The Performance of DFA’s Small Value Fund, DFSVX (and the Story of Rex and Dave)

The year was 1992, but Rex Sinquefield and David Booth, founders of mutual fund company DFA, were feeling trapped in the ‘80s. Rex was still wearing parachute pants and neon ties, and David drove a Pontiac Fiero and had White Snake and Mötley Crüe posters taped to his office walls.

Worse (depending on your opinion of White Snake), their flagship small cap fund had consistently underperformed the stock market through the 1980s.

“Hey man,” said Rex, handing David a Betamax tape with a pirated copy of Top Gun, “we’ve got to reinvent ourselves. Move forward.”

“Thanks for the tape” David replied, “One step ahead of you. Take a look at this.”

And with that he handed Rex a study that changed everything at DFA. It was a research paper called “The Cross‐Section of Expected Stock Returns”, and it was written by academics Eugene Fama and Ken French. The paper showed that differences in size and book value explained most of the variation in equity returns. The smaller the company, and the more book value it had, the better it seemed to perform.

Stocks with a relatively high book value became known as “value” stocks, and those with low book value became known as “growth” stocks.

Notably, the study showed that almost all the returns from the small cap stocks DFA was selling came from the group with a high book value. In fact, small growth stocks had, according to the Fama/French data, 0% returns over the past seven decades! Fama and French speculated that the excess returns of small and value stocks came from excess risk, though they couldn’t identify how.

DFA stands for “Dimensional Fund Advisors”, but DFA had only one stock “dimension” between its founding in 1981 and 1992 – company size. See my last post for details. The Fama/French paper showed how adding a second filter, for value stocks, might improve returns.

In 1993, DFA launched its small value fund, DFSVX, which owned only those stocks that Fama/French data said would produce fantastic returns – far more than the mere 5% per year bonus Sinquefield had claimed for small caps. DFA launched a number of value funds in the early ’90s: small value, large value and international value (large and small).

DFA stock funds were now two dimensional, and a new era had dawned. Rex discovered Pearl Jam and got rid of his earring. David amassed an amazing collection of Beanie Babies, though he never got Tigs the giraffe, which rumor has it he’s still hunting for on ebay.

Where were we? DFA likes to keep the academics whose research it follows comfortably on the payroll – you’d hate to have your marketing strategy upended by some unaffiliated professor who’d changed his mind or revised his data. And in fact, Eugene Fama, co-author of the study, had been on the DFA payroll for years as a part-time trader.

In co-opting their research into a marketing campaign, however, DFA took this to a new level, making Fama and French equity partners in the firm, and, over time, very rich.

We now have over 27 years of data to judge whether the incredible returns promised by Fama and French materialized for investors. First though, let’s look at risk. We’ll compare DFSVX to the Vanguard Total Stock Market Index fund (VTSAX). All data here from Morningstar:

As with the DFA Small Cap fund, the DFA small value fund exhibits large amounts of volatility versus the market as a whole. If you like wild swings in your portfolio value, DFSVX is for you.

Did investors get the amazing market beating returns promised, or at least strongly implied, by DFA? As always, I also show returns for the DFA fund including a 1% advisor fee, since paying an advisor is the only way to access their funds. The chart below shows the growth of a $10,000 investment in both the DFA and Vanguard funds on the day the DFA fund began trading in 1993 through today:

This one’s a tie – the DFSVX and VTSAX have had the same 9.5% average annual return. Stunningly, investors didn’t get even a penny of the amazing excess profits promised by the Fama/French data. In fact, they came out far behind Vanguard due to the advisor fee layer.

What happened here? For that, I’ll refer you to my last post about the DFA flagship fund, DFSCX, as the problems are the same. The first is cost – even without the advisor fee, the expense ratio of this fund is .5% higher than Vanguard’s.

The second is that academic data just doesn’t translate into real world fund results – the few, tiny, highly value-y stocks that accounted for the bulk of the Fama/French returns are too small and illiquid to be held in a consumer mutual fund.   

