Dear MAX,

I recently started my first job that has offered a 401(k) plan, and I was very excited to begin investing. The problem is, the funds in the plan are load funds, and after being a fan of your site I know that load funds should be avoided at all costs. Should I invest in my company's loaded 401(k) plan?

Yousef
Fort Dodge, ID

Dear Yousef,

We've reviewed hundreds of 401(k) plans for our Private Management clients and for investors who have used our MAXadvisor 401(k) Planner service. While many of those plans offer funds that normally charge a sales load to investors outside of tax-deferred accounts, the vast majority of those plans waive the regular load charge to people who invest through a 401(k) plan. We've often seen Templeton funds offered without a load charge through company-sponsored retirement plans that would cost investors 5.75% if they bought it at Etrade outside of their 401(k).

There are, however, some very lousy 401(k) plans out there that do, inexplicably, force participants to pay load charges. The dubious rationale behind paying load charges is that some investors need help choosing the funds that are best for them from the ten-thousand plus funds available. How this rationale holds up in a 401(k) plan in which investors have limited choices is beyond us.

You can find out if your 401(k) plan is loaded by asking your company's plan administrator (although if he was dumb enough to choose a loaded plan in the first place, there's a pretty good chance he won't know if the funds in it are load funds or not), and by reviewing your plan's literature. Don't be shy about calling your provider and asking them whatever questions you need to, either.

What should you do if you determine that your plan does, in fact, offer only load funds? Well, as much as it pains us to say it, you might want to go ahead and invest in your plan's load funds anyway – as long as your company matches your 401(k) contributions. The 'free money' your employer gives you through a matching program would more than make up for whatever load charges you are forced to pay. There is no sweeter deal in the investing world than 401(k) matching funds; take advantage if you can.

If your company doesn't have a contribution matching program, you should tell your job to take their 401(k) plan and shove it—you ain't investing there no more. You'd be better off investing the money you would have contributed to a 401(k) in quality no-load funds through a Roth IRA account. While you won't get the same up-front tax break you would by investing in your company's 401(k), you will enjoy tax-free withdrawals after you pass retirement age.

And even though you're a new employee who probably doesn't want to make waves, as soon as you're comfortable you and some co-workers should approach your plan's administrator and ask them to please, for the love of Pete, find a better 401(k) plan. There are many solid plans out there to choose from, none of which are loaded.

Thanks for the question.

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(Published 09/01/05) One of the hottest fund categories over the last three years (ending 8/31/05) has been utilities. The three-year total return for the Dow Jones Utility index is a whopping 90% –double that of the S&P500 over the same time period. The typical mutual fund in this category scored a whopping 73% return. Our favorite in this category, the American Century Utilities fund (BULIX), which has appeared in several of our MAXadvisor Newsletter model portfolios, scored a 77.5% return over the same three-year period.

With investor excitement for utilities stocks at the highest levels since the days before the Enron debacle, we are finally downgrading utilities to a negative rating. We think utilities funds should underperform the market and 60% of stock fund categories in the next one to three years.

Utilities has been one of our favorite categories since we started the MAXadvisor Newsletter. From April 2002 through the end of January 2004 we gave the sector our highest rating (Most Attractive – should outperform the market and 80% of stock fund categories over the next 1 to 3 years). Then, for the next eight months, we maintained a positive rating (Interesting – should outperform the market and 60% of stock fund categories over the next 1 to 3 years). We then downgraded utilities to a neutral, and finally sold much of our utility stakes in our model portfolios a few months ago. But even after our downgrades, the funds in the category just kept climbing higher.

Despite the sector’s continued outperformance, we’re now more confident than ever that a utilities downturn is imminent. The only reason we’re not downgrading to our worst rating is that new utility funds are not sprouting up like mushrooms (new fund launches are one of the strongest contrarian signals of trouble ahead for a category), but existing utilities funds and ETFs are hugely oversold already. The iShares Dow Jones U.S. Utilities Sector Index Fund (IDU) has $800 million in assets. Our own favorite, Utilities SPDR (XLU), has an unbelievable $1.97 billion in assets.

For comparison, the Technology SPDR (XLK) – which is also a portfolio holding of ours – has around $1.3 billion. The only sector ETF with more money is the Energy SPDR (XLE), and we just slapped our worst rating on natural resource funds – the category energy falls under.

