February 10, 2011

Advisor Ferri Shares His Favorite ETFs, Funds

Rick Ferri likes Vanguard and DFA, and most of all, he likes 'cheap'

Investment advisor Rick Ferri is virtually synonymous with ETFs. After all, the Troy, Mich.-based principal of Portfolio Solutions is a fixture at ETF conferences across the country, as well as author of The ETF Book, among others.

So when I sought him out in search of wisdom about which best-in-class ETFs he purchases for clients, I expected a long dissertation about the different ways to construct indexes and lots of financial jargon. But his response was refreshingly brief and simple: “The cheapest one,” he said.

For your basic S&P 500 fund, Ferri would recommend iShares S&P 500 index (IVV), with an expense ratio is just 9 basis points. While State Street’s SPDR S&P 500 (SPY) has the same expense ratio, its investment structure is less advantageous, he says.

As a unit investment trust, SPY reinvests company dividends once a quarter, whereas IVV has a mutual fund structure. “They can reinvest dividends as soon as the companies pay them. So if you’re looking for the performance of IVV vs. SPY in an up-market, IVV is going to outperform. In a down market, it’ll be the other way around,” he says.

And what about equal-weighted or fundamental indexes from companies such as Rydex or PowerShares?

Ferri doesn’t buy the “hype” that these funds outperform. In fact, he doesn’t think they represent an apples-to-apples comparison. An equal-weighted S&P 500 fund, he argues, is actually a mid-cap fund — not a large-cap like the more traditional S&P 500 funds.

Their equal weighting essentially “takes a lot of money out of the larger stocks and pushes that money down into the mid-cap and small-cap stocks,” he says. The traditional fund has an average market-cap of about $40 billion compared to a $12 billion average market-cap for an equal weighted fund.

“That’s a completely different animal,” says Ferri. “You can get the same thing by buying a mid-cap fund. There are a lot of ways to skin a cat.”

And as a professional cheapskate, his preferred way is to avoid costly large-cap and mid-cap funds altogether — in favor of the Vanguard Total Stock Market ETF (VTI), which has an expense ratio of just 7 basis points. He then adds other portfolio elements until the desired asset allocation and average market-cap is achieved.

“This [VTI] gives you exposure to almost 4,000 stocks. So you now own the market and you can add elements to tilt the portfolio.”

To bring down the market-cap and add a value bias, Ferri uses the Bridgeway Ultra-Small Company Market (BRSIX) and the iShares S&P SmallCap 600 Value Index (IJS).

“Vanguard just came out with competitive fund whose fee is lower. I’m still going with the bigger fund [IJS] because it has more liquidity.”

For real estate exposure, Ferri typically adds Vanguard REIT ETF (VNQ) to client portfolios.

I asked Mr. ETF if there might be mutual funds that still retain an advantage over their ETF cousins.

He again surprised me: “Whether you select a mutual fund or ETF is really the last thing you need to worry about as an investor,” he said. “I’m going to use the best. This hype about you have to use only ETFs is ridiculous.”

And, indeed, he uses two DFA mutual funds to give his clients international exposure: DFA International Small Cap Value (DISVX) and DFA Emerging Markets Core Equity (DFCEX). While Vanguard has a cheaper emerging markets ETF, Ferri feels he gets everything he needs with DFCEX

“It does everything all within one fund. Emerging markets are maybe 15% of our total equities portfolio; we just buy one fund that has it all in there.”

Overall, Ferri takes a pretty mercenary approach to fund selection. He shows no loyalty to DFA for example:

“It’s almost to the point with ETFs where you can emulate the whole portfolio we’re managing.” He predicts that in one year’s time, there will be ETFs to replace the mutual funds he’s currently using, at which point he says he’ll just publish a model ETF portfolio on his website.

But then again, his clientele has the same mercenary approach in hiring an investment manager. Ferri charges a cut-rate 0.25% management fee for his services. (Clients with smaller portfolios may end up paying more in that his minimum fee per household per year is $2,500.)

While the costs are low, Ferri thinks they’re getting the optimal portfolio. “The funds that we’re using are very good. We think they’re best in class,” he says.

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