For a while now, I’ve known that our DFA funds have been underperforming their benchmark indices. As a result, I wanted to write a post to explore the extend of this underperformance as well as attempt to provide an explanation as to why this has occurred.
DFA Australian Core Equity Trust (net of fees) vs All Ordinaries
The following graph shows the growth of $1.00 invested in the DFA Australian Core Equity Trust vs $1.00 invested in the All Ordinaries from 31/1/2007 through to the 31/7/2021. All returns are net of fund management fees and assume net dividends are reinvested; but do not take into account transaction costs.
The above graph shows that the DFA Australian Core Equity Trust (blue line) has underperformed the All-Ordinaries Index (red line) over the 14.5-year period. A key period is the 4th quarter of 2012 where the index starts to outperform and remains ahead until the end of the sample period. I’ve summarized the initial and final values in the table below:
| DFA Australian Core Equity Trust | All Ordinaries | |
| Starting value | $1.00 | $1.00 |
| Finishing value | $2.27 | $2.47 |
| Total return | 123.34% | 141.74% |
| Number months | 174.00 | 174.00 |
| Number of years | 14.5 | 14.5 |
| Annualized return | 5.70% | 6.28% |
| Difference | -0.58% |
What we can see is that the DFA Australian Core Equity trust has experienced an 18.4% (0.58% p.a.) underperformance when compared with its benchmark index.
DFA Global Core Equity Trust (unhedged) vs MSCI World Ex Australia
The following graph shows the growth of $1.00 invested in the DFA Global Core Equity Trust vs $1.00 invested in the MSCI World Ex Australia from 31/1/2007 through to the 31/7/2021. All returns are net of fund management fees and assume net dividends are reinvested; but do not take into account transaction costs.
Here we see the performance of the DFA Global Core Equity Trust (blue line) roughly equal the MSCI World ex Australia Index (green line) until 2015 where the MSCI starts to outperform. The period from 2019 through to 2021 is where the gap really starts to widen. The summary values are shown in the table below:
| DFA Global Core Equity Trust (unhedged) | MSCI World ex Australia | |
| Starting value | $1.00 | $1.00 |
| Finishing value | $2.64 | $2.99 |
| Total return | 155.49% | 189.90% |
| Number months | 175.00 | 175.00 |
| Number of years | 14.58 | 14.58 |
| Annualized return | 6.68% | 7.62% |
| Difference | -0.94% |
The summary values show a 34.4% total outperformance in favor of the benchmark index which equates to a 0.94% p.a. difference. So, what is going on here? Is Dimensional actually adding value to its clients or is it better to be invested in a lower cost index tracking product?
Explaining the difference
Fund holding costs
The first difference between fund returns and any index return is fees. Because an index is theoretical it does not cost anything to hold; whereas a fund manager will charge a fee to deliver the product to its clients. Hence, a more even comparison would be to calculate the p.a. performance difference after the MER has been considered. This information is presented in the following table:
| DFA Australian Core Equity Trust | All Ordinaries | DFA Global Core Equity Trust (unhedged) | MSCI World ex Australia | |
| Annualized return | 5.66% | 6.24% | 6.64% | 7.57% |
| MER | 0.281% | 0.00% | 0.360% | 0.00% |
| Difference | -0.294% | -0.568% |
After fees are considered, the annualized outperformance of the DFA Australian and Global funds compared with their respective benchmarks still equates to a significant -0.294% and -0.568% respectively. At a very basic level it shows how a small performance difference over many years can equate to large losses/gains over long periods.
So, what’s the explanation for the after-fee performance difference in favour of the benchmarks? To answer this question, we need to understand that Dimensional’s funds tend to be tilted towards small and value stocks which makes their risk profiles (and returns) different to standard market indices.
Size and Value factor indices
From my previous post, size and value are 2 risk factors that influence portfolio returns. As a quick recap, small cap stocks are considered riskier than large cap stocks; and value stocks are considered to be riskier than growth stocks. Their respective outperformance is referred to as the size premium and value premium.
For comparison against benchmarks, I’ve chosen 2 Australian and 2 international indices to represent the small and value factors. While the indices I’ve selected are a good depiction of the small and value factors; DFA has their own unique method of constructing their funds so these indices are not 100% representative of the DFA fund makeup.
- Australian Small Ordinaries Index will be used to represent the Australian size premium. It is designed to measure the companies in the ASX300 but not in the ASX100 (ASX, 2021).
- MSCI Australia Value will be used to represent the Australian value premium. It is comprised of large and mid-cap stocks which exhibit value characteristics. The resulting fund exhibits lower P/E and P/BV ratios than the standard MSCI Australia Index. (MSCI, 2021). Note 1
- MSCI World ex Australia Small Cap Index will be used to represent the size premium internationally. The index captures a small cap representation of 22 developed markets, with approximately 4,400 holdings (MSCI 2021) Note 2
- MSCI World ex Australia Value Index will be used to represent the value premium internationally. It is comprised of large and mid-cap stocks which exhibit value characteristics. The resulting fund exhibits lower P/E and P/BV ratios than the standard MSCI World Index. (MSCI, 2021). Note 3
All Ordinaries vs Small Ordinaries and MSCI Australia Value Index
The following graphs show the performance of the Australian Small Ordinaries and MSCI Australia Value Index in comparison with the All-Ordinaries index.