Can you imagine utilities funds being more popular than tech funds? Certainly not a few years ago. This is why utilities have doubled the market return in the last three years – nobody wanted anything to do with these during the dot-com bubble. Between Enron’s collapse and stories of over-leveraged, new-economy-style energy companies teetering on the edge of bankruptcy, the stocks had nowhere to go but up. The fact that a utilities index paid almost 6% in dividend yield didn’t entice anybody.

The ultimate buy sign was when Vanguard decided to convert their utility fund (one of the only good, low-fee funds around, our former top favorite and portfolio holding) into a plain-vanilla, dividend income fund. Vanguard did this in late 2002 because they couldn’t give away shares of a utility fund at the time.

But the category has now come full circle. This is not a good time to buy utilities funds. It is a good time to sell, which is what we’ve been doing all year in our newsletter and other portfolios. Performance has brought utilities stocks back to their pre-Enron levels, when utilities stocks were priced as if failure in their leveraged business models was impossible.
Worse, yields have fallen near proportionally with the rising prices (dividend increases haven’t come close to matching stock price appreciation). Today’s utility buyer is getting a dividend yield perhaps 1% over the S&P500 (3% instead of 2%) and about the same P/E ratio for owning heavily regulated businesses in one of the slowest growth and oldest economy areas around.

Sure, new home buying will lead to some growth, but come on, is your run-of-the-mill electricity utility going to grow earnings like other components in the S&P500 – like Pfizer, Wal-Mart, and Microsoft? Utilities are supposed to be cheap; they are a nice bond alternative that can perform better with inflation because dividends can go up with price increases, but that’s about it. Today’s utility fund buyer is looking at the near doubling over the last three years while ignoring the fact that utility stocks are going to have a tough enough time keeping pace with the market over the next few years (much less outperforming even more).

We’re sticking with our two lone favorites here largely because there are not too many compelling choices – at least since Vanguard made their utility fund disappear. Does Vanguard regret this move now? Maybe. They launched a couple utility index funds last year (their original utility fund was actively managed). The first was an ETF, Vanguard Utilities VIPERs (VPU), followed a few months later by one admiral class open-end fund with a $100,000 minimum, Vanguard Utilities Index Fund Admiral Shares (VUIAX). Both are fine alternatives to our picks below as well.

Most utilities funds are load funds because brokers need something to sell to widows and orphans and still land commissions since churning a stock account for those needing fixed income and low-risk could get them into trouble. What few utility funds are available without a load are fairly expensive. Since utilities should be bought primarily for yield, this is unacceptable. At the current paltry utilities yields, a 1.2% expense ratio quickly turns a utility fund dividend yield into an S&P500 index fund yield because fund fees are paid with dividends first.

We had our highest rating on down-and-out utilities back in 2002 and 2003. In 2004 the area was about the hottest this side of energy. Money keeps dumping into utilities stocks, and dividend yields are now paltry after even more big gains in stock prices in 2005 (beyond what we expected). Given the likely business growth, this is bordering on absurd. When interest rates move up this hot area is going to fall.

Category Rating: (Weak) – should underperform the market and 60% of stock fund categories

Previous Rating (08/31/05): (Neutral) - Should match the markets return and perform in the middle of other stock fund categories

Expected 12-month return:-2%

Broadly speaking, there are three asset classes: stocks, bonds, and real estate. Cash, or money market funds, are really just a type of bond – very short term and very safe. While investors can gain access to all three with mutual funds, most own real estate directly. For many, real estate is their biggest, and often their best investment.

There are three main reasons real estate has generally been a successful investment for most people: 1) by buying a home, investors are effectively paying themselves rent 2) a mortgage is essentially a forced savings program paid into each and every month 3) because of the nature of the investment, real estate investors tend to avoid the poor decisions they make when they invest in other major asset classes.

Unfortunately, this last factor may be changing.

The main reason investors should worry about real estate bubbles is this: most experts say that real estate bubbles are simply impossible – at least on a national scale. In a recent article posted on bankrate.com, David Lereah, chief economist for the National Association of Realtors, was quoted as saying, "There is no national price bubble. Never has been; never will be."

