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Rick Ferri: Own Stocks To Offset Low Rates By Olly Ludwig | April 04, 2013

Rick Ferri, the head of Michigan-based Portfolio Solutions, is all but convinced that the ultra-low-rate environment put in place by the Federal Reserve after the market crashed in 2008 is here to stay for a long timeperhaps as long as 20 years.

That presents definite challenges for investors, particularly older investors who have historically gravitated increasingly to bonds as they head into retirement, Ferri told IndexUniverse.com Managing Editor Olly Ludwig. The problem is that even with a broadly diversified bond portfolio that includes highyield and TIPS debt, real returns are likely to be zero. The answer? Own more equities and, for retirees, for longer than has been the conventional wisdom. But only if you can take the heat of the extra volatility.

IU.com: What can seniors do to maximize returns in the bond market, given the low yields? Ferri: I look at it by starting out with the total bond market, which is a lotof Treasurys; a lot of agencies; a lot of mortgages and some corporates and Yankee bonds. Thats the Barclays Capital Aggregate bond market, the cornerstone of a fixed-income portfolio. That captures most things, but theres two asset classes it doesnt capture: high yield and TIPS. So if you wanted to create a more total total bond market, youd need to add some high yield and some TIPS, about 10 percent of each. IU.com: When you say 10 percent, you mean 10 percent of your bond-market allocation?

Ferri: Thats correct. But were a bit more exotic than that. We use a 60-20-20 combination.

IU.com: Were talking 60 percent ags; 20 percent TIPS and 20 percent high yield?

Ferri: Yes. All Im saying is that thats what we use. If you wanted to match the market, youd use 80-1010. And its just taxable, including mortgages. Not municipals. The 20-20-60 works well from a modern portfolio theory method, which means youre going to do rebalancing. When the high-yield market goes down like it did in 2008, we were more buyers of high yield because we need to get it back up to 20 percent of the portfolio. And then over the last few years, high yield has done extremely well, and its now more than 20 percent of the portfolio, so we sell some high yield and start buying something else like TIPS or aggregate bonds. But the rebalancing helps mitigate the risk.

With 20 percent of the portfolio in high yield, it makes up for the fact that Im getting nothing on the TIPS side, and the net result in my clients portfolios is that I end up getting a 2 percent cash flow yield out of the portfolio.

IU.com: So what percent of equities should a senior remain invested in?

Ferri: The bottom line is, How much money do you have? If you have $10 million and youre spending $100,000 a year, heck, you may as well be 100 percent in equity. Because youre never going to run out of money. The dividend yield on stock is 2 percent or higher if you have a diversified portfolio, so youre going to be making $200,000 a year on dividend income. So if youre only spending $100,000 a year, you may as well be 100 percent in equities.

If you were solely in bonds, like Bill Bernstein was telling you, theyre a zero-percent-returning asset class over the next 10 years, so youre going to get nothing on a real-return basis. So, every dollar you spend is actually principal that youre taking out of your portfolio. So the idea of moving to fixed income as you get to retirement is going to be based more on how much money you have and what kind of a financial position youre in rather than whether you can handle the risk.

IU.com: You just laid out a scenario where it makes no sense to hold any bonds whatsoever if your net worth is high enough. So what would be the other extreme, where you really have no choice but to go all-in with bonds?

Ferri: You have $500,000 and youre spending $50,000 a year. You dont have enough; youre going to run out of money. And youre going to run out of money whether youre in equities or in fixed income, but you could run out of money a lot faster if you were in equities in a down market and taking out a lot of money.

IU.com: Some peopleadvisorsargue that one of the reasons theres so much downward pressure on rates is that the size of this cohort of retirees is so big that whatever bond buying they do is going to keep some pretty steady pressure on bond yields. Do you buy that?

Ferri: No.

IU.com: Why?

Ferri: It is true that theres going to be more demand coming from baby boomers, but at the same time, youve got all these private pension funds that have to increase their equity exposure; otherwise, theyre not going to make their nut to balance their liabilities against their assets. So theyre doing the exact opposite of what a retiree does. What does a retiree do? They pay off their house, and they go to bonds. What are pension funds doing? Borrowing money and increasing their risky asset exposure.

