Ferri: A Methodology For Success

Rick Ferri is the founder of advisory firm Portfolio Solutions and the author of multiple books on investing. He’ll be speaking on Sunday at Inside ETFs about index-based investing.

What are the key topics you’ll be discussing at the conference?

The title of my talk is “Why Index?”

Why index? I'm an investment advisor. My life for the past 27 years has been advising individual investors, small foundations, pension funds, etc. As an advisor, I have a fiduciary duty to act in our clients’ best interest. This means acting with care, skill, diligence and prudence. That’s why I index.

Every advisor has to decide their approach when we look at building a portfolio. How are you going to get the job done? What do you believe? What is your process? Every advisor has to do this. It’s part of a being a fiduciary.

I’m working on a short book about managing portfolios successfully. It’s really a three-step process. There are three main components that can be broken down into six overlapping subcomponents.

What are the three main components?

First, you have to have a philosophy. What is your belief about investing? What do you believe is in a client’s best interest? We can break this down into two choices: active and passive. Either you’re going to attempt to outperform markets through individual investment selection or market timing, or you're going to be passive and accept market returns using a prudent long-term asset allocation. Philosophy, that’s No. 1.

Once you come to terms with your philosophy, you’re then in a positon to develop portfolio strategies for each client. How do philosophy and strategy differ? I can talk to a whole room full of index fund investors who enthusiastically believe in a passive philosophy, but when I ask how many of them have the exact same portfolio as another person in the room, no one will raise their hand. Philosophy is universal; strategy is personal. Everyone has different needs, so passive portfolio strategies can differ widely from one person to the next.

Strategy is what we talk about most with clients. How do you decide your asset allocation? How do you decide what funds to use? How do you implement this strategy? What custodians do you use? Do you use index funds, ETFs or both? There are many individual decisions to make.

The third main component is discipline. You have a philosophy for creating and implementing portfolios strategies, now you have to keep the client invested. How do you maintain discipline? How does your client maintain discipline? Discipline is the key to long-term success.

Philosophy, strategy and discipline all work together for investment success.

What are the subcomponents?

The three main components break down into six different subcomponents. I’m still working on the exact words for these six ideas, so bear with me.

First is to “question.” How do you get a philosophy? How do you know there’s a difference between passive and active? This comes from observation.

You see something or you read something and start wondering about it. You ask questions, you uncover facts, and these facts—given enough of them and over enough time—cause you to make connections. Then you ask more questions. The more you ask, the more you learn and the more you want to learn.

Eventually, you come to the second subcomponent: “resolve.” This is an epiphany, an “aha moment.” It’s when everything comes together. The clouds clear and the world makes sense, at least on this issue. You feel euphoric.

Once you have the resolve, the third subcomponent is “explore.” You’re determined to dig deep to discover all the different index options available. You explore how indexes differ, how ETFs differ from traditional mutual funds, and who the players are in the industry. Your mind can’t get enough.

The fourth step is to “build.” This is where you take newfound knowledge and build portfolios. You’ll start out with an asset allocation and then fill the asset classes with appropriate funds, ETFs and other products that make the most sense.

The fifth step is to “apply.” Your portfolios are not useful until you implement them. How do you do that? Do you use your 401(k) plan choices? Do you have personal accounts? How do you get this portfolio working?

Finally, the sixth subcomponent is “sustain.” This simply means staying the course. It’s how you avoid the noise and stay on track. There will be many temptations. The way you avoid falling is to ask more questions, seek more information, reinforce your resolve, reinforce your previous choices and make minor adjustments if needed.

When it’s all done, you’ve completely one cycle. Congratulations! Now go do it again.

Any other issues you’re planning on discussing?

I'll go into the evolution of indexing through four different levels. It’s my version of the stages of indexing broken into four pieces. The first is just basic “market tracking” products. I’ll talk a little about bout how the first index products evolved and why.

That leads to a second phase I call “slice and dice.” Broad equity market indexes were sliced into value, growth, large, small, individual countries, etc. The third phase is “strategy indexes.” This is a different animal. It’s active management redone as indexing.

Finally, “liquid alts,” which is basically using leverage of some sort in a variety of asset classes and strategies. When you explore indexing, you’ll run into all types, and categorizing helps.

I’ll also talk about times when active managers appear to outperform indexes. Most active funds are messy. The managers invest outside their styles, and that can lead to the illusion of outperformance when a pure style index underperforms.

I've been hearing more and more people talking about having a plan and sticking with it.

Let’s get back to the three keys to investment success: philosophy, strategy and discipline. Active and passive are universal, quite frankly.

You're going to see in my presentation that I'm not even making a judgment at the beginning whether you should be active or passive, because the rules are the same. It is a methodology that everyone can implement, whether active or passive.

You have to have a philosophy of what you believe, a strategy for implementing it, and the willpower to stick to it like glue. You can't start flip-flopping around. If you have no philosophy, you won’t have a successful strategy because you won’t keep the discipline. You need all three to succeed.

You’re a proponent of indexing. What do you think of the Dimensional Fund Advisor mutual funds, which are essentially passive and very quantitative, but not indexed?

In full disclosure, the advisory firm I founded and co-own uses some DFA funds.

DFA was an early pioneer in factor investing. This approach seeks risk premiums in addition to a market risk premium; such as value, size and momentum. Today many fund companies are going after these same nonbeta risks. That’s what the whole “smart beta” thing is about. Like DFA, many of the new funds are relatively low cost and can be highly concentrated in nonbeta risk factors.

I'm not completely convinced that if you're doing factor investing you should follow an index. Indexes can be restrictive, whereas an active fund doesn’t have to follow a strict set of rules. An active fund has the luxury of choice.

For example, an active fund may let momentum run for a while, as opposed to rebalancing on an index schedule. If you're going to run a large fund, you probably don’t want it known every day what you're buying and selling.

But in your opinion, plain-vanilla indexing is best.

If all you did was buy plain-vanilla low-cost index funds in a strategic asset allocation and rebalanced once in a while, you would have done pretty well over time. I think a fiduciary can invest this way and not worry very much about being dragged into court to justify why they chose this methodology.

Let’s review the concept of fiduciary duty. If you’re pursuing active management, why are you doing this? Is it in the best interest of the client, or are you doing it to build your track record using client money? I believe passive investing is the prudent choice for most clients.

Are explosions inevitable?

Passive portfolios are not immune to market downturns. When the markets go down, index funds go down. But at least it’s transparent. Investors know why their accounts dropped in value. An advisor doesn’t have to answer for underperformance.

Some people do panic and sell in a bear market. When this occurs, the philosophy/strategy/discipline process is broken. Perhaps it was never there to begin with. An advisor with resolve will help their clients have resolve.

How much hand-holding is involved in your job?

Advisors do a lot more hand-holding in downmarkets than upmarkets. People get nervous when their account values fall. It’s human nature. This happens at least one month per year, on average.

Successful advisors are aware of their clients’ needs and make time to address them. It’s probably the most important thing an advisor does after a person becomes a client.

Advising is mostly human psychology. We can't do anything about interest rates, we can’t control stock prices, we can’t know the future price of oil or gold or anything else. What we do know is our clients believe in us and we need to be there and be strong for them. People ask me, “What do you do for a living?” If they're an investor, I’ll say, “We manage investments.” If they're in the business, I’ll say, “We manage investors.”

The views and opinions expressed herein are those of the Rick Ferri, CFA, and do not necessarily reflect the views of Portfolio Solutions, LLC, its affiliates or its employees.