Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Welcome to our exclusive webinar for Morningstar.com Premium Members, Top Picks for Your IRA. Over the next hour, I'll be covering the basics of IRA contributions, and then we're going to hear from some of Morningstar's top researchers, who have brought along their best ideas for IRA investors.
Before we get into the presentation, I'd like to make a few notes about the webinar. First, we'll be tackling your questions later on in the session. If you'd like to submit a question, please email email@example.com. Second, we've prepared a guide to accompany this webinar. It delves into the nitty gritty of making IRA contributions, and it also includes one-sheet reports for the mutual funds and stock picks that our analyst team will share later on. Finally, if you'd like to download a PDF of the presentation, please download it from the link above the player. We'll also have a replay of the entire webinar available tomorrow at this same URL.
Now that those items are out of the way, let's take a look at our agenda for today. We are going to start by talking about the nitty gritty of IRA contributions. As many of you know, we are in IRA contribution season. You have until April 18 to make a contribution for the 2017 tax year, so I'll share some details about what you need to know before you make your contribution. Then, I'm going to spend some time talking about how to use Morningstar's resources and tools to help improve your IRA portfolio. Finally, in the bulk of today's presentation, we'll hear from some of Morningstar's top experts to get their best ideas for IRA contributions. Russ Kinnel will be joining us to share some actively managed fund picks. Ben Johnson will be here with some ETF ideas for IRA contributors. Sarah Bush is joining us with some fixed-income fund picks. Finally, Dan Rohr will be here to share some individual stock picks. We've got lots of concrete ideas if you are looking to fund an IRA or maybe make some improvements to your IRA portfolio.
In terms in what you need to know about making IRA contributions, a couple of key things: Contribution limits have been the same for a few years now. The contribution limit is $5,500 if you are under age 50; and $6,500 if you're 60-plus. That limit is the same regardless of whether you are contributing to a traditional or Roth IRA; it doesn't make a difference, the contribution limit is the same.
It's also important to note that if you can't swing a full contribution, so if you're looking at your budget and $5,500 or $6,500 seems out of reach for you, it's perfectly fine to make a lower contribution amount. The point is to get some money compounding on a tax-deferred or tax-free basis for your retirement, not so much how much you can contribute.
It's also worthwhile to note that age restrictions apply to traditional IRA contributions. It you're planning to make a traditional contribution, you must be age 70 1/2 or below. If you are contributing to a Roth IRA, the great thing is that age limits do not apply. You can continue to contribute past age 70 1/2.
It's also worth noting that income limits apply to both traditional deductible IRA contributions. If you want to make a contribution and deduct it on your tax return, you've got to come in below the IRS's income thresholds. There are also income limits that hold for Roth IRA contributions.
One thing that I wanted to mention though, before we leave this point about income limits, is that an idea that's available for people of all income levels is this idea of doing a backdoor, or sometimes called a two-step IRA.The basic idea is that you fund a traditional nondeductible IRA. There are no income limits, as long as you're not going to deduct that traditional IRA contribution on your tax return. Then shortly thereafter, you can convert that contribution to a Roth IRA. As of 2010, there are no income limits on doing those conversions either.
There are some important caveats to bear in mind if you're thinking about this maneuver, so if you're shut out of making a direct Roth IRA contribution, the main one is that if you have additional IRA assets beyond this smaller IRA that you're looking to fund via the backdoor, you can run into significant tax consequences at the time you make that conversion of that small, new IRA. This is an area, if you are someone who is shut out of a direct Roth IRA contribution, and by extension, you're shut out of making a traditional deductible contribution, get some tax advice before proceeding any further. But this backdoor maneuver is a handy maneuver to keep in mind for higher income folks.
Let's talk a little bit about the Roth versus traditional decision. If you have funded an IRA before, you know you hit that fork in the road where you have to decide do I want to make a traditional IRA contribution, or do I want to do a Roth contribution? The key thing to know is that the tax treatment is different. In the case of a traditional contribution, you may be able to make a deductible contribution. Your money will compound on a tax-deferred basis; but then when you pull the money out in retirement, that's when you'll owe taxes.
In the case of Roth IRAs, the tax treatment is really almost the opposite. You will put aftertax dollars into that IRA. The money will compound and grow on a tax-free basis, and you will be able to pull that money out on a tax-free basis, assuming that you've left the money in the accounts for five years after funding. It's really sort of the opposite tax treatment.
A couple of other points to make about Roth versus traditional: traditional IRAs carry required minimum distributions; Roth IRAs do not. Then, on another point I always like to make about Roth IRAs is that they give you a little bit more wiggle room if, for whatever reason, you need to get your money out prematurely. If you withdraw your Roth IRA contribution, not the investment earnings piece, but just the contribution; you're able to take that money out without any taxes or penalties or anything else at any time and for any reason. That's a valuable escape hatch. That's one reason I often tell young investors that a Roth IRA is a really simple, flexible idea if they want to jump start their savings. Even if it turns out that they need the money early and don't let it grow and compound for retirement, they still can pull their contributions out on a tax- and penalty-free basis.
Let's just talk quickly about how to decide if you are going to contribute to a Roth versus traditional account. The key thing to think about is what your tax bracket is today versus what you expect it to be in the future. If you think that your taxes are relatively high today and you can make a traditional IRA contribution and deduct it on your tax return, you're better off taking that tax break today, even if you have to pay taxes when you pull the money out in retirement. The reason that's better is because your tax bracket, you expect, will be lower in retirement. On the flip side, if you think that you're in a fairly low tax bracket today, and your taxes will go higher in the future; you're a good candidate for making a Roth contribution. You'd be able to pull the money out on a tax-free basis at that higher tax rate.
A lot of people, particularly young accumulators, might look at this and say, "I have no idea about my tax rate in the future relative to where it is today." In that case, assuming you can make both a traditional deductible contribution and a Roth IRA contribution, you might consider actually splitting your contributions across both account types. That's something that you can often do in the context of a 401(k) plan as well, where you're faced with that fork in the road, you can actually make both types of contributions.
