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Middle-of-the-Road Investing, Treasuries, and More

A roundup of investment news.

Morningstar Analysts, 08/03/2009

Middle-of-the-Road Strategy Can Pay off in the End
Small caps historically have outperformed large caps as the economy emerges from recessions. Since the market lows in March, small caps have handily outperformed larger stocks. Whether this trend will continue is anyone's guess, but a look at the past shows that the outperformance of small stocks and large stocks alternates over time and that these shifts in leadership between cycles can vary in length and magnitude, Morningstar research and communications manager Jim Licato says. Investors who don't want to get caught up in the commotion of guessing whether a particular cycle has started may want to consider mid-caps.

"What makes mid-caps potentially good investments is that they are large enough to have strong brand recognition yet small enough to experience solid growth," Licato says.

Licato points to the boom and bust of the 1990s and early 2000s as an example of how investors can benefit from mid-caps. In the 1990s, mid-cap stocks performed well--not as well as large-cap stocks but better than small caps. When the markets turned during the early 2000s, mid-caps weathered the turbulent market better than large stocks while slightly trailing small stocks. In both time periods, mid-cap investments provided consistent performance independent of the market's direction.

From January 2008 through May 2009 (view the related graphic here), mid-cap stocks slightly lagged both large- and small-cap stocks, with small caps leading the way. Whether large caps reassert themselves in this uneven market or small caps manage to stay on top, mid-cap investments should remain a solid option for investors who prefer not to predict the future.

Licato makes one more point: He examined the risk and return statistics of all three size groupings over the past 15 years and found that mid-caps produced the highest return of all three (6.5%) for the least amount of risk, as measured by standard deviation (19.6%).

A Contrarian's Take on Treasuries
Over on MorningstarAdvisor.com's Markets & Economy blog, financial advisor and blog contributor Janet Briaud gives a few reasons why it makes sense to have some Treasury bonds in your clients' portfolios:

1. There is still the possibility of deflation. "In fact, in the Financial Times' Economic Outlook (the week of June 14), we see that we are already experiencing some deflation: The annual CPI rate has fallen to -0.9%," Briaud writes.

2. The prices of goods are declining, especially large items such as houses, electronics, and cars. As investors wait on the sidelines for even cheaper prices, you have deflation.

3. There is a major shift from spending freely by investors and businesses to a new frugality. "I believe that this is a long-term trend as investors stop their high spending using leverage and instead pay off their heavy debt loads," Briaud writes. "The emphasis now is on cutting back on spending or taking care of what you have."

4. The unemployment rate is now more than 9%, but when underemployment is factored in, the rate is more than 15%.

5. One cannot rule out the possibility of the market testing the new lows, at which time investors will flee to Treasuries.

6. "As a contrarian, I am always interested in the least-loved asset," Briaud writes. "I have found that when everyone is saying the same thing, everyone is often wrong. Investors today believe that the interest rate on 10-year Treasuries is too low. But if, for example, we experience -1% inflation and we make 3% on our Treasury bond, a real return of 4% on our fixed income is quite attractive."

Peter L. Bernstein Remembered
Paul D. Kaplan, Morningstar's vice president of quantitative research and a frequent contributor to the magazine, wrote the following on the company's intranet site after the death June 5 of Peter L. Bernstein:

This week, while we were commemorating our 25 years of contributions to the investment industry, we received some sad news that dampened our celebrations. A great historian, commentator, writer, and editor in the investment field, and a friend of our firm, Peter L. Bernstein, passed away at age 90.

Peter published many books that popularized many of the investment theories that we use everyday in our work, such as Modern Portfolio Theory, efficient market theory, risk modeling, and alpha-beta separations. But Peter went beyond explaining ideas. In a unique way, he told the rich stories of how these ideas came about and the people that thought of them. In my view, three of Peter's books are must reads for us at Morningstar.