David and Rex didn’t produce the returns they promised investors. But they had a had a hell of a ride, and made a ton of money.  Sometimes they think about getting together and heading out for a night on the town. But they’re old now, in different states. They email. The other day Rex sent David his favorite quote from the ‘80s movie Risky Business, which he still has on Betamax:

It was great the way her mind worked. No guilt, no doubts, no fear. None of my specialties. Just the shameless pursuit of immediate gratification. What a capitalist.

Comparing Flagships – Understanding Almost 40 Years of DFA Underformance

 “there is a demonstrated phenomenon for small stocks as a group to outperform large stocks by roughly 5 percentage points a year in the last 50 years.”

DFA Founder Rex Sinquefield, in the Oct. 23rd, 1982 edition of the New York Times

In 1975, John C. Bogle founded mutual fund giant Vanguard. Its flagship product, now called the Vanguard 500 Fund (VFINX), was the world’s first consumer index fund. Its objective was simple – to capture the return of the S&P 500 index, less a small amount in fees.

In 1981, David Booth and Rex Sinquefield founded another mutual fund company, Dimensional Fund Advisors (DFA). DFA was based on another simple concept – that smaller stocks would outperform larger ones. Their flagship product, The DFA Small Cap Fund (DFSCX, later re-branded the “Micro Cap Portfolio”) was born.

Booth and Sinquefield’s idea made intuitive sense: smaller companies would probably be riskier than large ones, and that higher risk should be rewarded with higher returns. Small stocks also had “room to grow” and reward their investors with exponential price increases.

These theories were backed with empirical data – research had begun to show that small caps had in fact outperformed large caps over the preceding decades, with higher risk.

In some ways, Vanguard and DFA’s flagship funds were polar opposites – the 500 Fund held the largest 80% of the market, while DFAs Small Cap fund bet on the smallest 10% of stocks. They were, however, similar in that they eschewed stock picking, and attempted to passively track predefined segments of the market.

After almost 40 years, this post asks the question: “Which strategy should investors have followed?”

Let’s first look at risk. The DFA fund is unequivocally riskier that Vanguard’s. Compare the volatility of the two funds:

The standard deviation of the DFA fund is 24%, versus 17% for the Vanguard fund – an almost 50% difference. But did this increased risk translate into increased returns?

When looking at DFA results, the advisor fee customers pay must be considered, since you can’t own DFA funds directly. Here’s the 38.5-year growth of these two flagship funds, with and without a 1% DFA advisor fee. Source: Morningstar.

The Vanguard flagship grew at 11.4% per year, while the DFA flagship grew at 11.1%, or 10.1% after advisor fees. Vanguard investors wound up with at least an extra $115k on a $10k investment.

So, what happened? DFA investors got the higher risk they expected, just not the higher returns.

Part of the answer is cost. The DFA fund’s expense ratio is 0.5% higher than Vanguard’s. But ER isn’t the only fund cost. Trading small cap stocks, which tend to be illiquid and have higher bid/ask spreads, is more expensive than sticking with Bogle’s large cap strategy. And small cap funds must trade frequently, selling any stock that grows too large to meet its portfolio criteria. These expenses aren’t reflected in the ER, but they do reduce returns. They also make the fund tax inefficient.

This is why academic research tends to uncover small cap outperformance that investors are unlikely to see – that research fails to include advisor fees, or expense ratios, or transaction costs, or taxes.

Beyond cost, we might also revisit the assumption that small caps will outperform large caps significantly. Consider this chart of VFINX vs DFSCX prices since 1981 (Vanguard is red, DFA is blue):

Let me break it down for you.

Small and large caps had similar performance during the 1980s, with a slight edge to large caps. In the 1990s, as tech stocks like Cisco and Microsoft exploded, large caps outperformed. During the 2000s small caps clawed their way back, and by the 2009 Great Recession the two funds had identical long-term returns.

Small stocks were on track to handily outperform large during the 2010s…until 2019, when large caps caught up, and long-term performance was again identical. Small caps then proceeded to fall apart during the covid-19 crash of 2020.

