Richard [“Rick”] Ferri is the founder and CEO of Portfolio Solutions, LLC, a Michigan-based investment firm, and is an adjunct professor of finance at Walsh College. He has written five investment books. Ferri worked as a stockbroker with two major Wall Street firms for 10 years before starting his firm in 1999. Portfolio Solutions manages close to $700 million in separate accounts for high net worth individuals, families, nonprofit organizations and corporate pension plans.
Hard Assets Investor [HAI]: You advise your clients to
build portfolios comprised of diverse assets: large-cap stocks,
small-cap stocks, bonds and the like. Do you make room for ‘alternative
assets’ in these allocations?
Rick Ferri [Ferri]: We would make room for alternative investments if they made sense in the long term. An alternative investment would have to have an expected long-term real rate of return [a return in excess of the inflation rate], be available in a very low-cost index fund or exchange-traded fund, and have historic rolling correlations that showed positive diversification benefits during some periods.
Unfortunately, we have not found any alternative investments that fit all three criteria. Either the expected long-term real return is too low, or fees on the products are too high, or the potential diversification benefit is not worth the opportunity cost given up by substituting the alternative investment for equities.
If you are asking about commodities, it’s a returns issue. The long-term expected return of commodity investing is the inflation rate before fees. The only benefit may be lower portfolio volatility. But what is the point of lower volatility if that means giving up a 6 percent expected real return from stocks to invest in a zero percent real return commodity fund? You need to earn money if you are going to eat well in the future. You can’t eat lower volatility.
HAI: Let’s talk about diversification. First of all, what risk is being hedged by diversifying the assets in a portfolio? What metric do you use to measure diversification and its benefit?
Ferri: There are two major investing periods most people go through in life: the accumulation phase and the distribution phase. The accumulation phase begins when a person is out of school and starts a full-time job. The distribution phase begins when a person winds down their career and prepares for retirement.
During the accumulation phase, diversification hedges a behavioral risk, not a market risk. An investor’s biggest impediment is emotion. Diversification helps investors protect themselves from themselves.
Stocks have been the best-performing asset class during any 15-year period of time. So why not be 100 percent invested in stocks 100 percent of the time? It’s because most humans cannot handle the volatility. Investors love stocks when the market goes up and hate them when the market goes down. Over the last decade, investors clamored for technology stocks as they became incredibly expensive in the 1990s, only to dump them a few years later when some of the best names in the business were selling at historically low valuations. Diversification into fixed-income investments reduces the shock that investors see in their account values. That helps keep them in the stock market longer. The longer a person stays in the stock market, the better off they will be. As the old Wall Street adage goes, it’s not timing the market than counts, it’s time in the market.
The distribution phase brings a different, more ominous risk: the risk of running out of money. Diversification helps mitigate the risk of outliving your savings.
Most retirees take a fixed amount from their savings each year to live. As long as the annual rate of return on the money is positive by a few percentage points, that shouldn’t be any problem. However, it will not take long to run out of money if a prolonged bear market drives down the account value while money is distributed. Diversification into fixed-income investments is needed in retirement to reduce the risk of running out of money before a person runs out of life.
HAI: You’re fond of using exchange-traded funds in your portfolios. Why is that? What sort of advantages do ETFs enjoy over other investment vehicles? Any drawbacks?
Ferri: We’re actually indifferent to using ETFs or open-end mutual funds. We’re only interested in finding broadly diversified, low-cost, tax-sensitive, passively managed asset class investments. That’s led us to ETFs because they tend to be lower in cost and more tax-efficient than most open-end mutual funds.
The drawbacks of using ETFs are minor in my opinion. First, there are brokerage costs, which are less than $10 per transaction. Since we don’t trade a lot, commissions are minimal. Second, tracking error can develop between an ETF and its underlying net asset value. We control that by knowing where the underlying assets are priced before trading. We don’t trade at the opening and closing of market when spreads can be wide. A detailed explanation of ETF trading techniques are offered in my recently published work, The ETF Book: All You Need To Know About Exchange-Traded Funds (Wiley & Sons, 2008).
HAI: What about exchange-traded notes? If you had a choice between taking on exposure through an ETF or an ETN, which would you choose? Why?
Ferri: I like the concept of ETNs, but there are too
many uncertainties and the costs are too high. There are really three
issues that concern me. First, ETNs are not mutual funds. They’re debt
instruments subject to the risk of default by the issuer. Second, the
expense ratios of ETNs are generally higher than ETFs.
For example, the iPath MSCI India Index is priced at 0.89% per year while the comparable SPDR S&P China ETF is only 0.60%. Third, and perhaps most disconcerting, the tax treatment of ETNs is still up in the air. Providers claim that the structure provides complete tax control to the investors, but the IRS just negated that benefit for iPath Currency ETNs and now it’s looking at other ETN products.
HAI: There have been a lot of new indexes introduced recently that serve as tracking targets for ETFs and ETNs. Some of these have such complex index construction rules that they seem more like active, rather than passive, strategies. How does this benefit investors?
Ferri: There are two types of indexes tracked by ETFs and ETNs: market indexes and strategy indexes. These two index types have different purposes and the products that follow them have different fee structures.
Market indexes are measurement tools designed to reflect performance of financial markets and segments of those markets. Securities in a market index are passively selected and capitalization weighted. These indexes are used globally by economists, academics, central banks and the financial industry in general. They’re the basis for all asset allocation models. Products that follow market indexes are generally low cost and have low turnover.
Strategy indexes differ markedly from market indexes. Strategy indexes are designed to be investment products. They’re not market yardsticks nor are they used in academics or economics or in any asset allocation model. Strategy indexes are created using an alternative security selection method (rather than passive selection) or an alternative weighting method (versus market capitalization), or both. Unlike market indexes, strategy indexes have no raison d’être except to be licensed as commercial investment products or to promote other products.
Do funds based on strategy indexes benefit investors? Well, that’s the claim made by the fund companies who license those indexes and launch products based on them. But there is no conclusive evidence that there is a financial benefit. The hypothetical index return data highlighted in product marketing material is all backtested to perfection. Only time will tell if there are financial benefits in reality after fees and expenses.
And that brings us to this one certainty: Funds that follow strategy indexes have much higher expense ratios than funds that follow market indexes. I just finished writing a paper that compares strategy index ETF costs to market index ETF costs. The ABCs of ETFs: Alpha, Beta and Cost will be published in the May issue of the Journal of Indexes.
HAI: Thanks, Rick, for taking the time to speak with us.