How DFA Is Superior To Index Funds: An Analysis

|
Includes: DFUVX, VFINX, VIVAX
by: EB Investor

Summary

Indexation is a bubble waiting to burst.

Investors fail to learn from history and tend to only remember the gains of the recent past. This bias is creating behavioral anomalies in investor behavior.

Investors are far better served following an active based investment philosophy backed by sound academic research using DFA Funds.

"Every new indexed dollar goes to the same places as previous dollars did. This "guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up. There's no valuation or other parameters around that decision,"… the result will be a "bubble machine"-a winner-take-all system that inflates already large companies, blind to whether they're actually selling more widgets or generating bigger profits. Such effects already exist today, of course, but the market is able to rely on active investors to counteract them. The fewer active investors there are, however, the harder counteraction will be." - New Yorker Is Passive Investment Actively Hurting The Economy?

The bubble is about to burst. No I am not talking about the stock market, we are far from anything resembling the euphoria that generally characterizes the end of a market cycle. I am talking about the bubble that is passive investing. In my past work, we have explored how the concept of passive investing, so much as it takes place through the purchase of index funds, does not exist. Index funds are actually quite active. But investors fail to consider the effects of index investing on the economy, the markets, and ultimately the fate of passive investing.

As a Kiplinger article, "The Hidden Dangers of Index Funds" states "Indexes are constructed and then left alone for the most part, right? Not really. Even the S&P 500, which is weighted by market value and is not rebalanced, undergoes 20 to 25 changes in an average year as companies are added to and removed from the index, according to a study by Jeffrey Wurgler, a professor at NYU Stern School of Business."

Index Funds Are A Bubble that will End in Disaster

The growth of index funds has been nothing short of astounding. From the mid 1970's to today index funds have grown from $11 Million to $4 Trillion in assets. More and more investors from individuals to institutions are using index funds for their investment dollars, convinced that any type of active management is simply a silly effort and a loser's game, nothing could be further from the truth.

Still these investors press on, insisting that indexing for the long run, is the way to go. I could not disagree more. In the end the fundamental principle of investing in anything is simple: price is what you pay and value is what you get. I won't overpay for anything, and neither should you, whether its socks, pizza, or stocks. Overpaying for assets as I believe many are doing now as the largest companies are bid up ever higher amidst new index fund purchases, will have severe consequences for investors' long run investment performance. Overpaying for an asset limits the future returns on that asset. Investors seem to forget the lessons of the recent past: 1987, 2000, and 2008. Bill Ackman of Pershing Square had an excellent commentary on the current situation:

"We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds' constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on."

These sentiments were echoed by a number of leading investors. I don't know about you, but I never met anyone who got rich buying an index fund. But I do know plenty of active investors who have utilized the power of research to build a portfolio that has made many investors wealthy over time. Bruce Berkowitz reiterates the concept that the index fund bubble will burst, and investors are better served taking an owners view, stating that index funds taken to an extreme will end in calamity.

The 2000 Case Study

Many investors have forgotten about the beginning of this century, when companies that earned no money were bid up to astronomical prices. As a result many corporations in leading indexes fueled the bubble by buying more and more of these securities as funds flowed in. Ignoring the rationality of the move, index funds began to slowly increase their allocation of the index in technology stocks, and in 2000, investors saw trillions of dollars in assets disappear.

Conversely there were plenty of active managers who were able to identify the bubble forming in the tech sector, and keep clear. Furthermore, an investor who was tilting their portfolio towards value stocks, would have likely completely avoided the over weighting to the technology sector. Index investors however driven by their obsession with low cost over all else, were fully exposed to the market. When we look at market data from the peak of the tech bubble on March 10th 2000, a $10,000 investment in a Nasdaq index fund would have been decimated down to $1,770.57. Even worse it took an investor until 11/30/2014 just to get back to even and when inflation is factored in it took even longer. An investment in the S&P 500 Index Fund (MUTF:VFINX), or the Vanguard Value index (MUTF:VIVAX) did not fare much better losing investors significant sums of wealth and taking years to get back to even, let alone make money for shareholders.