Let's just quickly look at checking up on our IRA portfolio's allocations. If you are funding an IRA, I think a great starting point is to look at how your IRA portfolio is positioned today. Here I think Morningstar's X-ray tool can be such a great help. If you have a portfolio saved in our portfolio manager tool, you can x-ray it, and you'll see a screen that looks something like this that will show you your portfolio's asset allocation, and a lot of other data about your portfolio's positioning.
On my next screen, I just have a shot of our Instant X-ray tool. This is a quick and easy way to get your portfolio saved on Morningstar.com, if you don't already have one. If you have entered your portfolio, one of the key questions is, if I'm looking at this, how do I know if that asset allocation is on track? Well, on this slide, I have a couple of benchmarks that you can think about if you want to check up on the appropriateness of your portfolio's asset allocation. I always say a good target-date fund geared toward someone in your same age band is a great quick and dirty way to check up on your portfolio's asset allocation. I also often refer Morningstar.com readers to Morningstar's Lifetime Allocation indexes, which are a product of Morningstar Investment Management. We've got the link on this slide.
If you are a young accumulator, you certainly want to have appropriately high equity allocation; but if you're someone getting close to retirement, you want to think about making sure that you have enough in your portfolio in the safe stuff. That's cash for many of us, and that may be some bond exposure, some high-quality bond exposure in that portfolio.
Also check your portfolio's style positioning. If you haven't done so recently, as this bull market has worn on, we've seen many portfolios tilting toward the growth side of the style box, because growth stocks have generally out performed. That's something to check up on. You can also check up on your portfolio sector allocations relative to the S&P 500. That's not to say you need to be right on top of a broad market benchmark when looking at your portfolio, but it's a good starting point, just to make sure that you're not making any big inadvertent bets in your portfolio.
Also, check up on your individual holdings using Morningstar's tools and research. If you're a Premium Member, you have access to our analyst reports. You can see are star ratings for our individual equities. If you are fund investor, you can see our Medalist ratings for the mutual funds and the ETFs that you own in your portfolio. Do a checkup on what you have in your portfolio already. That might help you determine positions that you need to add or otherwise address in your portfolio.
That ends my prepared remarks. We are going to be bringing Russ Kinnel out here to share some actively managed mutual fund picks. If you'll stay tuned just a minute, we'll be bringing Russ out here.
Welcome back. I'm here with Russ Kinnel. He's director of manager research from Morningstar. He's brought with him some of his favorite actively managed stock fund picks. Russ, thank you so much for being here.
Russ Kinnel: Glad to be here.
Christine Benz: Russ, before we get into your specific picks, I want to clear up. You like index investing too, but I asked you to share some actively managed fund picks, because Ben Johnson is going to be talking about ETFs.
Russ Kinnel: That's right. I like both. I think most people, it makes sense to have some of both in their portfolios.
Christine Benz:I asked you to bring some core fund picks as well as some noncore or sort of supporting player picks. Before we get into the specific ideas, you noted that all of the funds you're that you're going to talk about today have beaten their benchmarks over the manager's tenure and that all of the managers have $1 million or more invested in their portfolios. Let's talk about the last data point, why you think that that's something that's worthwhile for investors to look at.
Russ Kinnel: We've studied it, and it actually has pretty good predictive value. It's the second best fund predictor out there. When managers have more than $1 million in their funds, the funds tend to perform better. Whether that's a cause, that it motivates them, or an effect is hard to say. Either way, it is a valuable data point. It would be even better if we could know more than that, but that's the SEC's rule. It maxes out at a million. It's a really useful data point.
Christine Benz: Nonetheless, a fairly substantial investment. Let's talk about your first pick. This is FMI Large Cap. Large cap blend, the ticker is FMIHX. The obvious question is we've seen this huge torrent of assets going to passively managed products, and it seems like investors have identified large blend in particular as a place where they really should index. What's the case for this fund?
Russ Kinnel: I think active management can work anywhere. I don't think large blend is necessarily much more efficient than, say, large value or large growth. It's just that a lot of the core index funds end up in large blend. I think, in a case like this, you have a fairly concentrated portfolio; but it's fairly stable, boring companies. I wanted to get some funds that were not heavy in FAANGs. This is a fund that's got fairly middle-of-the-road companies. They look for good private market value. Pat English has really produced good results over the long haul. Costs are reasonable. You have names in the portfolio like Berkshire Hathaway, Comcast; so not too hot, not too cold, I guess.
Christine Benz: Another thing to note is that value investing has been enduring its own long, dark night. That it really has underperformed at the expense of growth stock investing.
Russ Kinnel: That's right. I'm a contrarian, so you'll notice there's a value theme to a number of my picks here.
Christine Benz: That tees up the next one very nicely. Fidelity Low-Priced Stock, FLPSX. It's a mid-cap value fund. This one is probably pretty well known to people watching, but let's talk about why, after all these years, you still like it so much.
Russ Kinnel: It's one I don't talk about a lot, because it is big, and we're always worried, "Is it running too much money?" It's actually smaller than it used to be. It's at $38 billion now versus $49 billion is about where it peaked. Not that I would call it svelte. Joel Tillinghast has done an amazing job. It's a low-cost fund, about 68 basis point expense ratio. He's just an extraordinary investor who really gets to know his portfolio. Obviously low turnover strategy, but just a very good value investor who continues to produce good results year after year after year.
Christine Benz: A logical question, and this is something I know that you look at in your work, and the team does, Joel Tillinghast has been on the job a long time. Has Fidelity articulated a succession strategy? I know they've appointed some people to run components of the portfolio. What's going on with the next generation of who will run this fund?
Russ Kinnel: They haven't officially said what's going to happen, but as you say, they have a number of investors running small sleeves of the fund. When Tillinghast took a break, they were all overseeing it. I would assume you would see something like that, because there are just not a lot of people who can run a $38 billion small/mid-cap fund like this. I would guess you're going to have a number of people take over. I think the good part of that is it's still a low-cost fund. If Tillinghast retires tomorrow, you still have a low-cost, diversified fund. It's not like this is leveraged into really funky instruments. At worst, it's more of a boring fund than a good one. I'm not too worried about Tillinghast retiring; but obviously that would diminish the appeal, once it happens.
