Vanguard  versus  The  Enhanced  Indexers,  DFA,  RAFI,  and   WisdomTree:  Is  Traditional  Indexation  Passé?

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Edward  Tower,  Professor  of  Economics  at  Duke  University  and  Visiting  Professor  at  Chulalongkorn   University.  tower@econ.duke.edu   Chao  Yang,  MA  candidate  at  Duke  University,  cy67@duke.edu.   December  12,  2012.     Prepared  for  the  Bogleheads  eleventh  national  reunion,  Philadelphia,  October  2012.     Comments  welcome.  

ABSTRACT  
Vanguard  provides  low-­‐cost  capitalization-­‐weighted  mutual  funds:    traditional  index  funds.  The   asset  allocation  of  DFA’s  core  funds  is  determined  by  fundamentals  as  well  as  market  cap.  RAFI’s   allocation  depends  on  four  fundamental  factors—dividends,  cash  flow,  sales,  and  book  equity  value.   WisdomTree’s  is  also  determined  by  fundamentals  alone.  We  compare  them  with  corresponding   Vanguard  mutual  fund  portfolios.  We  examined  fund  returns  from  March  2007  through  June  2012.     Focusing  on  US  funds  only,  DFA  had  lower  returns  than  portfolios  of  Vanguard  funds  that  mimicked  their   style;    RAFI  and  WisdomTree  out-­‐returned  Vanguard.  Two  cheers  for  enhanced  indexation  and  one  for   traditional.    

1.  INTRODUCTION  
Vanguard  provides  low  cost  cap-­‐weighted  mutual  funds.  These  are  traditional  index  funds.  The   asset  allocation  of  DFA’s  core  funds  is  determined  by  fundamentals  as  well  as  market  cap.  Those   PowerShares  funds  that  are  based  on  RAFI  (Research  Affiliates  Fundamental  Indexes)      allocate  assets   according  to  four  fundamental  factors—dividends,  cash  flow,  sales,  and  book  equity  value.   WisdomTree’s  asset  allocation  is  also  determined  by  fundamentals  alone,  with  a  focus  either  on   dividends  or  earnings.  All  three  are  now  old  enough  with  a  long  enough  track  record  that  comparison   with  corresponding  portfolios  of  Vanguard  mutual  funds  is  possible.  This  paper  makes  that  comparison,   using  data  from    the  end  of  March  2007  through  June  2012,  inclusive.  Three  results  stand  out.  Focusing   on  US  funds  only,  DFA    had  lower  returns  than  portfolios  of  Vanguard  funds  that  mimicked  their  style;                                                                                                                          
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 Thanks  go  to  Rob  Arnott,  Bill  Bernstein,  David  Grabiner,  Jerry  Lee,  Mel  Lindauer,  Allan  Sleeman,  Larry  Swedroe,   William  Thomas,  Steve  Thorpe,  Xiaolu  Wang,  and  Biyuan  Zhang  for  constructive  criticism.  Their  approval  of  the   paper  is  not  implied.  Bill  Bernstein  redirected  an  earlier  version  of  the  paper  to  focus  on  the  Fama-­‐French  loads   and  suggested  using  the  four  factor  Fama-­‐French  loads.  He  also  suggested  examining  the  RAFI  funds.  This  version   of  the  paper  runs  with  the  ideas  in  his  (2006)  Efficient  Frontier  article.  This  paper  corrects  a  previous  version  which   did  not  recognize  that  only  two  RAFI  funds  existed  for  the  entire  period  of  the  analysis.  Thanks  to  Rob  Arnott  for   correcting  this.  

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Electronic copy available at: http://ssrn.com/abstract=2179188

RAFI  and  WisdomTree  out-­‐returned  Vanguard.  Thus,  some,  but  not  all  fundamental  indexers  have   performed  well.  

 

2.DO  THE  EXPERTS  PREFER  ENHANCED  TO  TRADITIONAL  INDEXATION?   William  J.  Bernstein  (2006)  writes:  
“  Fundamental  indexing  is  a  promising  technique,  but  its  advantage  over  more  conventional  cap-­‐ weighted  value-­‐oriented  schemes,  to  the  extent  that  it  exists  at  all,  is  relatively  small.  Attempts  should   be  made  to  confirm  this  work  within  a  multifactor  framework  both  abroad  and  with  pre-­‐Compustat  U.S.   data.   Even  assuming  that  fundamental  indexation  produces  returns  in  excess  of  its  factor  exposure,  caution   should  be  used  in  the  practical  application  of  this  methodology.  Differences  in  the  expenses,  fees,  and   transactional  costs  incurred  in  the  design  and  execution  of  real-­‐world  portfolios  can  easily  overwhelm   the  relatively  small  marginal  benefits  of  any  one  value-­‐oriented  approach.  The  prospective  shareholder   needs  to  consider  not  only  the  selection  paradigm  used,  but  just  who  is  executing  it.”  

John  C.  Bogle  and  Burton  G.  Malkiel  (2006)  write:    
“As  index  funds  gain  an  increasing  share  of  the  portfolios  of  mutual  funds,  …    academics  and   practitioners  are  hotly  debating  how  these  portfolios  should  be  composed.  Capitalization-­‐weighted   indexing,  until  now  the  dominant  approach,  has  come  under  fire  for  overweighting  portfolios  with   (temporarily)  overvalued  stocks  and  underweighting  them  with  undervalued  ones.     Eugene  Fama  and  Kenneth  French  have  suggested  that  higher  returns  can  be  generated  by  indexed   portfolios  of  stocks  with  small  capitalizations  and  low  price-­‐to-­‐book-­‐value  ratios.  Robert  Arnott  has   argued  that  a  better  method  for  indexing  is  to  weight  the  stocks  in  the  index  not  by  their  total   capitalization,  but  rather  by  certain  "fundamental"  factors  such  as  sales,  earnings  or  book  values.  Jeremy   Siegel  has  proposed  that  the  "fundamental  factor"  should  be  the  dividends  that  companies  pay.  These   analysts  have  all  argued  that  fundamentally  weighted  indexes  represent  the  "new  paradigm"  for  index-­‐ fund  investing.     Are  they  correct?  We  think  not.  There  is  no  doubt  that  fundamentally  weighted  indexes  have   outperformed  capitalization-­‐weighted  indexes  during  the  past  six  years,  which  witnessed  the  collapse  of   the  "new  economy"  bubble  and  partial  recovery.  But  we  need  to  be  cautious  before  accepting  any  "new   paradigm"  that  implicitly  suggests  that  the  "old  paradigm"  -­‐-­‐  reflected  in  more  than  $3  trillion  of   capitalization-­‐weighted  index  investment  funds  -­‐-­‐  is  in  error.  During  the  three-­‐plus  decades  that  such   passively  managed  funds  have  been  available,  they  have  provided  for  their  investors  returns   substantially  superior  to  the  returns  achieved  by  actively  managed  equity  funds.  We  need  to  understand   why  capitalization-­‐weighted  indexes  make  sense  -­‐-­‐  even  if  market  prices  are  "noisy"  and  can  fluctuate   above  or  below  the  values  they  would  have  in  a  perfectly  efficient  market.”    

