Three Fund Families – Three Philosophies: An Update

Posted on Monday, June 23rd, 2014

by James W. Heard, CFP®, President, Windham Brannon Financial Group, LLC

This article first appeared at the height of global markets in the fall of 2007 and was updated in 2010.  The article compared real world examples of three competing investment philosophies, and it helped to illustrate why we use DFA so extensively in our portfolios.

We’ve updated the performance numbers and fund information through December 2013.

Executive Summary

At Windham Brannon Financial Group (WBFG), we understand that your trust in us is affected by many factors, one of those being investment performance.  But trust also comes from knowledge, and when you have insight into how we think, you are more confident in the work being done on your behalf. This article is just one way we provide that trust-building knowledge.

To help you understand the WBFG investment philosophy, we prepared an analysis of three well-known firms — the Frank Russell Company, the Vanguard Group and Dimensional Fund Advisors — examining their investment and management techniques.

We demonstrate that while each firm has played an important role in the development of portfolio management, we believe that DFA’s approach based on the Fama-French Three-Factor Model is the most appropriate for helping our clients achieve long-term success.  The soundness of the underlying theory and their proven track record of success demonstrate to us that our clients’ interests are best served by following the DFA approach.

Introduction

The debate regarding the usefulness of traditional, active money management continues. For our analysis, we define traditional active management as money management based upon the perceived ability to consistently exploit pricing inefficiencies of securities, asset classes, or markets.  The method used to identify these inefficiencies is not important, but the belief that pricing inefficiencies exist and that they can be consistently identified by fundamental or technical research is the basis of all traditional active management.

The Frank Russell Company, The Vanguard Group, and Dimensional Fund Advisors have built their respective investment management businesses using three very distinct investment philosophies.  The first relies upon traditional active management, the second relies upon indexing, and the third relies upon something very different.  Within the context of the active management debate, we believe it is instructive to review these philosophies and the resulting performance.

While this study is not definitive because the examined time period is too brief, it does provide compelling information.  These firms and their founders have made tremendous contributions to modern finance and the field of investing.  The investing public and the financial advisory profession are better because of the work of all three firms.


The Frank Russell Company

Background

The Frank Russell Company started in 1969 when J.C. Penney hired the firm to consult on the management of the retailer’s pension plan portfolio.  Rather than hiring Russell to actually invest the pension fund, J.C. Penney hired the firm to hire the managers.  While this is a process we take for granted today, it was groundbreaking at the time.

Philosophy

Russell’s concept is simple— reduce the risk and increase the return to the client by hiring the “best of the best” to manage each asset class and, in most cases, hire more than one manager with different styles.  These management styles are often represented by a value manager, growth manager and blend manager.

Achievements

  • Within five years of its founding, Russell landed 40 major U.S. companies as clients, including GM and AT&T.
  • The basic concept of a multi-manager, multi-asset class and multi-style approach has remained in place since the firm’s founding and is considered by most experts to have revolutionized the investment management process.
  • The firm began the benchmarking process in investment monitoring, creating some of the most widely used indexes in the industry—the Russell 1000, 2000 and 3000 Indexes.
  • Today, Russell consults on more than $2.5 trillion in investment assets and manages more than $250 billion through their institutional mutual funds using the same process they provide for their clients.
  • While Russell has plenty of competition, they are regarded as one of the leaders in evaluating and selecting money managers, due in part to their immense resources. According to Pensions & Investments, Russell consistently ranks in the top four of pension consulting firms based on global assets under advisement.

Windham Brannon’s Evaluation

Given Russell’s experience, pricing power and powerful resources, it would be reasonable to conclude that the company should produce superior returns.  Our conclusion: Russell’s returns are disappointing.  On average, their funds do not match the market benchmarks, and their peer ratings are generally mediocre.  For all its resources and experience, Russell’s performance appears no better than an index fund (see table to follow).