Christine Benz: Next fund is a foreign stock fund. It's Tweedy, Browne Global Value, ticker TBGVX. It lands in our foreign large-cap value category. This is one that I own. It has global in its name, but it is mainly in foreign stocks, right?
Russ Kinnel: That's right. It's mostly in foreign. We put it in a foreign category. It's just a very good value strategy. It's got deep roots tying them to Ben Graham and Warren Buffett. Buffett actually bought his first shares of Berkshire Hathaway through Tweedy back when they were more of a market-maker. You really see that influence, but it's a nice team-run approach. They're value investors, but I think they do a good job of keeping track of what's going on in the whole market. We were out visiting them about a month ago in Greenwich, Connecticut. They moved there from Midtown not too long ago. I was happy to hear from the whole team, not just the managers, but the analysts. I feel like they've got a good group of people there.
Christine Benz: Here's another one, though, where you have some deeply seasoned managers running this fund. What's the story on succession strategy there?
Russ Kinnel: That's right. Well, it's very much a team approach. Really, you need a consensus so ...
Christine Benz: And that helps, right?
Russ Kinnel: Right, right. It's not really, one person retires, and then everything changes. Really, you have a lot of people have ownership of that current record. Yes, gradually one would expect, over the next few years, there could be one or two more retirements, and people gradually shifting in. They keep gradually adding people too, and filling the staffing. They're pretty fully staffed at the moment, so I feel pretty good about the process.
Christine Benz: Dodge & Cox Balanced also on your list of core funds that we like. This fund is Gold rated, it lands in our allocation 50-70% equity category. The ticker is DODBX. Let's talk about the fund, why you like it. Again, this is probably one that a lot of our viewers will be familiar with, but let's talk about why you think it deserves consideration.
Russ Kinnel: This is really a great set it and forget it fund that ticks pretty much every box you want in a fund. Low costs, great management, stable management. Just incredible how many people go there for their entire career. Very few people leave. A good, well-articulated value strategy behind it. They're looking at the whole capital structure, so the same people looking at the stocks are looking at the bonds; and so if it looks at a better investment on the bond side, they can buy the bond. If it's a better investment on the stock side, they can buy the stock. Just great long-term results.
Christine Benz: It's not that common to see an allocation fund that has such great resources on both the stock and bond side. Usually funds might be good at one area, not so good at the other. This is a firm that we have confidence in both sides of the shop.
Russ Kinnel: Yeah, that's my most common gripe about allocation funds, is maybe they're good at one thing, but not the other; so why would I put those two together. I'd rather have them specialized, but Dodge, you'll see, we have Dodge & Cox Income as a Gold fund, Dodge & Cox Stock as Gold; so we really think highly of both sides of the process.
Christine Benz: Next, let's move onto the noncore picks. Oakmark Global Select, ticker OAKWX. This lands in the world stock category, and it's Silver rated. Let's talk about that fund.
Russ Kinnel: Yeah, so world stock, you'd think that's got to be core, but to me, it's not really core because it's so concentrated. Bill Nygren and David Herro are two great managers. Both have won Manager of the Year; but they're each only contributing 10 stocks, so you have a big concentration, not only in top names, but also by industry. Currently, they have about 40% in financials. To me, that says not really quite a core holding, even though it officially covers the entire world of equities. Just a very strong value-oriented fund.
Christine Benz: The last noncore pick is an emerging-markets stock fund, T. Rowe Price Emerging Markets Stock, PRMSX is the ticker. Let's talk about that. Emerging markets have been on fire recently. We're not encouraging trend chasing, but let's talk about why you like the fund; and also how you might think about adding a fund to your portfolio, if you, say, already have a foreign stock fund.
Russ Kinnel: Emerging markets have been on fire, though the last five to 10 years, they've lagged; and they still haven't caught up with that. I like the fund because one, T. Rowe is a nice, dependable firm. They don't make crazy bets. Gonzalo Pangaro has 25 years’ experience; not on the fund, but in investing. You have a very experienced manager, taking that sort of typical T. Rowe growth at a reasonable price strategy, applying it across emerging markets. He's built an early, strong record; so I like that a lot. In terms of how you use it in your portfolio, I think it's a useful diversifier. Emerging markets can be different from the rest of the markets. It's really useful to have. Obviously, it's noncore for a reason. Emerging markets are higher risk; they're higher volatility. When things go bad there, they can go really bad. Sometimes the sell-offs in the emerging markets coincide with the U.S. selling off; so it's a good diversifier, but it's not perfect. It's not like a core bond fund or something.
Christine Benz: Russ, always great to get your insights. Thank you so much for being here.
Russ Kinnel: You're welcome.
Christine Benz: In just a few moments, we will be back with Ben Johnson. He is firector of
global ETF research for Morningstar. Please sit tight. We'll be back in just a few moments. Thank you.
Hi, and welcome back. I'm joined here today by Ben Johnson. He is director of global ETF research for Morningstar. Ben, thank you so much for being here.
Ben Johnson: Thanks for having me, Christine.
Christine Benz: Russ just talked about some of his favorite actively managed picks for an IRA. You're going to talk about ETF funds that you like. You divided them in a little different way. You're going to start by talking about some capitalization-weighted funds, so traditional index trackers as well as some strategic beta type products. Let's start with the cap-weighted funds. Vanguard Total World Stock Index, VT is the ticker. That's a world stock fund. It's Silver rated currently. This is a real minimalist pick. If you just want to get it done with a single equity fund, this seems like a good fund to start and end with.
Ben Johnson: This is the ultimate one-stop shop for equity investors. It tracks the FTSE Global All Cap Index. That index is made up of nearly 8,000 different stocks. All the way from $900 billion in market capitalization, Apple, who we all know and love, to $200 million worth of market capitalization for the Thai Food Group. You're talking about a portfolio now of nearly every stock on the planet. It captures 98% of the market capitalization, of the world's public stock markets. It puts a bow around those nearly 8,000 stocks, and it delivers that package to you for a fee of 11 basis points. That's 11 bucks on a $10,000 investment. For one and done, total, global, world equity exposure; there's really no better option than VT.
