Comparing U.S. Equity ETFs: VTI vs. DFUS

Key Concepts

• DFUS (Dimensional US Equity Market ETF): A US total market ETF that aims to deliver market returns without strictly following an index.
• VTI (Vanguard Total Stock Market ETF): A US total market index ETF that tracks the CRSP US Total Market Index.
• Index Funds: Investment funds that aim to replicate the performance of a specific market index.
• Index Rebalancing: The process by which an index adjusts its holdings to reflect changes in market composition (e.g., IPOs, stock buybacks).
• Adverse Selection: The phenomenon where firms issue stock when their share price is perceived as high and buy back stock when it's perceived as low, creating a potential cost for index funds that must trade based on index rebalancing schedules.
• Lazy Indexes: Hypothetical indexes that rebalance less frequently and incorporate market composition changes with a lag, potentially leading to higher returns.
• Factor Exposures: The sensitivity of an investment's returns to specific market factors (e.g., value, profitability, investment).
• Small Cap Growth Stocks with Weak Profitability/Aggressive Investment: Specific types of small-cap stocks that have historically shown poor returns and are excluded by DFUS.
• REITs (Real Estate Investment Trusts): Companies that own, operate, or finance income-generating real estate. DFUS excludes REITs.
• Tracking Error: The difference in performance between an investment fund and its benchmark index.
• DTMEX: The predecessor mutual fund to DFUS.

DFUS vs. VTI: A Deeper Dive into Total Market Investing

This video provides a detailed comparison between DFUS, a US total market ETF that does not follow an index, and VTI, a traditional US total market index ETF. The core argument is that while index funds are an excellent innovation, there are opportunities for improvement, and DFUS demonstrates some of these potential enhancements.

Performance Comparison and Investor Reactions

• Outperformance: Since its inception as an ETF in June 2021, DFUS has outperformed VTI. This performance has led to some pushback from investors who are strongly committed to index investing.
• Author's Stance: Ben Felix, Chief Investment Officer at PWL Capital, emphasizes that low-cost, total market index funds are still great tools and that this analysis is not intended to dissuade happy index fund investors. However, he stresses the importance of avoiding dogmatism in investing and being open to potential improvements.

The Science Behind Index Investing and Potential for Improvement

• Foundation of Index Investing: Index investing is rooted in theories like Modern Portfolio Theory, the Capital Asset Pricing Model, and the Efficient Market Hypothesis, supported by evidence showing active managers' difficulty in consistently beating indexes.
• Scientific Approach to Improvement: Despite the strong theoretical backing of index investing, applying scientific thinking and updated theories can lead to modest improvements. DFUS represents such an attempt by making evidence-based tweaks to fund management.

DFUS: A Non-Index Approach to Total Market Exposure

• DFUS (Dimensional US Equity Market ETF): Aims to deliver market returns without strictly adhering to an index.
• VTI (Vanguard Total Stock Market ETF): Tracks the CRSP US Total Market Index with the sole objective of matching its performance net of costs.
• Key Differences: While both offer broad US market exposure, DFUS differentiates itself through its non-index approach and specific stock exclusions.

The Costs of Index Rebalancing and Adverse Selection

• Index Rebalancing Mechanics: Stock market indexes rebalance quarterly to incorporate changes like IPOs, new share issuances, and stock buybacks. This means that between rebalancings, the index and the actual stock market can diverge slightly.
• Adverse Selection in Indexing: The paper "Index Rebalancing and Stock Market Composition" (2025) highlights that index funds are subject to adverse selection. Companies tend to issue stock when they believe their share price is high and buy back stock when they believe it's low. IPOs also tend to occur when firms perceive their valuation to be high.
• Implicit Cost for Index Funds: Index funds, by tracking indexes, buy stocks when firms issue them (potentially at high prices) and sell when firms buy them back (potentially at low prices). This trading behavior, driven by index rebalancing, results in an implicit cost.
• Empirical Evidence: The research suggests that portfolios mirroring index fund rebalancing trades have historically shown negative returns and load negatively on value, profitability, and investment factors. This is estimated to impose a 60 basis point annual performance drag on total market indexes.
• "Lazy Indexes": The paper also introduces "lazy indexes" that rebalance less frequently and delay incorporating market composition changes. These hypothetical indexes have shown potential to boost returns by 40 to 60 basis points annually by avoiding adverse selection.
• DFUS's Advantage: By not tracking an index at all, DFUS can largely avoid these adverse selection costs associated with index rebalancing. It delays buying IPOs and employs trading rules designed to increase expected returns, rather than solely matching index composition changes.

