Investering i en volatil verden

Morningstars amerikanske strateger diskuterer deres tips for å investere i en verden hvor rentenivået er stigende, hvor aksjeverdsettelsene ligger nå, og noen av deres investeringsideer.

Jeremy Glaser 23.07.2013 | 11.45
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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Welcome to our Midyear Strategist Roundtable. We are going to talk with several Morningstar newsletter editors about how they are thinking about investing in a rising-rate environment, their cash stakes, and also the biggest surprises so far in 2013.

I'm joined with Josh Peters, director of equity income strategies and also the editor of Morningstar DividendInvestor; Matt Coffina, editor of Morningstar StockInvestor;Sam Lee, editor of Morningstar ETFInvestor; and Russ Kinnel, who is our director of mutual fund research and also the editor of Morningstar FundInvestor.

Gentlemen thanks for joining me.

Russ Kinnel: Good to be here.

Josh Peters: Good to be here.

Glaser: One of the big pieces of news recently has been the runup in interest rates and some of the turmoil in the bond market. How much longer do you think that interest rates could keep rising? Do you expect this to be a trend that’s going to continue?

Kinnel: I mean certainly there is a potential for it to run longer. We're really still in the early stages of [Fed officials] just talking about tapering their [bond-buying] efforts at some point. We had a very long bond bull market, and so we are just kind of in early stages. So it's hard to predict where that stops.

Glaser: So what does that mean for your fixed-income holdings? Is this a time to kind of really reassess your entire bond position? What kind of categories do you think are going to do better or worse in this environment?

Kinnel: I think on the first question at least you want to talk a look and see how your bond fund has done in the last month and half because that at least is going to give you some sense for how much interest-rate-risk was there. I think now it means you've got some better yields. Yields are still not great, obviously. We have a long way to go before they are really attractive, but they are better. And there might start to be some interesting opportunities. For instance in high yield you are seeing yields that are little more respectable these days.

Sam Lee: Yeah, I'd like to chime in. You have to put the interest-rate rise in historical context. About 2.6% yield on the 10-year Treasury is still extremely low by historical standards. And I think it's unlikely that interest rates will shoot up 5% to 10% anytime soon because right now the economy is deleveraging. So, households have a lot of debt. The government has a lot of debt. Historically, in periods of deleveraging, the central bank and the government tend to collude to keep long-term interest rates down, and that eases the burden of paying off debt service.

So, the U.S. government did that after World War II. They amassed a huge pile of debt far in excess of what we have right now, and they managed to pay that off by suppressing interest rates for very long time. So, there is no reason why they couldn't do that. They can't keep on continuing to do that.

That said, bonds are a very unattractive asset class. You're going to get the yields in the best-case scenario. You will probably get something a lot worse in a more reasonable scenario should interest rates normalize over time. So, if you're heavy in bonds, going long term is probably a really dumb idea. Warren Buffett says the long-term government Treasury is the dumbest investment you can make right now.

Conversely, if that's dumbest investment, then the smartest investment is basically shorting it. You can't really short it easily because there are a lot of issues of path dependency, so you can get shaken out of your position. But a 30-year mortgage at a fixed rate of even 4% right now is still very, very attractive deal. After the mortgage interest-rate subsidy and inflation, your real cost on that loan is probably very low, and you have a natural inflation hedge in that asset class. So, taking a 30-year bond, if you are very creditworthy borrower--so don't go out and overleverage your portfolio--but if you have the opportunity and the means and the need to own a house right now, take out a mortgage.


Glaser: There's also been a big influx into things like bank-loan funds and other kind of more alternative fixed-income asset classes. What do you think about those strategies? Does that make sense as a fixed-income idea in a rising-rate environment?

Lee: Yeah, bank loans are an interesting asset class. For those who are not familiar with bank loans, bank loans are basically among the most senior loans in the capital structure, so they are collateralized by goods that are set aside, assets that are set aside from a company's balance sheet. So their recovery rates have historically been very good, and they also reset their interest payments periodically. It's tied to something like the LIBOR plus a spread. So that is actually a very attractive asset class right now because credit spreads in bank loans are still pretty reasonable. That said, I would probably not advocate investors cut a slice of their own portfolios to put in bank loans because I think that's going a little bit too active with your own fixed-income allocation. You should probably buy more of an all-asset bond manager who can actually allocate to bank loans instead of going out by yourself because you're going to actually have to pay quite a bit to access bank loans.