Christine Benz: That is very cheap as you say, but is there a way to get it done more cheaply, if I were to own discrete foreign stock and U.S. stock index funds?
Ben Johnson: If you were to shop elsewhere, even from just the menu of Vanguard ETF--so pair, say, VTI, which is their Total US Stock Market Index ETF, with VXUS, which is their international stock market ETF--and combine those in a portion that represents the portfolio that you would get with VT, what you would get would be a fee that would be incrementally lower, by about, let's call it, 4 to 5 basis points or so. Which you would assume in that trade-off is sort of the responsibility for ongoing monitoring and maintenance of that, which for many investors might be a perfectly suitable option, because frankly, if you look at the world today, it's roughly 50/50 split between U.S. equities and non-U.S. equities. That might not fit investors' risk appetite, so it's certainly not a fund for everyone. For those who want to set and forget for near forever, and just let the market do the heavy lifting, and pay a very low fee, I think it's a great option.
Christine Benz: I think another thing before we leave this one: Vanguard setup, on its index ETFs is a little different from some other providers in that if you want a traditional index mutual fund, you don't want heavy ETFs, you can do that too, right?
Ben Johnson: That's absolutely the case. Vanguard has a novel structure that's protected actually, by patent, whereby their ETFs are simply just a separate share class of their mutual funds. That has certain benefits. It lends them the benefit of scale, of having a broader pool of assets. That allows them in many cases to drive costs lower for investors. Vanguard investors have the option of looking at the ETF share class, which I think is most suitable for those investors that have smaller amounts to invest, that might not be able to access the admiral share, which requires a $10,000 minimum investment. They'll get better than investor share pricing via the ETF pricing that's at parity with the admiral share; but if you can afford the admiral share, and you simply don't want to have to deal with the transaction costs and all of the ins and outs of trading ETFs, the admiral share class of the index mutual fund is a perfectly suitable option. It may be a superior option for people who just aren't comfortable with navigating the ins and outs of ETF trading.
Christine Benz: Good to know. The next pick, this is, I would say, not such a core pick. This is a capitalization-weighted fund. This is iShares Core MSCI Emerging Markets, ticker IEMG. It's Bronze rated. Let's talk about why you and the team like it.
Ben Johnson: We like this chiefly because it's a market-capitalization-weighted strategy. When you're buying a broad-based market cap weighted index, you're effectively free riding on the collective decisions of active managers, of buyers and sellers of stock to set roughly the right prices over a long period of time, which allows for very low turnover, which is a feature of this fund, and a very low fee. At 14 basis points, it's extremely competitive relative to its peers in its category.
Christine Benz: Follow up question. If you like this fund, or you're looking at this fund, you'd better like China, right?
Ben Johnson: You had better like China. Chinese stocks, which fall under various definitions, make up nearly 30% of this fund's portfolio as it stands today. What I would stress there is that again, this reflects the opportunity set that's available to investors in emerging markets. China's rise to prominence in this particular index, especially very recently, has been driven by a surge in the technology sector, which has been spearheaded by a pair of tech giants, Tencent and Alibaba, which together comprise a pretty substantial piece of this index portfolio. It's important to peel back the label on the tin and understand both the country and the individual security level exposures that you're assuming in this fund. Decide whether or not you're comfortable with the risks that are associated with that, which have to do with doing business in China, the specifics of the tech sector, and there's an element of currency risk that's important to understand when it comes to investing in emerging markets as well.
Christine Benz: Those are more or less vanilla capitalization-weighted products. You also brought some strategic beta funds that put some spin on the ball, rather than investing in a cap-weighted index. Let's start with the first. It's Vanguard International High Dividend Yield Index, VYMI is the ticker. It lands in the foreign large-cap value category. It has a pretty nice yield of 3%. We have it rated as Bronze. Why do you and the team like this one?
Ben Johnson: We like it's very simple and elegant approach to constructing a portfolio of international stocks that pay above average yields. It starts with the universe of stocks that reside outside the US. It looks at those that are expected to have the highest yields over the next 12 months, and adds those to the portfolio until it winds up with about 50% of the market cap of the beginning universe. Now, what that does is it mitigates some of the risk that's associated with just investing in higher yielding stocks. They have higher yields for a reason, which may be that they're inherently more risky, that they're going through a rough patch. Investors are probably selling these stocks recently, for one reason or another.
Now, by anchoring on market cap, what it does is it pulls the portfolio toward the largest names in that universe; these are more stable firms. They are firms that tend to have either wide economic or narrow economic moats, in Morningstar parlance, which means that in all likelihood their dividends are more defensible. It also owns a large number of securities, especially relative to some other strategies that try to achieve a similar objective, which can hide some of the errors. Some of the issues that might crop up, when one or two or three of the stocks included in that portfolio prove to be sporting high yields for a very good reason, because they are indeed distressed.
Christine Benz: Your next strategic beta pick is iShares Edge MSCI Minimum Volatility. The ticker is USMV. Before we get into this particular fund, can you state what you think are the main advantages of a low volatility strategy? Why you might even want to approach the market in this fashion?
Ben Johnson: I think at this particular point in the market cycle, probably the key advantage of a low volatility strategy would be behavioral, to maintain equity exposure and maintain a type of equity exposure that you would be more likely to stick with. I say more likely to stick with in that the low volatility products that are out there, and USMV in particular, has shown over its track record--which has not, I should point out, included a bear market, but a number of pronounced drawdowns--to have much lower standard deviations, so just general volatility, relative to the market. Much less sensitivity as measured by its beta to the market. It's beta to the S&P 500 has been 0.67 over the past three years, which means anytime the S&P has moved 1%, it's gone up 0.67%. It's had relatively muted drawdowns as well. Those relatively muted drawdowns, I think, are a key feature that might help investors stick with this particular fund and stick with just U.S. equity strategy should we go through another bear market.
Christine Benz: That's an important advantage, keeping people in their seats. Let's turn to your last idea for IRA contributors. This is Schwab US Dividend Equity. The ticker is SCHD. This lands in the large-cap value category. It has a decent yield, and one thing that I've often thought about, you talk about these yield focused ETFs either being payers, or yielders, or growers. Where does this one land?
