MINI-COURSE SERIES
MUTUAL FUNDS Part II
Copyright Š 2012 by Institute of Business & Finance. All rights reserved.
MUTUAL FUNDS
1
REAL ESTATE For most investors, real estate represents the largest part of their net worth; over two-thirds of all American families own a home. Real estate investment trusts (REITs) are companies that own and operate income-generating real estate. There are also a number of mutual funds that invest solely in REITs. The four most common types of equity REITs are office buildings, residential (apartments), regional malls and shopping centers. All equity REIT performance figures herein are based on the FTSE NAREIT Equity REIT Index (all equity REITs on the NYSE, AMEX and NASDAQ Global Market List—market weighted). Mortgage REITs have experienced the following returns: 23% (2010) 25% (2009), -31% (2008) and -42% (2007). For the first three months of 2011, equity REITs had a total return of 12.8% vs. 3.8% for mortgage REITs.
Equity REIT Returns [annualized returns ending 12/31/2010] 2010
28.0%
3-year annualized
0.7%
2009 2008
28.0% -37.7%
5-year annualized 10-year annualized
3.0% 10.8%
2007 2006
-15.7% 35.1%
15-year annualized 20-year annualized
10.5% 12.2%
INVESTING IN A HOUSE There are two key points to keep in mind when analyzing the benefits of home ownership. First, national price appreciation of residential real estate has historically been modest. Over past 30 years (ending 12/31/2007), house prices increased 6.0% annually vs. 4.1% for inflation, according to Freddie Mac. Factoring in the declines in 2008, 2009 and 2010, residential real estate annualized return figures drop by at least one full percentage point. Second, home ownership is expensive. It is comparable to owning a mutual fund or variable annuity that charges 3% annually (homeowner’s insurance, property taxes, and maintenance costs) and also has a back-end sales charge of 6-7% (the real estate selling commission plus closing costs). Annual expenses are higher than 3% if improvements or monthly mortgage costs are included.
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MUTUAL FUNDS
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HOUSING PRICES VS. REITS FHFA is the federal agency regulating Fannie Mae, Freddie Mac and 12 Federal Home Loan Banks. The index below represents home sales throughout the U.S. NAREIT is a real estate investment trust trade group. The index is comprised of all publicly traded equity REITs in the U.S. The largest real estate mutual fund oversees $6 billion. Home Prices vs. REITs
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 average annual return 3 of losing years Average losing year
FHFA Index
REIT Index
2.9% 2.2% 2.4% 1.3% 4.6% 2.7% 4.6% 5.0% 4.9% 7.2% 7.3% 6.9% 7.0% 10.4% 11.1% 4.7% -0.4% -4.9% -4.3% -1.3% 3.3% 4 out of 20 -2.7%
35.7% 14.6% 19.6% 3.2% 15.3% 35.3% 20.3% -17.5% -4.6% 26.4% 13.9% 3.8% 37.1% 31.6% 12.2% 35.1% -15.7% -37.7% 28.0% 28.0% 14.2% 4 out of 20 -18.9%
REITs > Homes ✓ ✓ ✓ ✓ ✓ ✓ ✓
✓ ✓ ✓ ✓ ✓ ✓
✓ ✓ ✓
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MUTUAL FUNDS
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The drop in real estate home prices since 2006 may be greater than the figures shown above. According to the S&P/Case-Shiller index of 14 major cities, from the 2006 peak to the end of 2010, home prices dropped 31%, including a 4% drop in 2010 (vs. a total decline of 11% for the same four years above based on FHA figures). During most periods, equity REITs outperform residential real estate—especially if you factor in costs of ownership (e.g., 7% selling commission and closing cost, 1-2% a year in property taxes and 1-2% a year in repairs and replacements plus some dollar amount for maintenance and property management if the home is rented out). The costs of home ownership are not reflected in the FHFA Index figures above. The 3 types of REITs are equity, mortgage and hybrid. Equity REITs are companies that own and operate income-generating real estate; mortgage REITs invest in mortgages while hybrid REITs own real estate and mortgages. Over 140 REITs are publicly traded (115 of which are equity REITs). From 1976-2010, the return (serial) correlation between equity REITs and the S&P 500 ranged from 25% to 80%; the correlation between REITs and long-term government bonds has ranged from -20% to40%. In 2001, S&P added REITs to the S&P 500 Index. Viewing the returns from 2000 through 2010, it is easy to see adding a well-diversified real estate fund can be quite beneficial when it comes to risk-adjusted returns. As shown below, there is little consistency between REIT, stock and bond returns. Annual Return Differences: U.S. Stocks vs. Med-Term Bonds vs. REITs [2000-2010] 2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
U.S. Stocks
11%
-11%
21%
32%
12%
6%
15%
6%
37%
29%
15%
U.S. Bonds
10%
9%
10%
4%
3%
2%
4%
7%
5%
5%
6%
REITs
31%
12%
4%
36%
33%
14%
36%
18%
38%
28%
28%
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BANK LOAN FUNDS A relatively new category, bank loan funds allow the interest-rate sensitive investor to receive a high level of current income with low volatility. Also referred to as “prime rate� funds, the portfolios are comprised of bank loans. In this case, the bank lends money to borrowers who frequently have less than stellar credit profiles. The proceeds are often used for leveraged buyouts. The bank then packages these loans and sells them to institutional investors and mutual funds. There are two major selling points to prime rate, or bank loan, funds. First, yield can be quite appealing, even compared to intermediate- or long-term bonds. Second, the yields are adjusted quarterly. These adjustable-rate funds come close to eliminating interestrate risk. Keep in mind that when interest rates fall, so do the yields on these securities. The three negatives to bank loan funds are: (1) losses are possible, (2) limited liquidity, and (3) high fees. Over the past decade, prime-rate funds have only had one negative year. Some bank loan funds borrow money so that they can leverage their holdings.