Glaser: And Russ, what about things like emerging-markets debt funds, local currency mutual funds? Are those an asset class that offer some protection there, or are they sort of a bit of a riskier bet?

Kinnel: It's definitely a riskier bet; that much I'm certain of. There is some appeal there, but as we've seen very recently, emerging markets still pack a lot of risk, and we've seen investors starting to flee both emerging-markets equity and bond funds. We're seeing unrest in Brazil, and that’s kind of altering the narrative that we had for few years there of emerging markets are the place you want to be because they have less debt and stronger growth prospects. And that’s been overturned a little bit. I think we are seeing a lot of money go into unconstrained bond funds too. I think there is some obvious appeal there because they can bet against rising rates. They can go short or long. But you have to recognize that these managers have a lot of flexibility, and they are not always going to get those macro calls right. So they are useful as a small niche in your portfolio, but they are going to disappoint you some of the time.

Glaser: So let's turn to the equity side a little bit. Matt, when you look at some of the companies that you own in your portfolio or others that you look at, how much sensitivity does corporate America have to these rising rates? Is this going to be a big problem on that side of the ledger?

Matt Coffina: When I think about interest rates, I really think of them having two conflicting effects on stock prices. One is that interest rates are only going to go up if the economy continues to improve. I think the Fed's have been very clear that there is a linkage there. They are not going to look to destroy the recovery by raising rates too soon. They are not committed to tapering if the economy can’t support it and so on. So greater economic growth in general would mean higher cash flows for companies, and that would tend to be a good thing for stock valuations.

On the other hand those future cash flows have to be discounted back to present value, and a component of discount rates is interest rates. So higher rates would, all else equal, mean lower stock valuations. And I think this is why we see a lot of volatility in stock prices in reaction to economic news. So sometimes investors focus on the numerator, cash flows and higher potential for cash flows with economic growth, and sometimes they focus on the denominator being the discount rates.

So there is really no way to predict when we get better-than-expected economic news. We had worse-than-expected news in the gross domestic product report. It's really very hard to predict how the market's going to react. At the moment, it seems like the market's more focused on interest rates, so bad economic news is actually good because it means the Fed's not be raising rates as quickly.

Thinking about specific stocks, I think the best way for investors in stocks to insulate themselves is to own at least a few companies that would specifically benefit from higher rates. In our Tortoise and Hare portfolios, some of the names that come to mind would be Charles Schwab. Their revenue is very much leveraged to interest rates across a couple business lines. They have asset management products like money market funds, where they've been waiving their fees to guarantee a positive return to investors; they'll be able to the waive fewer of those fees over time as interest rates rise.

Other names that come to mind would be some of the big banks like Wells Fargo and J.P. Morgan Chase. Over the long run those companies should do better in a higher-rate environment just because the spreads they earn on loans will be higher. Two more that come to mind would be Paychex and Automatic Data Processing. These companies both quite a float from customers, so they process payrolls on behalf of employers. They collect the payrolls before they have to actually pay them to the employees, and in the meantime they invest that flow. And they've really been earning very little return on that float recently because of the low-interest-rate environment. Higher interest rates would mean higher cash flows for those companies.

I think the names that you have to be little bit more concerned about would be anybody that does well in a low-interest-rate environment. In our portfolios we have First American Financial, a title insurer. That's a business that could see much lower transaction volumes with higher rates as people aren't looking to refinance their mortgages, and maybe lower activity in the resale market, as well. So, that will be a name to watch on the downside.

And then dividend payers are often seen as a substitute for bonds. So, at least in the short run, we could see some volatility in dividend-paying stocks. Although, in general I would much prefer a high-yielding dividend-paying stock where the yield is likely to grow and keep up with inflation over time, rather than a bond where your yield is fixed and that yield is going to deteriorate in value over time with inflation.