Ben Johnson: SCHD is interesting, because it tries to kind of combine the best of both worlds. It starts with a subset of stocks that have paid dividends for 10 years, so there's an element of sustainability and growth that's infused in this index methodology at the onset. It then looks at the highest yielding half of that first cut, so income is a bit of a yield orientation, a bit of a value orientation. It then looks at that subsequent cut, and screens on the basis of different fundamental metrics to understand whether or not these dividend payments are indeed sustainable, whether or not they will grow. It's kind of a cocktail of both yielder and grower.
What you've seen and what comes out in the wash is a fairly concentrated portfolio. It holds around 150 stocks, of very high quality firms that have indeed grown their dividends over time, and in all likelihood will continue to do so over time, but might be relatively depressed with respect to their valuation. You're not going to get a huge value kicker here, but there's a whiff of that in the mix as well.
Christine Benz: Ben, thank you so much for being here to share your picks. It's always great to hear your insights.
Ben Johnson: Thanks for having me.
Christine Benz: Join us here in a few moments. We'll be bringing back Sarah Bush. She will be sharing some bond fund picks to consider for your IRA. Just sit tight for just a couple of moments. Thank you.
Hi, and welcome back. I'm joined now by Sarah Bush. She is director of fixed-income strategies in Morningstar's Manager Research Group. Sarah focuses on bond funds, and she's brought with her some of her best ideas for IRA contributors in the realm of fixed-income.
Sarah, thank you so much for being here.
Sarah Bush: Thanks so much for having me.
Christine Benz: Sarah, before we get into your picks, I get this question a lot. What's the case for fixed-income investing right now? Investors are worried about, potentially, how rising interest rates could affect their bond portfolios. They're asking me whether they shouldn't just invest in dividend paying stocks instead? What's the case for bonds as part of a portfolio?
Sarah Bush: That's a great question, and we're very sensitive to that this year. We've seen losses in a lot of fixed-income bonds. I would first of all say, with yields going up, it's actually a better time to be investing in bond funds. Yields are the number-one predictor of the types of returns you're going to see over the long haul in bonds, so rising yields are actually a good thing. Then, I think investors need to think about their overall portfolios. If bond funds are providing a diversification role in your portfolio, that doesn't change when we see some moves in interest rates. High-quality bond funds tend to do very well during periods of equity market turbulence.
Even if you look at what we've seen so, year to date, the Agg's down 2%, that doesn't feel good, but when we've seen volatility in equity markets, sometimes we've seen S&P 500 move by that much in a day. Bond funds, even when they're doing badly, high-quality bond funds--I want to make that distinction--tend to hold in pretty well and provide that ballast in your portfolio.
Christine Benz: You mentioned the Agg, and that is Bloomberg Barclay's Aggregate Index. That's kind of a core index that bond funds benchmark themselves against. Let's get into your picks. At the top of your list is Fidelity Total Bond. The ticker is FTBFX. It's intermediate-term bond category. We rate it as Gold. What's the case for this fund?
Sarah Bush: Fidelity has just really broad resources across a number of fixed-income sectors. They're very good at investment grade and high-yield credit. They've got a good mortgage team. They've seen a little bit of turnover there, but they've got a very strong mortgage team, and they've got a good emerging markets team. Fidelity Total Bond is what we call a core plus bond offering. It goes beyond the Agg that we were talking about. That's all investment-grade, dollar-denominated securities. It can invest in high yield and invest in emerging markets. Manager Ford O'Neil, who's been there a long time, has done just a really great job with that tool kit. He's been sensitive to valuations, not always risk on. Then, the fund's also very cheap, which is clearly really, really important for fixed-income options.
Christine Benz: I asked you to categorize your picks as either core or noncore. You would put this one is the core category, so if I need some ballast to offset what might be going on in my equity portfolio, this is pretty good idea for that slot.
Sarah Bush: Absolutely, although I will point out that because it has this core plus, it has that flexibility to do high yield, there are certain periods of credit stress that it may under perform a pure investment grade indexlike option, so that's something to be aware of.
Christine Benz: Good to know. The next core bond fund pick that your brought is Western Asset Core Plus Bond, ticker WACPX. Also Gold rated, also lands in our intermediate-term bond category. This one just got an upgrade to Gold. Let's talk about why you and the team think it's a good core fixed-income pick.
Sarah Bush: When you're looking at these core, and this again is a core plus fund, we see a lot of the same things we see at Fidelity: just depth in a number of different areas of the market. This one, good credit team. They do a little bit more on macro, so they're doing a little bit more work on trying to anticipate where interest rates are going to go. Fidelity doesn't do that. They've done pretty well with that, and so I think that's another strength of this fund. This one also goes a little bit further. It will do some non-dollar currencies, in small amounts, and a little bit more of structured credit. Those nonagency mortgages, which got into a ton of trouble during the crisis, but managers who've invested in them since then have actually done very well. It's been a nice performing part of the market.
Christine Benz: Last question on this one is the share class that I just referenced, that WACPX, that has a $1 million minimum. For people who aren't in a position to buy that, can you buy it somewhere else with a lower minimum? And then what are the costs like, if I'm in a lower minimum share class?
Sarah Bush: That's a good point. There's an A share class on this fund. It is available through some of the NTF platforms. (non-transaction fee) Including Vanguard and Schwab, but you do want to be a little bit more careful, because the expenses are a bit higher in those A shares. That's something that those investors should be thinking about.
Christine Benz: If you move away from the institutional share classes, you sometimes get a little bump up in the expense ratio. A pair of funds that you think are good core ideas, both from Baird, Baird Aggregate as well as Baird Short-Term Bond, these aren't household names among bond investors. Let's talk about why you and the team like the team at Baird so much, and why you've given both of these funds Silver ratings.