Jonathan  Steinbert,  the  CEO  of  WisdomTree  speaks  to  Olly  Ludwig  (2012):  

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Electronic copy available at: http://ssrn.com/abstract=2179188

  dividend-­‐  and  earnings-­‐based  ETFs.  a  “new  paradigm”  in  which  the  traditional   indexes  like  the  S  &  P  500  will  make  way  for  fundamental  indexing.  If   WisdomTree  wanted  to  be  an  asset  manager  in  the  ETF  industry.  “I  think  the   claims  they  make  are  outrageous.  Siegel  said  in  an   interview.   Steinhardt.  But  if  that  is  so.  Our  performance.   Perhaps  not  surprisingly.  value  stocks  outperform  growth  stocks.  we  knew  that   Vanguard  would  eventually  be  a  major  force  in  the  industry.“So  WisdomTree  was  attempting  to  do  something  better  [than  Vanguard].  We  worked  on  index   construction.  The  hypothesis  is  probably  not  exactly  true.  which  are  weighted  by  market   capitalization.   since  inception  on  equities.  when  Wisdom  Tree  wanted  to  get  into  the  business  of  being  an  ETF  sponsor.  Here  it  is.   Also.  Bogle's  position  has  the  virtue  of  an  economic  theory  to   back  it  up:  the  efficient  markets  hypothesis.   “We  should  be  shifting  to  another  paradigm  to  look  at  how  markets  work.  which  constructs  indexes  based  on   measures  like  companies  that  pay  dividends.  “I  don’t  think  the  price  of  a  stock  is  always  in  line  with  fundamentals.  But  that  fact  seems  to  undermine  the  basic  premise  of  the  funds  that   Siegel  is  promoting.  we  needed  to  do  something  that  was   differentiated  from  Vanguard  and.  as  reported  in  today’s  New  York  Times.   According  to  Mr.  three-­‐  and   five-­‐year  time  frames  since  inception—are  delivering  better  returns  on  an  after-­‐fee  basis  than  the  cap-­‐ weighted  indexes  that  pretty  much  have  no  fee.  has  been  active  in  developing  these  indexes  and   sponsoring  exchange-­‐traded  funds  based  on  them.   3     .  Better  returns.”   I  am  placing  my  bets  with  Bogle  on  this  one.  rather  than  just  a  company’s  size.  is  that  they  overweight  overvalued  stocks  and  underweight  undervalued  stocks.  there  is  a  “revolution”  under  way.  is  that  active  money  management  has  historically  not  done  as   well  as  passive  management."  He  refers  to  some  of  the  data  provided  to  back  up  the  premises  of   WisdomTree  as  “data  mining.”   Mr.  whose  chairman  is  Michael  H.  so  an  index  should  be  constructed  to  invest  in  the   cheaper  value  stocks  rather  than  the  expensive  growth  stocks.”   Greg  Mankiw  (2006)  writes:   “I  am  a  fan  of  both  Jeremy  Siegel  (Wharton  economist  and  author  of  “Stocks  for  the  Long  Run’)  and  John   Bogle  (Vanguard  founder  and  index  fund  pioneer).  “Beware  when  you  hear  about  the  new  paradigm.  Siegel.  Siegel  thinks  markets  are  inefficient.  the  company  Mr.  with  less  risk.  Siegel  advises.  which  helps  to  explain  a  lot  of  what  we  see  in  the  capital  markets.  WisdomTree.  presumably.  and  that  became  the  basis  of  our  equity  platform  today—fundamentally  weighted.  …   Mr.  quite  frankly.  Bogle  disagrees.  on  something  like  more  than  70  percent  of  our  funds—from  one-­‐.  I  think  there  are  a  lot  of   factors.  the  legendary  former  hedge  fund  manager.  even  before  they  fully  embraced  it.  better.     By  contrast.”  Mr.”  he  said  yesterday.  I  am  therefore  fascinated  by  the  intellectual  and   financial  battle  between  them.  why  not  advocate  active  money   management?  The  answer.  but  it  may  be   true  enough  to  make  it  sensible  for  typical  investors  to  follow  its  prescriptions.  Siegel  says  the  central  problem  with  traditional  index  funds.   Historically.

  The  total  market  is  weighted  by  market  capitalization  (price  times  shares  outstanding).  Tax  efficiency  argues  in  favor  of  the  traditional   index  funds  that  Bogle  recommends.   Portfolio  structure  forms  the  basis  of  Dimensional  strategies  and  provides  the  framework  to  implement   insights  from  financial  science  and  practical  experience.  newly  modified  for  greater   efficiency.  The  hubris  that  makes  active  management  often  fail  may  also   infect  economists  who  make  up  mechanical  rules.  The  total   market  is  defined  as  the  aggregate  capitalization  of  the  NYSE.     3.     Finally.  To   balance  out  the  greater  small  and  value  exposure  and  still  include  every  stock  in  the  market.  AMEX.  RAFI.  We  chose   4     .”   The  DFA  funds  are  further  described  on  the  DFA  web  site.”     Our  (ET  and  CY)  takeaway  from  this  is  that  we  all  need  to  see  how  well  leading  enhanced   indexers  have  performed  relative  to  Vanguard.  It  is  hard  to  beat  the  market.  DFA.  The  engineered  approach  to  applied  core  equity   is  a  natural  evolution  of  our  experience  in  building  multifactor  strategies.  the  start  of  all  of  our  series.   Dimensional's  applied  core  strategies  seek  to  buy  the  total  US  market  in  proportions  that  provide  higher   exposure  to  the  risk  premiums  associated  with  size  and  value  identified  by  Fama  and  French.  AND  WISDOMTREE   Here  is  the  description  of  Dimensional  Fund  Advisors’  core  funds  from  the  DFA  home  page   (2012).  but  it  is   easier  to  beat  the  IRS  by  a  combination  of  (1)  focusing  on  capital  gains  over  dividends  and  (2)  deferring   capital  gains  realization  via  reduced  portfolio  turnover.  the  weight   of  large  cap  and  growth  stocks  is  reduced.  the  turnover  and  transaction  costs  normally  associated  with  maintaining  multiple   components  are  strongly  reduced.  causing  large  cap   growth  companies  to  dominate.  a  leading    traditional  indexer.  Because  the  core  equity  architecture  is  seamlessly  integrated  across  the  full  range  of   securities.  As  a  result.  Our   core  strategies  adopt  the  total  market  approach  by  targeting  return  premiums  across  the  multiple  asset   classes  of  the  US  equity  market.  The  applied  core  equity  strategies  alter  the  weighting  of  stocks  by   considering  both  a  company's  market  cap  and  its  book-­‐to-­‐market  (BtM)  ratio.  or  by  building  a  portfolio  from  component  asset  classes.  The  US  Social  Core    Equity  2  and  the   US  Sustainability  Core  1  funds    were  founded  after  March  2007.  I  am  skeptical.   “Asset  allocation  is  traditionally  achieved  in  two  ways:  by  owning  a  core  portfolio  that  replicates  the   characteristics  of  the  total  equity  market.  and  NASDAQ  Global  Market   System  companies.  exposure  to   the  riskier  small  and  value  shares  that  research  shows  offer  higher  expected  return  is  increased.   Siegel's  position  appears  to  be  that  active  money  managers  aren't  smart  enough  to  beat  the  market  but   his  mechanical  rule  is.  tax  efficiency  is  important  in  taxable  investment  accounts.

