Long-term picks for today's market.
By Russel Kinnel | 02-13-18 | 06:00 AM | Email Article

This article was originally published in the January 2018 issue of Morningstar FundInvestor. Slight adjustments were made to reflect recent market changes. Download a complimentary copy of FundInvestor here.

Russel Kinnel is director of manager research for Morningstar.

The markets enjoyed a great rally in 2017, and then we gave some of that back in recent weeks. I don't know if this is a dip you should buy into or the first leg down in a serious sell-off.

But a quick recap of 2017 is in order. Emerging markets were the best place to be. The average India fund gained 47%, the average China fund was up 42%, and diversified emerging markets were up 34%. Foreign developed markets did almost as well, with gains between 22% and 32% for foreign categories.

And the United States was no slouch, with gains of 21% for large blend and 28% for large growth. The farther you move toward small value, though, the more mundane the gains are. Small blend was up 12% and small value 9%. That's the biggest gap between large growth and small value since 2007.

Bond markets were solid if less exciting. The average taxable intermediate-bond fund gained 3.7%, and the average intermediate muni-bond fund gained 4.6%.

Interestingly, some of the leaders continued to lead by losing less in the sell-off. Foreign funds recouped some losses because the dollar fell sharply, and large growth continued to pummel small value.

The two takeaways from the 2017 rally are: 1) You can't afford to be out of the market. It is tempting to market-time, but rallies are unpredictable, so stick with your plan no matter what the headlines say. 2) There are no screaming bargains left out there. Low interest rates and economic growth have pushed investors around the world to keep buying stocks, bonds, and any other financial asset. And no, a 10% sell-off doesn't really change that.

The New Tax Law
As we start 2018, we also have a dramatic change in taxes in the U.S. It should prove a boon for corporations, and it is also expected to add a trillion to the deficit. You should talk with your tax preparer to see what impact it will have on you, but so far, as investors sift through all the changes, it does seem like there are some clear takeaways.

First, analysts expect much of the benefit in lower tax rates to flow through to shareholders in the form of dividends and stock buybacks. Thus, we have a new support to the equity market just as it seemed to be getting too pricey.

Second, we have a boatload of stimulus coming at a time when the economy is already strong. When we got stimulus amid the recession of 2008-09, it didn't spur inflation. But we might not be that lucky this time with the economy going full throttle.

The New Fed
Jerome Powell replaced Janet Yellen as Federal Reserve board chair, but that's not all. Stanley Fischer and Daniel Tarullo have resigned from the board of governors. In addition, there were two openings when President Donald Trump took office. Thus, you have four pending vacancies. Trump has nominated Marvin Goodfriend to take one of those seats, but Goodfriend hasn't been approved yet.

It is very rare to see so much change in such a short period of time at the Fed. And markets hate uncertainty at the Fed. The current Fed had signaled it planned to hike interest rates three times in 2018, but does that plan really matter with a line change in the works?

It is not clear whether this change is bullish or bearish for equities or for bonds. It would seem to increase the chances that volatility picks up at the very least.

Let's take a look at my ideas for where to invest.

Small Value
Small value last lagged large growth by a wide margin in 2007 and before that in 1999. In the ensuing years, small value outperformed dramatically the first time but only modestly the second time. This certainly reminds me of 1999 when small-value stocks just looked stodgy and boring in comparison with the dynamic Internet and technology companies powering the markets.  Facebook ,  Apple ,  Netflix , and  Alphabet  are going gangbusters, so who has time for the insurance brokers, electronic-component makers, and real estate investment trusts that are the bread and butter of small value?

 Royce Special Equity  is the sort of fund I love after a year like the one we've just had. Not because of how much money it just made me, but because of how much money it will save me in the coming years. Longtime manager Charlie Dreifus is an accounting stickler who likes cheap stocks. It is a style that does OK in market rallies and brilliantly in downturns (because it loses less than peers and the market). We give the fund a Morningstar Analyst Rating of Silver because we love the strategy and Dreifus, but we also know that comanager Steven McBoyle could well take the reins in the next few years. 

