Finding Shelter From the Storm

When it comes to wealth building, most investors would prefer never to hear (or read) another word about 2008. And frankly, we agree. But in order to move forward, it’s important to face up to the past. So now might be a good time to open up those quarterly mutual fund statements you’ve been ignoring. Go ahead. We’ve got your back. Here in our annual investment guide, we’ll show you how to repair and fortify your portfolio for the future.

In the guide’s main story, “Finding Shelter from the Storm,” we offer several ways to strengthen your investments by peppering your portfolio with investing experts’ “safer” holdings. Those include a list of mutual funds that concentrate their holdings in Treasury bonds, municipal bonds, corporate bonds–and even some stock funds.

Then, in “Regain Your Balance,” we’ll show how steep devaluations in assets can upset your portfolio’s equilibrium–and illustrate how to reallocate your holdings to regain an appropriate mix of stocks, bonds, and other investments. Finally, in “Make Lemonade from Lemons,” we’ll help you make the most of 2008’s capital losses (that is, if you actually sold shares for a loss) with some tips on how to turn them into a lower tax bill. That doesn’t sound so bad, does it?

Few people can honestly say they saw the dark clouds on the horizon. Although the financial markets were lackluster through much of early 2008, there was scant reason to suspect the market maelstrom that followed. As we are all painfully aware, late fall saw stocks spiral downward faster than bankers, brokers, and insurers could beg for bailouts. Even a late glimmer of sunlight in December couldn’t prevent the year from becoming investors’ worst since 1931.

Mutual fund investors found few safe harbors to ride out the storm. On average, domestic stock funds lost about 39% of their value, according to mutual fund research firm Morningstar. International stock funds did even worse, dipping almost 45%. Specialized categories such as Latin American stock funds lost nearly 60%.

Some wise souls managed to find relative comfort, however. Masses flocked to the safety of Treasury bonds. Funds holding long-term Treasury bonds, for instance, returned more than 27% in 2008. Other types of fixed-income funds, however, lost ground. Still, the average bond fund loss of roughly 8% seemed positively dreamy compared to the beating stock funds took.  Bond funds–especially Treasury bond funds–were among the few safe havens for mutual fund investors last year.

So, what’s in store for 2009? Is there any vehicle that’s safe?  “To many people, a safe investment is one where you won’t lose any money,” says financial planner Vicki Brackens of Brackens Financial Solutions Network, an affiliate of MetLife in Syracuse, New York. “If that’s your definition, and you’re looking for safety, you shouldn’t be in mutual funds. Saying you want a ‘safe investment’ is like saying, ‘I want to go swimming but I don’t want to get wet,’” she says. “Mutual funds have risks. Investors should focus on managing the risk they’re taking in order to aim for attractive returns.”
Bond funds can be a key element in risk management. Investors tend to worry about accumulating losses over fewer years–and usually far less steep–than individuals who purchase stock funds.

That doesn’t mean that you should give up on equities; many have been winners over the long haul. Allocating fixed-income funds among your portfolio holdings can keep you from losing too much ground during bear markets though. That’s been true for Gerald and Evelyn Williams, both 61-year-old retirees living in Syracuse. Aside from cash and real estate, their investment portfolio is divided in the following manner: a third in bond funds and the remainder in stock funds, according to Brackens, their financial adviser. While the Williams’ equity investments lost a little more than 30% in 2008, their bond funds produced a loss of roughly 11% last year, helping to ease the overall pain. “It was a little scary,” Evelyn recalls, describing how she felt when their stocks slid last year. However, as Gerald asserts: “It was not as bad as it could have been, because we are diversified.”  The two are still invested in a handful of bond funds, including the Loomis Sayles Strategic Income Fund (NECZX) and PIMCO Total Return Fund (PTTDX).

SEEK OUT STRONG BONDS
Going forward, bonds may offer stocklike appreciation. In fact, bond funds that took losses in 2008 could rebound in 2009 if credit markets return to normal. In that case, bonds might deliver capital gains in addition to yields ranging from 4% (from tax-exempt municipal bond funds) to 11% (from funds holding high-risk corporate “junk” bonds).
Which types of bond funds are likely to offer both safety and upside potential?

