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Picks and Strategies to Navigate Today's Market

Mon, 7 Apr 2014

Roundtable report: Morningstar strategists offer up their best ideas for a fully valued, low-yield market with few attractive choices.

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Video Transcript

Jeremy Glaser: Hi, and welcome back. I'm Jeremy Glaser, markets editor for Morningstar. Welcome to our second panel: Navigating Today's Market, a Q&A with some of Morningstar strategists.

Over the next hour, we're going to look at a number of topics, from current equity valuations to what's happening in the fixed-income market, to what's happening in the retirement, and also a bit on how to deal with manager changes.

I'm here joined today by John Rekenthaler. He is a vice president of research and also the author of the Rekenthaler Report on Morningstar.com. With Russ Kinnel, our Director of mutual fund research and the editor of Morningstar FundInvestor. Sam Lee is a strategist and editor of Morningstar ETFInvestor. Elizabeth Collins, she is the chair of our Economic Moat Committee and also the author of the upcoming book on Why Moats Matter.

Thank you, everyone, for joining me.

John Rekenthaler: Good to be here.

Glaser: I have some questions. We're also going to be taking questions from the audience. So if you have any questions, please submit them into the box next to the player and we'll try to take as many as we can.

So let's start with equity valuations and what's happening with the stock market right now. It seems like we're hitting record highs, or near record highs, on a pretty regular basis. Do you see stocks as just being too overvalued right now, Elizabeth?

Elizabeth Collins: That's a good question. Thanks, Jeremy. Actually, you're totally right. In aggregate, we think that our coverage universe--and we have a global coverage universe--is slightly overvalued based on our estimates, our analysts' discounted cash flow models, our intrinsic values. We think that our coverage universe is trading in a price to fair value estimate ratio of about 1.04; so slightly overvalued.

Now, having said that, there are pockets of opportunity and pockets of overvaluation. For example, we think that the tech sector is particularly overvalued. Meanwhile, we think that the energy sector has a lot more opportunities, and we think that the energy sector in aggregate is undervalued.

Glaser: But that doesn't seem like a tremendous overvaluation. It sounds like we're basically within that fairly valued range.

Maybe some other indicators--people talk about the Shiller P/E or some other ways of looking at the market--are flashing a much more dangerous warning sign. Sam, I know you've looked at these pretty extensively. What are your thoughts on valuation?

Sam Lee: I think markets are more on the expensive side, especially relative to other markets. The U.S. stock market trades at higher price earnings, price book, price sales than other major markets all around the world. And I think that it's in the more elevated range. The Shiller P/E right now is about 25-26. Historically, it's averaged around 15.

People will say, the Shiller P/E says that the market is grossly overvalued. But I think that while the Shiller P/E is useful, it depends on what the average is. So the 15 average comes from looking at 130-plus years of average Shiller P/Es in the U.S. Is that relevant today? I would say probably not. The equilibrium Shiller P/E, that is the fair Shiller P/E, is probably considerably elevated [versus history], because U.S. equity markets are much safer today. The U.S. is a global superpower rather than an emerging market as it was 100 years ago. Everything is cheaper, more liquid. Taxes are less onerous. Information is clearer. So, I think that justifies a higher Shiller P/E.

But that said, I do think that many investors are becoming complacent. A lot of people are piling into the markets after a good five-year run, and they're saying, wow, the market is reasonably valued or very cheap, and they're looking at recent experience and projecting that forward.

Historically, the markets' intrinsic per share earnings growth after inflation has been about 1% to 2% per annum. So, this current market rally was not driven by necessarily a huge surge in the earnings power of the U.S. economy, but it was more about the revaluation from low valuations to high valuations right now, and you can't expect that to continue indefinitely. So I'd put myself into the slightly pessimistic camp.

Kinnel: From a funds perspective, I would say, what I worry about is a repeat of 1999. When I see really aggressive funds have had tremendous returns--they've got Twitter and Tesla and Netflix, and a lot of [exposure to] areas where it really feels a little more speculative. I worry a little more about that than the rest of the world, which doesn't seem so extreme.

Rekenthaler: I would worry too if it felt like 1999, or maybe 1996. But of course, that's when the irrational exuberance, Alan Greenspan's comment, occurred.

Speaking of 1996, the Shiller ratio was about at this level in 1995-1996, and we had a nice run from there, although we paid for it, at least the technology stocks paid for it.

Then again, about 2004 it was there and made some good money for the next three to four years, although we paid for it again. I'm going along with Sam's conclusion of the message being mixed right now. I wouldn't say there are clear signals. I don't feel like we're in a 1999 bubble. I was here in 1999--it did feel different--but at the same time, a lot of the pessimism has gone by.

In terms of the signals being mixed, one example would be the study that Russ does every year, the Loved and Unloved funds. It's a contrarian study, and you find the fund categories that get the most cash tend to do poorly, because they are too popular and overbought, and the categories that are being redeemed tend to do well.

