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Bold Bond Picks, Top Cannabis Stocks, Tips for Gig Workers

On this week's podcast, the pitfalls of market-cap-weighted indexing, what M&A activity means for payment processors, and floating-rate funds.

Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe for free on iTunes.

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Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar.com. Bond funds are often thought of as "sleepy" investments: the types of funds investors hold for their income and stability. However, some bond funds have a good deal of leeway in their mandates and have used their flexibility to generate exceptional long-term results. Today, we're looking at three Gold-rated funds from our new intermediate core-plus bond category that have done just that.

Sarah Bush: Loomis Sayles maybe best-known for bond fund legend Dan Fuss' Loomis Sayles Bond Fund but the firm has another topnotch offering in Gold-rated Loomis Sayles Core Plus. The fund's appeal starts with the experience of longtime managers Peter Palfrey and Rick Raczkowski. They draw on a deep and experienced analyst group. That research prowess is important, especially given the fund's broad and bold mandate. The fund can and has invested sizable stakes in high-yield corporate credit, emerging markets debt, and non-U.S.-dollar currencies. This can make for a potent mix, and indeed, the fund stumbled in 2015. Over time, however, the team has put its flexibility to good use, and they've sidestepped many risk market sell-offs. The fund has also posted good returns in healthy credit markets leading to a topnotch long-term record.

Eric Jacobson: Gold-rated Harbor Bond has always been a kind of back door into PIMCO's Total Return strategy, because it offers the same strategy as PIMCO Total Return run by the same management team but with a modestly priced institutional share class into which Harbor allows investors with only $1,000 minimum investment. This fund and PIMCO's overall Total Return strategy are much, much smaller than they were a few years ago. But PIMCO has managed those outflows very well. Meanwhile, the strategy is run by Scott Mather, Mihir Worah, and Mark Kiesel, all senior leaders at the firm who align a truly vast array of managers and analysts across the entire spectrum of the bond market. The fund itself is what we refer to as a core-plus offering:It still focuses on the high-grade U.S. market, but with the benefit of flexibility to add in sectors and structures outside the markets' plain-vanilla core. There are ultimately a couple of key arguments for this fund and the strategy more broadly. One is that PIMCO has proven that it's still an extremely strong organization and it's still home to some of the industry's best investors, including the managers of this fund. PIMCO still managed to perform well when this fund and PIMCO Total Return were much, much larger. But the job eventually just got harder and harder. The managers running this strategy today still have terrific resources at their disposal, though, and they can put them to work more easily inside of more-manageable portfolios. Those are just a couple of reasons we still believe this is a great option for investors in need of a high-quality bond fund.

Benjamin Joseph: Gold-Rated Dodge & Cox Income stands out for its relatively patient and, at times, contrarian approach to investing. The managers, who average 21 years of experience, start with an investment horizon of three to five years. They run a fairly compact, mostly cash-bond portfolio. The team tends to favorite corporates, noting that the yield advantage offered by the securities is an important contributor to total returns over time. Over the long haul, patience and a focus on fundamentals has paid off. The strategy's trailing 10-year annualized return of 4.9% through June 2019 beats two thirds of existing peers and outperformed its Bloomberg Barclays U.S. Aggregate Bond Index benchmark by 100 basis points. Its performance also looks strong on a volatility-adjusted basis, with a Sharpe ratio over the same period that lands in the best quintile of its category. With low fees and skilled managers, this fund is a strong option.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. More and more workers are employed in the gig economy. Joining me to share some financial tips for gig economy workers is Tim Steffen. He is director of Advanced Planning for Baird. 

Tim, thank you so much for being here. 

Tim Steffen: Thanks for having me. 

Benz: Tim, let's talk about some of the decisions, the financial decisions, that confront gig economy workers. One of the basic ones is sort of how to classify yourself as a person working in the gig economy as a contractor. What are the options?  

