Lower Portfolio Risk to Boost Return

Do you know the difference between total return and investor return? Most investors are familiar with the concept of total return. The total return of a fund is simply the sum of the capital and income return of a fund over a certain holding period. The total return of a fund of course assumes a buy-and-hold strategy.

Investor return (a Morningstar term) is a measure of the experience of the average investor in a fund. Investor return does not assume a buy-and-hold approach. Instead it accounts for all cash flows into and out of the fund in an attempt to measure how the average investor in the fund performed over time.

Investor return is not a replacement for total return, but an important complement. Total return indicates how a fund manager performed over a certain time period, but investor return shows how the average investor in a fund performed.

Hot funds with strong recent performance often show total returns that are higher than investor return, as do volatile funds. One of the reasons investor return in volatile funds can lag total return is that investors pile into funds when they are in an uptrend, but bail out after performance turns south. You end up with a situation where there are more assets in a fund when returns are poor than when they are strong. That lowers investor return.

The formerly overhyped Legg Mason Value Trust Fund offers a telling illustration of this concept. For those of you who are not familiar with it, this is Bill Miller’s fund. Prior to a recent streak of poor performance that began in 2006, Mr. Miller’s fund was touted by the financial press as being the only mutual fund to outperform the S&P 500 for 15 consecutive years. Let’s first look at the total return of the fund. For the 15-year period ending July 31, 2010, the Legg Mason Value Trust Fund earned a compound annual total return of 6.87%, compared to a return of 6.48% for the S&P 500. That’s not bad; even after some atrocious relative performance in 2006, 2007, and 2008, Mr. Miller managed to outperform the index by a few basis points. But how did the average investor in his fund do? The 15-year investor return for the Legg Mason Value Trust Fund was only 4.40%—a significant difference of 2.47% per year.

Compare the experience of the Legg Mason fund to a balanced fund such as Vanguard Wellesley Income. Over the last 15 years, the compound annual total return of the conservative Wellesley Income Fund was 8.1%, and the investor return was 7.73%, a difference of only 0.57%. Wellesley’s investor return was closer to the total return because investors in the fund didn’t bail out when markets were down. Wellesley’s low volatility provided investors with comfort and confidence to hold their shares. In my forty-plus years in the investment business, I have found that during down markets, investors are less likely to bail out of funds with modest volatility than those with high volatility. Bailing out of your funds during down markets is a sure way to destroy wealth. The better strategy is to increase your comfort level by lowering your portfolio’s risk. Chances are you’ll end up boosting your return.

Need Yield?

Do you invest in stocks for income? Is your portfolio focused primarily on U.S. stocks? If so, you might consider diversifying globally. The dividend yield on the U.S. stock market is one of the lowest yields in the world. In the chart below, I show the yields of 23 of the world’s major stock markets. The dividend yield on U.S. stocks is only 2.11%, compared to an average of 3.09% and a high of 5.45% in Spain. The U.S. is the sixth-lowest-yielding stock market in the group. If you invest in stocks for dividends or income, a global approach is advisable.

When you take a global approach to dividend investing it is possible to craft a portfolio that is better diversified across industries than a U.S.-only portfolio. Take the U.S. oil and gas industry as an example. Oil and gas production is a capital-intensive business. In the U.S., the independent oil and gas companies fund their capital expansion projects primarily with internally generated funds. After capital expenditures, there is often not much cash left for dividend payments. But in a country like Canada, there are oil and gas production companies that offer high dividend yields—in some cases yields north of 5%. How do the Canadian oil and gas companies pay such high dividends? Instead of funding capital expansion plans with internally generated funds, they tap the capital markets. For income-oriented investors, the strategy has appeal.

In Young Research’s Global Investment Strategy, we advise high-yielding international stocks that you’re unlikely to find in any other investment strategy report. We also cover special situations, global fixed-income markets, and commodities and currencies. If you are not now a subscriber, please join us. Click here to sign up for a subscription.

Consumers: TV Not a Necessity

T.V. sets are falling out of favor with consumers and fast.  According to a recent study released by the Pew Research Center the percentage of Americans who consider television a necessity dropped 10 percentage points from 2009. The drop was the largest among a group of 12 items covered in the Pew Study. Ironically though, while fewer consumers consider a television set a necessity, T.V. ownership per household reached a record in 2009.

