Investing is always an uncertain enterprise, full of risks that can keep you up at night and risks you can't even imagine. But there has seldom been a time when so many uncertainties were in play at one moment, all of them potentially buffeting your portfolio. They range from the political to the macroeconomic, from debt and unemployment here to the fate of the Eurozone, the slowdown in China, and the threat that Mideast strife could send oil prices soaring. Federal Reserve historian and former White House economic adviser Allan Meltzer, who at 84 has seen his share of business cycles, recalls only one period like this: the late 1930s. In those years, Franklin Roosevelt was denouncing big business and war clouds were forming over Europe. Today Europe is at peace, but frailty in virtually every major economy forms the backdrop for next year's markets.
Start with the damage done by the 2008-09 financial crisis. Even three and a half years after the recession formally ended, households and companies are still so focused on paying down debt, some economists say, that they're not spending and investing at normal rates, and won't until debt levels are again sufficiently low. Several key measures of household deleveraging are showing progress. Among them is the ratio of debt-service costs to after-tax income, which according to the Federal Reserve has fallen from about 14 percent five years ago to 11 percent by the first quarter—the lowest since 1994. "That is a significant improvement," says Stuart Hoffman, chief economist for PNC Financial Services Group.
Another casualty, housing, may finally be on the mend. That would be a boon for owners and also for the construction industry, which normally employs about 5 percent of the workforce and generates about 4 percent of GDP. According to the widely watched Case-Shiller index, house prices in the second quarter were up 6.9 percent from the first quarter and up 1.2 percent from a year earlier. A Federal Reserve study issued in June showed that median household net worth shrank 39 percent in the three years through 2010, led largely by collapsing house prices; a healthy bounceback would do lot to repair household finances and boost consumer confidence. "If home prices bottom out you might see some of that pent-up demand come to the surface," says Beth Ann Bovino, deputy chief economist for Standard & Poor's. "I think 2012 is going to be the first year [since 2005] that housing actually contributes to growth instead of contracting."
Then there is the political uncertainty that outlasts the election: the question of how Congress will navigate the "fiscal cliff" of tax increases and spending cuts due to take effect in 2013 under the 2011 budget deal. The combination, many fear, would knock the economy back into recession. The Federal Reserve has projected growth rates next year and in 2014 of as high as 3 percent and 3.8 percent, respectively. But it also rather suddenly announced a third round of "quantitative easing"—buying up securities in order to inject liquidity into the still-struggling economy—in mid-September. In a significant shift, the Fed also said it would not put an end date on the program, vowing to pursue it until unemployment falls. It also promised to keep interest rates low into 2015, a half year longer than previously planned.
Even if the Fed is right about growth, another big obstacle to recovery—high unemployment—is sticking around for a while. Economists say GDP needs to grow by a minimum of 2 percent just to absorb new entrants into the labor force, to say nothing of re-employing the people thrown out of work by the recession. Annualized GDP growth was running only 1.3 percent in the second quarter, revised from 1.7 percent, the Commerce Department reported. In September the Fed forecast the jobless rate falling at best to 7.6 percent in 2013 and 6.7 percent in 2014, though that was before the Labor Department reported a surprisingly large dip, to 7.8 percent, for September—the lowest rate on President Obama's watch.
Which leads, improbably, to markets that have seemed to be ignoring the gloom. As the fourth quarter opened, the major U.S. stock indices were nearing their all-time peaks reached five years earlier; the S&P as of early October had more than doubled from the March 2009 trough of 677 that left it 57 percent below the all-time high (1565) reached just 17 months earlier. That slide had been its sharpest in 75 years. Even with the recent huge rally, however, the index was still 27 percent below where it would have been had it risen just 5 percent annually since 2007.
The situation is similar with bonds, which have soared in recent years. As of early October, the Vanguard Total Bond Market Index was up 36 percent (or an annualized 6.4 percent) over five years. Many market-watchers expect bonds' value to drop, perhaps precipitously, when there is a recovery strong enough to prompt an increase in interest rates. "We think it's the single largest looming risk out there," says Ben Marks, head of Marks Group Wealth Management, an adviser that split off from UBS in 2008 and now runs $450 million for a clientele whose average age is 57. "Investors need to be very careful not to reach for yield. Our concern is that in the next three to five years, these investors are going to give up everything in principal, and more, that they earned in additional yield."
Where does this leave investors? Many who fear the uncertainty ahead are no doubt puzzling over where to look for decent income without the sort of volatility that causes ulcers. If you're among them, expect a tough time in this ultralow-yield world finding it in funds that don't place you on a roller coaster of risk. The bottom line: Bonds have been bid up so avidly that it's probably too late for older investors to look for pure yield in anything low-risk enough to suit them; yields, which move inversely to price, are nearing bedrock. At this point, you may want to consider moving some of your money beyond the apparent stability of fixed-income assets, which many advisers will tell you are not as safe as they may look, given the possibility of inflation returning and interest rates rising.
Marks isn't the only one warning clients not to chase yield. "Given the risks, it just doesn't seem tenable right now to recommend a portfolio with yield as a key goal," says Christine Benz, Morningstar's director of personal finance. "My bias is to recommend a portfolio that's set up to deliver total return—some current income, but also capital gains."