Steffen: Sure. Yeah. So, keep in mind, you are a business owner here. So, you got to figure out how you're going to structure your business. Most gig economy workers are going to be what we call a sole proprietor. This is where you are your own boss; you don't have any partners. You might have an employee or two, but you own the business yourself. So, it's sole proprietors, kind of, the generic term. Other forms, you might see there's something called a partnership. There, you got to have at least another owner of the business with you. You could take the step to incorporate yourself. And then, you've got the C corporation or S corporation options. But sole proprietor is where most of these gig economy workers are going to land. 

The other thing that many of them consider is something called an LLC or a limited liability company. These are kind of unique structures. They are set up by states. Individual states have their own rules in how they are structured and how you set them up. But typically, very easy to do. They provide you a lot of the same benefits of being a sole proprietor from a tax standpoint, but with an added layer of liability protection, hence the name LLC. So, sole proprietor is kind of the base one that a lot of people choose. And if you are just starting out in the business, that's probably the way to go. If you are going to be in this for the longer haul, maybe looking at the LLC is probably the next way to go.  

Benz: Okay. So, you say, a key thing once you've sort of decided how you're classifying yourself, another thing to think about is record-keeping, making sure you are keeping good records. Any tips to share there?  

Steffen: Yeah. Again, this is a business, so it's got to--important to operate it as a business. Be careful to separate business expenses from personal expenses. Get a separate bank account, a separate credit card. Maybe even have a dedicated workspace in your house if you're going to do that. Try not to comingle your personal and your business stuff too much. Maybe even get a separate cell phone line or something like that for the business itself. And then, really keep track of what your expenses are. I've talked to some folks who are in this kind of gig economy world and it comes tax season, they are saying, right, "I really didn't keep any records. I'll just go back and recreate it." That's really hard to do. You might have all the receipts laying around, and you might have kept some logs here and there. But to recreate it after the fact is a big challenge. So, really keep good records of as you're going through the process. Maybe invest in something like a QuickBooks or some other software. Maybe even hire a bookkeeper. Maybe a sibling or a parent who is retired who wants to help out, they could keep track of that for you. It's really important to put the time in ahead of time rather than trying to recreate afterwards.  

Benz: Okay. So, another thing that you say is really important to keep track of would be any automobile expenses. It's obviously going to be top of mind for Uber and Lyft drivers. But not just them, right?  

Steffen: Yeah, exactly. I mean, if you are in the rideshare world, those entities do keep pretty good track of some of your miles that you're driving, especially when you've got riders in your car. But there may be more to it than just that. You might be doing other driving around where you maybe don't have a rider but it counts as a business expense. Or maybe you are not in the rideshare world at all. You've got a home-based business where you are going out to people's homes and you're doing the parties where you're selling food or candles or toys or whatever it might be. As you're driving out to those homes, that's all business miles. So, really automobile expenses are a big one and you really need to keep good record of those. The IRS is very particular about how you do that. They want to make sure that you've got a separate log that keeps track of your dates and your distances and why you were doing it and all that. So, really keep good records of that. 

From a tax standpoint, it will make your life a lot easier. You can deduct all your actual expenses for the car, but they give you this a nice flat standard mileage rate which is really handy. For 2019, it's $0.58 a mile. Every business mile you drive, you can take a deduction for $0.58. So, that can add up pretty quickly and certainly simplify your record-keeping, too. So, just make sure you keep track of those miles. There's other expenses you can deduct on top of that, but the mileage is the big one for those drivers. 

Benz: Okay. Other expenses--home office, I remember when I was taking this tax course at CFP Land, our instructor practically had us repeating that this is one of the biggest ways to get yourself into trouble on your tax return. What should people know about deducting their home office expense? 

Steffen: So, everybody thinks they have a home office, but for tax purposes it's pretty specific rules. You got to have a dedicated area for that business. It can't be your kitchen, because your kitchen is not your dedicated business unless you are a chef, I suppose. But it's got to be an area that's dedicated to the business. It's also got to be the primary place where you are meeting with customers and operating the business itself. You're an Uber driver, for example, you're on the road--that's maybe more your office. But you might have an office at home where you are handling records and bookkeeping, some of that other kind of stuff. It's got to be dedicated. And then, if you can do that, if you can have that home office, it opens up the world to some other deductions you can claim. You can actually allocate some of your home costs to the business. Maybe some of your mortgage interest, some of your property taxes, your home insurance, your Internet coverage at home. Any of those other things that you could allocate to the business itself. So, if you can qualify with a home office, it can really open up a great world of deductions for you. 

