Morningstar Conference 2012

Help! What Should I Do With My Cash?

2012-06-21T22:45:55Z

As moderator Miriam Sjoblom noted at the outset, five years ago few would have expected a session on what to do with cash to draw a near-capacity crowd at the Morningstar Investment Conference. But times change, and the credit crisis of 2007-08, along with potential money market reforms being debated in Washington, have drawn new interest to the subject.

Sjoblom, associate director of fund analysis for Morningstar, was joined in the discussion by Brian Reid, chief economist for the Investment Company Institute; Bob Brown, president of Fidelity's bond group; and Jerome Schneider, who heads PIMCO's short-term and funding desk. The panelists agreed that how investors use, and view, money market funds has changed. No longer are they merely seen as a place to park cash before investing in stocks and bonds. Now, said Brown, they are "an essential component of a diversified portfolio." Brown referred to "the stratification of cash investing," with some investors using money markets for immediate cash needs and others seeing them as a vehicle for income generation and wealth preservation.

Panelists agreed that money market reforms enacted in 2010, including increased liquidity requirements, had helped improve the instrument's reliability, but Reid expressed concerns about proposed reforms such as those requiring that mutual funds use a floating net asset value. Doing so, he said, would affect the "transactibility" of the funds. The panelists said that detaching mutual funds from the stable $1-per-share model could cause investors to put their cash in other, less transparent instruments.

Although the future of cash remains unclear, what is clear is that the lessons of the credit crisis will continue to drive the discussion. "I think the lesson learned in 2008 is: What you thought couldn't happen can actually happen. And that's not going away any time soon," said Brown. "That's going to be part of the money market picture for a long time."

With yields on money market funds close to zero, Brown said there is opportunity for mutual fund companies to introduce products that can provide higher returns with modest increases in risk, citing Fidelity Conservative Income Bond FCONX, which opened last year and which holds about 40% of its portfolio in high-quality bonds, as an example. Schneider mentioned PIMCO Enhanced Short Maturity Strategy ETF MINT, which invests primarily in ultrashort bonds, as another example.

Schneider said that incremental moves up the risk spectrum can create new opportunities for cash investors. He cited nonfinancial companies with high cash flows and covered bonds as potential sources of increased returns on cash. "There definitely are opportunities out there for investors," he said, "but you have to be dynamic." He also discussed the rapid rate of change in credit markets today compared with years ago and said that at PIMCO, assessing credit markets currently calls for "trying to find the ripples in the water before they become big waves."

Asked to identify sweet spots in the overall fixed-income market, Schneider mentioned covered bonds (bonds backed by mortgages and guaranteed by financial institutions), U.S. financials, short-dated high-yield bonds, and hedged Mexican and Japanese bonds. Brown named 10- to 30-year bonds, high yield, insurance, U.S. financials, and REITs.

- Adam Zoll, assistant site editor

Grantham: We're in the Mother of All Paradigm Shifts

2012-06-22T15:17:48Z

GMO co-founder and chief investment strategist Jeremy Grantham argued Friday at the Morningstar Investment Conference that the world is in the midst of a great paradigm shift driven by explosive population growth and its corresponding pressure on natural resources.

A GMO equal-weight index of 33 commodities showed a 100-year decline in after-inflation prices from 1900 to 2000, save for both World Wars and the 1970s inflationary oil shock, which sent prices temporarily spiking upward.

But something happened 10 years ago, Grantham said. 100 years of decline turned around starting in 2000, with real commodity prices rapidly regaining all the ground they lost over the preceding decades.

That's not to say the last 10 years were a smooth ride for commodity prices. "2008 felt like a speculative bust in commodities," Grantham said, "But then everything bounced back. There has never been a major crushing like that, that immediately went back and hit its old high." The resilience of commodity prices after the financial crisis even further support the argument, Grantham said.

Why a Paradigm Shift Now?
Grantham cites more people as a primary driver in the sea change, with the world population growing from about 2 billion in 1938 (the year of his birth), to about 7 billion today, on its way 9 billion or more, creating a hockey stick population chart over the last 70 years.

China is another factor, Grantham noted, as its share of world commodity usage has ballooned. The country now uses 53% of all the world's cement, 48% of all iron ore, and 47% of all coal. China's demand for animal feed is also soaring, with annual soybean imports growing from 10 million metric tons to 55 million over the last 10 years, according to Grantham's presentation.

A greater population will mean pressure on all sorts of commodities, but the most pressing issue is food and agriculture. "The real problem will be feeding 10 billion people," Grantham said. "At a certain point fertilizer takes you backward and offers diminishing returns." As fertilizer usage has grown by about 5 times since 1960, we've also seen a decline in annual crop yield growth, according to Grantham's presentation.