Well, you've got two U.S. stock categories: One is on the loved list and one is on the unloved list, the large blend and the large growth. They are not going to go in different directions. … You're getting a mixed signal on your Loved and Unloved list. I think that's a mixed signal and, as Sam says, I'm slightly pessimistic as well on that, too.

Glaser: That leads to my next question about investor behavior or what investor should do if we are in this market that's either somewhere from a little bit overvalued to maybe more pessimistic, quite a bit overvalued. What should investors do or what are they doing? Are we seeing big flows into certain parts of the market, people chasing performance? Are we going to see again a repeat of investors using good funds poorly?

Kinnel: The other study I have done recently was a study on investor returns, where we found that the gap between actual fund returns and investor returns had grown. Part of that was, it goes back to 2009 when investors were selling their stocks and buying bonds. Clearly, a case of selling low, and obviously five years later, that's been magnified by the great rally we've had. More recently, they've started to sell bonds and buy stocks--again, it worries me a little bit.

I guess, my answer would be: one, be cautious--this is not the time to get greedy; and two, really build a good plan and have the right expectations, so that you don't get thrown as much. Investors do poorly when they get emotional and they feel fear, greed--and so the antidote to that is one, to buy funds that tend to be on the cautious side, that don't have the extremes; but two, to have a plan, so you really understand why you own what you own.

Rekenthaler: Just to add to this, I would say, from a tactical perspective, one of the lessons that you get from the work that Russ does and mind the gap is, most people, when they make trades of funds, they are bad trades. They would've been better off being in the fund that they were in as opposed to making the trade. It's not because they buy a bad fund, but they buy a bad asset. They buy an overpriced asset.

In general, I think if you're looking at making a trade and you're moving into a category or type of asset that has had good performance over the last five years, you probably shouldn't make that trade. Now, if you are looking at reshuffling your portfolio and moving to something that's performed poorly, your odds are better. It's paradoxical, but that's how it works.

Glaser: We have a question from a user, asking that, because markets are cyclical, are you worried about a correction anytime soon? What would some of the warning signs be for a correction? And if you were worried about it, should you do anything? Should you try to make that trade? John seems to think that maybe you're going to do yourself more harm than good.

Kinnel: I would say that, one simple thing is just rebalancing to back to your original target asset mix. So, today that would mean selling some U.S. equities, and that's not a bad thing. But what I wouldn't do is go further and say, "Oh, I've got to get out. I've got to go down to 10% equities," because market timing is hard, as John has suggested. Collectively we see people, whether it's institutions or individual investors, tend not to get those moves right. So, I don't think you want to go to extremes. I think rebalancing make sense, but other than that, maybe just be cautious and understand that we are in a great rally. It's been a while since we had a correction.

Glaser: Russ, do you think it would make sense, if somebody … for example, my portfolio, my equities tend to be pretty U.S. focused. Is it a good time for me to diversify outside of the U.S.? You would probably say it always is, but is this a particularly good time?

Kinnel: Europe and emerging markets have both had some rough years lately. So by a lot of people's measures, they are relatively cheap. U.S. and foreign, I don't see why you don't have a 50/50 mix or something like that. I don't think the exact mix matters. Emerging markets had a rough year last year, so they are probably a little cheaper. Europe's had a rough five years, though more recently it's rallied. So, I would say, it's not a bad time to diversify.

Lee: I agree. In my own portfolios, the portfolios I manage for the ETF investors, I'm overweight international equities. So I'm about anywhere from half U.S. equities of my total equity allocation to about only a third U.S. equity. So I think...

Rekenthaler: So my 5% international position is light?

Lee: It's very light. But I come from an asset allocator's perspective. The U.S. economy, I think, is special. The U.S. stock market is special. So it warrants higher valuations, but I don't think it warrants the higher valuations we see today. A lot of people are thinking that the U.S. is way better; why own these international stocks, emerging markets stocks. The U.S. market has kicked butt over the past five years. But in the long run, it's the opposite. The intrinsic values of big global stock markets don't shift around too dramatically. So if the U.S. has rallied furiously over last five years, and the others have languished, it doesn't mean that the U.S.'s intrinsic value has grown that fast. The chances are it's overshot, and the international markets have undershot.

Kinnel: The last time that we heard, "You don't need foreign markets, the U.S. is so awesome," was '99.

Rekenthaler: I will say, when you look at the revenues of the companies that I own through mutual funds or direct stocks, it's a lot more diversified. I've got a lot of big multinationals. It's less of an issue than it used to be--the markets are clearly correlated.

Lee: Well, I would actually argue that would argue for diversification, because if the U.S. stocks are heavily exposed to international equities--so they're competing in these economies that these foreign firms are also competing in--you're paying a higher multiple for every earning that the U.S. firm is getting versus a lower multiple of domestic stocks.

Rekenthaler: But the U.S. firms are more efficient.