* Capital Ideas: The Improbable Origins of Modern Wall Street (1991)

* Against the Gods: The Remarkable Story of Risk (1996)

* Capital Ideas Evolving (2007)

For many years, Peter edited the journal that he founded, the Journal of Portfolio Management. It is one of the most prestigious journals among institutional investment professionals. Over the years, important research papers by people at Ibbotson appeared in its pages, including papers by Roger Ibbotson, Peng Chen, Tom Idzorek, and myself.

These Prominent Funds Have Got the Hang of 2009
Managers of core domestic-equity funds have faced an exceptionally turbulent environment in the first half of 2009. But the skippers of large-cap offerings have encountered a very favorable climate in recent months, and Morningstar senior fund analyst William Samuel Rocco points out that a handful of funds that have taken advantage of the surge.

After all the ups and downs, the average large-value fund has returned 2% for the year to date through June 26. But David Williams guided Columbia Value & Restructuring UMBIX to a 14% return. Williams is an extremely patient investor who readily buys stocks in bunches and considers overseas opportunities as he looks for firms that can improve their profitability via reorganizations, management changes, or acquisitions. Meanwhile, David Kiefer and Avi Berg have produced a 14% gain at Jennison Value PBEAX. Kiefer and Berg are contrarians, and their late-2008 decision to add their stakes in then-beleaguered Goldman Sachs GS and Morgan Stanley MS has been a boon, because both names have returned more than 75% this year.

The typical large-blend offering has gyrated to a 5% gain this year. Mason Hawkins and Staley Cates have led Longleaf Partners LLPFX to a 23% return, though, by sticking to the names in their concentrated portfolio through tough times when they believe the trouble is temporary. Bill Fries, Connor Browne, and Ed Maran of Thornburg Value TVAFX have executed their distinctive strategy deftly in the first half of 2009. The fund is up 19% for the year to date through June 26. Joe Milano has earned a 23% return at T. Rowe Price New America Growth PRWAX. Milano has accomplished this feat through strong stock selection and by being willing to differ from the crowd.

FINRA Takes On Leveraged ETFs
It appears that as Morningstar's ETF team was calling for increased oversight on leveraged and inverse funds (see "How Leveraged ETFs Compound the Misery" in the April/May issue), FINRA was posting a response of its own.

In a recent regulatory ruling, FINRA warns of the risks of these funds and reminds financial advisors of their fiduciary responsibilities regarding the marketing, suitability, and understanding of these products. The ruling also calls on advisor firms to have adequate supervisory procedures in place to ensure that these obligations are met. For the providers of these products, FINRA reminds that all marketing material must include the disclosure about the daily return period and daily rebalancing in addition to warnings about what return patterns will look like over the long term.

"This is a huge step forward toward protecting individual investors from having exposure to these products unwittingly inserted into their portfolios," says Scott Burns, Morningstar's director of ETF analysis. "We hope that platform advisory firms and registered independent advisors alike will get the message. It will also give us at Morningstar a regulatory leg to stand on when dealing with questions from individuals and advisors alike regarding the use of these funds."

Sale to BlackRock Should Benefit iShares
The sale of Barclays Global Investors to money-manager BlackRock has generated a lot of questions from investors about what the sale means for the future of the iShares group, ETF investors, and the ETF industry as a whole. To find some answers, we went to Scott Burns, Morningstar's director of ETF research.

How will this affect any iShares ETFs that investors own?
The sale will have no effect on the ETFs currently supported by iShares. IShares creates, markets, and administers the funds upon their release, but it is not the market maker or clearinghouse for these ETFs. That happens on the exchanges. It should be noted that the iPath group that provides exchange-traded notes is not included in the transaction and that those funds will continue to be serviced and sponsored by Barclays Capital.

Will BlackRock increase fees on these products?
It's highly unlikely given the hypercompetitive ETF landscape. Liquidity does have a downside for ETF providers like iShares. That is, if investors don't like your fees or your product they can vote with their wallets and easily buy your competition's fund with a few clicks on their computers.