Benz: Okay. So, let's talk about some of the other tax issues, the self-employment tax, for example.  

Steffen: Yeah. Most people who--or many people--who got into the gig economy used to work somewhere as an employee at some place. When you are an employee, you are subject to something called FICA tax, which is the 6.2% tax you pay to fund Social Security; you are also subject to a Medicare tax of about 1.5% or so. Your employer is also paying that same tax. So, while you are paying it, they are paying it in themselves. You get into this gig economy where you own the business, you are now the employee and the employer. So, you have to pay both those halves. And the other thing to keep in mind there is that while you are paying that tax, you're not subject to withholding, because there's no employer to withhold from. You got to get into the habit of making estimated payments perhaps. And you got to build not just the income tax but also this FICA and Medicare, this self-employment tax as we call it. You got to build that into your tax payments as well. So, as a gig employee you got a lot more things to be aware of that can increase your tax liability, things maybe you hadn't thought about. 

The flip side of that is, under the new tax reform you maybe able to take advantage of something called qualified business income, which is a new deduction that's available for owners of pass-through businesses where you can actually exclude up to 20% of your income from the business from tax. Again, not everybody is going to qualify for that. Most lower-income businesses and mostly side businesses aren't going to be real high income. They are probably going to qualify for the deduction. But it's a nice advantage that these small business owners didn't have before. So, the taxman taketh, the taxman giveth a little bit too. You just got to understand so you don't miss out on those things. 

Benz: And get some advice, it sounds like. 

Steffen: Absolutely.  

Benz: Okay. A couple of other things. Retirement plan contributions--don't forget about those, and don't forget about liability insurance. Let's talk about those things.  

Steffen: Sure. If you're an employee, your employer has probably got a plan for you of some kind, maybe a 401(k) or a 403(b) or something like that. Again, now, you are the business owner; unless you set up a plan, you don't have anything. So, you got to go set up a retirement plan. A SEP IRA, that's the most common type that we see for these types of businesses. They are easy to set up; they are inexpensive to maintain; and you can put away 20% of your income basically into that plan and get a deduction for that. So, that's a nice tool. You can also still do a traditional IRA. Maybe you do a Roth IRA as well depending on which one makes sense. So, don't forget about putting some of that money aside for retirement. It's easy to enjoy the income you are getting from the business, but you got to set some of that aside for later as well. 

And on the insurance side, you are again operating a business. You are opening yourselves up to exposure to customers. You've got employees perhaps on the road doing things. Some liability insurance probably wouldn't be a bad idea. Especially these rideshare economies, the Uber and the Lyft world. Your current auto insurance may not cover you if you are using your car in a business like that. So, check with your carrier and make sure you are covered. If not, add the additional coverage on there. It will be a well worth the expense. 

Benz: Okay. And should I also think about an umbrella policy with my homeowners? 

Steffen: Sure. Yeah. I mean, we always recommend umbrella policies in almost all cases. But especially if you are somebody who is operating a business where you are opening yourself up to even more liability. You're not a surgeon; you're not out there operating on people. So, you're not that kind of liability. But you've still got some added liability because you've got employees perhaps and who knows what they are doing, and you are just out on the road, perhaps more--anything can happen. So, a little bit of liability coverage never hurt.  

Benz: Tim, always great to get your perspective. Thank you so much.  

Steffen: Thanks again.  

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

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Brett Horn: Every time you use a card, there's multiple companies involved. Acquirers work with merchants to allow them to accept card payments. There's, of course, the network, which is typically going to be Visa or Mastercard. And then there's the card issuer. The card issuer in turn works with payment processor companies to help process transactions. Historically, these areas of the industry have been separate. But a wave of M&A in 2019 is bringing these areas together, with Fiserv buying First Data, FIS buying Worldpay, and Global Payments and TSYS combining. 