This may go down as one of the most infamous quotes in investing history, up there with respected Yale economist Irving Fisher, who in 1929, shortly before the great stock market crash, proclaimed that “stock prices have reached what looks like a permanently high plateau".

With investing, there is no such thing as “never”. The fact that something hasn’t happened in the past does not mean it can’t happen in the future.

People like real estate. They trust it. They can live in their investment. After a sharp bear market and numerous Wall Street scandals, the same can’t be said about stocks. Much of this good feeling was capped off with recent massive gains in real estate prices around the country, notably in certain hot markets.

The sentiment could be summarized by a short piece on CNBC to plug her show by the vivacious and orange-tinted Suze Orman:

“Hi everybody I’m Suze Orman. Now have you noticed that the markets really haven’t gone anywhere over the past year or so? What should you be investing in? I’m here to tell you that I still believe the number #1 investment for you is real estate…”

We have two reasons for being skeptical about Suze’s claim. For one, she has been wrong in the past - some have poked fun at her for being a big proponent of “the Cubes” or QQQ (recently changed to QQQQ), the Nasdaq 100 Index ETF back in the stock bubble years - an investment choice still down around 70% from the high. Two, we disagree with her because we think real estate doesn’t really beat the stock market over long time periods because of the nature of homes vs. stocks.

Recent memory aside, home prices do not climb much faster than inflation over time. There is a sound economic reason for this – homes can be built out of materials that are highly correlated to inflation. Even the cost of labor used to build a home is closely tied to inflation. Home prices are capped at a slim margin over the cost of building a new home, and the cost of building a home tends to move with commodity prices and labor costs.

This is not to say fortunes can’t be made in real estate - notably with coastal homes that are in limited supply or from buying in an out-of-favor neighborhood before it becomes popular. But for many, homes are the ultimate commodity investment - it works mostly because so much money is plowed into it (divert 30% of your income each month into anything and it will be worth a small fortune someday).

The reason we recommend real estate in general as an asset class over real commodities is that real estate can be rented for income, and income producing ability (now or in the future) is the true definition of an investment over a mere speculation like hoarding copper.

Investors often look to real estate when stocks let them down. The last true real estate bubble in America took place in the early to mid 1920s – the great Florida land grab. What really kicked off the rampant speculation by individuals was a sour stock market. From peak to trough in 1919 to 1920, the Dow suffered a 47% drop – one of the fastest and most furious in history.

Early gains made by speculators in Florida’s development led to wild stories of easy riches that sucked in more and more money – into dumber and dumber investments (sound like the tech boom to anyone?). Before long, hucksters were selling underwater land as the next multimillion dollar hotel location to greedy investors looking to flip their way to instant wealth. The expression, “If you believe that, I’ve got some swampland in Florida for you” lives on to this day.

Investors also like leverage. Borrowing makes the relatively low risk world or real estate investing as exciting as . . . well, tech stocks. Today it is not uncommon for someone with very average credit and only a moderately stable income to plunk down $25,000 on a $500,000 home. If the home climbs 20% to $600,000 (which it has been doing for years now, so why should it stop...) the investor turns $25,000 down into $125,000 safely. Try doing that in stocks!

On the other hand, somebody who borrows $475,000 (to buy a $500,000 house that cost $300,000 a few years ago, and could be worth that much again) could lose his job and be unable to make the payments—that will climb if interest rates go up. It’s pretty hard to turn $25,000 into a negative $175,000 with stocks.

A recent real estate broker’s guidebook on New York and Florida (that looks like a stock analyst’s report) noted some startling price trends: 2-4 family townhouses in Brooklyn were up 174%, studios in New York City up 20%, lofts up 35%. More startling was the time frame of the big returns: 1 year.

Everyone is so sure that real estate will continue to move onward and upward that the cost of buying a home is now at record highs in relation to the cost of renting the same property. In some hot markets it costs just 50% or less of what it would cost per month to buy to simply rent. It is entirely possible that an investor would do better renting the house they want to buy, and parking the difference each month in an index fund – at least for shorter periods of time of 1 – 7 years.

More sobering is the thought that the relationship between renting and buying could become exaggerated quickly if rates rise (which increases the costs of home buying) or if rents fall (which could happen in a recession). Suddenly homes may not be just 25% overpriced, but perhaps 40%.

