Filling in the Gaps in Your American Funds Portfolio

You can do quite well in your investment life only holding American funds, but investors attached to the family may occasionally want to venture away for something that it doesn't offer. After all, its large-cap stock funds are rather similar, its lone small-cap fund leaves something to be desired, and it doesn't run niche funds that stress a single sector or smaller asset class. This month, I'll discuss where you can get exposure to what American lacks. I'll assume American Funds investors work with a full-cost broker and will be limited to funds with loads.

Small-Cap Substitutes
First, investors may very well want to choose a different small-cap fund than  American Funds Smallcap World (SMCWX). This is American's only dedicated small-cap fund, and it has more than $10 billion in assets even after recent market declines. It's global in nature--it probably couldn't be otherwise given its size--and though it's been serviceable, its performance hasn't been stellar: It underperformed the S&P Global < $2 Billion Index for 10 years through March 2008.

Investors would have to replace Smallcap World with two funds, one domestic and one foreign.  Diamond Hill Small Cap (DHSCX) would work well for the domestic option. Veteran manager Tom Schindler leads a talented management team that trades lightly and isn't terribly benchmark-sensitive. The fund's hefty energy exposure will make it a bit volatile as commodity prices gyrate, but we think that the managers make a strong case for why their energy stocks are undervalued. On the foreign side,  Columbia Acorn International Select (LAFAX) fits the bill. At $3 billion, its average market cap indicates that its average firm is more medium-size than small. Manager Chris Olson applies a moderate-growth strategy well, and the fund has outpaced more than 80% of its foreign small/mid-growth peers over the past five years through early April 2009.

Treasury Inflation-Protected Securities
Second, investors may want a fund dedicated to Treasury Inflation-Protected Securities or bonds in their portfolios. These are loans to the U.S. government that pay semiannual interest, just like plain Treasuries, but their coupons and underlying principal, or face value of the bond, are automatically increased as one of the main measures of inflation, the Consumer Price Index, increases.

TIPS seem like a perfect investment, though debates rage about whether the CPI is a good measure of inflation or whether the government understates price increases. Also, TIPS' market prices can fluctuate relatively widely depending on whether investors think inflation is rampant and protection deserves a premium, or whether they think it's at bay and protection against it isn't very valuable. A good way to figure out if TIPS are a good deal is to compare them with plain U.S. Treasuries (those without inflation protection). If a plain or "nominal" Treasury is yielding 3%, and TIPS are yielding 2%, then the break-even inflation rate is 1%. In other words, the market is assuming 1% inflation. If you think there is, or will be, more inflation than 1% for the period to maturity, then TIPS would be a good investment in our hypothetical example.

Assuming that you're working through an advisor who deals with load funds, a good TIPS fund is  PIMCO Real Return (PRTNX). PIMCO is a premier bond shop, and we're generally fond of its funds, including this one. This one will take more liberties than other TIPS funds, however, and those liberties can hurt at times. Basically, the fund is able to achieve full exposure to TIPS by using derivative instruments that don't require it to invest all its assets in TIPS. The fund is then free to make some other bets that its manager and PIMCO think are worthwhile. When a bet on bonds of large financial-services firms went south in 2008, the fund suffered poor relative performance. This year, however, the fund is back near the top of its category, and its 10-year record remains excellent, as the fund has bested 80% of its peers over that time.

American doesn't think TIPS constitute a separate asset class, and, therefore, hasn't rolled out a fund dedicated to them. It prefers allowing its bond managers to own them in their diversified bond funds as they see fit depending on their assessment of the instruments' valuation at a given moment. That's a legitimate approach, but so is permanently owning a fund dedicated to TIPS, as long as you don't think that the government cheats too badly on the CPI.

Real Estate
Another fund that could complement an American Funds portfolio is a real estate fund dedicated to real estate investment trusts. Real estate funds have gone from being sleepy diversifiers to some of the most volatile funds available. In the wake of the technology meltdown earlier in this decade, investors flocked to real estate funds because they preferred to invest in hard assets as opposed to firms dedicated to making money from the Internet. REITs also pay high dividends, which investors began to find exciting again. REITs are organized so that they avoid income tax at the corporate level in exchange for being forced to pay out 90% of their reported earnings as dividends.

This dividend requirement, however, has been one of the causes of REITs' recent troubles. The requirement makes it necessary for the firms to borrow money to finance growth. With such funding cheap and available as late as early 2007, many firms gorged on debt. Now, however, many REITs are unable to refinance existing loans because credit is unavailable. Those that can refinance also are finding that they can't borrow at the low rates to which they've been accustomed. Finally, a slowing economy is leading to lower rents and occupancy levels, making it hard for firms to maintain dividends.

Still, despite this litany of bad news, the prices of REIT stocks have tumbled hard. Price/FFO (funds from operations--a REIT cash-flow metric) was recently as low as it was in 2000, before the stocks embarked on a torrid multiyear run. In 2000, the businesses generally didn't have the debt problems that they do now, but not every REIT is burdened with a crushing level of debt. Additionally, many fund managers have told Morningstar analysts that foreign real estate firms, especially those in Asia, don't have the debt problems that their domestic counterparts have. This may explain why international real estate is generally outperforming domestic real estate so far in 2009.

If investors want to wade in slowly,  JPMorgan U.S. Real Estate  is a good option. With a veteran management team and more than 20 investment professionals on staff, this fund's advisor, Security Capital, runs a concentrated portfolio (usually fewer than 30 stocks) of its best ideas. Lately, it is emphasizing the highest-quality properties, so a top holding is  Boston Properties (BXP), which owns the finest class A office space in major American cities. For international exposure, investors can turn to  Cohen & Steers International Realty (IRFAX). Cohen & Steers has decades of experience investing in real estate, and the firm has offices around the world with analysts doing local research. We think allocating 5% to 10% of a portfolio's assets to real estate can be a prudent long-term strategy.

Commodities
Continuing with the hard-asset theme, investors may want to supplement their American Funds holdings with a commodity fund. If the world's governments succeed in stemming global deflation, commodity prices are likely to increase. Commodities also make good long-term holdings in moderation, because they behave differently than stocks and bonds over extended periods. Another PIMCO fund,  PIMCO Commodity Real Return (PCRAX), would be our choice. This fund invests in derivative instruments that replicate the performance of the Dow Jones-AIG Commodity Index, a broad index of agricultural and energy-related commodities as well as metals. By using derivatives to gain the commodity exposure, the fund is able to deploy excess cash into TIPS to achieve an additional layer of inflation protection. Again, as with real estate, 5%-10% here over the longer haul should be plenty.

Distressed Securities
Finally, the current market environment is likely to lead to investment opportunities in bankruptcies and distressed securities. We think Mutual Series has the experience and capability to navigate these difficult, but often profitable, waters. Within that fund family, we'd go with  Mutual Discovery (TEDIX) because it's the most diversified and flexible fund in Mutual Series' lineup. Managers Anne Gudefin, Mandana Hormozi, and Charles Lahr haven't been shy about holding cash lately, and that's helped the fund's performance dramatically. However, we think they're poised to pounce on juicy distressed opportunities as they arise.

Maintain a Long-Term Focus
Should you diversify your portfolio beyond the American Funds lineup, you may be tempted to try to time your buys and sells based on short-term market trends, but we'd stay focused on the long term. Add to your positions in new funds slowly so that you're not buying in at the top of one asset class or rushing in as another one hits the skids. We'd also be mindful of cost. Most funds can't beat American when it comes to price, but expense ratios can subtract from your returns year in and year out. Morningstar's research has shown that funds with higher fees are much more likely to underperform their peers over the long haul.

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