Of these three deals, we like the Global Payments/TSYS merger the best. I think the deal positions Global Payments to capitalize on a couple of key trends within the acquiring industry. First is international expansion. Historically, Global Payments has been ahead of peers in this respect, with a quarter of its revenue coming from outside of the US. I think the combination of Global and TSYS' international footprint will help further facilitate international expansion for the company.

The second is e-commerce. E-commerce increasingly is becoming an area that's just too big for traditional point-of-sale acquirers like Global to ignore. In the first quarter, e-commerce for the first time accounted for 10% of all retail sales. One of the critical factors, though, in serving the online market is combating fraud. The Nielsen report estimates that over half of all card fraud is related to card-not-present transactions, while those transactions make up only 15% of total card volume. I think having information on both the consumer and the merchant's side will allow Global Payments to build better fraud detection systems and help them better exploit this trend.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. What are floating-rate loans and what role do these investments play in a portfolio? Joining me to discuss this topic and share some favorite funds is Brian Moriarty. He is an analyst in Morningstar's manager research group.

Brian, thank you so much for being here.

Brian Moriarty: Thank you. Happy to be here.

Benz: Brian, let's talk about how these bank loans, or floating-rate loans, work and how they're different from conventional bonds.

Moriarty: So, they are different in a few ways. First and most important is they are traditionally senior in a capital structure. Compared to a high-yield bond, this means they get paid first in the event of any sort of distress or default.

Benz: So, as an owner, you have priority.

Moriarty: Exactly. Correct.

Moriarty: Something else to keep in mind is that they are not securities in the legal sense, which means they're still traded over the counter. And they're actually typically less liquid than high-yield bonds, despite the fact that they're more senior in the capital structure. So, a little bit of a trade-off there.

Benz: So, in hearing that, I'm thinking this is not a marketplace where I'd be wanting to be out there picking individual loans. I'm probably better delegating this to a professional investor, I would think.

Moriarty: Absolutely. Yes.

Benz: So, let's talk about the floating-rate part of these loans and why they are perceived to be a decent place to be in a period of rising yields. I think that was one of the attractions when everyone was sure that yields were just going to climb inexorably higher. Why do these investments stand to perform reasonably well?

Moriarty: Yes. So, the defining feature of a bank-loan fund or bank loan is that they pay a floating-rate coupon. So, what this means is that the coupon is pegged to traditionally three-month Libor plus a spread. So, as Libor moves, the coupon paid out by the loan will also move with it, up or down. Now, this can obviously benefit holders or investors in a rising-rate environment because as Libor increases, the interest rates increase, and the coupon that they're receiving is increased along with it. And this offsets the traditional major risk of fixed-income investing, which is rising interest rates.

Benz: So, if they're not as sensitive to interest-rate risk, let's talk about the other key risks that these investments face, which is credit risk.

Moriarty: Exactly, yes. So, bank loans are traditionally issued by below-investment-grade-rated companies. So, we're talking about BB, single B, CCC, and below. So, they operate in a lot of ways similar to high-yield bonds. Many times, the same companies are issuing both loans and bonds. So, there is a lot of credit risk involved. Traditionally, like we've mentioned earlier, because they're more senior, they tend to hold up a little bit better than high-yield bonds in a distressed period. But they still are liable to lose money. They lost money in 2008, in 2015, and again in 2018. Something else to keep in mind is that the growth of what's called the loan-only capital structure, so this is something that's gotten a lot of headlines recently, and it's where a company only issues a bank loan and there's no debt below that, which reduces or eliminates one of the defining features that we talked about, which was their seniority in the capital structure. If there's nothing below them in the capital structure, that sort of defeats the purpose.

Benz: So, let's talk about how an investor should think about this within a context of a broadly diversified portfolio. It sounds like I definitely want to think of it as part of my risky basket of fixed-income securities. But within a total fixed-income allocation, what's a reasonable percentage of that bond allocation to allocate to bank-loan or floating-rate products?

Moriarty: Sure. I mean, it's a nice diversifier to traditional fixed income, again, because of its floating-rate nature. But it is still credit risk, there is still the potential to lose money. So, it should move up or down depending on your risk appetite, but obviously not something that would be a majority of your fixed-income allocation. So, something to diversify within your fixed-income allocation, but still not the majority, maybe 10% or 15%, what you're comfortable with. But you certainly need to be aware that it's credit risk, it's going to be correlated to the equity markets and so on.

