Where to Invest Now

As I was leaving the TV station earlier this week, I was stopped by a friend who asked for my thoughts on the markets. He had recently upped his contributions to the retirement plan and indicated his intention to invest 100% in bonds based on his dismal outlook for the economy. Hmmm. At first blush, this seems like a perfectly reasonable and conservative approach. It’s hard to argue that the outlook for the economy doesn’t paint a bright picture, at least in the near term. And setting up a systematic savings program is one of the most basic keys to accumulating wealth. However, I suggested he consider a slightly different approach to his investing strategy.

First let’s look at the stock market. For the decade ending 2009, the stock market has delivered negative returns and this year continues to disappoint investors. Could it be that much of the downside risk is already wrung out of the stock market? Sure, it could go down further but for someone who is systematically putting fresh money in each month, I’d say the stock market is a very good bet if you don’t plan to touch your money for at least five years. At this point, the greatest risk to the stock market may be ‘event’ risk…something like Greece defaulting on its sovereign debt. There is a small risk of a double-dip recession, but that seems unlikely. The good news is that corporations have used the economic downturn to take dramatic steps to cut expenses and improve systems. In short, they are lean and mean! Once the economy perks up, increased revenue will quickly accrue to their bottom line…think profits!

Now let’s take a moment and review the bond market. We are in the midst of the worst interest rate environment that I can remember. The Federal Reserve has set interest rates at zero percent and is actively pursuing policies that continue to keep interest rates low. It’s a disaster for retirees who depend on interest income to pay their bills each month. Investors, afraid of the stock market, continue to pile money into bonds and bond mutual funds, and in many cases, are buying longer maturities and lower quality just to get any kind of yield. What this creates is a kind of bond market ‘bubble’. Eventually, the Federal Reserve is going to take the lid off of interest rates and we’ll likely see them rise dramatically. At that time, bond holders, especially holders of longer maturity bonds or bond funds, will see values drop dramatically. Worse, it may be years before bonds recover from the bursting bubble.

What’s an investor to do? Since the stock and bond market future is never predictable, consider a mixture of high quality dividend-paying stocks (examples: AT&T, Southern Company and Eli Lilly) with bonds having medium to short maturities (example funds: VFSTX, PTTOX). You’ll want to own a basket of at least 20 stocks. Keep a close eye on your bond funds and be ready to shorten maturities when the Fed begins raising interest rates. An allocation of 60% stocks and 40% bonds should allow you to capture much of the stock market return with significantly less volatility.

Searching For Income – Convertible Bonds

In response to the economic crisis that began in 2007, the Federal Reserve has purposefully driven interest rates down in order to stimulate our economy. This artificially low interest rate environment has wreaked havoc on retirees who are dependant on interest from their investments to pay their bills and run their retirement lifestyle. As a result, retirees are constantly scanning the investment horizon in search for higher returns. One investment vehicle that has garnered attention is the convertible bond. A convertible bond is a bond issued by a publicly traded corporation that gives the bondholder the option to convert the bond to a certain number of shares of the corporation’s common stock at a specific price. Convertible bondholders are essentially creditors of the issuing company who have the right to become owners.

Convertible bonds are not a new investment product and, in fact, became popular in the latter part of the 19th century when the railroad and telephone companies used them as a means of financing their expansion. One of their primary advantages includes the ability to capture additional profits should the stock price rise above the conversion price. If the stock does poorly, you have the safety of owning a bond and collecting interest. As with all financial products, advantages come at a price. You will receive a lower yield than you would for a comparable non-convertible bond, so if you never convert to shares of stock, you have earned a sub-par return. Also, many convertible bonds are callable at the option of the issuing company at a price that effectively limits your profit potential should the stock price rise significantly.

