When Shearwater Capital was founded in 1999, most financial advisors were recommending actively managed funds with exorbitant annual expense ratios. We had to convince our clients that they would be better off with a low-cost passive investment approach. We provided data showing that the great majority of actively managed funds failed to beat their benchmarks and there was no justification for paying the higher fees associated with active management. Now, 20 years later, things have changed. Many investors today are sold on the concept of index funds (i.e. passive investing) and ask why we are still using Dimensional funds rather than traditional index funds with their slightly lower annual expense ratios. It’s a fair question. The purpose of this newsletter is to explain our continued preference for Dimensional funds.
Traditional index funds mechanically follow an established market index, such as the S&P 500 for large cap U.S. stocks. Index funds are referred to as passive investments because the holdings in the funds are blindly dictated by the underlying index.
Dimensional’s approach can be thought of as “passive plus.” Most Dimensional funds follow an asset class, such as small cap U.S. stocks or inflation-protected bonds. Since these funds are not tied to an index, Dimensional has the flexibility to add value by employing long-term, short-term, and intra-day drivers of increased returns derived from the peer-reviewed academic finance literature.
Long-term drivers of expected returns include company size (small cap vs. large cap), relative price (value vs. growth), and profitability (high vs. low). Smaller companies have historically outperformed larger companies by a significant margin over long time periods. In a similar manner, value stocks have historically outperformed growth stocks. The excess returns provided by small cap and value stocks have been validated across multiple time periods in domestic, developed international, and emerging markets. In addition to these drivers, many of the Dimensional funds also use a profitability filter, in which the least profitable companies within each asset class are screened out.
The primary short-term driver of increased returns is momentum, which academic research has shown to have a small but significant effect on stock prices. Many of the Dimensional funds employ a momentum algorithm in which value is added by delaying the sales of stocks with upward momentum and accelerating the sales of stocks with downward momentum.
The main intra-day driver of returns is the impact of trading on securities prices. Large buy orders can drive up the price of a stock or bond, while large sell orders can have the opposite effect. Dimensional’s trading algorithms are designed to minimize market impact by optimizing trade execution, monitoring the size and timing of trade orders, and selecting the best venues for routing orders.
We love the fact that Dimensional uses these drivers to fight for each potential fractional gain in long-term returns, but does this strategy actually work? Historical data indicates that any single driver of increased returns can have periods of under-performance. For example, value stocks have under-performed growth stocks for the past several years. Employing all the drivers simultaneously increases your statistical likelihood of success. Over the past 20 years, 85% of Dimensional funds have outperformed their benchmark indexes, compared to only 15% of all mutual funds available in the U.S. over the same time period.
Even small incremental gains in returns add up significantly over time due to the power of compounding. The table attached shows the impact in dollar terms of hypothetical $100,000 investments in a select group of flagship Dimensional stock funds over the 15-year period ending December 31, 2018:
Each of these funds employs one or more of the drivers of returns discussed above except the US Large Company Portfolio, which functions more like a traditional S&P 500 index fund. Index funds are designed to match the returns of their benchmark indexes; however, they typically trail their benchmarks by a small margin due to expenses.
Shearwater Capital is a fee-only investment advisory firm, meaning that our only source of revenue comes from investment management fees. We have a fiduciary responsibility to act in our clients' best interests at all times and we receive no commissions or fees from product sales. We generally prefer Dimensional funds over traditional index funds because we believe they provide the greatest value for our clients.
As always, please feel free to contact me if you have any questions, comments, or concerns.
Jeffrey J. Brown, MD CFA CFP®
Principal, Shearwater Capital
 Transforming Lives Through Financial Science; Dimensional Fund Advisors, 2019
 Long-Term Track Record of Equity Funds Outperforming Their Benchmarks; Dimensional Fund Advisors, 2019