However, the tax code offers several other benefits to help make it easier to pay college costs. They include the following:

Coverdell Education Savings Accounts
Like 529 plans, these vehicles offer investment income and withdrawals for education expenses free of taxation. The catch, though, is that contributions are limited to $2,000 per year per student, and the student must be under age 18 when the account is opened. With 529 plans, contributions can’t exceed the dollar amount needed to pay for the beneficiary’s education, but just about all 529 plan limits exceed $250,000.

Nevertheless, Coverdell ESAs offer some significant advantages. For one, these plans are offered by a number of financial firms and institutions. Once you set up an account, you may have a broad range of investments from which to choose. If you’re an experienced investor you can direct Coverdell contributions where you’d like, into low-cost mutual funds, for example, or into investments with exceptional upside potential. With 529 plans, which are professionally managed, you have less control. Moreover, 529 plans limit tax-free withdrawals to post-high school expenses. With a Coverdell you can tap the account for K-12 costs as well as college bills, tax-free. You might use a Coverdell to pay for private school or for academic tutoring, for example. The Tax Relief Act of 2010 extends the tax provisions of Coverdell ESAs through tax year 2012.

A married couple’s income cannot exceed $190,000 to make the full $2,000 Coverdell contribution; for single taxpayers, the income limit is $95,000. If that’s a problem, you can give the money to someone with a qualifying income—perhaps a retired grandparent—who can make the $2,000 contribution for you.

Income Shifting
If you are self-employed, a professional, or a business owner, you may be able to shift income from your high tax bracket to a child who’ll owe no or low taxes. The savings on your tax bill can then go toward a college fund.

Suppose, for example, Dr. Alice Duncan, a self-employed physician, hires her teenage daughter Kim to work weekends and school holidays to maintain her office’s IT system and help with billing and other tasks. Over the course of a year, Kim works 500 hours and receives $15 an hour, which is the going rate for such work in their town.

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With the proper paperwork supporting that she paid Kim a fair wage for work actually performed, Dr. Duncan can deduct her daughter’s wages, $7,500, on her taxes. Assuming she’s in a 35% tax bracket, she saves $2,625 in income tax. Kim, meanwhile, offsets her $7,500 in earned income with the $5,800 standard deduction, leaving only $1,700 in taxable income. Since Kim is in a 10% tax bracket, she owes $170 in taxes and the family saves nearly $2,500—which can be put in a fund for future college costs.

Cedric M. Bright, a physician in Durham, North Carolina, says that employing a child might be a great idea to help cope with rising college costs. Dr. Bright and his wife, Maria, have a 4-year-old son, Andrew. When Andrew enters college 14 years from now, they can expect to pay about $260,000 for a four-year private college education. “We expect him to go to college,” says Dr. Bright, “and the costs then might be twice what they are today. It might be the case that a bright youngster will be able to do valuable work for a parent.”

Putting a youngster on the payroll may force parents to pay Social Security, Medicare, and unemployment taxes, reducing the ultimate tax benefit, if their business is structured as an S or C corporation. However, says Genevia Gee Fulbright, a CPA in Durham, “some parents may get tax breaks if they run sole proprietorships or partnerships in which each partner is a parent of the child. If they employ their dependent children under age 18, those wages are not subject to Social Security, Medicare, or federal and in some instances state unemployment taxes.”

Tax Credits
Both the American Opportunity and Lifetime Learning credits are available through 2012 to offset college costs. You can’t use both for the same child, though. Of the two, the American Opportunity tax credit offers the better deal, tax savings of up to $2,500 per student. To save $2,500, you must spend at least $4,000 on tuition, fees, books, supplies, and equipment.

Other conditions apply. To take advantage of the American Opportunity tax credit, you must pay expenses for a student in the first four years of post-high school education who is pursuing an undergraduate degree and going to school at least half time. To get the full $2,500 tax credit, your income cannot exceed $80,000 for single taxpayers or $160,000 for those who file joint returns. The credit phases out with incomes up to $90,000 (single) or $180,000 (joint).

“For those who qualify,” says Fulbright, “the American Opportunity tax credit is up to 40% refundable.” Thus, if you claim a tax credit of up to $2,500 and the credit is greater than your tax liability (even if your liability is zero), the difference is refundable to you, up to 40% of the credit you’re claiming, which is $1,000 if you claim the full $2,500.

• Precious metals funds returned 41.56%, on average. They invest largely in gold mine stocks, which soared as the price of gold hit record levels.

• Real estate funds were up 27.08% last year, bouncing back from disastrous years in 2007 and 2008.

• Technology funds gained 20.00%. They own stocks of technology companies such as Apple and Microsoft, as well as hot Internet stocks.

• Diversified emerging markets funds returned 19.26%. While this was only slightly better than last year’s average, these funds, which invest in companies that are in countries such as China and Brazil, have returned an outstanding 14.92% a year for the past 10 years through 2010.

Can these sectors lead the way again in 2011? black enterprise rounded up some of the smartest financial advisers and market-watchers we know to offer a glimpse into how some of today’s hottest sectors are likely to perform in the near future.

Photo: Chris Hamilton

Go for the gold. Precious metals funds have returned 25% per year through 2010, as gold went from about $265 an ounce to about $1,420. Is there room to go higher, and thus take precious metals funds to yet another stellar year? “Definitely,” says Arnett Lanse Waters, managing member and registered principal at A.L. Waters Capital in Braintree, Massachusetts. “We could see gold at $1,700 an ounce by this summer. Long term, $2,500 is a realistic goal.” Waters cites several reasons for his optimism. “Among industrialized countries,” he says, “growth will likely be slow. People who are concerned about economic stability may buy gold.”

The increased demand for gold will push up its price. At the same time, Waters sees strong growth in emerging markets as companies use gold and other precious metals for their increasing manufacturing needs. “There’s prosperity in India,” he says, “where people tend to be big buyers of gold. On holidays there, women get gold jewelry. In addition, the Chinese are opening up the gold market inside China, which means more people will be able to buy.”

While the demand for gold may be increasing, the supply is limited to what’s in the ground and what can be brought to market. “Mines in South Africa can’t operate beyond 50% of capacity, because of the country’s weak power grid,” Waters contends. “They’re also subject to frequent strikes over mine safety issues.” Thus, strong supply constraints may keep the price of gold heading higher.

Not everyone is convinced, though. “Gold could be anywhere from flat to negative this year,” maintains Lee Baker, president of Apex Financial Services in Tucker, Georgia. “I don’t foresee anything near last year’s performance. The global economy may continue to improve without any significant inflation. A lot of the run-up in gold was fear-based, and if the economy continues to improve, albeit sluggishly, some of that fear will subside.” Investors may want to hold some precious metals funds, but they shouldn’t overload on a category that has risen dramatically in the last decade. Baker suggests that no more than 3% to 5% of your portfolio should be in precious metals.

Photo: Rayon Richards

Is real estate’s recovery for real? Many people think of housing when they consider real estate funds, but a number of these vehicles have minimal investments in residential properties. They usually hold REITs, or real estate investment trusts: companies that manage portfolios of real estate to earn profits for shareholders. Most REITs are publicly traded; some are not. REITs are more likely to own office buildings and industrial properties, not apartment buildings. Real estate funds, therefore, tend to rise and fall with the overall economy. For years, investment prognosticators have been warning of a commercial real estate bubble; however, Baker sees “continued upward movement in 2011” for this fund category. J. Michael Salley, a financial adviser with Salley Wealth Advisors Group L.L.C. in Summerville, South Carolina, an independent investment advisory and financial planning firm, agrees, noting that “the real estate market continues to recover, albeit very slowly.” If occupancies pick up amid an expanding economy, these funds are likely to do well this year.