Benz: So, if I'm looking at these products, how do I make good choices? What are the key things to focus on? It sounds like understanding the strategy is key, understanding the risk-taking going on. What else?

Moriarty: Absolutely. So, one thing to keep in mind is that returns within the bank-loan category tend to be tighter than returns within the high-yield bond category. This means the range of outcomes is more limited.

Benz OK.

Moriarty: And in an environment like that fees play an even bigger role than maybe traditionally you would expect. So, a low-fee option would be the most important consideration. Knowing what you're getting, as you mentioned, a more traditional or conservative asset manager, who is avoiding maybe the riskiest parts of the loan market, avoiding a lot of those loan-only capital structures, or as we mentioned at the beginning, the less liquid nature of a bank loan, that can actually hurt an investor if they're trying to get their money out at the same time as everybody else, that can have a disastrous impact on the fund or on your returns. So, knowing which managers pay more attention to liquidity or tend to hold a little bit more cash or more-liquid instruments to help manage that risk.

Benz: So, if I'm looking at the yields of these products, is that a rough proxy for the risk-taking that's going on?

Moriarty: Absolutely.

Benz: So, if I see a really good yield, I can safely assume that might be a riskier one.

Moriarty: Yes, thank you. That's an excellent point. So, definitely, the higher the yield is a very good proxy for risk. The higher the yield, the more risky whatever the underlying loans are going to be. And vice versa, the lower the yield, you can safely assume that it's a more conservative holding within a portfolio.

Benz: So, let's discuss some of your team's favorite funds within this category. Let's start with one that's Silver-rated. This is one from T. Rowe Price, but you say this is a more aggressive option.

Moriarty: Yes. So, this is T. Rowe Price Institutional Floating Rate. It's the only Silver in the category. Everything else is either Bronze or Neutral or below. And it's an interesting one because the managers have actually done a good job of toggling back and forth between offense and defense. So, they are certainly willing to take on more credit risk than many peers. But they've also done a very good job of cutting that risk in markets where they're not getting paid for it, or where they're getting concerned about valuation. That's a difficult thing to do. But over time, they've done that very successfully. And in addition to the traditional things we like about T. Rowe Price--a strong parent, strong investment team, and attractive fees--that has turned into one of the most attractive offerings in the category.

Benz: How about people who are seeking a more conservative option? I know that there are a few funds that you and the team like of that ilk.

Moriarty: Yes. So, many of the ones that we rate that are Bronze-rated all fall into this more conservative umbrella. So, this would be funds like Voya Floating Rate, Pioneer Floating Rate, Eaton Vance Floating Rate. Eaton Vance has a couple of flavors, but the plain Eaton Vance Floating Rate Fund is more conservative. All of these fall into that conservative umbrella. They pay a lot of attention to liquidity, and you would be well served if that's your risk appetite with one of those offerings.

Benz: Brian, thank you so much for being here today.

Moriarty: Thank you.

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

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Ben Johnson: For Morningstar, I'm Ben Johnson. Market-cap-weighted indexing is an efficient way to leverage the wisdom of crowds. Unfortunately, harnessing the market's wisdom also involves participating in its madness. Market-cap weighting, like any strategy, has its pitfalls. Here to discuss these pitfalls and a fund that looks to exploit them and take advantage of them is Phil Bak. Phil is the founder and CEO of Exponential ETFs.

Phil, thanks so much for joining me.

Phil Bak: Thank you.

Johnson: Phil, talk to me a little bit about the drawbacks of a cap-weighted approach to building a stock portfolio and how investors might be able to spot those drawbacks and overcome them through a different approach to building a portfolio of stocks.