Percent of Consumer Who Rate TV as a Necessity

Existing Home Sales Plummet

Existing home sales plummeted 27% in July to a new 15-year low. Existing home sales have now entered double-dip territory. At the current rate of sales, there is a surplus of more than 12 months of existing home supply—a 28 year high.

Existing Home Sales


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Which Portfolio Would You Rather Own?

Balanced Portfolio vs S&P 500

Given a choice, most investors would rather own the portfolio represented by the blue line in my chart. But in reality, many own something closer to the portfolio represented by the black line. The black line tracks the performance of the S&P 500. The blue line tracks the performance of a balanced portfolio. The balanced portfolio is invested 30% in corporate bonds, 30% in intermediate-term treasuries, 30% in equities, and 5% each in gold and the Swiss franc. The balanced portfolio is also rebalanced annually.

Over the last decade, my balanced portfolio earned a compound annual return of 8.07%, compared to a compound annual loss of 0.95% on the S&P 500. And the higher-returning balanced portfolio was much less risky than the S&P 500. The standard deviation of my balanced portfolio was only 5.5%, compared to 21.1% for the S&P 500—that’s three times the risk for a negative return. Sound like a compelling opportunity to you?

The S&P also had more down years than my balanced portfolio. The index was down four out of the last ten years. In down years, the average loss was 20%. My balanced portfolio had one down year, and the loss was only 2.63%. The contrast between the two portfolios is stark. The balanced portfolio is the hands-down winner in terms of return and risk. Of course, over many decades one should expect a buy-and-hold equity-only portfolio to outperform a balanced portfolio, but for conservative investors, and those in or nearing retirement, the added volatility is often not worth the prospect of additional return. I invest with a balanced approach and advise the same for you.

A Must-Have MLP Fund

You don’t want to miss the boat on master limited partnerships (MLPs) especially now that the asset class is receiving more press. A recent Wall Street Journal piece by Tom Lauricella and Carolyn Cui, “Frenzy in Energy Partnerships,” shed more light on the relatively unknown natural resource pipeline market, which has been attracting billions of dollars owing to its attractive 6%–7% yield. In fact, as the article points out, through the beginning of this month, MLPs rallied 15% on the year and 11% per year over the past 10—as measured by the industry benchmark, the Alerian MLP Index—for basically collecting rent on pipes. And over the past 10 years, the industry has grown from less than $20 billion to its current $200 billion, leaving some investors worried about current valuations.

At these levels, selection becomes ever more crucial, a fact not lost on SteelPath Fund Advisors’ MLP expert Gabriel Hammond. Before buying an MLP, he studies what the whole company would be worth, asking a simple question: “What would we pay for those assets to bring them onto our own balance sheet?” In doing so, he puts a price on MLPs based on their future stream of income and competitive advantage in a high-barrier-to-entry business.

I like a properly chosen mix of MLPs for your equity portfolio, especially as we prepare to enter the Great Reflation. During inflationary times, you want to own assets, like the pipelines and pumping stations of MLPs. Also, the rent on their pipes is usually indexed to the Producer Price Index (PPI) to guarantee an inflation-protected stream of income. And since it’s a volume business, you don’t have to live or die by the daily price swings in oil and natural gas, the two main pipeline commodities.

MLPs are sensitive to interest rates. Steelpath Fund Advisors wrote the following back in 2009 when average yields were 8%: “In practical terms, this means that a 100 basis point shift to a 9.0% yield would result in an 11.0% price decline in the group.” Not comforting to those in retirement, I’m sure. But the analysis goes on to say, “Because of the ability to grow their cash flow base, MLPs relatively outperform in a rising interest rate environment.” If caught in such a situation, I would certainly be content just patiently collecting yield, much as with a preferred stock with the added boost of an inflation-protected income.