The graph above shows that both the Small Ordinaries and the MSCI Australia Value index has been outperformed by the All-Ordinaries index over the 14.5-year sample period. The small cap index (green line) seems to start lagging from the start of 2008 and doesn’t recover. The value index (purple line) underperforms from 2007 but then makes a strong recovery and pushes past the All Ordinaries (red line) in 2013, only to be strongly outperformed by All Ordinaries in 2017 through to 2021.
The above graph shows the outperformance of the size (green line) and value (purple line) factors when compared to the All-Ordinaries index (0.00% line) – positive values indicate that the factor is outperforming the index (positive premium). It is interesting to note that when the small cap index outperforms the All Ordinaries, the value index seems to underperform. This is especially apparent midway through 2011 through to early 2016 where the value index massively outperformed but the small cap index underperformed significantly. They seem to continue this swap roughly once a year for the next 5 years.
A further observation is that even though both factors have periods of underperformance and outperformance the overall outperformance is not enough to offset the time and severity of the underperformance. This is especially true of the size factor.
Possible reasons for factor underperformance in Australia
Approximately 25% of the companies that comprise the Small Ordinaries index are materials (mining) or energy companies (S&P Dow Jones Indices, 2021). In addition to this, smaller mining companies often have higher per unit costs of production than their larger counterparts; hence are more sensitive to downward swings in commodity prices. With the mining boom ending in about 2013 (Australian Government Productivity Commission, 2017) we see that this is sector is largely responsible for creating a drag on the small cap index relative to the All Ordinaries.
With interest rates on the downward trend after the GFC a key movement that emerged was the ‘search for yield’ where retirees were forced out of bonds and cash into riskier asset classes such as stocks. As evidenced by the makeup of funds such as the Vanguard Australian shares high yield ETF, some of the highest yield stocks are found in the large cap sector of the Australian stock market (Vanguard 2021). As a result, this ‘search for yield’ helped the All-Ordinaries index outperform the Small-Ordinaries.
MSCI World ex Australia vs MSCI World Small vs MSCI World Value
When comparing the international indices over the 14.5 year sample period we see that the MSCI World Ex Australia (green line) has been outperformed by the MSCI World Ex Australia Small Cap Index (red line). However, the MSCI World ex Australia Value Index (purple line) has underperformed MSCI World ex Australia Index significantly.
Look at the rolling 12-month year-on-year performance we see that the small cap index outperforms the MSCI World ex Australia most of the time. In other words, the small cap premium is mostly positive which is largely in line with existing research on the small cap premium.
The value index, however, mostly under performs the MSCI World ex Australia resulting in a negative factor premium. This is especially the case between 2017 and 2020 where the value index significantly underperformed.
Possible reasons for value factor underperformance internationally
Internationally, the US market has undergone Quantative Easing since 2008 which has increased the money supply and been accompanied by falling interest rates (Schulze, 2017). Growth stocks, which are generally expected to have higher long-term profits but lower short-term profits than their value counterparts are mathematically more sensitive to interest rate movements (Lamont, 2020). This ‘easy money’ and low interest rate environment has resulted in growth stocks being looked upon more favorably than their value orientated counterparts. The rise of companies like Tesla, which was loss making for many years, is an excellent example of this.
Looking forward
Stopping short of making predictions about the future, I believe that if interest rates do rise over the next few years in response to higher inflation, we would likely see the value indices outperforming their respective benchmarks in Australia and internationally. Given that we are seeing above target inflation rates in the US through 2021 (Statista 2021), the conditions may be becoming favorable for value stock outperformance. I believe this to be true for both Australia and internationally.
For small stocks, the research, which is mostly conducted on US stocks, suggests that they are riskier than large stocks and should continue to compensate investors with above market long-run returns. I am, however, questioning the degree to which the research on risk factors is true for the Australian market given its skew towards mining and energy stocks. I suspect that factors such as the commodity cycle could play a more significant role in determining the small cap premium.
On track to achieving our goal
So, given the reasons why our Dimensional funds have underperformed their indices, are we looking to move out of these funds and into a product that tracks the index more closely in search of higher returns?
The short answer is no.
I believe that the last 20 years of super low interest rates and Quantitative Easing are an anomaly in history which have resulted in occasions where premiums for the value and size factors have been negative. If market conditions return to a state like they have been for the majority of the 20th century, then we should start to see performance that is similar to the research on risk premiums; and as a result, DFA fund outperformance compared with their benchmarks.
