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Focus On: Real Estate Funds

June 1, 2006

(Published 06/01/2006) Real estate mutual funds are due for a drop.

Fundamentals were strong in real estate in recent years (of course, fundamentals were strong in tech back in the 90s). Real estate funds primarily own REITs (real estate investment trusts – essentially investment companies that own and operate buildings for rent), and to a lesser extent, real estate-related stocks like homebuilders (Hovnanian (HOV) and Lennar (LEN), and others that benefit from housing booms, like Home Depot (HD).

With property prices escalating, REITs have done spectacularly well. With new homes selling as fast as they can build ‘em (and with fat profit margins over construction costs) homebuilders have been raking in cash.

Just because an asset class takes off doesn’t mean it has to stop – Powerfund investors don’t sell just because they`re up. Two key factors kill many mutual fund golden geese: 1) declining fundamentals (over-valuation), and 2) inflows of too much money from performance-chasing investors.

Real estate mutual funds fail the Powerfund test on both counts. Today we can safely say that fundamentals are eroding, particularly in REITs, and inflows are strong.

REITs can be risky. If the economy turns south, rental revenue dries up and all available income to the REIT goes to pay interest on their massive debt (that’s how they bought the properties in the first place). However, in a strong economy with high rents and climbing real estate values (leading to windfall profits when an REIT sells a building) the business is very profitable and REITs can generally payout very high dividends to shareholders (by law they have to pay out income, much like a mutual fund).

While the stocks of homebuilders like Hovnanian have already collapsed almost 50% in price on little more than fears over future home sales (despite great earnings), REITs remain hot. While the fundamentals at REITs are strong, the prices of REITs are even stronger. This means, even taking into consideration better earnings and more valuable property, REITs are expensive.

The best indication of REIT overvaluation is the dividend yield on a low-fee REIT index fund, like one of our favorites in this category, Vanguard REIT Index (VGSIX). When you adjust out for dividends paid by REITs that are not from operating income, the yield on this fund is below 4%. A few years ago an REIT index paid about 6% in dividends or more.

So what? The S&P500 doesn’t even quite pay 2% (though ordinary stock dividends are usually taxable at a lower rate than REIT dividends, which are taxable like bond interest, or as ordinary income in most cases). REITs are bought for income, sort of like utility stocks (which are also overvalued now). Sure there is potential for growth in rental income (though there is a higher likelihood of growth in stock dividends) and more appreciation of underlying real estate assets, but there is also a chance for declines.

This risk usually means investors should get more yield in an REIT than, say, a money market fund or a government bond. That is no longer the case. Why bother? Investors can get 7% in a Vanguard junk bond fund if they want a lower-risk return. There will need to be a continuing housing and economic boom to earn more in most REITs than in a low-risk bond portfolio. Like all overblown areas, investors are paying too much for the future’s likely revenue stream.

The best thing that could happen to an REIT investor at this point is a big increase in inflation – because rents to the REITs would go up, as would their property values. Any slowdown in housing or further increases in interest rates could lead to a 15-25% decline in an REIT index.

As for fund company and investor behavior, there has been a pick-up in new real estate fund launches in the last three years. The Vanguard REIT index has about as much money in it as the Vanguard Energy fund, another over-invested area. Trouble is, REIT and real estate-related stocks don’t have the combined market cap of energy stocks so this represents a fairly large fund assets-to-underlying business size ratio.

For the record, we recently sold our last real estate fund stake in a client account due to valuations issues.

Category Rating: 5
Previous Rating: 5
Expected 12-month return: -12% (lowered from -7% in our last favorite fund report)

1. SSgA Tucker Active REIT (SSREX) 11/02 129.40% 86.52% 10.57% 34.13%
2. Mercantile Divrs Real Estate (MDVRX) 9/01 126.78% 95.89% 9.25% 27.55%
3. T Rowe Price Real Estate (TRREX) 9/01 154.56% 123.67% 10.46% 32.95%
4. Vanguard REIT Index (VGSIX) 8/02 109.86% 63.14% 9.38% 30.13%

New AARP Fund

May 25, 2006

It's a match made in mutual fund marketing heaven.

AARP, the organization dedicated to the interests of persons who aren't quite as young as they used to be, launched its first three mutual funds and the end of 2005. And you don't have to be over 50 – the minimum age to join AARP – to invest in them.

AARP's Conservative, Moderate, and Aggressive Funds are geared toward investors with risk tolerances ranging from, well, conservative to aggressive. Each fund invests in a different mix of three underlying index funds managed by State Street Global Advisors. Those indexes track U.S. stocks through the MSCI U.S. Investable Market 2500 Index, international stocks through the MSCI EAFE Index, and U.S. Bonds through the Lehman Brothers Aggregate Bond index.

According to AARP, the aim of the new no-load funds is to make the investment process easier in hopes of encouraging people to increase the amounts they invest.

"It is no secret that individuals are not saving enough for retirement," said AARP Financial President Larry Renfro in a prepared statement. "We believe investors are overwhelmed by the numerous choices available to them in the marketplace and the difficulty of assembling and managing a retirement portfolio on their own."

Like Vanguards successful LifeStrategy funds, the new AARP funds are meant to be a 'set it and forget it' investing solution – at least until your risk tolerance changes. (A complete no-work solution would age with you, and gradually get more conservative as the Vanguard Target Retirement, Fidelity Freedom, or T. Rowe Price Retirement funds do.) All an investor needs to do is determine their risk tolerance, pick a fund, and write a check. AARP's funds do the diversifying and rebalancing for you.

The new funds come with a 0.50% expense ratio through November 1st 2007 – inexpensive, but more costly than Vanguard's LifeStrategy offering that charges just 0.25%. Vanguard LifeStrategy fund's cheaper cost makes them hard to beat in a head-to-head comparison, but AARP does have a minimum investment requirement of just $100 versus upwards of $3,000 for the LifeStrategy funds.

