Focus On: Real Estate Funds
(Published 06/01/2006) Real estate mutual funds are due for a drop.
Fundamentals were strong in real estate in recent years (of course, fundamentals were strong in tech back in the 90s). Real estate funds primarily own REITs (real estate investment trusts – essentially investment companies that own and operate buildings for rent), and to a lesser extent, real estate-related stocks like homebuilders (Hovnanian (HOV) and Lennar (LEN), and others that benefit from housing booms, like Home Depot (HD).
With property prices escalating, REITs have done spectacularly well. With new homes selling as fast as they can build ‘em (and with fat profit margins over construction costs) homebuilders have been raking in cash.
Just because an asset class takes off doesn’t mean it has to stop – Powerfund investors don’t sell just because they`re up. Two key factors kill many mutual fund golden geese: 1) declining fundamentals (over-valuation), and 2) inflows of too much money from performance-chasing investors.
Real estate mutual funds fail the Powerfund test on both counts. Today we can safely say that fundamentals are eroding, particularly in REITs, and inflows are strong.
REITs can be risky. If the economy turns south, rental revenue dries up and all available income to the REIT goes to pay interest on their massive debt (that’s how they bought the properties in the first place). However, in a strong economy with high rents and climbing real estate values (leading to windfall profits when an REIT sells a building) the business is very profitable and REITs can generally payout very high dividends to shareholders (by law they have to pay out income, much like a mutual fund).
While the stocks of homebuilders like Hovnanian have already collapsed almost 50% in price on little more than fears over future home sales (despite great earnings), REITs remain hot. While the fundamentals at REITs are strong, the prices of REITs are even stronger. This means, even taking into consideration better earnings and more valuable property, REITs are expensive.
The best indication of REIT overvaluation is the dividend yield on a low-fee REIT index fund, like one of our favorites in this category, Vanguard REIT Index (VGSIX). When you adjust out for dividends paid by REITs that are not from operating income, the yield on this fund is below 4%. A few years ago an REIT index paid about 6% in dividends or more.
So what? The S&P500 doesn’t even quite pay 2% (though ordinary stock dividends are usually taxable at a lower rate than REIT dividends, which are taxable like bond interest, or as ordinary income in most cases). REITs are bought for income, sort of like utility stocks (which are also overvalued now). Sure there is potential for growth in rental income (though there is a higher likelihood of growth in stock dividends) and more appreciation of underlying real estate assets, but there is also a chance for declines.
This risk usually means investors should get more yield in an REIT than, say, a money market fund or a government bond. That is no longer the case. Why bother? Investors can get 7% in a Vanguard junk bond fund if they want a lower-risk return. There will need to be a continuing housing and economic boom to earn more in most REITs than in a low-risk bond portfolio. Like all overblown areas, investors are paying too much for the future’s likely revenue stream.
The best thing that could happen to an REIT investor at this point is a big increase in inflation – because rents to the REITs would go up, as would their property values. Any slowdown in housing or further increases in interest rates could lead to a 15-25% decline in an REIT index.
As for fund company and investor behavior, there has been a pick-up in new real estate fund launches in the last three years. The Vanguard REIT index has about as much money in it as the Vanguard Energy fund, another over-invested area. Trouble is, REIT and real estate-related stocks don’t have the combined market cap of energy stocks so this represents a fairly large fund assets-to-underlying business size ratio.
For the record, we recently sold our last real estate fund stake in a client account due to valuations issues.
Category Rating: 5
Previous Rating: 5
Expected 12-month return: -12% (lowered from -7% in our last favorite fund report)
| RANK/FUND NAME/TICKER | ADDED | SINCE ADD | vs. S&P | 3 MONTH | 1 YR. |
| 1. SSgA Tucker Active REIT (SSREX) | 11/02 | 129.40% | 86.52% | 10.57% | 34.13% |
| 2. Mercantile Divrs Real Estate (MDVRX) | 9/01 | 126.78% | 95.89% | 9.25% | 27.55% |
| 3. T Rowe Price Real Estate (TRREX) | 9/01 | 154.56% | 123.67% | 10.46% | 32.95% |
| 4. Vanguard REIT Index (VGSIX) | 8/02 | 109.86% | 63.14% | 9.38% | 30.13% |
Focus On: International Diversified
(Published 06/01/2007) What's the #1 indicator that a fund category isn't going to perform well? The number of new fund launches in it.
Fund companies launch new funds when they spot an opportunity to make money – not for fund investors, but for themselves, in the form of fees paid by new shareholders. Frequently, the most "saleable" funds are those that have performed well in recent years, enjoyed a significant buzz, and received steady, positive media coverage.