Investors may be attracted to REITs and REIT funds because of their potential for significant cash flow, oftentimes on the order of 6.5% to 7%. As business entities, REITs avoid the corporate income tax because they pass on rental income to investors. Morningstar reports that the trailing 12-month yield from real estate funds through the end of February is now 2.74%, which is much higher than the dividend yield on most categories of stock funds.

Salley has placed a number of his clients in nonpublicly traded REITs. “They are relatively stable and offer a competitive dividend yield with the potential for growth, if the REIT is offered publicly in the future.” Only financial advisers can provide investors with access to private REITs. In general, our experts recommend that investors have no more than 10% of their portfolio in real estate– related assets.

Photo: Dewey Chapman

Tech’s time is coming … again. Even after a superior year in 2010, technology funds have remained in the red for the past 11 years, according to Morningstar, which ranks them near the bottom of all fund categories in 10-year returns. Part of that lagging performance was the result of a post boom correction that began in 2000, and part is due to the two recessions so far in this young century. What’s ailing the tech sector more recently? In weak economies, corporations cut back on technology spending; then they race to catch up when the business cycle improves. That time could be upon us, say some experts. “We see tremendous value in top-tier technology companies such as Apple,” says Douglas Coe, managing partner and chief investment strategist at Moody Reid Financial Advisors in Kansas City, Missouri. “Emerging market economies are beginning to surge, which could lead the world out of a global slump. That means more demand for technology, as well as for commodities, from the Pacific Rim and from India. Values are good in many cases. You’ll want to own high-quality tech companies for long-term growth.” Indeed, worldwide enterprise technology spending is expected to grow by 3.1% this year to $2.5 trillion. That growth is expected to continue slowly but steadily over the next five years, according to Gartner Inc., a market research firm.

Photo: Chris Hamilton

Emerging markets? Still evolving. As noted, developing nations such as Brazil, China, and India have become major players in the global economy. Their economies are growing at a faster pace than the U.S. economy. China, for example, saw economic growth that topped 10% last year, while the U.S. economy grew at just a 2.8% pace. Increasing demand for gold from citizens of emerging market countries has helped precious metals funds. A global economic expansion in 2011 could boost tech funds. In this environment, should investors also put money into funds that hold emerging markets stocks?

Experts are generally upbeat when it comes to looking abroad for growth. “President Obama’s January summit with President Hu Jintao of China emphasized the importance of global trade to our economic future,” says Salley. As global trade grows in importance, investors should develop a truly global portfolio. Baker concurs, asserting that investors hoping to capitalize on such trends should go to the maximum of their asset allocation ranges. “For example,” he says, “if someone has a target range of 4% to 6% in emerging markets, go with 6%.”

Added attractions. Besides the fund categories we’ve mentioned, several others are attractive this year. Natural resources funds and equity energy funds, for instance, could be standouts if the price of oil increases—because these funds generally own oil company stocks. “We like oil companies,” says Waters. “If gasoline goes to $4 a gallon, the oil companies will make money. Many millions of people in the emerging markets are buying more cars and therefore will buy more gas. That will increase the demand for oil, driving up prices. A weak dollar may also cause oil prices to go up.” Coe is bullish on energy stocks, too. “Alternative energy is here to stay, though getting it to a macro level will take years to develop.” He also says healthcare is a category worth owning. “With baby boomers reaching age 65 starting in January of this year, they’ll be requiring more medical care and attention. This sector should be an outperformer.”

If any or all of these fund categories appeal to you, be sure to do your research, read the fund prospectuses, and consult an adviser. How much should you invest? “Typically, my clients have 7% to 8% in gold and 15% in integrated oil companies,” Waters says. “The rest is divided between cash and a stock market index fund.” He explains that his approach is American-centric. “With high unemployment, states running out of money, and jobs programs not being developed, the next four to six years in the U.S. economy will be challenging.”

Baker suggests more modest allocations to sector funds. “I’m not inclined to go beyond a 5% allocation in technology,” he says. “That’s assuming the investor already has a diversified portfolio. Virtually any domestic large-cap stock fund is going to have some technology exposure, perhaps 20%. When making decisions on these sector or satellite positions, investors should do so in the context of their overall portfolios.” As an investor, heeding this expert advice on allocation will ensure that you follow the latest investing trends without going overboard.

—Additional reporting by LaToya M. Smith

In times like these, it’s important for all of us to return to the fundamentals of investing. That is, properly spreading risk by diversifying your portfolio of holdings among various sectors of the global economy and efficiently allocating assets among stocks, bonds, cash, and commodities.

The financial headlines are littered with reasons to apply these tried-and-true principles. Many categories of mutual funds were losers in the first seven months of 2010. Foreign stock funds lost ground, especially those with European holdings. Other poor performers included funds with heavy exposure to commodities, especially oil, and healthcare funds. The bottom line? We seem to be in a market without clear trends.

To protect yourself from future market turbulence, it’s wise to hold a mix of various funds that own different types of stocks. And don’t forget bond funds, which can deliver lower risk to your portfolio. So, how do you gauge whether your portfolio is equally balanced in terms of the investments it contains—and the amount of your nest egg divided among various types of assets? In this article, you’ll read about investors who, while serious about securing their financial future, are in need of some help when it comes to balancing and properly allocating their holdings in a way that fits with their goals. black enterprise asked financial advisers to evaluate each of these investors’ strategies and suggest ways to navigate today’s uncertain markets.

The Rehab Specialist
Kandria Daniels, 35, Chicago
Value of invested assets: $40,000
Current savings strategy: As a certified rehabilitation counselor, working for a company that processes disability claims, Daniels specializes in helping people get back to work. Now she wants to find out if she should rehab her investment strategy.

Daniels’ strategy has been to balance the types of mutual funds in her 401(k). She has a stock fund, a bond fund, and a stable value fund. (Stable value funds generally invest in short-term, high-quality bonds that have low risks and low returns.) Within those funds, she has invested 77% in bonds, 15% in domestic stocks, 3% in foreign stocks, and roughly 5% in cash equivalents.  She’s now contributing 5% of her income to her 401(k), even though her company matches up to 6%.

Outside of her 401(k), Daniels has been contributing to a 529 college savings plan for her 11-year-old child, where she invests in a stock fund. She also has modest amounts in a Roth IRA—mainly invested in a bond fund—and in a tax-exempt bond fund.

Daniels also holds down a part-time job at a local retailer to help her build her investment accounts. She also pulls in cash as a landlord too. “I own a duplex,” she says, “where I live on the second floor. My parents live on the first floor and my grandmother lives in the basement.” The rent she collects allows Daniels to bring her monthly mortgage from more than $2,000 down to less than $1,000. “I would like to invest in rental property,” says Daniels, “perhaps a multiunit complex. I have also flirted with the idea of starting a mentoring program for teenage girls.” Those desires, though, come in second to her financial goals: saving for her child’s college fund and for her own retirement.