Peters: It sounds like pretty much my take. We have seen some volatility in higher-yielding stocks in the last couple of weeks. We had tremendous outperformance actually for defensive high-quality, high-yield stocks in the first quarter and mid-April in fact. And so they are kind of due for I think a little bit of a comeuppance. You don't expect that in a market that's rallying double digits over a short period of time that dividend-paying stocks, those conservative boring companies with the nice dividends, are going to outperform, but they did. So since then they've basically given back that outperformance, but the two portfolios that I manage actually still have very nice low-double-digit total returns on the year and are still outpacing the S&P 500, even with the increase we've had in interest rates. That's because these stocks they may have bondlike qualities, but they have the best of the bond qualities of high and consistent current income. But they don't have the drawback of that fixed component. The dividends are much more likely to grow than be cut, and you get to participate in a growing economy that way.

So the only group that really stands out as a notable underperformer are the REITs. The way I like to approach interest rates is to say what's priced in? And if you looked at even say utilities, let alone consumer staples or telecom, those stocks are trading, even before interest rates started to move up, pretty much where you'd expect them to be if the 10-year Treasury were at a normal rate, let's call it inflation of 2% plus a 2% real return premium, so 4% overall. REITs on the other hand have traded down. Their yields had fallen, and their prices had risen almost in perfect tandem with the 10-year. They were discounting at very low baseline level of long-term interest rates. So as those started to move REITs have gotten slammed, but the market is jumping out in front of that trend. I'm now looking at Realty Income, one of my very favorite REITs, well my favorite REIT flat out, one of my favorite overall companies trading with a yield well over 5% and below our fair value estimate for the first time in quite a while. So it’s probably not too early to start looking at some of those higher-quality names again.

Glaser: You mentioned some volatility in dividend stocks. There's been volatility across the equity market. Might this give some investors some flashbacks to the financial crisis or the summer of 2011 with some of the debt-ceiling debate that was going on? How concerned should an individual investor be about volatility in the market? Is it something they should be trying to guard against, or is it just kind of the price of admission to being in equities now?

Peters: I think it's price of admission. And there are strategies, certainly areas of the market that you can go in that you would expect less volatility than the market overall; if the stock market drops 10% than these particular stocks are maybe down 5% or 7%. But I think it really comes down to time horizon and what's the money for. If you are reinvesting a certain amount of money that you have in stocks, but you know you are going to need to withdraw that say five years from now to start making college tuition payments for your child or a grandchild, it shouldn’t be in the stock market in the first place because the market can go down and stay down longer than you can expect it to recover in order to make yourself whole when you need the money.

You need, I think, to be in the strongest position to have a view to keeping that money in the stock market almost indefinitely, and the approach that I take is that let the dividends, which are only ever positive flows of cash to you as the shareholder, let those carry the load in providing those shorter-term awards that you need to, say, fund portfolio withdrawals or just reinvest to buy more shares and collect more income in the future.

Lee: I agree with Josh. Equities have returned about 6.5% after inflation over the past 100 years in the U.S., and that 6.5% real return wasn't a steady 6.5% yield every year. There were literally decades where you were down. So, if you're invested in equities, you have to be willing to accept the fact that there will be literally decades where you earn nothing. You just have a lot of volatility. Your stomach is churning and that's just the price of equity investing. I think people have a very unrealistic expectation of what assets are supposed to return, especially because during the past 30 years we had a tremendous lowering of interest rates. And the lowering of interest rates doesn't just help bonds, but it helps every single financial asset out there because, as Matt said, there is the discounting mechanism.

So, investors who largely have been investing over the past 30 years have been investing in probably one of the most favorable environments for financial assets in the history of humankind. And so, people have a very skewed perception of what the market is capable of. Even the crisis of 2008 was actually by historical standards not that extreme. They were actually previous instances where the markets fell almost as much, such as in the 1970s, for example, and people don't remember that.

So if you're investing in the equity markets, you literally have to be invested for 10-, 20-, 30-year periods. You're basically rolling the dice. You are getting rewarded for bearing the risk that you may never be made whole over a 10-year period. But over a 20-, 30-year period, you will probably come out ahead, albeit you'll probably suffer some ulcers.