IU.com: So, absent the Fed, do you think there would be a backing up of yields in the current environment?

Ferri: Well, the Federal Reserve is pushing a lot of people into equities, because they have to get a rate of return, and these pension funds cant get it from bonds. And younger people who want to get a rate of return cant get it from bonds. Stocks are cheaprelative to bonds and relative to the cost of capital. And everybody knows it except the baby boomers, because theyre all following the standard financial planning advice: When you reach the age of 60, you need to be x percent in bonds. Maybe they should sit back and ask: Do I actually need to be 60 percent in bonds when Im 60 years old?

IU.com: Is that actually happening? It seems to me theres a greater openness to owning more equities later in the life cycle than in previous generations, or am I just imagining that?

Ferri: The fact that the stock market continues to go up, the fact that interest rates continue to stay lowbelow the inflation rate forced by Federal Reserve actionis causing people who are wise investors to reconsider this age-in-bonds model. Theyre thinking, wait a minute, if theres a really high inflation rate, do I want to be in bonds or do I want to be in stocks?

A lot of people have figured out that its really stocks that are the better hedge. Maybe some combination of stocks and some bonds makes sense. Bonds could be used to rebalance and lower the volatility of the stock portfolio. But then, who says that the historic level of bond volatility will prevail going forward? It could be much worse. With interest rates so low, bond volatility could be much higher over the next 10 years.

IU.com: You mean, as rates revert to the historical mean?

Ferri: Well, if youre buying 10-year Treasury notes at 2 percent and interest rates go to 4 percent, the value of your 10-year Treasury note is going to drop by 20 percent. That is volatility. You have to go back to the 1970s to see that kind of volatility. And a lot of investorsbaby boomers like myselfdidnt have a lot of money back then, so we didnt know how that affected us. So theres not a lot of experience there.

So theres a lot of risk in bonds, unless you do what Bill Bernstein says, which is to keep it all short. Well, theres a risk in keeping it short too: Youre guaranteed to lose 2 percent a year because the inflation rate is 2 percent.

IU.com: Now, taking a step back, if the Fed is really the crucial agent herethats what youre telling mewhat can we expect the future to hold?

Ferri: You can expect Japan from our Fed. Japans central bank has continued to add reserves for decades in order to keep interest rates low. We could be going into somewhat of the same thing, though we have the benefit of the echo boomers. Our kids are making up for us. There are enough of them to make up for us, whereas in Japan, there hasnt been.

In any case, I dont know if youve had to a chance to look, but the Federal Reserve has increased its balance sheet by $100 billion in the last month. In the last 12 months, theyve increased it by $300 billion. The Fed balance sheet as of last week is $3 trillion and some $200 odd billion as of the end of last week. Its rising, and theres no end in sight, because theres very little inflation and the world is awash in dollars because theres very little demand.

I see the Fed keeping interest rates low for the next 20 yearsbelow the inflation rate. And investors, if theyre not in equity, are going to get a negative real return on their money. Its tough.

IU.com: Given that, is the advisory business entering a different kind of reality, and even if its the Fed thats driving this story, theres a cause and effect that you have to take into consideration as an advisor, and that is to increase allocation to equities across the life cycle? Is that the takeaway here?

Ferri: If you can stand the heat, yes. But the problem is now youre getting into the yin and the yang of investing. The yin is the technical side of this, which is mathematically, What should you do? Well, mathematically, you should buy income-producing assetsreal estate, stocks, things that can grow. Thats the only way you can get from here to there.

The problem is, that doesnt mean youre not going to have volatility. So, can you stand the heat; can you stay in the kitchen when the temperature gets high? And if you cant, then you need to be in bonds.

IU.com: Thats the Bill Bernstein angle. Hes presuming most people cant stand the heat, so why even open that can of worms? But youre framing it as a question, yes?

Ferri: Thats exactly correct. And Bill has it right. If you cant stand the heat, you need to be in bonds and accept a negative real rate of return in bonds.

It comes down to this: How well do you know the markets and how well do you know yourself? Classical theory says that as youre heading into retirement, you should be reducing equity and going into bonds. My point is that if you can delay that, delay it. Because the longer you can delay that, the better off youll be.