It sounded too good to be true. You could hold just 32% of your investments in a special group of stocks, keep the rest in risk-free government bonds, and earn the same return as other investors with 100% stock portfolios.
Or, so suggested an article in the Dec 23, 2011 New York Times. Written by Ron Lieber, it was titled “Taking a Chance on the Larry Portfolio”.
The Larry in question was Larry Swedroe, a noted financial author and advisor. And the Portfolio in question was a radical one. I’ll let Lieber explain:
As for the Larry Portfolio, which he prefers to refer to by more technical names, the only stocks it contains are mutual funds that hold small or value stocks (preferably both) from around the world. Everything else tends to go into very safe bonds.
In the article, and more specifically in other writings, Swedroe makes it clear that his preferred stock holding is a single investment, the DFA small value fund (Larry’s company sells DFA funds, which you have to go through an advisor to buy).
As small value stocks compose only about 5% of the stock market, this idea flies in the face of basic diversification principles. But Swedroe believed the risks were worth it – that small/value stocks offered such great returns that investors could cut back dramatically on the percentage of stocks they owned, and still get the returns of the market as a whole. This was based on historical data:
If you wanted to gin up a portfolio to match closely (at 9.8 percent) that [the S&P 500 index] performance with much less risk, all you would have needed to do was put 32 percent of your money in a fund mimicking the United States stock index of small and value companies that Mr. Fama and Mr. French developed. Then you’d put the other 68 percent of your money in one-year Treasury bills.
It’s been eight years since this article, so I decided to see how those who’d taken a chance on the Larry Portfolio had made out.
I built a Larry Portfolio, with a mix of 32% small value stocks, and 68% short term treasuries, then compared it to a 100% stock portfolio. For the small value stocks, I used DFSVX. For treasuries, I used the Vanguard Short Term Treasury fund, VFIRX. And for the stock market as a whole, I picked the Vanguard Total Stock market index fund, VTSAX, which closely follows the S&P 500 index mentioned in the article.
Here are the returns for the past eight years, and the final value of each:
A $1,000 investment in the Vanguard market fund, which just tracks the US market as a whole, would have gained $1,973 between Dec 31, 2011 and Dec 31 2019. That same investment in the Larry Portfolio would have increased in value by $427. Even a 100% investment in that supposedly high returning DFA small value fund would have gained only $1,286.
Looked at another way, if you’d taken a chance on the Larry Portfolio in 2011 with your $300k retirement nest egg, here’s how much money you’d have at the end of 2019:
So, what happened here? How did the Larry Portfolio go so horribly wrong?
One answer can be found by looking closely at the second quote above. When discussing the returns of the US market, the article uses the S&P 500 index as a proxy – an actual index with verifiable returns, involving many large, liquid stocks for which historical data is readily available.
But those incredible small value returns? They’re based on a dataset created by two academics, Eugene Fama and Ken French, both of whom have long been on the DFA payroll.
This data, sometimes compiled from old newspaper clippings, was often populated with a few tiny stocks too small and illiquid for mutual funds to hold. In other words, nobody ever got those incredible small value returns.
In the article, Lieber offers readers a prescient warning:
In fact, whenever something like the Larry Portfolio looks different from whatever the Dow or the Nasdaq are doing, there is sizable risk of regret.
I think it’s fair to say that in the case of the Larry Portfolio, like so many other free lunches promised by financial advisors, that regret risk was realized. There’s a lesson in there somewhere.
DFA vs Vanguard 
Where is the evidence that the data was populated with a few tiny stocks too small and illiquid for mutual funds to hold?
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I’d start by looking at the data on Ken French’s website. Even today, where transaction costs are far lower than in decades past, transaction costs eliminate much of these supposed “premiums”: https://rodneywhitecenter.wharton.upenn.edu/wp-content/uploads/2018/03/Weller-1.pdf
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It’s well known that the value premium has been negative, at least in the US market over the last decade. So you’d expect a small cap value fund to underperform the the broad market over this time period. And, of course, the value premium can be negative for longer periods than just 9 years, but over the long term value has outperformed. So you need to make these comparisons over longer periods of time to make these sort of claims. Larry Swedroe warns about this “tracking error disease”. If you don’t understand that value can have quite long periods of underperformance (if it didn’t, it wouldn’t have long term outperformance), you shouldn’t invest in these value strategies, and just stick with total market strategies, as there’s risk you’ll sell out at just the wrong time locking in loses.
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It’s true that value funds sometimes outperform and sometimes underperform, just like everything else. But there’s no evidence value funds outperform growth consistently- we’ve only had value and growth index funds for 20-25 years, and during that last 15, growth has outperformed. The idea that Wall Street has left you a trillion dollar free lunch in “value stocks” is fantasy.
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Data going back to 1926 shows value outperforms growth.
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Readers, can you spot the flaw/fraud in this particular argument? Many DFA victims can’t. The answer is that “value” had never outperformed “growth” in real world mutual funds, only in made up data sets (which trade frequently but exclude transaction costs) by folks paid by DFA. In those data sets, a few tiny, illiquid stocks from many decades ago, stocks your funds will never own, generated the vast majority of the outperformance.
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