 the  first  comparison  of  DFA’s   core  funds  with  corresponding  Vanguard  funds.  Although  Tower  (2009)  attempted  to  compare  Vanguard   with  WisdomTree.  EXHIBITS   The  equally-­‐weighted  portfolios  for  DFA.   although  PowerShares/RAFI  did  kill  in  2009  all  nine  of  the  sector  funds  that  existed  in  March  2007.  so  there  is  no  systematic  bias   introduced  by  choosing  an  equally-­‐weighted  portfolio  to  examine.  and  the  first    PowerShares  RAFI  Fundamental  indexes   were  established  in  2005.  and  3   respectively.     5     .  Similarly.  The  equally  weighted  WT  portfolios  with  a  dividend  and  an  earnings  focus  are  examined  in   Exhibits  4  and  5  respectively.  but  neither  one   has  focused  on  DFA’s  core  funds.to  evaluate  US  funds  in  existence  in  March  2007  and  which  were  concerned  simply  with  risk  and  return.   5.  This  is  because  data  on  their  returns  starts  only  in  2005.  HAVE  ANY  ENHANCED  INDEX  FUNDS  BEEN  KILLED?   Survivorship  bias  is  potentially  an  important  issue.  HAVE  WE  DONE  ANYTHING  NEW? Tower  and  Yang  (2008)  and  Tower  (2009)  have  compared  Vanguard  with  DFA.   It  is  a  simple  way  of  describing  the  performance  of  the  funds  offerered  by  a  fund  family.  2.  RAFI  and  WT  are  examined  in  Exhibits  1.  we  ignore  these  two  funds.  DFA  and  WisdomTree  killed  none  of  the  funds   in  the  categories  we  considered.    The   comparison  Vanguard  portfolio  will  depend  on  the  weights  we  use.       The  Research  Affiliates  Fundamental  Indexes  and  WisdomTree  funds  are  further  described  on   the  PowerShares  and  WisdomTree  web  sites.       6.  No  PowerShares/RAFI  funds  in  our  share  categories  were  killed.  The  third  two   columns  do  the  same  using  Sharpe’s  style  analysis.   4.  Here  we  provide.  the  time  period  was  too  short  to  be  confident  of  any  conclusions.  The  second  two  columns  do  the  same  using  the  FF  three  factor  model.    There  is  no  reason  to  think  that  the  equally-­‐weighted  portfolio  is  optimal.  and  we  do  not  know  of  any  Vanguard  versus  RAFI   comparisons.   Consequently.  the  first  two  columns  evaluate  the  enhanced  index  funds  using  the  FamaFrench   four-­‐factor  model.  to  the  best  of  our  knowledge.  so  this  is  the  first   substantial  comparison  of  Vanguard  and  WisdomTree.   In  exhibits  1-­‐5.  the   data  on  WisdomTree’s  funds  starts  only  in  2006.

  Columns  5  and  6  compare  the  enhanced  index  fund  portfolio  with  the  best  tracking  portfolio  of   Vanguard  funds.   Exhibit  6  examines  individual  funds  using  the  FF  four  factor  model.  and  momentum  is  the  return  of  stocks  that  have  previously  had  high  returns   minus  the  return  of  stocks  that  have  previously  had  low  returns.  rm-­‐rf  is  the  market  return   minus  the  risk-­‐free  return.  by  regressing  the  monthly   6     .  then  the  tie  is  broken  by  the  Vanguard  portfolio  which  best  tracks  the  enhanced  fund  portfolio   in  the  sense  that  the  standard  deviation  of  the  fund  return  minus  the  vanguard  clone  return  is   minimized.  SMB.       We  use  the  Microsoft  excel  regression  utility  and  Microsoft  solver.   We  compare  each  enhanced  fund  or  enhanced  portfolio  with  a  portfolio  of  Vanguard  US  index   funds.  THE  FAMA  FRENCH  FOUR  FACTOR  MODEL   Ken  French’s  web  page  provides  monthly  series  of  the  four  FF  factors:  rm-­‐rf.Columns  1  and  3  compare  the  enhanced  index  fund  portfolio  with  a  portfolio  of  Vanguard  index   funds  that  shares  the  same  FF  loads  with  the  enhanced  index  fund  portfolio.  minimizing  the  short   position.  and   momentum.  If  a  requisite  portfolio  that  contains  no  shorts  is   found.  as  described  above.  such  that  the  share  of  the   Vanguard  portfolio  held  short  is  as  small  as  possible.  We  use  the  regression  utility   to  determine  the  loads  of  the  enhanced  fund  and  all  the  Vanguard  funds.  and   momentum.  without  regard   to  the  short  position  of  the    Vanguard  portfolio.  rebalanced  monthly.  HML  is  the  return  of  stocks  with  a  high  ratio  of  book  value  to  price  minus  the   return  of  a  low  ratio  of  book  value  to  price.  HML.   7.  rm  is  the  market  rate  of  return.    The  only  way  we  can  do  that  is   to  allow  some  Vanguard  funds  to  be  held  short.  HML.  The  data  are  monthly  excess   (arithmetic)  returns.      Columns  2  and  4  are  the  same  except  that  the  criterion  for  the  comparison  Vanguard   portfolio  is  that  it  be  the  best  tracker  of  the  enhanced  fund  portfolio  in  the  same  sense.  SMB  is  the  return  of  small  company  stocks  minus  the  return   of  big  company  stocks.  Column  5  allows  only  the  Vanguard  short  term  bond  index  fund  to  be  held  short.  SMB.  rf  is  the  risk-­‐free  rate  of  return.  while   column  6  does  not  constrain  the  Vanguard  short  equity  position.    The  factor  loads  are  the  coefficients  of  the  regressions  of  monthly  returns   of  the  enhanced  fund  or  enhanced  fund  portfolio  or  the  Vanguard  fund  on  rm-­‐rf.  We  constrain  the  four  factor  loads  of  the  Vanguard  portfolio  to  be  the  same  as  that  of  the   enhanced  fund  or  fund  portfolio  the  Vanguard    portfolio    is  mimicking.

returns  of  the  enhanced  and  Vanguard  funds  on  the  four  differential    FF  returns.  we  imagine  a  Vanguard   investor  who  holds  a  broad  portfolio  of  Vanguard  index  funds.  We  refer  to  the  best   tracking  portfolio  using  either  criterion  as  a  Vanguard  clone  for  the  enhanced  fund  or  portfolio.     The  technique  we  use  hinges  on  the  idea  that  if  we  regress  Y1  on  a  vector  of  X’s  and    we  regress   Y2  on  the  same  vector  of  X’s.  It  may  happen  in  other  circumstances  too.  we  minimize  the  share  of  the  portfolio  that  is  short.  and  if  there  exists  a  portfolio  with  no   shorts  we  select  the  best  tracking  portfolio.  Its   advantage  over  the  average  arithmetic  return  is  that  the  total  return  over  several  periods  depends  only   on  the  average  geometric  return  over  the  individual  periods.  we  allow   the  Vanguard  clone  to  hold  some  assets  short.   (i.  However.  so  the  average   arithmetic  return  is  not  a  unique  indicator  of  the  total  return.  This  is  the  average  differential  return  continuously  compounded  over  the  entire  period.  for   example.  so  we  dropped  the  attempt.  We  then  use  Microsoft   solver  to  find  the  portfolio  of  Vanguard  funds  that  has  the  same  loads  as  the  enhanced  fund.   8.  We  expect  this  to  be  the  case.  in  column   1’s  simulation.  However.     We  had  hoped  to  risk  adjust  the  Vanguard  portfolio  by  requiring  that  the  standard  deviation  of   the  Vanguard  portfolio  return  equal  that  of  the  enhanced  fund  return.  frequently  there  was  no  solution.    As  discussed  in  the  previous  section.  and  considers  diversifying  into  an   enhanced  fund  by  buying  the  enhanced  fund  and  simultaneously  adjusting  his  Vanguard  holdings  up  or   7     .  by   requiring  the  sum  of  the  portfolio  weights  add  to  one.  expressed  in  percentage  points  per   year.  we  can  calculate  the  coefficients  of  regressing  Y1+Y2  on  these  same  X’s  as   the  sum  of  the  coefficients  in  the  Y1  and  Y2  regressions.  The  alpha  in  all  six  of  our  Exhibits  is  the  average  continuously-­‐compounded  geometric   return  of  the  enhanced  fund  minus  that  of  the  Vanguard  clone.  total  return  depends  on  both  the   average  arithmetic  return  and  the  standard  deviation  of  the  average  arithmetic  return.  has  higher  HML  or  SMB  loads).e.     We  had  wanted  to  compare  the  enhanced  fund  with  a  Vanguard  clone  that  was  made  up  solely   of  funds  held  long.  Consequently.    In  column  2’s  simulation  we  select  the  best  tracking   portfolio  without  regard  for  the  proportion  of  the  portfolio  that  is  held  short.  when  we  constrained  the  factor  loads  to   be  the  same  for  the  enhanced  index  fund  and  its  vanguard  clone.  if  the  enhanced  fund  is  more  focused  on  value  or  small  stocks  than  any  of  the  Vanguard  funds.  To  justify  this  conceptually.  in  some  cases.  solver   could  not  find  an  equilibrium.  However.  INTERPRETING  THE  EXHIBITS     In  what  follows  enhanced  fund  may  refer  either  to  an  individual  fund  or  an  equally-­‐weighted   fund  portfolio.