Collins: I'll echo what you guys have been saying with our global coverage universe, and based on our fair value estimates, that North America looks more overvalued, Asia-Pacific, based on our intrinsic value estimates, looks more undervalued from an individual stock-picker perspective.

Glaser: So would you say it's more of a stock-picker's market then? That you really need to pick your places?

Collins: I think that is always the case. I wear a stock-picking hat most of the time, not like these guys. We'll say what we always say, which is that it's important to look for companies that have sustainable competitive advantages and to buy those companies when they are trading for less than intrinsic value. You're never going to hear us say anything different than that.

Glaser: But in a market that doesn't have a lot of stocks trading below their intrinsic value, are there sectors that you're finding values? Where should an individual stock-picker be looking right now?

Collins: You're right. We're in an unfortunate position right now. For example, we don't have many, or any, wide moat companies--companies that we think can sustain economic profits for 20 years or more--trading at a 5-star price, meaning significantly undervalued.

We do, however, have a lot of wide moat companies, or enough wide moat companies, trading for a 4-star price. Household names like Unilever, Wal-Mart, Berkshire Hathaway. So there are opportunities, especially from an individual investor's perspective, in the stock-picking part of your portfolio, where you don't have to stay fully invested, and where you can be more flexible and you can take these opportunities and be more concentrated, things of that nature.

Glaser: If it is a market where you really do have to be careful, is that a case for active management right now, versus indexing. Or is that really not the kind of thing you want to try and time with valuation or with the kind of market you're looking at?

Lee: I would say that, philosophically, you don't switch between active and passive management depending on valuation. Mathematically, the passive side will always collect the market return minus fees, and the active side will also collect, in aggregate, the market minus fees. So switching isn't necessarily a good proposition. Are there some managers who are more skilled doing overvalued markets and more expensive markets? I don't know, and it's hard to say. These are the types of judgments that are very difficult to come to an informed rational conclusion about. So I would say that it's not time to switch around; find active religion or passive religion.

Rekenthaler: The thing about corrections is, each one of them is so different. If you look at 2000 to 2002, active managers did quite well in aggregate, and many of them very well relative to a market index. And hedge funds--which are like active management squared and also with active management squared or cubed fees--did even better. They were breaking even when the markets were losing 20%.

So then you draw a conclusion, and active managers were saying this, "See, we'll protect against downturns." Then 2008 hits and everything is going down at the same time. There are really no havens, no places to hide out, not just in the U.S. stock market but overseas, and everybody goes down together, and it's a completely different experience. So which one of those two do we look as our model for the next correction? It's probably going to be something different entirely.

Kinnel: I don't believe in active stock-pickers' markets versus indexing. If you correct for market cap, etc., you really see active management do about the same every year. And even if there were [stock-pickers markets], it would be even harder to predict when that happens. So I think you should stay with your plan.

Glaser: So if you were either active or passive, what would some funds be that you might be interested in right now? Maybe funds that have a non-U.S. bent, or that maybe are looking in parts of the U.S. market that are a little bit less expensive.

Kinnel: Well, one I'll throw out there for the reasons we've touched on. I think world stock funds are great because you get a stock-picker, you just give … the world and that's really how they look at it. So a fund like Dodge & Cox Global is a great one. You've got very good value investors, looking out at the long term, and you just give them free rein to make their best pics. There are a lot of other world stock funds, but to me that has a lot of appeal. When you talk to active managers, they really think of sectors--they rarely think, oh, I have got to buy a U.S. pharma or something like that. It's much more they think in terms of sectors and globally. So, I think world stock funds make a lot of sense.

Glaser: Sam, do you have any passive picks?

Lee: My picks are very boring. Just go with a low-cost, market-cap-weighted international ETFs. Vanguard has couple of excellent ones. One is VEU, Vanguard FTSE All-World ex-U.S., and the other one is Vanguard Total International Stock Market, VXUS. Both are dirt cheap. You can just sock your international equities exposure with those funds.

Rekenthaler: Sam, is there an ETF that's just the world, not ex-U.S.?

Lee: Vanguard Total World Stock Market, VT, but the problem with that is it's expensive. So you might as well just own a U.S. and an international ETF.

Rekenthaler: And have a lower aggregate expense ratio?

Lee: Yes.

Glaser: Let's shift our focus to fixed income. We've gotten a lot of questions asking about how to think about your bond sleeve. One question: Is it wise to invest in bond funds, considering that interest rates look like they only have one way to go, which is up? How should we think about your bond allocation? Why should you hold fixed income today?

Kinnel: I think, one, for some of the reasons we laid out: It's hard to predict the direction of markets. It's good to diversify. There is still some diversification value. Bond funds or bonds are not going to make you rich, and there is a fair amount of risk. A year ago, we were talking about TIPS being particularly risky, and in fact, they did get hit last year. There are some ways--bank-loan funds, TIPS--that may help you a little in an inflationary or a rising rate market, but bank loan funds have really gotten a ton of money in. So bank loans are not particularly attractive.

