to market DFA's strategies/methods/practices, but can either of you two DFA fanatics(Larry/Eric) explain how DFA's Small Cap (DFSTX) returned only $32,332 on $10,000 over ten years while Vanguard's VSMAX returned $32,538 considering they(DFA) have the advantages of increased lending revenue, not having to conform to an index etc? Size does matter. Expenses do matter. Vanguard is bigger and it is cheaper.

Bradley

Bradley,

Snarky comment aside, the last 10 years saw micro underperform small despite a big size premium. So the micro inclusive DFSTX only beat the micro excluding NAESX by 0.1% over the last decade. At 15 years, there was a size premium and micro beat small, so DFSTX beat NAESX by 1%.

Eric

[EDN]

Here is the important question; on a net, net basis, does slice and dice outperform? It always cost more than the TSM benchmark, always has higher turnover and higher taxes, always requires more oversight (perhaps an adviser. which is another fee). So, is TSM the efficient investment strategy that most people should use?

I can argue that it is, specifically when the average extra cost to do slice and dice with an adviser using DFA funds exceeds 1.0%. At that extra fee level, it seems that all the "alpha" from slice and dice goes to managers and advisers.

Rick Ferri

Rick, yes it definitely has, and is expected to continue to do so. Especially if one uses best funds to deliver the return premiums and has discipline or gets help with discipline to stay the course.

Eric

[hafius500]

, if you look at the average market cap of something like the Vanguard Total Stock Index or Russell 3000, you see about 70% in large and mega cap companies, 20% in mid cap, and 10% in small cap. If you don't think that is heavily weighted towards big companies, I'm not sure what is.

You said it again, YOU are deciding what is large, what is mid, what is small (and what is value and what is growth). and then YOU are deciding to change your portfolio allocation away from the market based on YOUR analysis of market segment composition and expected return. That is active management decision.

Rick Ferri

Rick,
.........
For your definition of active management to hold, you would have to admit that two investors with TSM and TISM in different percentages are making active decisions, or two investors that hold TSM and TBM in different percentages based on their personal circumstances are making active decisions. Are you saying these are active management decisions?

Eric

Investor A doesn't know more than the professional average investor with a global (stock/bond) mandate and buys a 'diversified' portfolio of actively managed global funds.
Investor B decides for himself how much to invest in domestic and international funds.

A is a passive investor.
B is an active investor.

Very simple!
A passive investor copies the representative active investor.
An active investor decides that he is different from this 'average' investor. But this decision can be right or wrong. Therefore it's an active decision.
Only if all investors were fully informed and totally rational and if markets were completely efficient we might say it's a passive decision. But this would collide with Samuelson's argument about the impossibility of fully efficient markets - and with the existence of markets..

[supertreat]

Larry,
Thanks for the information - that helps me understand the difference. I did a bit of shopping around and it appears that most of the funds you mentioned aren't available to individual retail investors - are there any funds of these families that you recommend that are available to individuals like myself?

[Bradley]

Bradley,

..... the last 10 years saw micro underperform small despite a big size premium. So the micro inclusive DFSTX only beat the micro excluding NAESX by 0.1% over the last decade. At 15 years, there was a size premium and micro beat small, so DFSTX beat NAESX by 1%.

Eric

Not sure why you included NAESX in your reply, the question was between DFSTX and VSMAX, anyways.......... so if I understand your explanation, the reason DFA’s small cap underperformed Vanguard’s small cap fund was because DFA’s small cap fund included more smaller companies than Vanguard? That seems to conflict with earlier explanations that DFA creates more revenue from lending because they have more smaller companies in their funds, which according to Larry “own larger lending revenues”. When you consider the DFA “advantage” of not being forced to “maintain” strict index requirements that Vanguard is held to, in addition to DFA’s supposedly superior lending revenues I find it telling that Vanguard can outperform over any time period, let alone the last ten years.


Hard to overcome expenses.......

DFSTX.......e/r .37
Advisor fee .50 .60 .70
Total expense .87 .97 1.03

VSMAX ......e/r .10

Bradley

[stevewolfe]

Not sure why you included NAESX in your reply, the question was between DFSTX and VSMAX, anyways..........