During the final stock bubble years in the late '90's, fund companies launched new tech or growth funds every few days. Back then, brand-new tech funds could bring in hundreds of millions (if not billions) right from the get-go. A classic example was Merrill Lynch Internet Strategies, which launched on March 22, 2000 (within days of the market peak). The launch arrived just in time to bring in over a billion dollars (with a sales load…) before diving nearly 80% in the first year alone.
Today, most new fund launches are ETFs (exchange-traded funds) that run the gamut from countries to currencies and tech to telecom. Many offer access to extremely specialized commodities, currencies, or investment strategies. Traditional open-end mutual funds, on the other hand, are arriving with much less variety. Since December 2006, the majority of new funds are international funds (although some are global). No less than two dozen new international funds have been launched in the wake of that category’s recent sizzling performance. Many investors focus on specific "hot" areas in international markets, like international small cap or real estate investments. There's even a renewed interest in single-country open-end funds.
Apparently, investors aren't anxious about making international investments after they experience great returns. Quite to the contrary, they look for even more focused and risky ways to make their money. We last saw this behavior during the good old tech bubble days, when general tech and growth fund launches in the 90's morphed first into focused Internet funds, then later into new and different types of Internet and telecom funds – remember "b2b" (business to business) "content," and "Internet infrastructure" funds?
Another indicator that we use is fund investor money flow, which analyzes which funds investors are buying and selling. Since fund companies launch funds in sectors where they perceive a demand, it should come as no surprise that investors have been piling into international funds at a record pace. Virtually all new fund dollars are going into foreign funds, even though the U.S. market has been plenty hot itself in recent years. We’re talking tens of billions a month – the sort of numbers that tech and growth funds saw in early 2000.
As contrarian investors, we firmly believe in doing exactly the opposite of what the investing herd does. The more popular a fund category is today, the more likely it is to under-perform tomorrow. That’s why we're downgrading international diversified funds yet again, from a 
(Weak) to our lowest rating, a 
(Least Attractive). Back in 2002, we rated international funds a 
(Most Attractive), and they held on until April 2004, when we cut the category down to a 
(Neutral). This category continued to perform well. A year later, in 2005, we downgraded international diversified funds to a (Weak), which is where their rating has remained prior to this edition. We're also now forecasting a negative return for this category - a first for us.
From best to worst in six years. Well, maybe we sold the emerging market and small cap foreign funds in our model portfolios just a bit too early. Maybe we’re still a little early - we’ll just have to wait and see. Maybe, just maybe, for the first time in fund history, the fund types that investors want the most will beat the market and the other fund categories over the next few years. But we doubt it.
Category Rating: (Least Attractive) - should underperform the market and 80% of the remaining stock fund categories over the next one to three years
Previous Rating: (last change 3/31/05): (Weak) - should underperform the market and 60% of the remaining stock fund categories
Expected 12-month return: -1% (decreased from 1% in our last Favorite Fund Report)
| RANK/FUND NAME/TICKER | ADDED | SINCE ADD | vs. S&P | 3 MONTH | 1 YR. |
| 1. UMB Scout WorldWide (UMBWX) | 9/01 | 117.95% | 71.40% | 4.22% | 16.81% |
| 2. Dodge & Cox Intl Stock (DODFX) | 8/02 | 184.08% | 119.81% | 6.21% | 24.41% |
| 3. Forward Intl Small Comp (PISRX) | 3/04 | 94.39% | 64.51% | 7.09% | 21.87% |
| 4. Harbor International Inv (HIINX) | 12/03 | 86.33% | 54.25% | 4.57% | 21.41% |
| 5. Fidelity Spartan Intl (FSIIX) | 8/02 | 127.80% | 63.53% | 4.64% | 21.48% |
Focus On: Technology Funds
(Published 09/01/06) The last time we upgraded technology-oriented mutual funds was in August 2002, when we raised the category from a (Weak) to a (Neutral). At the time, the Nasdaq was in the 1,300 to 1,400 range – close to the crash low and near the index levels of 1996.
Why didn’t we upgrade to a 
(Interesting) or even a (Most attractive) given the opportunity in tech at the lows of 2002? The main reason was, at the time, there were better opportunities in other fund categories and our rating system is relative to the market.
Recent subscribers may think of us as negative on most fund categories, but at the time of our 2002 tech upgrade we had top ratings on several fund categories: small-cap growth, telecom, natural resources, utilities, convertibles, balanced, international diversified, global, global balanced, Japan, Asia, Europe, and Latin America. Most funds in these categories have beaten tech stocks over the three years following August 2002. Today, with valuations and investor optimism where it is, we’d be more excited about tech only if the Nasdaq was at 1,300.
