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On the Radar for 2012

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

2011 blindsided even some of the best investors, and 2012 likely has a few surprises up its sleeve. But Morningstar's Christine Benz, director of personal finance, says there are few specific things that investors can put on their radars for next year. She's here with me to explain. Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, a few things that investors might want to look out for in the coming year. The first one involves a very hot topic around here: income investing, dividends in particular. This is a very popular thing among investors right now. What should they be thinking about when it comes to dividend payers?

Benz: You're right, Jason. Everywhere I go, people want to talk about dividends, MLPs, anything that kicks off an income stream, in part because bond yields are so low right now. But I do think investors looking at dividend-paying stocks need to keep a couple of things in mind. First, I'm getting a little concerned that some investors are using dividend-paying stocks to completely supplant bonds.

They're worried about bonds they're fed up with the low yields on their bonds. But I am concerned that investors maybe are underestimating the volatility potential that dividend-paying stocks have versus bonds. So, a back-of-the-envelope look at standard deviation, the typical large-cap value fund that has any dividend yield at all has a standard deviation of about 16 over the past decade. The typical intermediate-term bond fund has a standard deviation of just 4.

Stipp: So, quite a difference.

Benz: Quite a difference. So, I think you need to be careful, and you really need to think twice before taking your whole fixed-income portfolio and swapping in dividend-paying stocks, because your stability of principal will just not be there for you.

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Stipp: Another thing at Morningstar, we pay close attention to are valuations. So, what do valuations look like on dividend-paying stocks. Might these stocks look undervalued as well as offering a dividend, which could be a double benefit for investors?

Benz: Well, possibly so. So a nice dividend yield sometimes is a good signal that a company is relative attractively valued. But one thing I was just looking at, Jason, is the fact that some of the best-performing sectors for the year-to-date--consumer defensive, real estate, and utilities--also do offer rich dividend yields.

So, my concern is that some investors have been gravitating to dividend-rich sectors and paying a little bit less attention to valuation--you need to mind both, because they do go hand-in-hand. My thought is that if you are opting for some sort of dividend-focused fund or dividend-paying stock, you really do need to keep tabs on valuation.

Stipp: So, certainly if this is taking a bigger part of your portfolio, there is the potential for this area to become frothy, so certainly one to keep an eye on.

Christine another thing I know that we also track is tax treatment, and it's been fairly favorable for dividends. What's on the radar for taxes, though, in the future?

Benz: Well, in 2013 the currently favorable tax treatment of dividends is set to go away and revert to what it was before 2003, which meant that you were charged ordinary income tax rates on your dividends. That's quite a switch and I think it has implications on a couple of fronts: First of all it's not a done deal. So, Congress could extend the currently favorable tax treatment; that's a possibility. So, you don't want to make any changes until we have some certainty on that front.

But assuming that the current dividend-tax treatment will go away, that would mean that it could put downward pressure on dividend-paying stock prices, and it also could create a headache for individual investors who have dividend-paying stocks in their taxable portfolios. They may ... decide they want to undo that, and the risk is that could cause them to unlock capital gains, if they have gains in those securities over the time that they've held them.

So, it's just something to keep an eye on. Nothing to act on until we have some clarity on what's going to happen, but I do think that it's a reason to keep dividend-payers stashed within your tax-deferred accounts to the extent that you can, because there just isn't any clarity right now.

Stipp: So, keep an eye on valuations. Make sure you're putting these dividend-payers in the right accounts, and don't necessarily supplant your entire fixed-income portfolio, because we could see some more volatility in dividend-payers than we would in fixed income?

Benz: I think so.

Stipp: Okay, Christine. So, the second thing, another trend that we've been following very closely, is the popularity of emerging markets. There is a big story behind emerging markets and why they look attractive on a fundamental level. What should investors be thinking about these areas of the world going into 2012?

Benz: Well, you're right, Jason, its one area that has kind of bucked the trend. Equity funds in general have been seeing huge outflows over the past few years. Emerging markets funds have actually been seeing inflows for most of that period.

And I think investors are naturally attracted to the growth story involved with emerging markets. It seems pretty obvious that the long-term growth from these markets will be greater than is the case from developed markets. There again, though, I think investors need to be careful not to underestimate the volatility potential of emerging markets; it can be really extreme, some of these sell-offs. We have had a little bit of a taste of it so far in 2011, and investors have to expect that that volatility will continue.

