The Index Fund Revolution and Competing Philosophies
The investment landscape transformed in 1976 when Vanguard launched its first retail index fund, building on research from a Wells Fargo team that included future Dimensional Fund Advisors (DFA) founder David Booth. While Vanguard popularised low-cost market-cap-weighted indexing, DFA pursued a more nuanced approach rooted in academic factor research – targeting small-cap, value, and profitability premiums identified in Eugene Fama and Kenneth French’s influential asset pricing models.
Factor Investing in Practice: Theory Meets Reality
DFA’s strategy systematically tilts portfolios toward:
- Small-cap stocks (historically higher returns despite recent US underperformance)
- Value stocks (low price-to-fundamentals ratios)
- High-profitability companies
- Avoidance of aggressive growth stocks
This contrasts with Vanguard’s pure index approach, which captures only the market risk premium. Historical data since the 1990s shows:
- DFA US Small Cap Value outperformed Vanguard 500 Index by 2.4% annualised since 1993
- DFA Emerging Markets beat Vanguard’s equivalent by 1.1% annually since 1994
- International value strategies showed particularly strong relative returns
The Double-Edged Sword of Risk Premiums
While factor investing enhances long-term expected returns, it introduces significant volatility:
- US small-cap value underperformed the S&P 500 by 6.3% annually during 1993–2000
- Trailed by 4.5% annually in the last decade’s growth-dominated market
- Required 10+ year commitments to realise premium capture
Implementation Considerations for Australian Investors
Key practical insights:
- Access: DFA funds primarily available through advisers in Australia, while Vanguard ETFs trade directly
- Costs: DFA’s US ETFs charge 0.28–0.36% MER vs Vanguard’s 0.03–0.15%
- Portfolio Construction: Factor tilts require rebalancing discipline to maintain target exposures
- Currency Risk: Both firms’ international holdings introduce AUD volatility considerations
Strategic Implications
The choice hinges on investors’:
- Willingness to endure decade-long underperformance periods
- Belief in persistent factor premiums outside US markets
- Capacity to implement through advised or self-directed channels
As factor returns have diminished in US equities but remained robust internationally, a blended approach using Vanguard for core exposures and DFA (or similar factor ETFs) for strategic tilts may offer optimal balance. Retirees should particularly weigh sequence-of-return risks against potential long-term premium capture.