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REITs, Target Dates, Dollar-Proofing, and More

A roundup of investment news.

Morningstar Analysts, 12/08/2009

REITs Look Good over the Long Term
REITs struggled mightily in 2007 and 2008, returning negative 15.7% and negative 37.7%, respectively, after racking up double-digit percentage returns in seven out of the eight years between 2000 and 2006 (equating to a compound annual return of 22.3%). REITs have bounced back in 2009 thus far, producing an annualized return of 23.3% through September.

Morningstar research and communications manager Jim Licato analyzed a longer (1972-2008) time period, and he found that REITs have generated an attractive compound annual return of 11.2%, placing them between large stocks (9.5%) and small stocks (12.5%).

Breaking down the total return, the income generated from REITs has been relatively stable and consistent, while the price return has fluctuated widely from year to year. With clients who are hesitant to invest in REITs because of the most recent real estate crisis, it may be helpful to show them what they would have experienced if they held REITs over long time periods. Consequently, the volatility of this alternative asset class should become much more palatable for them.

The chart below illustrates the realized losses in REITs for one-, five-, and 15-year periods.

(View the related graphic here.)

Of the 37 one-year periods from 1972 to 2008, eight periods resulted in a loss (22% of the years examined). When increasing the holding period to five years, however, none of the 33 overlapping five-year periods ended with a loss. Similarly, not one of the 23 overlapping 15-year periods produced a negative return.

These results go back to the income potential of REITs, which are required to distribute at least 90% of their taxable income to shareholders on an annual basis. During a year in which REITs may be struggling from a price-appreciation perspective, it always has the income component to fall back on. On the flip side, when REITs are prospering from a price-return perspective, the income return further enhances the asset class' total return.

The real estate bubble and burst may have your clients a bit hesitant when it comes to investing in an asset class like REITs. Clients must realize that they can expect to experience losses from time to time when investing in REITs.

But with a long investment horizon, losses can potentially be recouped.

Five Concerns about Target-Date Funds
Testifying before the U.S. Senate's Special Committee on Aging on Oct. 28, Morningstar vice president of research John Rekenthaler said that the target-date fund industry needs to address five concerns:

1. The wide range of fees charged by the target-date fund families Morningstar tracks. "On the low end, one target-date family has an expense ratio of only 0.19%. On the high end, another has an expense ratio of 1.82%-more than nine times higher than the first family," Rekenthaler said. "The issue of expenses is particularly important with target-date funds because of their very long time horizons."

2. The tendency of target-date funds to invest solely in their own company's underlying funds. "No reputable institutional investor would hand over his or her entire portfolio to a single asset-management firm," Rekenthaler said. "The institutional investor would not expect a single firm to excel at all types of investing. Yet that is implicitly the position taken by most fund families in running their target-date funds."

3. The lack of manager ownership. "Target-date funds would seem to be the ideal way for a fund manager to 'eat his own cooking,' given that target-date funds are openly marketed as being suitable for every possible type of investor," Rekenthaler said. "Yet only two out of 58 target-date managers whom we track list $500,000 or more invested in their own funds. Even more strikingly, 33 of the managers, or 57%, show nothing at all."

4. The variation in glide paths among funds closing in on their retirement dates. Rekentha­ler used 2010 funds as an example. "Two fund families have more than 70% of their 2010 funds' assets placed in equities. Conversely, three families have fewer than 30% of their 2010 investments in stocks. This divergence in asset allocation resulted in a wide difference in performance during the dramatic 2008 market,

5. Lack of transparency. "In gathering the data for an industry survey, Morningstar struggled to collect even the basic stock/bond/cash informa­tion for some of the target-date funds," Rek­enthaler said. "If Morningstar with its market presence and staff of data experts scrambled to learn the characteristics of the industry's target-date funds, then surely the everyday employee who seeks to learn more about his default investment faces real difficulties."

Rekenthaler testified that Morningstar recommends improved disclosure as the prescription for addressing the five concerns:

1. Create three new data tables that would be used only for target-date funds.

* A table comparing the fund's fees against the industry median fee and the industry's cheapest fees.
* A table showing the fund's use of proprietary mutual funds, again comparing with the industry median and the industry's lowest use.
* A table comparing the fund's glide path against the industry median. The fund company would be required to mention areas where it differs significantly from the median and the reasons for those differences. 

2. Move the manager ownership information that is contained within the obscure Statement of Additional Information to a position of greater prominence in the prospectus.

"Target-date funds are a clear benefit to employees who have 401(k) plans," Rekenthaler said. "They must improve further, however, if they are to fully earn their position of being at the heart of America's retirement future."

Dollar-Proofing with ETFs
The rising concern about the U.S. dollar's value has become impossible to miss. Gold has risen above $1,000 an ounce; investors desperate for energy exposure have kept natural gas in steep contango all year; and every other day, Morningstar's ETF analyst team gets an e-mail asking about foreign currency funds such as PowerShares DB US Dollar Bearish UDN. To address these concerns, Morningstar ETF analyst Bradley Kay drew up a model portfolio for investors who have a bearish opinion of the world's biggest currency.

The portfolio contains a hefty 58% allocation to global equities. For U.S. equities, Kay uses Vanguard Total Stock Market VTI and avoids overweighting U.S. small caps, which lack the foreign revenues that could cushion U.S. large caps in case of a dollar decline. After an incredible runup in 2009, Kay also avoids overweighting emerging-markets stocks relative to other foreign markets. "Thus, the two Vanguard ETFs based on the cap-weighted FTSE All-World ex-US indexes worked beautifully to fill out our sizable foreign equity stakes," Kay says. He substantially overweights international small-cap stocks, because they do the least business in U.S. dollars.

