How DFA out-smarts the index funds
Index funds are a great tool. They give investors ultra low cost access to a broadly diversified portfolio. In short, rather than picking and choosing which stocks to own, and indexing approach will just hitch its horse to an “index”, or simply a basket of stocks chosen based on a characteristic. Many index funds will track the S&P 500 (the largest 500 US based stocks) or even the entire stock market (Total Stock Market Index). Small company stocks can be accessed by purchasing index funds based on the Russell 2000 index.
There is a potential flaw in the ointment, however. Funds that track an index are inflexible. Most indices only apply the formula which figures out which stocks it should own annually. Furthermore, most are completely agnostic regarding the qualities of the companies that constitute the index.
Inherent in most indices is that they own stocks in proportion to the size of the companies. Fair enough. But the size of the company is determined based on the price of the stock. Normally, this is not a problem. It is understood that Apple is a much bigger stock (total value of all stock outstanding $2 trillion) than let’s say, Crocs Inc, the footwear maker (total value of stock $7 billion). Apple is 285 times bigger by this measure than Crocs – so an index fund tracking the market would hold 285 times more Apple than Crocs. I guess it makes sense to own more of the big (and presumably more stable) companies than smaller more risky ventures.
The problem is that sometimes things get a bit crazy in the market. Crocs for instance, is a profitable company. It made $400 million in profit last year. (probably benefiting from work at home!). But what about the meme stocks – Game Stop and AMC (theatre chain) being the best publicized examples. Stock prices for both these (so-called “meme stock”) companies soared – making them bigger and bigger over the last 12 months. However, they were only growing on paper. There is no reason for the high prices, except for rampant speculation by (mostly novice) investors. Investing in firms such as these is not investing, it is gambling. Both of these companies lose money. On no rational basis should these stocks be worth what they are worth. But funds that must follow an index need to buy more and more of these stocks even as stock prices becomes untethered from reality. In short, if you own an index fund you are going along for the ride. Remember, the index is completely agnostic as to the qualities of the companies that constitute it!
Now this is not to disparage index funds. They still outperform most traditional stock mutual funds which try to make money by picking stock “winners” and “losers” with a team of analysts and managers. But I’d still rather not take part in stupid!
This article by Dimensional highlights how their investment process – which most of the time behaves just like an index - can provide a different result in times of ridiculous excess. Dimensional manages its “index-like” funds to offset somewhat the tendency of most index funds to overweight the biggest most expensive companies. Their process will modestly overweight smaller, cheaper, and more profitable companies. Research indicates firms with these characteristics tend to generate higher returns over long time periods. Furthermore, Dimensional employs certain “filter” criteria which can exclude some companies altogether. Critically in the case of meme stocks, it excludes companies with very expensive price tags that are not profitable. Again, research shows that, taken as a group, companies with these traits tend to generate inferior returns over long periods of time.
It pleases me to note, as I read their article, that thanks to its intelligent approach to indexing, Dimensional no longer owns ANY Game Stop or AMC across all its portfolios. Do the tilts and screens Dimensional employs mean that its funds will always beat out their traditional “pure” index competitors? No. But I do like the added built in intelligence that is baked into this approach. I like that my clients enjoy all of the benefits of indexing (low cost, broad diversification) while reducing some of the negatives that are associated with indexing. This is why we have long recommended Dimensional products to our investment clients, and continue to believe their approach will continue to generate superior risk adjusted investment returns.