My answer would be: don't chuck all your bonds, but maybe be conservative. A fund like Fidelity Intermediate Muni: because munis have had a little rough go of it, so they are still relatively attractive, and intermediate just because it has a little less interest rate risk.

I think there's some merit to holding it, but it's not exciting, and it's not a time to take big risks to chase yield.

Lee: Bond pricing is fairly easy. Your expected return is going to be the yield, especially in high-quality bonds, and yields right now are miserable. So if you own bonds, you are going to lose money probably after inflation and after taxes. And the reason you own bonds is, as a deflation hedge. That is, if a recession, if Japan 2.0 occurs, then bonds will do very well. Bonds are for helping you sleep, helping you get through those rough patches.

Warren Buffett advocates a lot of equity exposure, but in his recent shareholder letter, he disclosed that he has instructed in his will that the trustee should invest in 90% Vanguard S&P 500 Index and 10% in short duration U.S. Treasury bonds. The reason why he says that you should own 10% bonds for his wife is because it will help you tide over during terrible markets when you don't want to be selling. So bonds are for helping you sleep. But that said, they are not going to make you rich.

Incidentally, a lot of people are thinking that since bond yields are so low, they are going to go out on the risk curve, and they're going to invest in higher-yielding things, and that obviates the role that bonds should have in your portfolio. Historically, the best place to take your risk is in equities, and the best place to have a more conservative posture is in fixed income. When you go into the nether realm of aggressive fixed income--junk bonds, bank loans, things of that sort--the risk-adjusted returns have actually not been that good. Historically, the junk bond index has only barely outperformed the equivalent-duration Treasury bond index. Historically, there's been a very thin credit premium to junk bonds, and a lot of that credit premium disappears once you take away frictional costs. So my advice is, tread carefully. You really can't do much, so take your lumps and go to low-yield, high-quality bonds for the most part.

Rekenthaler: One of the big trends in bond funds the last couple of years has been the move to unconstrained or non-constrained or non-traditional bond funds. Funds that will have a much lower duration, less interest rate sensitivity, more flexibility. The argument, which makes sense, is, we know interest rates are historically low … this is when they came out a couple of years ago--they've backed up a little bit … and why be long, on a long fund? Own a non-constrained fund that can be not as interest rate sensitive when rates do back up, and we know the Fed is going to raise rates and so forth.

But the problem with that is, so many of those funds, how are they getting yield? They're still getting some sort of yield and some return. They're getting it on credit risk. They're taking credit risk. When they take credit risk, they become a lot more correlated with stocks. So now, instead of being diversified into stocks and bonds, you have stocks and quasi-stocks. If we get the stock correction, I think some people are going to be surprised at how their bond funds don't protect them, if they're in some of the newer bond funds. So I would caution people to think, what are you buying this bond fund for? And if it's truly for diversification and protection, then you need to let go of a lot of these newer ideas and the credit-sensitive ideas, and just have a boring 2% to 2.5%, whatever it is, high-quality governmental fund.

Lee: You don't even have to go with high-quality governments, because interestingly enough, banks offer CDs and even high-yield accounts that offer 1.5%-2% yields. So between the Barclays Aggregate Bond Index, which yields about 2%, and a risk-free FDIC-insured CD that a bank offers, I think it's a no-brainer to go with the CD. So I don't understand the trend toward short duration high-quality bond funds, because you're going to get a crappy yield, and you're better off owning a CD.

Rekenthaler: One final thing on the non-constrained or nontraditional bond funds. It's a very mixed group. So my comments will apply to some of those funds but not others. That's an area where you really need to do your homework and look at each fund individually, because some of them take a lot of credit risk, some less. Some of them the durations move around a lot and so forth. So, they're unpredictable funds that take a lot of work, actually, to monitor and to hold.

Glaser: Russ, do you have a sense of which ones you think are more conservative there, and which really go out on a limb?

Kinnel: FPA New Income is unconstrained, but it almost always errs on the side of caution. So it's going to have less interest rate risk and less credit risk. It'll move out … if bond yields ever get a little healthier, they might move out to something close to the Barclays Aggregate.

Then you'll have a fund like PIMCO Unconstrained that has much more flexibility. It might have less duration than the market, it might have more. It might have more credit risk, it might have less. So that one has a lot more flexibility and is more aggressive. As John says, you don't know exactly where it's going to be, because Unconstrained doesn't mean always betting on a rise in interest rate. So I think the FPA fund, if you are looking for a cautious fund that's not going to get burned very much, that's an attractive one. And they removed the load. So it's accessible for no-load investors. They removed the load about a year ago. So I like that one.

Glaser: We heard about inflation a little bit in the first panel that we just haven't seen a lot yet. Is inflation something that you're concerned about? Is now the time to get ready for it? If so, it sounds like trying to take risk in bonds doesn't makes sense. Does it make sense to look at stocks for inflation protection.

