Ferri: Confessions Of An Index Investor

Ferri: Confessions Of An Index Investor

Leading index investing expert admits he doesn’t invest in all index funds.

Reviewed by: Richard Ferri
Edited by: Richard Ferri

Leading index investing expert admits he doesn’t invest in all index funds.

I’m a diehard index fund fan. I’ve written books on index funds, lectured on index funds, co-authored an award-winning paper on portfolios of index funds, and Forbes even named me “The Indexer” when I began writing for them several years ago.

The problem with being “The Indexer” is that I don’t invest in all index funds. Truth be told, my portfolio is a combination of funds that follow indexes; quantitative funds that don’t follow indexes; and actively managed funds. I don’t even consider following an index as being paramount in portfolio management as long as you’re capturing the risk premiums you’re seeking in a low-cost and efficient manner.

I point out in All About Asset Allocation that the investments you select for your portfolio should have a unique risk. This unique risk should be investable at a low cost and expected to generate a positive risk premium over the long term.

How to determine if unique risk exists in an investment is where fundamental analysis comes in. You’ll have to dissect what makes the investment tick. This can take a lot of time and effort. If you’re not inclined to crunch numbers until your eyes turn red, I suggest Anitti Ilmanen’s excellent 570-page reference guide on the subject, titled Expected Returns: An Investor’s Guide to Harvesting Market Rewards” (Wiley, 2011). You can download a free abridged edition of this book from the CFA Institute.

There are unique risks captured by broad asset classes and unique risks captured by strategy. My goal is to capture the diversified risks I choose to invest in using the most efficient manner. Sometimes that is best accomplished with an index fund and sometimes it is best accomplished with something else.

Buying a total market index fund captures the “beta” of an asset class at a low cost. Beta can be thought of as the overall risk and return of an entire market. It’s a risk that cannot be diversified away. The best example of using an index fund to capture beta is the Vanguard Total Stock Market ETF (VTI | A-100). This portfolio tracks the CRSP Total Stock Market Index, which had 3,699 constituents as of June 30, 2014, representing nearly 100 percent of the U.S. investable equity market.


Capturing beta is best accomplished with an actively managed fund in some asset classes. This is because the market indexes tracked by index funds don’t capture as much of the market as an actively managed fund, and the index fund can be more expensive than the active fund. Municipal bonds are a good example.

The largest municipal bond index fund is the iShares National AMT-Free Muni Bond ETF (MUB | B-75). This ETF has an expense ratio of 0.25 percent and holds 2,185 securities as of July 24, 2014.

In contrast, the actively managed Vanguard Intermediate-Term Tax-Exempt Fund Admiral Shares (ticker: VWIUX) has half the expense ratio at 0.12 percent and holds almost double the number of bonds at 4,121 as of June 30, 2014. The duration of MUB is longer term than VWIUX, meaning there is more risk, while the SEC yield of the two funds is nearly identical.

Overall, I consider the actively managed VWIUX to be a better representation of the intermediate-term municipal bond market than MUB, even though the iShares ETF is tracking an index. That’s why I prefer to use VWIUX in portfolios rather than MUB.

Investing in factors creates more complexity than capturing market beta. A factor is a noncap-weighted risk premium that has occurred between pairs of stocks such as growth versus value and small-cap versus large-cap.

Beta is still the most important risk factor in the Fama-French three-factor model because it still accounts for 70 percent of the typical diversified portfolio return. However, two other factors—size of the stocks in a portfolio; and the price-to-book value of the stocks—can make a significant difference in portfolio returns. Capturing value and size premiums does not require an index fund.

I use nonindex tracking funds from Dimensional Fund Advisors (DFA) to capture size and value premiums in my portfolio. That’s because these funds provide concentrated risk factors, and this gives me the most exposure per dollar of fee paid.

There are low-cost alternatives to DFA that I also recommend. See my previous blog, To Tilt or Not to Tilt?, to learn more about using other factor funds to capture risk premiums.

I’m an index fund investor, but I’m not a purist. My goal is to capture the risks I’m seeking at the lowest cost feasible. Often, the best way to invest in a risk is with an index fund, but sometimes it’s best to use an active fund and/or a quant fund. The trick is to know the risks you’re seeking and know how much it costs to gain access to those risks using different methods.



Rick Ferri, CFA, founded Portfolio Solutions and is a leading expert on low-cost index fund investing. He has also author six investment books.


Richard Ferri, CFA, is founder and managing partner of Portfolio Solutions. He directs the firm's research and education, and is head of the Investment Committee. Ferri writes regularly for the Wall Street Journal, Forbes, the Journal of Financial Planning and his own blog at www.RickFerri.com.