Bill Gross, the founder of Pimco, is the godfather of savvy bond investors and, if you’re looking for a good bond fund Pimco should be on your list.  He wrote a thought provoking piece in the May 28^th issue of FORTUNE: How to Sleep Well at Night. Bill says that bonds are less volatile than stocks, provide a higher and steadier source of income, and allow you to sleep better at night. (That’s true, although I’m going to argue in coming weeks that good performing dividend paying stocks will provide a higher level of income than bonds over time, but that’s another story.)

 

Bill admits U.S. Treasuries, which are currently yielding under 5%, may be 50 basis points (.5%) overvalued. He also acknowledges that you can get just as good returns at the bank (I’d say in money market funds). 

 

Why buy bonds? International recycling of dollars will drive yields lower, says Bill. Demand will drive up the price. Wow! The more we buy overseas, the more money foreigners will invest in U.S. Treasures. We should all go out and buy Japanese and German SUVs and use them for our daily commute. Maybe buy some French wine and a new Korean made stereo system while we’re at it. The more we spend on foreign goods, the greater the demand for U.S. Treasuries. (By the way, if Treasures have lower yields that’s good for the stock market, too! Part of the stock value equation is the Treasury yield plus an imputed risk, or rate of return, so if Treasury yields decline, the required return for stocks declines and the stock market goes up.)

 

Sounds too good to be true, Bill. It seems to me that supply and demand works the other way. The more dollars foreigners hold, the higher return they’ll demand to hold even more dollars/Treasury bonds. I also worry that perhaps a government, such as China, might hold all those Treasuries over our head at some point seeking something in return. (I’m happy to be financially independent of my parents, I don’t want to become financially dependent on China.)  

 

If Bill’s right that long term Treasuries are overvalued (who am I to argue with him?) and if I’m right about how supply and demand works, you might be right to hold only short term bond funds.

Wall Street’s principal product for retail investors these days is the “fund of funds.” As the name suggests, it’s a fund which owns pieces of a number of other funds with similar investment objectives. Recent examples I’ve seen include a hedge fund fund of funds, a private equity fund of funds and an international debt fund of funds.

 

Your broker will extol the advantages of a fund of funds, such as access to funds you couldn’t buy individually because their minimums are too high or you’re reducing your risk in a riskier investment class. Like the funds they invest in, funds of funds often have fairly hefty minimums and are illiquid. It may take you a month to three to get your money out and you can’t easily make addition investments or small withdrawals. The way I see you’re paying double fees – one to the mangers of the real funds and a second to the fund of funds manager (who may just happen to work for the brokerage house who is trying to sell you the product). AND, buying a group of similar funds only ensures that your return will regress to the mean. (Can you say: super expensive index fund?)

 

You can participate in most investments, including intentional debt (there are even a few private equity funds) through mutual funds.  Mutual funds are cheaper, have similar or better performance (this requires a little work on your part or a good adviser), modest investment minimums and offer daily liquidity. What’s wrong with this picture? The broker selling you the product makes less money then if you buy a fund of funds. (Funds of funds may have their place in your portfolio if you participate in hedge funds, private equity and other such investments and buying individual funds isn’t right for you, but there aren’t many of “you” out there.) 

 

Make intelligent investment decisions: buy mutual funds.

International mutual funds should be a part of every investor’s portfolio. I’ve beaten this drum before (see A Euro, A Yen, a Buck or a Pound and The CIA Guide to International Investing).  But when the cover of BusinessWeek asks: What’s the Most Extreme Emerging Market on Earth?  (remember the Sports Illustrated curse) I begin to get a little nervous. Let’s stick with China for a minute. The Hang Seng (Hong Kong stock market) is up 30% in the past year. This is against a current back drop of Chinese government concerns about their stock markets becoming too speculative, widening the trading range of the Yuan, and possible U.S. trade limitations.  

 

International markets will go down at some point in time and I take the above as warning signs that a correction might occur sooner rather then later. Does this mean you should sell your international mutual funds or not buy, if you don’t yet own any? No. What it does mean is – don’t get carried away.  Markets that have risen the most are most likely to correct the most AND markets of “newer economies,” i.e., riskier economies/counties, will be more volatile then the markets of mature economies.