DFUS's Stock Exclusions and Their Impact

• Targeted Exclusions: DFUS intentionally excludes specific types of small-cap growth stocks with weak profitability, aggressive investment, and high securities lending fees. These are often referred to as "junk" or "small crap growth" stocks due to their poor historical returns.
• Interaction with Research: While not solely designed to avoid adverse selection, these exclusions align with research findings that factor exposures related to these types of stocks contribute to the poor performance of index rebalancing portfolios.
• Exclusion of REITs: DFUS also excludes REITs as a product design choice by Dimensional. This exclusion is not based on specific research but allows investors to add REIT exposure separately if desired.
• Addressing the REIT Argument: To counter the argument that REIT exclusion explains DFUS's outperformance, a model portfolio combining DFUS with a REIT ETF (VNQ) was constructed. This analysis showed that while adding REITs did reduce returns, a significant portion of the excess return remained, attributable to other factors like exclusions and avoiding adverse selection. The 60 basis point excess return after adjusting for REIT exposure aligns with the findings in the "Index Rebalancing and Stock Market Composition" paper.

Market Cap Weight of Excluded Stocks

• Misconception of Exclusion: The argument that DFUS misses a large portion of the US market due to fewer holdings is addressed. While VTI holds more stocks (3564 vs. 2430 for DFUS), the market cap weight of DFUS's exclusions is small.
• Russell 3000 Benchmark: DFUS is benchmarked against the Russell 3000, which covers approximately 98% of the US stock market. DFUS excludes only 3.6% of the market cap weight covered by the Russell 3000.
• Breakdown of Exclusions:
  • REITs account for approximately 2.6 percentage points of the 3.6% exclusion.
  • The remaining 1% consists of the previously mentioned small-cap exclusions.
• Performance of Excluded Small Caps: Over the observed period, these excluded small-cap stocks returned approximately -10% annualized. At a 1% weight in the portfolio, this contributed a negative 0.1% to returns, leaving substantial excess returns to be explained by other factors like trading flexibility and avoiding adverse selection.

Historical Performance and ETF Conversion

• Pre-ETF Performance: The predecessor mutual fund to DFUS, DTMEX, underperformed VTI by an annualized 0.47% from September 25, 2001, to June 11, 2021.
• Reasons for Pre-ETF Underperformance:
  • Tax Efficiency Objective: DTMEX prioritized tax efficiency, which involved strategies like holding lower dividend yield stocks and avoiding unqualified dividends and short-term capital gains by holding stocks longer. DFUS, while also tax-efficient, has different methods and no longer specifically targets low dividend yield stocks.
  • Higher Expense Ratio: DTMEX had a significantly higher expense ratio than VTI for most of their shared history. In 2001, DTMEX was 0.25% vs. VTI's 0.15%. By 2018, VTI was 0.03% while DTMEX was 0.22%.
  • Evolving Exclusions: The current exclusions in DFUS were not fully implemented in DTMEX during its entire history.
• Comparability of Data: The author argues that the pre-ETF conversion data is not directly comparable to DFUS's current ETF performance due to these material differences in objectives, expenses, and exclusions.

Conclusion: Structural Improvements to Total Market Investing

• Strengths of Index Funds: Total market index funds are praised for being low-cost, low turnover, broadly diversified, and tax-efficient.
• DFUS as an Evolution: DFUS retains these favorable characteristics while introducing structural improvements.
• Avoiding Index Timing Costs: DFUS's ability to avoid the market timing costs associated with index rebalancing is a key advantage.
• Distinction from Active Management: Unlike traditional active management, which often involves concentrated portfolios and higher fees, DFUS remains a broadly diversified total market fund.
• Potential for Tracking Error: The primary cost of deviating from an index, even with potential outperformance, is tracking error. This means DFUS's performance may differ from VTI, and investors need to be comfortable with this possibility.
• Actionable Insight: For investors willing to consider non-dogmatic approaches and accept the possibility of tracking error, DFUS represents a potential slight improvement over the already excellent concept of low-cost total market index funds.

Notable Statement: "Index investing stems from a scientific approach to thinking about managing portfolios. It's rooted in theories like Marowitz portfolio theory, the capital asset pricing model, and the efficient market hypothesis, and supported by mountains of empirical evidence demonstrating the inability of active managers to beat index funds most of the time." - Ben Felix.

Notable Statement: "An index is not the market. Its returns are not identical to the returns of the market. In other words, it has tracking error to the market." - Ben Felix.