Bond yields are supposed to increase with the length of time until the bond matures and you get your principal back. (When I talk about bonds I’m really mean any fixed income investment: bonds, bills, notes, CDs, and so on.) A basic, maybe the basic principle of investing is the risk/reward trade-off. You have to take risk to earn a return. The corollary is also true. The more risk you take, you greater should be your expected reward (return).

 

The risk/return trade-off means there should be a positive relationship between the expected return and the maturity of a bond. The longer to maturity, the higher the yield. Why? Because the longer until maturity, the greater the risk. Risks include inflation reducing the value of the bond, rising interest rates, having to sell the bond at a loss prior to maturity, and, except for US Treasuries, default by the issuer.  

 

The yield curve (return vs. maturity) should be an upward sloping line – yields rise as maturity increases. This is the normal state of the bond market. But look what’s happening right now. The Treasury curve is inverted (I’ll explain that in a minute) and the yield on other fixed income securities is almost flat. Something’s wrong with the bond markets.

 

The Treasury market is upside down. For example, the yield on one year Treasuries is 4.94% and the yield on five year Treasuries is 4.54%. You’re losing 40 basis points of return annually for taking 4 years additional risk. (That’s the inverted yield curve.) Now, you might be willing to take that bet if you thought inflation or interest rates would going to move significantly lower over the next five years but do you really that’s going to happen?   I thought not. One year CDs yield 5.05%, 10 year CDs yield 5.75%. That’s almost a flat curve (no pun intended). Do 70 basis points (.7%) really compensate you for 10 year’s illiquidity and inflation/interest rate risk? What’s the penalty for early withdraw on you CD?

 

Inverted yield curves don’t last for long and are usually an indicator of a peaking/declining economy. Mutual fund investors should be wary. It’s a good time to stay short-term in your bond portfolio and a good time to be cautious about the stock market (especially with the Dow over 13,000). Liquidity is a smart response to an inverted yield curve.

When it’s an Exchange Traded Fund (ETF), according to John Bogle.   Mr. Bogle is the founder of the Vanguard funds and a champion of low-fee and index funds. He’s one of those people who’ve forgotten more about mutual funds then I’ll ever know.

 

An ETF is supposed to be similar to an index fund. ETFs and index funds are market baskets of securities designed to track the performance of a market index, such as the S&P 500. (Proponents argue that ETFs can have lower costs, greater liquidity, and be more tax efficient then index funds.) 

 

In Mr. Bogle’s just-published book The Little Book of Common Sense Investing he argues that ETFs have been hijacked by day traders and that many ETFs will not track the indexes they’re designed to mimic and will not meet investors expectations. You can find a summary of his arguments in the April 30 BusinessWeek article What’s Wrong With ETFs?  (Yes, I know it’s April 25^th, but publishers seem to be able to foretell the future. As an investor, I wish I could do this.) He’s not alone in expressing concern about ETFs. Two articles which discuss the potential pitfalls of ETFs are Beware the Flaws in Trading ETFs in The Street and Too Many ETFs in Forbes, both published March 20^th.

 

Are all ETFs bad? Of course not. Are they a viable substitute for index funds? Yes, the well-structured liquid ETFs are. Even Vanguard evidently does not entirely agree with its founder. It offers over 30 ETFs. Hopefully, Mr. Bogle would find Vanguard’s ETFs to be in the good category.

 

ETFs are like any other investment. You can’t just go by the name, you’ve got to open the door, dig around and reach your own conclusion if it is what it says it is and if it’s right for you.

So the Dow hit an all-time last week. That’s great for all of us equity investors, unless, of course, you bought smaller cap or technology sector funds in the late 90s when the NASDAQ was racing up to the 5,000 level. Since the NASDAQ has only “recovered” to 2,500, you might not be such a happy camper.  Let’s also not forget that the Dow fell by almost 700 points from February 20 to March 16 this year, or that the Chinese stock market fell 4% in one day last week. 

