If you stayed the course over the past year and stuck with your investing plan, you're probably feeling much better about your portfolio than you did a year ago. Nearly every investment class -- U.S. and foreign stocks, bonds, and commodities -- has rewarded patient investors.
Before you lapse into complacency, though, consider some of the risks out there. In the U.S., debt among all levels of government is too high. The same goes for household balance sheets. Employment, income growth and consumption may remain subdued for years to come, weighing down economic expansion. Interest rates, which essentially declined for nearly 30 years (lifting bond returns), have nowhere to go but up. And the picture is no cheerier in Japan and most of Europe.
Many risks -- excess leverage, government deficits, higher taxes, currency instability, defaults by nations -- will stay with us for years, so it might be time to build more diversification and safety into your portfolio. And because you can make a plausible case for inflation or deflation, you might also want to build in protection against either occurrence.
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It is with these goals in mind that we made some adjustments to the Kiplinger 25, our favorite no-load funds. In particular, our new list includes a short-term bond fund and a merger-arbitrage fund. Our method of picking funds remains the same. We prefer funds with low fees run by managers with long, solid track records who work for fund families we trust. We like funds with low turnover that investors can hold for the long term.
New funds on the list
Vanguard Dividend Growth (symbol VDIGX) has all the attributes we look for in a fund, plus a strategy we find appealing (see Why Dividends Matter). Manager Don Kilbride aptly calls his method of investing in companies that steadily increase their payouts "simple but not easy." The key is execution.
This large-company fund's mandate is also simple: Increase dividend income by at least three percentage points in excess of inflation each year. Kilbride projects that dividends paid by the 49 stocks his fund currently holds will grow at an annualized rate of 11% over the next five years. That would boost the fund's effective yield from 2.1% today to 3.6% in five years based on today's net asset value.
Kilbride says that if you can correctly identify stocks with a rising stream of dividends, it "leads to capital appreciation over time." You also get companies with some nice characteristics: strong balance sheets and cash flows; relatively little need for big capital expenditures to maintain profitability; and lower stock volatility. Although the fund lost 42% during the 2007-09 bear market, that was 13 percentage points less than the decline of Standard & Poor's 500-stock index.
In constructing his low-turnover portfolio, Kilbride likes to use a "barbell strategy" of combining companies that have boosted their payouts for decades, such as Procter & Gamble and Sysco, with a new generation of dividend growers, including Staples and Western Union.
Primecap Odyssey Growth (POGRX) is a relatively new large-company growth fund with a fine pedigree. Primecap's five managers have posted outstanding results running three funds for Vanguard with a similar investing style. Primecap invests in growing companies selling at attractive prices and holds their stocks for seven or more years, on average. Odyssey Growth is allocating 63% of its portfolio to health care and technology.
Chuck Akre is a familiar face with a new fund. When Akre departed FBR Focus last year, we decided to follow him and switch to his newly debuted fund, Akre Focus (AKREX). The main reason was Akre's compelling track record: During the nearly 13 years that he ran FBR Focus, the fund returned an annualized 13%, trouncing the Russell 2000 Growth index of small, rapidly growing companies by an average of ten percentage points per year.
Akre hasn't changed his method, which is to identify highly profitable small and midsize businesses with the ability to generate earnings growth of at least 15% annually. But he says that the scarring experience of the financial earthquakes of 2007-09 has made him more conscious of how big-picture economic issues affect consumers. One of his key takeaways is that "the plight of the consumer is significant and real," which implies much more austerity in the coming decade than during the past ten years.
One new focus for Akre is discount retailers. "People still go to stores, but they're stingier with what they spend," he says. He's also hunting for companies that are capable of generating revenue growth even in a soft economy by selling to other businesses. His largest position is in FactSet, number three in the financial-data business, after Bloomberg and Thomson Reuters.
Running an international fund is a challenge these days. Japan, the largest developed foreign economy, has basically been trapped in deflation for 20 years. The British economy is drowning in debt, and much of the rest of Europe is also ailing. One reason we like Harbor International (HAINX) is that the fund, which has returned an annualized 12% since its inception in 1987, has demonstrated an ability to perform well across business cycles and shifting landscapes.
Hakan Castegren, born in Sweden and based in Bermuda, has been at the helm since the fund started. Today he is joined by four co-managers who live in Boston. Ted Wendell, one of the co-managers, says a consistent theme from the beginning has been to look out three to five years and identify companies that could increase profit margins by boosting sales, cutting costs or, best of all, doing a bit of both.
For example, Wendell points to Nestle, the Swiss food-and-beverage giant, as an example of a company that increases revenues and chips away at expenses nearly every year. As with many stocks in Harbor's concentrated portfolio, the fund has held Nestle for more than a decade. On average, it holds stocks for seven to ten years -- an eternity by fund-industry standards.
Harbor is well suited to serve as the core of your foreign-stock holdings. If you can pony up $50,000, buy the institutional-class shares, which charge a much lower annual fee than the investor class (0.83% compared with 1.20%).
Funds that zig
Modern portfolio theory teaches that if you skillfully combine investments that move out of sync with one another, you can increase your portfolio's return while reducing volatility. But it's getting tougher to identify investments that zig when others zag. For example, the degree to which emerging-markets stocks and commodities move with the S&P 500 has risen dramatically in recent years.
We've added Arbitrage Fund (ARBFX) to our list this year because of its ability to march to its own tune. This fund invests in takeover stocks after a merger or acquisition has been announced. There's typically a gap between the share price of the target after the deal is disclosed and the closing price of the deal. Arbitrage seeks to capture the final few dollars -- or cents -- of appreciation by investing in deals that are most likely to reach fruition.
The beauty of Arbitrage is that it has a low correlation with both stocks and bonds. John Orrico, the fund's senior manager, notes that merger-arbitrage strategies have historically captured about two-thirds of stock-market gains while suffering only one-third the volatility. During the 2007-09 bear market, Arbitrage remarkably gained 1.6%. Since its September 2000 launch, the fund returned 6% annualized, an average of six points per year better than the S&P 500.
Orrico, who runs the fund with Todd Munn and Roger Foltynowicz, says that at any given time his team is typically studying 120 to 150 transactions and will invest in 40 to 50 of them. He particularly likes those of $500 million or less, because small deals are likely to attract more competing bids with higher offers.
You won't get rich holding Vanguard Short-Term Investment-Grade (VFSTX), but that's not the aim. At a time when yields on money-market funds are insulting and many investors fear rising interest rates, there are worse places to park short- to medium-term savings. Short-Term has produced gains every year for the past 15 years, except in 2008, when it shed a modest 4.7% -- a loss it more than recouped with an equally implausible 14% rebound in 2009. The fund yields 2.4%.
Bob Auwaerter has managed the fund since 1983, which may explain some of the consistency (Greg Nassour became a co-manager in 2008). Auwaerter, who's also head of Vanguard's entire fixed-income group, can tap into a pool of about 40 credit analysts who are divided into teams focused on categories such as investment-grade bonds, asset-backed securities and Treasuries.
Auwaerter expects a subpar economy because of anemic job growth, consumers' inability to borrow and a growing tendency to save rather than spend. He thinks this implies that interest rates will rise only slowly. The fund's duration (a measure of interest-rate sensitivity) is 2.2 years, so a one-percentage-point rise in interest rates should translate into a 2.2% decline in the fund's net asset value.
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