Funds that fit the bill
To help you sort through the thousands of mutual funds that claim to accomplish both goals, U.S. News has compiled a list of domestic and international stock funds, as well as some from the fixed-income universe, that have a record of delivering an attractive total return with relatively modest risk. We started by screening funds tracked by Morningstar for those that beat their category's total returns over the past 10 years while yielding more than the 10-year treasury, which was at a meager 1.7 percent as of early October. To fit the needs of average investors, we limited our search to no-load funds with low expenses, easy availability, long-standing management tenure (at least five years), and Morningstar's "silver" analyst rating (or better), a risk-adjusted measure of how its analysts expect a fund to perform relative to its peers. To minimize the dangers of an uncertain investing climate, we've eliminated funds that hold riskier, long-duration bonds, as well as funds with a "high" Morningstar risk rating.
One can quibble about the criteria used to choose the funds—as did some of the advisers we spoke with. Tom Orecchio, an adviser with Westwood, N.J.-based Modera Wealth Management, says investors should also be alert for "style drift," or how much the fund manager strays from the investment style (large-cap, mid-cap, passive, active) you thought you signed up for. "Remember, the managers don't know what you hold elsewhere," says Orecchio. "Even if they don't change [their] risk profile, they could change your risk profile by what they add to the portfolio." Clearly, arriving at an asset allocation that makes you comfortable should drive your portfolio design more than the appeal of particular funds. As always, this list is intended to help you begin your research on income-producing options, not to provide easy answers.
To a lot of folks, "income" means "bonds." To be sure, there is a place for bonds in an income-seeking portfolio. Indeed, when Lipper's Jeff Tjornehoj ran a screen that identified the highest-yielding 25 percent of funds and the least volatile 25 percent, all that came up were fixed-income mutual funds. G. Andrew Ahrens, CEO of Lafayette, La.-based Ahrens Investment Partners, puts his clients in a broadly diversified portfolio whose holdings range from domestic and international equities to precious metals—and bonds. Among bond funds, he likes the Fidelity New Markets Income Fund for emerging-markets exposure and the Vanguard Inflation-Protected Securities Fund, which invests primarily in Treasury Inflation-Protected Securities, or TIPS, bonds whose principal adjusts for inflation.
Fidelity New Markets Income and Fidelity High Income, which top the U.S. News bond list, achieve their impressive results (12-month returns topping 22 percent and 19 percent, respectively) by taking on the risk of some high-yield bonds—below-investment-grade corporate issues ("junk") or the debt of emerging-market governments prone to default when economies stall. The other bond funds on the list similarly invest in a diverse mix of debt and defend against higher interest rates by sticking with securities of relatively low "duration," a measure of bond-price sensitivity to changing interest rates. The longer the maturity, the greater the duration, which is why many advisers are steering clients toward shorter maturities.
The arithmetic of rising interest rates does not look good for longer maturities. On July 24, the yield on the benchmark 10-year treasury was a record-low 1.4 percent. Some six weeks later, as the price fell, it was 1.87 percent. "If someone had bought into a bond fund on July 24 that had the same duration as a 10-year treasury, by Sept. 14 they would have lost 4.4 percent of their principal," says Marks. "I don't think investors fully appreciate the risk associated with potential volatility in interest rates, especially when they're at such low levels." He notes that it's "entirely possible" that the 10-year yield will revert in 30 months to what it was 30 months ago: 4 percent. "If you buy something today that has the same duration as the 10-year treasury, which many mutual funds do, you'll lose 22 percent of your principal if the 10-year goes back to 4 percent." A key holding for Marks is the Lord Abbett Short Duration Income Fund, which rotates among sectors that include government bonds and mortgage-backed securities.
The income-producing fund possibilities outside of bonds, as reflected on our funds list, are often value funds like Vanguard Windsor II and T. Rowe Price Equity Income that focus on stocks selling at a discount to their value and those invested in companies paying attractive dividends. The Vanguard Dividend Growth Fund, as its name implies, looks for companies that have steadily raised dividends over time but trade at reasonable prices. What allays risk is a bias toward big-name, large-cap stocks that have proved themselves through every kind of market over many years. Its top holdings—PepsiCo, Johnson & Johnson, and Occidental Petroleum—yield 2.5 percent to 3.5 percent and trade at price/earnings ratios of 11 to 22.
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It's a similar story at the Dodge & Cox Stock Fund, a value-oriented, somewhat contrarian fund whose top holdings are Wells Fargo, Capital One, and Comcast. The fund had a bad 2008, but has bounced back since. Morningstar analyst Dan Culloton stands by the fund, noting its low expenses and seasoned management.
It's true that stocks generally seem riskier than bonds. But the answer lies as much in fund managers as in asset class, says Ahrens. He looks for "active" managers who aren't "just trying to clone an index" and who hold up well in bear markets, invest in their own funds, and have been at the helm for several years. The objective is to find managers capable of generating "positive alpha" with "low beta"—alpha being finance-speak for returns generated by smart management, and beta meaning the degree of risk a fund takes. "The S&P has a beta of 1.0," says Ahrens. So if your manager boasts "a beta of 0.6, then he has 40 percent less risk, or less volatility than the S&P. If you can find that manager who's maybe 20 percent less risky than the S&P but he's capturing 90 percent of the S&P's upside, that's a manager you want."
It used to be that you could derive ample income from relatively low-risk assets just by making a simple trade-off: a little more yield for a little less stability. These days, modest yields still carry lots of risk, depending on what interest rates do. With the Fed vowing to keep rates low into 2015, and the economy apparently stuck in low gear, the challenge of finding income without taking on too much risk probably won't be much easier in 2013 or 2014. "We have been trying to caution people that we are in a low-rate, low-yield, lower-return environment," says John Ritter of Cincinnati-based adviser Ritter Daniher Financial. "And we're likely to be there for a while."