In addition, the new AARP funds have a 2% redemption fee if sold within 60 days of purchase – the Vanguard LifeStrategy funds do not.

For inexperienced investors who don't have enough to meet Vanguard's minimums, the new AARP funds are a no-worries option, and are certainly a better place for your money than under the mattress or in your saving account. That said, we aren't big on these turnkey solutions for more experienced investors.

Fund of funds can be expensive. The worst thing about mutual funds is that expenses are taken out of your investment returns. A fund of funds adds an additional layer of expenses on top of those associated with the individual funds in its portfolio. While AARP's funds of funds are cheaper than many non-fund of funds out there, others (usually the kind that buy funds from several fund families) have significant double-layer fees – the fund of funds itself, and the expenses of the underlying funds. Single-family fund of funds tend to be cheaper because they are happy making money on the underlying funds and are merely using the fund of funds as a conduit to their other funds. In this case, AARP Financial (the fund advisor) pays State Street to manage the money in index portfolios, not unlike many Vanguard funds, which pay sub-advisors to actually choose stocks and bonds.

Furthermore, the diversification of these funds is obviously not geared toward each investor’s individual situation. Broad conservative, moderate, and aggressive allocations will work for most investors, but some people will require a bit more fine-tuning than these funds provide.

AARP's good name and marketing muscle could make these funds a success, but investors of all ages can probably do better elsewhere.

More information can be found at www.aarpfunds.com.

Dow Nears Record High

May 16, 2006

Part of our job at MAXfunds is to get you excited about investing when everybody else is not, and fearful of investing when everybody else is excited.

To us, “everybody” refers to mutual fund investors. The tens of millions of fund investors have a nasty habit of getting most excited about investing close to the top of market cycles, and getting negative at exactly the worst time – when stocks are close to bottoming out.

As you’ve been reminded every few minutes by the financial news media, or just every few hours by regular news channels, or every day by newspapers, stocks (or rather the Dow Jones Industrial Average) are always within spitting distance of an “all time” high.

While the bear market ended in late 2002, to some the market is not “over” the bubble era until the stock indexes pass their old highs. Today, many stock indexes are way past their old highs – larger-cap and tech indexes are the only ones still below the high water mark. These were the areas fund investors over-loved in the past – the higher they rise, the harder they fall.

Too bad the financial media doesn’t make more of a to-do over record fund investor inflows and outflows. The last time fund investors put over $50 billion of new money into stock funds in one month was February 2000. As it turned out, this was the month right after the Dow peak – at 11,722.98 on January 14th. The Nasdaq peaked on March 10th, and the S&P500 on March 24th.

Over the next couple of years, the Dow fell 38%, the S&P500 almost 50%, and the Nasdaq almost 80%. So much for investing with the herd.

Toward the end of the bear market investors had finally had enough. The largest one-month outflow from stock funds was in July 2002 – when investors pulled just over $50 billion out of stock funds. Though the Dow didn’t bottom until October of 2002 (at 7,286.27) it came pretty close in July of 2002. Today the Dow is up some 60% not including dividends from the 2002 lows.

In fact, the entire period from 2002 to 2004 investors were unenthused about plowing money into stock funds. As recently as last year inflows averaged around $11 billion a month – nothing to sneeze at, but that’s about what Janus alone brought in during the late-nineties’ halcyon days. Considering millions of workers are automatically having their paychecks diverted to mutual funds each week and boomers have yet to retire en masse, $11 billion is almost chump change.

Now that stocks seem to be a good deal to investors again (flirtation will all-time highs will do that) they are getting back in.

In the first three months of 2006 investors have put almost twice as much into stock funds as the first three months of 2005 – $93 billion compared to $47 billion. In March investors placed $34 billion in new money into stock funds – the second biggest buying month in almost six years. When all the numbers are in, April and May should eclipse March – especially with all the Dow-near-a-record hype.

Sadly, fund investors are not plowing into funds that buy large-cap U.S. stocks so much as funds that invest in far hotter areas: natural resources, commodities, newfangled ETFs that focus on ever smaller areas, and anything international. In other words, the opposite of where they sent their money in early 2000.

The current hype of record stock prices and resulting record inflows by fund investors is a nice time to pause and take a look at what you are doing to your portfolio.

Are you more excited about stocks than you were before they ran up 60%? Are you plowing into funds that ran up 100% or more in the last few years? Are you investing with the herd?

If you are not swayed by our warnings, you should read the current missives of a handful of top investors we read regularly. All have track records far longer and better than 98% of the fund managers, experts, reporters, pundits, charlatans, and the like. Certainly better than fund investors who buy after run-ups and sell after wipeouts.

Miller Time

Bill Miller has among the longest S&P500 beating streaks in the fund business, managing a few successful Legg Mason funds. In his latest commentary (read a PDF of it by clicking here) he warns investors against making the exact same mistakes they have made time and time again, buying whatever is hot that the media covers with the most optimism and gusto. While his focus this time is on the overblown commodity bull market, the logic applies to all investments:

“Investing is all about probabilities, and just because there appears to be a strong consensus prices are going to keep going up, doesn’t mean that is wrong, or right. The consensus does tend to be wrong at the turning points, being invariably bullish at the top and bearish at the bottom. Remember all the advice to go to cash AFTER the 1987 Crash, since it was clear a depression would follow. Or how “risky” the high yield bond market was in the summer of 2002 AFTER the Enron and Worldcom collapses led to record spreads? I can’t help but be skeptical of the advice to start or increase a position in commodities AFTER the biggest bull move in 50 years.

