Looking For Value From Vanguard

by: Eric @ SERVO

When assessing value investing strategies, it's important to look beyond expense ratios and study how value funds construct and implement their portfolios.

Despite extremely low expense ratios, traditional value stock indexes from Vanguard in the US have failed to deliver the value premium.

The lack of value stock indexes from Vanguard in non-US markets has led to lower long-term returns and reduced portfolio diversification.

My article last week looked at the long-term benefits to holding a diversified portfolio that included a tilt to large cap and small cap value stocks globally. To illustrate the results, I used the structured asset class mutual funds from Dimensional Fund Advisors (DFA) as my proxies for the value stock categories, unlike the market indexes, where I substituted Vanguard index funds. Why not use Vanguard results across the board? Vanguard has an obvious expense ratio advantage over DFA and just about everyone else, and investors have voted with their wallets - Vanguard has more assets than any other mutual fund company.

The issue is, when you look to Vanguard for value, they either don't measure up or don't even offer strategies for a given asset class. Take a look at the table below.





DFA US Large Cap Value fund (MUTF:DFLVX)


Vanguard S&P 500 fund (MUTF:VFINX)


Vanguard Value Index (MUTF:VIVAX)


DFA US Small Value fund (MUTF:DFSVX)


DFA US Small Cap fund (MUTF:DFSTX)


Vanguard Small Value Index (MUTF:VISVX)


DFA Int'l Value fund (MUTF:DFIVX)




MSCI EAFE Value Index


DFA Int'l Small Value fund (MUTF:DISVX)


MSCI EAFE Small Cap Value Index


Vanguard manages index funds in the US covering large and small value stocks. But they don't capture as much of the value "premium" as the asset class funds from DFA do. Since 1993 (DFLVX inception), the DFA US Large Value fund outpaced the Vanguard Value Index (net of a higher expense ratio) by 1% per year. Since 1998 (VISVX inception), the DFA US Small Value fund outpaced the Vanguard Small Value Index (net of a higher expense ratio), again by 1% per year.

Surprisingly, the Vanguard value funds even underperformed the S&P 500 and small cap "market" funds, despite the fact that these "neutral" (holding both growth and value) funds obviously have less exposure to value stocks than the Vanguard value indexes. This should dispel any myth that the Vanguard underperformance is due solely to "less exposure to the value factor."

Things get considerably more challenging with Vanguard once we leave the US market. Vanguard doesn't offer an index fund that buys international large value stocks or small value stocks. You're stuck with a plain-vanilla market index like the MSCI EAFE. The chart above finds, since 1995 (DISVX inception), the DFA Int'l Value fund bested the EAFE Index (before expenses associated with an actual index fund that buys EAFE stocks) by 1.3% per year. The DFA Int'l Small Value fund did 2.7% per year better. Clearly, there's a significant cost (return drag) to investing only in international market indexes that doesn't show up in simplistic expense ratio comparisons.

But what if Vanguard did offer large and small value indexes in foreign markets? Would they be worth a look? Here I've reproduced the returns on a likely index provider - the MSCI EAFE Value and EAFE Small Value Indexes - for comparison purposes (source: DFA ReturnsWeb). These indexes don't have any fees, and any index fund or ETF that tracks them would likely trail the index return by 0.2% to 0.3% or so.

Even still, the apples (net of fee DFA fund return) to oranges (gross of fee index returns) comparison shows a clear advantage to DFA: The DFA Int'l Value fund did +0.7% per year better than the EAFE Value Index while the DFA Int'l Small Value fund did +0.4% per year better than the EAFE Small Value Index. The lack of value stock indexes from Vanguard in non-US markets isn't just a return issue, either. Large and small foreign value stocks also have lower correlations to US asset classes and have provided an additional diversification benefit.

What accounts for these significant net-of-fee differences that are consistent across geographical regions over meaningfully long periods of time? First, as previously mentioned, DFA does hold a deeper subset of the lowest-priced value stocks, about the cheapest 30% compared to the cheapest 50% for Vanguard. And the small cap funds hold almost purely small and micro cap stocks compared to small and mid cap stocks for Vanguard.

DFA screens out stocks with low-to-negative profitability and when buying and selling, they do so patiently throughout the year, hanging on to companies with positive momentum while waiting to buy stocks with the strongest negative momentum. And, finally, DFA is a more active security lender, earning a few more basis points on average from lending out stocks overnight and earning a return (that gets credited back to the fund) for doing so.

All of this adds up to much purer asset class exposure with noticeably better long-term returns that is not isolated to just one area of the market.

I like Vanguard. They've done a good job of educating investors on the importance of broad diversification and minimizing fees. But given the option, in the crucial asset classes that belong in a "core" diversified portfolio*, I just don't see the value in using Vanguard.

*I would add that the DFA US Large Cap Equity fund (MUTF:DUSQX) and DFA Five-Year Global fund (MUTF:DFGBX), which cover the other two core asset classes not discussed in this article, represent superior options to the Vanguard S&P 500 fund and the Vanguard Short-term Bond Index fund as well, but the reasons are beyond the scope of this article.

Past performance is not a guarantee of future results. Mutual fund performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

Disclosure: I am/we are long DUSQX, DFLVX, DFSVX, DFIVX, DISVX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.