What does the transaction mean for iShares and its leadership in expanding the number of ETFs and their adoption?IShares is the largest sponsor of ETF products, and its dedication to marketing and product development has helped spur the booming acceptance of these products, regardless of provider. I have no reason to believe that BlackRock will not continue to support the growth of iShares and their role in pushing the ETF market forward in terms of development and acceptance.

This transaction also brings new opportunities for iShares. BlackRock has a stable of established managers and funds to help iShares develop new actively managed ETFs. BlackRock also has a sizable global salesforce and expertise in marketing to institutions. BlackRock reps marketing iShares products could help increase adoption of ETFs by deep-pocketed money managers, helping to improve the overall asset size and liquidity of ETFs. That's something that would benefit investors and traders alike because it would help keep spreads tight and eventually lower the overall fees.

Wide-Moat Deals Remain as Value Gap Tightens
At the end of the second quarter, the market had come closer to fair value, Morningstar stock analyst Bill Bergman says. "We still see buying opportunities, especially among wide-moat companies. And we've been raising our fair value estimates, on balance, in recent months," Bergman says. "But the market rally since March has considerably closed the wide gap between price and fair value that prevailed during 2008 and into early 2009. Consider Buys have grown increasingly scarce."

Digging into the totals provides some useful color on recent valuation developments. Morningstar's equity analysts report the fair value estimates of 2,080 firms. Since the end of the first quarter, the number of fair value increases has run a bit ahead of the decreases (293 versus 280). In turn, the median increase in fair value estimates was larger than the median decrease. The increases are concentrated among firms that Morningstar has determined to lack an economic moat. The relief in the market in recent months is also evident in no-moat stocks, which saw the largest median percent increase in stock prices in Morningstar's coverage universe. On balance, the widespread stock-price increases outweighed positive net changes in Morningstar's fair value estimates, and the market-cap-weighted average price/fair-value ratio rose from 0.65 in the first quarter to 0.88 currently, while the simple median price/fair-value ratio rose from 0.77 to 0.92. (Companies with a price/fair-value ratio of less than 1.0 are undervalued; those with a ratio more than 1.0 are overvalued.)

While the market as a whole may look close to fairly valued, Morningstar's analysts still see opportunities, particularly among wide-moat firms. The median price/fair-value ratio for the wide-moat category looks significantly more attractive than elsewhere in Morningstar's coverage universe. Morningstar's Wide Moat Focus Index fell less than broader market averages from a 2007 peak into the March 2009 low, and it has since risen more than market averages. This index is an equal-weighted index focused on some of Morningstar's favorite wide-moat companies, and it has outperformed wide-moat companies as a group in recent months.

Five Still-Solid Government-Bond Funds
Government-bond funds have taken it on the chin this year as the recent market rally has brought back investors' appetite for risk. Long-term government-bond funds, a notoriously volatile bunch, are down more than 19% for the year to date through June 10. Intermediate-term government-bond funds have fared better, losing just 0.32%, while short-term funds have eked out a 0.63% gain. Those returns pale in comparison to the S&P 500, which is up more than 5% for the year.

Not all government-bond funds are struggling. Morningstar analyst Katie Rushkewicz says that some funds that have seen a reversal of fortune. Leading the pack are intermediate-term funds Putnam U.S. Government Income PGSIX and Putnam American Government Income PAGVX. Both funds tanked in 2008 because of nongovernment exposure and an aggressive approach that included leverage, but they're up 12.75% and 9.04%, respectively, for the year to date through June 10. Several short-term government-bond funds have held their own, including Wells Fargo Advantage Short Duration Government Bond MNSGX and Sit U.S. Government Securities SNGVX, which have gains of 4.04% and 3.59%, respectively. Predictably, most long-dated government funds have gotten trounced. PIMCO Real Return Asset PRAIX is the lone long-term fund in the black, up 2.81% so far in 2009.

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