The Vanguard Group

Background

Built by John C. Bogle in the early 1970s, Vanguard was created on the belief that the approach by Russell and other active managers was futile. Since its inception, Vanguard’s history has proven Bogle right on many accounts, and the data and studies supporting his initial contention have multiplied.

Philosophy

According to the firm’s background literature, Vanguard has a multifaceted investment and money management philosophy –

  • Investing is a long-term proposition and asset allocations are heavily dependent on the time that will be needed to achieve investment objectives.
  • Balance across asset classes and diversification within those asset classes are essential.
  • Costs (such as management fees and transaction fees) are predictable and should be controlled.
  • Continuity promotes stability. Reducing excessive turnover of managers, advisors, and assets within a portfolio is beneficial to achieving long-term success.

Achievements

  • Vanguard manages more than 160 domestic funds (including variable annuity portfolios); plus additional funds in international markets.
  • U.S. mutual fund assets have grown from $1.8 billion in 1975 to approximately $2 trillion as of September 30, 2013.
  • The Vanguard 500 Index fund is one of the largest mutual funds in the world ($155 billion as of January 31, 2014), and while many are concerned Vanguard has drifted toward more active strategies, the fund group is still the retail investor’s choice for index mutual funds.

Windham Brannon’s Evaluation

As expected, Vanguard’s index fund returns are in line with their appropriate benchmarks. What sets the firm apart, however, is their execution—indexing sounds simple in theory, but the execution can be complex, and Vanguard executes their index strategies well.  Comparisons of Vanguard index funds to other index funds are beyond this study, but suffice to say that Vanguard still is considered a leader in the world of index mutual funds.


Dimensional Fund Advisors (DFA)

Background

DFA was founded in 1982 by University of Chicago School of Business graduates Rex Sinquefield and David Booth. Sinquefield had already cemented his name in the modern finance history books by compiling the first database of stock prices with Roger Ibbotson through the Center for Research in Security Prices (CRSP). Since its first compilation, the database has been produced annually in a publication called Stocks, Bonds and Bills.  Booth helped start the first institutional index fund at Wells Fargo.  What drove these two into the investment and finance industry was a professor doing groundbreaking work in finance—Eugene Fama. In the 1960s, Fama published work confirming the randomness of stock prices and coined the phrase we use today—Efficient Market Theory.  Fama later teamed with Ken French to build upon the Nobel Prize work of William Sharpe (professor emeritus at Stanford Business School and winner of the 1990 Nobel Prize in economics) to identify the factors that determine stock returns and, consequently, explain stock portfolio returns.  Fama’s work was recognized in 2013 when he was awarded the Nobel Prize in Economic Sciences.  Read more here.

Philosophy

In a 1992 paper, Fama and French introduced the Three-Factor Model. Their goal: identify risk factors that could be used effectively and simply to explain the returns of stock portfolios.

The model’s premise is that stock market and portfolio risk factors can be reduced to three primary factors:

  • sensitivity to the equity risk premium (total stock market return minus T-Bill return) measured by beta
  • exposure to growth or value stocks as measured by the book-to-market ratio (the inverse of Price/Book)
  • exposure to large or small capitalization stocks

According to the model, a portfolio’s expected return is simply the beta adjusted equity risk premium increased or reduced by the other two factors, and value and small cap exposure increase returns due to their higher risk while growth and large cap stocks reduce returns due to lower risk.  (Note:  More recently, other factors such as momentum and profitability have been added to the mix of variables DFA uses in securities selection, the Multi-Factor Model.)

This model, though not perfect, went much further than Sharpe’s capital asset pricing model (CAPM) to explain the behavior of stock portfolios.  More importantly, the model was relatively simple to use.  While its validity has been challenged often, today – at least in academic circles – it is well accepted.

Booth and Sinquefield used the Three-Factor Model to construct their portfolios at Dimensional Fund Advisors, thereby completing the loop from theory to practice. They eventually condensed their investment philosophy into four core beliefs:

  • Capital markets work (capitalism is more efficient and effective than any one person or entity could be);
  • Risk and return are related;
  • Diversification is critical to reducing uncompensated portfolio risk; and
  • Portfolio structure explains a portfolio’s past performance and, more importantly, its expected future return.