Collins: When we think about inflation from the perspective of companies and their ability to weather inflationary storms, we again tie it back to economic moats, and whether or not companies have competitive advantages. Companies that don't have competitive advantages, sell commodity products, don't have any cost advantages, are price-takers also on their supplies won't be able to weather the storm of inflation. They'll have margin compression. Meanwhile, companies that do have competitive advantages, companies that have bargaining power over their suppliers or have brands, have strong intangible assets and therefore pricing power against their customers, those types of companies will be able to weather the inflationary storm, and that's what we look for with our economic moat rating.

Glaser: Are there any other inflation hedges that you think might be worth looking at now? Or is inflation just not a concern?

Lee: Inflation is always a concern. It's always occurred with governments and economies that use paper currencies, because it's rational for governments to inflate away their liabilities. Policymakers, the people in charge, have a strong incentive to promise a lot of things right now and let other people pay the bill down the road.

Historically, when the U.S. government or when big governments are heavily indebted, they've tended to let the printing presses run a little bit and let inflation erode their liabilities. You saw this after World War II, you saw this after the American Revolution. Even a government as credit worthy and sterling as the U.S. has resorted to inflation before. So if history is any guide, then inflation is probably going to be a tool that will be used.

Rekenthaler: I think when we talk about inflation, we can think about it in a couple of ways. Your question is, is there perhaps an inflation shock coming this upcoming year or the next year--relatively soon as opposed to further out--and how to position your portfolio for that. It's tricky. Probably just be broadly diversified. But that concerns me less than the notion of inflation eroding purchasing power over a long period of time. That's what really affects your life, if you find yourself in an inflationary regime, like in the '70s, and it's year-after-year and you're locked into the wrong assets.

When you take a longer perspective, actually stocks do very well as an inflation hedge. Even in Weimar Republic, stocks maintained a lot of their value when people had their Deutschemarks in a wheelbarrow …

Kinnel: John was just a new fund analyst back then, and he remembers.

Rekenthaler: Rekenthaler is a German name. No, I wasn't quite there at the time, but there were people who have done research on this.

And commodities and gold that are thought of as inflation hedges … Actually, people remember that because of the 1970s and they did well in the '70s, but there have been other inflationary periods and in other countries where they've not held up particularly well.

A lot of people think, if inflation is around the corner, own a lot of gold. Or if the government is going to erode the value of the greenback down the line, own gold and own commodities. I think, actually, own stocks, because companies can adjust their prices and will adjust their prices, and there are some short-term shocks, but over the long term, they continue to make money in inflationary environments.

Lee: I agree 100%. Although if you are a retiree or someone near retirement, one problem is, equities do tend to experience P/E compression when we are in an inflationary regime. So if you can't weather the storm for another 10 years or so, then you might be out of luck…

Rekenthaler: Mine was the long-range answer definitely.

Lee: Yep. So if you have to sell a lot of equities in an inflationary, low P/E type of market, then you are going to be hurt no matter what.

So in this case, there are only really two good options. One is TIPS. So somehow annuitize a stream of known expenses that you are going to make, or even cash, because the central banks have historically raised short-term interest rates enough to make it such that cash maintains much of its purchasing power, especially if it's in interest-bearing assets.

Kinnel: Following up on your TIPS point, Vanguard recently came out with a short-term TIPS fund. People were shocked, I think, when some of the long-term TIPS funds, including Vanguard's, got hit last year, because they have inflation protection, but not rising rate protection. We had the perfect storm for TIPS last year. Vanguard now has a short-term TIPS fund, which is more of a pure inflation hedge, so I think that's worth a look, too.

Glaser: On the commodities front, even if you did want to think about investing in gold, does it make sense to buy gold miners on the equity side of that business, buy commodity-related companies? Would that be another way to play that?

Collins: Let me answer the gold/gold miners question first, because it's a separate beast than other commodities producers.

Over the past several years, if you were deciding between owning gold outright or through an ETF, GLD, versus owning the gold miners, the answer is unequivocal. For sure you should have owned gold--not the miners. The miners faced cost inflation, geopolitical risk, production disappointments, and gold mining equities severely underperformed gold the commodity.

Now versus other commodities--oil, copper, things of that nature--we do think that it's, again, going back to stock picking, is a great idea, because you can find companies. You get the commodity price assumption right; that's hard. But then you can also look at company-by-company analysis, figuring out which companies have competitive advantages. Which ones will be able to grow production faster than the market expects. Which ones have the opportunities to lower their cost profile. This is where putting on your stock analyst hat plus a commodity pricing forecasting hat can lead to outperformance.

Glaser: Do you have any ideas of that nature right now?

Collins: Sure. Like I said before, the energy sector is one where we see a lot of undervaluation right now, and the energy team does have a handful of picks right now.

