You Can't Beat The Market? Don't Tell That To DFA

| About: DFA U.S. (DFSVX)

Summary

Investors largely agree that you can't reliably beat the market.

Traditional active management is riddled with flaws: high costs, excessive turnover, and buying the wrong securities at the wrong time.

DFA shows that if you diversify broadly, keep costs and turnover low, and focus on securities with higher expected returns, beating the market isn't just possible, it's probable.

One of the things you hear repeatedly from investors and financial commentators is the axiom that you can't "beat the market." This is mostly true, justifiably derived from the miserable track record of traditional active managers who pursue concentrated security selection and market-timing techniques to outperform indexes. Not only do 80%+ of traditional active managers fail to outperform their index over time, the ones who do outperform over one period of time are not able to maintain that outperformance over subsequent periods.

The failure of active management can be attributed to a few things: (1) they tend to pick the wrong securities at the wrong times, (2) they cost too much, and (3) they trade too often, reducing net returns, especially after taxes.

But what happens if we look at investment strategies that aren't attempting to blindly track an index, and instead focus on securities with higher-expected returns (lower price, smaller cap, and higher profitability stocks) while maintaining broad (index-like) diversification and ultra-low costs? Turns out beating the market is pretty easy.

Let's start with the returns last year for 11 of the oldest mutual funds managed by Dimensional Fund Advisors (DFA) across US, international and emerging markets asset classes. In 10 of 11 cases, the DFA fund outperformed its index even before we consider any real-world index fund or ETF costs.

Asset Class

DFA Fund Return

Index Return

Difference

US Large Cap

12.6%

12.0%

0.6%

US Large Value

18.9%

17.3%

1.6%

US Small Cap

25.6%

21.3%

4.3%

US Small Value

28.3%

31.7%

-3.5%

Real Estate

8.4%

6.7%

1.7%

Int'l Large Value

8.4%

7.4%

1.0%

Int'l Small Cap

5.8%

4.3%

1.5%

Int'l Small Value

8.0%

7.9%

0.1%

Emerging Mkts Large

12.1%

11.2%

0.9%

Emerging Mkts Value

19.8%

14.9%

4.9%

Emerging Mkts Small

10.9%

2.3%

8.6%

If 6 or 7 of the DFA funds beat their index last year, we might chock that up to a random outcome. But when over 90% outperform net of their expense ratios, we have to conclude that that's a persistent result.

But the first chart lists only a 12-month period. And let's be honest, long-term investors are (or should be) indifferent to short-term results. What happens if we look at 5 years (still too short in my opinion), 10 years (yes, still too short), or 15 years? We could do that, and the results wouldn't change much. But any of those periods are less relevant knowing that we have live data on each of the DFA funds dating back to 1998, and index data starting in 1999. Odd, I know, that DFA was managing asset class funds before there were even indexes to track each of these segments of the market. Even today, there are no index funds or ETFs that invest in several of these indexes.

So what happens when we look at the longest period available (1999* to 2016) for DFA's funds and their closest available index?

Asset Class

DFA Fund Return

Index Return

Annualized Difference

US Large Cap

5.4%

5.4%

-0.0%

US Large Value

8.1%

6.6%

1.5%

US Small Cap

10.9%

8.1%

2.8%

US Small Value

11.4%

9.6%

1.8%

Real Estate

11.0%

11.0%

-0.1%

Int'l Large Value

5.8%

4.7%

1.1%

Int'l Small Cap

8.9%

7.6%

1.3%

Int'l Small Value

10.3%

8.7%

1.5%

Emerging Mkts Large

8.8%

8.5%

0.3%

Emerging Mkts Value

11.0%

9.0%

2.0%

Emerging Mkts Small

12.0%

8.4%

3.5%

Virtually the same pattern that we saw over the last 12 months has held for the last 18 years. Of the 11 DFA funds, 9 outperformed their index, one fund tied its index, and only one fund underperformed its index, and even then by just 0.1% per year (less than the expense ratio on an index fund in that category). What's more, we're not talking about nickel and dime-sized levels of DFA fund outperformance. We routinely see 1%, 2% and even 3% (in one case) higher annual returns, even before further deducting the prerequisite index fund or ETF fees.

What's more, every single DFA asset class fund outperformed the S&P 500. (Are you seriously still questioning the value of broad diversification?) Acknowledging that a direct comparison between US large stocks and some of these other asset classes is not exactly apples to apples, we still have to marvel at 5-6% per year higher returns in some cases.

What to make of all this? We can still say generally that it's hard to beat the market. And that traditional active managers can't do it using prehistoric management techniques that have long since been invalidated. But if an investment manager can design low cost, broadly-diversified portfolios that minimize turnover and market impact while focusing on dimensions of higher expected return (value stocks, small cap stocks, and higher profitability stocks), then beating the market or outperforming the index becomes a much easier task, achieved quite reliably.

Or, in response to suggestions that "you can't beat the market," you can simply answer "don't tell that to DFA."

*One could have seen these funds combined in broadly-diversified portfolio examples in 1998 by reviewing page 50 of that year's Matrix Book, reproduced here.

_____________________________________

Source of data: DFA Returns Web

DFA Fund/Index

US Large Cap = DFA Enhanced US Large Company Fund (MUTF:DFELX), S&P 500 Index

US Large Value = DFA US Large Value Fund (MUTF:DFLVX), Russell 1000 Value Index

US Small Cap = DFA US Micro Cap Fund, (MUTF:DFSCX) Russell 2000 Index

US Small Value = DFA US Small Value Fund (MUTF:DFSVX), Russell 2000 Value Index

Real Estate = DFA Real Estate Securities Fund (MUTF:DFREX), Wilshire REIT Index

Int'l Large Value = DFA Int'l Value Fund (MUTF:DFIVX), MSCI World ex US Value Index

Int'l Small Cap = DFA Int'l Small Cap Fund (MUTF:DFISX), MSCI World ex US Small Cap Index

Int'l Small Value = DFA Int'l Small Value Fund (MUTF:DISVX), MSCI World ex US Small Value Index

Emerging Mkts = DFA Emerging Markets Fund (MUTF:DFEMX), MSCI Emerging Markets Index

Emerging Mkts Value = DFA Emerging Markets Value Fund (MUTF:DFEVX), MSCI Emerging Markets Value Index

Emerging Mkts Small Cap = DFA Emerging Markets Small Cap Fund (MUTF:DEMSX), MSCI Emerging Markets Small Cap Index

Past performance is not a guarantee of future results. Index 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/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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