mini-course series - mutual funds (part 2)

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MINI-COURSE SERIES

MUTUAL FUNDS

Part II

MUTUAL FUNDS 1

PART II

IBF | MINI-COURSE SERIES

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 num-

ber 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 Mar-

ket 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%


2008 -37.7% 10-year annualized 10.8%

2007 -15.7% 15-year annualized 10.5%


INVESTING IN A HOUSE

There are two key points to keep in mind when analyzing the benefits of home owner-

ship. 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 per-

centage point. Second, home ownership is expensive. It is comparable to owning a mutu-

al 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 es-

tate selling commission plus closing costs). Annual expenses are higher than 3% if im-

provements or monthly mortgage costs are included.

MUTUAL FUNDS 2

PART II


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 eq-

uity REITs in the U.S. The largest real estate mutual fund oversees $6 billion.

Home Prices vs. REITs

FHFA Index REIT Index REITs > Homes

1991 2.9% 35.7% ✓

1992 2.2% 14.6% ✓

1993 2.4% 19.6% ✓

1994 1.3% 3.2% ✓

1995 4.6% 15.3% ✓

1996 2.7% 35.3% ✓

1997 4.6% 20.3% ✓

1998 5.0% -17.5%

1999 4.9% -4.6%

2000 7.2% 26.4% ✓

2001 7.3% 13.9% ✓

2002 6.9% 3.8%

2003 7.0% 37.1% ✓

2004 10.4% 31.6% ✓

2005 11.1% 12.2% ✓

2006 4.7% 35.1% ✓

2007 -0.4% -15.7%

2008 -4.9% -37.7%

2009 -4.3% 28.0% ✓

2010 -1.3% 28.0% ✓

average annual return 3.3% 14.2% ✓

3 of losing years 4 out of 20 4 out of 20

Average losing year -2.7% -18.9%

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PART II


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 be-

tween 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%

MUTUAL FUNDS 4

PART II


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 pro-

ceeds 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 interest-

rate 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 liquidi-

ty, 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* 4.0%

* annualized (note: std. dev. over the past 3 years was 14%)

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PART II


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 long-

term 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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PART II


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 exam-

ple, an EAN may be structured so that the investor gets 1.25% to 3% for every 1% in-

crease 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 princi-

pal. 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 exam-

ple), 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 inves-

tors 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 be-

tween 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 peri-

ods, market neutral funds should hold up better because they have pretty much

hedged everything.

MUTUAL FUNDS 7

PART II


Management skills and trading costs are magnified in long-short and market neu-

tral 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 Annuities – Certified Annuity Specialist® (CAS

®)

o Mutual Funds – Certified Fund Specialist®

(CFS®)

o Estate Planning – Certified Estate and Trust Specialist™

(CES™

)

o Retirement Income – Certified Income Specialist™

(CIS™

)

o Taxes – Certified Tax Specialist™

(CTS™

)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree.

For more information, phone (800) 848-2029 or e-mail [email protected].

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mini-course series - mutual funds (part 2)

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