MLPs Fail, But REITs Have Luster

08/23/2012 9:55 am EST

Focus: INCOME

Lee Munson of Portfolio LLC explains why he made the tough decision to exit MLPs, and why he is turning to high-yield bonds for income. He also tells MoneyShow.com about a real-estate REIT he likes right now.

Kate Stalter: Today our Daily Guru guest is Lee Munson. He's the founder and chief investment officer at Portfolio LLC.

Lee, the last time we talked for MoneyShow, we discussed your views of the traditional model of asset allocation. So many retail investors have become familiar with that, but you prefer to look at risk, rather than the particular assets included in the mix. Can you tell us about that?

Lee Munson: Well, absolutely. The number one thing that people have to remember is that an asset allocation pie chart was designed to convey one thing: How much risk should an investor actually take. The problem with the pie chart, though, Kate, is that it only really tells you the nominal amount of a particular asset class-like how much in stocks you have, versus bonds.

Now, this will work out very well and all would be forgiven with pie charts if it wasn't for the fact that risk does not remain constant. Meaning, as we all know, sometimes stock markets become more volatile than maybe they've been historically. The same thing happens in the bond markets.

So what our firm tries to do is use statistical methods, just like Modern Portfolio Theory 50 years ago, to try to find out how much we can lose on the downside. Because as Warren Buffett said, job No. 1 is don't lose money.

If we can find out how much we can risk, how much we can lose at any particular time, that's going to drive our asset allocation decision, because we're still making those rather than the percentage of how much stock versus bonds we have.

Kate Stalter: Let's segue into some specific topics. International markets is the first one I want to bring up. That's something that consistently in the news, one way or another. When we last talked, you had a preference for domestic equities over European or emerging markets. Are you still seeing good strength in the domestics?

Lee Munson: Absolutely. I think that we could see even higher highs before the end of this year on the S&P 500. Not so sure about small cap, but I think small cap will probably trend with the broader US markets.

What is different than the last time we talked is that China appears-perhaps, maybe-to be bottoming out. So No. 1: liquidity is turning up in terms of the CHIBOR. Chinese government spreads are actually inflecting down.

The most important thing that people forgot is that last year, China's yield curve was inverted. Anybody who has been around capital markets for a long time will tell you inverted yield curves always spell disaster. Now those yield curves are no longer inverted.

These are all great points, and it also looks like the industrial commodity indexes, which is really what China banks, on have started to bottom out.

Now does that mean Europe is going to be saved? No. Europe is a basket case and will continue to be a big risk in the headlines and otherwise probably for another few years. So if you're looking for something outside of our borders here in the United States, the first place I would look for is China and the other emerging markets that make money off of China.

Plus, never before have Chinese equities sold at a 20% discount in valuation to the broad basket of emerging markets. We're seeing that now. I think it's a great opportunity for more intrepid investors.

Kate Stalter: Let's talk a little bit about some of the domestics, particularly REITs. This is another area I've heard you mention in the pastâ€" specifically, getting REIT exposure through ETFs. What are you seeing there right now?

Lee Munson: Well, one of our largest positions across the board in our more moderate to aggressive models is the Vanguard REIT Index (VNQ). It's extremely cheap to buy. It's liquid. You should know what's inside of it. There's only about 80 names. Eleven percent of it is Simon Property Group (SPG), so it's not diversified like the Wilshire 5000 or the Russell 3000.

But REITs are racking up-I think we're on our fifth straight month of asset gains. It pays a dividend that has been 40% to 50% more than the dividend on the S&P 500.

What's really interesting about REITs is that of this slow, mediocre, kind of half-crappy recovery that we're experiencing right now, commercial real estate is the most consistent performer across all the asset classes in general, because we have a gradually healing commercial banking system. You can't have a trillion dollars get pumped into banks and commercial real estate, and not be able to refinance and benefit from that.

I would say the downside on REITs, statistically when we model, it appears to be less than its analog, which might be small cap. It usually has the volatility of small caps.

So I'd say that's one of the first places that people should look if they're looking for some growth, as well as some income and have that wind underneath their sails. Because the group basically got blown up back in 2008. So I think it's a great sector to have exposure to. I think its prospects are better than small caps between here and the end of the year.

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Kate Stalter: You mentioned investors who are seeking income. What are some other places that they should be looking at right now? I hear a lot of talk about MLPs, for example.

Lee Munson: You know, we loved MLPs at the beginning of the year, but it really hurt some of our relative performance, because that group all year has been correlatingâ€" moving up and downâ€"with the energy sector. Historically, that's not always been the case.

We made the very, very difficult decision this summer after spending years in the sector, making very good money during those last few years, to exit completely out of our ETN and ETF MLP positions. I can tell you in three short bullet points why that is:

  1. It's correlating with the energy markets, and that's not traditionally why we bought them and what they've done.
  2. There is a glut of new exchange traded notes and exchange traded funds that have entered the market.
  3. It's limited to how large and how many gains it could have. I think too many people are chasing too few profits, and it doesn't give you that diversification. It makes the risk-return unattractive.

So if you're looking for income and you've got 20 years, I wouldn't count MLPs out, but I think if you're looking for the bread-and-butter of your portfolio, you need to rethink it, you need to recheck it.

It was the hardest decision that I've had to make professionally this year, which was: Do we continue with this after they've been so generous, or do we walk away and give it a break? We walked away and we're going to give it a break.

Kate Stalter: Any other areas that you are turning to instead for income?

Lee Munson: Well, outside of the REIT market, I think that you still have to look at high yield. I always feel silly when I talk about junk bonds. It's traditionally not been the greatest sector on earth. It has a reasonable correlation to the stock market, and it's called junk for a reason.

Why are we buying it? Why is it that this is the place that we're looking for income? No. 1 is because it has some income. No. 2, balance sheets on the whole are stronger than they used to be.

This big cliff in junk bond markets that people keep talking about doesn't seem to let up. Why? Because right now Treasuries are so low, and investors are so starved for yield, Wall Street is willing to try to meet the demand of the investing public by issuing more and more junk bonds, and rolling over junk bonds that a couple of years ago we weren't sure if a lot of these places were going to be able to refinance.

We still have issues where there's not enough supply to meet the market demand. So while historically I've been a little sour on the sector, it's a great place to find some income, find some yield.

However, what everybody has to realize is that game will end one day. And No. 2, junk bonds do not diversify your portfolio in the same way your plain vanilla corporate or Treasury bond will.

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