In the upstream space, the oil and gas production space, we have Ultra Petroleum, Devon Energy, and Denbury Resources. Then in the midstream space we have, Energy Transfer Partners and Tesoro. Those are some of our energy team's picks right now.

Rekenthaler: I would like to add: earlier I was skeptical about the value of most trades that people make in the mutual funds, but most people when they're making mutual fund tactical trades are moving into something that's gone up a lot. That's why they're buying it, because the total returns look great and the numbers look great for that fund or that asset.

Energy and precious metals, that's something that people don't like right now. They are moving out of those areas. They show up on your unloved funds list. That's a positive contrarian sign. Your stock team thinks there are values there.

I think when you look at the fact that the stock team and the contrarian sign of fund flows both are saying, in particular, that energy is an attractive area right now, that might be worth a tactical trade. That's a contrarian tactical trade.

Just because people in general don't trade successfully doesn't mean there aren't some trades that are worth making. It depends on your risk tolerance and how much you're willing to take a chance with portfolios. But that's where I would be looking to make a trade right now.

Glaser: On the energy side, we just got a question about if there should be concerns about MLP investing. These master limited partnerships have run into some bumps recently, with Boardwalk Pipeline Partners, obviously sharply cutting their distribution, and some worries about Kinder Morgan being aired very publicly. Do you think these are concerns that extend past that, or are these more idiosyncratic issues?

Collins: I don't think that anything has changed fundamentally about MLP investing. It's always been a situation where minority shareholders have different rights than they do in corporations. Also, MLPs, pipeline companies, are very capital-intensive, and they need access to capital markets, and they pay out much, if not all or more, of their free cash flow as distributions to unitholders. So they need to do well in order to pay their distributions, and those things have never changed.

What that means is that, what can look like steady companies that have pipelines aren't always because they need access to the capital markets. I don't think anything has changed. It just means that you need to know more about the companies that you're investing in. You can't paint them all with the same brush, and company-by-company in-depth analysis is important.

Glaser: Let's switch gears a little bit to talk about manager changes. It is a bit of a different subject. But we've had a very high profile situation with PIMCO, with Mohamed El-Erian's departure over the last couple of months being played out in the papers. We recently downgraded our Stewardship Grade and Parent Pillar on PIMCO and on some of these concerns. When you're thinking about these manager changes, how important are they really in the investment process? Is this just noise? How do you, as a fund investor, handle these big headlines?

Kinnel: I think you want to attack it by asking, how important was this person in the process? Who is replacing them? In most cases, a fund is run by a team of people, even if there is one person named as the manager. So, for instance, at PIMCO, Bill Gross is the named Manager on PIMCO Total Return, but there are scores of people contributing to this.

You have a mortgage group, a corporate group, sovereign. You have traders. You have analysts. A lot of people are contributing there. So you really want to assess who are the new people? Are they going to make changes? Often it's the case that one person leaves, but the rest of the team is still there, and they were largely responsible for the success anyway. So you can still have faith in a fund like that.

In the case of PIMCO, we did lower the stewardship because Bill Gross is 69, and his appointed successor just left, and so that leaves PIMCO in a lurch a bit of. All of this bad press makes it clear what I thought we already knew, which is that it's not an easy place to work. So I think you don't send your resume to PIMCO, but you can probably still send your money, because they still have a lot of very good people there. We're going to watch to see if more people leave, but we've got a lot of good people. We're still rating PIMCO Total Return Gold even though we lowered the stewardship rating of PIMCO.

I think you really want to understand who the managers were. When you buy a fund, you should even think through that case: How important is this one particular manager? Who's behind them? And that will help you to make a decision when there is a change.

Rekenthaler: A manager change is not a manager change, in the sense that it really depends on the situation. There is such a wide variety of funds and a wide variety of roles and responsibilities.

Let's take Fairholme Fund, the Bruce Berkowitz show. This is an old-fashioned fund in the sense that you've got a sole portfolio manager out there really just driving, his personality, the kinds of companies he likes. If suddenly he were to hand this fund over to somebody else, which is a little unconceivable, but if he were, it would end up being a very different fund.

Or you've got a short/intermediate-term Treasury fund, where no matter who's in charge of this thing, the range of returns is very small. You could put me in-charge--and I'd be the worst short/intermediate-term Treasury manager in the world probably, since I'm not trained for it--but there is only so much damage I can do. And there is a whole spectrum in the middle.

I think with PIMCO Total Return Fund--although the fund is very complex; you look at the portfolio and you're scratching your heads and so forth--actually, it's not really one of the wilder bond funds out there. It doesn't deliver that many surprises, historically. It's still ultimately a higher-quality intermediate-term bond fund. Even if one thought that Mohamed was the driving genius behind PIMCO's results--which we did think that he was a good part of the team, but not the person--there is only so much harm that could be caused there.

