2 Picks from a Fund Guru

01/09/2013 7:00 am EST

Focus: FUNDS

Sometimes it's a very good exercise to take questions from readers and give them the answers they're looking for, notes Samuel Lee of Morningstar ETFInvestor.

The folks at Morningstar.com asked me to respond to a few questions for a special feature they're running. I figured it would be good for ETFInvestor subscribers to get a peek first.

1. What are the biggest challenges or pitfalls facing investors today (and what mistakes do you think investors are making)?

Without a doubt, negative real interest rates. The developed world is still paying down the mountains of debt it stacked up over the past generation. The United States' total debt (public and private) as a percentage of GDP peaked at nearly 390% in 2008. It's now down to around 350%, still a long way from the 150% ratio the post-WWII US economy averaged until 1980. Europe and Japan aren't any better. In past deleveragings, interest rates remained depressed for 10-20 years. Heeding history, the bond market is pricing in zero to negative real interest rates for the next couple of decades.

All financial assets are priced in relation to prevailing interest rates. When rates are low, asset prices rise. When rates are really low, asset prices tend to be really high, all else equal. The biggest challenge is the reality that retirees, in aggregate, can expect to tread water or eke out modest returns. The 60/40 stock/bond portfolio is priced for low-single-digit real returns at today's valuations. This is a devastating outcome for retirees who haven't saved enough or are paying high fees for advice.

The understandable reaction is a scramble for yield. Junk bonds, master limited partnerships, REITs, and utility and telecom stocks have rarely been more popular. However, if an investor didn't have the stomach to own these risky asset classes when valuations were much lower (and margins of safety higher), why would he have the stomach now? I fear yield-chasing is going to hurt many investors.

2. On the flip side, what's working in investors' favor?

Investment options are getting better. Sound strategies, such as iShares' and PowerShares' low-volatility funds, are launching with rock-bottom prices. Index funds, whether in exchange-traded or traditional form, have never been cheaper. An investor can construct a great portfolio for a fraction of a penny on the dollar. If you're in high-cost funds, consider ditching them if you can get out cheaply. I'll echo Bill Gross: You can't afford to pay that 1% expense ratio on top of a 1% fee for advice when your expected real returns are closer to 3%.

The other thing that is working in investors' favor is the fact that many investors are terrified. European and emerging-markets equities are trading at decent discounts to the US market, even though their valuations aren't at bargain-basement levels in relation to history. I'm light in US stocks, heavy in international stocks, and I have some cash on hand in my portfolios.

3. What's one of your top picks for a core portfolio holding—one that's well-suited to ride out today's uncertainty and will be a keeper for years ahead? Or, if that's difficult to answer because you're more valuation-focused, what's one current portfolio holding you expect to hold for the long run (provided a sensible valuation)?

PIMCO Total Return ETF (BOND), though not because I think it's going to smash the ball out of the park. It's a far better choice for a core bond allocation than the fixed-income portfolios most investors have, which are hodgepodges of individual bonds and/or narrow asset classes. Most investors are going to fail at timing their sector, duration, and credit exposures, and they'll pay high fees to do it. Let the pros do it for you for a reasonable price. For most investors, investing isn't one of those activities in which you put in lots of time to get better results; once you're in a low-cost, diversified portfolio, it's hard to improve upon it.

I like BOND over passive, broad-market fixed-income funds for a few reasons. First, the passive funds are mimicking allocations set by non-economical factors. If the government issues a lot of debt and forces some big, institutional investors to own it, does it make sense to mimic this allocation mindlessly? Second, I'm confident PIMCO can beat its benchmark by capturing and repackaging many different sources of risk. Total Return can make bets on yield-curve characteristics such as convexity; it can dip into markets not in its benchmark, including emerging-markets and municipal bonds; and it can do these things efficiently.

PIMCO Total Return (PTTAX) has beaten its benchmark by more than 1% annualized average over its long career, and it has done so across a wide variety of economic scenarios. PIMCO's other funds have good records, suggesting PIMCO's firm-wide processes add value. And even if I'm totally wrong about PIMCO's skill, I probably won't lose much because both BOND's tracking error and fees are low. Finally, I think PIMCO's active management and BOND's greater diversification and higher yield are good enough compensation for the extra 0.45% fee above a passive fund.

Let me repeat: This is not an idea that you should expect to make you a ton of money. The bond market is pretty efficient, so even a heroic effort can be expected to yield only a couple of percentage points of outperformance over the long run.
4. What's your top opportunistic pick today? Why do you think that investment is un- or underappreciated?

I have two: iShares MSCI Emerging Markets Minimum Volatility Index (EEMV) and iShares MSCI EAFE Minimum Volatility Index (EFAV). There's an impressive body of research showing low-volatility stocks have performed about as well as the broad market (in foreign markets, better than the market) with less volatility. They tend to be boring, dividend-paying fare. This puzzling finding is sometimes called the low-volatility anomaly. Granted, low-volatility stocks are not cheap today, but I think they make it easier for investors to stay invested. The behavioral benefits are probably more important than whatever excess return low-volatility strategies afford.

Low-volatility strategies work, I believe, because benchmark-constrained managers are encouraged to own higher-volatility stocks (the average equity mutual fund beta is above 1) for various reasons, and because investors overvalue the dream of growth speculative stocks offer. There is little reason to think these factors won't be at work a decade from now.

Related Reading:

A Commodity ETF Growing Like a Weed

One ETN Worth Your While

Finding the Best US Equity ETFs

  By clicking submit, you agree to our privacy policy & terms of service.

Related Articles on FUNDS