The makeover: “Assuming an 8% investment return and 3% inflation, Kandria will have an annual retirement income from her portfolio of about $24,000—$26,000 in today’s dollars,” says Chris Long, a fee-only financial adviser in Chicago. “It’s a good start but with a couple of changes she could boost her retirement income from $35,000 to $39,000 a year.”

For starters, Daniels should increase her 401(k) plan contribution from 5% to 6% to get the full employer match, which is 66.67 cents on the dollar. “This is the one of the few ‘free lunches’ around and she should not leave it on the table,” says Long. What’s more, Long finds that Daniels’ investment portfolio is very conservative for a 35-year-old, with more than 80% in bonds and cash.

Once Daniels has increased her 401(k) contributions to 6% of her income and rearranged her investments there, Long suggests that her next $5,000 of annual investment dollars go into her Roth IRA, rather than into the 401(k) plan. “Some of the investment choices in her 401(k) have high fees or commissions,” he says. “She can shop for lower-cost options in her Roth IRA.”

For now, Daniels has a relatively small amount in her Roth IRA, so Long indicates that she should hold a single fund there: a target date fund. Such funds, offered by many mutual fund families, are heavy on stocks while the target date is far away and shift assets into bonds as that date approaches. “Considering that Kandria is a relatively conservative investor,” says Long, “she might be comfortable with a fund with a 2025 target date. However, she should look closely at the fund’s holdings before investing because target date funds vary from one company to another.”

The Professors
Adam, 36, and Anna, 32, Bradley, Boulder, CO
Value of invested assets: $95,000
Current savings strategy: The Bradleys teach at the University of Colorado. Married for four years, they’re expecting their first child in January. Anna, an associate professor of law and a founding member of Mediators Beyond Borders, intends to keep working so they can both continue investing for their family’s future.

After buying a house recently, Adam and Anna have seen their cash reserves reduced below their comfort level. As a result, one of their near-term goals is to rebuild their emergency fund, which most financial experts believe should equal six to nine months’ of living expenses. “We’ve been putting $2,000 a month into savings,” says Adam. “Our goal is $60,000, and we’re more than halfway there.”

The bulk of the Bradleys’ assets are in various retirement savings accounts from their current employer, former employer, and IRAs. Within those plans, they hold multiple mutual funds. Anna’s largest holding is in the University of Colorado’s plan, where more than three quarters of her assets are in one foreign stock fund.  “I put the money in that fund two years ago on the advice of an adviser working with a family member,” Anna explains. “Now I’d like to know if that’s a sensible allocation.”

Adam is a tenured associate professor of English who has published books on hip-hop music and culture. He is co-editor of Three Days Before the Shooting, Ralph Ellison’s second novel, published posthumously this year. Adam has most of his retirement money in a TIAA-CREF 401(k) account that holds contributions from two universities, one where he was formerly employed. More than 60% of that account is invested in mutual funds made up of stocks, with the balance in various types of fixed income.

The makeover: “Anna and Adam seem to be doing a lot of things right,” says Richard J. Peace, a financial planner with FSC Securities Corp. in Colorado Springs, Colorado. “I think they can make some improvements, though.”

For starters, Peace suggests building up an even larger cash reserve. With a newly purchased home and a child on the way, unexpected expenses are inevitable. “Rather than hold cash in a bank account or a money market that pays almost nothing,” says Peace, “they can use a mutual fund that holds high-quality tax-exempt municipal bonds.”
Once Peace turned his attention to the Bradleys’ investments, he immediately fixated on Anna’s portfolio, where more than three-quarters of her University of Colorado plan is in one foreign fund. “That’s a large risk,” says Peace. “I’m a fan of international investing but I think Anna might cut that back to around 40%.”

The other money in her Colorado plan might be divided into three 20% chunks to be split among a growth-and-income stock fund; a small-cap fund; and a balanced fund. “At her age,” says Peace, “Anna can invest largely in stock funds, which are likely to have superior long-term returns.”

Peace adds that “Four good funds with different investment strategies should be sufficient.” In her other investments, Peace suggests that Anna maintain the 40-20-20-20 strategy: international funds, domestic growth-and-income funds, small-cap funds, and balanced funds.

As for Adam, Peace finds that a similar asset allocation would be appropriate. “Now, Adam has nearly 30% of his investments in some form of fixed income. That’s too much for a 36-year-old with good financial prospects. If Adam is concerned about recent stock market volatility, which is understandable, he can focus on funds that hold dividend-paying stocks. Such stocks offer more income and less downside risk.”

The Supervisor
Corey Thompson, 41, Washington, D.C.
Value of invested assets: $100,000
Current savings strategy: Thompson is a supervisor in the district’s court system. Although he has worked there for 16 years, he doesn’t see himself staying put until retirement. Instead, Thompson, who is single, is looking to start an entrepreneurial venture, perhaps sometime in the next few years. He is weighing whether it makes sense to start a business in the U.S. or in Jamaica, where his parents live. To accumulate capital for his future venture, Thompson participates in the Thrift Savings Plan, a federal retirement plan that’s similar to a 401(k). He contributes enough to get a full employer match.

Thompson also puts $1,000 a year into a Roth IRA and some other money periodically into individual stocks via a Scottrade  Inc. discount broker account. Altogether, Thompson invests 10% to 15% of his income—all of which goes into stocks and stock funds. “Especially after how the market has dropped in the last few years,” Thompson says, “I think I can get better returns in stocks than I can get from bank accounts or other low-yielding investments.”

Besides his stock investments, Thompson recently took advantage of depressed real estate prices and bought a condo in Broward County, Florida (near Fort Lauderdale). Instead of taking out a mortgage from a third-party lender, he borrowed from his TSP account. “That way, I’m paying back money to myself, into my retirement account,” he says. “I’m using the condo myself, but I might rent it out for short-term stays.” And, if the local housing market improves, Thompson could have a valuable asset he can sell to help finance his dream.

The makeover: “If Corey wants to pursue an entrepreneurial endeavor, he should have at least one year’s worth of living expenses in the bank,” says Ivory Johnson, director of financial planning at Scarborough Group Inc., an investment advisory firm in Annapolis, Maryland. “Most small businesses fail because they have limited access to capital.

On a positive note, Johnson says that Thompson’s savings rate is good. “Also,” Johnson notes, “the Roth IRA makes sense because tax rates won’t remain this low forever.” That is, if Thompson has a traditional IRA he’ll owe tax on future withdrawals, possibly at higher rates, while a Roth IRA offers tax-free withdrawals.

What about Thompson’s investments? “I would recommend that he diversify his portfolio with alternative assets,” says Johnson. “When the market corrected, large-, mid-, and small-cap stocks all declined, as did international companies. Therefore, a portfolio with 100% stocks may not really be diversified.” Among alternative assets, Johnson singles out gold, which is “an incorruptible form of wealth” that is not correlated with the stock market. Other alternative assets that Thompson might consider are managed futures funds and long/short funds. Both types can make money if prices go down so they offer protection when market volatility increases.

Johnson suggests that Thompson reallocate his portfolio by putting 30% in gold funds, 25% in U.S. stock funds, 25% in foreign stock funds, 10% in managed futures fund, and another 10% in a long/short fund.

Dividend-bearing stocks offer several advantages:
Yield: If you get 2% or 3% or more from a stock dividend, you’re starting out with decent cash flow in these low-yield times.