In 2002 our rationale for the tech upgrade was–-
“…largely because the valuations of many tech stocks today are not that far out of whack with the rest of the market, adjusting for potential future growth. We don’t see tech stocks as a class dramatically underperforming the market as we have the last couple of years. We’d be perfectly happy if it takes five years for the NASDAQ to reach 2000 because from these levels that would be a 10% return per year. “
As it turned out, the turnaround in tech came on pretty strong after it finally bottomed in late 2002. The Nasdaq broke 2,000 – almost a double from the crash low – at the beginning of 2004 but has been holding at that level ever since. We downgraded the category back to a (Weak) in June 2004 (at Nasdaq 2,000).
Such is the nature of the stock market – often it takes an advance on the future prosperity of corporate America, and then has to sit and wait for fundamentals to catch up.
The Nasdaq took a quick dip to below 1,800 in 2004 after our summer downgrade and we upgraded back to a (Neutral) in September 2004. Along the way we’ve picked up some tech funds (usually ETFs like iShares Semiconductor – IGW) in our higher-risk portfolios during moments of weakness. Some we’ve sold after the Nasdaq ran up a few hundred points to the outer reaches of reasonable valuations.
We don’t see technology stocks as a particularly great value now, just reasonable compared to everything else, hence the upgrade to a positive rating – our first for tech. We expect a 6 to 8% return annually in the coming years, with some swings that may make it possible to see 10% or more with the right entry point.
Fundamentally, technology stocks are risky and sensitive to an economic slowdown (computer budgets get slashed during hard times – at home and at work). More important to us, investors are not that interested in technology anymore – they see better upside abroad or in commodities. Mega-cap tech, the old 1990s growth favorites, like Dell (DELL), Intel (INTC), and Microsoft (MSFT), are particularly out of favor compared with just about any time in the last decade or so (the market crash bottom of 2002 being the only possible exception). Some of this is warranted as growth going forward is going to be slow and margins compressed. Without a major recession it’s unlikely these sorts of companies will fall on much harder times – or at least do no worse than most other companies. We’d have to see actual panic selling in tech and even better valuations – maybe Nasdaq 1700 or so – to upgrade to our highest rating, but funds investing in tech stocks should perform better than most going forward.
Tech ETFs are among the least favorite of the more mainstream ETFs around. Total assets in all no-load tech funds and ETFs are just under $20 billion today. For comparison, near the bubble peak just two tech funds collectively had over $20 billion in assets (T.Rowe Price Science and Technology - PRSCX and Janus Global Technology - JAGTX).
More stunning is the fact that fund investors have lost more money in tech funds in the 2000-2002 crash than currently is in tech funds. They even lost more money collectively than was made in all those hot, triple-digit return years of the late 1990s. Buy high, sell low.
It’s almost impossible to find a tech fund that isn’t sitting on tens of millions – sometimes billions – in loss carryforwards from the crash. Paper gains quickly became very real losses for millions of investors. Don’t expect any taxable dividend distributions anytime soon in this category.
It’s a good idea to invest in fund categories that other fund investors have lost gobs of money in. It’s proof you are doing the opposite of other fund investors – and doing what the other investor isn\'t is the cornerstone of the Powerfund strategy.
Category Rating: (Interesting - should outperform the market and 60% of stock fund categories over the next 1 to 3 years)
Previous Rating: (Neutral - should match the market\'s return and perform in the middle of other stock fund categories).
Expected 12-month return: 8% (raised from 6% in our last favorite fund report)
| RANK/FUND NAME/TICKER | ADDED | SINCE ADD | vs. S&P | 3 MONTH | 1 YR. |
| 1. SSgA Emerging Markets (SSEMX) | 9/02 | 209.90% | 145.86% | -2.93% | 45.08% |
| 2. Excelsior Emerg Mkts (UMEMX) | 9/02 | 217.43% | 153.39% | -5.09% | 37.90% |
| 3. Vanguard Emerging Markt Indx (VEIEX) | 9/01 | 224.45% | 194.02% | -3.20% | 37.89% |
| 4. Bernstein Emerging Markets (SNEMX) | 9/02 | 270.69% | 206.65% | -3.26% | 36.36% |
Pentagon Sets Sights On Brokers
Normally when you hear the Department of Defense is presenting Congress with a report on their progress, a highly politicized debate over Iraq comes to mind. This time the report deals with protecting soldiers not from IUDs but RIAs (registered investment advisors), brokers, and insurance salesmen.
