Texas Fund Firm Out-Vanguards Vanguard

NEW YORK ( TheStreet) -- Investors have been pouring money into index funds.

Popular choices include exchange traded funds from Barclays' iShares and index mutual funds sold by Vanguard Group. But many investors would be better served by so-called passive funds offered by Dimensional Fund Advisors, an Austin, Texas-based money manager with about $165 billion in assets.

Shrewdly designed, many DFA funds have outperformed their competitors. During the past 15 years, DFA U.S. Large Company ( DFLCX) has returned 7.7% annually, topping the S&P 500 Index by more than 7 percentage points. Other DFA funds that have outdone popular benchmarks over long periods include DFA U.S. Small Cap Value ( DFSVX), DFA International Value ( CFIVX) and DFA Emerging Markets Value ( DFEVX).

DFA isn't well-known because it deliberately maintains a low profile. The company doesn't advertise and only sells its funds through a limited number of financial advisors. This is done because DFA believes that its approach can only work when shareholders invest for the long term. If flighty shareholders constantly bought and sold, the firm's investing strategy could be disrupted.

DFA bases its strategies on academic research, including key findings by Eugene Fama of the University of Chicago and Kenneth French of Dartmouth. Fama and French found that over long periods, small stocks tend to outperform large ones and value stocks outdo growth. To take advantage of the research, DFA stock portfolios tend to own stocks that are smaller and cheaper than the portfolios of competitors.

To appreciate how DFA works, compare DFA U.S. Small Cap Value and Vanguard Small Value ( VISVX). During the past 10 years, the DFA fund has returned 8.9% annually, about half a percentage point more than the Vanguard fund.

The gap in results can be explained partly by the fact that DFA's stocks are smaller and cheaper. DFA's holdings have an average market value of $571 million, compared with $1.1 billion for Vanguard. While DFA's stocks sell for 0.88 times book value, Vanguard's holdings sell for 1.1 times book.

Make no mistake, the DFA approach doesn't work every year. The company's funds often lag competitors during downturns because worried investors tend to dump shaky small stocks when risks rise. During rebounds, small stocks often excel as investors take on more risk. This pattern occurred during the market rollercoaster of recent years. In the decline of 2008, DFA U.S. Small Cap Value lost 36%, trailing Vanguard Small Value, which fell 32%. During the rally of 2009, DFA returned 33%, compared to 30% for Vanguard.

DFA figures that over long periods, its smaller stocks will prevail. The aim is to lag slightly in downturns, while outperforming by wider margins in upturns.

Besides focusing on smaller stocks, DFA seeks to gain an advantage from the methods it uses for trading and structuring portfolios. These differ considerably from the approach taken by Vanguard and other conventional managers of index funds.

For its portfolio, Vanguard Small Value aims to track the MSCI U.S. Small Cap Value Index by holding about 1,000 stocks. The portfolio is weighted according to market value. So bigger stocks account for a large percentage of assets in the fund.

DFA doesn't aim to track a standard benchmark. Instead, the company starts with stocks that are in the smallest 10% of those traded in the U.S. Of those, it emphasizes stocks that account for the cheapest 25% of assets in the group. The final portfolio includes up to 1,600 names. DFA portfolio managers don't weight their holdings according to market values or any fixed standard. Instead, they aim to emphasize shares that are cheapest to trade.

Say two stocks each are around the same size and price. But one is expensive to trade because there is a wide spread between the bid and ask prices -- the amounts that buyers are willing to pay and sellers will accept. To make the purchase, the DFA trader would have to raise his price. To limit costs, the trader would buy the cheaper stock and postpone bidding on the expensive one, perhaps waiting weeks or months until more favorable conditions appeared.

Diehard proponents of index funds question the DFA approach, saying it fails to deliver pure exposure to asset classes. DFA managers argue that their trading strategy holds down costs. That can boost returns for investors who have the patience to hold over the long term.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.