The excitement and enthusiasm surrounding commodities, and the belief that they will continue to rise, is not surprising. People want to buy today what they should have bought 5 or 6 years ago; call it the 5-year psychological cycle. Today people want commodities, emerging market, non-US assets, and small and mid-cap stocks. Those were all cheap 5 years ago and had you bought them then you would be sitting on enormous gains. But 5 or 6 years ago, everyone wanted tech and Internet and telecom stocks, and venture capital and US mega-caps. The time to buy them was in 1994 or 1995, when they were cheap. But in 1994 or 1995, people wanted banks and small and mid-caps, which should have been bought in 1990, and well, you get the picture.

In general, you can get a good sense of what to buy now by looking to see what the worst-performing assets or groups were over the past five or six years. That is long term for most people, and long enough to convince them that the malaise is permanent and to have migrated their money elsewhere, such as to whatever has done best in the past 5 or 6 years.”

The WB channel

Warren Buffett is the world’s richest investor. He is often quoted, but rarely followed, as if acknowledging his wisdom is enough for reporters before they go back to writing their 75th article on gold, oil, and commodity prices, just as they did in the late 90s (only then it was multiple articles on Internet and telecom stocks).

At his latest annual meeting of Berkshire Hathaway investors, Buffett was quoted opining on the insanity in housing and commodity markets. Buffett has $37 billion of Berkshire Hathaway’s money in cash – waiting for a little less optimism in the stock market before he dips in and buys (though he picked up a few companies recently).

“…At the beginning, it's driven by fundamentals, then speculation takes over. As the old saying goes, ‘what the wise man does in the beginning, fools do in the end.’ With any asset class that has a big move, first the fundamentals attract speculation, then the speculation becomes dominant.

Once a price history develops, and people hear that their neighbor made a lot of money on something, that impulse takes over, and we're seeing that in commodities and housing...Orgies tend to be wildest toward the end. It's like being Cinderella at the ball. You know that at midnight everything's going to turn back to pumpkins & mice. But you look around and say, 'one more dance,' and so does everyone else. The party does get to be more fun -- and besides, there are no clocks on the wall. And then suddenly the clock strikes 12, and everything turns back to pumpkins and mice."

Mr. Scaredy Cat

Robert Rodriguez has the best 15-year return in actively managed, non-sector mutual funds (albeit with some rough spots along the way, and a recent small-cap tailwind at his back). One way you don’t destroy a 17% plus average annual return over 15 years is by not going all in when valuations are stretched (like they are today in smaller-cap stocks, his area of focus).

FPA Capital (FPPTX), which is closed to new investors, currently has 43% in cash and bonds. In his last shareholder report (a PDF of which is available by clicking here), Rodriguez notes, “We remain convinced that prospective stock market returns are likely to be viewed as substandard by historical standards,” and closes on a dour note about our financially reckless government:

“Between questionable accounting and control over current spending, expansion of new entitlements, i.e., the payment for hurricane disasters and fighting
the war on terror, this entire government is creating liabilities that will one day come home to roost. I do not believe that we, as investors, are being sufficiently compensated for these potential risks as well as for economic and stock market risks. When your investment team uncovers investment opportunities that compensate us for these various risks, we will deploy your capital. Until then, we will wait patiently.”

GMO – OMG! (Oh my god…)

We’ve long recommended funds managed by GMO (Grantham, Mayo, Van Otterloo), though few of them are available to smaller investors (one no-load was Pelican, an old favorite fund pick in large-cap value around here that was merged into a load fund). A nice, low-fee choice today is Vanguard U.S. Value (VUVLX). GMO manages about $100 billion.

Investors can read their Quarterly Letter to the Investment Committee by registering for free on the GMO website. In the latest report, Jeremy Grantham notes the decision to sell after a long run of losses and buy after a hot streak hurts returns for all investors, including supposedly smarter institutional investors:

“Ironically, most of the risk to long-term investors in equities comes from panicking in the short term and closing out positions that then mean revert. (Classic examples of this would be institutions firing value managers and hiring growth managers in 1999 because they couldn’t stand the underperformance, and a whole generation of investors in the 1930s moving permanently out of equities.) Selling in declines throws away the powerful risk reduction effect of mean reversion. Most investors would be better off if they had a hard rule that everything they bought had to be held for 30 years or longer. Even more certainly, they would benefit if the rule only allowed the selling of an asset class at a price well above its long-term trend.”

Grossly Overvalued

Bill Gross at PIMCO has the best track record in bonds. While his opinion that the Dow was worth around 5,000 never played out in the market, his free monthly investment outlook is a must-read. In his latest As GM Goes, So Goes the Nation” + link- ) Gross casts doubt over the future of the U.S economy by likening it to GM – a company that is uncompetitive with lower cost, better, and more efficient global producers, and burdened by massive future underfunded liabilities,

“I think it important to recognize that General Motors is a canary in this country’s economic coal mine – a forerunner for what’s to come for the broader economy. Their mistakes have resembled this nation’s mistakes; their problems will be our future problems.”

While these experts differ on where you should put your money, they are in agreement that whatever the bulk of investors are infatuated in is generally a lousy investment going forward.

Mark Twain, after losses from ill-timed speculations, said it best: “I was seldom able to see an opportunity until it had ceased to be one.”

Viva la Revolution!

May 9, 2006

Newly elected socialist/populist Bolivian President Evo Morales sent military troops to natural gas facilities on May 1st, claiming state control over the country’s resources. Oil companies were given 180 days to renegotiate contracts with the country – almost literally at gunpoint.

Such a move is bad for the global “oil imperialists” of the world like Exxon Mobil, Petrobras and Total S.A. It doesn’t bode well for investors in Latin American mutual funds like T. Rowe Price Latin America (PRLAX) – our current Latin American fund category favorite.

When socialism is on the march it’s best to get your money out of the way.

This is not the first time Latin America has flirted with nationalization. Latin American countries’ real socialist binge was in the late 1930s when Bolivia and Mexico confiscated Standard Oil’s operations. Exxon, one piece of the old Standard Oil monopoly (post U.S. government break up), has now been nationalized twice in the same country.

