Kinnel's Favorite Funds for Diversification

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With 2016 winding down, Morningstar's director of manager research, Russ Kinnel, believes that diversification should be investors' watchword. He is here with me today to discuss some good funds for diversifying a portfolio.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: So, Russ, we've had this great rally in stocks in the postelection period here, and I think investors are kind of thinking about what's next for their portfolios. You say that really the key thing that they should focus on, rather than trying to predict the future, is just to make sure that their portfolios are diversified. So, in your latest issue of FundInvestor, you talked about some specific funds that you think do add diversification to a lot of investors' portfolios.

Let's start out with the first category, short-term bond funds. Why should investors look at them? I think one obvious question is, why should I look at a short-term bond fund versus just holding cash? Why should I take that even little bit of interest-rate risk with my money?

Kinnel: Yeah. You obviously are taking on a little risk, but you're also getting a chance for some yield and some returns, probably 1% or 2%. It's not exciting, but it's still something that you can get somewhat of a return on and ideally keep up with inflation. And I think it's another just, you want obviously ladders of different layers that you would redeem in case of an emergency but also for various funding needs. So, I think, most people could use a short-term bond fund.

Benz: So, let's start with a couple of your specific tips. One is Vanguard Short-Term Inflation-Protected Securities. Let's talk about TIPS in general, Treasury Inflation-Protected Securities, why they might be attractive in the current environment and why you think a short-term fund is an interesting thing to consider in this space.

Kinnel: Right. So, there's growing signs of inflation coming back. Oil prices rising a bit and other possible, some more infrastructure spending coming on. So, a lot of signs that we may have a little more inflation. So, what TIPS do is they adjust with inflation so that you essentially don't have to worry about rising inflation. The catch, of course, is that the traditional TIPS fund is a long-term fund, and that leaves it vulnerable to interest-rate spikes because interest-rate protection and inflation protection are related but not the same. Sometimes one moves and other doesn't. So, the appeal of a short-term TIPS fund is you don't have much interest-rate risk either. And then the final thing to know about TIPS is, the way they are adjusted up and down with inflation, gets taxed right away and so therefore ideally you can hold this in a tax-sheltered account.

Benz: So, if you have an IRA or if you happen to have such a fund in your 401(k), it's a good spot to put it in.

Kinnel: Right.

Benz: OK. Let's look at the next category under this short-term umbrella, municipal bonds and bond funds. This category has been pretty unloved recently since the election with worries that if taxes go down on the wealthy that people will want munis less. Let's talk about your pick in this area, T. Rowe Price Tax-Free Short-Intermediate Term, why you like the fund, why you think that investors, especially very wealthy investors, should stick with muni bonds.

Kinnel: Yeah. This is a nice fund. If the TIPS fund is for your tax-sheltered account, this is a good one for your taxable account. You're still getting that nice tax-free yield. T. Rowe does a nice job of running on a fairly conservative basis yet still being able to put out some yield and return. So, it's again, a good spot for a nice cautious investment. Obviously, this is not going to make you rich, but there's a lot of uncertainty out there, and I think it's a wise move to have some investments that you don't have much risk in.

Benz: You had a lot in your article about various foreign categories. Let's talk generally about the case for foreign investing, whether in stocks or bonds. I think a lot of investors have lost faith over the past few years. They've seen their U.S.-focused investments dramatically outperform foreign. Why do you think that foreign investment should remain part of investors' toolkits?

Kinnel: Well, partly for the reason you've just said, which is, the U.S. has outperformed foreign. These things go in cycles. So, usually, after the U.S. has had a run of outperformance, the tables flip. But also there's just added diversification. There's going to be times when the U.S. lags foreign. So, foreign is just a good way to diversify. I think it's funny that most investors across the entire world think that foreign equities are riskier, which is kind of funny because collectively that doesn't make any sense. So, we really think developed market securities in general are about equal levels of risk. So, it helps to diversify into foreign. Obviously, emerging markets is another subset of foreign that's higher risk, but developed foreign is really more or less equivalent risk to the U.S.

Benz: So, a specific fund that you would hold out is a particularly good diversifier is T. Rowe Price International Discovery. That's one that focuses on more small- and mid-cap stocks. Let's talk about that one and why you think that small- and mid-cap stocks overseas are particularly good place if you're looking to diversify your portfolio.

Kinnel: That's right. Foreign small- and mid-caps have a little greater diversification value than large-caps because they tend to be more closely tied to their domestic economy. Whereas, when you get into the really mega cap stuff, of course, those are really multinationals and it barely even matters what country they are domiciled in. So, you get a little more diversification. I chose this particular fund because it's just got a manager with a great record. Justin Thomson has been on board since 1998 and had tremendous returns. It's a relatively volatile fund, so keep that in mind. But I think for a nice diversifier, not a core position, but a supporting player, this is a really nice pick.

Benz: So, you might hold it alongside your big diversified developed markets focused product?

Kinnel: Exactly. If you've got, say, a core EAFE kind of fund …

Benz: Total market index.

Kinnel: … total market index or just a large-cap fund, like an American Funds EuroPacific Growth, something like that, this can be a nice complement.

Benz: Another category that you say is worthy of consideration, also falling under the foreign umbrella, is some of the emerging-markets bond funds. One that you like, kind of a tried-and-true fund, is Fidelity New Markets Income. Let's talk about first the case for emerging-markets bond investing and then secondarily the case for this particular fund.

Kinnel: That's right. There's a long-running debate about whether you are better off with emerging-market debt or stocks, but most investors choose stocks. But the debt can do quite well, and it has a little more safety than the equity, obviously depending on the strategy. I still would be clear that these are still fairly high-risk funds, so another kind of diversifier that can boost return and risk-adjusted return potential for your whole portfolio. But in and of itself, it's still going to be a fairly volatile fund. I like Fidelity New Markets Income run by John Carlson. It's just a really outstanding fund that kind of does a nice job of mixing aggression and conservatism.

Benz: And I know sometimes on these emerging-markets bond funds you can see really attractive yields. You would make the point that you don't want to swap out of your core domestic fixed-income product in favor of something like that simply because it's yielding …

Kinnel: Not at all. Core domestic intermediate bond fund is going to be significantly less volatile than an emerging-markets bond fund. Some emerging-markets bond funds also have a lot of currency risk as well. But by all means, do not abandon the core. This is more again a supporting player to round out your portfolio.

Benz: And for all of these funds, you would say, don't expect a near-term payoff. That if you are holding them as a part of your portfolio, you want to hold them for a period of years.

Kinnel: Exactly. These are funds I'm selecting for the long term. So, they look pretty attractive to me right now. But again, they are long-term investments. They are not investments that you hold for a year and move on. I think five or 10 years are probably the shortest time periods possible.

Benz: OK. Russ, thank you so much for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.