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Bond Investors, Undervalued ETFs, Frontier Markets, and More

A roundup of investment news from Morningstar Advisor magazine.

Morningstar Analysts, 07/12/2010

Are Bond Investors Too Late to the Party?
Investors need to select a healthy blend of asset classes in order to maintain portfolio income, lower risk, and outpace inflation, according to Morningstar research and communications manager Jim Licato. Fixed- income securities were relied upon rather heavily during the latest crisis as investors fled riskier alternatives. Prices were pushed up as a result, and yields fell sharply. However, yields, which have recently hit historical lows, will eventually start to move upward. Consequently, bond investors will then have to contend with falling prices because of the inverse relationship between prices and yields. Just how low will bond prices fall, and how much will the total returns of these investments suffer as a result?

A bond's riskiness and performance potential are closely tied to its maturity. The longer a bond's maturity, the more volatile its price when interest rates rise or fall. Historically, shorter maturity bonds have been relatively insensitive to movements in interest rates, dropping an average of 1.3% when interest rates have risen and gaining an average of 1.4% when interest rates have fallen. (Analysis covers the time period January 1970 to December 2009.) Bonds with longer maturities have been the most sensitive, dropping by an average of 8.3% when interest rates have risen and gaining an average of 9.7% when interest rates have fallen.

Bonds have historically experienced return fluctuations just as many other asset classes have. The image below illustrates the range of returns for different bond funds from 1985- 2009. During this time period, high-yield and long-term fund categories had the greatest upside potential but with more risk than their short- and intermediate-term bond-fund counterparts. As was mentioned earlier, long-term bonds offer higher rates of interest to compensate investors for risks associated with longer maturities.

While bonds may be losing their luster as the stock market has rallied of late, it is important to convey to your clients that while prices of bonds may be heading south in the near future, this investment vehicle can still be relied upon as a source of income and diversification. It wasn't too long ago that stock investors, while suffering through one of the worst bear markets in history, wished they had a considerable amount of their wealth in the fixed-income market to help lessen the pain.

(View the related graphic here.)

Five Undervalued ETFs to Let Run
Morningstar's ETF analysts recently ran a screen searching for ETFs that both have outperformed the domestic large-cap market over the past year and are still undervalued relative to the market. Here are five such funds that, if they already owned them, the analysts wouldn't part ways with just yet. (A price/ fair value of 1.0 means the security is fairly valued; anything under 1.0 is undervalued.)

iShares MSCI EAFE Index EFA
One-Year Return: 42.2%
Price/Fair Value: 0.87
This fund is the biggest and best-known ETF tracking the most established foreign large-cap index around, and it is still one of the best choices for a core foreign-stock holding. PAGEBREAK

iShares MSCI Canada Index EWC
One-Year Return: 52.8%
Price/Fair Value: 0.95
This single-country fund has a strong cyclical orientation. The top three sectors include financials (which accounts for 35% of the portfolio), energy (27%), and materials (19%). Risk-averse investors should note that this fund has a high exposure to commodities through its holdings in oil producers and gold miners.

Vanguard Total Stock Market ETF VTI
One-Year Return: 43.2%
Price/Fair Value: 0.96
This ETF covers the entire U.S. stock market for a rock-bottom cost of 0.09% a year, and it provides investors with one of the finest core holdings in the ETF universe. The fund tracks the MSCI U.S. Broad Market Index, which includes nearly all publicly traded domestic stocks.

iShares Dow Jones US Oil & Gas Ex Index IEO
One-Year Return: 41.9%
Price/Fair Value: 0.96
Given its extremely narrow theme focus, this thematic ETF should be treated as a satellite specialty holding to complement a diversified portfolio, albeit one that could be held for several consecutive years.

iShares Nasdaq Biotechnology IBB
One-Year Return: 41.2%
Price/Fair Value: 0.99
The fund tracks roughly 130 biotech firms that are listed on the Nasdaq and have market caps of at least $200 million. Suffice it to say that there aren't many Johnson & Johnsons JNJ or Pfizers PFE in that cohort: The fund invests nearly one third of assets in small-cap names that are plying innovative techniques to research, develop, and commercialize various drugs targeting certain diseases or therapeutic niches.

A Closer Look at Frontier Markets
Historically, international stocks offered risk diversification benefits as a result of lower correlations to U.S. stocks. However, correlations between U.S. and international markets have increased significantly over the past five years. At one time, emerging markets provided potential for diversification, but performance soon became coupled with developed markets. With U.S. and international markets becoming more correlated, frontier markets have grown in popularity. While frontier markets are believed to be less connected to developed markets, this may no longer be the case, according to Morningstar senior research and communications analyst Preethi Parmar. Investors thinking of diversifying their portfolios to include investments in frontier-market stocks may be wise to take a closer look.

This image illustrates the 12-month rolling correlation of U.S. stocks (represented by the S&P 500) to frontier-market stocks (represented by the MSCI Frontier Market Index) and international stocks (represented by the MSCI EAFE Index). As of December, correlation between U.S. and frontier-market stocks was as high as 0.7. This is much different from the days when frontier markets were negatively correlated to U.S. markets.

Buy These Funds While You Still Have a Chance
One of the few good things about the 2007-09 bear market was that a number of fine stock funds that had been closed to new investors reopened. Despite the stock market's robust rebound over the past year, most of these reopened funds haven't been overwhelmed with new money. As a result, they're still open--but that may not be the case for or long. Russel Kinnel, Morningstar's director of mutual fund research, recently pointed out three funds to get into while they're still open.

At Royce Special Equity RYSEX, hot performance generally comes during down markets. Manager Charlie Dreifus' emphasis on firms with clean accounting and healthy balance sheets has helped make this small-company stock fund one of the best performers during bear markets. In 2008, for example, it lost 19.6%, compared with a drop of 33.8% in the small-company Russell 2000 Index. Because of Special's performance history, money tends to flow into the fund near the end of bear markets.

Vanguard International Explorer VINEX, which invests in fast-growing small and midsize foreign companies, has a significant advantage over its rivals: It charges only 0.45% a year, 0.5 percentage point less than its next-cheapest no-load-fund competitor. A team from Schroder Investment Management, led by Matthew Dobbs, has produced strong long-term results with a patient approach, holding stocks about three years on average. The fund's asset level, currently $2.2 billion, is a little higher than it was when it last closed, in 2004.

The last time Sequoia SEQUX closed to new investors, in 1982, it remained shut for a quarter of a century. Assets at the time of the first closure were about $248 million; today, they total $2.9 billion. One of Sequoia's founding managers, the late Bill Ruane, had close ties to Warren Buffett. The fund is now in the hands of a new generation of managers, including Bob Goldfarb, who joined the firm in 1971 and has been a manager of Sequoia since 1998.

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