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Focus On: Convertibles

(Published 06/01/05) You can tell a lot about what’s hot and what’s not in mutual funds by just watching Vanguard.

Investors got gold fever? Vanguard closed their precious metals fund. Bond investors have no more Enron and WorldCom type fears? Vanguard closes their high yield bond fund. ETFs all the rage? Vanguard launches VIPERs. Nobody wants anything to do with utilities stocks? Vanguard re-badges their utilities fund as a plain-vanilla dividend growth fund.

We watch Vanguard closely, not just because several of their funds are in our model portfolios and on our favorites lists, but because Vanguard offers a strong signal of what smart investors should avoid or invest in.

Lack of investor interest is a good thing. Two of the hottest areas in the market over the last few years have been utilities and natural resources. Vanguard couldn’t give away their utility fund, so they gave it a strategy-altering makeover. American Century couldn’t find buyers for their global natural resource fund (an old holding in our newsletter) so they liquidated it. Both would have been up around 60% or more had they stuck by those funds as out-of-favor categories came back.

In 2003 plain old convertible bonds were on fire. Vanguard Convertible Securities (VCVSX) was up 31%. By 2004, investors were piling into Vanguard’s Convertible bond fund. In May when the fund neared a billion in assets, Vanguard simply had to shut the door. We dropped the fund as a favorite soon after, in August 2004.

From April 2002 until the end of September 2004 we had the convertible category rated 2 – Interesting. We had a convertible bond fund in our two safest model portfolios for much of this period. At the end of September 2004 we skipped 3 – Neutral and downgraded the convertible fund category to a 4 – Weak. (Too much of a good thing.)

Then a funny thing happened – convertible funds started to stink. Vanguard Convertible Securities was down 5.12% for the year to date as of May 31st, although it has recovered a bit recently.
Another funny thing happened: a half billion (about 50% of total assets) vanished from Vanguard Convertible Securities in a matter of months. In March of this year, Vanguard even opened the fund to existing investors while assets under management continued to drop (previously the fund was hard-closed, meaning essentially nobody could buy). Still, the assets fell.

On June 23rd Vanguard announced the fund was now open to new investors once again, but with a couple caveats: 1) the minimum is raised from $3,000 to $10,000, and 2) the fund will slap a 1% redemption fee anybody (who buys after September 15th 2005) selling within a year.

So now that the performance chasing investors have left the convertible bond market, we can safely upgrade the category to 3 – Neutral. We can also add Vanguard Convertible Securities back to our favorites list, it will join our other favorite pick and former portfolio-holding Northern Income Equity (NOIEX). Unlike Vanguard’s previously bloated fund, this fund has done fine over the last year, up about 11% landing it in the 10% of similar funds, although the fund underperformed when convertibles were red hot in 2003.

Category Rating: (Neutral) - Should match the markets return and perform in the middle of other stock fund categories

Previous Rating (12/31/05): (Weak) – should underperform the market and 60% of stock fund categories

Expected 12-month return: 5%

OUR FAVORITIE CONVERTIBLES FUNDS
RANK/FUND NAME/TICKER ADDED SINCE ADD vs. S&P 3 MONTH 1 YR.
1. Northern Income Equity Fund (NOIEX) 9/01 32.82% 12.75% -1.43% 8.89%
2. Vanguard Convertible Sec (VCVSX) 5/05 0.00% 0.00% 0.00% 1.19%

April 2005 performance review

The Conservative portfolio rose .29% in April, reflecting a strong bond market. Our equity funds were down for the month, but strength in larger allocations to bond funds overshadowed the losses.

Changes

We've been beating the market indexes pretty handily (and with less risk) across our portfolios these past three years, in both up and down markets. As we've noted in recent commentaries (and our latest category favorites report), it's time to lighten up in some hotter areas.

March 2005 performance review

Because of the relative complexity of these trades we have created an easy-to-use trade worksheet that subscribers who invest in the Conservative Portfolio can download, print out, and fill in to help them determine how much of their holdings need to be bought and sold to match our post-trade portfolios and to rebalance.

April 2005 Trade Alert!

Because of the relative complexity of these trades we have created an easy-to-use trade worksheet that subscribers who invest in the Conservative Portfolio can download, print out, and fill in to help them determine how much of their holdings need to be bought and sold to match our post-trade portfolios and to rebalance.

Trade Winds

We’re seeing many of these danger signs in the categories we have previously favored. As anyone who has owned funds in our model portfolios over the last few years has noticed, we’ve been heavily weighted in funds that invest in foreign stocks and bonds (notably emerging market stocks and bonds), small cap stocks (even microcap stocks), junk bonds, utility stocks, and value stocks.

The Great Real Estate Bubble

03/23/05 -

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.

February 2005 performance alert

We’re happy this portfolio’s performance. Only two of the funds were actually down for the month, Vanguard Short Term Corporate was down .21% - a decent indication of how this fund does when interest rates climb a bit. It would be difficult – if not impossible - to lose more than 10% in a year in this fund no matter what happens to the bond market.

Ask MAX: Can I build a fund portfolio with just $17,000?

03/16/05 - Ask MAX

Leena from Maine asks:

I read your article that recommended that investors with less than $15,000 invest in a Vanguard fund. Well, I have $17,000 to invest, and wanted to know how I should invest it. I took your risk quiz and am a moderate investor."

You’re referring to this article in which we advised Matthew, a young Navy sailor serving in Iraq, to invest in the Vanguard LifeStrategy Growth fund via an auto-investment plan. Matthew was starting out with just $2,000 (while adding $500 per month), and we told him to invest in this single Vanguard fund because it would give him a high degree of diversification (this particular fund is a collection of funds that owns other Vanguard funds) with a low initial investment requirement.

We told Matthew to stick to the Vanguard LifeStrategy Growth fund until he had grown his portfolio to $15k, then to come back to us to discuss where he should go from there. While the fund has risen more than 5% since Matthew asked his question back in November, we’re pretty sure he hasn’t reached the $15k threshold yet – but we’re guessing he wouldn’t mind if we answer your question in the meantime. You are starting out with more money than Matthew, but you are facing similar problems. Every investor, no matter how much money they are starting out with, should aim for certain goals when building an investment portfolio: diversification, low fees, and the right risk level.

Ask MAX: Can I convert my regular IRA to a Roth IRA?

Holly from Santa Fe asks:

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

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.