ichard Ferri would like nothing better than for the ETF market to be efficient enough so that he could use all ETFs. But it's not, says Ferri, founder and chief executive of Portfolio Solutions, a registered investment advisor in Troy, Mich. So the beta-driven portfolios the firm constructs for its high-net-worth clientele are asset allocations of various index funds–including ETFs– diversified among a variety of asset classes.
In its analysis of asset classes, the Portfolio Solutions team looks for unique risk factors in the marketplace, Ferri says, pointing out that U.S. markets have different risks than Treasury bond markets, for example, and the risks in Pacific markets differ from those of European markets. "The point is that in a 'normal' market–if one thinks such a thing exists–the correlations between Europe and Pacific and emerging markets and U.S. stocks tend to deviate; real estate deviates from U.S. and so forth," says Ferri.
Using a rolling correlation analysis to look at the deviations that occur lets the team see "how the correlations are shifting between asset classes to make a determination whether a particular asset class we're considering is actually a unique asset class or not, or whether it's just leveraged beta of some sort," Ferri explains. Mid-cap stocks, for example, are basically leveraged beta; their returns indicate there's no real risk in mid-caps, he says. Micro-caps, on the other hand, do have unique risk; sometimes they have a high correlation with large-cap U.S. stocks, but sometimes they don't. "Mid-caps almost always have a high correlation with large-cap U.S. stocks," he says. "All you've got there is leveraged beta, so we wouldn't use that, but we would use microcaps."
Once the team settles on a particular area of the market it wants to invest in, it looks at how best to represent that market class in its portfolios, says Ferri. "After we make the decision that we want to have, say, real estate in the portfolio, then we look at all the product that's available out there–both open-end mutual funds and ETFs–and based on the underlying index and cost and turnover and liquidity, [we] make a determination which product we're going to go with. If it turns out it's an ETF, then it's an ETF. If not, then we have an open-end fund."
After a portfolio has been created, says Ferri, "we just do rebalancing and tax management; we don't try to do tactical asset allocation, any stuff that requires speculation on the part of the managers."
The ETF advantage
Ferri says it's convenient when the method of delivery of an asset class is an ETF because this makes rebalancing simpler. "You can buy and sell ETFs all in the same day, whereas when you use an open-end mutual fund, you've got to wait a day or guess what you're going to get as an NAV; so it gets to be more complicated and time consuming to use open-end funds than to use ETFs."