While most other countries have moved to privatize formerly state-owned businesses over the last decade, this bold nationalization is a rare step in the other direction – a move for more state control.

This backlash against capitalism seems to counter our own president’s assertions that “freedom is on the march” across the globe, with democracies sprouting up like daffodils in the spring – populist leaders, like the new Palestinian leader, were democratically elected. There are a few reasons why some countries are going backward (they would probably say forward) economically speaking.

The global commodity boom has enriched some questionable countries. Iran, Russia, and Venezuela top the list. If only our own trade balances and foreign reserves were as strong as these and other natural resource exporters.

The windfall profits created by the boom can support populist social programs that would ordinarily be unaffordable.

These massive profits are an attractive revenue source for governments. In our own wealthy and pro-business country there is now talk of creating windfall taxes on big oil. Imagine if the U.S. were poor and all the oil companies here were from other countries? Somebody in congress would probably move to nationalize the oil companies, too.

Russia has made moves to increase governmental control of the country’s natural resource companies – partially as a flagrant power grab, but also to undo past wrongs in a privatization campaign that left the citizens of the country out in the cold.

The perception of America as an unchecked empire is certainly higher today in many countries than five or ten years ago.

It doesn’t help that the departing head of Exxon had earned about a half billion – 5% of Bolivia’s entire GDP. Exxon’s revenues will triple Venezuela’s GDP this year, or amount to half of Mexico or Brazil’s GDP – the largest economies in Latin America.

Bolivia is one of the world’s poorest countries with 64% of the population below the poverty line. Only Haiti and Guatemala are lower in the western hemisphere – and unlike Bolivia, they aren’t sitting on a third of the natural gas reserves of Canada.

Such poverty makes the benefits of capitalism and foreign investment a tough sell, and the populist overtaking of business and resources for the people an easy one. This explains why these new people's heroes aren’t simply moving to raise taxes on foreign corporations (though they plan such a tax hike on the mining industry), which would likely do more for government coffers than heavy-handed nationalization. In fact, the newly elected Bolivian President ran on a platform promising such an overthrow.

Venezuela is South America’s biggest exporter of oil and the driving force behind the new Latin American socialism. President Hugo Chavez has been helping neighboring countries make similar moves. According the New York Times, “Venezuela agreed to supply Bolivia with 200,000 barrels of diesel a month at subsidized prices, donated $30 million for social programs and sent literacy volunteers into the Bolivian countryside.”

This could be the start of a Latin American OPEC-like structure with strict government controls and ownership of all natural resources, not just for oil, but metals, gas, and agriculture products as well.

Emerging markets have been hot in recent years – often the more resource-rich the country, the hotter the stock market. The Russian stock market is up over 1,000% over the last seven years.

Latin American funds are among the hottest. Our favorite, T. Rowe Price Latin America (PRLAX), is up 400% in less than four years. Back in 2002 we had an outperform rating (we rate fund categories for future potential in our favorite fund report) on the entire Latin American fund category and broader, emerging market funds. We have steadily lowered this rating along the way due to the inflows of money and massive performance. Now we are lowering this rating to our lowest outlook.

Kicking out foreign investors and nationalizing assets appears to be a growing movement. It won’t benefit investors. While emerging markets are still cheap compared to developed countries, they are supposed to be in order to offset this sort of political risk. You can be confident that France and Germany aren’t going to nationalize companies doing business within their borders anytime soon.

A Gusher of a Bad Idea

April 28, 2006

A lot of good has come out of the exchange traded fund (ETF) revolution. ETFs have drawn billions of hot money dollars out of ordinary mutual funds, helping longer-term mutual fund investors’ returns by giving the fund manager a more stable asset base. ETFs are more tax-efficient than ordinary mutual funds. Even better, low-cost ETFs have put some pressure on fund fees.

But all is not rosy with ETFs. Like the opening of a riverboat casino near your home, ETFs give investors new opportunities to gamble. The average holding period for an ETF is measured in days, not years like with ordinary mutual funds.

A fresh trend in ETFs is giving investors a way to speculate on individual commodities. These commodity ETFs have full exposure to commodities directly or through futures contracts. Traditionally, commodities are physical items like food, grains, lumber, metals, and fuel – the generic building blocks of an economy. More recently the definition includes anything that trades on a commodity exchange, including currencies, financial instruments and indexes.

The most successful example of the new commodity ETFs is the StreetTRACKS Gold Shares fund (ticker GLD), launched in early 2004. The fund has attracted over $7 billion in investor assets, making it one of the ten largest ETFs.

A much anticipated, silver-focused ETF is due out soon. Earlier this year the Deutsche Bank Commodity Index Tracking Fund (DBC) was offered. This ETF is a slightly more diversified way to buy commodities and it owns futures contracts on Light, Sweet Crude Oil, Heating Oil, Gold, Aluminum, Corn, and Wheat.

The new U.S. Oil Fund ETF (USO) is trading almost a million shares a day (or about $70 million worth changing hands) mere days after launch. For reference, and a clear sign of how the speculator tail is wagging the economy dog, the U.S. imports about $800 million dollars worth of oil a day.

One thing is for certain: just about any diversified stock fund will beat this new ETF over the next ten years. Recent history aside, commodity investing is a disaster for most investors.

Here is why you can't win betting on commodities:

1) Commodities are a zero-sum gain. Unlike stocks and bonds, there is no wealth transfer from the investment to the owner, now or in the future. For you to make money in oil futures, somebody else has to lose money.

2) Other people know more than you. Billion-dollar hedge funds and oil companies trade oil futures daily. They tend to win more than you. Even if their predictions for oil are just as flawed as yours, they will beat you because the game is slanted in their favor. Oil companies control production and have a better grasp of supply and demand issues than you do, and leveraged, billion-dollar hedge funds can create self-fulfilling spikes up and down in oil by their own trading. Hedge funds also have access to better information and employ ex-oil company traders to work for them. Do you think in a zero-sum game you can beat a BP oil trader on the other side of the contract you just bought?