Coffina: I think the thing that I would just add to that is that equity investors are rewarded for the volatility they have to bear and the fact that you can go a decade without earning much of a return and that's that 6.5% real return over the long run that Sam was talking about. So in the long term, bonds right now I think you'll be lucky to see a 1% real return depending on what inflation does. For equities, at least a mid-single-digit real return seems reasonable over the long run.

Also I would say, I think the right kind of strategy, one that's focused on companies with very strong, improving competitive positions that increase in intrinsic value steadily over time, I think that's a strategy that can do well. You know even the Tortoise and Hare have done very well over the last decade-plus despite a market that hadn't really gone anywhere, and the reason is that some companies just consistently grow their earnings, grow their dividends. And either the stocks are going to be more valuable in the future or they are going to be extremely cheap in the future, and then there are much greater return prospects after that.

I think I would just say investors shouldn't be scared out of equities just because there can be these periods of volatility. Nothing is guaranteed over a short time horizon, but if you do have a longer-term time horizon and the reality is that most people are investing for long-term goal--you want to send the kid to college, you want to have a good retirement, leave a generous inheritance behind, and so on. Equities are still the best place to be in financial markets over the long run in terms of generating real growth and purchasing power.

Glaser: Let's talk a little about valuations then. Even with this volatility, our equity analysts still think that stocks are basically fairly valued, maybe slightly undervalued. Does that mean that this is a time to take some money off the table, maybe if you are overallocated or your asset allocation has run up a little bit in equities, or do they still look relatively attractive?

Coffina: It's very hard to say. I think a fairly valued market over the long run should return something like 9% or 10% in nominal terms, somewhere in the midsingle digits in real terms. But again you have to have a long time horizon. So from my perspective I'm trying to have a little bit of a cash position. Right now we have a 5% cash position in our Tortoise portfolio, about 3.5% in the Hare. And that’s cash available to take advantage of opportunities that might present themselves in the future. But really there is no guarantee that those opportunities are going to present themselves.

I have no doubt that the market will have future corrections and future bear markets. There'll be times when the stock market is down 10% or 20%. But there is no guarantee that once it’s down 20% that it won't still be higher than where it is today because, again, companies do tend to increase an intrinsic value over time as earnings grow and dividends are raised and so on.

So in general I try not to time the market, but I think it is a good time to have a small cash position on hand just in case the market does offer us better opportunities in the future. I wouldn’t look to raise cash much above 5%, in my portfolios at least, unless the market were materially overvalued, and I don’t think that’s the case today.

Glaser: How do the rest of you think about your cash positions?

Peters: I try to make it point to hold as little as possible. But that’s because in my model portfolios, asset allocation is not really what it's about. It's about individual selections for individual stocks within a portfolio overall including other asset classes. You can say the market looks fairly valued give or take, I'd agree with that assessment, but that actually still makes it a pretty good deal. When you are comparing it to cash--that yield is 0% but does have the opportunity to perhaps pick up some bargains at a future date--or bonds--that I would think are still overpriced so under-yielding relative to what would be legitimate return on the risk you are taking let alone getting farther out in terms of the risk spectrum--to be in the stock market at a fair price I think is still a pretty good deal.

And equities still have a lot of room to provide a lot more income. The payout ratio on the S&P 500 is still well below historical levels, in the mid-30% range. It's coming up from right around 30% or little bit under 30%, but historically it would be more like 50%-55%. So, that's something, again, you can't get from the bond market. You can buy stocks and, yeah, you've got put up with some volatility, but bonds are going to give you volatility, too, and no growth of income. I think the stock market when I start to think about five, 10, 20 years having to compete for the dollars of more and more retiring baby boomers in their portfolios, companies are going to have to stay competitive on the income front. And that's something that isn't really about short-term changes in interest rates; that's just the way people's preferences are going to evolve.

Kinnel: I think, cash can really make times like this look very different. If you've got, say, 10% in cash and the markets get really volatile, this asset class and that asset class sell off, all of a sudden you're a bargain-hunter, you're a shopper. And those things look a lot better than if you're fully invested and all you can do is feel the pain. And if you're long-term invested, you can put that volatility to work for you.