Sarah Bush: Baird is a very straight forward shop. It's based out of Milwaukee. A very experienced management team, a very straight forward approach to bond investing, so you're not going to see derivatives in these portfolios. I mention that Western, for example, has used currency which some of the other competitors have. These guys don't do that at all. They don't make big macro bets. They're duration-neutral, so they're not trying to take a view on what's going to happen with interest rates. Very plain vanilla, kind of focusing more on credit selection, making the right call, which maturity bonds are more attractive today. Again, not making those interest rate bets, but where are you getting paid for that risk. They're very cheap, so they don't have to do as much. They don't need all the bells and whistles of all these moving pieces, because they're really quite affordable. This is a shop we really like.
I would also point out that Baird Aggregate Bond, in particular, this is a fund that doesn't do any below investment grade debt, so I would think of this, this is not a core plus fund. This is a fund that really is focusing on that investment-grade, high-quality part of the market. That's the part of the market you'd expect to do really well when you get those equity sell-offs, so very good for diversification.
Christine Benz: That's a great point. If I've done my homework, and my X-ray has come back saying you've got way too much in equities, you need to get some bonds. Something like this would be an appropriate choice. Those are all great core fund ideas. You also brought a couple of non-core. Maybe sort of peripheral players. Let's start with the first, Templeton Global Bond. This fund's ticker is TGBAX. It lands in the world bond category. It's Gold rated. Its fortunes tend to kind of wax and wane, because it does have a very idiosyncratic strategy. Let's talk about that.
Sarah Bush: This is a global bond fund, so can invest across the world. It has, in recent years, really held large stakes in emerging-market stocks, so I would think of this as a diversifier. The manager there, Michael Hasenstab, has been very cautious and concerned about rising interest rates and risks for inflation. If that's a concern that you have in your portfolio, this is a fund that expresses that view. I think it's kind of an interesting play for diversification. If you want a little bit of emerging markets exposure in your portfolio, it's good. But you've got to have a lot of patience with this one. This is the kind of fund you should not be buying based on recent performance, and you should really be willing to hold over the long haul.
Christine Benz: It's performance will tend to be not so much bondlike, as maybe a little more equity like; so I need to be prepared for that as well.
Sarah Bush: Right, right. You can see that volatility. This is another fund too, just to highlight, there's a lot of non-dollar currency in it. That's what gives it a lot of the volatility, is having that exposure to non-dollar, both long positions and short positions.
Christine Benz: That's been helping it recently no doubt, but it presumably has hurt it at other points in time.
Sarah Bush: Right. There's times where that's really hurt the portfolio.
Christine Benz: Let's look at another fund. A little less sexy, I would say, than that Global Bond Fund. Vanguard Short-Term Inflation-Protected Securities, VTAPX is the ticker. That lands in our inflation-protected bond category. It's Gold rated. Let's talk about why someone might look at this fund, and why someone might look at TIPS in the first place, because they really haven't performed well, treasury inflation-protected securities.
Sarah Bush: This is a place, where if you're just going to look at trailing returns, which we really don't think people should, you might overlook. Inflation is the great enemy of a bond portfolio. It's eroding your purchasing power. It's something all investors--all investors, all portfolios--need to be thinking about. Although inflation has been muted, and inflation expectations, though they picked up a little bit, have been muted, this is kind of a great insurance policy for your portfolio. We don't have a crystal ball. We don't know what's going to happen in the future. This is the type of investment that's really going to help insure your portfolio, if we do get an unexpected increase in inflation.
Christine Benz: In contrast with a lot of the core TIPS products, this one's not going to be super interest-rate sensitive, because it's focused on the short-term bonds.
Sarah Bush: Right, and TIPS, this is something you have to be aware of with TIPS, the sort of longer term TIPS products can be very volatile. Although they're protecting you from inflation risk, you can still see a lot of volatility. This fund is less volatile, and another interesting thing about it, which Vanguard did a bunch of research before they launched it; they pointed out that in fact the short-term TIPS are a little bit more responsive to changes in inflation, so it actually does a really good job of providing that protection without the same kind of volatility that you might see in a longer term fund.
Christine Benz: An IRA is really an ideal receptacle for a holding like this, because of some of the tax considerations. You're not going to find a Treasury Inflation-Protected Securities fund in many 401(k) plans. If you're looking to kind of populate areas that your 401(k) doesn't provide, this is maybe a category to give a look to.
Sarah Bush: That's absolutely right. You do have to be cognizant of those tax issues, so an IRA is a great place to hold these.
Christine Benz: Sarah, always great to get your picks and your insights. Thank you so much for being here.
Sarah Bush: Thanks, Christine.
Christine Benz: Hang on for a second. We're going to be bringing Dan Rohr out here to share some individual stock picks. He will be joining us momentarily.
Welcome back. I am joined now in the studio by Daniel Rohr. He is director of Morningstar's North America equity research effort. He's brought some individual stock picks to share with us today. Dan, thank you so much for being here.
Dan Rohr: Thanks for having me, Christine.
Christine Benz: Before we get into the specific ideas, I'd like to hear about our coverage universe overall, or our equity coverage universe. Can you talk about whether after nine years into this rally that we've all been enjoying, is the coverage universe still looking a little bit picked over?
Dan Rohr: I'd definitely say so. Just to give our viewers some context here. Of the roughly 930-ish U.S. stocks we cover right now, we only have 13 rated 5 stars, which would be equivalent of a strong buy. A little bit over 1% of our U.S. coverage universe. As far as those 5-star stocks are concerned, that's one of the lowest figures I can recall in my 11 years here at Morningstar. We've got roughly another 180, about 19% of the coverage, rated 4 stars. Collectively, between those 4 stars and 5 stars, you're talking about 20% of our coverage is worth considering. Look at the other end of the spectrum, we've got nearly a third of our coverage rated sell or strong sell. By that measure, we think the market is overvalued, albeit, not extremely so.
Christine Benz: That's something that investors can kind of have in the back of their minds if they're looking at their IRA portfolios today, and have not done any re-balancing recently. That's yet another signal to consider perhaps bumping up your exposure to safe securities. Let's get into your picks though. You did look into the universe, and looked at some of the higher conviction ideas among the analyst team. Let's start with the first. This is Compass Minerals. The ticker is CMP. It's a 4-star small-cap stock. It lands in the metals and minerals sector. This is not a household name. Let's just start by talking about what this company does.