Bank Loan Funds [through 2010] Year
Return
Year
Return
Year
Return
2010
9%
2005
5%
2000
4%
2009
42%
2004
5%
3 years*
2.5%
2008
-30%
2003
10%
5 years*
2.6%
2007
1%
2002
1%
10 years*
3.3%
2006 7% 2001 1% 15 years* * annualized (note: std. dev. over the past 3 years was 14%)
4.0%
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ROLLING PERIOD RETURNS The longer the holding period, the greater likelihood of positive returns. The worst single years were: -37% for large cap (2008), -38% for small cap (2008), -8% for longterm bonds (1994) and -5% for med-term bonds (1994). Since 1980, the worst 5-year rolling periods were: -2% per year for large cap (2004-2008), -3% per year for small cap (2004-2008), -2% per year for long-term bonds (1965-1969) and +1% per year for med-term bonds (1955-1959). Percentage of Time Positive Annual Returns [1980-2010] category
# of positive periods
% of the time
Large cap stocks
24 out of 31 years
77%
Small cap stocks
23 out of 31 years
74%
Long-term gov’t bonds
27 out of 31 years
87%
Med-term gov’t bonds
28 out of 31 years
90%
REITs
25 out of 31 years
81%
Percentage of Time Positive Returns All 5-Year Rolling Periods [1950-2010] category
# of positive period
% of the time
Large cap Stocks
51 out of 57
89%
Small cap stocks
54 out of 57
95%
Long-term gov’t bonds
52 out of 57
91%
Med-term gov’t bonds
57 out of 57
100%
Percentage of Time Positive Returns All 10-Year Rolling Periods [1950-2010] category
# of positive periods
% of the time
Large cap stocks
51 out of 52
98%
Small cap stocks
52 out of 52
100%
Long-term gov’t bonds
51 out of 52
98%
Med-term gov’t bonds
52 out of 52
100%
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ENHANCED APPRECIATION NOTES Enhanced appreciation notes (EANs) are designed to provide some or all of the stock market’s upside potential, while partially or fully insulating the investor from downside risk (note: some of these securities have no downside protection). EANs are usually linked to major indexes and provide an enhanced participation on the upside— up to a limit, or cap (note: index returns for EANs never include dividends). For example, an EAN may be structured so that the investor gets 1.25% to 3% for every 1% increase in the index. If the ratio is 1.25-to-1 and the index went up 10% (excluding any dividend) during the life of the EAN, the investor would receive a total return of 12.5%. Issuers usually cap the upside potential of EANs. As an example, if the participation rate is 200% or 300% on the upside, the cap for the year may be 13-20%. Some EANs provide a level of downside protection, described as a percentage of the investor’s principal. For example, the first 10-20% of the loss may be fully absorbed by the issuer; the investor would then incur any loss in excess of this figure. This means that the investor has no chance of loss provided the index never exceeds the level of downside protection provided by the issuer. Typically, the barrier is set at 70-75% of the initial level (the value of the index when the investor buys the EAN). If the covered loss is ever breached (20% or 25% in this example), the investor would have full downside exposure past the point of protection.
LONG-SHORT FUNDS [130/30 FUNDS] “Market neutral” and long-short funds both have the objective of protecting investors when the market drops. Management typically engages in short selling (betting stocks are going to go down) coupled with traditional long-term investments. The typical expense ratio for this category is about 2%. There are significant differences between fund strategies. Most long-short funds invest a majority of their assets in common stocks. They then short other stocks with the remaining 20-30% of the portfolio. “Market neutral” funds, by contrast, usually invest an equal portion of their assets in “long” (owning the stock) and “short.” Long-short funds do better than their market-neutral rivals when the market is rising (since the majority of their assets are “long” stocks). In down markets, investors should expect to make very little, if any. During negative periods, market neutral funds should hold up better because they have pretty much hedged everything.
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MUTUAL FUNDS
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Management skills and trading costs are magnified in long-short and market neutral funds. A bad long-short manager can consistently lose money; a bad long-only fund manager may lag his or her benchmark but will still make positive returns most of the time. Over the past five years (ending 5/10/2011), long-short funds averaged 0.3% a year (1.5% a year over the past three years and 5.6% for the past 12 months).
THINGS TO DO Your Practice Phone up the spouse of one of your best clients. Tell them you want to throw a surprise birthday party for the other spouse. Get a list of the client’s friends from the spouse and invite them to a birthday lunch. The Next Installment Your next installment, Part III, will cover three topics: mutual fund class A, B and C, a review of performance and hedge funds. You will receive Part III in a few days. Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o
Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)
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