Now, obviously, you don't want to go too far. Cash is returning zero, and that's before inflation. So you don't want to go crazy with it, but I think a little bit of cash is healthy. Then obviously from a planning perspective you want to have enough cash to meet, what do they say, six to 12 months of your income needs.

Lee: I actually like cash. I think it's underrated in a lot of aspects. People consider cash dead money, but as Russ alluded to, the real value of cash its option value. So that is its ability to buy any asset class. Cash is basically like a call option on the entire universe of asset classes, and that call option is more valuable if you expect volatility--especially downside volatility--to be more pronounced. And I think that's actually a reasonable assessment in today's environment because interest rates are so low. Should interest rates go up that will hurt every asset, even stocks, and stocks can actually be considered very long-duration bonds with growing earning streams. So stocks actually have quite a bit of interest-rate sensitivity if you control for all other factors, especially the economic exposure stocks offer.

That said, I think stocks are more attractive than bonds, and I think cash is much more attractive than bonds. If you have a heavy bond allocation, I think you should pare that down and put that in cash, especially if you have access to higher-yielding bank accounts. So there are certain bank accounts or certificates of deposit that offer a 1.5% interest rate, and that's a very good deal, especially when the Barclays Aggregate Bond Index offers a 2.0% rate. So you can take zero interest-rate risk and earn a competitive return by investing in these high-yielding bank accounts, which are not accessible to institutional investors; they are only available to retail investors. Or you can take your risk on the bond front, and I would rather go with cash than debt.

Glaser: Sam, how do you think about some of those very short-duration bond exchange-traded funds that some see as a cash proxy. How do you think about those?

Lee: They are utterly pointless right now because they are yielding 1%, 2%, and you have no idea what risks they're taking in order to obtain those yields. Most people do not have a good understanding of what kind of risks are involved, especially in the short-term funding markets because there are ways to get a higher yield that looks very steady but will blow up once in 10 years. And you have no idea if these products are taking on that risk or they have some kind of magical formula to eke out higher yields. And if you want higher returns allocate a little bit more to stocks, rather than stretching out on the cash spectrum.

Cash is valuable because it offers liquidity. And that liquidity often dries up for these cashlike products at a moment's notice. So the risk/reward ratio is not in the favor of these cashlike products.

Glaser: Josh, you mentioned that you expect to see more dividend growth, that there is more room for income in S&P 500. For the first half of this year, we had a lot of talk about dividends, a lot of talk about stock buybacks, kind of capital allocation with companies kind of sitting on these big cash hoards. What's your take on how boards and how management teams are handling this cash? Do you think things are moving in the right direction, or are we going to have more kind of activist hedge funds and more fighting in the next couple of years, trying to unlock more of that money?

Peters: Yes. We are moving in the right direction, but there is a lot more fights to be had. I think the culture of corporate America is such that most CEOs and directors think of themselves not as representing owner interests but as being the owner and enjoying the kind of control and the kind of perks associated with controlling a giant enterprise and whole, and to the extent that they are paying out a dividend they are parting with some of that control. They are imposing discipline on themselves. Some companies do it freely because they want to and because they think it's best for their shareholders; they know it's best for their shareholders. Others have to be dragged kicking and screaming.

The way I look at it is that demographics, not interest rates, but demographics are going to be the key long-term force driving more dividends out of the market, out of these companies and into the hands of shareholders over the long run. But it's going to be a long messy process. I think we are moving in the right direction, but the best way I think to play this is to go with the traditional companies, the General Mills, Southern Companies, Procter & Gamble's, and things like that, that already pay the good yields, because even though other companies can come up and raise their dividends and join the ranks of stocks yielding 3%, 4%, 5%, you can't duplicate their defensive and qualitative characteristics. You can't manufacture more companies like utilities to meet investor demand like you could just manufacture dot-coms back to satisfy the demand in the dot-com boom.

So, to me that is still the sweet spot, and you don't have to guess when a company is going to get with the program and start to pay a bigger dividend. You don't have to wait around for that to happen if it ever does. You can start outearning a very good yield and count on a fair amount of consistent dividend growth to drive total return that is independent of improvement in this very critical area of dividend policy.