It’s likely that future demand will be solid for oil and natural gas MLPs. Living in the northeast, I recognize firsthand the dire need of additional pipeline infrastructure. As of now, we depend on a significant amount of imported liquefied natural gas. In addition, renewable energy technologies, and specifically solar and wind power generation, have a long way to go before replacing oil and gas. Exploration and production companies are also more and more likely to get out of the pipeline businesses they own, shedding a non-core competency, probably creating more MLPs. And let’s not forget that their new discoveries from shale will need to be brought online, especially if there’s a push to move away from foreign oil. SteelPath’s prediction of 1% energy demand growth seems realistic as our population grows, spreads out, and consumes more energy.

I recommend the no-load, no-12b-1-fee SteelPath MLP Income Fund (MLPZX). If you are interested in owning less than $1 million of these institutional shares, you’ll likely need to work with an investment advisor. Richard C. Young & Co., Ltd., initiated a position when the fund first opened, enabling clients to own smaller amounts. I think you too will benefit from the steady income MLPs generate in the equity component of your portfolio, especially in retirement.

How Many Utilities are in Your Portfolio?

A powerful relative strength rally in utilities stocks is underway. The S&P 500 Utilities Index has outperformed the S&P 500 index by 12.5% since early April. Investors are bidding up high yielding utilities stocks in search of yield.

S&P 500 Utilities vs S&P 500

This Economy is Booming

The economic recovery in Brazil continues to gain momentum. Brazilian GDP grew at 11.4% in the first quarter of 2010. Inflation remains tame by Brazilian standards at less than 5%, employment is up smartly, unemployment is at a record low, and consumer confidence is near pre-recession highs.

Contrast the strong performance of Brazil’s economy to the record high unemployment, record low employment, and very low consumer confidence in the U.S., and it quickly becomes apparent that investors need to broaden their investment horizon beyond the U.S.

Diversification across sectors and market capitalizations is simply not enough. Your portfolio should be well diversified across asset classes including currencies, gold, domestic and international equities and bonds, including non-U.S. dollar denominated bonds.

Take a look at the first chart here. Brazil’s GDP is growing at faster and faster rates signaling strong recovery from its recession at the end of 2008.

In the second chart you’ll see that the recession may have actually helped cool Brazil’s inflation, as it was getting caught up in the worldwide cycle of price increases.

In the third chart you can see that unemployment in Brazil has fallen to near record lows and employment is at a record high.

In the final chart you’ll see that having jobs and dependable pricing might be having an effect on the mood of Brazilians, as their confidence is nearing record highs.

Don’t fall prey to diversification models that focus on market caps and value/growth indicators. In today’s globalized economy you have to think broader than that. Young Research’s Global Investment Strategy provides investors detailed information on investing worldwide. If you are not already a subscriber, please join us today.

An Investment Strategy Guaranteed to Win

In investing there is only one variable that an investor can control, and that is cost. Cost is vital to your long-term investment success. Lower costs necessarily result in higher returns. There is no disputing this fact. As an example, take two funds with the same gross return, Fund A and Fund B. Fund A has a 1% expense ratio and Fund B has a 2% expense ratio. After fees are deducted, Fund A will return 1% more than Fund B. Anybody capable of basic arithmetic should be able to figure this out. Yet, millions haven’t. The mutual fund industry is jam-packed with high-expense-ratio-load funds and those with 12b-1 marketing fees.

Morningstar, the fund data company most famous for its fund star ratings system, released a study this week on the predictive ability of expense ratios. Morningstar compared compound annual returns for five different categories of funds over five different time periods ending in March of 2010. The fund company split each mutual fund category into quintiles based on expense ratio and compared the returns on those quintiles. As Morningstar puts it, “Expense ratios are strong predictors of performance. In every asset class over every time period the cheapest quintile produced higher returns than the most expensive quintile.” For the domestic equity category, the lowest-cost funds on average performed 1.38% better per year.

The first item I look at when I’m evaluating a fund is cost. If a fund has a load or a 12b-1 fee, I won’t even consider it, nor should you. I don’t care what the fund invests in or how good a track record it boasts. When I buy mutual funds for myself, my family, and my clients, I buy only no-load, no-12b-1-fee, low-expense-ratio funds, and I advise the same strategy for you. It’s a guaranteed winner.