Over the next 40 years, I expect small caps to slightly outperform large caps “on paper”, and underperform them in real world funds. The wise investor will hold both parts of the market – through a single, tax efficient total market index fund from Vanguard or similar.

Booth and Sinquefield’s experiment with small caps made them very rich men. Their customers, not so much. Bogle never made enough money have an elite business school renamed in his honor or take over a state. The fruits of his labor, as the chart above shows, went to Vanguard owners/customers. Consider carefully who you trust your life savings with.

Checking in on the Larry Portfolio

It sounded too good to be true. You could hold just 32% of your investments in a special group of stocks, keep the rest in risk-free government bonds, and earn the same return as other investors with 100% stock portfolios.

Or, so suggested an article in the Dec 23, 2011 New York Times. Written by Ron Lieber, it was titled “Taking a Chance on the Larry Portfolio”.

The Larry in question was Larry Swedroe, a noted financial author and advisor. And the Portfolio in question was a radical one. I’ll let Lieber explain:

As for the Larry Portfolio, which he prefers to refer to by more technical names, the only stocks it contains are mutual funds that hold small or value stocks (preferably both) from around the world. Everything else tends to go into very safe bonds.

In the article, and more specifically in other writings, Swedroe makes it clear that his preferred stock holding is a single investment, the DFA small value fund (Larry’s company sells DFA funds, which you have to go through an advisor to buy).

As small value stocks compose only about 5% of the stock market, this idea flies in the face of basic diversification principles. But Swedroe believed the risks were worth it – that small/value stocks offered such great returns that investors could cut back dramatically on the percentage of stocks they owned, and still get the returns of the market as a whole. This was based on historical data:

If you wanted to gin up a portfolio to match closely (at 9.8 percent) that [the S&P 500 index] performance with much less risk, all you would have needed to do was put 32 percent of your money in a fund mimicking the United States stock index of small and value companies that Mr. Fama and Mr. French developed. Then you’d put the other 68 percent of your money in one-year Treasury bills.

It’s been eight years since this article, so I decided to see how those who’d taken a chance on the Larry Portfolio had made out.

I built a Larry Portfolio, with a mix of 32% small value stocks, and 68% short term treasuries, then compared it to a 100% stock portfolio. For the small value stocks, I used DFSVX. For treasuries, I used the Vanguard Short Term Treasury fund, VFIRX. And for the stock market as a whole, I picked the Vanguard Total Stock market index fund, VTSAX, which closely follows the S&P 500 index mentioned in the article.

Here are the returns for the past eight years, and the final value of each:

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A $1,000 investment in the Vanguard market fund, which just tracks the US market as a whole, would have gained $1,973 between Dec 31, 2011 and Dec 31 2019. That same investment in the Larry Portfolio would have increased in value by $427. Even a 100% investment in that supposedly high returning DFA small value fund would have gained only $1,286.

Looked at another way, if you’d taken a chance on the Larry Portfolio in 2011 with your $300k retirement nest egg, here’s how much money you’d have at the end of 2019:

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So, what happened here? How did the Larry Portfolio go so horribly wrong?

One answer can be found by looking closely at the second quote above. When discussing the returns of the US market, the article uses the S&P 500 index as a proxy – an actual index with verifiable returns, involving many large, liquid stocks for which historical data is readily available.

But those incredible small value returns? They’re based on a dataset created by two academics, Eugene Fama and Ken French, both of whom have long been on the DFA payroll.

This data, sometimes compiled from old newspaper clippings, was often populated with a few tiny stocks too small and illiquid for mutual funds to hold. In other words, nobody ever got those incredible small value returns.

In the article, Lieber offers readers a prescient warning:

In fact, whenever something like the Larry Portfolio looks different from whatever the Dow or the Nasdaq are doing, there is sizable risk of regret.

I think it’s fair to say that in the case of the Larry Portfolio, like so many other free lunches promised by financial advisors, that regret risk was realized. There’s a lesson in there somewhere.