And finally, it's always an issue when bad news is around a fund that perhaps people sell off the fund and force it to sell under pressure, and so forth. This fund has a lot of liquid and easily tradable assets. It's hard to see a run on the portfolio.

Lee: I actually bought a couple of PIMCO closed-end funds just days after Morningstar downgraded the Parent rating, and there was all this news. It really doesn't matter, because the fundamentals are sound. Mohamed El-Erian, while he was a big name and he went around talking a lot to the media, his actual money management skills are somewhat doubtful. If you look at the Mohamed El-Erian-run funds, they've been clobbered by their benchmarks over the past three years or so. So, it doesn't seem like he was such a good trader, and it wasn't necessarily a huge loss to the PIMCO team.

I do think that this is an interesting litmus test: If this kind of news makes you scared and you pull out all your funds from a fund family, then maybe you shouldn't have been in that fund family in the first place, because you didn't have the conviction or necessarily the sound understanding of how that person played a role in the process, and so forth.

Glaser: It seems that issues like this really could just be a lot of noise, and not just at PIMCO, I'm sure there will be future manager changes, future issues that really you have to tune this out?

Kinnel: There are other times when we have downgraded funds--T. Rowe Price Health, William Blair International Growth--where the lead manager really was crucial to the fund's success. So, you do have to take it on a case-by-case basis and really understand each change.

Like Fidelity Low-Priced Stock: Yes, Joel Tillinghast has a lot of people supporting him, but what he does running this massive small- to mid-cap fund and still having great results with a thousand names is … no one else does that. That's the sort of fund I would certainly worry about [a manager change], even with a lot of support. So, as John says, a case-by-case basis.

Rekenthaler: I'm not critical of the coverage. It's a big story when you have a Chief Investment Officer, CEO, a major player at a gigantic firm like PIMCO leave, and somewhat surprising. Manager changes can be very important to a fund. So the coverage is warranted. I think that when you look through and you evaluate it, in this case, it's not as big a deal as in some other cases, but people are right to write about it.

Glaser: So, taking a step back here. It seems like a lot of investors just don't have a great choices right now. We talked about the equity market: you might want to stay the course there, but that there is the potential for correction.

With fixed income, you should just stay in a plain-vanilla, more conservative fund, and you're not going to get a lot of great return there, probably negative real returns after factoring in inflation there.

What does this mean for retirement? What does this mean for investors who are actually trying to invest so that they can stop working at some point, or who are in retirement now? Are we facing a retirement crisis, because of this lack of good choices? Are we going to see a lot of people potentially come up short, and then what's that going to mean more broadly?

Kinnel: One good bit of news is, we just had a tremendous rally. So, I think the average 401(k) balance grew by something like 20%-22% last year. At least the balances are a little better. So, that's not such a bad thing.

But you're right. I don't think there is a ton of attractive places to invest today. I know you have some thoughts.

Rekenthaler: Well, performance is lumpy in markets. That's the nature of it. Now I don't think many people just decided to get into stocks in 2009 and didn't have stocks before that. But if they did, you are up a 130% on your original investment. Literally, the stock market can go nowhere for 10-15 years, and you're going to be doing well relative to inflation, most probably, unless inflation spikes. Still it was a good investment.

Losing money is a one thing, but if this market just sort of bounces around for two or three years, we've all done very well, if you've been in the market over that time period. So that's one thing to mention.

The other is the notion of our retirement crisis, I hear that a lot: "It's a retirement crisis." And people wave their arms, and it gets tied in with defined benefit plans being phased out and 401(k), and people run their 401(k)s. It's really hard for me to be able to tell how much of that is smoke and how much fire is underneath that.

I was looking at some numbers the other day. Over the last 20 years, easily, the best-performing age group in terms of the median household income is people aged 65 and older. People aged 65 and older have done very well relative to every other age group in the U.S. So if that's a crisis, take me there.

Glaser: What's driving that...

Rekenthaler: Maybe over the next 20 years, the lines reverse themselves. I would say people don't know that. We heard about a retirement crisis 10-15 years ago, even as their incomes have been growing.

I'm not quite sure what was driving it. I think some of it is that these people have had substantial 401(k) plans, some of them. Somebody who is 65 now might have had a 20-year, 25-year 401(k) plan. Also, the financial markets have been friendly.

But I would just submit: Usually when I hear about a retirement crisis, and I hear this a lot, and I look at what's the argument underlying it, I'm having trouble finding a good, strong argument for why now it's worse than 10 years ago or 15 or 20 years ago, and what's different.

Lee: I think I know why the 60-year-olds have done exceptionally well recently. It's because over the past 30 years, we've had one of the greatest bull markets for financial assets of all kinds in history, because in the early 1980s, we started off with interest rates in the teens, and now they're close to 2%, 1%, 0% for cash.

As interest rates have fallen, the present value of all these assets have grown. Fixed-income equities have done tremendously well. They went from very low P/E multiples and very high yields to high P/E multiples and low yields. If you're not ready for retirement now in one of the most benign 30-year periods, then you probably would never have been ready for retirement in other periods.

