Posts Tagged ‘high yield’

The markets are down, making mutual funds all that much more important for risk averse investors. That is not to say stocks do not have their place, but the reason I love mutual funds so much is because they offer so much diversification (some would argue over-diversification) that risk becomes somewhat limited. So what does that mean for a mutual fund investor? It means greater participation in specialty funds like gold funds, small cap funds, BRIC funds, and so on. What this ultimately means for your every day investor is:

• yes, the markets will tank and bring down their investments. But when core investments drop, other investments hold down the fort. Which investments will it be? Bond funds? High Yield Investments? Small Cap funds? If I or anyone else could predict such things ahead of time, we would never both with those core holdings in the first place, would we? By being properly invested, the risk of being wrong is reduced or eliminated… something’s gotta win.
• opportunities to rebalance. Maintaining a proper asset mix is essential to long-term success (compared to chasing the winners every time a winner is identified). This means that as markets increase or decrease, the asset mix will shift. This calls for rebalancing, trimming those assets that have done well and dumping money into smart mutual funds that have not fared so well. This achieves two things: it reduces over-exposure and it allows to buy assets when they are considered “lower.”
• buy more when markets suck, buy less when they are heroic. This is the basis of dollar cost averaging, something we should probably stress more often at this site. Still, when markets tank, it reminds us of the importance of never throwing all of our money on the table at once. It reminds us to ease into a position(s) gradually.

Now what does this all mean to how I would invest 10,000? It means that if I was given $10,000 today and told that I had to invest it (instead of spending it on a bunch of toys for the summer), I would:

1. Determine my asset allocation model. You can do that right on this site if you want, or you can ask your advisor to help you figure it out for you. Mine will show: 60% Equities and 40% Income (this is after I decided to ignore the cash recommendation and invest instead in fixed income). Seems conservative unless I am a balanced investor, yes. But let’s take a closer look…
2. Research the following mutual funds; a good Balanced Fund like the PIMCO All Asset fund, which is a medium risk, high return 4-star rated fund. I would throw $7,500 at this fund because it is not only well managed, but the underlying assets are those that I actually believe in. And then I would invest in the Ivy Small Cap fund (a fund I have been laughed at for picking and sticking to, but one that maintains all of the fundamentals that I personally believe in and trust). This fund will allow me to invest $1,500 of the remaining $2,500, leaving me with $1,000 which I would throw at the Franklin MicroCap Value fund, another 4-star fund but one that has virtually no risk associated with it and a track record that would make old pros blush.
3. Review, review, review. Yes, three times.  Per month, that is. Because I think these assets are placed so well, the portfolio would fall out of balance fairly quickly.

If permitted, I would add a 4th point: split the $10,000 into ten $1,000 contributions. This would not be possible in the case of the funds I chose here, but if I had, say, $40,000 to invest, I would invest 10K now, the remaining $30K over the next 2 years. And all of it would be in mutual funds; small cap funds and a balanced fund, maintaining as close to a 60/40 split as I possible can given that balanced funds will not report in real-time what their holdings are.

An interesting philosophy exists, whether you invest in mutual funds or straight equities, that suggests we can all know where to invest if we go against the current rather than with it. In other words, if we adopt a contrarian mentality, we stand see some sold long-term gains in our portfolios. As an investment strategy, this is not always an easy thing to do. When you get into picking the best mutual funds, it becomes even tougher. (And of course if we are short-term traders, then it becomes virtually impossible).

So, where to invest…

Common sense and history tell us that if we all invest in a single asset, we drive the price of that asset up. Look at Oil in 2007. Look at Gold today. Look Apple shares. But the risk you run when you follow the herd is that you end up buying that asset somewhere near the peak of its price range, exposing your portfolio and investment to some serious and very real risks. For these reasons, we often try to find that diamond in the rough, that undiscovered security that is trading at a terribly low valuation — look at RIMM seven years ago, for instance, Teck Resources (TCK) even 1 year ago. Again, with the power of hindsight, we would all be retired by now, and we would all be millionaires.

With this “find the diamond in the rough” mentality, a couple of things can happen. One, we take on exaggerated risks because the assets we buy are simply cheap; they lack the fundamentals to support investing in them at all. The second thing that happens is that we hit a grand slam, we pick the right security at the right time when everyone else threw money at the latest and greatest Wall Street gem. The latter, of course, is an example of Contrarianism and this is exactly how we should invest, according to some.

