So here's what I do. I rip blurays (main movie only) in either an .mkv, or I use DVDfab and have the normal bluray folder structure and the .m2ts file(s). For example, Avatar is nearly 38GB.

Win7 64bit
8GB, 2133Mhz ram
i5-2500k
Gigabit Z68X-UD3H-B3

With VLC transitions are smooth, but with XBMC, if there is a camera change - so going from one scene to the next or changing the angle at which we're viewing the main character, the screen usually turns a solid color and blocks of pixels materialize to show the current image playing. It's very bad at the beginning of the Lion King, happening every time they show a new group of animals, which is about every few seconds. It makes movies unwatchable.

Do I need a dedicated GPU just to use XBMC?

Ok, I found my answer already.

1. Since I use an Intel GPU (built into the chip), I needed to disable DXVA2.
2. It was already enabled, but make sure Vertical Blank Sync is enabled.