 For  the   8     .  column  3  corresponds  to  column  1  and  column  4  corresponds  to  column  2.58  %  per  year  with  significance  of  0.  The  prediction  error  standard   deviation  is  the  standard  deviation  of  the  error  in  the  return  of  the  enhanced  fund  predicted  by  the   clone.  this  is  what  one  would  expect  when  the  differential  return  is  so  large.  The   statistical  test  is  performed  on  continuously  compounded  monthly  returns.  performed  using  Microsoft  solver’s  “t  test:  paired   two  sample  for  means.  “Sum  of  shorts”  is  the  fraction  of  the  portfolio  that  is  held  short.  and  there  is  a   0.  except  we  ignore  the   momentum  factor.  The  Vanguard  weights  in  Exhibits  1-­‐5  are  the  amounts  by   which  each  Vanguard  fund  holding  is  adjusted  down  (+)  or  up  (-­‐)  as  a  percent  that  is  invested  in  the   enhanced  fund.09  %.  So  each  of  the  regressions  behind    columns  3  and  4  is  on  rm-­‐rl.   The  fund  excess  standard  deviation  is  the  amount  by  which  the  fund  is  more  volatile  than  its   clone.  Is  the   three  factor  or  the  four  factor  model  better?    For  the  equally  weighted  DFA  portfolio  the  three  factor   regression  had  a  higher  R  square  corrected  for  degrees  of  freedom  and  a  more  significant  F  test.  Of  course.  the  sum  of  the   negative  weights.   “Correlation  of  returns”  is  the  correlation  of  the  monthly  arithmetic  returns  of  the  enhanced   fund  and  its  Vanguard  clone  determined  in  the  simulation.  and  SMB.  and  the  weights  add  to  one  hundred  percent.   The  weights  show  the  portfolio  weights  that  make  up  the  Vanguard  clone.    That  is  to  say  its  continuously  compounded   rate  of  return  exceeded  that  of  its  Vanguard  clone  by  -­‐2.  The  Vanguard  funds  are  listed  by  ticker  and   named  in  section  11.  Negative  numbers   denote  shorts.58  percentage  points  per  year.  This  is  the  probability  that  the  differential  return  in  the  universe  has  a  different  sign   from  that  in  the  sample.  A  smaller  number  means  the  Vanguard  clone  is  a  better  predictor  of  fluctuations  in  the  fund   return.down  so  as  to  maintain  the  same  FF  loads.”  The  DFA  equally-­‐weighted  portfolio  described  in  the  first  simulation  of  Exhibit  1   has  an  alpha  of  -­‐2.  Thus  the  excess  return  of  the  DFA  portfolio  is  significantly  less  than  its   Vanguard  clone.09  %  probability  that  the  universe  from  which  those  returns  was  drawn  has  Vanguard  under-­‐returning   the  DFA    portfolio.  THE  FAMA  FRENCH  THREE  FACTOR  MODEL     In  Exhibits  1-­‐5.     9.  The   third  and  fourth  columns  are  constructed  in  the  same  way  as  columns  1  and  2.    A  negative  number  means  the  fund  is  less  volatile  than  its  clone.  HML.   “Significance”  is  a  one  tailed  test  for  alpha.The  spreadsheets  with  our  calculations  are  available  upon  request.

 The  technique  consists  of  picking  portfolio  weights  for  the   Vanguard  index  funds.  such  that  the  standard  deviation  of  the  arithmetic  return  differential  between   the  enhanced  fund  and  the  Vanguard  clone  is  as  small  as  possible.  then  the  equities  in  the  enhanced  fund  are  less  leveraged  than  the  equities  in  the     Vanguard  portfolio.equally  weighted  RAFI  and  for  the  equally  weighted  WT  portfolio  the  four  factor  regression  had  the   higher  R  square  corrected  for  degrees  of  freedom  and  the  more  significant  F  test.   10.     11.  In  column  5.    Column  6  is  the  same.     VFINX  500  Index  Investor  Inv   VEXMX  Extended  Market  Index  Inv   VTSMX  Total  Stock  Mkt  Index  Inv   VIVAX  Value  Index  Inv   VIGRX  Growth  Index  Inv   VMVIX  Mid-­‐Cap  Value  Index  Inv   VMGIX  Mid-­‐Cap  Growth  Index  Inv   NAESX  Small  Cap  Index  Inv   VISVX  Small  Cap  Value  Index  Inv   VISGX  Small  Cap  Growth  Index  Inv   VIMSX  Mid-­‐Cap  Index  Inv   VBISX  Short  Term  Bond  Index  Inv     9     .  Here  are  the  Vanguard  index  funds  we  select   from  (in  the  order  of  CRSP  codes)  and  preceded  by  their  tickers.  The  Sharpe  calculations  are  presented   in  columns  5  and  6  of  Exhibits  1-­‐5.  If  that   coefficient  is  positive.  So  the  three  factor   model  is  better  for  DFA  and  the  four  factor  model  is  better  for  the  other  two.  so   shorts  are  prohibited.    A  negative  coefficient  picks  up  the  case  where  the  enhanced  fund  is  more  leveraged   than  the  Vanguard  clone.  we  constrain  all  portfolio  weights  to  be  non-­‐negative.  with  one  exception  which  is  the  Vanguard  Short-­‐Term  bond  fund.  THE  VANGUARD  FUNDS   Some  Vanguard  funds  are  unavailable  in  other  than  the  investor  share  class.  To  make  these  calculations  comparable  to  the  other  two  we  do  not  risk  adjust.  So   we  use  that  share  class  for  all  of  the  Vanguard  index  funds.  except  we  do  not  constrain  any  of  the  portfolio  weights   to  be  positive.  except  we  substitute  Vanguard   investor  share  index  funds  for  the  indexes.  THE  SHARPE  METHOD   Sharpe  (1992)  proposed  using  “style  analysis”  to  explore  whether  a  mutual  fund  over-­‐returns  a   portfolio  of  indexes  with  the  same  style.  We  use  the  same  technique.  denoted  by  Inv.