Right now, I think a lot of people don't realize how good they have it. But I do worry about people who are in their 40s and 50s, who are going to be coming into retirement 10-20 years from now, because since interest rates and yields are so low, and they are probably going to hike up over the next 10 to 20 or 30 years, their returns are almost certainly not going to be as good as the returns that people enjoyed over the past 20-30 years. So, if you're in retirement right now, you're actually sitting pretty well. If you're in your middle-age, then you might be in trouble. You've got to save.

Glaser: We've heard from a couple of people in retirement now who are looking for income who don't feel quite as pretty as you might say there.

If you're looking for current income, where can you go? Are there dividend-paying stocks that seem reasonable at all right now, or have those asset classes just become too expensive?

Collins: We have seen income-generating stocks do very well in recent years, because of the interest rate type of activities that we've all talked about today, but there are some picks. I talked earlier about Energy Transfer Partners, an MLP that's one of our energy team's picks, and that does pay a higher distribution yield, similar to a dividend yield. So that is one stock pick idea for income.

Kinnel: I would say, too--Christine Benz, who is coming on later this afternoon, has talked a lot about the importance of total return for income, too. If you're growing your principal, that can be a real tailwind for your income as well. So, don't just think about current yields; think beyond that.

On the more aggressive bond front, I still like Loomis Sayles bond, but there is credit risk, among other things. So certainly be cautious there. I mentioned two others earlier, Fidelity Intermediate Muni and FPA New Income. Those are on the conservative side. They are going to give you a modest amount of income.

Rekenthaler: The ETF team a couple years ago had me look at some preferred stock funds that are mostly banks and financial preferred ETFs. They're basically at the same price and the same yield that they were back then, which is paying about a 6% yield, well above-market. So I did buy some of that for my portfolio, although I'm generally a total return person, getting a little income component in the portfolio. But there I'm taking credit risk, and really those are disguised equity funds, that pay a 6% yield. So if you want the yield with some equity risk, these preferred stock ETFs are not a bad way of going.

Kinnel: I also like Matthews Asian Growth and Income, which is a fund, again, with lots of equity risk, but if you look at it versus other emerging-markets stock funds, it's got more income and less risk, because it has got convertibles, preferreds, some bonds, some dividend-paying stocks. I like emerging-market funds that veer off toward a more conservative path, rather than just chasing the highest-growth, highest-valuation names. So, that's one of my favorites. But again, obviously, if you're in retirement, be careful with that, because if you look at the year-on-year returns, you can see there's a 30% loss one year, a 40% gain the next. So this is not a low-risk bond fund, by any stretch.

Lee: I have a couple of ideas, although I hesitate to share them, because …

Rekenthaler: That's why you're here.

Lee: … because usually you want to do your due diligence. If I throw out a name, and you go out and buy it just based on me throwing out a name, then you are in trouble, because you haven't done a proper level of due diligence. So take these as your own starting point. If you don't understand why I like this after you've looked at it yourself, then don't do it.

But one I like is a closed-end fund; it's pretty expensive, fairly illiquid, fairly high-risk, so you don't want to put too much into it. It's PIMCO Dynamic Income, ticker PDI. This one is trading at about a 4%-4.5% discount. And the reason I like it is because it's loaded up on the junkiest, most beaten-down residential mortgage-backed securities. So it's backed by housing collateral, and housing is becoming much more valuable. So this is an implicit bet on housing.

Not only that, but the manager, Dan Ivascyn, has over $10 million of his own assets in this fund, and he had been buying throughout last year. I think that's a very interesting signal, because Dan Ivascyn runs many, many different funds, but he has discretion over which securities go into which funds. I do think that he is highly incentivized to put his best income-generating ideas in PDI. So this is actually one of my larger holdings. It's done very well since I've bought it, but it's also very risky, and if you look at it and you don't understand it, then don't buy.

Kinnel: I'm not sure I buy that he is incentivized to favor one security over the other. Most fund companies have pretty good policies in place to limit that. I'm sure he is incentivized for that fund, but I hope he is not saying, I'm going to hose these investors over here.

Lee: It's not necessarily to hose the other investors. It's because it's a closed-end fund, so it's one of the few vehicles that can accept the least liquid and also…

Kinnel: Right, right. There are some differences with others. That's right.

Lee: He can't put it in PIMCO Income, which is his biggest charge, because it's not going to put a dent in the returns, but he can put it in PDI.

Glaser: Unfortunately, we're about out of time here. But it does sound like, although there are some potential issues in the market, as we talked about in the first panel, and again here with valuations and with bonds, that time-tested advice of having a good strategy, sticking to it, and making sure you're rebalancing sounds like it's still the best way to navigate the market.

Kinnel: Indeed.

Glaser: John, Russ, Sam, and Elizabeth, thank you so much for joining for me.

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