Ag resource shortages are particularly acute for potassium and phosphate, which are produced mainly in select areas of the world. "It's unevenly distributed," Grantham says, adding that the ag resource issues are already contributing to global instability, including the Arab spring.

What does it mean for investors? "Think about farms, resource funds--fertilizer," Grantham said. "But it's not how to get rich this year. The euro will be much more important [in the short term]."

In an earlier interview with Morningstar, Grantham underscored his conviction, "I think the trend is up [in resources], and that makes a big difference for those who own the assets in the ground," he says. "This is the biggest change in the long-term business outlook I've seen in many, many decades."

Premium Members, stay tuned: We'll be posting a video replay of Grantham's full presentation next week. We'll post the link on our conference overview page.

--Jason Stipp, site editor

Hasenstab: U.S. Treasuries Are Risk-Free No More

2012-06-21T02:37:00Z

Michael Hasenstab, manager of Templeton Global Bond TPINX and co-head of Franklin Templeton's international bond team, kicked off the 2012 Morningstar Investment Conference with a talk on the potential crises and opportunities in the global markets.

A key point of his speech was that U.S. government debt will no longer provide a risk-free return going forward. With Treasury yields at historic lows, investors aren't being compensated for the extreme amounts of indebtedness and the excessive printing of money in the U.S. Instead, Hasenstab argues, investors will need to take risks elsewhere to avoid losing money from currency debasement.

Those risks will need to be carefully placed. Hasenstab pointed to two major issues that loom in the market today: The European debt crisis and China's slowing growth. For Europe, despite the real problems that Greece faces, Hasenstab does not believe that the European Union will fall apart. Greek debt will need to be restructured to give the country a fighting chance, but the problems surrounding Greece will be ring-fenced rather than spread globally. Hasenstab added that this will largely depend on the stability of Spain and Italy. Spain has just begun to deal with its banking crisis by recapitalizing the banks, but the country began with a 40% debt to GDP level, which allows it some room to shift debt from the banks to the government. Spain has allowed external auditors to report on its balance sheet, which should help ease the market's concerns. Italy faces the problem of higher debt and low growth, but Hasenstab believes that the country's policymakers are making the right long-term decisions to avoid a major crisis. Hasenstab also talked about how the European Central Bank has the capacity to use its balance sheet to serve as a backstop for the region.

In China, the main concern is that the country's government will make a policy error that topples the economy. Hasenstab points out, though, that the government has taken several steps toward easing monetary restrictions and encouraging economic growth. He also noted that the country can use its $3 trillion in reserves to recapitalize banks in the event of a banking crisis. That gives the country a very large insurance policy to deal with nonperforming loans. He hasn't yet ruled out the potential for China having a hard landing in the future, but he does not see that happening now.

Since Hasenstab doesn't believe the world is falling apart, for the reasons above, he discussed finding good investment opportunities in emerging markets. Whereas the average developed country has a debt to GDP ratio of over 100%, the typical emerging-market country has a ratio under 40%. From a credit perspective, emerging-market countries offer better opportunities than developed markets. Granted, investing in emerging markets comes with additional volatility, but it's necessary to withstand that short-term volatility to avoid the risk of permanently losing capital in developed countries. One region that Hasenstab finds particularly attractive is Asia, where the countries haven't been printing money, debt levels remain low, and growth is strong.

- David Falkof, mutual fund analyst

Trading Costs: Pros Share Tips on How to Slap the Invisible Hand

2012-06-21T20:47:53Z

Savvy investors shop for low-expense funds and aim to reduce the drag of taxes by using IRAs and 401(k)s. But another type of cost is harder to identify, let alone manage: trading costs.

Speaking at the Morningstar Investment Conference on Thursday afternoon, two experts shed light on exactly what trading costs are, and also shared tips on how to limit their drag on a portfolio’s returns. Dimensional Fund Advisors’ portfolio manager and trading expert Robert Deere discussed how DFA works to limit trading costs for its largely passive lineup, while BlackRock’s Jonathan Clark, head of the firm’s fundamental trading desk, provided perspective on managing trading costs for the firm’s actively managed equity offerings.

The pair broke trading costs into two key baskets—brokerage commissions, which mutual funds are required to disclose in their statements of additional information, and so-called frictional costs, which are not disclosed but nonetheless can take a bit out of fund returns. If the bid-ask spread—the differential between what buyers are willing to pay for a security and the price at which sellers are willing to part with it—is wide, those frictional trading costs will be higher. Generally speaking, the more liquid the security (i.e., the more buyers and sellers there are), the narrower the bid-ask spread will be.

Deere pointed out that larger buyers of less-liquid securities can find themselves confronting particularly high frictional trading costs. “Say you went into a drugstore needing 25 tubes of toothpaste,” he said. “If you need five more than are on the shelves, the price of the ones in the stockroom will be the same price as the ones on the shelf. On Wall Street that’s not what happens. If you buy five more, they’re going to be a higher price.”