Bradley, likely he included NAESX (which is the investor share class of Vanguard Small Cap Index) vs. VSMAX (which is the Admiral share class of Vanguard Small Cap Index) because the former has 15 years of performance history and the later doesn't (it wasn't added as a share class till around 2000 if memory serves).

[Bradley]

As to Bradley's comments about fanatics,Eric and I only use DFA funds, and in my case the funds of Bridgeway as well, And if I was a DFA "fanatic" then why would I recommend/use Bridgeway's funds? It's all about the engineering and management of the portfolio and nothing to do about some cult. Should be more careful about the words you choose.


Best wishes
Larry

Larry,

The term fanatic was not meant to be disrespectful, sorry if you took it that way. Like devotee, enthusiast, zealot it was meant to describe persons showing more than ordinary support for, adherence to, or interest in a cause, point of view, or activity. In your case that refers to your DFA beliefs. Cult was your descriptor not mine.

Bradley

[Rick Ferri]

Here is the important question; on a net, net basis, does slice and dice outperform? It always cost more than the TSM benchmark, always has higher turnover and higher taxes, always requires more oversight (perhaps an adviser. which is another fee). So, is TSM the efficient investment strategy that most people should use?

I can argue that it is, specifically when the average extra cost to do slice and dice with an adviser using DFA funds exceeds 1.0%. At that extra fee level, it seems that all the "alpha" from slice and dice goes to managers and advisers.

Rick Ferri

Rick, yes it definitely has, and is expected to continue to do so. Especially if one uses best funds to deliver the return premiums and has discipline or gets help with discipline to stay the course.

Eric

I agree that discipline is the primary way an adviser adds value, but you're assuming an awful lot by inferring DFA will have the best funds in all asset classes going forward.

Rick Ferri

[arcticpineapplecorp.]

That is a benefit, albeit at higher cost than the two fund portfolio. Vanguard TSM ETF (VTI) is only 0.6% and iShares 600 Value (IJS) is 0.25%. A 75-25 split on these two funds is only 0.11%. The DFA US Core Equity 2 Portfolio has a 0.22% fee (US Core Equity 1 Portfolio is 0.19%).
Rick Ferri

RIck, do you want to edit your 2nd post regarding these fees...Vanguard shows TSM as .06%, not 0.6%.
6 basis points (the real amount) is different from 60 basis points (listed above). Semantics perhaps but I'm sure you'd prefer to be accurate in your posts especially for the uninitiated. Thanks.

[Rick Ferri]

Fixed. Thanks.

[tetractys]

For some, active management has to do with fund managers, and not with the investors per say. When it comes to individuals, the tried and true terms of investor vs. speculator should be preferred. Why repackage and sell used bait? -- Tet

[larryswedroe]

Bradley
First, I am no more a fan of DFA or any other fund than the data and logic lead me to be. When there is a better alternative I use it and recommend it. Have no reason not to. It simply about where the "science" leads one

Second,if you want to understand why your comments about the relative performance of DFA and Vanguard funds are wrong suggest you read this blog post I just happened to write.
http://www.cbsnews.com/8301-505123_162-57573864/when-indexing-works-and-when-it-doesnt/

It's about what we can call the purity hypothesis.Here's a good example. Say you have a fund A that is really small and deep value and another fund B that is more mid to small in size and value, but not as deep. You have a year or multi-year period when large beats small and growth beats value, you should expect Fund B to outperform. Some years mid caps do the best. But over long term you should expect the smaller and the more valuey fund to outperform. The examples I gave you showed exactly why what happened can be explained and even predicted if you knew ahead of time that micro would underperform small.

I would add that there are other differences which could also explain the relative performance. DFA excludes both REITs and utilities for good reasons. Vanguard does not. So when you have periods when those two outperform you would expect Vanguard's fund to benefit, and vice versa. So you have to do what's called an attribution analysis to understand why the performances were what they were.

I hope that is helpful

Best wishes
Larry

[larryswedroe]

supertreat
First, DFA's funds are available in many corporate retirement plans and in some 529 plans.
Second Bridgeway's funds with the exception of the Omni Funds are also available to the public
Third, you can look for ETFs and other funds that have the closest valuation metrics to these funds, smaller and more valuey, while still with broad diversification.

