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Filling the Gaps in Your American Funds Portfolio

Consider small-cap, TIPS, real estate, commodity, and distressed-security funds.

John Coumarianos, 04/28/2009

You can do quite well in your investment life only holding American funds, but investors attached to the family may occasionally want to venture away for something that it doesn't offer. After all, its large-cap stock funds are rather similar, its lone small-cap fund leaves something to be desired, and it doesn't run niche funds that stress a single sector or smaller asset class. This month, I'll discuss where you can get exposure to what American lacks. I'll assume American Funds investors work with a full-cost broker and will be limited to funds with loads.

Small-Cap Substitutes
First, investors may very well want to choose a different small-cap fund than American Funds Smallcap World SMCWX. This is American's only dedicated small-cap fund, and it has more than $10 billion in assets even after recent market declines. It's global in nature--it probably couldn't be otherwise given its size--and though it's been serviceable, its performance hasn't been stellar: It underperformed the S&P Global < $2 Billion Index for 10 years through March 2008.

Investors would have to replace Smallcap World with two funds, one domestic and one foreign. Diamond Hill Small Cap DHSCX would work well for the domestic option. Veteran manager Tom Schindler leads a talented management team that trades lightly and isn't terribly benchmark-sensitive. The fund's hefty energy exposure will make it a bit volatile as commodity prices gyrate, but we think that the managers make a strong case for why their energy stocks are undervalued. On the foreign side, Columbia Acorn International Select LAFAX fits the bill. At $3 billion, its average market cap indicates that its average firm is more medium-size than small. Manager Chris Olson applies a moderate-growth strategy well, and the fund has outpaced more than 80% of its foreign small/mid-growth peers over the past five years through early April 2009.

Treasury Inflation-Protected Securities
Second, investors may want a fund dedicated to Treasury Inflation-Protected Securities or bonds in their portfolios. These are loans to the U.S. government that pay semiannual interest, just like plain Treasuries, but their coupons and underlying principal, or face value of the bond, are automatically increased as one of the main measures of inflation, the Consumer Price Index, increases.

TIPS seem like a perfect investment, though debates rage about whether the CPI is a good measure of inflation or whether the government understates price increases. Also, TIPS' market prices can fluctuate relatively widely depending on whether investors think inflation is rampant and protection deserves a premium, or whether they think it's at bay and protection against it isn't very valuable. A good way to figure out if TIPS are a good deal is to compare them with plain U.S. Treasuries (those without inflation protection). If a plain or "nominal" Treasury is yielding 3%, and TIPS are yielding 2%, then the break-even inflation rate is 1%. In other words, the market is assuming 1% inflation. If you think there is, or will be, more inflation than 1% for the period to maturity, then TIPS would be a good investment in our hypothetical example.PAGEBREAK

Assuming that you're working through an advisor who deals with load funds, a good TIPS fund is PIMCO Real Return PRTNX. PIMCO is a premier bond shop, and we're generally fond of its funds, including this one. This one will take more liberties than other TIPS funds, however, and those liberties can hurt at times. Basically, the fund is able to achieve full exposure to TIPS by using derivative instruments that don't require it to invest all its assets in TIPS. The fund is then free to make some other bets that its manager and PIMCO think are worthwhile. When a bet on bonds of large financial-services firms went south in 2008, the fund suffered poor relative performance. This year, however, the fund is back near the top of its category, and its 10-year record remains excellent, as the fund has bested 80% of its peers over that time.

American doesn't think TIPS constitute a separate asset class, and, therefore, hasn't rolled out a fund dedicated to them. It prefers allowing its bond managers to own them in their diversified bond funds as they see fit depending on their assessment of the instruments' valuation at a given moment. That's a legitimate approach, but so is permanently owning a fund dedicated to TIPS, as long as you don't think that the government cheats too badly on the CPI.

Real Estate
Another fund that could complement an American Funds portfolio is a real estate fund dedicated to real estate investment trusts. Real estate funds have gone from being sleepy diversifiers to some of the most volatile funds available. In the wake of the technology meltdown earlier in this decade, investors flocked to real estate funds because they preferred to invest in hard assets as opposed to firms dedicated to making money from the Internet. REITs also pay high dividends, which investors began to find exciting again. REITs are organized so that they avoid income tax at the corporate level in exchange for being forced to pay out 90% of their reported earnings as dividends.

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