Thu, 13 Oct 2011
Despite market fluctuations, patient investors could have realized over 6% compounded annual returns over the last decade with a disciplined buy-hold-rebalance strategy, says Portfolio Solutions' Rick Ferri.
Christine Benz: Hi, I am Christine Benz for Morningstar. I recently attended the annual Bogleheads Conference, and I had the opportunity to sit down with Rick Ferri. Rick is founder and CEO of Portfolio Solutions, and he is also author of several books about indexing, ETFs, and asset allocation.
So, Rick, thank you so much for being here.
Rick Ferri: Thank you. Appreciate it.
Benz: So, I would like to touch on this topic of tactical asset allocation. It's really been on many investors' minds recently. We all came through the trauma of the financial crisis, and investors say to me and say to each other, "buy-and-hold didn’t work for me. I can’t just sit there."
What do you say to those who might be inclined to be more tactical at this juncture?
Ferri: Well, I would say two things, Christine. One of them is that, buy-and-hold did work, but it wasn’t just buy-and-hold. Its buy, hold, and rebalance. Investors have a strategic asset allocation to equities, to fixed income, lets say a 50-50 mix, and if the market goes down, they do a rebalancing. So, it’s not just buy-and-hold and let it float. It’s a rebalancing.
And if investors did that over the last 10 years in a portfolio of U.S. equities, international equities, bonds, and some real estate, they would have actually produced over 6% compounded return over the last 10 years. And since 1999, the peak of the market, the return on that portfolio was over 5%, compounded. So buy, hold and rebalance works.
Now the idea that I hear a lot on television is that we are in a very volatile market now, and the only way that you can make money is if you are more active with your portfolio, and this idea of having a static asset allocation and rebalancing isn’t going to work in the future. I think that’s marketing hype, and it’s the money managers who are trying to promote some sort of a product, that are saying that.
I mean it does work; it has worked. If somebody is very uncomfortable about the market, and they are feeling inclined to start doing tactical asset allocation, the problem probably is that they have too much risk in their portfolio right now, and they probably always had too much risk in their portfolio. So they want to think about reducing the risk in their portfolio but reducing it permanently, but it's more of a long-term strategic decision than a tactical one.
Benz: Another thing that I have been hearing from investors is about fixed income; investors are quite worried. They are concerned about what interest rate hikes could mean to their bond portfolios, as well as if they get too junky with their fixed-income portfolios, what could happen if the economy weakens. And so there, again, I am hearing investors saying, "I need an active bond manager right now, because it's going to be a challenging fixed-income environment." I know that you are very much an indexing proponent, but what’s your take on that idea?
Ferri: I don’t think that the people who are doing bond index funds are saying now they need to switch to an active manager. Again, I think that the people who maybe weren’t doing indexing, maybe were doing something else, maybe there were trying to be tactical themselves, might be saying that, but the people who are doing a fixed allocation to different index products have done very well, and I don’t think there is any reason to change.
The portfolio that I run is a fairly simple portfolio. I have a 60% allocation to the Vanguard Aggregate Bond Market Index, which covers Treasury bonds, it covers investment grade corporate bonds, and it covers mortgages, all there 60%.
Benz: Quite heavy on the government, piece though, I think that’s what has had some investors worried.
Ferri: It has, but actually the fund has done well.
Benz: It has beaten most active funds for sure, recently.
Ferri: So you get everything there, but on the corporate side, what is not in the aggregate bond market, what is not on the Total Bond Market Index Fund is two areas: high-yield bonds and Treasury inflation-protected securities. Neither one of those are in the aggregate bond market index fund.
So, I have a position of a 20% in the Vanguard High-Yield Corporate Bond Fund, and I have a position of 20% in a TIPS index fund, or that you can use the Vanguard TIPS Fund. So 20-20-60, and then you do a rebalancing between those every year or so, and that has been a very consistent portfolio. It's worked very well. So you're getting a little bit more corporate exposure with the high-yield bonds.
Benz: Okay. But the high-yield and the TIPS funds are both active actually, right?
Ferri: With Vanguard they are, but there's only 29 TIPS out there. So, pretty much the Vanguard TIPS Fund owns almost all of the TIPS that are in a TIPS Index Fund, and if you look at the correlation between the returns of the Vanguard TIPS Fund and the Barclays TIPS Index, it's 99% correlated. That's very, very highly correlated. So it's almost an index fund, not quite, but it's very low cost, and that's what I like about it.
Benz: How about foreign bonds?
Ferri: I like the concept of foreign bonds, because it gives you exposure away from the U.S. dollar. I don't like hedged foreign bonds, where you are spending money to hedge back into U.S. dollars. The whole idea of doing foreign bonds is to hedge against the U.S. dollar. The problem with foreign bond funds is not the concept, it’s the cost.
Foreign bond funds are three to four times more expensive than U.S. bond funds that have the same asset classes in them. So if you are going to go with a foreign bond government, sovereign debt, in the U.S. you can get a Vanguard fund for maybe 0.1% or 0.15%. If you are going to go foreign, now you are paying 0.45%, 0.5%, 0.6%, 0.7%, and you've just destroyed the whole purpose for diversifying internationally. You’ve wilted away whatever excess return you are going to get from the currency diversification. So it's not the concept, it’s the cost I don't like.
Benz: Do you think those costs that are associated with foreign bond funds are real cost or are they just sort of convention, like, this is more exotic so it should cost more?
Ferri: The latter. It's more exotic, we can get more for it, so let's get more for it. That's what I truly believe, and I think a lot of funds are this way. Even small-cap funds, and why should it cost more to manage a ... U.S. small-cap fund than a U.S. large-cap fund? Same market. Why does it cost more? Well, because I think that people are used to paying more, so the people who are marketing these products can get more for it. So, yeah, it's a problem.