Working in the military can be a tough job with not much in the way of financial reward. This is why unscrupulous insurance and investment salesmen deserve the new military surge against dangerous investment advice targeting enlisted men and women:
Whenever the U.S. military gears up for a war, (Georgia state insurance commissioner John Oxendine), its personnel become prey for unscrupulous financial advisers because they’re young, naïve and don’t have a lot of experience with finance.
'To me, this is nothing more than being a war profiteer,' he said.
The Department of Defense’s inspector general is scheduled to present Congress with a draft of a report about progress in this effort at the beginning of next month.
The law also states that the military must track advisers and insurance agents who have been kicked off military bases for dishonest sales of investment products.
The law, titled the Military Personnel Financial Services Protection Act, mandates that the secretary of defense, currently Robert Gates, keeps a list of names and addresses of advisers that have been barred, banned or restricted from military bases."
The crackdown stops certain questionable sales practices:
And certain product features, such as automatic premium payment provisions, are prohibited completely. The new regulation also adopts Defense Department solicitation rules. For example, it is now a 'deceptive trade practice' for an adviser to solicit in barracks, day rooms and other restricted areas."
We like the Personal Commercial Solicitation Report, which "lists insurance and financial product companies and agents currently barred from soliciting on specific DoD installations as reported by the military services."
The report contains such gems as, "Agent barred for loitering near enlisted quarters; falsely inferring command endorsement; and attempting to discourage a military member from reporting him for soliciting on-duty personnel and soliciting personnel in a mass audience."
Apparently some war profiteers hock financial peace of mind…
Don't Forget the Little Guy
Jonathan Burton at Marketwatch says that when shopping for mutual funds, don't just go with the big boys like Janus and Vanguard. Smaller fund firms tend to deliver better returns than industry giants:
The best-performing small firms often do better than similarly high-ranking large firms, regardless of whether they own small-cap, midcap or large-cap stocks or follow a value or growth investment style. Forty percent of money managers in the top 25% of their peers have less than $2 billion in total assets under wraps, according to research from financial-services firm Northern Trust Corp.
For investors, the message is that giving money exclusively to industry giants shuts out a large group of talented stock pickers. Broadening horizons to include small firms boosts the odds of finding innovative managers with results in the top 25% of their peers, says Ted Krum, a vice president at Northern Trust who helps institutional clients with money-manager searches.
New research Krum expects to release this fall looked at results over five years through 2006 for managers investing in small-cap and midcap stocks. It found that among firms in the top 25% of their class, the smallest players, handling less than $1.4 billion, delivered returns almost two percentage points better than the giants.
Tiny investment shops returned 16.5% annualized on average in the period, which covered both bull and bear markets, while firms of $1.4 billion to $17.9 billion in size averaged competitive 16% gains, the forthcoming research says.
Performance slipped as assets grew, the study reports. Midsize firms with $17.9 billion to $66.5 billion gained 15.6% on average, while the biggest outfits, managing $66.5 billion to $785.4 billion, posted average gains of 14.7%."
Funds from smaller fund companies mentioned in the article:
Al Frank Asset Management (VALUX)
Amana Trust Growth Fund (AMAGX)
Amana Trust Income Fund (AMANX)
MAXadvisor Powerfund Portfolios Update
Note to subscribers of the MAXadvisor Powerfund Portfolios: September's feature article has been posted. Subscribers can log in by clicking here.
This month we look at what August's market turmoil means for Powerfund Portfolio investors.
The MAXadvisor Powerfund Portfolios is a collection of seven model mutual fund portfolios ranging in risk from very safe to quite aggressive. Each portfolio is made up of a group of terrific, no-load, low-cost mutual funds that are carefully chosen to work together to lower volatility and increase returns. You can learn more about the MAXadvisor Powerfund Portfolios (and sign up for a free trial if you like what you see) by clicking here.
Obvious Advice of the Week
Scott Burns at MSN Money meets this week's article quota by telling us that when shopping for mutual funds, you're better off going with cheap rather than expensive:
The least expensive one-eighth of large-blend funds had an expense ratio of 0.50% or less and provided an average return of 6.90%. More important, 49 of the 69 funds in the group provided superior returns, so you had a 71% chance of superior performance simply by selecting the least expensive funds."
While this advice might be a bit on the "duh" side for savvy MAXfunds readers, we reckon it never hurts to get a reminder every now and then.
Ask MAX: You call THIS a MAXadvisor Favorite?
Russ Asks:
You call the Vanguard Precious Metals & Mining Fund (VGPMX) a MAXadvisor Favorite Fund, but it has a MAXoutlook of -16%. Why do you call a fund a MAXadvisor Favorite if you think it is going to perform so poorly in the next year?"