Dan Rohr: Very simple business model here. It's a company that mines salt from underneath Lake Ontario, sells it to municipalities in the U.S. Great Lakes region for use on roads during the winter.
Christine Benz: This one earns a wide moat rating currently. What accords it that moat?
Dan Rohr: In commodity land what you tend to see is it's all got to come down to costs. That really is for the most part in commodity land, materials more broadly, the main source of structural competitive advantage. Compass has got low costs for a couple of reasons. One is geology. The mine from which they extract the salt happens to have unusually thick seams of salt, which means a lower cost per ton extracted. Layered on top of that geological advantage, you've got a geographic advantage. As I mentioned earlier, that mine happens to be sitting underneath Lake Ontario. For a commodity like salt, where transportation costs comprise a disproportionate share of the total delivered cost to customers.
Christine Benz: Right, salt is cheap, right?
Dan Rohr: Salt is dirt cheap. The transportation cost to get that salt from the mine to customers, in say Cleveland or Chicago, is unusually low, because barge transportation is far lower than say truck or train.
Christine Benz: Whether you're looking at this company from a fundamental business perspective, or you're looking back on its total returns; it hasn't looked that hot. What is Morningstar's forward looking view about why we think it should perform better in the future?
Dan Rohr: You're right, Christine. This stock has been an awful performer for several years now. Why is that? I think it fundamentally has to do with the fact that it just hasn't snowed a whole lot in the U.S. Great Lakes region for the past couple years. Less snow means less salt, which means lower volumes, lower prices for Compass. I think to some extent the market has concluded with this name that because of global warming, the future is going to look a lot like the past couple years. To go about assessing that claim, we took a look at the past 120 years of snowfall in 10
major cities in Compass's operating footprint. We found a couple interesting things with that exercise. First is we found global warming has greatly increased the year-to-year volatility in snowfall. You look back at the past couple decades, and out of that 120-year period, the last couple decades have included both the snowiest and the least snowiest year. That might not be too counterintuitive to our audience.
More interestingly, what we found is stability in the typical year. You look at the typical year in say the most recent decade. Compare that to the typical year back in the 1950s. Not a whole lot of difference. It seems that while global warming's increased the year-to-year volatility of snowfall, the typical year is going to bring a similar amount of snow. On that basis, we're pretty comfortable with our forecast that eventually we will see a rebound in snowfall. We'll see a rebound, as a result, in salt demand, salt volumes for Compass, prices, and profitability.
Christine Benz: Your next pick is 4 stars. It's Procter & Gamble. This is going to be quite a familiar name to most of our viewers. It's a mega-cap stock, operates in the consumer staples sector, obviously. What doesn't the rest of the investing population know about P&G that Morningstar thinks it does? What's our competitive edge in recommending P&G?
Dan Rohr: Christine, I honestly think it's related to our long-term focus. The market, as a whole, generally tends to be a bit more short-term oriented. You look at the short-term results, P&G short-term hasn't been great. In the most recent quarter, which I think they reported late January, organic sales growth of 2%, flattish operating margins, so not a whole lot to get excited about. If you were to assume that the future looks a lot like the most recent quarter, then the market's right. This stock is trading exactly where it should be.
We do not think that 2% sales growth and stagnant margins are a sign of things to come. Our optimism is predicated on the prospective benefits of what's been a really massive overhaul of this company's product line. That's going to take some time to bear fruit. This is a company that's shed more than 100 brands over the past several years to narrow its focus on what are really the best opportunities. We think that's going to result in better capital allocation across brands, yielding better innovation, and as a result better top-line growth and some margin expansion as well.
Christine Benz: I think when people are looking at kind of stable, defensive companies like this, they really have not performed all that well in the kind of risk-on market that we've had over the past several years. It seems like there's reason to believe that in some sort of broad market downturn, you might see these stable growth companies do relatively better. First, do you agree with that? Then second, if a down equity market is accompanied by some sort of recessionary environment, or that's the catalyst, is there the potential for consumers to trade down in terms of some of their choices? Are they more likely to look at the store brand paper towels versus the Bounty? What's your take on both of those questions?
Dan Rohr: Very good questions. I would expect this stock to outperform in a market downturn. That's certainly what we had occur in the great recession. That's largely because just looking at the fundamental economic forces behind that, even in recessions, consumer spending tends to hold up a bit better than the investment side of the economy. Then you look at within the broader consumer spending category, staples, which is what P&G sells, of course tend to hold up better in terms of demand than discretionary purchases, like autos, appliances, jewelry. You're right that there probably will be some trading down in that eventuality. That's certainly what we saw in the great recession, but not enough in our view to offset the relative strength of consumer staple spending versus other areas of the economy.
Christine Benz: The last pick, which I hope you can cover pretty quickly because we do want to take some questions, is Dominion Resources. The ticker is D. This is a 4-star stock. It lands in the utilities sector. Let's talk about what this company does. It's a large-cap company, but not necessarily a household name like P&G.
Dan Rohr: It's a household name if you live in Virginia.
Christine Benz: That's your power company?
Dan Rohr: Yeah. It owns power plants. It owns the lines that move that power to consumers. It owns natural gas gathering, transmission, and distribution pipelines. It's also nearing the completion of a liquified natural gas export facility in Maryland.
Christine Benz: A little bit of a stumble on the return front recently, although very good long-term results from this company. Do you think that the interest-rate sensitivity that bedevils so many utilities is what has hit this company recently?
Dan Rohr: I think that's a big part of what's been going on. As you note, a lot of investors have treated dividend paying stocks, including utilities, as something, rightly or wrongly, as a bond proxy. When we have low rates, you get a lot of folks buying utilities to get those income streams that they can't otherwise obtain from bonds in a lower rate environment. With rates on the upswing, you start to see that unwind somewhat.
Christine Benz: Dan, great to hear your insights. Thank you so much for being here to share these stock picks.
Dan Rohr: Thanks.
Christine Benz: We'll be right back with Jeremy Glaser. He's going to come out and share with
me some of the questions that you've been submitting as we've been talking here. Stay tuned, we'll be back momentarily.