While fund firms may track trading costs internally, they’re not disclosed to the public. However, the pair shared examples of investment types that tend to incur higher trading costs than others. On the short list? High-turnover funds, and those that traffic in less liquid stocks, especially small- and micro-caps. Clark noted that the bid-ask spreads for the large-caps that populate the S&P 500 are apt to be minimal, whereas bid-ask spreads for small-cap stocks could be 200 as high as basis points or more.

Clark advised investors to check out the daily trading volume of the securities in a portfolio to gain a view of the liquidity of its holdings. The pair also agreed that emerging markets stocks can have wider bid-ask spreads from those from developed markets.

Deere pointed out that client activity can jack up turnover, which in turn can heighten trading costs. “If you’re in a fund that has a lot of noisy turnover caused by client flows, unless it’s a very inexpensive fund, I’d be inclined to find another fund.” Complex strategies, such as those that involve leverage, can also lead to higher trading costs, he said. “As you go more esoteric, you’ll have to pay a premium.”

Yet as big a negative as trading costs can be, the two concluded that costs have come down substantially for investors over the past decade, especially commissions. Deere noted, “It used to be that you’d pay 10 basis points (0.10%) in trading costs; now if you pay more than 1 cent it raises eyebrows.” The advent of electronic trading has also squeezed bid-ask spreads, the two panelists concurred. But, Clark noted, “frictional costs have fallen more modestly.”

The Quarter-Century Club: Undaunted Veterans

2012-06-21T03:33:07Z

The first day of the Morningstar Conference ended with insight gleaned from the experienced members of The Quarter-Century Club. The session included Susan Byrne, founder of Westwood Management; Will Danoff, who has run Fidelity Contrafund FCNTX since 1990; and Brian Rogers, longtime manager of T. Rowe Price Equity Income PRFDX. It was moderated by Morningstar president of fund research Don Phillips, an industry veteran coming up on his 25th anniversary with Morningstar.

Doing the Right Thing
If there is one concept these old-timers want to impart to younger colleagues, it is that fiduciary responsibilities come first. Danoff spoke of meeting Warren Buffett for the first time. "It was during the Enron and WorldCom [scandals], and he spoke about the immorality of CEO compensation. I realized he wasn't just a wise businessman, he took it to another level and was clearly at a higher moral ground."

Byrne called for a renewed emphasis on stewardship: "This is not our money. This is a sacred trust. Younger people may have had that trust broken for them." Rogers agreed, observing, "Back in the day, smaller firms had a clear sense of fiduciary obligation. We weren't public companies."

Building an Organization
Byrne has in recent years turned over her money-management responsibilities at Westwood, and Phillips asked how she managed her "elegant dismount." She emphasized the effort that goes into building a team of analysts and managers who can carry on an investment philosophy: "We started 10 years ago, and that's about how long it took."

Danoff spoke to the depth of Fidelity's analyst staff. "I try to surround myself with people who make me better," he said. "Big firms such as Fidelity accumulate institutional knowledge. Everyone at Fidelity started as an analyst and grew up in a firm that is committed to growing you into the investor you are. As the organization grows, we are working hard to keep our culture.

"Hiring good young people is the most important thing," added Rogers. "You have to have an almost laddered series of ages in the investment group. Once you get someone in the door, you need to be willing to take a chance on the 30-year-old. My colleagues and I ended up where we are because someone took a chance."

Finding Opportunities Today
None of these time-tested managers is confounded by today's jittery markets. Byrne pointed to the number of large- and mid-cap stocks with dividend yields on a par with those of 10-year Treasuries. "Those yields are not going to get you where you want to be," she observed, "but you can find companies that are going to compound the growth of that dividend in double digits. That strategy is going to beat fixed-income and inflation no matter what the Federal Reserve does."

As Phillips observed, Fidelity Contrafund belies the myth that the bigger a fund gets, the more it resembles the market. Indeed, Danoff finds no shortage of ideas: "The public is almost giving up on stock-pickers, but the harder I look, the more names I find!"

Software companies such as SAS, for example, are fostering innovation (such as cloud computing) that hasn't been seen in years. "These aren't cheap stocks," Danoff noted, "but the wind is clearly at their back. Pick a favorite few names you know, and when they get down to an 8% free cash flow yield, add to those positions."

Global growth also spells opportunity for U.S. companies, said Danoff, offering Wal-Mart WMT, Nike NKE, and Colgate-Palmolive CL as examples of blue chips that can sell to a growing middle class all over the world.

Rogers also struck an optimistic note. "Investor sentiment is bad," he conceded. "But we've seen that movie before. It doesn't mean the next 10 years will be like the last 10." He cited the classic Buffett advice to be greedy when others are fearful, and ended with a kicker: "Take a look at emerging markets!"

- Laura Lallos, senior mutual fund analyst