 Vanguard Small-Cap Value Index  is another possible route. It is not going be as defensive as Royce Special Equity, but its low costs make it a very good bet to outperform the average small-value fund over the next five to 10 years. The Admiral shares have a $10,000 minimum and charge just 0.07%.

 American Beacon Small Cap Value is somewhere in between the two. American Beacon farms out fund management to six different subadvisors. Many of them are firms we like, such as Barrow Hanley and Hotchkis & Wiley. The wide reach of subadvisors means the fund has a pretty diffuse portfolio, so you won't get a lot of drama here. In most years, returns are not that far from the index.

Dividend Strategies
This trend seemed rather overdone (and it might still be), but then the tax bill gave another shot in the arm to dividend-payers and stock-repurchasers alike. Not to mention that low bond yields make it pretty appealing to draw some income from equities.

 Vanguard Dividend Growth  is closed, so I'll recommend the passive equivalent.  Vanguard Dividend Appreciation Index  charges just 0.08%, and I figure it should benefit from dividend hikes and stock buybacks. The fund follows an index that screens for stocks that have boosted dividends for at least 10 years but then excludes REITs and limited partnerships. (The fund is available in open-end and exchange-traded fund forms.)

 American Century Equity Income  ticks two boxes for me. First, you get a nice yield of equity dividends. Second, you get a pretty conservative fund with defensive characteristics, and that's something I want in this market. Phil Davidson has been plying this strategy for a very long time, and his skill in managing risk continues to impress.

 American Funds Washington Mutual  follows an old-school discipline to deliver yield, returns, and downside protection. It wants a dividend yield greater than the S&P 500 but sticks to investment-grade companies with a long history of paying dividends. It has some solid defensive characteristics and generally loses less in corrections. The fund is available without a load in most No Transaction Fee networks.

Inflation Plays
Productivity gains and sluggish growth outside the U.S. in recent years have kept inflation under wraps. But as I mentioned, the huge stimulus and deficit increase could mean that inflation could return. If you have a bond-heavy portfolio that is vulnerable to rising inflation rates, it makes sense to have some protection. However, I wouldn't make inflation protection a huge part of my portfolio. Also, these are not very tax-efficient, so they are best held in a tax-sheltered account like a 401(k) or IRA.

 PIMCO Commodity Real Return Strategy gives you a heaping dose of commodities so that you can make a nice return when oil or other commodities surge. Manager Mihir Worah uses total-return swaps to replicate the Bloomberg Commodity Index. Worah then invests the collateral money for those swaps in Treasury Inflation-Protected Securities so you get commodity exposure and inflation-linked bonds. Be careful, though--commodity funds are a very volatile group.

 Vanguard Short-Term Inflation-Protected Securities Index  is appealing because short-term TIPS give you inflation protection without interest-rate risk. It's nice and cheap to boot.

Let's Get Cautious
It seems to me that caution is in order, so here are four particularly cautious funds.

 Vanguard Short-Term Tax-Exempt is the lowest-risk fund in the Morningstar 500. To be sure, there's not much upside here, but it's a fine place to put some of your emergency funds or funds for other short-term needs.

 Vanguard Wellesley Income  is another one that always makes my list of conservative funds. It has a fine mix of high-quality bonds and a slug of value stocks. Subadvisor Wellington has the deep resources to make this work nicely, and Vanguard can bring that to investors for just 0.22% a year.

 T. Rowe Price Retirement Balanced has a static stock/bond mix of 40%/60%. The Silver-rated fund allocates money to an array of strong T. Rowe Price funds, so you get tremendous diversification and a skilled group of managers.

 FPA Crescent is a little higher-risk than the others because it has more in equity and is more idiosyncratic. But I love Steve Romick's emphasis on absolute returns. Over the long haul, he's been adept at mixing defensiveness with aggression, and the fund has been pretty easy to own. Returns land in the top decile over the trailing 10- and 15-year periods.

 

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Russel Kinnel has a position in the following securities mentioned above: RYSEX AWSHX FPACX Find out about Morningstar's editorial policies.
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