In these challenging times, the aftermath of the Great Recession coupled with the more recent geopolitical shocks in the Middle East are making investors stay cautious. However, five experts on equities, bonds, retirement, actively managed exchange-traded funds and commodities offer their analysis of where to look for upside this year, and where to expect pitfalls. Despite the turmoil in places like Egypt and Libya, oil prices over the long haul are not likely to rise, and, in fact, another fuel source is destined to become the way of the future as the need for energy in emerging market nations continues unabated. In terms of products, annuities are gaining while actively managed ETFs are poised for explosive growth.

The contributors who offer their views are: Tom Roseen (Senior Analyst, Lipper/Thomson Reuters), Jeff Tjornehoj (Head of Americas Research, Lipper/Thomson Reuters), Tim Clift (Chief Investment Officer, FundQuest), Dan Rice III (Managing Director and Head of Global Resources, BlackRock) and Cathy Weatherford (President, CEO, Insured Retirement Institute).

GLOBAL EQUITIES: Investment Income At A Lower Price


The equity markets have been throwing a great party, but almost nobody showed up. But never fear: If you and your clients are among those homebodies, there may well be an after-party that you can still enjoy.

Political upheaval in the Middle East/North Africa region, continued sovereign debt concerns in Europe, and China's increasing bank reserve requirements to sop up excess liquidity from its markets, have just begun to nudge investors back toward domestic equities in the aftermath of a strong rally.

In 2009, while much public attention was placed on the economy's sluggish recovery, equity funds quietly turned in their second-best year since 1967. But investors, feeling betrayed by the equity side of the business after a tumultuous decade, had turned to safer investments. They injected about $5.50 into bond funds for every $1 into equity funds.

So despite seeing double-digit returns from equity funds in 2009 (33.7%) and 2010 (16.6%), investors gave equities the cold shoulder and instead embraced the old adage: "Fool me once, shame on you; Fool me twice, shame on me."

But to a large extent, that sentiment backfired. Fear and greed-long-time enemies of investors-caused the rush to buy high and sell low: not a good recipe for wealth creation.

While we have learned many investment lessons over the past decade, perhaps the most important one has been to not place all our eggs in one basket. Contrary to a few naysayers, asset allocation is not dead. In fact, it is all most of us have to play with. Encouraging clients to embrace a well-devised asset allocation plan with semi-frequent rebalancing helps smooth out severe swings and keeps investors in the game for eventual rebounds.

With the recent market recovery in the United States and mixed news from overseas, investors have begun to favor equity investments over fixed income. Domestic equity funds, in particular, are being favored over non-domestic, with conventional domestic equity funds (excluding exchange-traded funds) attracting $30.8 billion year to date through March 2, 2011. Non-domestic equity funds took in just $5.1 billion.

This is quite a change from the prior two years, when non-domestic funds, and especially emerging markets funds, were all the rage.

In mid-December, a group of all-star investment gurus convened at the Thomson Reuters Investment Summit. They generally agreed that 2011 would be another positive year for equity investments.

But what was especially highlighted by many of the experts was the large amount of cash that is sitting on the sidelines in corporate coffers-ready to buy back stocks and increase dividends.

Certainly, we are experiencing some trepidation because of rising oil prices. But investors still might want to consider turning their attention to the dividend payers of the world. Many of the advances of the previous two years were from capital appreciation brought on by cutting costs and improving margins. But now, investors are beginning to demand top-line growth and increased dividends. Some investors are worried that this recent rally has played out. But there is still an equity group that has been ignored until recently and is perhaps still undervalued: large domestic companies that are flush with cash and ready to benefit from continued, albeit slow, growth in the economy.

Large-cap dividend payers may turn out to be an attractive choice for tax reasons as well. With the recent extension of the Bush-era tax cuts, equity investors have the benefit of receiving qualified dividend income at the 15% tax rate, rather than the 35% rate they'd have to pay for regular income distributions from fixed income products.

So, as firms start putting their excess cash back to work, increasing shareholder value by buying back shares and increasing dividends, investors can enjoy the other component of total return-income distribution-after depending almost exclusively on capital appreciation in the recent past.

— Tom Roseen, Lipper



GLOBAL BONDS: Where Will Bond Fund Investors Go From Here?


Score one for chaos. In the constant ebb and flow of investments, bond funds enjoyed a great revival of investor interest in the Great Recession.

The largest and wealthiest cohort of investors-baby boomers-shifted massive sums of money from stocks to bonds and cash in an effort to stanch the bleeding from their accounts. Trillions in market value were lost by equities and scared investors took on a defensive posture. Flows data since the meltdown has confirmed as much: equities saw more than $263 billion in outflows in the 76 weeks from the market top to its trough, and only $54 billion has flowed back in the 103 weeks since.

And then, after the recent mid-term elections, some people got mesmerized by the siren song of a stock rally.

Even more recently, however, unrest in the Middle East, in utterly unexpected, chaotic, and infectious forms, weighed on stocks and shifted attention back to bonds.