 

Investing is a tricky business, especially investing in stocks. Just because one market or group of stocks is doing well doesn’t mean that you’re making money (although it also doesn’t mean that you should change your strategy and chase what’s in vogue. That’s probably the surest way to lose money.) So diversify your investments, trust a professional – two good reasons to buy mutual funds – don’t get swept up in the excitement on the upside and don’t become depressed when stocks correct. (Speaking of market corrections, rest assured that the Dow will correct.)

 

In my April 16^th posting, Elvis Has Left the Building, I talked about the seasonal effect of money flowing into the market from bonuses and retirement plan contributions. There’s a good article summarizing the pros and cons of this argument in yesterday’s New York Times, The Calendar Says ‘Sell,’ but Should you Obey? which makes for great reading. Just another reason to be cautious.

The world’s second biggest economy is Japan (behind the good ol’ USA). China, India, and Brazil have economies growing at 10%, 8%, and 3% (probably underestimated), respectively. That’s a lot faster then the roughly 2.5% expected US growth over the next year or so (absent a recession, of course). Together those three economies almost equal the US in GDP (as measured by official exchange rates). Add in Japan, and the combined GDP of these four countries exceeds the US. The CIA’s World Factbook is an excellent source of country information like this.

 

What’s my point? A good mutual fund investor would be wise to have at least 25% of his or her assets invested outside the US.  Global investing makes sense not only to avail oneself of higher growth rates but also because national economies, and international markets, many respond differently to the same event or over time. I’m not suggesting that the global economies aren’t linked, and becoming more so, but there still are differences based upon GDP growth and other national factors.

 

Where to start? Which counties do you think are attractive investments, i.e., their economies will grow. What are the opportunities in Mexico (domestic demand)? Canada (natural resources)? Germany (banking and automobiles)? Then, like with every other investment decision, consider the riskiness of the investment. Canada and Germany are pretty safe. Russia, for example, is another high growth economy, clipping along at 7% per year but probably a riskier investment. Egypt’s stock market is up 7% year-to-date (as compared to 2% for the Dow) reflecting the country’s 6% GDP growth rate, but Egypt’s also a riskier bet.

 

There are many excellent international mutual funds, some invest globally, some focus by region and some by country.  International funds invest in all sizes of companies and all classes of debt. Click on MUTUALdecision and you can find the top international funds or use our Mutual Fund Research Tool to select the international fund best suited to your investment objectives.  

What makes markets go up and down?   Economic growth, earnings growth, monetary policy, inflation, changing risk premiums, return expectations, and more. But, simply put, market movements all boil down to supply and demand. More money flowing into the stock market then investors are taking out will drive stock prices and, therefore, the value of your equity mutual funds, higher. More money going into the debt markets then being withdrawn will drive down interest rates and increase the value of bonds and bond funds.

 

Where does this additional money come from? Overseas investors and private equity funds which pay cash and take companies out of the public market are two sources. And, there’s a third source, a seasonal source, which occurs every year between January and mid-April.

 

The first quarter of every year is when most employees receive bonuses and/or their employer retirement plan contributions (or get around to investing if these payments occurred in December). In addition, the first quarter of the year is the last chance to make IRA and 401-K (or another non-employer sponsored retirement plan) contributions. The deadline for retirement-related contributions is typically April 15^th (April 17^th this year).

 

So, tomorrow the great annual retirement plan funding season draws to a close for another year and a source of new monies flowing into the market dries up. This is another reason why I’d be a cautious investor right now. But don’t despair --  

 

Elvis will return next January.

Neither do fees. There I’ve said it and just alienated the 74% of mutual fund investors who, according to an Investment Company Institute study Understanding Investor Preferences for Mutual Fund Information, consider fees and expenses when making their fund investment decisions. Now, just like everyone else, I don’t want to pay any more then I have to for anything I buy, but when it comes to investments I’m more interested in my risk-adjusted return after expenses then I am with the amount of the fees and expenses. Let me explain. If your choice is between two US mid-cap value funds (two funds with about the same amount of risk) and one has a 1% expense ratio and returns 11% after expenses and the second has a 2% expense ratio but returns 15% after expenses, would you be willing to bear the higher expenses? I thought so. An oversimplification? Of course, not the least of which is because funds in the same risk category tend to have the same pre-expense return. But a central tenet of this Blog and academic research is that some funds (more specifically, fund mangers) tend to either outperform or underperform their risk class over time. (Proponents of index funds will dispute this and index funds are good investments but that’s the subject for another day.)  Conclusion: start with the right mutual fund type/risk level for you and consider returns first.

