The investment spectrum moves from active management to passive and everything in between. In its most active sense, the active camp is that of a day trader, scouring the markets constantly for tidbits of information that are going to get them a leg up and acting instantaneously to take advantage of it. These folks have quite the task. In the age of information, they are competing against the collective wisdom of every trader. They are, quite simply, going to need a massive amount of luck over a long period of time to make it a successful venture. In short – probably improbable.
Index funds sit comfortably on the other end of the spectrum. All they need to do is make sure they contain the same stocks that exist in the index they are mirroring. The 500 stocks in the S&P are the classic example. Index funds reconstitute themselves once a year to factor in the stocks that have left and those that have entered the index. This reconstitution impact is a big issue for index funds. Stocks entering the index typically appreciate, and stocks leaving do just the opposite. Regardless, the index fund has to buy the former high and sell the lower low. This annual reconstitution impact accumulates year after year. In the long term, it’s significant.
In the face of active management and pure index investing, Dimensional Fund Advisors (DFA) offers a better solution. Built in the halls of academia at the University of Chicago, the theory was put into play in 1981 when DFA opened its doors. While DFA is closer to the passive end of the spectrum, there are some key differences between the two:
- DFA tilts to small and value companies. Globally since 1920, small and value companies have outperformed large cap and growth companies.
- In 2013 DFA added a direct profitability factor as well. In short, companies with high direct profitability outperform those with less.
If you can’t beat the markets, join them. In the case of DFA, do so in a way that leverages the evidence of market returns.