Tax shelter: So-called qualified dividends (the kind paid by most dividend stocks) are taxed no higher than 15% in 2010. Investors with a taxable income of $34,000 or less (or $68,000 for married couples filing jointly) owe no tax at all.

Quality: When you buy a dividend-paying stock, you’re generally purchasing shares of a solid company. “Dividend-paying companies are those that generate excess cash,” confirms Christopher Davis, a senior mutual fund analyst at Morningstar.

Safety: With their cash payouts and history of profitability, dividend stocks tend to do relatively well in bear markets. “Some studies have shown that dividend-paying stocks have significantly outperformed non-dividend payers in down markets going as far back as 1970,” says Tom Lydon, president of Global Trends Investments in Irvine, California, and founder of ETFTrends.com.

A mutual fund or exchange-traded fund (ETF) with portfolios composed of dividend-paying companies can provide all of these advantages without being forced to pick individual stocks. According to Morningstar, there are nearly 100 dividend-focused stocks, mutual funds, and ETFs. To help you choose among them, it’s helpful to know how dividend funds can be sliced and diced.

Mutual funds vs. ETFs. The dividend funds with the longest track records are mutual funds. Typically, of course, they are actively managed, which means a portfolio manager has identified dividend-paying companies that will make good investments. Although there are exceptions, most dividend-focused mutual funds emphasize large domestic companies.

ETFs have gained popularity in recent years because of their low costs, tax efficiency, and transparency. Dividend ETFs generally follow an index of such equities. For example, the largest dividend ETF, iShares Dow Jones Select Dividend Index (DVY), tracks the Dow Jones U.S. Select Dividend Index. Since many dividend ETFs track foreign indexes, they serve as an access point to add foreign dividend payers to your portfolio.

High-payers vs. growers. Dividend mutual funds and ETFs generally split into two groups. One group focuses on stocks with above-average yields. Among the highest-yielding dividend funds, Eaton Vance Tax-Managed Dividend Income Fund (EADIX) currently yields well over 5%. Its top holdings include familiar names such as McDonald’s and ExxonMobil. This mutual fund also holds some high-yielding preferred stocks and may use “dividend capture” strategies, acquiring stocks just before they make their dividend payouts.

Other funds actually have low dividends. That’s because they buy stocks with rising dividends, theorizing that such companies are growing and will amply reward investors in the future. Franklin Rising Dividends (FRDPX), for example, limits its choices to companies that have increased or maintained its dividend rate for the last four consecutive years. Growth companies may trade at relatively high prices, though, which would drive down the dividend yield.

Performance payoff. With so many dividend funds following different strategies, performance varies widely. Nevertheless, dividend funds generally performed well in the last bear market. During 2008’s downturn, the leaders among domestic large-company dividend funds posted smaller-than-average losses and are ahead of the S&P 500 in performance over the last three years.

—Donald Jay Korn

In an ideal world, you’ll start saving for college while your little one is still in diapers and simply tap your education fund to pay the tuition bills as they come due. The reality, though, is that even the most diligent savers may find it hard to amass six-figure amounts for higher education, especially if they’re also socking money away for retirement. In that case, financial aid—grants, low-interest loans, and work opportunities—may need to fill the gap. Families in this situation are in good company. Nearly two-thirds of all college students receive some form of financial assistance, according to the National Center for Education Statistics.

Saving the most money for your youngster’s higher education, while also remaining eligible for the best financial aid package is a tricky balancing act. To maximize financial aid, you’ll need to minimize what’s known as your “expected family contribution” or EFC. Suppose you fill out the Free Application for Federal Student Aid (FAFSA), which determines that your EFC is $20,000 in your child’s freshman year. If you’re sending your child to a state school where the total cost is $18,000, you won’t qualify for any need-based aid. However, if your child is accepted at a school where the total cost is $42,000 and your EFC is $20,000, you may get as much as $22,000 worth of financial aid. “The lower your EFC, the more financial aid your student might receive,” says Joe Hurley, founder of SavingforCollege.com.

Lowering your family’s EFC is a matter of putting college savings in the right place. “One way to reduce your EFC is to save in the parent’s name rather than the child’s name,” says Hurley. That’s because the Department of Education assesses a student’s assets at 20% for college costs, versus no more than 5.64% for a parent’s assets. How does that work, exactly? Let’s say you opened up an investment account for your daughter when she was born. Over the years, you have contributed to the account, watching it grow to $25,000. When your daughter applies for college aid, that $25,000 in her name will add $5,000 (20% of $25,000) to your family’s EFC. On the other hand, if you had kept that $25,000 in your name, it would add only $1,410 (or 5.64% of $25,000) to the family’s expected contribution. In this example, your EFC is $3,590 lower, by investing in your name, and your daughter might begin her freshman year with $3,590 more in financial aid.

Saving and investing in your own name makes sense if you have young children who are many years from college. But what can you do if you have teens or pre-teens who already have substantial assets in their own name? One tactic is to take cash from savings and investment accounts and put it into a 529 college savings plan, Hurley advises. These plans, offered by every state, allow you to earn investment income, tax-free. Withdrawals are also tax-free, as long as the money is spent on college bills. “Assets in a 529 plan are assessed for financial aid at the parent’s rate, up to 5.64%,” says Hurley, “not the student’s 20% rate.” You’ll wind up with fewer student assets, more parent assets, and a greater chance for increased financial aid.

This article originally appeared in the June 2010 issue of Black Enterprise magazine.

In an ideal world, you’ll start saving for college while your little one is still in diapers, and simply tap your education fund to pay the tuition bills as they come due. The reality, though, is that even the most diligent savers may find it hard to amass six-figure amounts for higher education, especially if they’re also socking money away for retirement. In that case, financial aid—grants, low-interest loans, and work opportunities—may need to fill the gap. Families in this situation are in good company. Nearly two-thirds of all college students receive some form of financial assistance, according to the National Center for Education Statistics.

Saving the most money for your youngster’s higher education, while also remaining eligible for the best financial aid package is a tricky balancing act. To maximize financial aid, you’ll need to minimize what’s known as your “expected family contribution” or EFC. Suppose you fill out the Free Application for Federal Student Aid (FAFSA), which determines that your EFC is $20,000 in your child’s freshman year. If you’re sending your child to a state school where the total cost is $18,000, you won’t qualify for any need-based aid. However, if your child is accepted at a school where the total cost is $42,000 and your EFC is $20,000, you may get as much as $22,000 worth of financial aid. “The lower your EFC, the more financial aid your student might receive,” says Joe Hurley, founder of SavingforCollege.com.

Lowering your family’s EFC is a matter of putting college savings in the right place. “One way to reduce your EFC is to save in the parent’s name rather than the child’s name,” says Hurley. That’s because the Department Education assesses a student’s assets at 20% for college costs, versus no more than 5.64% for a parent’s asset. How does that work, exactly? Let’s say you opened up an investment account for your daughter when she was born.

(Continued on page 2)

Over the years, you have contributed to the account, watching it grow to $25,000. When your daughter applies for college aid, that $25,000 in her name will add $5,000 (20% of $25,000) to your family’s EFC. On the other hand, if you had kept that $25,000 in your own name, it would add only $1,410 (or 5.64% of $25,000) to the family’s “expected contribution”. In this example, your EFC is $3,590 lower, by investing in your own name, and your daughter might begin her freshman year with $3,590 more in financial aid.

