I know very few people who began their investing lives as Couch Potatoes. Most started out in mutual funds or as stock pickers and, somewhere along the line, realized they were overpaying and underperforming.

These days, it’s easy to learn about the indexing alternative, but that wasn’t true even a decade ago. And when Rick Ferri began his career in the financial industry, it was heresy.

I recently had the pleasure of interviewing Ferri about his newest book, The Power of Passive Investing (Wiley, 2010), and I asked him about his own journey.

After earning a degree in finance, Ferri was an officer and fighter pilot in the US Marine Corps. He left active service in 1988 at 30 years old, earned his CFA designation, and started a new career in the financial industry. At that time, passive investing was almost unheard of, at least among retail investors. (Vanguard had been around since 1975, but by the late 1980s it still held only $30 billion in assets, compared with $1.4 trillion today.) Certainly Ferri knew nothing about indexing when he joined Kidder, Peabody and Co., a veritable old Massachusetts-based brokerage.

“Who wears the pants?”

I asked Ferri to describe what his early days a broker were like.

“This was 1988, so you would say things like, ‘Hello, this is so-and-so from Kidder, Peabody. Is Mr. Jones there?’ If Mrs. Jones answered, you’d ask her to put Mr. Jones on the phone — you did not talk to Mrs. Jones. And if Mr. Jones said something like, ‘I have to speak to my wife about that,’ you were told to say something like, ‘Who wears the pants in this family?’  Honestly, this is what they told you to say.  This was the broker playbook.

“They would have contests, where the person who got the most orders in one day got dinners and show tickets.  And you had to try to sell the stock of the day — whatever some analyst was promoting. Even if I didn’t know anything about the person, I would call and say, ‘You’ve got to buy a thousand shares of this company.’ These ideas about suitability, know-your-client, we’d get to that later.

“I tried managing stock portfolios myself, but quickly realized I didn’t know what I was doing. So I started using money managers. The clients would hire the managers, pay them 1% or 1.5% per year to select the stocks. Then our firm would also get 1%, or there would be brokerage commissions, which were extremely high. We made sure we picked money managers who had a decent amount of turnover so we would get paid.  The ones who did tactical asset allocation were great, because they always had a good story, and there was a lot of trading going on.”

The awakening

Ferri later joined a larger brokerage that functioned the same way. He quickly became uneasy with the whole industry:

“I caught on to what was going on: they were trying to pick managers, but they weren’t really believing they would outperform the market. They just wanted managers with a good story, so the brokers could sell the story and we could collect our 3% wrap fee. They would say to the client, ‘These are superior managers who you can’t get on your own because their minimum account size is $10 million. But under our program you can get them with just $50,000.’  Of course, that’s completely irrelevant. Managers are not going to outperform just because they set a high minimum. Especially once you charge 3% in fees — then the client is just screwed.”

By this point Ferri’s interest had been piqued by Burton Malkiel’s classic 1973 book on the futility of active management, A Random Walk Down Wall Street. Then one day in 1996, he was browsing in a bookstore and stumbled upon Bogle on Mutual Funds, by Vanguard founder John Bogle. “The book was inspirational to me. This is was not just theory: Bogle had the data in there, showing how the managers had underperformed the markets, and why. And I thought, ‘This is exactly what I have been seeing every day for the last eight years.’”

Then Ferri committed an act of financial treason. He fired most of the managers handling his equity portfolios and bought SPDRs (pronounced “spiders”), one of the earliest ETFs that tracked the S&P 500. “I still had to use active management for international equities, and I was using some commodities, which were unbelievable cash cows for brokerage firms. We’re talking 5% to 6% a year in cash flow. But my deal was that I would use index funds as much as I could — for which I would get paid nothing.”

“Screw the client”

You can imagine how this went over with Ferri’s supervisors. “They were saying, ‘How are you going to hit your 1%?’ They didn’t care what you sold clients, as long as you hit your revenue target — and if you weren’t going to hit it, then you should get rid of the client. They never, ever asked you, ‘How are your clients performing?’ That wasn’t even in the equation.

“I was using SPDRs and bond ladders, and there wasn’t much revenue from that, so they told me to use more commodities. I said, ‘That’s not prudent, because the clients already have 10% of their portfolio in commodities.’ And they said, ‘Well, make it 15%, or 20%.’ It’s like the word prudent wasn’t even in their vocabulary.

“I realized I needed to do something. So I went to my boss and I said I wanted to create an index-fund wrap program, where we would just use Vanguard index funds and ETFs. We’d charge 50 basis points for doing the asset allocation and creating portfolios with the right blend for each individual client’s needs. And he laughed at me. ‘What are you, nuts? What business do you think we’re in?’ I said, ‘But this is the best thing for the clients.’ And he said, ‘Screw the client! We’re not in business for the clients. We’re in business for the shareholders. Don’t you get that?’ And I said, ‘I get it loud and clear.’ But I needed that confirmation — to know that this was not the right place for me. I needed to leave the brokerage industry.”

Ferri went on to found Portfolio Solutions, a Michigan-based investment management firm that builds index portfolios and charges clients 0.25% (subject to a minimum annual fee of $2,500 per household). So far he has never asked any of his clients who wears the pants in the family.

In my next post, we’ll hear more of Ferri’s investment ideas and I’ll offer readers an opportunity to win a copy of his latest book.