Hope that helps
Larry

[Bradley]

Bradley

I would add that there are other differences which could also explain the relative performance. DFA excludes both REITs and utilities for good reasons. Vanguard does not.

I hope that is helpful

Best wishes
Larry

Larry,
Not sure what you mean when you say “DFA excludes both REITs and utilities for good reasons”. DFA has a REIT. REITs are an integral part of the Core Four Portfolio. Once again Vanguard’s fund outperforms DFA’s comparable fund.

Vanguard’s REIT VNQ has outperformed DFA’S REIT DFREX over the past day, week, month, YTD, 1yr, 3yr, 5yr and 10 year period. In other words Vanguards REIT has outperformed DFA’s REIT for every standard time period displayed on M* since it existed. How can this happen if DFA is so much better at creating lending revenue? How can this happen with all the advantages DFA supposedly has and you continually mention on this forum?

Using Dunn’s Law to explain Vanguard’s outperformance merely strengthens support for indexing vs DFA’s quantitative and costly methods. As you are aware of, there will be periods when DFA portfolios will outperform and there will be periods of time when DFA underperform Vanguard portfolios. To say that DFA has the best funds for all asset classes with the exception of Bridgeway is silly. By the way, I believe your preferred Bridgeway fund is/was BOSVX an actively managed value micro cap? You have posted that you now use this fund as your Small Cap Value fund. Even though this fund was hand picked by you and BAM it has underperformed the much cheaper passive iShares etf IJS Small Cap Value fund used in the Tight fisted Investing Portfolio.

In it’s one and only full year performance(2012) Bridgeway’s Omni fund returned 17.74% underperforming both iShares IJS who returned 18.24% and more appropriately the passive micro cap IWC with a 19.51%.

In my opinion, it defies the principles of this forum and logic to place money in an expensive actively managed fund with no track record to fill a Small Cap Value allocation when cheaper and better performing options are available.


Bradley

[M1garand30064]

What are the good reasons for excluding REITs and utility companies?

[larryswedroe]

Bradley
ONe problem is you are critiquing issues you don't have the knowledge to do. DFA excludes both REITS and regulated utilities from its stock funds because their risk characteristics are very different. In fact DFA treats REITS as a separate asset class, which is why it has a REIT fund. So Vanguard's say small value fund will own both REITS and regulated utilities while DFAs funds will not. That can go a long way to explaining differences in returns for especially short periods (and especially when term risk is a big factor in returns).

As to the two REIT funds, the two funds are virtually identical, they both exclude the same type of REITS. Thus basically what explains their differences in returns in the difference in expense ratios. Same thing true of their S&P 500 fund and DFA's large cap fund. Basically difference is expense ratios.

Sorry your statement about Dunn's law makes absolutely no sense whatsover. It's the equivalent of saying that there are times when bonds will outperform stocks so should own bonds, not stocks. The question is what is the expected return. If you want to own small and value stocks because you expect higher returns (and accept the risks) and you like the diversification benefits then you should prefer the DFA to Vanguard funds, and should then weigh the higher costs vs the benefits.

The Bridgeway fund is not actively managed either. And yes it underperformed because the unexpected happened. Midcap value stocks had the best performance. If we wanted midcaps instead of small caps we would prefer the Vanguard fund!! You are making here the mistake of confusing strategy and outcome. It's the investment equivalent of complaining that you bought life insurance and did not die!! The risks with funds such as DFA and Bridgeway is the risk of tracking error vs. some index. Smart investors ignore the risks because they have no expected value, should be purely random--and of course negative over time or you would prefer the index fund. Note the fund was not only handpicked by us, but we helped in the design, making it more valuey and smaller than similar funds. Now the fund also underperformed the more similar DFA SV fund, again a purely random outcome, that will happen from time to time. Those who don't understand these issues should not invest in such strategies because they will make the same mistake you're making

Nothing I've said defies any of the principles put forth here. No disrespect intended but it's only your lack of knowledge of the subject that leads you to that conclusion. The funds are passively managed, use the "science of investing" in their design, capture the returns of the asset classes they are designed to capture and do so in a low cost and tax efficient manner. That's the principles espoused here. So your statement about an expensive and actively managed fund are wrong on all counts.

Best wishes
Larry