Why I’m Selling My Vanguard Index Funds for Dimensional Funds
I'm selling all of my Vanguard index funds and investing them in Dimensional Fund Advisors funds.
This was actually originally going to be just a post, but then I realized...there's a lot I have to say about this, and I want to make sure I get my whole point across—not just a bullet-point summary.
To understand where I'm coming from, let's go waaay back to the beginning: when I was 14, just starting high school.
I had heard somewhere on the internet that investing was the best way to get rich. Compound interest could turn $10 into $10,000 with enough patience. That had me hooked.
Unfortunately, at the time, investing was an expensive endeavor. Transaction fees with traditional brokers ranged anywhere from $5–$15 per trade. Seeing as I could only come up with $50 to invest, I decided that all was lost, and my poor self would never rise to compete with the bourgeoisie.
Fortunately for me, there was an up-and-coming app called Robinhood that not only eliminated transaction fees entirely but also gave investing an almost video-game-like appearance.
If I did well, the neon-green line would send dopamine bouncing around my adolescent skull. If I did poorly, I would only crave better performance.
(I later learned that this design was intentionally highly addictive for Robinhood's benefit...but it served its purpose in getting me started.)
My phone of choice was a OnePlus 7 Pro, an Android phone—and even company—that you've probably never heard of. I would say that it described my personality at the time pretty well. I did my research, found something that I thought was the best available, and stuck with it.
With the Robinhood app downloaded, I borrowed my dad's ID (with permission...I think) to open up a new investment account. I immediately took it upon myself to transfer my first $100 in and began investing.
Now, what I referred to as "investing" then was more akin to "playing a game only slightly better than roulette."
In my defense, I believe that is how most people get started investing: picking random stocks that interest them and hoping they go up.
I traded furiously for the first two weeks, hoping to make some insane return, but instead, I just ended up stressed and losing money.
Desperate to find a better way, I went back to the internet to find a real strategy.
Lo and behold, the internet had a favorite strategy: index funds.
Vanguard's were considered the best because they had some of the lowest fees. They offered an extremely inexpensive way to invest in a diversified basket of stocks, which could outperform the vast majority of stock-picking active managers over the long term.
I was told to buy and hold because trying to time the market was futile.
And so, I invested and forgot about it.
For years.
I eventually switched away from Robinhood, but even then, I kept using Vanguard index funds.
For five years, I didn't question the system. I kept my head down and put money into index funds.
And then I started studying finance.
I began working for wealth management firms—companies full of people hoping to find some way to set themselves apart.
My first firm?
Didn't resonate.
The owner spent more time getting schmoozed by sales teams and chasing shiny objects than actually looking at the data.
Second firm?
More interesting.
Their strategy was backed by some research and made logical sense, but it wasn't rooted in particularly strong evidence. I felt like there were holes in their strategy, and even the research they based it on seemed flimsy to me.
Third—and current—firm?
Now we were on to something.
Something different.
They didn't use index funds like I was used to, but they weren't ignoring the research, either. They used funds by a company called Dimensional Fund Advisors.
Side note—Dimensional is actually the company that pioneered the index fund.
I was skeptical at first.
It took me six months of research to finally understand and become convinced that this could actually be better than traditional index funds.
Here's why.
You Can Outperform the Market...Kind Of
In finance and life, there is one thing that holds true: you must take on risk to get a return.
You cannot have a higher return without taking on greater risk, and anyone who says otherwise is trying to sell you something.
If you buy one stock, there are a lot of things that could go terribly right—or terribly wrong.
Whichever one you pick could be the next Nvidia, or it could be tomorrow's Enron.
Individual stocks are exposed to all kinds of random risks.
For instance, there's the risk that the CEO gets up one morning and decides that he wants to commit fraud. Sure, that's not a very big risk—last time I checked, most CEOs prefer staying out of jail—but for any single company, it absolutely could happen, and there's no way to systematically predict it.
In comes diversification.
Diversification doesn't get rid of risk. It simply blends different risks together in a way that allows many of them to cancel each other out.
For every Bernie Madoff, there is a Steve Jobs.
Imagine a game of tug-of-war. If you have just one person pulling the rope, it will move wildly wherever that person decides to go.
However, if you put 100 people on one side and 110 people on the other side, the rope will remain much more stable. It may move back and forth depending on which side has stronger people on a given day, but it's generally going to lean toward the side with 110 people.
This is what a diversified basket of stocks does.
It cancels out much of the risk associated with individual stocks while leaving only the risks that all the stocks are exposed to.
We call that risk market risk.
When you think about market risk, think of things like a pandemic shutting down global trade. All companies were affected, regardless of what they did on an individual level.
When you have a well-diversified portfolio, you are primarily exposed to market risk, and it follows that you will make market returns.
No more.
No less.
This is where index funds stop.
They buy the market, expose themselves to the market, and their returns track the market. They are, by nature, constrained to this and cannot go much further.
But...
What if there were other risks you could expose yourself to that could potentially increase your returns?