Glaser: Josh, Matt, you both talk a little bit about high-quality companies being attractive. Russ, Sam, do you agree with that? Do you think that kind of the best place for equity investors right now is in these higher-quality, more defensive names?

Kinnel: I think so. Certainly there is a lot of potential there, and I think a lot of the opportunities are in investments in general where you don't have maximum yield, but a little below, so a dividend-growth fund like Vanguard Dividend Growth [is better] as opposed to an equity-income fund or high-yield fund that doesn't have the highest yield because I think those securities with the highest yield have just been so overbid that a lot of the opportunities are in that next layer down where the income isn't quite as high, but it may well give you a better return and a better risk/reward profile.

Peters: I think that's exactly correct. To own the highest yielding of anything is usually a very bad idea.

Kinnel: And today it's really bad.

Peters: Yeah, and the number-one threat in equity income is not higher interest rates, it's your dividend gets cut. And then you don't get the income you expect, and you get a big capital loss to boot, which then you might have to turn around and reinvest at a lower yield. So, yeah, I prefer to avoid the highest-yielding stock in any particular group, unless there's something that makes it truly unique, like Paychex, for example, Matt mentioned earlier; I own it too. It has a higher payout ratio and a higher yield than ADP, its competitor, but that is just the choice that they have made in terms of dividend policy and capital allocation. They buy back fewer shares as a result. Both businesses are very steady. There's no reason Paychex can't support that yield. But to buy the utility with the highest payout ratio means you're probably buying the one with the least growth and the largest percentage chance that you're going to get a cut in the future.

Lee: Yeah, and there are also just some cynical companies that issue shares simply to pay out dividend yields, and there are also products that do the equivalent, such as closed-end funds, for example, which basically return your capital and they're bid up at massive premiums. So the highest yielding of anything is often used to lure unsophisticated investors into taking on more risk than they realize.

Peters: Absolutely correct.

Kinnel: That's a game that fund industry has played forever. There used to be a fund called Alliance North American Government that also had some [holdings in] Mexico and Argentina, but [the managers did not want investors to] pay any attention to that. So it's a long game we've seen forever.

Peters: I remember that one.

Glaser: Sam, what are some of your favorite high-quality ETFs if you're looking to go that route?

Lee: I think Vanguard Dividend Appreciation, ticker VIG, is an excellent, excellent core holding for a U.S. equity allocation. Basically what it does is it invests in companies that have raised their dividends 10 years straight. And basically what that does is that weeds out but the highest-quality companies, so sort of like a Warren Buffett type of portfolio of McDonald's and Intel and other well-known household names.

So you know that these companies will be around for a very, very long time, and I think one of the aspects of quality that is underappreciated is the fact that quality companies are able to resist the forces of creative destruction, and quality strategies therefore are actually probably the true time-horizon arbitrage play. So a lot of equity investors talk about time-horizon arbitrage. That is if I have a longer horizon than the other investor, then I can buy things that the rest of the market will overlook. Quality strategies are exactly that because a lot of their value comes out 10, 20 years. So you know with a high degree of certainty that these companies will be around 10, 20, maybe even 30 years from now. A lot of these companies that are in the top 10 that are not high-quality will probably not be in the top 10, 20 years from now.

So quality I think can be described as a Warren Buffet-type of strategy that really insulates you from creative destruction and insulates from the creative forces of capitalism.

Glaser: So shifting gears a little bit, Russ mentioned Argentina and Mexico there briefly. And that brings up the point of slowing growth in the emerging markets which has been one of the big stories in 2013 so far. Has this slowdown in places like China and elsewhere created any opportunities? Do you see better options outside the United States, or has kind of that U.S. high quality still where you want to place your bets.

Coffina: From my perspective we still have the vast majority of our portfolios invested in the U.S. I still think that’s the best place to be over the long run in terms of regulatory stability and companies that are very high-quality in terms of stewardship and so on. And we have a lot of multinationals based in the U.S. that can get you that same emerging-markets exposure without taking on as many of the risks. Companies that come to mind would be for example MasterCard. Some 60% of their revenue comes from outside of North America, and they really benefit from the growth in electronic payments in international markets. Potash Corp. of Saskatchewan is a name I always use. As populations grow across the world and especially in emerging markets, and as they grow more prosperous, they are going to want to eat more meat and fruits and vegetables all of which require more fertilizer. Potash being the largest and lowest-cost producer of potash fertilizer is another way I think to gain exposure to emerging markets without directly investing in them.

