Sun, 16 Nov 2014
Investors need to be aware that a strategic-beta approach could take years, if not decades, to produce a premium, says author Rick Ferri.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Bogleheads Conference. I'm joined today by investment expert Rick Ferri. Rick, thank you so much for being here.
Rick Ferri: Thank you, Christine. Thank you for having me.
Benz: Rick, we've been hearing so much about strategic beta or smart beta. I'm wondering if you think that there's just a lot of hype behind this idea or do you think it's a legitimate investment concept.
Ferri: Well, let me address the term smart beta first, and then I'll discuss what's really going on. Smart beta is a smart marketing term, which is being misused, in my opinion, to try to get people to invest in strategies that they might not fully understand. The risk of investing in these strategies, if you're doing it because you're attracted to the term smart beta, is that an investor or even an advisor may not fully understand the riskiness behind it and, therefore, may put their clients into something that they're expecting an excess return from. And then they don't get it, or they don't get it for a long period of time, because these strategies, as we'll discuss in a few minutes, sometimes take many, many years, if not decades, to actually get a premium from. If you are just buying this because it's smart, chances are you're not buying it for the right reasons. So, I am not against the strategies. I think that when used correctly, they can help your portfolio. I'm against the way they are being marketed because I think it's shortsighted.
Benz: Let's talk about the part of the strategy that you think is legitimate and that you, in fact, incorporate into your client portfolios.
Ferri: So, the strategy of using strategic beta, or what I call additional beta, is to realize that there are other risk factors in the markets besides just the market itself. And if I decide to take those risks that are persistent in the market, then I should get an excess return over the market. So, the use of these strategies, strategic beta, additional beta, is to determine what the risks are, which ones are legitimate and which ones are just anomalies, and then, if I decide to [go this route], allocate some of my portfolio to those risks above and beyond just a beta portfolio. And that's how you implement this.
Benz: Let's talk about some of the tilts that one might reasonably incorporate into a portfolio. What are you looking for when you're thinking about tilting a portfolio in one direction or another?
Ferri: I think that you have to try to differentiate anomalies in the market from true additional risks. The way you do that is you look at whether these additional risks or these betas occur in all markets--not just the U.S. market but internationally--and if they occur over independent periods of time, so you can isolate out whether this is actually an additional risk that you're getting paid for because it's universal or if this is just an anomaly that could go away. I think that if you look at value investing, in general, and you look at it across the entire globe and look at it in all markets, literally in all markets, value investing has outperformed. And so you ask, "Well, why has value investing outperformed?"
The reason is because when you're investing in value stocks, you are investing in lower-quality companies that have less growth, may have more debt on the balance sheet, or lower return on equity, more mature industries. And therefore, people perceive that as being more risky than investing in growth stocks that are in new technologies and new industries.
So, you're going to get paid a premium for taking risk in the older industries that are less attractive than you would in growth industries. So, if you are going to take that extra risk, then you should get an extra return over investing in, say, growth industries. So, the whole concept of additional betas or additional risks is isolating out those that are truly universal and that have an economic reason for giving you a higher return, and then making a decision in your portfolio regarding how much of these additional risks you're going to have in addition to market risk.
Benz: How about tilting a portfolio toward small caps? There is certainly a lot of data to support that small caps have outperformed over time.
Ferri: It's interesting that you bring up small cap, because through the early 1980s when the first research was done on this--back during the 1970s, I should say--it was found that small-cap stocks, especially micro-cap stocks, gave you an excess return above and beyond market risk that couldn't be explained. Well, it could be explained through liquidity. Micro-cap stocks, small-cap stocks had far less liquidity.
The companies themselves tend to be geographical or to just be involved in one industry, one product line. So, there was more riskiness in small-cap companies than large-cap companies. Therefore, they should give you a higher return. And because of the illiquidity of some of these companies, there was an illiquidity risk. So, you could justify economically why small-cap stocks should give you an additional return or additional risk premium over large-cap stocks.
What has occurred, though, since all of that research has been done is that the ability to invest in small-cap and micro-cap stocks has become commodified. You can buy them through mutual funds. You can buy them through ETFs. So, getting access to those small markets now is no longer as difficult as it used to be.
There is a reasonable argument that can be made that there shouldn't be, going forward, a risk premium paid for those illiquid securities because they are not illiquid anymore, and you can buy and sell them very quickly with an ETF. So, the one risk factor that may have been diminished--or may have been arbitrated away, if you will--through the new products that have come along is actually the small-cap premium.
So, if I were going to be a buyer of risk premiums, I would say that the small-cap risk premium is probably not one of the ones that I would concentrate on. Although if I included that in a package of risk premiums that has small-cap value, with momentum, high yield, low-beta-type package, that would make sense. But to do it just small cap, I'm not sure if that's legitimate anymore.
Benz: How about emerging markets? Is that a tilt that one might reasonably incorporate into a portfolio?
Ferri: The question of emerging markets is whether or not it's a risk premium for taking risk other than the illiquidity or the political risk that you find in emerging markets, and the answer is no. If you want to take extra risk by going more in emerging markets because there's added political risk or economic risk of those markets or liquidity risk of not being able to trade some of those stocks, then you should get paid a higher return for that.