In comes factor investing.
Here's a little tidbit of information.
There are four commonly discussed "factors," or characteristics of stocks, that have historically been associated with higher expected returns over long periods of time:
- Value stocks
- Small-company stocks
- More profitable companies
- Stocks that have recently performed well
Now, before we go forward, let's jump back to the beginning.
We started this whole thing by saying:
"You must take risk to get a return."
This completely breaks down if we know that certain types of stocks systematically beat the market.
By this hypothesis, nothing systematically beats the market on a risk-adjusted basis.
Unless...
Maybe...
There's a different kind of risk that we haven't talked about yet.
And if we expose a portfolio to these new kinds of risk—value risk, small-company risk, profitability risk, and momentum risk—it may outperform the market by a significant margin.
Rigidity Makes for an Easy Target
I'm going to tell you a story about a town of bakers.
Gene is a smart store owner who sells all sorts of products. Most of all, though, he sells donuts.
In fact, the entire town specializes in donut sales—Boston cream, glazed, old-fashioned, you name it. They have a type of donut to satisfy every desire.
One of Gene's biggest clients is a big company called BorkCorp, which comes out every few months and buys a truckload of donuts.
Their methods of purchasing are a bit odd, though.
A month before they come, they send an email with a detailed list of every donut they're going to buy. Everyone knows exactly what they're going to get well before they arrive, and they never leave town without buying the donuts, no matter the price.
Gene, being the clever businessman that he is, decides he's going to do something sneaky.
He wakes up early the morning BorkCorp is coming to town and sprints down to the donut factory, list in hand.
This month, BorkCorp is going to buy chocolate-frosted and raspberry-filled donuts.
Gene's plan?
He's going to buy up every single one of the chocolate-frosted and raspberry-filled donuts and sell them at a higher-than-usual markup to BorkCorp.
Since he'll be the only one with the donuts they need, he figures he'll make a killing.
Much to his dismay, Gene isn't the only one who had this idea.
When he arrives at the factory, there are five...ten...fifteen other store owners, and counting!
Everyone has had the same clever idea.
With almost the whole town present, bidding begins for the chocolate-frosted and raspberry-filled donuts.
Knowing he could probably sell them for more to BorkCorp, Gene ends up buying some for a price 10% higher than he would usually pay. He then turns around and sells them to BorkCorp for a higher-than-usual markup before prices return to normal the next day.
In our story, the store owners win.
The donut factory wins.
The only person who got fleeced?
BorkCorp.
Now, you're going to have to bear with me for a second here, but this is exactly what happens to index funds—or at least, this is the argument.
They are required to rebalance their portfolios on a set schedule, following a set formula. Everybody in the market—including a lot of very smart businesspeople like Gene—knows approximately when and how much they're going to buy.
These smart businesspeople can bid up the price of stocks before index funds come in and purchase them, then allow prices to normalize afterward.
The result?
Index funds can potentially be taken advantage of in a way that passes invisible costs on to you, the investor.
If only a fund could be more flexible in the way it buys and sells, it could potentially solve the problem through greater flexibility and unpredictability.
So...What's Your Solution?
Dimensional Fund Advisors has developed an approach designed to address some of the limitations of traditional index funds.
They're not stock-pickers, but they aren't purely passive investors, either.
Instead, they build their portfolios around evidence-backed ideas such as factor investing while maintaining flexibility around trading and rebalancing.
The goal isn't to predict which individual company will become the next Nvidia.
It's to systematically target characteristics that research suggests may be associated with higher expected returns while maintaining broad diversification.
Okay, But How Have They Actually Performed?
This is where things get interesting.
According to Dimensional, 85% of its funds have outperformed their respective benchmarks net of fees, compared with 15% of traditional active managers.
Those are some pretty good odds.
Of course, performance statistics always depend on the benchmark, time period, fund universe, and methodology being used. So I'm not saying this number alone proves anything.
But it certainly made me want to investigate further.
And investigate I did.
Conclusion
I'm not saying that you should immediately sell everything Vanguard offers and buy Dimensional funds.
For me to make the change, it took:
- Six years of investing experience
- A bachelor's-level finance education
- Working at three different wealth management firms
- Reading dozens of academic papers
- Attending multiple industry conferences
- Personally grilling sales representatives from Dimensional
With that in mind, I can hardly ask you to throw away such a proven investment strategy as buying an S&P 500 index fund.
What I do ask you to do, however, is keep an open mind and be willing to learn more.
Don't blindly accept the internet's love for index funds.
Don't blindly accept my argument, either.
Do your own research.
Read academically vetted sources. Understand the assumptions behind different investment strategies. Look at the evidence. Understand the risks. Consider fees, taxes, diversification, and your own goals.
Then form your own opinions.
Because if there's one thing I've learned after six years of investing and studying finance, it's this:
The best investment strategy isn't the one everyone tells you is the best.
It's the one you understand well enough to believe in—and have the discipline to stick with.