 

This is the first in a series of periodic postings on mutual fund fees and expenses and their impact on mutual fund investors.

On the surface, the latest jobless report was good news. The unemployment rate fell to 4.4%, a great number by anyone’s standards. More jobs means more people setting up new households, buying cars, buying burgers, etc. This increased demand keeps the economy growing and ultimately pushes the value of your equity mutual funds higher. So far, so good.

 

Now, let’s look behind the numbers. 56,000 new jobs in construction. Wow!  That’s great. Homebuilding is rebounding (and everyone trying to sell their home can rejoice because the housing market has turned around). But, wait, that’s not quite true. Construction lost as many jobs the month before, so it’s just back to even. Not so good.

 

Where did the economy shed jobs? The manufacturing sector. Why is this important? Because that’s where the high wages (and benefits) are paid.  Where did the economy gain jobs? Retailing, leisure and hospitality, among others. These are mostly low paying jobs. The sales associate at your local discount store or front desk check-in person does not make as much money as the person building automobiles or airplanes. Not good.

 

The recent employment report suggests the economy will chug along for a while longer but it does not suggest any acceleration in growth and has an ominous undertone for the intermediate and long term. Investment caution is advised.

The Best-Managed Mutual Funds by BusinessWeek, April 2, looks through a different lens in picking top performing mutual funds. The article, or more specifically Standard & Poor’s and Business Week, selected 24 top funds based upon risk-adjusted return rather then absolute performance.   This is the right way to evaluate a mutual fund’s (or any investment’s) performance. 

 

Understanding risk is a recurring theme of mine. The point is that funds which take more risk should have higher returns. A Chinese Internet fund should (may?) outperform a US Big Cap Value fund over time. The key to successful investing is to pick/know your risk tolerance level and then find the funds which will generate the highest return for your risk profile. 

 

Some of the S&P/BW “winners” come from well-known fund families such as Fidelity and T. Rowe price but many are funds, and even fund families, which are not household names. It’s a little bit of a black box as to how Standard & Poor’s/BusinessWeek pick their winners but its refreshing to see a non-conventional list and the stories of the funds make for interesting reading. (Note the common thread: the fund managers love what they do, they’ve been at the same fund for a while; they aren’t afraid to go against the herd and they cast their net wide to find interesting investments.)

Economists, with the possible exception of Alan Greenspan, continue their forecasts of slower growth and no recession in 2007. This is in spite of the collapse of the housing market, weak auto sales and - new item - reduced business spending. The Fed remains concerned about inflation. Sadly, economists abilities to predict the future rivals weather forecasters ability to predict when and where hurricanes will strike. I don’t doubt that economists and weather forecasters are sincere hard working people using every tool at their disposable. But, their early 21st century models are incomplete. So, I’m going on record as saying that I believe there is a greater than 50% chance of a recession occurring in the US in the next 12 months. If business inventories or unemployment rise (the former is more likely to happen first), then the odds go up.

 

A recession suggests a 20% market retreat off its highs beginning, not when the recession actually begins, but when investors believe a recession is in the offing. What’s an investor to do? I’ll repeat my mantra.  Review the riskiness of your investments and make sure your optimism didn’t get the better of your judgment.  If you own an investment which is either too risky/volatile for you or you won’t feel comfortable holding in a down market, sell it now! Make sure you have a good level of cash and/or fixed income investments and enough should you need to draw on them during a downturn. If you have large amounts of idle cash, invest it slowly, but invest it -- don’t try to market time. No one, sadly including me, can time the market.  Lastly, write down on a piece of paper or somewhere on your computer why you’re holding your investments. Then, at the height of despair in the bear market pull it out as a reminder as to why you don’t want to sell out at the bottom.