Ferri: ETFs Just One Of Many Tools For Investors

Shoebox design has not changed much in 50 years. Shoeboxes are still the same shape, made of the same flimsy cardboard and hold one pair of shoes. The color and lid design do vary among companies, but it’s not a big deal for shoe buyers. We’re only interested in what’s inside the box.

The expansion of exchange-traded products (ETPs), which include exchange-traded funds (ETFs), has provided investors and advisers with more choices over the years. As of March 31, 2015, “The global ETF/ETP industry had 5,669 ETFs/ETPs, with 10,961 listings, from 247 providers listed on 63 exchanges in 51 countries,” according to data compiled by ETFGI.com.

This diverse product mix has helped push down costs across the fund industry and provided better access to previously clumsy asset classes such as commodities. This is a good attribute.

As the ETP market expanded, some companies began promoting the idea that an all-ETP portfolio was a better approach to investing than all mutual funds or a combination of both. This message even spawned an entire industry devoted to the all-ETP portfolio.

The rise of Internet-based “robo advisors” such as Wealthfront and Betterment are gaining momentum and assets by promoting model portfolios using only ETPs. In addition, nearly every wire house brokerage firm now has its own model ETP portfolio program.

Open The Box

I see the all-ETP portfolio as the wrong approach to investing.

It’s like buying shoes based on how the shoebox is constructed rather than the quality of what’s inside. We should give more thought to the risk exposures we’re seeking to put in a portfolio and the different ways of accessing those exposures than deciding to go with all-ETPs first and limiting ourselves to only those products.

Find The Right Fit

My portfolio-construction strategy starts from a macro view.

After determining the overall risk level using a broad asset allocation approach, I seek the unique risk within each asset class to provide an expected future risk premium and to potentially offset other risks in a diversified portfolio. An analysis of the fundamental differences within asset classes is at the essence of this work. Correlation analysis helps make this determination. My book, “All About Asset Allocation,” outlines this approach.

The next step is to analyze the indexes that track each asset class that I’m seeking. Many different types of indexes have been introduced in recent years and that has made this analysis more complex. It’s best to have a simple model to work from. My analysis starts with the broadest capitalization-weighted index I can find. This provides the purest form of market risk, or beta.

Focus On The Features

After selecting an index, I research the products that track it.

Sometimes these products exist and sometimes they don’t. When one exists, it might be an ETP or a traditional mutual fund, or there may be more than one product available and more than one structure. I’m not concerned if the product I select is a traditional mutual fund, an ETF or some other ETP structure. What matters are its meaningful features, like the diversification, risk exposures, cost per unit of risk, liquidity and tax efficiency.

Think Outside The Box

My search doesn’t stop with index products.

There are a few actively managed mutual funds that represent certain asset classes and risk factors better than their index product counterparts. Municipal bonds are a good example.

Vanguard has actively managed municipal bond mutual funds that are more diversified and lower cost than equivalent municipal bond index funds or ETFs I’ve seen. 

Dimensional Fund Advisers offers quantitatively managed factor-based mutual funds through authorized advisers; these funds often capture unique risk factors in the markets better than a comparable index fund can. A myopic commitment to index funds or ETFs alone would miss these opportunities.

When The ETF ‘Shoe’ Fits …

After all the work is done, I believe investors are best served by an eclectic group of ETFs, open-end index funds and some actively managed open-end funds. These products should be selected for the risks they capture (and the commensurate expected returns), and for their ability to manage the costs involved in tracking those risks.

I’ve been using equity ETFs when warranted since the mid-1990s and have found them a useful resource under the right circumstances. However, my decision to invest in ETFs or any ETP has never been about the box it comes in. It’s about what’s inside. The growth in the ETP industry gives us more choices, and that’s a good thing.

For a full list of relevant disclosures, click here. Rick Ferri, founder of Michigan-based Portfolio Solutions, is a widely recognized index investor and the author of several books on index investing.