Bad Investment Ideas for 2010

I always did like the Grinch a lot better before those meddling Whoville residents swelled up his heart.

In tribute to that (ig)noble creature, I offer Bad Investment Ideas for 2010. Unlike all those sappy happy Best Investment Ideas pieces from my fellow Morningstar analysts that congest your inbox and befoul your spirits, this article delivers recommendations that would warm the Grinch's soul, if he had one. Ideas that, if implemented, would lead to wonderfully empty space under next year's Christmas trees.

Opening the Bad Investment Ideas menu are the highly leveraged exchange-traded funds--the funds that carry 100% leverage or greater. When it comes to causing misery, these funds are irreplaceable. Heads you lose, tails you might lose. Who could wish for more? These funds lose pots of money when the market moves against them, and they can also lose money when the market moves with them. Beautiful! Bull fund, bear fund, no matter what the animal fund, if you hold a highly leveraged ETF for a prolonged period, there's a high probability that you'll bleed red. The Grinch is giggling.

The bulk of our meal, however, will not come from bioengineered food, but instead from a distinctly old-fashioned source: hot money. My hunting ground consists of the fund categories that attracted the most new investor assets in 2009. These choices are nowhere near as reliable as the highly leveraged ETFs for faring poorly. Some of these categories will perform well in 2010, perhaps even spectacularly well. But as a general rule, loading up on one year's most popular fund types is a fine way to shed tears the next year.

No need to be pedantic; matching up the exact categories is less important than seeing the overall trend. For 2009, the sales trend was quite simple: bond funds were a big yes. A Very Big Yes. Nine of the top 10 selling U.S. mutual fund categories during 2009 have been bond funds, with the lone exception being diversified emerging-markets stocks. At $120 billion in net new cash flow, intermediate-term bond funds alone have gobbled up as much cash as all ETFs and target-date mutual funds--combined.

Some of these purchases, to be sure, have proven savvy. The bond market produced some extraordinarily awful performances in 2008, with many lower-quality and less-liquid securities ending the year trading at deep discounts and sporting abnormally high yields relative to Treasuries. Those who got in early, and many did, enjoyed a terrific rebound. But that party is largely over.

And what's left, I believe, is an unduly large preference for bonds. A decade ago, the everyday investor expected that stocks would return about 15% annually over the long term (there were a host of polls to prove it). Today, that same investor is locking into a bond market that pays 2% per year on Treasuries over the next five years, and 4.5% per annum for the next 30 years. Were investors too cheery about stocks in 1999? You betcha. However, the pendulum has most definitely swung in the other direction.

So the main course of Bad Investment Ideas for 2010 consists largely of bond funds. Treasuries are a natural. The astute folks at  FPA New Income (FPNIX) wrote flatly in September that "Treasury yields" were "devoid of investment merit." (As bad ideas go, ones that are devoid of merit tend to rate highly.) As part of this analysis, they pointed out that if Treasury yields revert to the normal level that they've held over the past half century, then the holders of a 30-year Treasury would be in the red for the next six years. Now, I don't see 30-year yields hitting 6.3% anytime soon, but the point remains that low yields + a long time horizon = sharp pain from a modest rise in prevailing interest rates. When it comes to bad, pain is good.

Treasuries are not alone in their potential to cause suffering. In some ways, GNMA mortgages are worse. The Federal Reserve has done a terrific job of boosting Ginnie Mae securities prices through its massive agency mortgage purchase program. So terrific that at times this year, after adjusting for the optionality of mortgages (i.e., mentally adjusting the yield of Ginnies to account for the unfortunate fact that mortgage securities get longer when interest rates rise, and shorten when they decline), Ginnies have sometimes traded at higher prices than Treasuries. Low underlying yields made even lower by an artificial and temporary market stimulus � just the prescription for bad fun.

Finally, there are five-year TIPS. A while back, these securities got so hot that they boasted a negative real yield, meaning that investors agreed to own them in exchange for getting a yield that was absolutely, positively guaranteed to be less than the inflation rate. Such a deal. Today, real yields have risen to 36 basis points. The particularly rotten aspect of these securities is unlike 20-year TIPS (which are a better deal), these securities won't be around if and when CPI truly spikes, because whatever inflationary pressures are currently building won't appear in earnest over the next few years. So holding five-year TIPS is like buying fire insurance for the monsoon season.

Although bonds have dominated the hot funds list, they've been supplemented by two additional sectors. One is diversified emerging-markets funds, the only non-bond category to crack the Top 10 mutual fund sales list in 2009; meanwhile, several emerging-markets categories have made the ETF best sellers' chart. Of course, U.S. investors are hardly alone in gobbling on the emerging markets. It's a global phenomenon, fueled by dinky interest rates and greed. Yes, it's a bubble.

And when it comes to Bad Investment Ideas, there's nothing quite like a bubble. The trouble with bubbles as bad ideas, of course, is that they can continue to expand for a long time after being identified. As Mr. Keynes stated, the market can remain irrational longer than you can remain solvent. (Or I.) So emerging-markets stocks are a trifle dangerous as a Bad Idea for 2010. But I sure wouldn't label them a good idea.

In the same spirit should be mentioned that other hot sector, gold. Earlier this year, Morningstar created not one, not two, but six--yes, six!--new fund categories to accommodate all the new commodity funds that have been launched. Chief among the commodities, of course, has been gold, that staple of 1 a.m. infomercials. If my father were still alive, he would be buying gold. When investors like him get in, you should get out. (The man remains the only perfect contrarian indicator I have ever known.)

Speaking of enticements, this investment is so seductively bad that it almost snared me: currency funds. Just last month, I was nosing around the list of short-term currency funds, seeking protection against the declining dollar because I knew that the dollar would continue to fall. Then I realized that what I actually know about the dollar's future wouldn't flood a very small thimble. About the dollar, Jim Rogers recently said, "When everybody's on one side of the boat, it's time to go to the other side." Diversification into other currencies is a good idea. Rushing to shed dollars today is a Bad Investment Idea for 2010.

Finally I must, for once, side with the crowd. Nobody is rushing to buy regional bank sector funds, for the simple if not always useful reason that those funds always seem to be going down. They got whacked in 2008 along with everything else, and then got whacked again in '09. Predictably, this unrelievedly bad news had me scouting for a bargain. Not this time. If I am to buy into an industry with unrelievedly bad news, including being early in the cycle of writing off ever-worsening commercial mortgages, then I want to do so with prices at rock bottom. Yet many of these banks sell at a substantial premium to book value and with price/earnings ratios in the teens. So count me in the majority on this item, and count regional bank stocks as my concluding Bad Idea.

Here's a truly Grinchlike idea: cut and paste this column, replace all the uses of "bad" with the word "good," and send along to a mortal enemy, along with your best wishes for 2010. But please leave my name off that effort, OK? Even those of us with itty-bitty hearts have some pride.