02%/month.    Over  the  period  of  our  calculations  the  continuously  compounded  rates  of  return  for  the   Vanguard  clone  and  the  Vanguard  Real  Estate  Investment  Trust  were  1.  so  March  2007  marks  the  start   date  of  all  of  our  comparisons.  and  the  expected  out-­‐ performance  of  Vanguard  would  be  higher.  2012.    If  the   enhanced  fund  is  more  valuey  or  more  growthy  than  any  of  the  Vanguard  funds.  The  average  significance  of  the  alpha  on  a  one  tailed  test  is   3.43%/month  and  the  average  excess  volatility   of  the  DFA  portfolio  is  0.  Had  Vanguard  held  no  real  estate  in  the  clone  portfolio.  How  does  that  affect  our  calculations?  Here  is  one  representative   calculation.   respectively.     Exhibit  6  presents  simulations  for  all  of  the  individual  funds  for  all  three  fund  families.  real   estate  accounted  for  5.   Throughout  all  of  these  simulations.  We  chose   to  present  only  the  four  factor  simulations  with  no  limits  on  the  size  of  the  short  portfolio.   Exhibit  1  presents  the  results  of  our  simulations  for  the  DFA  equally-­‐weighted  portfolio.  this  simulation  will  be   able  to  replicate  the  style  of  the  enhanced  fund.  like  the  DFA  equally-­‐weighted   portfolio  have  negative  alphas.01%/month.  The  average  alpha  is  -­‐0.S.     Two  commenters  on  this  paper  have  remarked  that  the  Vanguard  clones  held  more  real  estate   than  did  the  DFA  core  funds.     13.The  WisdomTree  earnings  funds  started  only  in  February  2007.  There  is  only  a  3.57%  and  0.  All  three  DFA  funds.  The  corresponding  figure  for  the  DFA   clone  was  0.  (These  figures  are  three-­‐year  averages  from  the  January  2012  Morningstar   Principia  disk).     12.  except  those  used  in  Exhibit  8.  DFA   DFA  has  three  U.  For  the  Sharpe-­‐no-­‐equities-­‐short  clone  of  the  equally-­‐weighted  DFA  core  portfolio.    The  average  alpha  is  -­‐1.73  percent  of  the  portfolio  on  average.87  %/year.  so  the  alpha  is  significant  at  standard  levels.  to  the  extent  that  investors  can  use  Vanguard’s  Admiral   funds  or  Vanguard’s  ETFs.27%.  We  choose  to  work  with  them.  The  average  excess  volatility  of  the   DFA  fund  is  a  small  0.  the  Vanguard  return  would  have   been  0.  the  Vanguard  expense  ratios  would  be  lower.27%  probability  that  the  DFA   average  alpha  is  superior  to  the  Vanguard  clone  in  the  universe  from  which  the  observations  are  drawn.52%  per  year.  core  funds  that  were  alive  in  March  2007.333  percent.057%  percentage  points  per  year  higher  relative  to  the  DFA  clone  return.  POWER  SHARES  FTSE  RAFI  FUNDS   10     .  All  data  series  end  on  June  30.  In  all  six  of  the   simulations  of  the  equally  weighted  DFA  portfolio  the  alpha  is  negative  and  the  DFA  portfolio  is  more   volatile  than  its  Vanguard  clone.

76%/year.   Exhibit  2  presents  calculations  based  on  the  equally-­‐weighted  portfolio  of  the  two  FTSE  RAFI  US   PowerShares  funds  that  existed  for  the  entire  period  of  our  analysis.     Exhibit  6  shows  the  alphas  for  the  two  individual  RAFI  funds.jsp).  Both  alphas  are  positive.  WISDOMTREE   There  are  eleven  U.  The  average  alpha  is  2.   14.  The  equally-­‐weighted  portfolio  is  described  in  Exhibit  3.  and  an  excess  volatility  of   0.The  FTSE  web  page  reads  “FTSE  has  partnered  with  Research  Affiliates  to  create  the   innovative  FTSE  RAFI  Index  Series.56%.05%/month.20%/month.  and  excess  volatility  of  wisdom  tree  0.S.65%/year  and  the  average   excess  volatility  of  the  RAFI  fund  is  minus  0.01%.  significance  8.  free  cash  flow.  and  the  average  significance  is  14%   on  a  one  tailed  test.  WHY  ARE  FUND  ALPHAS  SMALLER  THAN  THE  EQUALLY-­‐WEIGHTED  PORTFOLIO  ALPHAS?     11     .21%.  The  average  alpha  is  plus  3.  The  average  alpha  is   2.  They  range  from  0.  Exhibit  6   shows  the  alphas  for  the  three  individual  WT  funds.  The  alphas  for  both  portfolios  are  strongly  positive.  The  equally-­‐weighted  portfolio  of  the  earnings  funds  had  an  alpha  of  2.  Every  alpha  is  positive.  The   averages  are:  alpha  +2.57%/year.   Since  WT  bases  some  of  its  indexes  on  earnings  and  some  on  dividends.   At  the  end  of  2011  there  were  nine  US  PowerShares  based  on  the  RAFI  indexes.32%/year  and  the  average  excess  volatility  of  the  WT  funds  is  -­‐0.  we  were  curious  to   know  which  indexation  was  superior.  WT  set  up  its  dividend  funds  before  its  earnings  funds.  index  constituents  are  selected  and  weighted  using  four  fundamental  factors-­‐total  cash   dividends.  based  on  the  four  factor  calculation  minimizing  the   short  %.63%/year  to  4.  As  part  of  FTSE’s  new  range  of  non-­‐market  cap  weighted   indices.89%.com/Indices/FTSE_RAFI_Index_Series/index.  based  on  the  four  factor  calculation   minimizing  the  short  %.   15.”   (http://www.06%/month.12%/month.   the  average  excess  volatility  of  the  RAFI  portfolio  is  0.  total  sales  and  book  equity  value.  Our  study  deals  only  with  the  two   that  were  based  on  the  RAFI  indexes  from  March  2007  on.17%/year  and  an   excess  volatility  of  -­‐0.  The   equally-­‐weighted  portfolio  of  the  dividend  funds  had  an  alpha  of  2.  WT  funds.06%/month.  they  are   not  significantly  different  from  zero  at  the  ten  percent  level.ftse.  However.  But  seven  of   these  were  not  based  on  the  RAFI  indexes  until  the  beginning  of  2011.