Kay allocates 20% of the portfolio to fixed income and splits the stake between domestic and international inflation-protected securities. "Because a falling dollar probably means that central banks are dumping U.S. bonds and yields are rising, we kept our TIPS allocation in a short-duration fund," Kay says. He says that he would have added foreign credit bonds to the portfolio but that is not possible with the ETFs available today. Instead, he splits 10% of the portfolio between two currency ETFs that together cover a range of the biggest global currencies.

Kay puts the remaining portions of the portfolio in gold ("it will certainly benefit if the dollar falls further"), small oil and gas producers ("to capture energy prices"), and Monsanto MON ("whose genetically modified crops will provide the higher yields demanded by farmers as prices rise").

The portfolio is not immune to a falling dollar, Kay admits. He says that it's more dollar-dulling than dollar-proofing. After all, it would be unwise to move entirely out of the dollar and into protective assets such as commodities and short-term bonds. If the bet turns out incorrect, such a skewed portfolio would miss out on considerable potential gains while also opening itself up to severe losses from falling gold and energy prices.

Without tremendous certainty about an impending collapse, Kay says that investors should stay diversified and merely tilt away from worrisome exposures.

(View the related graphic here.)

Mainstream Funds for Going Hybrid
With investors still fearful of risk and yet also afraid of missing a rally, Arijit Dutta, an associate director of mutual fund analysis with Morningstar, recently suggested one possibility: Take the middle ground offered by preferred stocks and convertible bonds. Dutta offers some examples of managers who have made hybrids an important part of their strategy:

Calamos Growth & Income CVTRX
The fund is close to being a poster child for hybrid investing. The portfolio is split between common stocks and hybrids and is designed to provide a balance between upside potential and protection from sudden downswings.PAGEBREAK

Fidelity Strategic Dividend & Income FSDIX
Lead managers Joanna Bewick and Chris Sharpe allocate assets into stocks, real estate investment trusts, convertibles, and preferred stocks according to their bottom-up assessment of where they see the best value to grow income.

Franklin Equity Income FISEX
This fund's focus on hybrid securities is fairly recent, timely, and makes a lot of sense based on management's competitive advantage. Comanagers Alan Muschott and Ed Perks gave the portfolio a makeover in 2008, incorporating a heavy role for preferreds and convertibles in the strategy.

Thornburg Global Opportunities THOAX
Lot of aspects of this offering suggest that it is one of the most aggressive world-stock funds. So it's particularly interesting that managers Brian McMahon and Vinson Walden have found compelling opportunities in corporate bonds and preferreds.

Nuveen Tradewinds Value Opportunities NVOAX
Manager Dave Iben will place massive bets against the benchmark if he sees great long-term prospects elsewhere. Hybrid securities are also a permanent feature of Iben's strategy. We would like the fund even more if expenses were to come down.

Post-Reform Health-Care Picks
The exact outcome of health-care reform is uncertain, but speaking Nov. 5 at the 2009 Morningstar Stock Forum, analysts Bill Buhr, Debbie Wang, and Karen Andersen said that some companies stand out by being able to weather the possible outcomes. More-diversi­fied pharmaceutical companies are most attractive in the face of uncertainty. Some favorites include:

* Novartis NVS has a large exposure to gener­ics, which the analysts said they think will be a winner from reform.
* Abbott ABT has done a good job making smart acquisitions. It has a strong product portfolio and less exposure to patent expira­tions than many pharmaceutical companies. Its diagnostics business should also buffer it from volatility in the drug market.
* Johnson & Johnson JNJ also has a strong pipeline of drugs. It also has great free cash flow and device and over-the-counter busi­nesses, which offer downside protection.

Biotech as a whole isn't as undervalued as pharmaceuticals, but the analysts said that they like Genzyme GENZ. Genzyme has had manufac­turing issues that have opened the door to competitors, but the analysts said that they think the competitive concerns are overblown. In terms of devices, the analysts said that new developments that demonstrate a clinical benefit will be able to command pricing. For example, Medtronic MDT is working on an MRI-compatible pacemaker. Since 50% to 75% of pacemaker patients eventually will need an MRI, such a device should be able to fetch higher prices.

Three Stock Picks Keep It Simple
Paul Larson, editor of Morningstar StockInvestor newsletter, offered portfolio strategy pointers and shared his latest stock picks Nov. 5 at the 2009 Morningstar Stocks Forum.

Larson's central criteria is finding stocks with wide moats, and he stressed the competitive advantage of having a long-term focus. He said that he's OK with concentrated positions as long as investors are confident in the company. In his words: "Fewer baskets, closer watching of eggs." Larson's picks: 

* Exelon EXC is composed of two utility com­panies, ComEd and PECO; and a nuclear power generation business, Exelon Generation. The utilities are only narrow-moat businesses, but they are relatively stable. Exelon Generation, however, is a wide-moat business. Exelon is the largest nuclear power operator in the country, with 17 reactors. Exelon's valuation is compel­ling. It should earn a little over $4 a share in 2009, about 12 times earnings, and Larson said that he thinks that the company can earn at least $7 per share in 2012 as rate caps expire.

* Enterprise GP Holdings EPE, a pipeline investment MLP, is also attractive. It receives royalties from operations of various companies it owns. They provide a minimal amount of incremental capital but get a disproportionate amount of growth. It's a stable, wide-moat business. Taxable accounts are the preferred vehicle for MLPs.

* Lowe's LOW doesn't have the widest moat, but it has advantages stemming from econo­mies of scale and a national brand, and its currently low valuation makes it really at­tractive. Lowe's has had a rough go of it during the housing struggles. Same-store sales have been weak, and operating margin has fallen. But Larson thinks that same-store sales will go up 1% next year and grow at 5% for the next few years.

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