Is 25% overpriced a bubble? It is when the average home only has about 50% equity on the books. In other words, if homes fell 50% in price, there would be no equity left in residential real estate, and the outstanding mortgage debt would exceed the market value of the property.

This is startling because homes are now our greatest asset. Today, total household wealth is higher than ever, largely because appreciating home prices have made up for any losses in stocks.

Saying that only some regional markets are overpriced is like saying only some stocks were overpriced in the 2000 stock bubble. Therefore, buying – even on margin – is safe. Florida, New York, California, New Jersey, Massachusetts, Connecticut, and Las Vegas represent more than 50% of the total market cap of all U.S. property, so it’s hard to say the bubble is only localized. Exxon Mobil (XOM) wasn’t overpriced in 2000, but Cisco (CSCO) was.

Brokers used to let customers buy stocks on up to 90% margin because stocks were a sure thing. After the crash of ’29 people realized the error in their logic.

Maybe real estate won’t crash. Maybe prices will just stay at the current levels until fundamentals catch up. Maybe we’ll never learn the risks of 5% down. Let’s hope so – an economy partially fueled by home equity loans can’t take a bear market in home prices.

Better if we think a bear market in real estate is something that doesn’t exist.

Dear MAX,

Can I convert my regular IRA to a Roth IRA, and should I?

Holly
Santa Fe, NM

Dear Holly,

First, let's tackle the "can you" part of your question, then we'll move on to the "should you".

Can You? The answer to this question is relatively simple to determine. You can convert from a regular to a Roth IRA if your adjusted growth income is below $100,000. That figure applies to both single filers, married couples filing jointly, and heads of household.

If you're married and you're filing separately, you're out of luck. Rules concerning conversions specifically forbid married persons filing separately from converting their IRAs.

That's about all there is to the "can you" part. But now things get a bit more complicated.

Should you? Let's get the bad news out of the way first: If you convert from a regular to a Roth, you could be liable for a big tax hit on your IRA money. Convertees are responsible for paying taxes on any and all money they contributed to their regular IRA that they deducted from their taxable income. That means that all that income tax you didn't have to pay when you made the original contribution is suddenly due to Uncle Sam, in one big, ugly chunk.

The amount you pay in taxes is determined by your current tax bracket. If you have $100,000 in your account, you may wind up with an immediate tax bill of $25,000, if you are in the 25% tax bracket. If you are in the 33% tax bracket, you would owe $33,000.

The thought of writing a check that big to the IRS is enough to stop many a potential regular-to-Roth converter dead in their tracks. But despite the potentially horse-choking tax bill, a conversion from a regular to a Roth IRA is a good way to go for certain people.

If you're a younger investor (we couldn't help but notice that you coyly declined to reveal your name in your question), a Roth conversion is probably a good idea. That's because you have plenty of time before retirement to make up the money you lost to taxes during the conversion.

Certain older investors can benefit from a conversion as well. Roth IRA contributions are taxed (or rather made with after-tax dollars); distributions are not taxed. Regular IRA contributions are not taxed; distributions are. If you are fairly sure you'll be in the same (or higher) tax bracket when you become eligible for distributions, and you don't plan on taking large distributions for at least five years, a Roth IRA conversion could end up saving you a bundle in taxes over regular IRA distributions.

(If you'll be retiring or you're planning to begin taking distributions from your regular IRA in less than five years, converting to a Roth is not an option. Convertees who begin taking distributions within the five-year window will have to pay a 10% penalty on the distributed money.)

Another point to consider is whether or not you will depend on your IRA for income when you retire. In a traditional IRA, you must begin taking distributions at age 70 ½. If your retirement plan isn't counting on those distributions to sustain you in your golden years, then a conversion to a Roth may be a good idea. Because you aren't forced to touch the money you have in your Roth IRA account, it can continue to grow and grow. That means you could throw yourself a hell of a party when you reach your 100th birthday, or you could pass your Roth onto your kids, tax free.

Still can't decide if converting is the right move for you? The good people at H&R Block have a great little conversion calculator that can make the choice a little easier. Click here to give it a try.

Thanks for the question.

MAX

Want to ask MAX a question of your own? Send him an email by clicking here. Please include your name and where you live.