Saving and investing in your own name makes sense if you have young children who are many years from college. But what can you do if you have teens or pre-teens who already have substantial assets in their own name? One tactic is to take cash from savings and investment accounts and put it into a 529 college savings plan, Hurley advises. These plans, offered by every state, allow you to earn investment income, tax-free. Withdrawals are also tax-free, as long as the money is spent on college bills. “Assets in a 529 plan are assessed for financial aid at the parent’s rate, up to 5.64%” says Hurley, “not the student’s 20% rate.” You’ll wind up with fewer student assets, more parent assets, and a greater chance for increased financial aid.

The Costs of College (Tuition, Fees, Room & Board)
2009-2010 Academic Year

Private College
Total: $35,636
Increase from ’08 to ’09: 4.3%

Public College (In-State Student)
Total: $15,213
Increase from ’08 to ’09: 5.9%

Public College (Out-of-state student)
Total: $26,741
Increase from ’08 to ’09: 6.0%

Source: College Board

This article will appear in the June 2010 issue of Black Enterprise.

]]> http://www.blackenterprise.com/2010/04/14/college-aid-101/feed/ 3 http://www.blackenterprise.com/2010/04/01/catch-the-international-flight/ http://www.blackenterprise.com/2010/04/01/catch-the-international-flight/#comments Thu, 01 Apr 2010 05:00:30 +0000 Donald Jay Korn http://www.blackenterprise.com/?p=65920

Living and traveling abroad gave Dominique Moore a firsthand view of overseas investment opportunities. (Photo by Kevin Allen)

First, the good news. The stock market crash of 2008 lasted through March 9, 2009, but things improved rapidly after that. From March through July of last year, Standard & Poor’s 500 stock index gained 35.62%, enjoying its best five-month run since 1938. For the entire year, the average U.S. stock fund returned about 33%, and virtually every category of mutual fund tracked by Morningstar wound up with positive results.

Now, the not-so-good news: Even the strong rebound of 2009 couldn’t make up for 2008’s crisis-fueled losses—and the rest of the decade’s abysmal performance. The 2000s, in fact, were the worst decade in almost 200 years of recorded stock market history. The S&P 500 lost an inflation-adjusted average of 3.3% each year between the end of 1999 and November 2009. For the entire decade, the average U.S. stock fund returned about 1.8% a year. You would’ve done better (and spared yourself a lot of heartburn) by simply rolling over bank CDs for 10 years.

For investors who applied the old textbook lessons of diversification (that is, managing risk by filling your portfolio with a variety of investment vehicles and holdings from different industries and global regions), the strategy paid off. Over the last 10 years, international stock funds have done much better than domestic funds, returning more than 3% per year. And, by comparison, diversified emerging markets funds were excellent performers, delivering annualized returns greater than 9% during the 2000s:

Let’s put that performance in perspective. If you had invested $10,000 in the average U.S. stock fund at the end of 1999 and kept your money there, your stake would have been worth about $13,250 by year-end 2009. By comparison, the same amount placed in the average diversified emerging markets fund would have grown to roughly $22,250. What’s contributing to this outsized growth? While industrialized nations struggled to escape the recession in 2009, emerging markets such as Brazil enjoyed economic growth of more than 4%; China’s economy grew by more than 9%.

Many in the U.S. are beginning to catch on to the international investment flight. In 2009, Americans invested a record $64 billion in foreign mutual funds, and more than half of that flowed into emerging markets equity funds; the rest went into foreign bond funds. Shaba Lightfoot was among those investors who looked beyond U.S. borders for investment opportunities last year. Lightfoot, a 27-year-old student affairs coordinator at the Association of American Veterinary Medical Colleges, a nonprofit in Washington, D.C., started investing in emerging markets when her employer switched retirement plan providers to AUL OneAmerica last winter.

After conferring with an AUL investment counselor, Lightfoot decided it was time to diversify her holdings. She placed about $5,000 in the American Funds Euro Pacific Growth Fund (A EPGX). The fund has nearly 29% of its assets in Asian, Latin American, and other emerging economies, with holdings in small firms as well as large corporations. The aim of the fund is to provide long-term growth. In 2009, the fund grew roughly 39%. “I had all my eggs in one basket,” she says. “I could have suffered a major loss if the performance was poor, but now I’m diversifying and developing a solid retirement plan.

Growth Prospects
Market experts are equally optimistic about emerging markets. “It’s not reasonable to expect another year like 2009,” says Bill Rocco, a senior analyst at Morningstar. “However, emerging markets funds are likely to reward long-term investors.” Simply put, developing economies are expected to grow more rapidly than the economies of the U.S., Western Europe, and Japan. There are literally billions of people in the emerging markets whose standard of living is improving. That mass movement toward the middle class is likely to lead to hefty profits—and higher stock prices—for the companies in those countries. The world’s largest emerging economies are Brazil, Russia, India, and China. Others include Argentina, Mexico, Poland, South Africa, South Korea, and Turkey. What all these countries have in common aside from transformational economies are large populations and abundant resources.

Lee Baker, president of Apex Financial Services in Tucker, Georgia, agrees that growth in the U.S. is likely to lag. “We’re industrialized and our economy is mature,” he says. “We’re not going to see huge investments in infrastructure, relative to our population.” Emerging markets, by contrast, are in the beginning stages of industrialization. “They’re building bridges and roads and airports. Those projects create good-paying jobs, so the emerging markets are starting to have the kind of middle class that we’ve had for years. Billions of people will be buying more goods and services.”

Modern technology makes a huge difference, notes Ivory Johnson, director of financial planning at Scarborough Capital Management Inc., an investment advisory firm in Annapolis, Maryland. “Now, people in the emerging markets have the same access to information we have in the U.S.,” he says. “That makes those countries even more competitive.”
Outsourced jobs from larger industrialized countries also influence growth in emerging regions. “Manufacturing jobs keep going over there because of the cost advantage,” Johnson says, “and they’re not coming back.” He notes that the U.S. dollar may continue to weaken as a result of the increasing national debt, and a weaker dollar will probably add to the returns of foreign investments, including those from emerging markets.

There are myriad reasons why investors look to emerging markets. Dominique Moore, 42, an attorney in Baltimore, became convinced of the viable investment prospects abroad after seeing a few of these vibrant markets up close. “I lived in South Africa for four years, and I traveled throughout the continent. I got to see how trade works, with raw materials going out and finished goods coming in,” says Moore. “Now that I’m back in the U.S., I notice that most of the things we buy come from other countries. I think the emerging markets will probably continue to have high growth, compared with developed economies.” Putting her investment dollars behind her beliefs, Moore has owned Driehaus Emerging Markets Growth Fund (DREGX) for several years. The widely diversified fund’s holdings go beyond the more familiar emerging countries to also include stocks from places such as South Africa, Egypt, Indonesia, and Israel. In 2009, the fund gained more than 70%.

Justin Garrett Moore (no relation to Dominique Moore), an urban designer with the New York City Department of City Planning, is investing in growing economies out of a sense of moral obligation to help less developed markets, in addition to the projected financial benefits. He has invested in a number of emerging overseas markets through his 457 retirement plan. The 30-year-old holds the TIAA-Cref International Equity (TRERX), the Aberdeen Global SRI Equity Fund, and New Alternatives (NALFX) fund, all of which have roughly 12% of their holdings in emerging markets. Although investing overseas was once seen as high risk, Moore recognizes the superior growth prospects. Besides, he says, “I’m young, so I can take on more risk.” Moore also devotes a small portion of his investment dollars to microfinance ventures in developing nations.

