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ETFs: More Arrows in the Quiver for Your Portfolio

Scott Burns

Scott Burns: Tips for building your ETF portfolio. Hi there. I'm Scott Burns, director of ETF analysis. Today I am joined by Rick Ferri, the founder of Portfolio Solutions and the author of "The ETF Book." Rick thanks for joining me.

Rick Ferri: Thank you Scott.

Burns: I thought we would take some time today to talk about building portfolios. You know, you work for Portfolio Solutions. You manage around just under a billion dollars in assets. And I know you are a veteran of the conference circuit. People want to hear what you say.

Let's talk a little bit about just the basics of portfolio construction. Where should somebody begin?

Ferri: Well, at the very beginning of portfolio construction is investment policy. Forget about how the asset allocation is and what funds you should buy.

Before you even get to that point, the beginning, right at the beginning, is going to be, "What is the money for? What is the duration of the money? When are you going to need it? Are you putting money in? Are you taking money out?"

And so, investment policy is right at the beginning before you even get into portfolio construction.

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Burns: Right. I think that is a step a lot of people just miss. They find a fund and go looking for an idea or find a strategy and go looking for an idea instead of having the idea, the need, first and then finding the appropriate solutions.

So let's assume we have our policy determined. Now we start thinking about the portfolio construction and where we go next steps, and how we look at the funds and the asset allocation. Where do you go next with that?

Ferri: Sure, and we can break it down, because you really just described three new different steps there. The next step after investment policy is to look at asset allocation. How much risk should you be taking? How much income do you need in order to match your liabilities in your investment policy?

So you have to set your asset allocation between stocks and bonds, risky assets and safe assets, to the level that is appropriate for your investment policy.

Once you have the stock and bond mix, now you can break it down into sub-categories. How much do you want to put in U.S. stocks versus international stocks, small cap versus large cap? How much do you want to put in investment-grade bonds, Treasury bonds, Treasury Inflation Protected Securities? So you are going to break it down into sub-asset classes.

Not actually as important as the actual asset allocation between stocks and bonds, but does add flavor to the icing on the cake, so to speak. Then, the next thing is a security selection.

Burns: So in security selection, generally, you use a mix of ETFs and mutual funds, right? And where do you prefer ETFs versus mutual funds? I know you get asked this question a lot.

Ferri: Well, to me it is a more arrows in the quiver. You have got ETFs that have come into the marketplace in a big way over the last 20 or so years. And you had mutual funds, index funds, and so it is just more product to look at, which, of course, means more books to write.

Burns: [laughs] Good for you!

Ferri: [laughs] You just have to look at the way in which these underlying indexes are constructed. If you like the way the underlying index is constructed that you are going to use for a particular sub-asset class, then you go out and you see if there are index funds available or ETFs available.

And you make your selection based on fees, diversification, liquidity, and a whole lot goes into actually selecting the fund that is appropriate for that specific asset class and sub-asset class.

Burns: Gotcha. So you really do have to do a lot of your homework. Now one thing. When you talked about your asset allocation, I noticed you kept it very simple, and that is always something I've liked about you. You keep it very simple. But we talk stocks, bonds. What are you thinking on commodities, on alternative asset classes? You know, risk neutral strategies, those kinds of things. Do those make it into your portfolios?

Ferri: Well, not to my portfolios. No. [laughs] Should people use commodities or zero beta asset classes? Sure. I think that is fine for everybody to have a little bit of money in a bingo account. And if they want to try these things, that is fine.

You don't need them in the long run to meet your financial objective. You have an investment policy, your liabilities. You have your asset allocation. You use stocks and bonds to meet your asset allocation investment policy.

All this other stuff is, again, it is the flavor of the icing on the cake. It is not even the icing on the cake. I mean if you want to do that, you should do that in an account that isn't going to break you if it doesn't work out the way you want.

You are going to have to trade commodities, because commodities are a zero returning asset class. They are a price-driven asset class. They don't pay dividends or interest.

So if you are not in it at the right time and out of it at the right time, or you are not in the right fund at the right time, whether long or short, you are not going to make any money. I wouldn't rely on that to meet your investment objectives.

Burns: OK. Well I think that everything is great advice there, I do think when we look at it, we want to start from that policy first and move forward.

Do you have anything else? Do you see any other just common mistakes that people make when they look at things, or comments that you hear, either through the book or through your column on Forbes?

Ferri: Well, I think the common mistake that I hear a lot is what you alluded to, people who are right to the fund selection. You know, which funds should I buy for this environment? It is really putting the cart before the horse.

The question should be: What is the right policy for what you are trying to do, and then work that way, rather than going to the funds that... What is the flavor of the month? What is the hot fund to buy today? Is palladium outperforming gold? I mean, those are really irrelevant...

Burns: Which it is, at this time.

Ferri: Yeah, today it is. I don't know about tomorrow. And OK, it is OK for your fun money. But your really serious money, you have got to do it from top down.

Burns: Right. OK. Well thanks for joining me, Rick. I am Scott Burns, Director of ETF Research for Morningstar. For this and other ETF commentary, please check out the ETF center on Morningstar.com and Morningstar's ETF investor newsletter.