Treasury bond funds. Last year’s big winners, Treasuries remain safe harbors because they won’t default: Uncle Sam can just print more money to repay bondholders. Nevertheless, Treasury bond funds may be “overstretched” now, says Lawrence Jones, Morningstar’s associate director of fund analysis. “Although the flight to quality could continue, which would help Treasury bond funds, other types of bond funds look like they offer better value,” he says. “Treasury bonds may be the most overvalued asset class now.” The Rydex Government Long Bond 1.2x Strategy Investment Fund (RYGBX) and the ProFunds U.S. Government Plus Investor Fund (GVPIX) were two big performers in the category last year, with total returns of 50% and 49.6%, respectively.
Nimble bond funds.  Jones suggests that investors seeking relative safety in the bond market choose a fund that’s run by a savvy manager who can move among various types of bonds to find those that are most appealing. Those might include investment-grade corporate bonds, “junk” corporate bonds, Treasury bonds, and mortgage-backed securities.

Robert Rodriguez and Thomas Atteberry were Morningstar’s fixed-income managers of the year in 2008. Not only did their FPA New Income Fund (FPNIX) gain 4.3% last year, it hasn’t suffered a calendar year

loss since Rodriguez took over in 1984. “The managers anticipated some of the problems subprime mortgages would cause and increased their cash holdings,” says Jones. “They will take risks such as moving into high-yield bonds when they think that market is attractive.” The portion of holdings in the fund that were replaced with other holdings in 2008 was 32%.
Another fund manager with a reputation for moving his holdings among bond categories and, as a result, making his investors loads of money is Bill Gross. His PIMCO Total Return D Fund (PTTDX) had a similar 4.5% return last year, focusing on issues (mortgage-backed securities, bonds issued by financial firms) that have explicit or implicit support from the federal government, according to Jones. Some mortgage-backed securities (Ginnie Maes, Fannie Maes, Freddie Macs) have federal backing. Bonds issued by financial firms such as Citigroup are thought by some to have federal backing because the government has shown it won’t let these companies go under.

Among the beneficiaries of Gross’ expertise is Tami Corrie, 39, a Covington, Georgia, probation officer who invests in mutual funds through a deferred compensation plan at work. “I was really upset when I saw my investments lose value last year,” she says. “But then I discovered that I did a lot better than other people I know.” Says Lee Baker, CFP, president of Tucker, Georgia-based Apex Financial Services, who advises Corrie on her selections: “Among those funds, Tami has about 35% invested in bonds. Besides 32% in PIMCO Total Return, she has 3% in PIMCO High Yield D Fund (PHYDX). That’s a higher allocation to fixed income than most of my clients Tami’s age, but those holdings served her well in last year’s meltdown.”

Balanced funds. Another option for investors seeking safe harbor is a balanced fund–one that holds stocks as well as bonds. Outside of her deferred compensation plan, for example, Corrie invests in Russell LifePoints Balanced Strategy Fund (RBLSX), which typically has about 40% or more of its assets in bonds and the other 50%-plus in a mix of domestic and international stocks, including real estate securities. This fund had a string of solid years from 2003 through 2007 but lost 30% last year. “The bonds in this fund provide a decent cushion from stock market downturns,” says Baker. “Although it lost money in 2008, it didn’t lose as much as most stock funds. With Russell LifePoints, Tami has some protection with bonds, but also has a chance for gains from stocks. One of the biggest detriments to long-term investing is not having exposure to the stock market when a rally occurs, which might happen in the coming year or so.”

Balanced funds also get support from Adam Bold, founder of the Mutual Fund Store, an Overland Park, Kansas-based investment advisory firm. “Balanced funds are always somewhat of a safe haven because they offer some downside protection as well as upside growth potential,” he says. Among his favorites

are James Balanced: Golden Rainbow Fund (GLRBX) and Permanent Portfolio (PRPFX), which holds precious metals; Treasury bonds; stocks; and assets denominated in Swiss francs. Permanent, which lost 8.4% in 2008, has a 10-year return of 8% that is considered among the best of all balanced funds. Says Dean Barber of Barber Financial Group in Lenexa, Kansas: “It’s a one-stop shop for hedging against inflation. The manager has done an impressive job which has served his shareholders well.”

Corporate bond funds. While investors flocked to Treasuries in 2008, many ditched corporate bonds. That’s a trend that may change in the coming year. “From a risk-return perspective, investment grade corporate bonds may be more attractive than stocks now,” says Morningstar’s Jones. Why? Bonds issued by solid companies trade at depressed prices so yields are up. Funds holding such bonds offer yields as high as 6% or more these days. If the economy strengthens and high-quality corporate bonds regain some of their value, investors could enjoy double-digit returns historically produced by equities–without bearing stock-fund volatility. Among funds holding high-grade corporate bonds, Westcore Plus (WTIBX), which lost less than 2% last year, boasts a strong 10-year return of 5.35% through January 2009.