3) Inflation is a bad long-term return. Many futures market participants are just trying to hedge away the risk of their own production or lock up supply for future needs – the real reason futures markets were setup in the first place. The primary rationale for individuals owning commodities is to hedge against inflation, not lock in a price for oil they will drill out of their own backyard next month. Unfortunately, inflation is a mediocre return and is easy to beat. Any major asset class (real estate, stocks, bonds) will at least match inflation over very long periods of time, and generally will beat it. Gravel will match inflation over time. A Vanguard money market fund is a near perfect, no-risk inflation hedge. You’ll at least match inflation over the long haul with a low-fee money market fund, as the sort of investments these funds buy have yields that move with inflation most of the time.

4) Carry costs will eat into inflation return. This fund costs 0.40%. That’s on top of the high trading costs of rolling over futures contracts every few months. This digs into your low inflation-linked returns. While this fund is easier and cheaper than buying actual oil futures for most investors, it still has ongoing costs. Just like Vegas, only you have to pay for your drinks.

5) When you think a commodity is a good idea, it is probably very near the end of move up. The fact these kinds of funds are even getting launched is a bad sign. You could make the case for a gamble on commodities back in 2000 when everybody was hopped up on new-economy riches and anything old-economy was dead (including oil stocks). As the long-term return on commodities is roughly the inflation rate, it’s likely that hopping in after a stretch of inflation-beating returns will be followed by negative returns. At best, commodities are a short-term speculation on inflation picking up (or just inflation fears) or a gamble on some supply disruption in the future.

The long haul returns look bad. Forget about the inflation-adjusted losses anyone who bought oil or gold during the peaks a few decades ago would still be showing today; returns from ordinary levels are still poor.

If you stuck a barrel of oil in your garage back in 1950 and sold it today, you’d be up 20x on your money ($3 to $60). Of course, if you parked a brand new 1950 Cadillac next to the oil and didn’t touch that either, it could be worth about 20x as much as well ($3,000 then, $60,000 today if mint/undriven). Gold was about $35 an ounce in 1950, offering a similar return to the Caddy. Bottom line, any hard asset will move more or less with inflation over the long haul. The less manufactured the product, the closer the relationship (steel bars vs. cars).

Keep in mind that your home could easily have climbed 50 times in value, your stock portfolio 100 times over the same time period.

You’ll never reach your retirement goals simply matching or “keeping up with” inflation. Worse, the potential for buying high and selling low with commodities is higher than with stocks, bonds and real estate. Commodity-linked investment “opportunities” don’t get launched (and draw in big money) when commodity prices are low. They get launched when everybody thinks it’s a brilliant idea. Nobody wanted to buy oil futures when oil was $10 a barrel in 1998. Now that oil is around $70 a barrel investors are lining up.

If you want to make money in commodities, write a book about commodity investing, or better yet, launch a commodity fund. On that note, the person who launched this oil ETF manages a regular stock mutual fund. In that fund he is underweight energy stocks compared to the S&P500.

Apparently, selling oil-related investments is smarter than investing in them right now.

Ask MAX: Capital Gains Quickies

April 24, 2006

Dear MAX,

I'm a mutual fund investor who was hit with taxes on my fund holdings this year (after a few years without paying any). Frankly, I'm not entirely clear on what a capital gains distribution is. I asked my accountant and he didn't seem to be able to explain it to me. Can you help?

Minneapolis, MN

Dear Andrew,

In most cases, mutual fund investors haven't had to worry about their fund’s tax bills since 2000. Weak market returns from 2000-2002 meant that there weren't any capital gains to distribute in the early part of the decade, and the losses many funds realized offset some of the gains made in the following years. But strong performance of many funds from 2003 to 2005 has finally caught up with fund investors, creating a rough tax burden for many of them this year. In 2005 Lipper estimates fund investors paid a whopping 58% more in taxes on fund distributions than in 2004.

We love mutual funds. Mutual funds provide cheap and easy investment diversification, they're easy to get in and out of, they're highly regulated, and they allow investors access to expert financial guidance at a low price. As investments go, we think that mutual funds are far and away the best available for the vast majority of investors in America.

But there are a couple of things about mutual funds that we don't like: Fund investors never know exactly what they're invested in, some mutual funds charge excessive fees, and worst of all, mutual funds sometimes hit investors with large and unexpected taxable distributions.

Capital gains are an unavoidable mutual fund evil. Capital gains distributions occur when a fund makes a profit on its purchases and sales of securities. Like in your own portfolio, if a fund sells a stock at a higher price than it paid, it realizes a capital gain. If it sells securities at a lower price, it realizes a capital loss. If the gains are greater than the losses over a given period, the fund has 'net realized capital gains', which by law have to be distributed to fund shareholders each year.

Most fund companies announce their fund's capital gains distributions in late winter, and when the distribution is actually made the NAV (net asset value, or price of each fund share) of the fund drops by the amount of the total distribution (long and short-term capital gains, as well as dividends accumulated by the fund from stocks). Shareholders of the fund are either mailed a check for the amount of the gain, or are given the amount of the gain in new fund shares. If investors are automatically reinvesting, as most do, the value of their investment will be the same before and after a distribution – but they’ll own more shares at a lower price.

What stinks about capital gains is that while the value of each shareholder's investment doesn't change one bit after a distribution is made, investors still have to pay taxes on the amount of the distribution.

In 2000 Warburg Pincus issued a whopping 55% capital gain distribution to shareholders of their now defunct Japan Small Company Fund. This means that if you were unfortunate enough to own shares of that fund, you had to pay tax on the equivalent of 55% of your investment. The fund, by the way, was down 71% that year.

Unfortunately, there is no foolproof way to avoid getting hit with a fund-related tax bill. Some funds make big distributions year after year. Other funds rarely if ever do. It's very difficult to predict with any certainty how large a fund's distribution will be before the fund company announces it.