Jeremy Glaser: We got a lot of really great questions during the entire event. I know we're running a little bit short on time, but we'll try to get to as many of them as we can. Christine, the first one is really about the best time of year to make an IRA contribution. As we're here in March, this might be when a lot of people are thinking about it ahead of that tax day deadline, but is that really the right time of year to be making these kinds of contributions?
Christine Benz: Many people do wait until the very last minute, and there is a benefit I suppose, if you are in a position to potentially make a deductible IRA contribution. You can see whether that might actually help lower your tax bill, and you usually have the greatest visibility into your tax bill as you get close to the contribution deadline. That's one, perhaps small reason, to wait to the last minute. Vanguard did some interesting research a couple of years ago, where they actually first noted that a lot of their contributions do come in at the last minute, but they noted that people are foregoing some compounding. That's particularly important for young investors who, say, they wait until March or April of each year to fund their IRA. That's 15 weeks each year, of foregone compounding on the contributions. That's something to keep in mind.
All else being equal, you are eligible to make a contribution for that tax year once the calendar page turns. Better to fund those IRAs earlier, rather than wait until the last minute; although, I'll say this is one area where I'll say do as I say, not as I do, because I'm sometimes in this world of people who stuffs in a contribution at the last minute.
Jeremy Glaser: Let's talk about RMDs. We have a question from a user who is 68, and they're trying to think about ways to reduce their RMDs from their traditional IRAs. What are some strategies there? Is there anything that could possibly be done?
Christine Benz: Well, the first one I would mention, and this is something we've talked about before, if you are in the pre-required minimum distribution, post-retirement year--so for some of us this is maybe a five-year window or so--you can think about, in those years, the opportunity to convert some of those traditional IRA assets to Roth. As I said at the outset, Roth IRA assets are not subject to RMDs. This is a place where you want to get some tax advice. It may be an opportunity to convert just enough in each of those years to avoid pushing yourself into a higher tax bracket. That's one strategy.
Another strategy, once those RMDs commence, is that you can think about using a qualified charitable distribution to steer some of your RMDs over to charity. That's an idea for the charitably inclined, who are subject to RMDs, so they are post-age 70 1/2.
Then finally, there is the idea of using a qualified longevity annuity contract. Certainly not for everyone, but this is another way that some investors might think about reducing their RMDs going forward, because the amount that you steer to this qualified longevity annuity contract would not be subject to RMDs. Those are just a few strategies to bear in mind. Definitely get some tax advice about the advisability of any of them before undertaking them.
Jeremy Glaser: The next question is a follow up from one that you asked Sarah Bush about the high minimum in some funds. It’s from a small investor who is looking at some hefty minimums in some cases, or a lot of different funds, but they don't have that many assets to spread across that many funds. What does someone like that do? Is there a way to simplify your thinking around a portfolio to not run into these issues?
Christine Benz: Well, as Sarah mentioned, even if you are looking at a fund where the institutional class has a high minimum, some of these funds are available without any loads or transaction fees. Not the institutional share class, but the A share class. The expense ratio might be a little bit higher, so you want to be mindful about that. Really the floodgates have opened up for a lot of these shops that heretofore had only been available through brokers with full loads.
Now American Funds, for example, sells its lineup on Schwab's platform, and other no-transaction-fee platforms. That's something to look at, and it's a great way to reduce the number of accounts that you have to oversee, reduce the number of statements and 1099s that you have to manage. There a lot of great reasons to consider consolidating with a single provider. You just do have to watch those expense ratios if you're a smaller investor with lower minimum amounts to invest.
Jeremy Glaser: I'm afraid I'm going to ask you to look at your crystal ball a little bit. There was a question about if you think there is any regulatory risk around Roth IRAs, concerns that it maybe it won't be as tax free as people are hoping. Is that a real risk? Is that something that should potentially change how you're investing?
Christine Benz: I hear this a lot, and I guess anything's possible; but when I think about the Roth IRA, with the exception of this backdoor thing, which has let a lot of high income folks in the door, really the Roth IRA and its contribution limit is set up to be a vehicle for investors of more modest means. There's certainly middle and perhaps upper middle income investors to save within. I don't think if Congress is looking at areas to tinker with, I don't see them monkeying with Roth's tax treatment.
Then another key thing I always point out is worst case scenario, they're not going to re-tax the after tax dollars that you put into that IRA to fund it in the first place. I can say with some degree of definitiveness that that would not happen. Your contributions at least would not be subject to additional taxation. I think that Roth IRA investors can rest easy. I do think that this backdoor Roth loophole, at some point, may be closed down the line; but that's not something that really should affect people who are thinking about making the contributions right now, because right now it's a legitimate maneuver to take advantage of.
Jeremy Glaser: The final question is about re-balancing. If you do a portfolio X-ray, or look at your asset allocation, and realize it is quite a bit out of whack and need to make some big changes, what's the best way to do that? Is it in one fell swoop? Is it more gradually over time? What would be your recommendations there?
Christine Benz: Really great point, and I think quite a pertinent question right now. I think it comes down to life stage. If you are a younger investor, and I would say anyone under 50, probably not a huge reason to get too excited about having an overly aggressive asset allocation unless your retirement date is also fairly close at hand. If you're someone who's closing in on retirement, if you're looking at retiring within the next five to 10 years, you're the person who needs to get serious about rebalancing if you haven't done anything to your portfolio for a while. There I would say just rip the Band-Aid off, and make those changes as soon as possible.
It's really important though to think about where you do that rebalancing, and an IRA is a perfect place to try to help achieve better balance in your portfolio, your IRA and your 401(k)--any place where you're not going to get dinged on taxes to make changes and potentially lighten up on something that's performing really well, like stocks have. You want to focus your rebalancing efforts there. An IRA is really the perfect place to start doing your tinkering and see if you can achieve your desired asset allocation.
Jeremy Glaser: Christine, thank you.
Christine Benz: Thank you, Jeremy.
Jeremy Glaser: Thank you for joining us today. A replay of this webinar will be available soon, along with the transcript. If you have any feedback, please send us an email at firstname.lastname@example.org. Thank you very much for joining us.