 

I (being very American) lump the world’s economies into four categories (with representative examples): 

1. Mature - Germany, Japan.

2. Big New - China, India.

3. Emerging - Vietnam, Egypt.

4. All Others.

 

I’ll leave it to you to fill in the rest of the counties in each category (maybe you can tell me if Russia fits into 2 or 3). Volatility in a nation’s markets increases as the size and maturity of those markets decreases. An analogy is U.S. Big Cap, Mid Cap and Small Cap stock funds. Investing internationally is no different then investing in the U.S. – understand the risk and diversify.

Think gas prices will remain high or go higher? I do.  Demand is growing. Gasoline consumption is up 2% in the U.S. this year. China, India and the other new economies crave energy.  Ask yourself this: Are you plugging more stuff into the wall each year? Political instability in Nigeria, Iran, and Venezuela could limit supply. And, there’s only so much oil (natural gas and coal) in the ground. I’m not suggesting we’ll run out but it will become more expensive to extract it.

 

How can you benefit from higher energy prices? By investing in energy companies. There are two ways to do this. You can buy a Natural Resources sector fund or you can buy a Value fund which holds energy stocks. The sector mutual fund is the “pure play.” It holds energy stocks and, probably, stocks of minerals i.e., iron ore and copper, mining companies. The risk with a sector fund is that there aren’t a lot of them to choose from and they aren’t diversified. Don’t get me wrong. A sector fund is diversified within its focus area, i.e., owns a number of energy and mining companies, but any fund which investors in only one part of the economy is inherently riskier then a broadly diversified mutual fund. The other way to “play energy” is through a large cap or mid cap value fund. These funds typically have some energy exposure. The downside of this approach is that value mutual funds have only a portion of their assets invested in energy stocks.

 

With either a Natural Resource fund or a Value fund (or any fund, for that matter), don’t just go by the name. Check the fund’s holdings to see if they match your expectations. Different fund managers view and approach their mandates differently. You can find a list of the top rated Natural Resource and Value funds and their top holdings at MUTUALdecision. You can drill down (no pun intended) further by going to the fund’s website for a complete list of its holdings.

 

Which investing approach is right for you? It depends upon how much risk you’re willing to take and how your other assets are invested (think diversification of your entire portfolio). Having an energy investment might ease the pain the next time you fill up.

The Dow recently hit an all-time high. The S&P may be next. The Wall Street pundits are saying the markets are going higher. Stocks will go up. Interest rates will go down, based on last week’s inflation report, meaning that bond prices will go higher. But wait, Alan Greenspan says there’s a 1/3 chance of a recession before the end of the year (that’s within the next seven months, folks). A recession certainly won’t be good for stocks. 

 

What’s an investor to do? Invest for the long term. How? By finding good professional managers, i.e., mutual fund mangers, and sticking with them.  These men and women come to work every day and think about nothing except how to invest your money. (Okay, they may also think about where they’re going for lunch and their kids soccer game, but all of us think about these things at work, don’t we?)

 

If a doctor shouldn’t operate on his own family and a lawyer shouldn’t represent himself, should an investor manage his or her own money?  I propose a simple test. Compare the five year performance of your portfolio to the performance of top ranked mutual funds with similar objectives (you can find these funds at MUTUALdecision).  Compare your stock holdings to one or more similar equity funds and your bonds to a comparable bond fund. Did you outperform your benchmarks? (If so, please send me a list of your holdings, so I can buy them.)

 

Now for the bonus round question: compare the annual fluctuation in the value of your holdings to the fluctuation in price of your mutual fund sample. Which is greater? This is a rudimentary gauge of risk.  If the mutual funds were less volatile, that’s another argument in their favor.

 

So, unless you have the time, discipline, and track record, keep a little money aside for the next Google, but invest the rest in good mutual funds.  Investing your money is too serious a matter to be anything but a full-time job.

 

In poker you hold when you’ve been dealt a great hand (something that never has happened to me) or you believe the chances are more likely that you’ll end up worse off if you draw cards. Good poker strategy, bad investment strategy.