Funds with big turnover ratios tend to make larger-cap gain distributions than funds with low turnover ratios, because turnover ratios measure the amount of trading a fund manager engages in. If the manager doesn't trade much (and hence, has a low turnover ratio) there is less chance to run up significant capital gains. Worse, funds with high turnover are generally realizing short-term taxable gains (gains on stocks sold within a year of purchase), which are taxed as income (high rate) and not as long-term capital gains (low rate). Fund managers could care less – they are ranked on pretax returns.

The best way to lessen the capital gains bite is to own your mutual funds through a tax-deferred account like an IRA or a 401(k). If that's not an option and the idea of looming tax bills keeps you up at night, you might consider so-called tax-managed funds – mutual funds whose managers take active steps to reduce the possibility of generating taxable gains for their shareholders. Vanguard Tax-Managed Balanced Fund (VTMFX) is a good low-cost pick in the tax-managed category.

Call your funds toward the end of the year and check their websites for distribution dates and estimated distribution amounts. Links to fund websites and phone numbers are available from fund pages on the MAXfunds.com site.

Do not buy a fund that is about to make a large distribution, particularly if that distribution is going to be largely short-term capital gains. Consider selling a fund that you may want to sell soon anyway if it is going to pay a large capital gains distribution. This is especially true if you have a loss you can realize on the sale, or a long-term capital gain (low tax). Often there is a similar fund you can buy, or you can simply wait until the IRS’s so-called wash sale time period (60 days) elapses and buy back the same fund.

Consider ETFs when there is not a compelling mutual fund choice available. ETFs are not as tax-inefficient as ordinary mutual funds; they are almost always low turnover, and they generally don’t build up taxable gains that require sudden large distributions to the unfortunate investors who own the fund on a certain date.

Consider funds that have recently – particularly if they once had a large asset base. While this seems like a bad idea on the surface (who wants a loser?), funds that have fallen on hard times generally have tax loss carry-forwards on the books that will wipe out any realized gains for years to come. Such funds often perform well as they have contrarian appeal. This is by no means a recommendation to buy long-term losers, or funds that are not merely suffering from a strategy that is temporarily out of favor.

Thanks for the question.


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Ask MAX: We Aren't Married, Will She Owe Taxes When I Die?

April 13, 2006

Dear MAX,

I'm 62 years old and am not married but I have lived with my girlfriend for over 17 years. She is the main benefactor in my will (which includes a house and a decent-sized mutual fund portfolio), and I plan on leaving her my IRA assets. Will she be required to pay taxes on those assets?


Atlanta, GA

Dear Ron,

Stuffy old Uncle Sam still doesn't give his full blessing to unmarried couples.

When married people die, they may leave their spouse an unlimited amount of assets free of federal estate taxes. That's called the marital deduction.

Unmarried couples do not receive an unlimited marital deduction, and therefore your girlfriend could be due a nasty tax bill after you leave this mortal coil.

Your estate is the total value of all of your assets, less any debts, at the time of your death.

If you died tomorrow and your assets total less than $2 million (the current federal estate exemption, increasing to $3.5 million in 2009), your girlfriend won't have to pay anything by way of taxes.

If you want to leave an IRA or property in excess of the exemption, it will trigger the dreaded estate tax - currently as much a 46% of the estate's value.

Under the laws in effect for the tax year 2006, if you die with an estate greater than $2,000,000, the amount of your estate that is over that amount will be subject to a graduated estate tax that climbs to as high as 47 percent. That $2,000,000 is an exclusion, meaning that the first $2,000,000 of your estate does not get taxed. (Note: the estate tax is going to be nullified on January 1st, 2010, but will return the next year; so if you can arrange it, you'd be very considerate to kick the bucket between those dates.)

If your estate exceeds (or if you think it will exceed) the estate tax exemption, consider gifting some assets to your partner before you die. In 2006 you can give as much as $12,000 a year to whomever you like without either you or they having to pay taxes on it. Do enough gifting and you might be able to lower your estate’s value to below the estate tax exclusion amount.

Even if your estate is small, there will be expenses at your death. There are administrative costs, court costs, legal fees, probate expenses, and sometimes state inheritance or estate taxes (in Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Ohio, Oklahoma, Pennsylvania, Tennessee, but not in Georgia) even if your estate is worth only $50,000 .

These pesky costs mean that your girlfriend will have to come up with the cash to pay them. That can be a problem if the bulk of an estate is tied up in a home. Your girlfriend might be forced to sell your house in order to raise the money.

If you're going to stick your girlfriend with a bill when you pass on, think about leaving her enough cash to pay the taxes. Life insurance is a solution, since it provides cash to your partner upon death, which can be used tax-free by your partner either to pay estate taxes and other post-death expenses, or to pay living expenses.

Better yet, if you start to feel a bit under the weather, head to Vegas and get hitched.

Thanks for the question,


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Mutual Fund Longshots

April 9, 2006

George Mason did very well in the NCAA playoffs: the underdog college basketball team got all the way to the final four. Few thought it was possible – the odds of the Patriots winning started out at a long shot 150-to-1. Such odds, which are set by experts and betting behavior, meant that almost nobody thought the Patriots would do as well as they did.

In fact, the Patriots were this year's Cinderella team – even beating favorites like UCONN and North Carolina. With sports, big upsets are quite rare. With mutual fund investing, the favorites often lose.

There is a high correlation between past performance and future performance in sports. Chances are, Tiger Woods will beat most other golfers this year. Mike Tyson, in his prime, was a near-guaranteed winner. Just having Michael Jordan on your team practically assured an NBA championship.

Betting on proven winners in sports is such a safe bet that bookies have to set high hurdles of success (point spread or regular odds) for such a wager to pay off – otherwise almost everyone would win all the time.