What is Contrarianism?

This type of investment practice can mean a different things for different investors. The obvious interpretation is to sell when and what others are buying, and vice versa. It speaks to Warren Buffett’s famous quote: “Sell when others are greedy and buy when others are fearful” (not an exact quote, but the message is bang-on).

On a deeper level, it involves going in areas that others are ignoring. It means buying Citigroup (C) when it was trading at $1.02 and everyone else was not only ignoring it, but buying bonds at ridiculously low rates. It also means believing in the company’s fundamentals, trusting that the Board is doing the right thing by appointing Vikram Pandit after Charles Prince resigned (of course, each company will be different, the names will change but, in Bon Jovi’s words, the streets are the same).

It is in my opinion that this second type of Contrarian investment practice is the one we want to adopt as amateur, novice and even intermediate investors. Not only is it less risky (e.g. ignoring a strong asset class altogether and dumping money into unfavored classes even when fundamentals do not support it), but we can actually apply this practice to mutual funds purchases.

Now, understand that great websites like Morningstar have built tremendous intellectual capital, websites, and businesses doing exactly the opposite. That is to say that their models often favor top-performing funds where regular investors are flocking (this website’s Top Picks are great funds that Morningstar has ranked well, also). And other sites like FundAlarm also takes this view, ranking funds as “dangerous” if they fail to meet or exceed their group or category for three measurement periods.

But Contrarianism takes a different view. Often, the mutual funds you should invest in under this theory are those with net redemption figures, which are often triggered by poor performance track records that gets noticed by those two websites mentioned in the previous paragraph. Some Small Cap Funds like the Ivy fund (YTD return of 9.74%) we like, for example, invest heavily in small to medium cap financial services firms. Investing in this Ivy fund could certainly be considered a contrarian move; investing, on the other hand in the High Yield Investment fund that we recommend (YTD return of 3.80%), would not have been.

While both funds above are in completely different asset classes, they have both outperformed their peers, which leads to a natural question: do Contrarian Investment Practices really work?

The simple answer is: yes they do, especially with mutual funds.

(More to follow… check back soon as we take a deeper look into this interesting investment strategy and provide a tangible foundation to our argument).

As far as mutual funds go, the Cash and Cash Equivalent asset class has got to be the most unattractive for many investors. It lacks the wild swings that the specialized, small cap funds enjoy, it doesn’t even have the high yield that a lot of dividend funds can brag about and, well, it’s cash. Can anything cool be said about cash? Well, no, not really. But investors need to care about cash equivalent funds. Here is why:

• The obvious. Cash equivalent mutual funds generally do not depreciate in value. Their benefit comes neither from price fluctuations and volatility nor from interest earned, but from liquidity and safety. When Warren Buffet managed to stash away over $86 Billion during the market downturn of 2008, he was not whining about a lack of interest being paid on those funds. Instead, he knew that unlike his equity investments in the companies he felt had great long term capital growth prospect, he could draw on his cash reserves whenever he wanted… it would always be there waiting for him.
• Cash equivalent funds need not be “boring.” Since investors should always have a minimum of 5% invested in cash (even our most aggressive Asset Allocation Model recommends a minimum of 5% in Cash and Cash Equivalent Funds), it makes sense to explore a little. This means taking on a little more risk if such a position fits your investor profile. Some alternatives to straight Money Market funds, for example, could be Vanguard’s Short-Term Bond Index fund. This fund invests primarily in US Treasuries, yet its yield is actually 2.64%. Not bad for a bond index fund and given its short-term nature, even mild fluctuations are not something one can expect. And with $16.5 Billion under management, it seems to me that Vanguard will not have trouble meeting your redemption request. Plus, this fund in particular has never seen its value deteriorate over the course of a 12-month period. In other words, even if you were to experience a temporary pull back in this fund, simply holding on for a few more months will return any losses. By adding a bit of spice to your Cash portfolio, you can actually enjoy the benefits of Cash liquidity and safety and take advantage of bond-like and dividend-caliber yields.
• Cash is a perfect place to park funds earned on gains. Let’s face it. Markets rise and they fall. When one crystallizes gains on equity funds or even bond funds, logic often leads folks back into the same asset class from which they are exiting. This makes absolutely no sense! If you were to pull out of an equity fund because it returned a hefty 30% over, say 3 months, why jump back into equities? If equities were expected to keep rising, why pull out at all? The idea is to hold onto one’s gains and if core- and high-yield bond funds do not offer the promise of a good return, then why no park those funds in Cash? Looking back at Warren Buffett, that is exactly what he did. He did not simply wake up one day with $86 Billion in cash; he built those reserves, trimming gains as he went along during the market expansion period. This reserve allowed him to invest in companies he believed would have great prospects for gains, like Burlington North Railway.

