Ferri: No Reason for Alternatives

Christine Benz: There has been a lot of interest in alternatives as well, with retail investors embracing various flavors of alternatives, managed futures and whatever else you want to throw under that alternatives' umbrella.

I'm wondering your take on what role, if any, such investments should play in investors' portfolios?

Rick Ferri: Well, I would use the word should. Should play, zero.

Benz: Why?

Ferri: They have no reason for being in a portfolio. The only reason you might put one of these in a portfolio is because you're curious, and you might see how it works, but there's no reason to have it.

What I like to believe in is things that pay cash flow. Stocks pay cash flow in the form of dividends. Bonds pay cash flow in the form of interest. If you have real estate, it pays cash flow in the form of rents. Things that pay cash flow, that's what I like in a portfolio, because in the long run they generate value.

Things that don't pay cash flow, like commodities. All you're betting on is that, the greater fool is going to come along and buy it at a higher price later on. And I'm just smart enough to know when these markets are going to go up, and when these markets are going to go down. So, I don't play the commodities game or the alternatives game. Now, some people say, well if you put those in your portfolio, it lowers the volatility of the portfolio. My answer to that is, it doesn't increase return, even though it lowers volatility, it also lowers the return over time.

If you look at the return of commodities, over the very long-term, not over the past four or five years with the price of gold, I'm talking about over your lifetime, if you own commodities in a portfolio, own alternatives' in a portfolio, it actually decreases the return of the portfolio. Yes, it might decrease the risk also, but you can't eat lower risk. You can only eat higher return. So, I am a cash flow person, I like cash flow from stocks, bonds, real estate, and those are the only three asset classes I put in a portfolio.

Benz: So, some people, though, have looked to commodities as an inflation hedge or a way to mitigate the effects of higher prices on their portfolios. Would TIPS be the key way that you would urge clients to obtain that inflation protection?

Ferri: There are two types of inflation. There is anticipated inflation, which is what we all believe is going to happen, and that's already embedded in stock yields, stock prices. It's embedded in bond prices. It's embedded in TIPS prices. It's already embedded in all of your assets--this 2%, 2.5% expected return. Now, you can sort of discount Treasuries right now, because the Fed is manipulating Treasury yields at this point. But all other asset classes--stocks, corporate bonds--they have embedded inflation already in it.

What you're talking about with TIPS is unanticipated inflation. So, if inflation is higher than what people thought, it was 4%, 5%, 6%, that's where having TIPS in the portfolio gives you the unanticipated inflation hedge.

Since TIPS came out, I believe that's the way to do it. It's low-cost. You still get some yield from it, not much, but some. I think that's the way to play the unanticipated inflation hedge in your portfolio.