The main reason choosing mutual funds winners is so difficult is that just because a certain fund or manager has done well (beaten other funds) in recent years doesn't mean they will continue to do so going forward. As strange as it sounds, funds with strong three-year records have about the same chance of performing well over the next three years as a fund chosen at random.

With sports, unlike investing, skill is apparent, and luck doesn’t carry you very far. It is pretty clear who will win – so clear that odds makers in Vegas can determine, with a fairly high degree of accuracy, how many points one team will score in beating another. Fund odds makers are called analysts, and their record is far spottier. In mutual funds, streaks end.

Fund investors often follow the recommendations of various magazines, top fund lists and the like in placing their bets, or they make decisions that are based largely on past performance. Either way, they are betting on the fund beating most other funds, and the relevant index, or they would buy another fund or the index.

Certain funds bring in billions of dollars based on the assumption that the winning ways of the past will continue. These collective wagers tend to lose primarily because money changes the odds. In sports, the bookies change the odds based on inflows of money (bets). In funds, the money ruins the odds all by itself.

We have written extensively over the years about how inflows of money can dampen returns for a mutual fund going forward. Here is one way to look at it:

Unlike sports figures, fund managers have to carry their winnings with them into the game. They have to invest more and more money successfully and reproduce their past performance with the dough. If Michael Jordan had to carry all the money that was wagered on him in a backpack during a game, bookies wouldn’t have to put a big point spread on a Chicago Bulls game – the weight of the money would create a handicap that the underdog wouldn’t be burdened with.

Even worse, money ruins returns for all parties involved as more and more of it chases the same ideas. Eventually you have additional dollars making investments that simply can’t return enough to payoff all the investors. If everybody decided to open a pizza place in their town because a new Pizza Hut did, well, eventually everybody would be having financial problems because there would be more pizza than customers. What works for the few doesn’t automatically work for the many.

This is why some of the favored funds of recent years have performed so poorly. Go back to 2000 and the favorites were anything managed by Janus, Firsthand, Turner, Oak Associates, and PBHG. All went on to have multi-year “slumps” while the other funds won. Pick any fund with a strong record over the last five years and chances are, few investors were betting on it in 2000.

More recently, after the bear market, the “favorites” moved to new families and funds. Money literally was being transferred from any given Janus fund to Clipper (CFIMX), Jensen (JENSX), and Oakmark (OAKMX). These relatively unknown funds from the 90s brought in billions while Janus and others lost billions as shareholders departed in droves.

Today, these three favorites are at the bottom of the barrel. Throwing darts would have worked out much better. Over the last three years (compared to hundreds of similar funds) Clipper is in the bottom 1%, Jensen the bottom 4%, Oakmark the bottom 2%. You’d have done far better in just about any Janus fund – old favorites that started wining again once they stopped being favorites.

When a mutual fund can’t float like a butterfly, the shareholders often get stung.

Using Dividends To Divine Future Returns Part II

March 31, 2006

In the first part of this article, we’ve talked about the S&P500 index in general and the current, somewhat paltry yield. Funny thing is, when you look at the actual stocks in the index, things look a little brighter.

Here are the top 10 stocks and dividend yields in this market cap-weighted index:

Ticker Name Div Yield
XOM ExxonMobil 2.11%
GE General Electric 2.90%
MSFT Microsoft 1.29%
C Citigroup 4.14%
BAC Bank of America 4.26%
PG Procter & Gamble 2.10%
PFE Pfizer Inc. 3.63%
AIG American Intn’l Group 0.90%
JNJ Johnson & Johnson 2.20%
MO Altria Group 4.35%

Note that almost all of these stocks pay larger dividends than the S&P500 as an index (1.7%). How is this possible, when these stocks make up some 20% of the index?

What we’ve seen is a near flip-flop of the market in 2000. Back then, all the mega-cap stocks traded at such lofty valuations that dividend yields were slim. Worse, from a dividend point of view, tech and growth stocks with no dividends topped the charts, so to speak. The smaller stocks in the S&P500 were actually cheap, and many had far-above-market dividends.

Since 2000 the smaller-cap stocks in the index (which are really more like mid-cap stocks, given that few really small-cap stocks are in the S&P500) have raced up (many have more than doubled), while the mega-cap stocks fell, often by as much as 50%. Some more stable tech stocks, like Microsoft (MSFT), started paying dividends.

Now the more expensive smaller stocks in the index are weighing down the dividend yield of the index. You can tell something happened along these lines by looking at funds over the last few years.

Small-cap funds have killed the S&P500 – many have doubled while larger-cap-oriented funds are largely flat or down – still.

An equally weighted S&P500 index really shows the action of the last few years. Keep in mind the S&P500 is market cap-weighted, meaning when you put $1,000 into the Vanguard 500 Index (VFINX), about 3.2% or $3.20 of your money goes into General Electric (GE), while only 0.02% or $0.20 goes into Goodyear Tire & Rubber (GT). No wonder mega-cap stocks were overpriced in 2000; everybody was piling into them through index funds.

With an equally weighted index, every stock in the S&P500 gets the same weight. If you put $1,000 into this retooled index, each holding gets a 0.20% allocation, or $2.00. Doing so means smaller-cap names get larger allocation than they “normally” would, while larger-cap names get a smaller allocation.

According to Standard & Poors, the equally weighted index is up 78% over the last seven years. The normal, cap-weighted index is up just 13%. More startling, if you invested in the equally weighted index at the top of the market bubble in 2000, you’d be up over 50% today, while you’d still be down in the traditional index. Same stocks, totally different returns if re-jiggered. Of course, nobody offered an equally weighted index fund in 2000 (that came years later, after it was a good idea…).

It was a little over five years ago when I penned my anti-indexing tome, “Index Bomb: A Popular Investment Theory Knocks Markets Out of Whack”. The article ended with “Maybe someone should start a fund that shorts the top 50 stocks in the S&P 500,” meaning that mega-cap stocks were overvalued back then.