 

There is no such thing as a hold investment. (Yes, I know hold recommendations are issued every day, but they’re copouts.  I consider every investment recommendation that’s not a buy to be a sell regardless of what label’s put on it.) There are only two investment decisions – buy and sell. If you own (hold) a mutual fund and do not sell it, you’re making a buy decision. I should end right here, but I’ll continue.

 

If you own (hold) a mutual fund and you do not feel comfortable buying more either because of price, or outlook, sell it. (An exception would be if you held the fund in a taxable account and next week your gain would transition from short term to long term, then you might consider waiting a week.)

 

Investors are emotional beings and we become attached to our investments. Inertia and fear of the unknown also play into investor “hold paralysis.”   It’s too easy to fall into the trap that of holding a fund which has been a good performer or has performed poorly because you don’t want to take a loss (among the worst reasons to hold any investment). Ask yourself: Have your investment objectives changed?  Has the fund manager changed? What’s the outlook for the fund?   Most importantly, each time you review your investments ask: would I buy this fund today?

 

Investing (done right) is not gambling. The future is unknown but there is a lot of information out there (and on the MUTUALdecision website) for you and, unlike poker, somebody doesn’t have to lose for you to win.  

The old adage simply means: go with the flow. Despite what we may think, despite what the economy is telling us, if stocks are heading higher, be along for the ride. If they’re heading lower, bail out. 

 

I stated urging caution about the stock market two months ago (my opinion hasn’t changed, rising gas prices being the latest reason). Since then the Dow is up 8%, at an all-time high, and the S&P is up 7%, 25 points away from its all-time high. As I said in my April 2 posting, Hurricane Season, no one, including myself, can predict the market but we can make prudent investment decisions.  I’m glad the stock market has gone higher. It’s good for all of us (except you short sellers), but I’ve used this rally to rebalance my mutual fund portfolio (i.e., take money out of the stock market) and I hope you’ve done the same.

 

Of course the market may go higher. Don’t fight the tape, right? But you should take this opportunity to reassess your mutual funds and rebalance your portfolio.  You do have a target cash/bond/stock mix, don’t you? Is it still the right mix given your investment goals and time horizon? Pay particular attention to your riskier investments. These look the best right now but will fall the most in any market decline (don’t let emotion tell you otherwise). The prudent investor sticks to his or her strategy and portfolio rebalancing is a natural way to take advantage market highs and lows. 

You may not want to fight the tape but don’t get tangled up in it either.

Or a Yuan. (With apologies to all you Cabaret fans.) Mutual fund investors need to be aware of the currency risks you’re taking (or not taking) when investing internationally. Is your mutual fund hedged against the dollar or not? Do you want your fund to be hedged or not? What difference does it make to you? Let’s start with the last question first.

 

Currencies do fluctuate is value (except for the Yuan, whose exchange rate is fixed by the Chinese government, but it will be revalued upward against the dollar at some point). For example, in 1999 €1.00 cost $.85. Today the exchange rate is about €1.00 = $1.36. (Condolences to any of you who are vacationing in Europe this summer.) Any dollar dominated investor, such as those of us in the good old USA, would have seen substantial appreciate in the Euro dominated investments (European stocks and bonds) we made a few years ago just based on currency movement. The European investor who bought dollar dominated US stocks or bonds wouldn’t have been so lucky. The Dow at 13,000 would have brought little joy to the Euro investor’s heart since most of his or her gains would have been lost to the deprecation of the dollar versus the Euro. 

 

There is a way to protect yourself against currency swings and that’s to buy a mutual fund which hedges – tries to eliminate or minimize the currency risk. No hedge is prefect and all hedges cost money, which reduces your return. But a currency hedge factors out one risk leaving you, the investor, with the underlying risk of the investment, i.e., the return on the bonds or the performance of the stocks in the mutual fund portfolio. Mutual funds disclose whether their fully, partially or not hedged, so read up on your international fund before you invest in it.

 

Hedged or unhedged, which is right for you? It depends, first and foremost, on how much risk you want to take. Remember, an adverse currency swing could wipe out all the fund’s portfolio gains and, particularly in a bond fund actually result in a loss. Secondly, it depends on your outlook for currency movements.

 

Global diversification is a good (necessary?) investment strategy. (For more on this on see my posting: The CIA Guide to International Investing.) Like every other investment, you need to do your homework and know what (and how much) risk you’re taking.