 while  the  portfolio  which  is  rebalanced   monthly  has  a  zero  two  month  return.  and  the  other  returns  close  to   minus  100%  in  the  first  month  and  100%  in  the  second  month.    This  one  combines  an  asset  which  returns  100  percent  in  both   periods  with  another  which  returns  close  to  minus  100  percent  in  both  periods.  the  absolute  value  of  the  portfolio  return  is  less  than  the   average  absolute  value  of  the  individual  asset  return.  Exhibit  7  describes  the   use  of  the  alphas  calculated  for  the  first  period  to  predict  the  second-­‐period  alphas.The  average  absolute  value  of  the  fund  family  mutual  fund  alphas  is  less  than  that  of  the   portfolio  alphas  in  the  corresponding  column  1  of  exhibits  1-­‐3..  The  two  month  returns  of  each  of  the   two  assets  over  the  two  months  are  close  to  minus  100%.  Thus  rebalancing  reduces  the  volatility  of   the  average  alphas.  and  for  the  second  it  is  close  to  minus  100%  for  an  average  of  close  to  100%.  The  corresponding  average  continuously-­‐compounded  rates  of  return  are  69  %  for  the  first   fund.   Now  consider  another  portfolio.  In  part.  minus  infinity  %  for  the  second  fund.       For  example  consider  an  equally-­‐weighted  portfolio  of  two  assets.  one  of  which  returns  plus   100%  in  the  first  month  and  close  to  minus  100%  in  the  second  month.  this  is  because   our  alphas  are  continuously  compounded  return  differentials.  when  all  returns  are   continuously  compounded.  Suppose  one  mutual  fund  over  a  month   returns  plus  100%  and  a  second  returns  minus  100%.  The  two  month  return   for  the  first  asset  is  300%.   16.  the  Sharpe  model  with  no  limits  on  any  Vanguard  asset  held  short.    Again.   More  important:    on  average  the  alphas  shown  in  our  tables  are  lower  in  algebraic  value  for  the   individual  mutual  funds  than  for  the  corresponding  portfolios  of  mutual  funds.    The  absolute  value  of  the  portfolio  return  is  less  than  the   average  absolute  value  of  the  individual  asset  return.  Thus  the  average  return  for  the   rebalanced  equally-­‐weighted  portfolio  exceeds  that  of  the  component  assets.    We  consider  two   models.  One  reason  for  this  is  that  rebalanced  portfolios  of  assets  whose  returns  are  not   perfectly  correlated  show  more  stable  average  rates  of  return  than  the  average  of  the  rates  of  return  of   the  component  assets.   The  rebalanced  portfolio  returns  0%.  The  portfolio  with  equal  weights  on  the  two  funds   returns  0%.  and  0  %  for  the  portfolio.  DO  ALPHAS  PREDICT  EXCESS  RETURNS?   We  divided  up  the  observations  on  the  equally-­‐weighted  portfolios  discussed  in  exhibits  1-­‐3  into   two  periods:  March  2007-­‐December  2009  and  January  2010  through  June  2012.  and  the  Sharpe  model  with   12     .

 and  the  second-­‐period   alphas  are  on  the  vertical.  Following  their   lead.  For  the  DFA  funds  and  for  the  WisdomTree  funds  all  of  the  signs  of  the  first   period  and  comparable  second  period  alphas  agree.  which  is  the  excess  return  of  the  equally   weighted  enhanced  portfolio  over  the  index.   Next  are  presented  the  standard  deviation  of  returns  for  the  enhanced  and  the  Vanguard  portfolios.  The  signs  of   13     .     17.  The  first-­‐period  alphas  are  on  the  horizontal  axis.  the  α  of  Vanguard  vs  index.  the  α  of  enhanced  versus  Vanguard.    Several  readers   suggested  that  Vanguard’s  index  funds  change  their  weighting  from  time  to  time.    For  the  RAFI  funds  the  first  period  alphas  are   positive  and  the  second  period  alphas  are  negative.  five  of  the  US  Russell  indexes.   We  decided  to  focus  only  on  the  Sharpe  model.  so  it  would  be  better   to  compare  Vanguard  index  funds  and  enhanced  index  funds  with  baskets  of  indexes.  and  Vanguard  out-­‐returned  DFA.  Last  are  the  Vanguard  portfolio   weights.  which  is  the  same  for  the   Vanguard  portfolio.  but  not  for  RAFI.  We  conclude  that  the  alphas  had  some  predictive   power  for  DFA  and  WisdomTree.     Again  RAFI  and  WisdomTree  out-­‐returned  Vanguard.  We  constrained  the  portfolio  weights  to  add  to  100%  and  disallowed  shorts.  while  WisdomTree  has  lower  Volatility.  since  the  periods  were  too  short  to  get  reliable   estimates  of  the  FF  factors.     Exhibit  8  presents  the  α  of  enhanced  vs  index.  which  is  the  excess  average  return  of  the   enhanced  equal-­‐weight  portfolio  over  the  Vanguard  clone.only  the  Vanguard  short-­‐term  bond  index  fund  permitted  to  be  held  short  (labeled  no  equities  short).  minimizing  the  standard  deviation  of   the  prediction  error.   followed  by  the  excess  standard  deviation  of  the  enhanced  portfolio.  Relative   to  Vanguard.  DIRECT  COMPARISONS  WITH  INDEXES   One  reader  was  put  off  by  the  use  of  short  positions  in  an  earlier  version  of  this  paper.  The   index-­‐clone  portfolio  is  constructed  using  the  weights  from  this  regression.  He   suggested  comparing  the  performance  of  the  enhanced  indexers  with  indexes.  presented  in  the  January  2012  Morningstar  Principia  disk.  The  best  explained  Vanguard  portfolio  is  that  which  has  the  minimum  standard  deviation  of   excess  return  of  the  Vanguard  portfolio  over  the  index-­‐clone  portfolio.  All  returns  are  continuously  compounded.  and  four  of  the  US  S&P   indexes  .  Then  we  found  the  Vanguard   portfolio  (with  all  funds  held  long)  which  is  best  explained  by  the  monthly  returns  of  the  index-­‐clone   portfolio.  we  regressed  the  monthly  returns  of  the  equally-­‐weighted  enhanced  index  portfolios  against  all   twenty-­‐one  of  the  broad-­‐based  US  MSCI  indexes.  DFA  and  RAFI  have  higher  volatility.

 2006).   Dimensional  Fund  Advisors  home  page.  “Turn  on  a  Paradigm?”  Wall  Street  Journal.the  alphas  and  excess  volatilities  from  the  direct  index  comparisons  are  the  same  as  in  our  earlier   calculations.   14     .com/2006/08/siegel-­‐vs-­‐bogle-­‐on-­‐index-­‐funds.  while   the  US  DFA  Core  funds  under-­‐returned.com/strategies/us/.  Olly.    August  15.  Malkiel.  A  14.com/ef/0adhoc/fi.html?showall=&fullart=1&start=4  (  September  7.   REFERENCES   Bernstein.html.    Two  cheers  for  enhanced  indexation   and  one  for  traditional  indexation!    In  every  simulation  the  DFA  funds  are  more  volatile  than  their   Vanguard  counterparts.       Is  traditional  indexing  passé?  Well-­‐performing  enhanced  indexers  are  the  traditional  indexer’s   friend.  Accessed  July  9.blogspot.efficientfrontier.  CONCLUSION   These  calculations  show  the  US  RAFI  and  US  WisdomTree  funds  out-­‐returned  Vanguard.   2006).  William  J.  “WisdomTree’s  Steinberg:  True  Self-­‐Indexer.dfaus.htm  (2006).net/Turn%20on%20a%20Paradigm.   http://gregmankiw.  John  C.com/sections/features/14451-­‐wisdomtrees-­‐steinberg-­‐true-­‐self-­‐indexer-­‐ .  Greg  (2006).   Mankiw.   http://www.”  Efficient  frontier.  both  for   individual  funds  and  for  equally-­‐weighted  portfolios  of  the  funds.     http://lifetimefinancialplanning.  pp.  This  is  true  for  every  simulation  we  performed.     The  different  results  for  different  families    is  consistent  with  William  Bernstein’s  caution  quoted   in  section  1:  “The  prospective  shareholder  needs  to  consider  not  only  the  selection  paradigm  used.indexuniverse.  (Tuesday.  “Fundamental  Indexing  and  the  Three-­‐Factor  Model.  2012   Ludwig.”  Greg  Mankiw’s  blog.  http://www.  “Siegel  vs  Bogle  on  Index  Funds.  They  make  the  market  efficient.  For  the  other  fund  families  the  volatility  relative  to  Vanguard  depends  on  the   simulation.”     Seven  different  ways  of  evaluating  each  mutual  fund  family  seems  like  overkill.”       http://www.  2012).  and  restore  traditional  indexation  to  an  equal  footing  with  smart   enhanced  indexing.   Bogle.  But  we  wanted   to  be  sure  we  were  fair  to  each  mutual  fund  family.   18.  and  Burton  G.pdf  (June  27.  but   just  who  is  executing  it.