Bak: When you're buying a market-cap-weighted fund, you're buying at the current valuation. And you know, you could say that, hey, the market doesn't know if something's going to go up or down from here. So, it's a very safe and defensible way to invest. However, in those times where the market overvalues certain asset classes or certain geographies, you're always going to be buying at the height. So, if you look at it, before the global financial crisis, the financial sector was at its highest peak valuation in the U.S. Right now, we've got some technology names that have runaway valuations. If you look at it on a global level, the U.S. relative to the rest of the world is on peak-level valuations right now. Market-cap weighting, you're always going to be buying high. You're always buying high, and you're always selling low. And if you think about how the portfolio would rebalance in a market-cap-weighted index fund, or even on a global level, you're always going to be buying high and selling low.

What we look to do is do the opposite. We take the reciprocal of the market cap. We invest smallest to largest, and therefore we're always going to be the counterweight to market-cap weighting. We're going to be underweight the overvalued asset classes. We're going to be overweight the undervalued asset classes. And every time that you rebalance the portfolio, what you're doing is, you're taking profit from the stocks that have run up, you're putting them back into the stocks with the most room to run. So, it's a built-in buy low, sell high methodology that adds what we call a mean reversion factor to the returns.

Johnson: Your fund--RVRS is the ticker for this ETF--simply just takes the S&P 500 and effectively just flips it on its head.

Bak: That's right. It could not be more simple. And we're trying to keep it simple. All we want to do is extrapolate that equal weight premium. So, if you look at it, historically, equal weight has outperformed market-cap weight more often than not, not always, but more often than not. And we're saying, well, how does that premium come to be? There is a size tilt, but it's not just a size tilt. There's also--at rebalance for equal weight--there's a profit-taking mechanism that capitalizes on mean reversion. We want to extrapolate that. We want to give people more of that.

Johnson: Like any good strategy, Phil, I would imagine there's some risks involved here. You noted that, like equal weight, this portfolio will tend to drift more towards smaller-cap names. What are some of the risks towards flipping the S&P on its head, and how might those manifest themselves? What should investors be aware of?

Bak: We do have a slightly higher beta than a market-cap-weighted fund. There is a risk to not participating in a run of the top-end stocks. And we've seen that over the last two years with the FAANG names going on a run. Reverse cap weight will have a lot less allocation to those names. But over the long term, we think the strategy does have efficacy. If you look at the diversification of the fund itself, there is a much further distance between the top-end stocks by market cap in the S&P and the median. So, Apple and Amazon and Microsoft, they've run up to valuations that are well, well, well past the median, whereas on the downside, the smaller side, they're a lot closer together. So, what that means is, when you flip it over and you take the reciprocal of the market cap, you get a distribution of the 500 stocks that is far, far more diversified than you would with the market-cap-weighted version. So, you can use it in combination with a market-cap-weighted fund and greatly enhance your diversification of the holdings of those 500 stocks.

Johnson: Phil, I really appreciate you spending time with us to help better understand the strategy, its benefits, and its risks.

Bak: Well, thank you, Ben.

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Kristoffer Inton: We recently launched coverage of the cannabis industry, and we see massive market growth not fully accounted for in today’s share prices.

Prohibition has kept cannabis largely in the hands of criminal enterprises. However, legalization is gaining momentum. In the United States, 11 states and Washington, D.C. have legalized recreational cannabis, and 35 states have legalized medical cannabis or products that are low in THC and high in CBD. This is despite the fact that it remains illegal at the federal level.

By 2023, we think the U.S. government will no longer prohibit cannabis, instead allowing states to choose the legal status of cannabis within their borders.

Meanwhile, Canada has already legalized recreational cannabis in October 2018, with distribution continuing to expand. Internationally, more and more countries have recognized the benefits of medical cannabis and are expanding access.

With cannabis' popularity already growing organically due to expanded use cases, widening legalization will further catalyze demand.

Our research indicates that legal cannabis sales will grow nearly 9 times larger their current size by 2030. Large, underserved demand in the U.S., Canadian, and global medical markets will drive massive top-line growth and fixed cost leverage for cannabis companies, supporting a "green rush" through at least the next decade.

Canopy Growth and Curaleaf are our top picks. Canopy provides attractive exposure across all markets, as well as a consumer-goods-focused strategy. Curaleaf provides pure-play exposure to the U.S. market, where we see growth for both its recreational and medical end markets.