I continue to approach emerging-markets stocks with extreme caution, and it's not just because of the slowing growth that we are seeing now. There are innumerable other risks that you take on when you are investing in emerging markets. We actually only own one emerging-markets company in the Tortoise and Hare that's Baidu, and even in that case, which I think that's the highest-quality of the Chinese ADRs, there are things that we have to worry about, like the company's variable interest entity structure, which means that our ownership connection to the assets in China is a little more tenuous than what I would ideally like and that you would get from a U.S.-based company. We have to worry about slowing growth. We have to worry about the government and censorship and compliance with all the government restrictions around that.

So, in general, I think that you can do very well in the U.S. I don't think you have to look too far afield to find opportunities. And where there are opportunities in emerging markets, they are worth looking into, but I don't think that there is any need to make emerging markets more than a relatively small percentage of your portfolio.

So, again, we have one emerging-markets company between two portfolios. It's about a 6% position, and I really don't have anything else on my radar in terms of specific emerging-markets stories.

Peters: I think, it's best to let the big U.S. and developed-markets multinationals take the risk.

Kinnel: I'm a little more contrarian, I think. When everyone wants to own emerging markets I get scared, but when people start to flee like now, then I think there's some opportunities. I like a fund like Matthews Asian Growth and Income Investor, which is MACSX. They are very good Asian investors, real experts, and they look for dividends and some preferreds. And I think it's a really good, more conservative approach to emerging markets. For developed markets I like a fund like Dodge & Cox International, DODFX, just a very good value strategy that's been proven over a long stretch. And I think there are enough good foreign companies that it's worthwhile. It's good diversification, but unfortunately investors tend to often be a little late in the cycle. They wait until there's lots of good news overseas, and then they buy. Or they hear some bad news, and then they sell. Unfortunately, it's not really the way to do it.

Lee: I'm sympathetic to Matt and Josh's position that emerging markets are something that you should shy away from because you're taking on a lot of risks that U.S. companies don’t. You might be expropriated, the accounting isn't as good, the managerial quality probably isn't good, you run the risk of China undergoing a revolution, who knows? The probability of a revolution or some kind of massive market disruption happening in the U.S. is very close to zero, especially over the next 50 years. In China, not so close to zero.

So for those reasons I think investing solely in U.S. companies is a very justifiable thing to do. That said, I think emerging markets are fairly cheap right now because everyone knows that emerging markets are slowing. They have terrible governance, and so on, and right now I think valuations are fair enough that some of that is discounted. I wouldn't say that emerging markets are extremely cheap, especially in relation to their own history. But I think they are very cheap in relation to U.S. stocks and developed-markets stocks.

So, if you're more of an asset allocator, I think that overweighting emerging-markets stocks can make a lot of sense, and that's what I'm doing in my own portfolio. So, about one third to one fourth of my equity allocation, depending on which portfolio I'm talking about, is in emerging-markets stocks. That said, I tend to own more higher-quality emerging-markets names, so I prefer the lower-volatility stocks, the higher-quality ones. So, my favorite ETF for emerging markets is iShares MSCI Emerging Markets Minimum Volatility ETF, ticker EEMV.

Glaser: So, what about Japan? Abenomics has been kind of another one of the talked-about stories with the doubling of the monetary base and kind of the other arrows in that quiver to kind of get Japan going again. Is this going to be effective? Should investors who maybe have shied away from Japan for a long time be taking another look?

Kinnel: Maybe. I don't know. It's really a tough call. We've seen already Abenomics led us to a nice rally and a nice sell-off, and I think it's really tough to call. I think that's why I like a fund like Dodge & Cox to do some stock-picking for me rather than try to make those macro calls [myself].