I think that they also--as with dividend-paying stocks--really need to keep an eye on valuation. So, as Bill Bernstein said at the Bogleheads Conference a couple of months ago, the beauty of emerging markets is that they, at certain periods of time, can get very, very cheap, and that’s when you want to be a buyer.

So, investors should stay attuned to that concept, that valuation is the best predictor of market performance, not GDP growth. So, just focus on valuation. I like the idea of owning emerging markets within the confines of a broadly diversified foreign-stock fund, where your manager can get developed-markets exposure and also can venture into emerging markets when valuation and growth prospects look attractive.

Stipp: So, story on emerging markets fundamentally is a very good one, but as we even saw this year, those markets can correct in times of uncertainty, so definitely keep the volatility in mind and make sure that you are not overpaying for these particular investments.

Benz: Exactly.

Stipp: Okay, Christine, another area that has troubled investors for a while is the fixed-income space.

Benz: It has troubled me.

Stipp: I think we were sitting here talking about dark clouds on the horizon for fixed income last year. As we’re going into a new year now, has the story changed with fixed income, and what should investors really be thinking about here?

Benz: It has somewhat changed in that the Federal Reserve has indicated that it would keep interest rates nice and low through mid-2013 at least, so that’s a little bit of a certainty, but I do think that there is still the threat there that if there is an unanticipated pickup in economic growth, that that could cause trouble for long-term bonds. I would have said a year ago--and I probably did, Jason--that investors should be careful about venturing into long-term bonds at this juncture. The typical long-term government fund in our database has something like a 30% return for the year-to-date in 2011, and I think that the risks are certainly there for people who are venturing into long-term bonds.

As would have been my advice a year ago, I really like the flexibility that you get with a broadly diversified intermediate-term bond fund with a manager who has a lot of latitude to venture into foreign bonds, short-term bonds, whatever looks attractive. I will acknowledge that the typical active bond manager, Bill Gross being a marquee name, but a bunch of others, has not done a particularly good job in 2011, or anyway has struggled from a performance standpoint. But I still like the flexibility you'd get with an active bond manager.

Stipp: So, stay diversified, consider an active manager, and certainly, we’re not recommending that you get out of fixed-income entirely?

Benz: No, no. I don’t think so because as we talked about in the context of dividend-paying stocks, the volatility profile will be so much lower, so for the money that you need maybe in the intermediate term, in the next two to five years, you definitely want to keep that safe and steady in bonds, despite the hovering storm clouds.

I would also say, Jason, for investors even those who aren’t in the highest tax bracket, it’s worth checking out munis and looking and comparing the yields on an aftertax basis of a municipal bond or a bond fund versus a taxable bond or bond fund. You may find that the muni is much better on an aftertax basis, even if you are not in the very highest tax bracket. So, it’s worth looking at our Bond Calculator; it's got a tab that lets you compare those yields. I think that’s a worthwhile exercise, because valuations in munis are arguably a little more attractive now than is the case with taxable bonds.

Stipp: Last thing, Christine, you mentioned or alluded to the tax treatment on dividends earlier. What other tax situations should we have on our radar for 2012 and going forward and what actions might we take in our portfolios given what we expect to see or might see happen with taxes?

Benz: So, as we talked about, Jason, dividend taxes are set to go back up at the beginning of 2013 to your ordinary income tax rates, so there won't be this qualified dividend treatments available to investors.

So, I think that does, as I mentioned, call for keeping dividend-payers, to the extent that you can, within your tax-sheltered account; it just gives you a lot more control over your tax picture.

And also investors should know that currently favorable capital gains tax treatment is also scheduled to go back up in 2013. So, capital gains are now taxed at 15% rate for most investors, at a zero 0% rate for investors in the 10% and 15% tax brackets. That's scheduled to pop back up in 2013 to 20% for most investors.

So, investors definitely want to keep that in mind. To me, if you were trading a lot before, you should knock that off because you really do want to trigger the fewest taxable capital gains that you possibly can, and also to the extent that you have funds in your portfolio, focus on those with low turnover and a history of good tax efficiency, because the tax regime will be more onerous than it has in the past.

Stipp: Given that taxes might go up, you certainly want to make sure you are maxing out those tax-deferred accounts.

Benz: That's absolutely right. That's a terrific point.

Stipp: All right, Christine. Well, we're now exactly sure what 2012 will bring, but these are some great things to keep on our radar. Thanks for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.