Rethinking Index Funds: Why Cost Isn’t Everything

The Drawbacks of Vanguard and Index Funds

By Kit Lancaster, Sterling Edge Financial

Larry Swedroe’s article, Structured Portfolios: Solving the Problems with Indexing (2014), raises crucial points about the limitations of index funds—a timely discussion in today’s investment landscape. While the popularity of index funds, particularly those offered by Vanguard, has surged due to their low cost, the focus on “cheap” investing may obscure deeper conversations about value and process. At Sterling Edge Financial, we aim to provide solutions that go beyond the superficial appeal of low costs to deliver long-term benefits for our clients. Here’s why we approach index funds with a healthy dose of skepticism.

The Drawbacks of Vanguard and Index Funds

Index funds like those from Vanguard offer undeniable advantages: low expense ratios, minimal turnover, tax efficiency, and transparency. However, as Swedroe highlights, their sole goal of replicating an index comes with significant limitations that structured portfolios—such as those offered by Dimensional Fund Advisors (DFA) and Bridgeway—are designed to address. Some of these limitations include:

1. Inconsistent Risk Factor Exposure

   • Vanguard’s index funds often fail to maintain consistent exposure to critical risk factors such as size and value. For example, their Small Value Index Fund (VISVX) holds stocks with a weighted average market capitalization of $2.7 billion, compared to just $1.2 billion for DFA’s Small Value Fund (DFSVX) and $0.6 billion for Bridgeway’s Omni Small Value Fund (BOSVX). This significant size difference dilutes the small-cap premium, leaving investors with lower expected returns.

2. Forced Transactions and Higher Costs

   • Vanguard’s funds are subject to rules that force them to buy and sell stocks at predetermined times, often resulting in higher transaction costs and tax inefficiencies. Structured portfolios mitigate this issue by employing “hold ranges,” which reduce unnecessary turnover and improve after-tax outcomes.

3. Front-Running Vulnerabilities

   • The transparency of Vanguard’s trading schedules creates opportunities for active managers to exploit predictable trades, increasing costs for index investors. Structured portfolios avoid this risk by trading strategically rather than on rigid schedules.

4. Inclusion of Low-Quality Stocks

   • Vanguard’s funds often include stocks with poor risk-adjusted returns, such as penny stocks and companies in bankruptcy. In contrast, structured portfolios apply filters to exclude these, resulting in a higher-quality investment.

5. Limited Tax Optimization

   • Vanguard’s funds lack the flexibility to employ advanced tax-saving strategies, such as tax-loss harvesting or preserving qualified dividends. Structured portfolios, on the other hand, are designed to minimize tax liabilities, offering superior after-tax returns.

Structured Portfolios: A Superior Alternative

Structured portfolios like those from DFA and Bridgeway retain the benefits of indexing while addressing its weaknesses. They provide targeted exposure to desired risk factors, such as value and size, and avoid the pitfalls of forced trades and front-running. As Swedroe notes, structured portfolios also focus on:

• Enhanced Factor Exposure

  • DFA and Bridgeway funds are designed to maximize exposure to value and size premiums, leading to higher long-term returns compared to Vanguard’s offerings. For instance, Bridgeway’s BOSVX has consistently outperformed Vanguard’s VISVX in years when small-cap value stocks have excelled.

• Tax Efficiency

  • Unlike Vanguard, structured portfolios exclude certain asset classes like REITs in taxable accounts, improving tax outcomes for investors.

• Patient Trading

  • Structured portfolios engage in patient trading strategies, capturing liquidity premiums during market disruptions, an approach unavailable to rigid index funds.

Comparing Returns: Vanguard vs. DFA and Bridgeway

Performance data illustrates the impact of these structural differences. For example, during the 15-year period ending in April 2014:

• Vanguard’s Small Value Index Fund (VISVX) returned 10.35% annually.

• DFA’s Small Value Fund (DFSVX) returned 12.26% annually.

• While newer, Bridgeway’s Omni Small Value Fund (BOSVX) demonstrated even greater exposure to the size and value factors, suggesting the potential for superior long-term returns.

These differences underscore the importance of a thoughtful investment process over pure cost minimization. While Vanguard’s low fees are attractive, they come at the expense of missed opportunities to maximize returns and tax efficiency.

Value Beyond Cost

At Sterling Edge Financial, we prioritize process over shortcuts. A structured portfolio approach allows us to balance cost, risk, and return in a way that aligns with our clients’ long-term goals. Vanguard’s funds may offer a low-cost entry point, but for investors seeking true value and consistent results, structured portfolios from providers like DFA and Bridgeway present a more compelling option.

Swedroe’s insights remind us that investing isn’t just about saving money—it’s about growing it effectively. By prioritizing execution and thoughtful design, we help clients achieve their financial objectives with confidence.