Ferri: 3-Fund Portfolio the Simplest Way to Best Return

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I recently attended the annual Bogleheads Conference, where I sat down with investment advisor and author, Rick Ferri. We discussed how investors can assemble truly streamlined portfolios.

Rick, thank you so much for being here.

Rick Ferri: Thanks for having me, again. I appreciate it.

Benz: We’re here at the Bogleheads event. A lot of the investors here are big believers in minimalist portfolios, and in fact, they like this idea of a three-fund portfolio, where you just got a total U.S.-stock, total international-stock and total bond market index. Let’s talk about what is the advantage of having such a skinnied-down portfolio versus one that is including more moving parts?

Ferri: More complex.

Benz: Yes.

Ferri: Simplicity is always a good thing. I guess the older I get and the longer I'm in the business--I’ve been in the business now for 25 years--that the simplicity of a three-fund portfolio just makes more and more sense and becomes more obvious. And I’m not really convinced that having anything more than that is going to do anything more for you, except maybe make your life more complex.

The three-fund portfolio is composed on the stock side of a total stock market index fund, a total international-stock index fund, and then a total bond index fund, which in a taxable account could be a municipal-bond fund. So, it's an intermediate-term bond fund instead of a total bond market fund, but its three funds total.

[The portfolio] might be, in fact, the simplest and may actually offer--net of cost, net of back taxes, and everything else--the best return to the largest majority of people out there.

Benz: The obvious question is how does one apportion assets across these three funds if its someone who does believe in the idea of keeping it really simple? How do you decide how much to have in each of the three parts?

Ferri: The asset allocation within the three funds is personal. The philosophy of having index funds--because we believe that in the long-term index funds are going to outperform--it is the superior strategy. It is going to outperform most investors. It is not going to outperform the markets. But superior investing doesn’t mean outperforming the markets, it means outperforming your neighbors. So, indexing does that.

Then the question is the strategy. How are you going to develop your portfolio? How much are you going to have in equity? How much are you going to have in fixed income? On the equity side, how much in international and how much in U.S.? That is all based on your personal circumstances, and there’s no great rule of thumb I’ve ever seen that can say this is the way it should be. You can make a case either way for having more equity or less equity with people who have a lot of money or people who have a little bit of money. But on the international/U.S. side, I think, for me personally, I like to go with about one third international [exposure] and then two thirds U.S. [exposure].

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Benz: And how do you arrive at that because the U.S. is actually smaller than foreign stocks as a percentage of the world market cap?

Ferri: From a global cap-weighted method, yes, U.S. stocks are maybe 40%, but you can make the case that a U.S. investor has to pay all their bills in U.S. dollars. So you can make the case of having more a home bias, if you will, to the U.S. But even within U.S. equities, you're also getting a lot of international exposure, because 40% of the profits that we accrue to companies in the stock market come from overseas revenue. You’re getting international exposure that way. And if you look at the international portion of it, probably 40% of those earnings come from the U.S. So there’s a lot of correlation in equities between foreign and U.S., and you could make the case you really don’t even need foreign stocks to get more diversification.

The only reason you're doing foreign stocks is to get a currency hedge. When you're looking at it from that perspective, then one third of your equity portfolio is in foreign currencies to give you a hedge against the U.S. dollar and then rebalanced occasionally--so when the dollar goes down, you're buying dollars, and then the dollar goes up, you're selling dollars and buying foreign currencies. That is a good portfolio strategy.

One third, two thirds, when you look at all the data, is a good middle-of-the-road number. Maybe the right number is going to be 100% foreign over the next 10 years or no foreign. I mean, we really don’t know. But I’m not making a tactical asset-allocation play here. It’s just a long-term strategic allocation.

Benz: And that weighting in bonds versus equities is the one that you say is a very personalized one that depends on a lot of factors, including your age, level of wealth, and so forth.

You've said that this three-fund portfolio could be sort of the beginning and end of an investor's portfolio, or people could use it as the core and then maybe layer on additional asset classes. When you think about that the latter group, people who maybe are using this as a core but thinking about additional asset classes, what asset classes do you think could be reasonably added to this portfolio, perhaps as smaller components over time?

Ferri: That’s a great question. So you got the equity side and you got the total bond market over here. The first asset class I'd probably add is Treasury Inflation-Protected Securities.

Benz: Because they're not in that big index fund.

Ferri: That's correct. First of all, they're not in the index fund. They're not in the total bond market, surprisingly, but that’s just the way the index is constructed. And the second thing is it gives you a hedge in the portfolio that’s not in the portfolio which is a hedge against an unanticipated jump in the rate of inflation. So having TIPS as an allocation on the bond side is a good start.

Benz: Do you like the new short-term TIPS product? Vanguard has one with the idea being that you're are sort of getting the interest-rate noise out of the equation and more or less getting that pure inflation protection piece.

Ferri: I like it for people who have short-term liabilities, meaning they're going to need this money in the next a year or two or three. The short-term TIPS fund is ideal for that because it takes away the risk of a jump in inflation without having term risk, which is the up-and-down movement of the fund itself. So it makes sense for that.

For people saving for retirement who are not going to be using the money for several years, or the withdrawals are going to be over long-term period of time, I would rather just use a regular TIPS fund. The regular TIPS fund covers short-term TIPS, as well, but also has long-term TIPS. But the duration [a measure of interest-rate sensitivity] of the bonds in the traditional TIPS fund more closely matches the duration of the liabilities, meaning they're way out there.