Analyzing which convertible bonds to purchase is a daunting task for most investors since it requires an in-depth understanding of bonds, stocks and corporate analysis. Your best bet is a convertible bond fund run by an experienced money manager. Consider no-load Vanguard Convertible Securities (VCVSX) run by manager Larry Keele, whose fund currently yields 3.8%. Convertible bond pioneer, John Calamos, along with his nephew, Nick Calamos, manage the Calamos Convertible fund (CCVIX), which currently yields approximately 3.1%. This load fund can be purchased on a no-load basis through Charles Schwab & Company.

Are convertible bonds or bond funds an appropriate investment for the individual investor? Sometimes referred to as ‘chicken stocks’, convertible bonds can provide risk adverse investors a way to participate in the often volatile stock market while reducing risk. However, the risk profile for convertible securities more closely resembles stocks. Take a look at the recent stock market extreme volatility for calendar years 2008 and 2009. For 2008, the stock market was down 37%. Vanguard’s and Calamos’ convertible bond funds were down 29.79% and 25.88% respectively. In 2009, the stock market rose 27% and these funds also rose 40% and 34% respectively. Convertible bonds are not for everybody but they are a valuable investment tool to add to your toolbox. Based on the recent stock market run-up since the March 9, 2009 lows, a lot of the short-term profit potential may have been wrung out of this strategy, so consider waiting on a market pull-back or plan on a long-term investment.

ETF’s – A Top Investment Tool

After more than a decade of extensive use by professional money managers, Exchange Traded Funds, or ETFs, are still not being heavily used by the general public.   This is an education problem since ETFs offer a number of advantages over both managed mutual funds (called ‘active’ funds) and index mutual funds (called ‘passive’ funds).    With actively managed mutual funds, the fund company hires a manager who actively buys and sells stocks and bonds in an attempt to outperform a certain benchmark such as the S&P 500 Index. With passively managed mutual funds, the fund company hires a computer programmer who ‘matches’ the exact same securities held in a particular index such as the S&P 500 Index. Let’s look at some of the comparative benefits of owning ETFs:



  • Like index mutual funds, an ETF represents a specific index such as the S&P 500 (U.S. large companies) or the Wilshire 5000 (the entire U.S. stock market) or the Russell 2000 (U.S. small companies). For example, by buying the ETF version (symbol SPY) of the S&P 500 Index, with one security purchase you own shares in 500 companies. 
  • Like index mutual funds, ETF expenses are very low. Where Vanguard Total Stock Market Index (VTSMX) mutual fund charges 0.18% annually, their own ETF version (VTI) charges a meager 0.09% annually. Compare this to the management fee of the typical actively managed mutual fund, which averages 1.4% annually.
  • ETFs are highly tax efficient. By law, mutual funds are required to distribute at least 95% of all net realized capital gains each year to their investors as of a certain date, called the ‘record date’. While this has been less of a problem with index mutual funds, it has been a significant problem with many managed mutual funds. ETFs minimize this problem as you only recognize gains when you sell an ETF in which you have made money. With a mutual fund, it is possible to actually have losses for the year, yet get hit with taxable gains on fund distributions.
  • ETFs trade like stocks…on an intra-day basis whereas mutual funds settle at the close of the day’s prices. Under the new paradigm we find ourselves today where dramatic market changes can happen in the course of a single day, this can be an important benefit. 
  • Many mutual funds, even no-load funds, charge a redemption fee when you sell your fund within a certain period of time from purchase (typically 90-days). ETFs do not have such restrictions, allowing investors to remain mobile and responsive to rapidly changing events.   While I believe in having a long-term investment strategy, it’s important to maintain the flexibility to make changes should extraordinary circumstances arise. 
  • You now have access to over 700 different types of ETFs, allowing you to be very strategic in your investing while still maintaining significant security diversification. We use ETFs extensively in managing our client’s portfolios and have found them to be an excellent cost efficient management tool. 


For more information about ETFs, visit the Resource Center at www.welchgroup.com; click on ‘Links’, then click on “Exchange Traded Funds”.