Multiple Choices
If emerging markets appeal to you, there are several types of funds in which you can invest:
Diversified emerging markets funds. As you’d expect, these funds buy companies based anywhere in the world, outside of the industrialized nations. Recently, the funds in this category invested largely (14.36% of assets) in Brazil, followed by China (13.55%), South Korea (9.34%), Taiwan (8.03%), and South Africa (6.21%). “For most investors, the best way to participate in emerging markets is through a diversified fund,” says Rocco. “Let the manager decide on the countries and stocks that seem most attractive.” Large mutual fund families often have researchers and analysts who focus on a specific emerging nation or region.

Latin American stock funds. These funds have been extraordinary performers. The average 10-year annualized return in this category is 15.23% through the end of January 2010. “They’re basically Brazil and Mexico funds,” says Rocco, “because most of the assets in these funds are invested in those two countries, especially in Brazil. They’ve profited recently from the strength in oil and metals companies based there.”

Pacific/Asia ex-Japan funds. Except for Japan, all Asian countries may be considered emerging markets; holdings in this category differ but they tend to focus on China, Hong Kong, India, and Korea. For the past 10 years, the average annual return for this category was 8.41% through January.

Investing in emerging markets, Garrett Moore believes, is a social responsibility. (Photo by Lonnie C. Major)

Rocco is generally not enthusiastic about regional or single-country emerging markets funds. “They may be more volatile than diversified funds,” he says. The Asian financial crisis of 1997–1998 punished regional stock funds there, while Latin American funds have posted losses in five of the past 12 years, including a 59% slide in 2008.

Do regional emerging markets funds ever make sense? “Perhaps,” says Rocco, “if you have a large portfolio that already includes domestic stock funds, an international fund for developed markets, and a diversified emerging markets fund. In that situation, you might invest a small portion of your portfolio in a region or country that you believe will do better than the rest of the world. But you should treat a regional or single-country emerging markets fund like a stock that might do very well or very poorly.”

Emerging markets bond funds. Government and corporations in emerging markets may borrow money via bond issues; several mutual funds hold these securities. These funds offer generous yields (the category average is now around 5%, compared with domestic bond funds, which average 4.42%) as well as the chance for capital appreciation.

Over the past 10 years, emerging markets bond funds have returned 11.07% a year, which was higher than the average for diversified emerging markets stock funds. They’ve been less risky than the stock funds, too: In 2008, when emerging markets stock funds lost nearly 55%, the bond funds lost only 17.64%.

Even though emerging markets bonds have been strong lately, Johnson is unmoved. “With any bonds you have exposure to interest rates. If rates rise from today’s low levels, your bonds will lose value. With emerging markets bonds, prices may fall rapidly if there’s any sign of political unrest.” Rocco agrees that emerging markets bond funds tend to be more volatile than other types of bond funds, but says they might be suitable for some portfolios. “Just as some investors might want to hold an emerging markets stock fund as part of their equity allocation, so an emerging markets bond fund might fit into a fixed-income allocation,” he says. “Along with the volatility, there is the chance for substantial returns.”

Playing the Percentages
Many observers like the growth prospects for emerging markets but caution against overloading there because of the risk of downward swings. Johnson says his clients typically invest 10% of their portfolios in emerging markets. “I like inexpensive, well-diversified funds,” he says. “If you buy one country or one region, you might be too dependent on one commodity or too exposed to a local economic problem.”

Apex’s Baker recently recommended to Marlene Blaise, 41, a cardiologist in Alpharetta, Georgia, that she invest 3% of her portfolio in Vanguard Emerging Markets Index Fund (VEIEX). The Vanguard fund’s low expense ratio is the key to its appeal: It charges 0.40% of assets per year, while the average diversified emerging markets fund charges 1.77% a year. “The cost advantage of this Vanguard index fund is so great,” says Baker, “that other funds will have a difficult time matching its performance over the long term. As for asset allocation, Baker says that Blaise’s 3% commitment is moderate for his clients. “Some conservative clients have no emerging markets at all, while others have as much as 5%. Down the road, I might suggest that Blaise increase her emerging markets allocation to 5%, perhaps by adding a country-specific fund focused in Brazil, India, or China.”

Blaise believes that venturing into an emerging markets fund will be worthwhile. “Emerging markets have tremendous growth potential,” she says, “probably more than developed markets have now. In addition, diversifying your investments makes sense.”

By diversifying into asset classes such as emerging markets, which don’t always move in sync with U.S. stocks, you may get valuable noncorrelation. In 2007, for example, the average U.S. stock fund returned less than 7% while diversified emerging markets funds returned nearly 37%, on average.

“When determining how much of your money to invest in an emerging markets fund,” says Rocco, “check to see how much of your portfolio is already invested there.” Suppose, for example, you want a 10% allocation to emerging markets. You own a foreign stock fund that invests mainly in developed markets; that fund makes up one-fifth of your portfolio. If that fund has 15% of its assets in emerging markets, you already have a 3% (15% of one-fifth) exposure to emerging markets through that fund. You could invest another 7% of your portfolio in an emerging markets fund to bring your allocation up to 10%. The experts who talked to black enterprise for this story recommend that no more than 10% of your portfolio be invested in emerging markets.

Patience is prudent. Emerging markets will probably deliver good returns over a 15- or 20-year time period because of underlying economic growth, but there may be sharp declines along the way as a result of economic crises, political instability, and other problems that developing nations can encounter. “You need a long time horizon,” Rocco says.

“I’m in for the long haul,” says Dominique Moore. “I reinvest all distributions back into the fund. I have no intention of selling. If the fund goes down, I plan to ride it out. I don’t watch over this fund too closely because checking too often doesn’t help my peace of mind.”

Slow and Steady
Rocco warns that investors should be cautious about investing in an asset class that has enjoyed as much recent success as emerging markets, because there’s a risk that you’re buying near a market top. He suggests investing gradually, using dollar-cost averaging, perhaps every month or quarter. That approach reduces the risk that you’ll invest a large sum just before prices plunge.

“There are some other ways to benefit from the expected growth of emerging markets,” says Johnson. “For example, China has more than 20% of the world’s population but has less than 15% of the world’s arable land and about 7% of its potable water supply. As emerging economies develop, the people in China and other nations will be eating more, and someone will have to feed them. That’s likely to increase demand for companies in businesses related to agriculture.”

Therefore, Johnson recommends that his clients own Van Eck Market Vectors Agribusiness ETF (MOO), an exchange-traded fund that holds stocks such as Monsanto and Deere, which provide farm-related products and services. Similarly, Johnson’s clients hold managed futures, which may deliver excellent returns if demand from emerging markets drives up commodity prices, including agricultural commodities. Rydex Managed Futures Strategy (RYHFX) is a mutual fund focusing on futures contracts. As billions of people in developing nations eat more food, drive more cars, and make more cell phone calls, you’ll want to hold some funds designed to capture the investment returns that are bound to emerge.

—Additional reporting by LaToya M. Smith

This article originally appeared in the April 2010 issue of Black Enterprise magazine.

