If You Are An Index Investor, Where Does Explore Investing Fit In?

In this week’s Forbes column, Rick Ferri asserts that “partial indexing works for Wall Street, not investors”. In this penetrating article, Rick ruthlessly uncovers Wall Street’s agenda is selling indexing for efficient markets while directing clients towards highly priced actively managed mutual funds for “inefficient markets”. As Ferry states, “Welcome to ‘Core and Explore’, also known by ‘Core and Satellite,’ ‘Barbell,’ ‘Core Plus’ and a variety of other witty names. The theory suggests that index funds (or ETFs) work best in large and liquid markets and that actively managed funds work best in small and less liquid markets. Accordingly, a combination of index funds and active management generates higher returns than an all index fund portfolio.”

With rapacious accuracy, Rick rips back the covers on Wall Street to expose the true motives in selling this story. Wealth managers are having an increasingly difficult time selling clients on the value of high priced mutual funds that are less tax friendly and have tragically underperformed low cost ETFs. In light of the giant swooshing sound of clients bailing out of the mutual fund merry-go-round for better constructed and performing ETFs, wealth manager came up with this core and explore pitch to sell manged products for small cap, foreign and emerging market investments. Unfortunately, Ferri points out that there actually is no such creature as an inefficient equity market. As he states:

“Core and Explore would be fine advice if it worked, but it doesn’t. The theory has several flaws. First, how does your adviser know which market is efficient and with is not, or if any market is efficient? The nation’s top academics cannot even agree. Second, why should your adviser suddenly become more skilled in selecting managers in inefficient markets simply because he or she is no longer selecting active managers in efficient markets? Third, there is no unbiased academic evidence to support the notion that active managers outperform in any market.

Two often presumed inefficient markets are U.S. small-cap stocks and emerging markets stocks. According to Core and Explore theory, these are two markets where active managers should have excelled. That has not happened. Data gathered from the S&P Indices Versus Active Funds (SPIVA) Scorecard for the first half of 2009 shows that over 67% of small-cap core funds under performed the S&P 600 index over the trailing five years and about 90% of actively managed emerging markets funds underperformed the S&P/IFCI Emerging Markets Composite index over the same time.

There are no inefficient asset classes where high cost actively managed funds consistently outperform their appropriate benchmarks. This means Core and Explore is about paying for something you do not need and likely will not benefit from. If your adviser has progressed to the point where he concurs with an all index fund portfolio, then you have a good adviser. If he insists that he can select superior funds on the explore side, then perhaps you should do some exploring on your own–for a new adviser.”

I am a big fan of Mr. Ferri’s and strongly agree with his poignant and entertaining expose. I would suggest an important caveat, however. Core and Explore does work, but only if you define the terms quite differently. I have used Core to reflect those assets which are directed at a long-term, reliable and scientifically sound retirement strategy. This Core portfolio should consist of indexes as recommended within the MarketRiders (www.marketriders.com) software. Explore, on the other hand, are the investments outside of my Core retirement portfolio that I am involved with that have a higher risk/return profile. I personally have ownership in a hydroelectric power company in Chile, oil and gas in the US, a retail store as well as equity in early stage tech companies – for me all part of my Explore strategy that complements the overwhelming majority of my assets in a Core indexed portfolio with MarketRiders. Even Ferri himself owns land in Texas and has investments outside his index portfolio. I personally like to direct between 10% to 20% of my investible liquid net worth in Explore style investments and see that percentage decreasing rapidly as I move into my 50s and towards retirement.

So, in conclusion, Core does fit with Explore, but when it comes to publicly traded equities, stay true to employing globally diversifed, low cost and tax efficient ETFs.