Now it is true that Cash Equivalent Mutual funds are not hot and sexy. Even the Vanguard Short-Term Bond Index fund quoted here has little to offer in the sex-appeal department, and that fund is considered above-average risk among its category! In fact, this fund’s 52 week range is a narrow $10.17 to $10.56. So if it is not yet clear why you should care about Cash Equivalent Mutual Funds, just think of Warren Buffett and ask yourself what he might add to the three bullet points above. Most investors will realize rather quickly that Cash really is an important element to a successful investment portfolio. Sexy or not.

Despite all of the press out there that suggests that high yield investments are not where investors want to invest, there is a small group of professionals (including those of us at the Mutual Fund Site) that believe that these mutual funds are indeed still favorably priced. But not everyone is well suited for high yield investments. Those people will typically chasing growth rather than income. For those investors, dividend funds might be where to invest.

The interesting thing with dividend funds is that they provide income, much like a bond fund or high yield investment would pay income (the difference is dividend income versus interest income). With dividend mutual funds, investors can expect yields around the 5% range, some higher and some lower depending on the fund you are considering.

But the kicker with dividend funds is that investors should be more focused on the growth prospects of the securities held within that mutual fund. The Vanguard High Dividend Yield Investment as an example pays roughly 5% but is also invested in large-cap value stocks. While that yield is certainly nice, the underlying holdings have an average P/E ratio of 15.7. This suggests that the future gains will come more from the growth of those underlying securities than the dividends themselves.

While we have not completed our full analysis of the Vanguard High Dividend Yield investment, this fund illustrates the difference between high yield funds and dividend funds. That key difference? Where the future returns are most likely to come from.

As for risk, the investor will need to determine the proper level of risk he or she is willing to assume. This will ultimately determine the type of fund (growth versus value, large cap versus mid- or small-cap, etc.) and can help create something of a short-list for the investor. In essence, however, dividend funds are similar to high yield bond funds. But the bottom line is that bonds will pay income and dividend funds pay dividends as a bonus; the key is in the long-term growth prospects.

So when it comes down to it, dividend funds are not the new high yield investments. They are merely different beasts co-existing for different investors with different needs.

Our site has seen a lot of traffic coming in to see what our 2010 Top Pick has been… and why. Although more and more investment sites are starting to see the true potential in high yield investments, there is still a lot of negativity when it comes to these types of mutual funds particularly for this year (2010). A lot of the uncertainty might have to do with just how well these bond funds have performed over the past year (2009), some returning just as much as the S&P 500 (and some returning even more). While there is a fair amount of risk associated with the types of funds, we are at a point in history that may never repeat itself for the balance of our lives.

…we are at a point in history that may never repeat itself for the balance of our lives.

At the Mutual Fund Site, we believe there are two things working in the favor of investors who look at high yield investments for 2010 (and our High Yield Investments: Top Pick for 2010 in particular). We will outline the advantages briefly:

1. As markets improve, so will yields on these high yield investments. While this statement runs contrary to the academic studies of the past, consider this: The credit crisis of 2007 – 2009 pushed rates on all types of non-government borrowing sky high. Government rates of course fell through the floor due to demand, and this high demand for government bonds and low money supply for corporate bonds created a wide spread between corporate and government rates.

As the economy improves, rates typically increase in order to keep the economy from overheating. This time is different because corporate rates are already high, meaning they will either stay the same or drop marginally. We see a few common reasons for this. The first being that with there being less perceived default risk, more money supply will head into the corporate side. As supply rises, rates will start to drop (or in the case of rising rates, stay the same). This will have the effect of narrowing those spreads between corporate and government rates. As well, default risk will tangibly reduce because as the economy recovers those companies that were seen as “suspect” will become healthy again while those that were expected to fail will have already failed and be gone.