Brown, who moved her cash from a low-yield money market fund, gets a better return in a short-term bond fund. (Photo by Rhea Anna)

Financial advisers constantly recommend this basic principle of fiscal management: Maintain an emergency cash fund of between three and six (or more) months of living expenses. But what’s the safest way to store the money, keep it at your disposal, and still earn some interest on it?

There’s no easy answer these days. Money market funds have traditionally been great parking places for cash. Few investors have lost money there, and you have easy access to your funds when you need them. When interest rates rise in inflationary times, money funds pay higher yields. But in the current economy, the Federal Reserve has kept interest rates low to spark a recovery. As a result, yields on money market funds are scant. According to iMoneyNet.com, the average money market fund yields only 0.03% ($3 in interest per year on a $10,000 investment); the highest 12-month yield is 1.06%.

“Maintaining interest rates at record lows for an extended period is still central to the Federal Reserve’s economic game plan,” says Greg McBride, senior financial analyst at Bankrate.com. “The Fed doesn’t want to throw cold water on financial markets by raising interest rates.” Therefore, money market fund rates will most likely remain stunted for a while.

Seeking stability
The possibility of collecting a meaningful yield while avoiding steep losses appeals to Linda Brown, 61, a psychology professor in Buffalo, New York. She invested heavily in cash after the stock market crashed in late 2008. “In 2009,” she says, “I kept losing money. The return on my money market fund was so low that I was paying more in fees.”

Since then, Brown has returned to a balanced portfolio but she is still leery of stock market volatility. “All my new contributions to the New York State Deferred Compensation Plan are going into the Stable Income Fund,” she says. This fund holds mainly various short- and intermediate-term bonds, often backed by insurance company guarantees. It now yields 3% to 4%. “I’m happy with that return, in today’s market,” says Brown.

This Stable Income Fund is a type offered as an option in many employer-sponsored retirement plans, and they’re also available for IRAs. “Short-term bond funds may be a good place for cash,” says Deborah A. Jordan, a financial adviser with Ameriprise Financial in Eden, New York.

Layers and ladders
Jordan advises her clients, one of whom is Linda Brown, to think of cash in terms of tiers. “Start with holding at least three months of spending money in a money market fund or a checking account,” she suggests. “Even if you’re not getting much of a

return, you’ll have money in case you need it right away.”

The next tier should hold money you don’t need right away. “One strategy is to build a CD ladder,” says Jordan. “You might put 25% of your money for this tier into a one-year CD. Put another 25% into another one-year CD that matures three months later, and so on, until 100% of your money in this tier is invested in four staggered one-year CDs. You’ll have a CD maturing every three months, if you need the cash. If you don’t need the cash, you can roll it into another one-year CD.”

Of course, taking money from a certificate of deposit prematurely will incur a penalty. Typically, fines are equal to three months’ interest on short-term CDs and six months’ interest on CDs longer than 18 months. It pays to consider penalties as well as interest earnings before you purchase a CD, since penalty structures vary widely nationwide.

The third tier, says Jordan, might be for cash you don’t expect to need for a few years— you might be expecting to pay college bills, for example, or a down payment on a house.

Net gains
Another way to get some return on your cash is to open an online savings account. “I’ve used Emigrant Bank’s DollarSavingsDirect for myself and for my clients,” says Susan Moore, a financial planner in Watertown, Massachusetts. The current yield is 1.5%; according to SavingsAccounts.com, other online savings accounts offer yields from 1.10% to 1.60%.

Typically, brick-and-mortar banks allow you to electronically link your personal checking account to the online savings account. If that’s the case, it’ll take just a few mouse clicks to transfer money from your checking account to the online savings account (to get the higher interest), or from the online savings account to your checking account (when you need the cash). These accounts should come with no fees or service charges.

As you might expect, online savings accounts are federally insured, up to $250,000 per account, per bank. Although you generally have access to your money when you need it, it may take a day or two to transfer funds into your checking account, so be sure to plan ahead.

Betting on bonds
If you can part with your cash for more than a year or two, you may get even higher yields with a short-term bond fund. These funds hold bonds that are maturing in a few years.

Moore’s suggestions include Vanguard Short-Term Treasury Fund (VFISX) and Fidelity Short-Term Bond Fund (FSHBX). As the name suggests, the former invests primarily in securities issued by the U.S. Treasury. So, shareholders don’t have to

worry about bonds defaulting. In times of crisis, investors bid up the price of Treasuries so this fund will probably do well (though if interest rates rise, bond funds typically lose value). The Vanguard Short-Term Treasury Fund’s current yield is around 1.6%; the interest is exempt from state and local income tax (but not federal) because the fund holds Treasury issues.

The Fidelity Short-Term Bond Fund has a higher yield, around 2.8%, because it invests in corporate bonds and mortgage-backed securities as well as Treasuries. (Non-Treasuries usually pay higher yields because repayment isn’t as certain.) This fund fell by around 12% from 2003 to 2008, with more than 7% of the losses occurring during the panic of 2008, when bonds other than Treasuries suffered heavily.

“Short-term bond funds aren’t risk  free,” Moore concedes, “but they’re low risk.” Indeed, the short-term bond fund track record is encouraging. In the past tumultuous decade, Morningstar’s short-term government bond fund category has yielded positive returns every year but two. The short-term bond fund category, including funds that hold nongovernment as well as government issues, has had only three losses—its most recent a 4.2% drop in 2008, when credit markets froze. Although past performance doesn’t guarantee future returns, it indicates that investors in short-term bond funds can probably collect a yield while they avoid steep losses.

This article originally appeared in the March 2010 issue of Black Enterprise magazine.

Wayne P. Weddington III likes ETFs as a hedging tool. (Photo by Lonnie C. Major)

Why do wealthy investors and institutions pay millions of dollars in admission fees to get into hedge funds? Because hedging—or using investment strategies that reduce financial risk—works. Says Nadia Papagiannis, editor of Morningstar Alternative Investments Observer: “Defensive investing can improve your long-term results.”

So, why doesn’t everyone do it? Well, hedge funds represent “the ‘velvet rope’ of the investment community,” explains institutional investor Wayne P. Weddington III in his book, Do-It-Yourself Hedge Funds (Grand Central Publishing; $24.99). “Yes, you can be invited to the party, but the guest list is predicated on you having a bank balance of more than $5 million,” the SEC requirement for investing in an unregulated fund. Aside from expensive initial investments, hedge funds present other barriers for average investors. Their fees are quite steep; and liquidity is very low, as many funds put limits on your ability to withdraw your own money. Another downside: Because hedge funds are not regulated by the federal government, many of them operate under extreme secrecy. Even investors aren’t privy to all the ways their money is being used.

Fortunately, you no longer have to own your own Caribbean island to participate in hedge fund strategies. Thanks to a handful of newly popular investment products, you can employ hedging techniques in your own portfolio—at a relatively low cost.

According to Morningstar’s Papagiannis, an increasing number of mutual funds offer strategies that hedge fund managers typically follow. “With these mutual funds,” she says, “the minimum investment might be a few thousand dollars and you have daily liquidity. Fees are relatively high for mutual funds, but still much lower than what investors pay for hedge funds.”

Several types of investment vehicles deliver hedging strategies:
Long–short funds: Out of some $33 billion invested in “alternative mutual funds,” long–short funds have almost $28 billion. They use some of their assets to buy favored stocks and other investments; these are “long” positions, in industry lingo, because they’re owned by the funds, which will profit from price appreciation.