59 2.50 -­‐230 0 0 291 -­‐125 -­‐98 -­‐6 0 35 0 0 -­‐1 4 3   3   Sharpe  no   Sharpe  no   factor   factor   equity   limit  on   min   min   funds   shorts.  18:  2  (Winter  1992).   Tower.  71-­‐81.”  Chapter  13  of  of   Mutual  Funds:  Portfolio  Structures.09 99.  Haslem.00 0.75 99.43  percentage  points  per   year  with  0.  min   min  pred   % error pred  e rror error average -­‐0.  “Asset  Allocation:  Management  Style  and  Performance  Measurement.70 99.  March  1.57 99.   2012  under-­‐returned  the  comparable  basket  of  V anguard  funds  by  1.  W.85 0.  237-­‐264.05 0.25 99.03 0.11 99.58 0.75 0.80 3.(  Winter   20080.  pp.03 0.  Analysis.66 -­‐0.”  Journal  of  Portfolio   Management.45 -­‐9 7 -­‐5 5 7 9 17 -­‐4 13 25 0 27 0 0.  1  tail correlation excess  std  dev  of  fund st  dev  of  predn  e rror sum  of  shorts   VFINX VEXMX VTSMX VIVAX VIGRX VMVIX VMGIX NAESX VISVX VISGX VIMSX VBISX 4  factor   4  factor   minimize   minimize   prediction   short  % error -­‐2. Simulation α  %/year Significance  of  α .67 0.  In  all  e xhibits  all  numbers  are  i n  %.27 99.  The  e qually-­‐weighted  portfolio  of  the  3  Core  US  DFA  funds.  “Classic  and  Enhanced  Index  Funds:  Performance  and  Issues.  (2009)  pp.76 -­‐1.39 -­‐170 12 2 92 -­‐29 -­‐29 -­‐2 -­‐5 67 -­‐8 -­‐17 16 1   -­‐2.06 0.  and  Stewardship.  pp.   Tower.26 -­‐380 22 27 -­‐92 61 40 -­‐61 -­‐48 223 -­‐75 -­‐102 105 -­‐2 -­‐1.  Edward.  17:4.Sharpe.43 3.  2009.48 -­‐391 10 -­‐22 340 -­‐149 -­‐131 23 21 92 -­‐35 -­‐14 -­‐39 5 0.   Hoboken:  Wiley.   Exhibit  1.01 0.35 -­‐10 22 -­‐5 5 7 9 16 -­‐3 13 24 13 1 -­‐1 15     .90 0.02  percentage  points  per  month  more  volatility.  F.  Edward  and  Cheng-­‐Ying  Yang.  edited  by  John  A.02 0.  2007-­‐June  31.  7-­‐19.  Management.29 0 11 15 5 23 0 0 4 28 13 0 0 0 -­‐0.92 0.      “Enhanced  Versus  Passive  Mutual  Fund  Indexing:  Has  DFA   Outperformed  Vanguard  by  Enough  to  Justify  its  Advisor  Fees?”  Journal  of  Investing.80 0.01 0.   short   pred   short.04 13.

57  percentage  points  per  year  with  0.95 12.13 -­‐1169 92 -­‐15 4 -­‐32 -­‐55 -­‐147 -­‐151 -­‐765 434 398 341 -­‐3 -­‐4 2.12     percentage  points  per  month  more  volatility.11 -­‐120 120 -­‐69 -­‐1 -­‐2 -­‐8 7 176 -­‐2 -­‐3 0 -­‐35 38 -­‐1 2.65 -­‐0.79 12.  1  tail correlation excess  std  dev  of  fund st  dev  of  predn  e rror   sum  of  shorts   VFINX VEXMX VTSMX VIVAX VIGRX VMVIX VMGIX NAESX VISVX VISGX VIMSX VBISX VBISX 16     . 4  factor   3  factor   Sharpe  no   Sharpe  no   4  factor   minimize   3  factor   min   equity  funds   limit  on   minimize   prediction   min   pred   short.68 0.  2007-­‐June  31.Exhibit  2.67 97.58 11.51 0.09 1.54 -­‐329 12 -­‐9 105 -­‐45 -­‐31 13 11 19 10 29 -­‐19 5 0   Simulation α  %/year Significance  of  α .47 -­‐250 -­‐21 -­‐50 -­‐108 49 33 67 67 -­‐70 112 17 0 6 5 1.10 1.75 98.  2012  out-­‐ returned  the  comparable  basket  of  V anguard  funds  by  2.84 95.16 -­‐4 5 0 0 0 15 0 9 0 0 60 3 18 -­‐4 1.21 2.20 2.30 98.  min   shorts.57 -­‐0.13 -­‐115 115 -­‐71 0 -­‐1 -­‐4 0 174 0 -­‐1 -­‐4 -­‐33 41 0 3.23 -­‐317 29 -­‐51 -­‐109 49 34 66 68 -­‐71 110 60 -­‐86 2 5 1.  March  1.03 98.64 0.52 1.35 95.57 13.53 19.75 97.  min   short  % error short  % error pred  e rror pred  e rror average 3.62 0.90 12.12 1.67 13.44 1.  The  e qually-­‐weighted  portfolio  of  the  2  RAFI  funds.88 0.

69 10.74 11.32 1.04 0.76 0 0 0 0 56 0 0 0 0 41 0 0 4 2.  2007-­‐June   31.01  percentage  points  per  month    more  volatility.50 98.  min   shorts.03 0.94 -­‐83 35 13 -­‐35 23 -­‐1 63 6 -­‐24 40 -­‐23 0 4 0.27 -­‐0.18 10.70 -­‐157 86 11 -­‐44 23 -­‐10 53 28 -­‐24 51 2 -­‐78 2 1.66 4.89 98.   Exhibit  3.21  percentage  points  per   year  with  0.   Simulation α  %/year Significance  of  α .74 99.49 -­‐338 -­‐43 -­‐14 281 -­‐105 -­‐109 108 -­‐4 0 0 -­‐62 43 6 3   3   Sharpe  no   factor   factor   equity   Sharpe  no   min   min   funds   limit  on   short   pred   short.46 0.98 -­‐329 54 11 11 -­‐5 -­‐31 85 29 -­‐103 75 23 -­‐54 4   17     .  2012  out-­‐returned  the  comparable  basket  of  V anguard  funds  by  2.87 -­‐0.  min   % error pred  e rror pred  e rror average 2.  March  1.01 0.04 1.21 99.83 5.21 8.21 99.  1  tail correlation excess  std  dev  of  fund st  dev  of  predn  e rror sum  of  shorts VFINX VEXMX VTSMX VIVAX VIGRX VMVIX VMGIX NAESX VISVX VISGX VIMSX VBISX 4  factor   4  factor   minimize   minimize   predictio short  % n  e rror 2.49 10.99 96.05 0.06 1.64 -­‐1314 291 73 -­‐414 76 44 181 147 -­‐569 317 282 -­‐331 3 2.31 0.  The  e qually-­‐weighted  portfolio  of  the  11  US  WisdomTree  funds.18 0.39 -­‐85 -­‐39 1 1 30 3 103 4 -­‐10 13 -­‐36 24 7 2.06 0.42 0.75 97.

