Consider small-cap, TIPS, real estate, commodity, and distressed-security funds.
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.
First, investors may very well want to choose a different small-cap fund than American Funds Smallcap World
Investors would have to replace Smallcap World with two funds, one domestic and one foreign. Diamond Hill Small Cap
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.
Assuming that you're working through an advisor who deals with load funds, a good TIPS fund is PIMCO Real Return
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.
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.
This dividend requirement, however, has been one of the causes of REITs' recent troubles. The requirement makes it necessary for the firms to borrow money to finance growth. With such funding cheap and available as late as early 2007, many firms gorged on debt. Now, however, many REITs are unable to refinance existing loans because credit is unavailable. Those that can refinance also are finding that they can't borrow at the low rates to which they've been accustomed. Finally, a slowing economy is leading to lower rents and occupancy levels, making it hard for firms to maintain dividends.
Still, despite this litany of bad news, the prices of REIT stocks have tumbled hard. Price/FFO (funds from operations--a REIT cash-flow metric) was recently as low as it was in 2000, before the stocks embarked on a torrid multiyear run. In 2000, the businesses generally didn't have the debt problems that they do now, but not every REIT is burdened with a crushing level of debt. Additionally, many fund managers have told Morningstar analysts that foreign real estate firms, especially those in Asia, don't have the debt problems that their domestic counterparts have. This may explain why international real estate is generally outperforming domestic real estate so far in 2009.
If investors want to wade in slowly, JPMorgan U.S. Real Estate
Continuing with the hard-asset theme, investors may want to supplement their American Funds holdings with a commodity fund. If the world's governments succeed in stemming global deflation, commodity prices are likely to increase. Commodities also make good long-term holdings in moderation, because they behave differently than stocks and bonds over extended periods. Another PIMCO fund, PIMCO Commodity Real Return
Finally, the current market environment is likely to lead to investment opportunities in bankruptcies and distressed securities. We think Mutual Series has the experience and capability to navigate these difficult, but often profitable, waters. Within that fund family, we'd go with Mutual Discovery
Maintain a Long-Term Focus
Should you diversify your portfolio beyond the American Funds lineup, you may be tempted to try to time your buys and sells based on short-term market trends, but we'd stay focused on the long term. Add to your positions in new funds slowly so that you're not buying in at the top of one asset class or rushing in as another one hits the skids. We'd also be mindful of cost. Most funds can't beat American when it comes to price, but expense ratios can subtract from your returns year in and year out. Morningstar's research has shown that funds with higher fees are much more likely to underperform their peers over the long haul.
John Coumarianos is a fund analyst with Morningstar.
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