It depends on the circumstances for the individual.

Benz: TIPS would maybe be the fourth holding if someone wanted to add something additional to this portfolio. What other asset classes would come to mind as perhaps complementary with that three-fund portfolio?

Ferri: So we’ve added a bond fund on the bond side. Let's go to the stock side, and let's add a real estate investment trust, REITs. Real estate is a huge component of the U.S. economy. Commercial real estate is something like 13% of 14% of gross domestic product. It's huge, but very small amounts of real estate are actually capitalized in equity. So, you're not getting a full exposure to real estate if you just buy the total market index fund.

Benz: You get some, though, right?

Ferri: You get some, about 3%. But you could add an element of real estate to your equity portfolio, and that would get your portfolio closer to what the actual economy is, which actually gives you in the long term a smoother ride, if you're looking at earnings and cash flows and such. And it lowers the overall volatility in the long term of the portfolio.

So the first one on the equity side that I would add would be REITs in a REIT index fund.

Benz: One other category that investors sometimes add because it doesn't occur in any of the major index products is some sort of hard-asset product, whether it be gold or a commodities tracker something like that. What’s your take on the addition of such a product to a three-, four-, or five-fund portfolio?

Ferri: There are people in this particular argument whether you should have hard assets or not have hard assets. There seems to be a lot of controversy on both sides. I prefer not to have hard assets because if you take gold, it pays no dividends, it pays no interest, and has no growth real growth potential. The price of gold goes back 3,000 years. We can look at it. There have been spikes up; there has been regression in that. It is the most regressing asset that we have seen. The regression to the mean, which is the inflation rate, is what gold does over the very long term.

Now to invest in gold, of course, costs money. To invest in commodities costs money. Yet there is no prospect for a real return from these asset classes. So, you're not going to beat inflation even over the long term. You're not going to get any interest, you're not going to get any dividends, and you're not going to get any growth about the inflation rate. Plus it is going to cost you money to be in these products. And whatever you put in there comes out of the stock and bond portfolio, which is producing income. On the stock side, it is producing growth. So, you're going to have a lower return by having this in your portfolio

What you may gain is a lower overall volatility of the portfolio. Some people will argue that because at times these alternative asset classes are not correlated with equities, though it varies all the time, sometimes the stock market goes down and commodities go down.

Benz: 2008 was a great example of that.

Ferri: 2008 was a perfect example--everybody was piling into these things in '07 because [hard assets were] supposed to be negatively correlated. But correlations shift, and then commodities went down more than stocks, so it didn’t work.

But there are times when commodities and gold are negatively correlated with stocks, and when the stocks go down, these things go up. So you make the case that if you have commodities in your portfolio and gold in your portfolio, you could actually take a greater allocation to equity because the volatility of the portfolio is now lower. You could make that up with greater equity.

It gets to be very complicated. And then you start looking at the cost of investing in commodities and investing in gold. And I look at it all, I've been looking at it for 25 years, and to me it just doesn’t make sense. If my goal is to invest, I want to invest in things that have cash flow. I want bonds; I want stocks. I look at the commodities and look at the gold as price speculation. If you guess right, you're going to do well; if you guess wrong, you really hurt yourself. So that’s where I fall.

Benz: One other asset class that I wanted to touch on does not occur in the total bond market index fund, and that's bank loans. We’ve seen so much investor enthusiasm for the asset class. I think they're viewed as a way to escape what could happen to bonds in a rising-rate environment. What’s your take on whether investors should go out and look at some sort of dedicated bank-loan investment?

Ferri: When you're talking about bank loans, you're talking about junk bonds. It's just a different type of junk bond, which may have people say that there weren’t as many defaults. There wasn't much downturn in the bank-loan area back in 2008-09, okay. That may have happened then; we don't know what's going to happen in the next market crash.

Benz: So, you're getting a very credit-sensitive security.

Ferri: Absolutely. It's 100% credit-sensitive, and we're talking about junk. I want to call it high-yield. These are high-yield investments, and by putting the word "bank" in front of it, I think that there might be this misnomer out there that maybe they're more safe than they actually are. But they're in fact junk bonds. [The funds are] made up all of junk bonds.

Now, do I believe that you should have a section of your bond portfolio in high yield? Yes. I think that a small section, because it’s not in the bond index fund, it's not in the total bond index funds.

Benz: Junk bonds aren't either.

Ferri: They're not. That's right. So, the TIPS and junk bonds are not in there. So, my allocation on the fixed-income side is 60% total bond market, 20% in TIPS and 20% in high-yield, and I was using the Vanguard High-Yield Bond fund.

Benz: Which is higher-quality.

Ferri: Higher-quality, but ironically there are some at times negative correlation between TIPS and high yield on this side. So, sometimes when TIPS go up, high yield goes down; but vice versa when TIPS go down, high yield goes up. So, you're doing a rebalancing every year with this 20/20/60 portfolio. It seems to work well. It has worked well for me, and my clients over the years. And again, it's not included already in the total bond. There is no such thing as a total, total bond market index fund.

Benz: They're missing pieces that you may or may not want to complement.

Ferri: Maybe we will see within a few years, but there isn't one now. So until they have one, you sort of have to piece this thing together. So these are the other pieces that you can add to the core three-fund portfolio