How can we like and hate the same fund? We’re not bipolar – here’s how it works:
We give MAXadvisor Favorite honors to at least one fund in every stock fund category. No matter how well we think a category is going to do , we'll try and find the best funds available to you. You'll find a Favorite Fund listed in some categories we think are currently a very bad place to be invested - categories like real estate, Latin America, and yes, precious metals.
Our MAXoutlook is our forecast for a fund’s performance over the next twelve months. This figure is largely driven by our forecast for the fund’s category, the fund’s quality and fees, and the fund’s risk level. Safer funds generally don’t have big negative forecasts even if the category ranks poorly. ...read the rest of this article»
Mad Investors
Barron's online did a comprehensive review of Jim Cramer's Mad Money stock picks, and the results are unsurprisingly mediocre:
Cramer, by all accounts, had a stellar career as a hedge-fund manager. And he is held out by CNBC as the guy who can help viewers make big money. But a comprehensive and careful review of his stock picks by Barron's finds that his picks haven't beaten the market. Over the past two years, viewers holding Cramer's stocks would be up 12% while the Dow rose 22% and the S&P 500 16%, according to a record of 1,300 of the CNBC star's Buy recommendations compiled by YourMoneyWatch.com, a Website run by a retired stock analyst and loyal Cramer-watcher.
We also looked at a database of Cramer's Mad Money picks maintained by his Website, TheStreet.com. It covers only the past six months, but includes an astounding 3,458 stocks — Buys mainly, punctuated by some Sells. These picks were flat to down in relation to the market. Count commissions and you would have been much better off in an index fund that simply tracks the market."
We'd normally advise people to go ahead an watch CNBC's Mad Money because of its entertainment value, but Cramer is so good at making his picks sound like can't miss investments opportunities that even I've occasionally been tempted to fire up E*Trade and dive in. Mad Money no longer sullies my TiVo. I watch Jeopardy instead.
Read Also:
Focus On: Large Cap Growth
(Published 03/01/2007) With yet another year of large-cap growth funds underperforming basically every other fund category out there, fund investors are finally throwing in the towel.
Lipper estimates that investors yanked $3.2 billion out of large-cap growth funds in the first four weeks of the New Year. What’s unusual is that January is a month where fund investors put almost $40 billion into stock funds – almost $20 billion alone into funds that invest in international stocks.
There have been many calls for out-of-favor, large-cap growth funds to lead the market – notably by us in the summer of 2006 when we upgraded large-cap growth funds to a
(Most Attractive) for the first time in our history. While the a stock market in general (large-cap growth in particular) has done fine since then, large-cap growth funds have not been where the big action has been.
Long-time MAXfunds readers remember how negative we were on the whole large-cap growth and tech craze in 2000 – with our anti-Janus articles and the like. We started our MAXadvisor fund investing service in early 2002 with a
(Weak) rating on large-cap growth funds. As large-cap growth continued to underperform other categories, we slowly increased the rating.
Why hasn’t large-cap growth taken off yet? The last year large-cap growth was king of the hill was 1998, when these funds scored about a 30% return. In 1999, larger cap growth funds were up almost 40% - but since other categories were even hotter (these were the bubble years remember), 40% was only an average return.
Small cap value funds – the funds that have been topping the charts more or less ever since the glory days – were basically flat during 1998 and 1999. No wonder fund investors bailed and put money in large-cap growth funds. Nobody likes a boring party.
Herein lies the reason large-cap growth stocks have yet to take off: they had so much over-valuation to work off. If one asset group almost doubles in two years, and another remains the same, it can take years of the cheaper asset group outperforming the former leader before relative valuations are back in sync.
Moreover, fund investors never really bailed out of larger cap growth funds. Today many of the formerly hottest funds still have billions in assets – though asset growth has slowed or reversed at one time or another in recent years. Today larger cap growth stocks would represent excellent value and opportunity to double your money in a few years, if only fund investors had pulled out tens of billions each quarter for the last seven years or so.
Unfortunately for us contrarians, mildly out of favor is about as good as it is likely to get here. Your best relative value in the market is large-cap growth stocks (and money markets…) and we expect this category to be in the top tier for the next few years.
Category Rating:
(Most Attractive) - should outperform the market and 80% of stock fund categories over the next 1 to 3 years
Previous Rating (6/30/06):
(Interesting) - should outperform the market and 60% of stock fund categories over the next 1 to 3 years
Expected 12-month return: 8% (increased from 7% in our last favorite fund report)