2. High income, high market value. Probably the most persuasive reason to hold high yield investments today is that the rates story (outlined above) will provide bond holders (again, visit our Top Pick story) will benefit from higher income. And if turns out that those rates start to drop rather than staying the same, then the other part of this equation is that the bonds in question will start to appreciate in value (remember, as rates drop, prices rise). This presents high yield investors with a double-bonus system of enjoying higher income derived from those original, inflated rates and the added bonus of higher market prices that the markets will pay for such high-rate bonds.

Remember, the primary motive to invest in bonds is the income (hence the “income class”). Unless the economy makes a miraculous recovery and starts providing returns that are far in excess of expectations, then those rates will not skyrocket. They will, at the very least, remain level, making high yield investments a great place to invest for 2010. And if your income class knowledge is sub-par (or you want to properly invest in this class) the only way to play this game well is through mutual funds or ETF’s.

Okay, you have just three years and a hundred thousand dollars burning a hole in your pocket. Three measly years and you need to know where to invest that money so that, in three years when you need that investment, you know that you have not risked that money for the sake of return. Where do you invest it? What type of mutual funds, including ETF’s meet this requirement?

Three years as a time horizon is a tricky one. It is neither short-term nor long-term. Some may call it medium-term, but when you have just three asset classes from which to choose – cash, income, equities – how to do you find that best 3-year time horizon. Because let’s face it; based on the interest rate environment, many bond funds now have a 5-year time requirement. And high yield investments, due largely to their speculative nature really should be longer-term, even if they come with the probability today that they will benefit from rates in the next 12-36 months.

Based on the interest rate environment, many bond funds now have a 5-year time requirement…

And equity funds, well, even the most conservative come with a minimum time investment of 5 years. Anything short of that is just far too risky for the investor. Of course, luck can always prevail and provide the right return after just 3 years, but there is no guarantee of that. Suppose you invested in 2005… three years later would put you into 2008, arguably one of the worst years for the markets. You would have been (censored), kicking yourself.

Okay, and let’s say you invested in bonds at the same time. Short of a government bond fund that saw rates plummet while the US borrowed heavily and saw some rates so close to zero that brokers quoted them that way, you would have also been (censored), kicking yourself for ever thinking that bond funds were the safest and greatest thing since, well, sliced bread.

In 2005, the best 3-year investment would have been a 3-year term deposit… with a financial institution that did not go under. But remember, even people who invested in Citibank were nervous in 2007/2008, lining up to get access to their money. Remember that panic?

But that was the past, right? Today, things are different. Citi is still around, rates are at their lowest and some of the best performing mutual funds in 2009 were indeed bond and equity funds. It makes high yield investments look really lucrative right, especially after this very site announced that its top pick for 2010 was a high yield investment fund. But even the most aggressive financial planner would recommend a 5-year time horizon on a fund like that!

So what are your options when it comes to a 3-year maximum time horizon?

Cash Equivalent

You could look at a cash equivalent fund, but kiss any kind of return goodbye.

You could also look at a term deposit but consider than rates are likely to increase, so if you lock up your money, you will lose purchasing power.

Bond Funds

While bond funds will present marginally more risk, your short-term bond funds will allow fairly decent turnover within the fund, mitigating the risk of holding longer term funds. While rates of return will not come close to those expected in some of the riskier funds, the idea here is to get back what you invest.

Diversify

Perhaps your best bet with your $100,000 and 3-years, would be to diversify your holdings. This might look like 30% short-term bond funds, 30% cash equivalent or Treasuries, 25% Cash, and 15% term deposit. The strategy might involve using the cash and cash equivalent funds to gradually increase your short-term bond holdings or term deposit holdings based on the performance over the next 2 years so that at the end of 2 years, your portfolio might have 65% short-term bonds and 35% term deposits that mature in the year that you need the funds.

A riskier investor might be able to absorb the potential volatility and impact that a lower-risk equity fund can offer, but most financial planners will not even touch that one… leaving you to make your trades with a discount broker.

At any rate, realize that with 3 years your investment options will be limited. And while growth and returns will be low, your objective should be to virtually guarantee return of capital. Even the most educated fund manager would subscribe to such a strategy, ensuring that investment risk is only so high as the expected rate of return.

Not very long ago, the idea of the income asset class, and bond funds in particular was to provide a decent level of interest income. A nice byproduct of bond funds was some of growth potential they had when bought at discounts or sold at premiums. Such mutual funds were rather blase, boring, even cookie cutter. But insofar as investment management was concerned, bond funds made a lot of sense. They paid better than cash-equivalent funds and for those rates they were still considered liquid; you were never locked in with these bonds funds like you might have been with a term deposit.

