Investors that have realized that passive management is the best way to go, often question what the difference between Dimensional Fund Advisors (DFA) and Vanguard are. Below are a few bullet points on the main differences.

Indexing Versus Asset Class Investing:

Vanguard is the leader by far in indexing investing. Index mutual funds follow a stated index based on it’s investment objective. By doing this, they are sampling the market for that specific asset class. DFA instead actually follows the entire asset class that corresponds to it’s investment objective. Think of it as sampling vs owning the entire asset class. Overall, asset class investing is much more diversified in terms of total underlying holdings.

Risk/Return Premiums:

Vnaguard and index mutual funds simply follow the stated index exactly and in the exact amounts the index states. DFA actually takes passive management a little further, using academically based principals, and takes advantage of areas of higher expected return. On the equity side, these areas include small companies, value companies, and profitable companies. By owning the entire asset class and tilting the weighting towards these areas, the goal is to increase performance over and above the benchmark over the long term. It’s pretty simple when you really think about it. Small companies and value companies are riskier than large and popular companies. Investors need to be compensated for that additional risk and that compensation comes in the form of greater expected returns. Also, companies with above average profits, leads to increases in their stock price and thus leads to increased returns. No one knows which company is going to be the next “hot” small company, value company, or profitable company, so they own them all.

Cost:

Both Vanguard and DFA are very low cost in comparison to other mutual fund companies and more specifically, other active management funds. In comparison betwen the two though, Vanguard slightly beats out DFA in terms of lowest cost. Why is this? Index fund management can be low cost because it’s basically computer driven and can be set to “auto pilot” to follow the stated index. DFA is slightly higher cost as their is more that goes into it. They aren’t trying to guess the market, but rather use time tested economic theory to weight their portfolios. All this requires more work than indexing, thus, has a higher cost. Also, investing in smaller companies generally has more costs, including trading costs, associated with it then investing in large and readily available companies. With DFA tilting their portfolios to small and value companies, it only make sense that the costs are also slightly higher.

Efficiency:

A big difference between the two is the efficiency in which they place trades. With indexing, once the stated index makes a change, all index funds that follow that index must make the same change at the same time. The market is still a market and it’s supply and demand. For instance, when Facebook was added to the S&P 500, all index funds that followed the S&P 500 had to buy Facebook at the same time. Low supply and high demand artificially increases Facebook’s stock price and after it’s all finished, the price falls back down to normal. But the index investors all bought high. DFA and asset class investing doesn’t have to follow these same constraints. As long as the company fits into the asset class, for example large growth, they don’t have to buy or sell that company along with everyone else. This leads to not having to buy or sell at artificially inflated or deflated prices.

Overall, DFA and Vanguard are both very good ways to invest. We actually use both in our practice as they both have their strengths. But, asset class investing is overall just a smarter and more efficient way to invest.