Lee: I own a little bit of Japan-hedged equities, mostly as a pure momentum play. So, this is not very Morningstar-like, but academic research has shown that momentum is an extremely powerful force in the markets. That is, it has been shown to work in every single asset-class study, provided you do it in a disciplined manner. So, as part of a momentum play, I bought a little bit of Japanese equities back in February. It's worked out decently well. So, momentum is a legitimate strategy, provided you do it in a very cost-effective way. You can't pay too much in taxes, and you can't pay too much in transaction costs. So, if you're not doing it in a systematic way, I would avoid Japanese equities.

Glaser: But what Japanese ETF did you buy?

Lee: WisdomTree Japan Hedged Equity ETF, DXJ.

Glaser: So, looking back over 2013 so far, what was the biggest surprise that caught you the most off-guard?

Peters: I don't think I was so surprised that interest rates started to move up; I was surprised by the swiftness of the move, which is a little embarrassing to admit because things don't just go from here to normal here. They overshoot; they move faster than you would expect. Now, that said, having gotten through this first move in a 10-year Treasury from having bottomed at around 1.5% to 2.5%, 2.6% now, we've already absorbed a lot of that blow, and I'm frankly glad to have a lot of it over with.

Other than that, for my portfolios I spend so much time just concentrating on the companies themselves: How safe are the dividends? How fast are they going to raise their dividends? I've been very pleased dividend increases, and for my portfolio holdings, have almost all come in either exactly at the increase that I've expected so far or a little bit ahead. That to me, especially coming from companies that do already commit a large portion of their resources to dividends, says even they are feeling like they're able to return a little bit more cash to shareholders in this environment and make sure that their yields stay competitive in front of investors who are looking for income as interest rates rise.

Coffina: I would probably say that what was most surprising to me is that anyone was willing to lend the Treasury money for 10 years at less than a 2% yield. I certainly would never take that bet, and even at a 2.5% yield, I don't think that that's a deal that I would want. So, it's maybe not surprising that the Fed is sort of all powerful when it comes to interest rates, but it is surprising that anyone would go along with it, especially when you have such high-quality stocks like those in Josh's portfolio yielding significantly more than 2%, where you also have the prospects for dividend growth over time and embedded inflation hedges in the nature of the business. I would say I'm not as surprised that interest rates have gone up as quickly as they have. I think the market reacts quickly whenever there is a signal that they're going to go up that it's going to happen right away. But it is surprising how low they got to begin with.

Lee: I wasn't terribly surprised by anything, not because I have a crystal ball, but because my confidence in my own forecasts is very low. I know that the market is largely unknowable, especially over the short run. So I tend to not think about or sweat the fact that, oh, interest rates moved up this much or they fell this much or this happened or that happened, because the real things that you should focus on are going to unfold over multiyear periods. So, everything that's happened in the market thus far hasn't been totally out of bonds in terms of the historical experience. It's actually been a fairly normal market in terms of the strength of the rally, volatility, and whatnot.

Kinnel: I'd say it was a little bit of a surprise that PIMCO was on the wrong side of this move. They were bullish on Treasuries and had some long Treasury Inflation-Protected Securities exposure, and that has really hurt their funds. And you may recall the last time they got something wrong, it was when they were predicting Treasuries would sell off. But they didn't sell off; they were on the other side.

And I think that's a really great example that here's maybe the best bond shop out there, certainly one of the best, with a lot of brilliant people who are much better at predicting rates than I am. But they have to take a position every day and establish short- and intermediate-term positions, and they still get it wrong. They are usually right, but it should be sobering for all of us that PIMCO could get that interest-rate call wrong, and it should remind all of us that it's tough to make those calls.

Glaser: So it sounds like the old adage that you should get your asset allocation right, have a long-term horizon, and look at those high-quality companies really remains unchanged even in a rising-rate environment, and even with the economic uncertainty. That's still the secret to investment success.

Peters: Success is at its best quite dull, quite boring.

Glaser: All right, well, Josh, Matt, Sam, Russ, I really appreciate you taking the time today and thanks for your thoughts.

Coffina: Thanks for having us.

Peters: You're welcome. Thank you.

Glaser: For Morningstar, I am Jeremy Glaser.

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