But bond funds of yesterday were a little misleading. They filled a void, sure. But they were boring underperformers that betrayed the true potential for wealth that bonds can offer. And for many income class investors, that potential for wealth was and still is tremendous.

One of the reasons why bond funds offer such great potential is thanks to nothing other than this most recent recession the entire world has had the (dis)pleasure of enduring. Perhaps the biggest benefit has come in the form of higher borrowing costs for corporate entities, all while government rates dropped to unprecedented lows. This, in turn created wider-than-normal spreads, presenting an historic opportunity for investors who are new to the income class.

Where investors stand to benefit however is in the arena of high yield investments, themselves bonds. What distinguishes these high yield investments from traditional investment-grade bonds is the coupon rate, or the rate of interest that the companies must pay to the bond holders. In the case of high yield investments, the rates paid are considerably higher than investment-grade or even government bonds because a lot of the companies whose bonds are held within the portfolio have been downgraded by rating companies like Moody’s and Standard and Poor’s.

In fact, many of the companies whose bonds make up the portfolios of these bond funds were rated as investment-grade just a couple of years ago but ever since the rating companies came under fire for some of the ratings they gave to some of those fancy Collateralized Debt Obligations (CDO’s, remember those?). Ultimately, the high yield bond funds are below investment-grade with BBB, BB, B ratings and some rated below B.

But, of course, the companies that issue these bonds need to pledge collateral against these bonds. This collateral is often an important asset to the company, vital to its ability to generate income. Now, consider a company that has bonds against which is pledged a considerably important asset to that company’s success. In addition to this debt, the company has probably issued common stock, or equity. In some cases, there may even be a dividend to be paid on such common stock, but it is rather unlikely (though not impossible) for below investment grade common stock.

A quick review of this scenario reveals that the first people to get paid first are the bond holders. So if there ever were any financial troubles, the bond holders would be paid first. The company, not wanting to risk losing this asset, vital to its ability to generate a single dollar, will do everything in its financial power to ensure their bond holders, where such bonds are investment grade or not, are satisfied. That the terms of their agreement are met.

And with spreads as wide as they are, all companies are paying a considerably higher coupon on their bonds. Therein lies the true opportunity for bond funds…. until those spreads start to narrow. And they will narrow, there is no question. As the economy recovers, all spreads will narrow. Government bond rates will rise and corporate bond rates will drop. Existing corporate bond prices will increase while government issues will drop.

So, in a nutshell high yield bond funds offer a great opportunity right about now. Most bond funds hold securities where the coupon is high. As rates drop, so will the bond price (that inverse relationship is a pretty thing). This helps with capital appreciation. But since the coupon was high to start with, there is also a nice trickle of income being poured into the investment. In essence, today’s high yield bond funds are not the same as the bond funds of yesterday. In fact, they are better. How much better comes down to an average yield of 10+% and 2009 performance of better than 35%.

As part of a press released issued today, the Mutual Fund Site is pleased to announce that its top pick is Janus Capital’s High Yield Fund (JAHYX). This fund is arguably the strongest performing fund in the high yield investments segment. While we cannot sell this fund through the site (you will need to speak with your planner as we are an information-only service), we can provide the following bullet points about this fund:

• Below average risk while achieving above-average returns for the past year, 3 years, 5 years and 10 years
• Tenured management (Gibson Smith since 2003)
• Average credit rating of holdings is B rated
• Average Yield is 11%

As noted in the actual release, we believe that Janus has properly traded the Yield curve with their current top 25 holdings. Additionally, we expect to see turnover (currently 109) slow over 2010 and 2011 as spreads between corporate and government issues narrow heading into late 2010 and early 2011. This presents the opportunity for safe growth within the fund, particularly as corporate credit risk diminishes with time.

We also believe that this fund has properly positioned its trading over the past year or so to take full advantage of downgrades by rating companies. It seems evident now that the fund managers were able to pickpocket the best opportunities insofar as corporate bonds were concerned in 2008 and early 2009. There are strong fundamentals backing virtually all of the fund’s Top 25 bond issuers, which we believe to be a truly exciting opportunity for today’s market-sensitive investors.

While there are other bond funds that have outperformed the High Yield Fund, we firmly believe that no other is as well-positioned for above average returns given the below-average risk shown here.

Make Smart Money

Mutual Fund Site Admin Team