While valuations today are not so favorable for large-cap over small that you should short smaller-cap stocks, investors will do better over the next five to ten years in mega-cap stocks (though we’ve cut back on our own small-cap stakes in our PowerPortfolios).

The S&P500 and the Dow are not bad ways to go, but investors should seek out mega-cap-oriented funds – the exact opposite of what would have worked in 2000. Since investors want maximum dividend yield, we’ve chosen the cheapest ways to own these stocks (fund fees come out of dividends first).

Some to consider:

Bridgeway Blue-Chip 35 (BRILX) – a no-load fund with an expense ratio of 0.15%
iShares S&P 100 Index (OEF) – an ETF with a 0.20% expense ratio
Rydex Russell Top 50 (XLG) - an ETF with a 0.20% expense ratio
Market 2000 HOLDRs (MKH) – essentially a basket of the largest stocks by market cap circa 2000 (a few are now much smaller, as they crashed and burned. HOLDRs must be purchased in 100-share lots)

Let’s assume investors are going to earn 6% over the next five to ten years in stocks. By our logic, small to mid-cap investors may see as little as 4%, and mega-cap investors 7% to 8%. A cap-weighted S&P500 should beat the equally weighted S&P500 index going forward.

Keep in mind that no dividend analysis or relative valuation model makes stock investing risk-free. With investing, you can be right and still lose a fortune. Our biggest fear – as we’ve sold all our micro-cap funds and are buying mega-cap funds in our PowerPortfolios – is that we’re only halfway into the small-cap-kills-large-cap trend. Who is to say small-cap stocks won’t get even more ridiculously valued and trade with average yields of 0.50% and P/Es of 40, much like mega-cap stocks did in 2000?

Vanguard Small Cap Index (NAESX) currently yields 1.08% while their 500 Index (VFINX) fund yields 1.71%. Even more surprising, Vanguard Small Cap Value Index (VISVX) yields just 1.97% – barely above the 500 Index, which has more growth-oriented names as well. Small-cap is fully valued. The only question is whether small is going to get insanely valued before it tanks. We’d still favor larger-cap.

Ask MAX: A Fee-Free IRA?

February 17, 2006

Dear MAX,

I want to get an IRA started for my wife and I this year. I understand we can contribute $8,000 between the two of us. I have read several sources stating that a self-directed IRA will allow me to keep more of my money.

I have had no problem finding brokerage firms to set up IRAs, but how do I go about doing this without paying a broker? Also, many mutual funds have minimum investments of over $8,000. Are these funds out of the question for me?


Dear Randy,

Individual Retirement Accounts were established by an act of congress in 1974, and have been confusing the heck out of individual investors ever since. With no less than eleven distinct varieties of IRAs, ever-shifting contribution limits and distribution formulas you need a degree in advance mathematics to understand, it’s no wonder we're all occasionally left scratching our heads.

Let’s run down your questions one by one:

First, contribution limits (okay, you didn't actually ask about contribution limits but you did mention it so I'm taking the liberty):

For married couples who file their income taxes jointly that are under 50 years of age, the maximum combined contribution amount for ROTH and the traditional IRAs (the two most common types) is indeed now $8,000, or $4,000 per year from each of you.

Starting with tax year 2006, if either of you is over 50 that person can contribute an additional $1,000, or $5,000 per year. This is called a “catch-up” contribution.

Beginning in 2008, the maximum contribution limit for people under 50 will increase to $5,000 and to $6,000 for people over 50.

Traditional, deductible IRAs have no income restrictions unless your combined income is over $150,000 and one of you is covered by a retirement plan at work and you file jointly. Assuming you are both under 50 and are not covered by another plan, you can each contribute $4,000 per year to your IRA.

ROTH IRAs are available only to single people making less than $110,000 annually, or married couples making less than $160,000. Only single investors making less than $95,000 or married couples filing jointly making less than $150,000 can maximize their contributions to ROTH IRAs.

Investors who make more than the lower number ($95,000 or $150,000) but less than the higher number ($110,000 or $160,000) can still contribute, but the amount is subject to a 'phase out' formula that is so devious in its complexity that attempting to explain it here would cause more confusion than enlightenment (read: we can’t figure it out). We will point you toward this Internal Revenue Service publication that includes a worksheet (Worksheet 2-2, scroll down the page a bit) that is, incredibly, not too difficult to use.

Setting up a self-directed IRA is actually quite easy. Simply contact E*Trade, Scottrade, Ameritrade, Schwab, or whatever brokerage you choose, and ask them to send you the forms to set up a ROTH or traditional IRA. These forms are slightly different from those you would use to set up an ordinary taxable account. But that's just about the only difference you'll notice between an IRA account and a taxable account you may already have at your discount broker. That, and you can’t use margin or trade options and futures in an IRA (though you can buy mutual funds that do so).

Same drill if you want to set up an account at a fund company like Vanguard or T. Rowe Price. Simply call them up and ask for the correct forms. Fill them out, send them in, and before you know it you'll be running your own self-directed IRA account. As long as you buy only no-load funds for your IRA (which we HIGHLY recommend you do) you won't be paying a broker one red cent for any of it. Brokers and funds love IRA money as it tends to stick around. Make sure you get the best deal possible – some brokers charge fees to handle an IRA. For example, E*TRADE charges a $25 annual custodial fee, but only if you choose paper delivery of account documents and statements.

As far as minimum investment requirements, we've got some good news: Most mutual funds have significantly lower minimum investment amounts for IRA investors. The T. Rowe Price Blue Chip Growth (TRBCX) fund has a $2,500 minimum investment requirement for taxable accounts, but just $1,000 for tax-deferred accounts. The Payden Global Fixed Income fund (PYGFX) has a $5,000 minimum investment requirement that is reduced to just $2,000 for IRA contributors.

Thanks for the question.


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