These funds also go short: they borrow securities expected to perform poorly and sell them at today’s prices. If those prices drop, the funds will buy back the securities at the lower price, return them to the lender, and thus clear a profit on the deal. In a bear market, when most stocks drop, profitable short positions can keep long–short funds from being clawed too badly.

“Most long–short funds are net long,” says Papagiannis, “because it’s easier and less risky to make money on the long side than on the short side, and because over the very long run the stock market has produced a positive real return.” If a fund is 60% long and 40% short, for example, it is 20% net long. It probably will participate partially in a bull market and not lose as heavily in a bear market.

Market neutral funds: These funds are designed to be neither net long nor net short. They attempt to add value by picking winners, on the long side, and by identifying laggards, on the short side.

Arbitrage funds: Funds in this category try to take advantage of market dislocations. In merger arbitrage, for example, a fund might buy the stock of the target company while shorting the shares of the acquirer. In convertible arbitrage, a fund might buy convertible bonds while shorting the stock of the company issuing the bonds. In these and other situations, the long–short structure provides downside protection while a skilled arbitrageur seeks to profit from mispriced assets.

How have these mutual funds performed? “They helped investors during the 2008 bear market,” says Papagiannis. The broad U.S. stock market (represented by the S&P 500 Index) lost 37% that year while the funds in Morningstar’s long–short category lost 15.4%, on average. That wasn’t a great performance but many investors would have been happy to lose only 15% in 2008.

Hedging against the downside usually means giving up some upside. Through the first 10 months of 2009, the long–short category gained only 7.5%, on average. During that time period, the S&P 500 was up more than 17% and the average domestic stock fund returned nearly 21%. Nevertheless, for the 22-month period (2008 plus 10 months of 2009), an investor would have been better off with the typical long–short fund than with the typical long-only domestic stock fund.

You might wonder, “Why do I need a long–short fund or any kind of alternative mutual fund? Why can’t I do it myself—go long on the stocks I like best, and go short on stocks I like least?” Frankly, short selling is not recommended for lay investors. It is complicated and extremely risky. Because short selling involves borrowing shares whose values can fluctuate wildly, you have unlimited loss potential if the stock you’re shorting shoots up instead of down.

ETFs: One way to avoid these problems is to buy “short exchange-traded funds,” also known as “inverse ETFs.” An ETF is a fund (often a collection of securities) that you can buy and sell on an exchange, just like a stock. In his book, Weddington, a partner at Brunswick Partners in New York, calls ETFs “the most effective instrument available to you to effect hedge strategies in your own portfolio. With ETFs you can truly accomplish what the professionals do.” Virtually all ETFs are index funds: they track a specific index. Inverse ETFs, though, are designed to move in the opposite of the index: If the S&P 500 goes down by 2%, for example, an inverse ETF based on the S&P 500 would go up by 2%. (A leveraged or “ultra” inverse ETF would go up 4%.) Of course, if the S&P 500 rises, the inverse ETF falls.

That may sound like an ideal way to hedge your stock market risk. You don’t need to set up a margin account; you can buy an inverse ETF through any broker, just as you’d buy a stock. There’s no interest to pay to carry the ETF and your loss is limited to the amount you invest.

So what’s the catch? “Inverse ETFs reset daily,” says Tom Lydon, president of Global Trends Investments in Newport Beach, California, and founder of ETFtrends.com. Thus, if the S&P 500 is up 1% on Monday, an inverse ETF on that index will fall by 1%. If the S&P 500 is down 0.4% on Tuesday, the inverse ETF will rise by 0.4%. And so on, day after day. Over time, the ETF’s result may drift from a true inverse.

For example, Vanguard Emerging Markets Stock ETF (VWO) tracks an index of stocks from the developing nations of the world. Those stocks were hit hard in 2008 so this ETF was down by 52%. You would expect an inverse ETF to be up by around 52% for that year but Short MSCI Emerging Markets ProShares (EUM) gained only 20%. Moreover, UltraShort MSCI Emerging Markets ProShares (EEV), which aims to double the inverse of the underlying index, actually lost 25%. “Inverse and leveraged ETFs are not for everyone,” Lydon concludes. “They are good to use in a situation where an investor wants to hedge current positions without having to sell them, or to capitalize on short-term moves in the markets.”

Papagiannis suggests that investors interested in hedging start with a long–short mutual fund, and perhaps some other alternative mutual funds, within their portfolio. “Shorting is not just the opposite of going long,” she says. “It takes very specific skills to successfully go short. Investors should look for funds managed by people who are experienced in short selling; the more concerned you are about stock market risk, the greater the portion of your portfolio you might allocate to alternative mutual funds.”

This article originally appeared in the January 2010 issue of Black Enterprise magazine.

In recent years, investors have reaped gains of roughly 25% when they own a merged or acquired stock. Here’s how it works: Suppose you own ABC Tech Co., now trading at $50 a share. Say XYZ Computer Corp. decides to take it over. In order to entice ABC Tech shareholders into approving the deal and selling their shares, XYZ must pay a premium to the current trading price. As a result of the announcement, ABC Tech’s stock is likely to be trading at $60 to $65, some 20% to 30% higher than the pre-takeover price.

As you might expect, such profitable plays have been hard to find ever since the stock market stumbled in 2008. According to Bloomberg L.P., M&A activity in the U.S. dropped by about 50% from 2008 to 2009, reaching its slowest pace since 2003. Toward year-end 2009, though, merger activity picked up. Takeovers involving U.S. companies rose from $26.6 billion in August to $49.1 billion in September.

Why the increased activity? A somewhat healthier economy and a stronger stock market build confidence among prospective acquirers. At the same time, stocks remain far below their peak prices, so buyers may find bargains. Perhaps most important, as a recent Goldman Sachs report put it, “Companies accumulated historically high cash balances over the past 12 months as they sought stability in face of an uncertain macroeconomic environment. Cash-rich balance sheets are ripe for use.”

Among those uses, big-fish companies may use their cash to feed on tasty smaller fish. “There are only so many things companies can do with cash,” says Seth Ellis, co-founder of RWE Private Wealth, a financial advisory firm in Orlando, Florida. “They can pay dividends to shareholders, invest internally, or purchase other companies. Recently, nonfinancial companies were holding around 5% of their assets in cash, which is extremely high by historic standards. A lot of that cash probably will be used for acquisitions.” The best acquisition targets, according to Ellis, can be found among companies with market capitalization of $250 million to $2.5 billion. In that size range, they’re big enough to be worth buying but small enough to make an acquisition practical. (Market capitalization is found by multiplying a company’s stock price by the number of its outstanding shares. For perspective, Apple has a market cap of more than $175 billion.)

“You should also look for companies with clean balance sheets and good operating prospects,” says Ellis. “There has to be something that makes them attractive besides the low stock price.” Ellis, also a partner at Gator Mezzanine Fund, which makes loans to growing Florida companies, says the top M&A opportunities may be in the technology area because acquirers don’t have to buy a lot of outdated “bricks and mortar,” such as obsolete manufacturing plants.

From March 2009 until late in the year, U.S. stocks had their best short-term run in 70 years. If stocks continue to soar, investors who choose well-priced small- and medium-sized companies may reap a buyout bonanza.

This article originally appeared in the February 2010 issue of Black Enterprise magazine.