Having said that, beating a particular benchmark is not a requirement for us to achieve our FI goal by the end of 2026. Our current modelling suggests that we can reach our target if we can maintain our savings rate between 50%-60% and our funds achieve a greater than 4.5% p.a. rate of return. Given, my past simulations on portfolio returns, I estimate a greater than 75% probability of this scenario eventuating.
Key takeaways
Tilting a portfolio towards certain factors is riskier than holding a standard index portfolio. While it comes with the possibility higher returns, as the last 14 years have shown, an investor must be willing to tolerate (sometimes lengthy) periods of under-performance. This is similar to how the stock market will underperform cash some years and outperform in others.
Further to this, it needs to be mentioned that tilting a portfolio completely towards one factor is a very risky investment strategy. In the best case international small caps outperformed the standard benchmark by a total of 10% over 14 years, but in the worst case Australian small caps underperformed the All Ords by a total of around 40% in the same period.
Engineer your freedom
Notes
- MSCI Australia Value Index (USD) used for the reference since MSCI Australia Value Index (AUD) factsheet is not available online. Data presented in this post is in AUD
- MSCI World Small Cap Index (USD) used for the reference since MSCI World ex Australia Small Index (AUD) factsheet is not available online. Data presented in this post is in AUD
- MSCI World Value Index (USD) used for the reference since MSCI World ex Australia Value Index (AUD) factsheet is not available online. Data presented in this post is in AUD
References
ASX, 2021, Capitalisation Indices, ASX, available from: <https://www2.asx.com.au/investors/learn-about-our-investment-solutions/indices/types/capitalisation-indices>
S&P Dow Jones Indices, 2021, S&P/ASX Small Ordinaries, S&P Global, available from: <https://www.spglobal.com/spdji/en/indices/equity/sp-asx-small-ordinaries/#overview>
MSCI, 2021, MSCI Australia Value Index (USD), MSCI, available from: <https://www.msci.com/documents/10199/ed27e54d-b9d9-4081-ac48-fea0436947b4#:~:text=The%20MSCI%20Australia%20Value%20Index,to%20price%20and%20dividend%20yield.>
MSCI, 2021, MSCI World Small Cap Index (USD), MSCI, available from: <https://www.msci.com/documents/10199/156e39f2-aa83-4645-b592-f38bee58f592>
MSCI, 2021, MSCI World Value Index (USD), MSCI, available from: <https://www.msci.com/documents/10199/b6f212c4-9897-455a-b323-d5073dd49f7b>
Stott, 2014, Why have small cap stocks underperformed?, Firstlinks, available from: <https://www.firstlinks.com.au/small-cap-stocks-underperformed>
Australian Government Productivity Commission, 2017, How resilient are Australia’s regional economies to the end of the mining boom?, Australian Government Productivity Commission, available from: <https://www.pc.gov.au/news-media/news/pc-news/pc-news-may-2017/regional-economies>
Vanguard 2021, Vanguard Australian Shares High Yield ETF (VHY), Vanguard, available from: <https://www.vanguard.com.au/personal/products/en/detail/8210/portfolio>
Shulze, E, 2017, The Fed launched QE nine years ago — these four charts show its impact, CNBC, available from: <https://www.cnbc.com/2017/11/24/the-fed-launched-qe-nine-years-ago–these-four-charts-show-its-impact.html>
Lamont, D, 2020, The maths of why growth companies are beating value, Schroders, available from: <https://www.schroders.com/en/uk/tp/markets2/markets/the-maths-of-why-growth-companies-are-beating-value/>
Dimensional, 2021, Dataset 31/1/2007 to 31/7/2021 Dimensional Australian Core Equity Trust (net of fees), Dataset viewed 15/8/2021 <https://returnsweb.dimensional.com/>
Dimensional, 2021, Dataset 31/1/2007 to 31/7/2021 S&P/ASX All Ordinaries Index (Total Return), Dataset viewed 15/8/2021 <https://returnsweb.dimensional.com/>
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Dimensional, 2021, Dataset 31/1/2007 to 31/7/2021 Dimensional Global Core Equity Trust – Unhedged Class Units (net of fees), Dataset viewed 15/8/2021 <https://returnsweb.dimensional.com/>
Dimensional, 2021, Dataset 31/1/2007 to 31/7/2021 MSCI World ex Australia Index (net div., AUD), Dataset viewed 15/8/2021 <https://returnsweb.dimensional.com/>
Dimensional, 2021, Dataset 31/1/2007 to 31/7/2021 MSCI World ex Australia Small Cap Index (net div., AUD), Dataset viewed 15/8/2021 <https://returnsweb.dimensional.com/>
Dimensional, 2021, Dataset 31/1/2007 to 31/7/2021 MSCI World ex Australia Value Index (net div., AUD), Dataset viewed 15/8/2021 <https://returnsweb.dimensional.com/>