Municipal bond funds. The story here is similar to the one for corporate bonds. Fearing that a weak economy will cause fiscal problems for states and cities, among other technical market factors, investors have sold municipal bonds. As a result, prices have dropped. Funds holding highly rated issues now yield 4% or more. What’s more, municipal bond interest is exempt from federal income tax. [See “Getting More for Your Muni,” Moneywise, February 2009.] Bold’s selections of muni bond funds include T. Rowe Price Summit Municipal Intermediate Fund (PRSMX) and American Century Tax-Free Bond Investment Fund (TWTIX), both of which had scant losses last year and  boast 10-year returns in the top 15% of their category.

Convertible bond funds. These funds hold bonds and preferred stocks that can be converted into the issuer’s common stock. “They give you the opportunity to focus on income during a down market and also take advantage of capital appreciation in an up market,” says Tracy Brown, a financial adv

iser with William Tell Financial Services in Latham, New York. “Although there are no foolproof mutual funds out there, a convertible bond fund and an intermediate-term bond fund can help investors who are looking for wealth preservation.” Among convertible bond funds, Brown is attracted to Franklin Convertible Securities Fund (FISCX), which currently yields more than 8% and has one of the category’s best 10-year records.

Sticking with stocks
Yes, it’s a bold option. Certainly last year showed that stock funds aren’t safe–by any definition. Yet it’s safer to invest in stock funds now than it was in, say, 2007, when the market peaked and investors poured in billions of dollars. “Stock funds look really cheap at this time relative to other times,” says Bold. “It’s hard to buy when the market is down 40% to 45%, but that’s the way to build wealth: buying low and selling high.” And investors today are certainly buying at discount prices. At the 2007 peak, the price-to-earnings ratio of the S&P 500 was around 24. Today, it’s about 19. For long-term investors, stocks and stock funds are on sale now.

That view is shared by Lance Dottin, 39, a teacher and coach in Cambridge, Massachusetts. “I’ve been investing in mutual funds since the early 1990s,” he says. “I’ve seen stock funds go up and down. They’re down now but I’m confident the stock market will come back by the time I retire, which probably won’t be for many years.” Dottin has 85% of his portfolio in stock funds, according to his adviser, Andrew Ward of Baystate Financial Services L.L.C. in Boston, who has recommended that Dottin stay the course. What types of stock funds look promising now?

Value funds. These funds hold shares of major companies selling at depressed prices. “Typically,” says Bold, “the conservative way to approach equity investments is to purchase shares of large-cap value funds, which tend to own the largest, most stable companies.” Among the funds Corrie holds in her deferred compensation plan, for example, are American Century Value Investors (TWVLX), which focuses on large companies, and T. Rowe Price Small-Cap Value (PRSVX), which invests in smaller firms. They boast 10-year returns of 3.97% and 8.42% respectively.

Sector funds. “When the economy is in a recession, certain types of companies do relatively well,” says Bob Johnson, associate director of economic analysis at Morningstar. “Funds that specialize in those sectors may hold up in 2009.” Johnson points to healthcare, for example, as a generally recession-resistant industry because people will still get sick, go to doctors, and fill drug prescriptions. “This sector lost less than the broad market last year,” he says. “Some of the major pharmaceutical companies are flush with cash, so they should be able to maintain their dividends.” Morningstar’s picks in this category are T. Rowe Price Health Sciences (PRHSX), which carries a 10-year return of 6.4%; Hartford Global Health A (HGHAX); and Vanguard Health Care (VGHCX), which has tallied a 7.9% 10-year return.

Johnson also is upbeat about utilities. “People still need electricity,” he says. “Typically, these companies can count on relatively steady revenues. Dividends may be substantial, too.” For “pure, no-frills utility exposure,” Morningstar says of Franklin Utilities Fund (FKUTX) that it “focuses almost exclusively on domestic regulated utilities with solid yields and stable returns, and such safe havens have become popular amid the market volatility.”

There might not be any guaranteed shelter from the storm among mutual funds, but some funds have lower risks than others. By including these safer havens in your portfolio, you may be able to ride out the scary times and cash in once the clouds have parted.

This story originally appeared in the 2009 issue of Black Enterprise magazine.