Seems impossible right? Isn't an index fund, when administered correctly, supposed to have a tracking error (fund return less index return) equal to the negative of the expense ratio?
Not if you're smart apparently. The important snippet from the
article.A small cap index fund cannot possibly own all of the thousands of stocks in its benchmark; instead it owns a "representative sample." Further, these stocks are usually thinly traded, with wide bid/ask spreads. In essence what the folks at DFA learned was that they could tell the market makers in these stocks, "Look old chaps, we don't have to own your stock, and unless you let us inside your spread, we'll pitch our tents elsewhere. Further, we're prepared to wait until a motivated seller wishes to unload a large block." In a sense, this gives the fund the luxury of picking and choosing stocks at prices more favorable than generally available. Hence, higher long term returns. It appears that Vanguard did not tumble onto this until a decade later, but tumble they did.
To complete the picture, this strategy works best in the thinnest markets, so the excess returns are greatest in the smallest stocks, which is why the positive TE is greatest for the DFA 9-10 Fund, less in the Vanguard Small Cap Fund, less still in the Vanguard Index Extended Fund, and minuscule with the S&P500.
There are some who say the biggest joke in the world of finance is the idea of value added active management. If so, then the punch line seems to be this: If you really want to beat the indexes, then you gotta buy an index fund.
That was written in 1998, and his example shows it worked back then. Does it still work today?
Let's start with the instituional plus shares (instituional plus shares have the lowest ER's of the funds that Vanguard offers) of Vanguard's S&P 500 index fund.
Here we see VIIIX slightly outperforms the index. Excellent!
What about instituional shares of Vanguard's Russell 2000 fund?
They lagged the index over the past 10 years.
But over the last 5?
Beat the index. Interesting.
What about Vanguard's instituional shares of their S&P Midcap 400 index fund?
Beat the index again!
Now obviously these funds beat their indices (over at least some time periods) by very slim margins. Nothing really to write home about. But still cool nonetheless.
Unfortunately many people don't have access to insittuitonal (plus) shares. So what about Admiral shares? VFIAX (S&P 500 Admral shares)
Unforutntately, no, VFIAX doesn't beat the index after expenses. But the percent difference in 10 year returns is a mere 0.0783%.
Somebody correct me if I'm wrong, but this means that before expenses this fund beat the index! The math:
- Assume VFIAX had an expense ratio of 0.05% each year over the 10 year period (I dont think this is true, but I couldn't find this data easily for the past ten years. If anything this is an underestimate of expenses, so this is fine for my point).
- If VFIAX had zero tracking error, then it would lag the index by 1-(1-.0005)^10 = 0.499% over a ten year period
- But VFIAX lagged the index by a mere 0.0783%
So sure, nobody's beating the market with VFIAX after expenses, but if Vanguard were able to cut costs even more, it would! Pretty cool huh?