The DFA US Value Fund (MUTF:DFUVX) on the other hand never sent investors below the amount they invested. Even during 2008 financial crisis, investors who made their initial investment at the peak of the tech bubble never lost their original investment in the fund, until the 2009 lows, which it quickly recovered from. Index investors cannot say the same. Most index investors were decimated, and took years to recover. Investors in the S&P 500 cumulatively returned 131.45%, while investors in DFA US Large Cap Value returned 382.9%.

Passive Investing Actively Hurts the Economy

An additional concern is the vast array of index products that seem to come in all shapes and sizes these days. Any aspect of the market that an investor wishes to index, there is an ETF for you. Indexation is beginning to be taken to an extreme that will create serious repercussions for the real economy. A piece that appeared in the New Yorker entitled "Is Passive Investment Actively Hurting The Economy?" made some excellent points for investors to consider.

"Depending on how you count, as many as twenty per cent of stocks are now owned by indexed funds. When you factor in "closet indexing"-when individual or institutional investors pursue indexing strategies without declaring them-the proportion of passive investors is higher still. As the number continues to rise, some scholars, economists, and investment professionals have begun to wonder anew how high it can go, and whether, as passive investing grows, it is having harmful effects on the economy as a whole… Typically, stocks are indexed by market capitalization-the value of a firm's share price times the number of shares-from highest to lowest. A market with more passive investors than active ones will continue to push money into the largest firms, whether these companies are actually performing strongly or not."

Academic Research Supporting The Negative Effect of Indexation

Commodities

"In January, three business-school professors-one from the University of Washington and two from Washington University, in St. Louis-drafted a paper examining the effects of passive investing on companies that rely heavily on commodities. The authors focused specifically on the futures and derivatives markets, studying agriculture, energy, and metals businesses, among others. While they acknowledge that their research is preliminary, they conclude that passive investing sends distorted signals about commodity prices. The firms they studied experienced disruptions in cash flow, production costs, inventory, and return on assets. In an e-mail, one of the researchers, Jonathan Brogaard, of the University of Washington, cited the theoretical example of a chocolate manufacturer that buys lots of cocoa beans. Historically, the price of beans on futures markets has reflected the demand for cocoa. But the relatively recent entry of passive investors into such markets distorts the demand signal that the price sends, because they're buying futures without reference to those kinds of traditional considerations. This can make it harder for the manufacturer to predict demand, potentially driving up costs."

Financial Services

"Another group of scholars is concerned that index funds can also hurt consumers more directly. In a study of banking ownership and competition, which was published in January, two University of Michigan business-school professors and a management consultant demonstrated that banks whose shares are often packaged in index funds tend to offer higher fees and rates for such services as account maintenance and deposit certificates than banks whose stocks are rarely or never included in index funds. The reason, the authors surmise, is that ownership by index funds gives banks an incentive to behave more as if they have a common owner. The reduced sense of competition leads the banks to charge consumers more."

Airline Industry

"In a discussion paper written last year, Einer Elhauge, a law professor at Harvard University, found that index-fund ownership was having a similar effect in the airline industry, where nearly eighty per cent of all stocks are owned by a handful of investors. Elhauge argues that institutional investors with an emphasis on index funds, such as Vanguard and Fidelity, are playing an outsized role in the sector, and that their rapid adoption is accelerating ownership concentration, resulting in higher prices for travelers."

In conclusion, the high level of investment dollars that are flowing into index funds are creating a bubble that will end badly for investors. When the characteristics of standard investment analysis are thrown aside, and fiduciary duty is given over to an index fund, true accountability ceases to exist. The vast amount of academic research proves that investors are far better served assembling a portfolio of investments that takes into account the science of investing. Tilting a portfolio towards value, small cap, profitability, and positive investment characteristics as DFA does has been proven to provide investors superior results than they can find in index funds.

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.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. I have used DFA Funds in client accounts.