As more and more emerging markets come online and as more emerging-markets stocks start trading in the U.S. as opposed to trading overseas, that might diminish somewhat, but there is a certain risk premium that you should expect to get from emerging markets for the political factors and the illiquidity factors and currency factors--that should persist. But, again, it's more risk that you are taking, and you have to decide how to allocate your risks in a portfolio.
Benz: Within fixed income, one might reasonably tilt toward corporate bonds; there has historically been a better return to be had by emphasizing corporates at the expense of government bonds. Is that a legitimate tilt in your view?
Ferri: I would expect the corporate bonds to outperform Treasuries because there is more risk there. Treasuries are guaranteed by the federal government. It's the power to tax. So, the Treasuries are going to be repaid, whereas with corporate bonds, there is a question of bankruptcy. And not just bankruptcy--that would be high-yield corporate bonds--but downgrades. Investment-grade corporate bonds could get downgraded to non-investment-grade, and that's really the risk of investment-grade.
So, these extra risks are there and, therefore, you should get paid a higher return. It gets back to what I talked about earlier: You have to justify these things economically, and you have to be able to look across the whole world and say, "Are corporate bonds yielding higher in other countries versus Treasuries or governments in other countries?" And the answer is yes. So, it's universal, and it happens in almost every independent period of time. And you can justify it economically by just sitting back and looking at it and saying, "Yes, there is more risk there because these companies are more highly likely not to repay their debt than the federal government is." So, therefore, you should get paid a risk premium for that. And then, it becomes a question of how much of that risk you want to have in your portfolio.
Benz: When you think about incorporating these tilts into your client portfolios, how do you go about doing that? Which of them do you actually use?
Ferri: Well, it is an evolving industry, if you will, around these additional betas or strategic betas and how to incorporate them. I have been incorporating them in my portfolio strategically, which basically means I've been taking a fixed allocation to index funds and mutual funds that concentrate on small-cap value stocks for the last 15 years. It's only been 25% of my equity portfolio, and I do it both in the U.S. and I do it internationally. Twenty-five percent of my U.S.-equity portfolio is in these additional-beta-type concentrations, and 25% of my international-equity portfolio is in these additional-beta concentrations--and have been for a long time. But the other 75% is strictly beta. It's just the market.
So, I'm taking a small tilt to try to capture some of that excess return for taking these risks, but I'm doing it very judiciously because they don't always work. And when they don't work, I don't want to have a large tracking error relative to the market, because even though I understand that these things eventually come back, clients may not understand it. And if they underperform for too long, they might abandon the strategy, which is the real risk. So, I think that the judicious thing to do is to do it in moderation.
Benz: Earlier you seemed somewhat dismissive about emphasizing small caps. So, why small caps and value?
Ferri: There is an argument that can be made that the value premium is higher in small-cap stocks than large-cap stocks. So, you could buy small-cap value stocks, as opposed to large-cap value stocks, and maybe get more bang for your buck, because what you are trying to do with these premiums is you're trying to get the highest concentration of the risk factor in your portfolio that you can for the price that you're paying.
So, if you wanted to have the highest concentration of value in your portfolio, the highest concentration of momentum, the highest concentration of small cap--whatever it is you are seeking--first of all, I think that you should try to bundle these things together. So, you should buy a fund that bundles these risk factors together, so your 25% alternative portfolio is a concentration of everything that's not beta, if you will, not market beta. You are trying to do that. And then, you are trying to pay the lowest price for that basket, because the price of doing that basket, or the price of doing these additional betas, is always higher than just doing beta.
Ferri: So, first, you have this hurdle rate that you have to get over, and then you have to get a premium from it. So, you want to bundle them together, find high concentrations. And that's how you want to do it. But I've had a 25% allocation to these for years. It's worked out. I don't know if it's going to work out in the future, because a lot of people are doing it now and that sort of dilutes the excess return going forward, but it has worked out.
Benz: Within fixed income, what tilts might one reasonably think about incorporating? And do you do that in your client portfolios?
Ferri: In fixed income, the tilts that you would have are simply to yield curve or to extending your maturities, if you wanted. As you go further out on the yield curve, you get higher yield. So, you have to determine how far out you're going to go on the yield curve, and we go to intermediate-term. I don't do short-term bonds. The only time I use short-term bonds is when a client needs the money within the next couple of years. If they don't need it within the next couple years, it's an intermediate-term bonds. Most people who are retired are not going to be taking all their money out of the portfolio. So, whatever emergency fund they might have, it might be in short-term bonds, but it's really a separate amount. The rest of it is in intermediate-term, so I'm going out on the yield curve to pick up that extra 1.5% yield.
The second part of fixed income is credit risk, which is simply the excess return--as we were talking about--that you get paid from buying corporates, or asset-backed securities, [as opposed to] buying Treasuries or government-backed securities. And so, you determine how much of that you are going to have. You can do this through investment-grade corporates or you can add a little bit of high yield. I actually use a little bit of the Vanguard High-Yield Corporate Bond Fund (VWEHX) for that exposure.
Benz: Rick, thank you so much for being here.
Ferri: Thank you.