AchievementsThreeFunds2013

Following the Three-Factor Model (and after, the Multi-Factor Model), DFA’s returns are impressive.  As shown in the table (which reflects the earliest common date available for each fund comparison), DFA funds show exceptional results, especially in the exposure within its small cap and value funds.

The bottom line: while the periods examined are not long, DFA’s initial results are impressive. Vanguard performs as expected, and Russell, despite its self-touted expertise, lags in almost every category.

As one might imagine, not all managers and academics are convinced.  Economic thought leaders such as Vanguard’s Bogle and Harry M. Markowitz (co-winner of the 1990 Nobel Prize for Economics) have written that the Multi-Factor Model approach has risks, primarily that the reversion to the mean phenomenon will ultimately catch-up to this strategy; however, Fama and French have long contended that if their factors are truly risk factors, they cannot be arbitraged away anymore than the difference between stock and bond returns can.

Windham Brannon’s Evaluation

Today, the Multi-Factor Model is a more effective tool for building portfolios around identifiable risk/return characteristics than indexing or traditional active management. While some may argue that the model’s performance period is too short to draw any specific conclusions, the initial results are promising.  Also, the fact that DFA created these portfolios to outperform ex-ante is a powerful persuader.  Better yet, developing plans and investment policy around more predictable factors can only serve our clients better.

Conclusion

As the world of modern portfolio theory continues to expand, new investment approaches such as fundamental indexing and products like exchange traded funds (ETFs) may add to the effectiveness of portfolio construction.  In this light, rather than view Russell, Vanguard and DFA in terms of “better” or “worse,” it’s more constructive to view them in light of their place in the evolution of investment theory, with each adding significantly to the advancement of portfolio management.

As for Windham Brannon and its clients, our belief is that the strong theoretical basis of the Multi-Factor Model bolstered by its track record makes it the favored investment approach that we believe will produce the best long-term results for our clients.


Note:  The author recognizes that all fund families have more funds than listed here.  The author attempted to use funds in his comparison that 1) were included in the original analysis, 2) has a track record longer than 10 years, and 3) focused on well-defined asset classes.  All comparisons were made from the first date on which the funds in each comparison existed in Morningstar data.

 


James W. Heard is president of Windham Brannon Financial Group, a wealth management firm with expertise in working with senior corporate executives. He has over 25 years of financial services experience and is a Certified Financial Planner (CFP®), Chartered Financial Consultant (ChFC), and Chartered Life Underwriter (CLU). He can be reached at jheard@wbfinancial.com or 678-510-2770.

© 2014 Windham Brannon Financial Group. All rights reserved. Any use of information contained in this article, including reproduction, modification, distribution or republication, without the prior written consent of Windham Brannon Financial Group, is strictly prohibited.

WBFG obtains historical and other information from a wide variety of publicly available sources. We have taken all reasonable care and precaution to ensure that the information is fair and accurate, or has been compiled from sources believed to be reliable. Nevertheless, we do not make any representations or warranty, express or implied, as to the accuracy, completeness, or fitness for any purpose or use of the information. The information may not in all cases be current and it is subject to continuous change. Accordingly, you should not rely on any of the information as authoritative or a substitute for the exercise of your own skill and judgment in making any investment or other decision. We shall not be liable for any direct, indirect, or consequential loss arising from any use of or reliance on the information from this article. WBFG and its affiliates do not have, nor claim to have, sources of inside or privileged information regarding expected future returns on any investment proposed. The recommendations developed by WBFG are based upon the professional judgment of WBFG and its individual advisory affiliates and neither WBFG nor its affiliates can guarantee the results of any of their recommendations. Clients at all times may elect unilaterally to follow or ignore completely, or in part, any information, recommendation, or advice given by WBFG and its affiliates. Past performance is not necessarily indicative of future results.

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