Many people know that index funds are cheap. That's why they beat most actively managed funds. But not everybody wants to manage their own money. Many seek advisers to build index-fund portfolios. Among such advisers, however, philosophies clash.
On one side, there are advisers using ETFs or indexed mutual funds from firms such as Vanguard, iShares, BMO, Horizon or TD Bank. On the other side are random walkers on the road less travelled. They use the slightly more expensive Dimensional Fund Advisors (DFA) funds. DFA's Canadian Core Equity Class (F) fund costs 0.38 per cent. By comparison, the iShares Core S&P/TSX Capped Composite Index costs 0.05 per cent. So are DFA's funds worth the extra money?
DFA has cult-like appeal. Eugene Fama, an economics Nobel Prize winner, sits on its board. It aims to beat the market. And its U.S. products usually do.
In 2014, Cogent Reports of Cambridge, Mass., gave DFA top honours for customer loyalty among U.S. mutual fund companies. But don't call them indexes. "I recoil when people think that what we do is being passive, because it has nothing to do with being passive," co-chief executive David Booth said. "We are trying to beat the market without forecasting in the usual sense."
DFA tilts its funds' emphasis toward smaller-cap and value stocks. The firm says such stocks have outperformed the market.
Burton Malkiel is an index fund purist. The Princeton economics professor wrote A Random Walk Down Wall Street, now in its 11th edition. I asked him about DFA. "I generally prefer minimum cost plain-vanilla broad-based index funds," he said. "But if an investor does want to add one of the 'smart beta type' offerings, DFA funds are among the best available."
Scott Burns is another passive investing pioneer. In 1991, the U.S. finance columnist created the original Couch Potato Portfolio. It consists of an even split between an S&P 500 stock index and a bond index. But he also likes DFA. He co-founded AssetBuilder, a U.S. investment firm that uses DFA funds. Mr. Burns also maintains a performance comparison between DFA and Vanguard's funds on AssetBuilder's website.
These aren't products for do-it-yourself investors. You can't buy them without a financial adviser. And before an adviser can sell DFA funds, they must attend a two-day educational conference (at their own cost) in Austin, Tex., or Santa Monica, Calif.
If you pay a financial adviser 1 per cent to manage your portfolio and another 0.38 per cent for fund expenses, total costs would be 1.38 per cent.
If a different adviser charged the same management fee, but used ETFs instead, total management costs could be 1.1 per cent or less. DFA's extra costs appear to be worth the money for Americans because many of them beat the market. But how do they perform in Canada? I looked at five-year equity returns, comparing DFA with available indexes and ETFs.
In the Canadian Equity category, DFA disappoints. Five-year returns for their Canadian Core Equity fund was 7.04 per cent. The iShares S&P/TSX 60 Index ETF (XIU) left it in the dust, earning 8.38 per cent. The iShares Core S&P/TSX Capped Composite Index ETF (XIC) averaged 8.37 per cent.
DFA also dragged in the U.S. equity category. Its non-hedged U.S. Core Equity Fund averaged 19.39 per cent. Vanguard, iShares and BMO don't have non-hedged U.S. indexes with five-year track records. But TD does. Despite its 0.38-per-cent annual cost, TD's e-Series U.S. index fund beat DFA with a 19.46 per cent annual return.
There was no respite for DFA's U.S. Core currency hedged fund. It averaged 15.11 per cent. But the plain-vanilla iShares Core S&P 500 Index ETF (Canadian dollar hedged) averaged 15.51 per cent.
DFA, however, also offers the U.S. Vector fund, which earned 19.42 per cent. "Vector has a stronger tilt away from the market toward the dimensions of higher expected returns (company size, relative price, and profitability)," says Sonny Wadera, a financial adviser with Kelson Financial. Its closest ETF asset class competitor might be the iShares US Fundamental Index ETF. It averaged 19.18 per cent, giving Dimensional the edge.
But most of DFA's funds underperformed the market. The International Core equity fund averaged 10.33 per cent. Again, there's no non-hedged ETF equivalent with a five-year track record. But TD has a non-hedged e-Series International Index mutual fund. It beat DFA, averaging 11.19 per cent.
With its currency-hedged International Core Equity fund, DFA scores a 9.67 per cent return. But once again, it trails TD's e-Series currency hedged International Index, which averaged 9.93 per cent. The iShares MSCI EAFE Index ETF (Canadian dollar hedged) beat it as well, earning 9.72 per cent.
Most of DFA Canada's funds have underperformed the market. But don't write the newcomer off just yet. The past five years haven't given us a full market cycle. The current bull runs while the next bear sleeps. We'll see what happens after the bear wakes up.
Fund returns are as of Feb. 28, 2015. Sources: iShares Canada; DFA Canada; TD Canada Trust
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