90 98.09 0.57 97.82 94.82 98.28 8.94 0.67 0.   March  1.04 97.11 29.84 -­‐0.05 1.31 0 0 0 0 60 0 0 0 0 35 0 0 5 2.07 1.56 11.77 0.19 -­‐55 8 0 2 37 -­‐7 75 -­‐17 0 27 -­‐31 0 6   3   3   Sharpe  no   Sharpe  no   factor   factor   equity   limit  on   min   min   funds   shorts.  2012  out-­‐returned  the  comparable  basket  of  V anguard  funds  by  2.26 -­‐432 149 18 -­‐113 15 -­‐31 112 44 -­‐78 70 17 -­‐108 6   2.  min   min  pred   % error pred  e rror error average 4.06  percentage  points  per  month    more  volatility.72 0.24 -­‐307 17 -­‐18 273 -­‐105 -­‐106 98 -­‐28 0 16 -­‐43 -­‐7 4 18     .  The  e qually-­‐weighted  portfolio  of  the  6  US  WisdomTree  dividend  focused  funds.56   percentage  points  per  year  with  0.96 -­‐686 353 47 -­‐204 -­‐42 -­‐80 158 116 -­‐84 87 21 -­‐276 4 1.90 97.Exhibit  4.94 -­‐1324 510 103 -­‐629 57 25 203 151 -­‐331 212 158 -­‐364 5 2.70 3.06 1.62 3.58 0.67 18.   short   pred   short.00 3.05 1.06 0.  1  tail correlation excess  std  dev  of  fund st  dev  of  predn  e rror sum  of  shorts VFINX VEXMX VTSMX VIVAX VIGRX VMVIX VMGIX NAESX VISVX VISGX VIMSX VBISX   4  factor   4  factor   minimize   minimize   prediction   short  % error 2.91 -­‐221 5 -­‐24 -­‐118 84 -­‐18 136 41 -­‐56 42 -­‐4 0 13 2. Simulation α  %/year Significance  of  α .52 0.34 97.15 1.  2007-­‐June  31.

17 17.06 0.77 95.15 1.12 15.90 98.06  percentage  points  per  month    l ess  volatility.25 2.06 0.  1  tail correlation excess  std  dev  of  fund st  dev  of  predn  e rror sum  of  shorts VFINX VEXMX VTSMX VIVAX VIGRX VMVIX VMGIX NAESX VISVX VISGX VIMSX VBISX   4  factor   4  factor   minimize   minimize   prediction   short  % error 2.   March  1.82 21.  2007-­‐June  31.52 0.71 -­‐0.31 0 0 0 0 60 0 0 0 0 35 0 0 5 2.  The  e qually-­‐weighted  portfolio  of  the  5  US  WisdomTree  Earnings  focused  funds.96 15.68 -­‐358 60 14 -­‐112 52 38 108 99 -­‐52 53 33 -­‐194 0 1.75 -­‐213 -­‐20 -­‐18 -­‐117 68 1 125 70 -­‐58 21 17 0 10 19     .46 -­‐409 61 14 -­‐97 23 -­‐1 120 61 -­‐82 52 18 -­‐74 6   2.36 0.98 -­‐0.11 29.  2012  out-­‐returned  the  comparable  basket  of  V anguard  funds  by  2.44 2. Simulation α  %/year Significance  of  α .24 2.57 97.02 -­‐399 -­‐93 -­‐16 272 -­‐118 -­‐80 159 19 -­‐24 -­‐12 -­‐56 44 6 -­‐0.03 -­‐162 -­‐92 0 3 18 9 126 25 -­‐26 1 -­‐44 72 8   3   3   Sharpe  no   factor   factor   equity   Sharpe  no   min   min   funds   limit  on   short   pred   short.  min   % error pred  e rror pred  e rror average 1.17   percentage  points  per  year  with  0.90 18.16 1.72 0.09 99.28 96.94 -­‐1324 510 103 -­‐629 57 25 203 151 -­‐331 212 158 -­‐364 5 2.  min   shorts.Exhibit  5.06 1.04 94.62 3.09 94.85 -­‐0.

87 PRFZ PRF   DTD DHS DLN DTN DON EZY EES EZM EPS EXT DES 3.41 0.49 -­‐0.54 3.74 0. significance  % sum  of  shorts   % fund  excess   sdev    % α  %/year Family DFA Name US  V ector  Equity  I US  Core  Equity  2I US  Core  Equity  1I DFA  Average PowerShares  FTSE  RAFI  US  1500  Small-­‐Mid  Portfolio PowerShares  FTSE  RAFI  US  1000  Portfolio Ticker DFVEX -­‐1.01 -­‐57 21 -­‐0.65 1.17 -­‐113 0.02 0.07 -­‐41 0.51 2.44 -­‐209 27 -­‐0.00 0.63 4.06 -­‐86 PowerShares  Average WisdomTree WT  Total  Dividend  Fund   WT  Equity  Income  Fund WT  LargeCap  Dividend  Fund WT  Dividend  e x-­‐Financials  Fund WT  MidCap  Dividend  Fund WT  LargeCap  V alue  Fund WT  SmallCap  Earnings  Fund WT  MidCap  Earnings  Fund WT  Earnings  500  Fund WT  Total  Earnings  Fund WT  SmallCap  Dividend  Fund WisdomTree  Average 22 -­‐0.03 -­‐49 14 10 16 5 42 0.22 -­‐137 11 -­‐0.05 -­‐40 0.01 0.  Individual  Funds.10 -­‐101 20 -­‐0.15 2.32 4 12 17 11 0.56 DFEOX -­‐0.    minimize  short  %.  All   RAFI  &WisdomTree  funds  outreturn  V anguard  with  l ess  average  volatility.Exhibit  6.06 -­‐60 31 0.18 1.76 3.20 -­‐116 13 0.64 3.19 -­‐95 14 -­‐0.    Every  DFA    fund  underreturns  V anguard.87 1.05 -­‐101       20     .55 DFQTX -­‐0.12 -­‐68 0.  Four  factor.65 3.32 4.39 1.01 -­‐44 -­‐21 -­‐20 -­‐28 RAFI 17 -­‐0.66 -­‐285 16 -­‐0.

        21     .

41 2.14 VFINX  (Vanguard  clone  weight  %) 37 0 2 VEXMX 0 18 0 VIVAX 6 5 55 VMVIX 0 19 1 NAESX 42 9 0 VISVX 15 49 43 sum  of  V anguard  clone  weights  % 100 100 100   22     .61 1.30 Excess  std  dev  of  enhanced  vs  Vanguard  %/mo 0.  No  shorts  (March  1/2007-­‐ December  31/2011) Family DFA RAFI   WisdomTree α  of  e nhanced  vs  i ndex  %/yr -­‐0.10 0.60 2.  1  tail  % 1.  α 's  calculated  with  e quity  i ndex  clone.16 Standard  deviation  of  V anguard  %/month 6.27 -­‐0.96 6.29 Significance  of  α .01 -­‐0.22 6.24 7.   Exhibit  8.73 Standard  deviation  of  e nhanced  %/month 6.90 1.54 7.44 0.  Sharpe.38 α  of  enhanced  versus  Vanguard  %/yr -­‐0.44 6.50 3.91 α  of  V anguard  vs  i ndex  %/yr 0.

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