Active vs passive; Vanguard vs DFA funds
Posted by: Michael Zhuang on: March 11, 2010
- In: Eugene Fama | Ken French
- Comment!
Active vs. passive investment
Passive money holds the market portfolio. Active money jumps around, but on aggregate it also holds the market portfolio. Before investing costs, the two types of money must have the same returns; after investing costs, such as information acquisition, trading, taxes, etc., active money must earn less than passive money. It is arithmetic.
Though there are hundreds of mutual fund families in the United States, all but two are squarely in the passive camp: Vanguard and DFA.
Vanguard vs DFA
Vanguard pioneered index investing. DFA pioneered Fama/French factor-based asset-class investing. Vanguard and DFA have the following differences:
- Philosophically, Vanguard lives in the CAPM world: only market risk is compensated. DFA lives in the Fama/French three-factor world: in addition to market risk, small cap risk and value risk are also compensated. DFA’s core funds have a tilt towards value and small cap; Vanguard’s total market fund does not.
- Vanguard’s indexing approach limits it to the most liquid section of the market that has been indexed by commercial index companies. DFA’s approach allows investment in obscure corners of the equity markets, resulting in a more complete equity exposure.
- To track the commercial indexes closely, Vanguard ends up paying liquidity costs; by being passive, DFA extracts an illiquidity premium.
- Vanguard’s mutual funds are open to retail investors; they are subject to the vagaries of emotional fund flows. DFA’s funds are only available to institutions and select advisors; “hot money” that hurts returns is kept away.
Thus it appears that DFA is superior in all aspects. Not true! Vanguard is organized as a mutual company. DFA is a organized as a for-profit asset management company. There is less conflict of interest in Vanguard’s corporate structure – Vanguard fund managers do not need to serve two masters. They serve one, their funds’ shareholders.
6 Responses to "Active vs passive; Vanguard vs DFA funds"
November 3, 2010 at 3:45 pm
Fama and French model can you explain this model for me
please i am working research about this model and realy i need help
November 3, 2010 at 11:40 pm
Mahmoud,
Reading this paper will get you started. By the way, the is the most referenced and quoted paper in all of modern finance.
Michael
April 29, 2011 at 2:25 pm
i think these model is theory and cannot be work in the real world so its wrong now because i can not find Efficient market .
i am finished my research about that
April 29, 2011 at 2:43 pm
Mahmoud,
In fact it works, the example is DFA funds. They were started in 1981 and now it is the 5th largest fund family in the US without one dime of advertisement.
Now can you find examples when the market is not efficient? Yes. In fact you can easily do so in hindsight. Few people have consistently in foresight though.
Saying the market is efficient is like saying you can find a dollar bill sitting on the open road. The logic is that if it’s there, it would have been picked up. Almost by default, the theory can’t be true all the time. In some obscure little traveled alleys, maybe you can find a dollar bill sitting there. However, you can’t make a living looking for those dollar bills.
September 15, 2010 at 6:22 pm
“Before investing costs, the two types of money must have the same returns; after investing costs, such as information acquisition, trading, taxes, etc., active money must earn less than passive money. It is arithmetic.”
That seems to assume that relative performance rests only performance during up moves in the market. Couldn’t an active model LOSE LESS – sometimes dramatically so – and outperform?
It would appear your argument in this case is based on an “everything else equal” argument. Unfortunately, the world isn’t equal in all cases…
best,
Dave
September 16, 2010 at 12:03 am
In the scenario you describe, an active model could lose less and therefore out-performing the market, but for this active model to out-perform, some other active models must under-perform. So on aggregate, active models can’t out-perform. This is as simple as a runner can’t out run himself no matter how fast he runs.
I agree that world isn’t equal, so there abound to be active models that will out-perform. But the odds of discover these outperforming models in advance is extremely small. Check out my post on Finding Winning Fund Managers.
Michael