The uncertainties raised by contested government changeovers (especially in parts of the world with lots of oil), have once again raised the profile of bond funds in the minds of investors beyond mere performance chasing. Once investors felt the pinch of volatility in the stock market, it did not take much to prompt them to flock to bonds. In January, the average taxable bond fund was up .4%, while funds saw outflows of $4 billion. In February, returns were almost identical, at .47%, and funds saw inflows of $16 billion.

While retail investors appreciate bond funds very much, they have favored sectors within fixed-income unevenly. Flows into government and Treasury debt funds have softened among the most safety-conscious investors, but they have not actually reversed as you might expect, given the current volatility in the Treasury market. Meanwhile, interest in riskier and higher-yielding corporate sectors — particularly bank loan funds — remains strong.

Bank loan funds (in Lipper's Loan Participation classification) have drawn nearly $15 billion in the past 12 weeks — as much as they collected in the previous 12 months.

Junk bond funds have collected the lion's share of taxable bond fund flows, with nearly $7 billion in the first nine weeks of the year. This puts their flows slightly ahead of the pace they set in 2009 when they drew a record $28.8 billion.

Such an insatiable investor appetite for yield will likely be met by issuers eager to rollover debt or leverage themselves further at narrower spreads.

Though borrowers clearly appear to be in control, Lipper's High Yield Funds category has already earned 3.4% year-to-date (and this comes after last year's stellar 14.3%).

The label "bond fund investor" includes a larger, wealthier, and likely younger population than ever before. Whether they work with an advisor, or even do it themselves, their activity since the equity market bottomed out has been defensive and rather dismissive of opportunities in other asset classes.

Whether it's in their long-term best interest or not, that sort of posture appears inflexible.


— Jeff Tjornehoj, Lipper



ACTIVELY MANAGED ETFs: Despite Transparency Concerns, Active ETFs Show Promise

Since their market debut almost three years ago, actively managed ETFs have been slow to gain adoption, particularly within traditional equity asset classes.

As of Feb. 15, there were 31 active ETFs with a total of $1.7 billion in assets, according to Morningstar data. That's a tiny fraction of the total ETF market of over $1 trillion.

That can be attributed partially to a slow application and approval process with the Securities and Exchange Commission, which can take months or even years, although that process is getting quicker.

Another reason for the low numbers is the concern over transparency. Currently, ETFs are required to disclose portfolio holdings on a daily basis. This has kept many asset managers from entering this market, as they are unwilling to disclose their intellectual capital on such a short-term basis. On the equity side, despite transparency concerns, there are a few initiatives that hold promise for growth.

  • Less traditional asset classes, such as real estate, long-short or non-U.S. equity, tend to be less liquid and therefore less affected by transparency issues.
  • There is an outstanding proposal from one firm (Managed ETFs LLC) to offer non-transparent ETFs. The firm was acquired last year by Eaton Vance, and this would position them to be the first to offer such a structure. If they gain SEC approval, other managers in the equity space-who had been concerned about the transparency issue-would be more willing to launch active ETFs.

These limitations are less of an issue for active bond ETFs. With just nine active bond offerings currently available, this product is still in its infancy and it is where we expect to see the biggest asset gains. It appears to be a natural fit for active ETFs for several reasons:

  • Replication of bond portfolios is generally more difficult than for equity portfolios. It can be nearly impossible to purchase every bond position that a manager or index may hold. This has been one of the drawbacks of passive bond ETFs. Many of these ETFs have experienced high tracking error versus their benchmarks due to this replication challenge. Numerous passive bond ETFs use a proxy of holdings to replicate duration, quality and sector exposure to mimic an index, but have experienced varying degrees of success.
  • Since replication is more difficult, transparency is less of an issue for bond managers. The largest bond managers are realizing that the size and execution advantage they have in the bond markets can more than make up for the concern of anyone trying to copy their portfolios.
  • The ETF cost and tax structure can be more advantageous than mutual funds. The trust vehicle that is typically used for ETFs enable firms to pass on the cost savings to investors. We have already seen one firm (Huntington Asset Advisors Inc.) seek SEC approval to convert their existing mutual funds into active ETFs to gain these advantages.

Active bond ETFs are in the early stages of what will likely be the biggest area of growth within the ETF space. As more bond managers get familiar with the cost and tax advantages they can gain while not being burdened with replication issues, we will likely see active bonds as the next big wave of growth in the ETF space.

— Tim Clift, Fundquest



COMMODITIES: Weighing the Middle East: An Outlook on Commodities Amidst Political Turmoil

While recent political turmoil in the Middle East and North Africa has caused disruptions in commodity prices and oil in particular, investors should not overreact to these disruptions or try to read too much into the situation.

Current events are unlikely to have a lasting impact on prices, unless oil production facilities are damaged. While that is a possibility, oil prices are likely to come down to levels seen prior to these events.

Over the past 30 years there have been numerous examples of even more heated conflicts that caused disruption in the oil market. But ultimately, the forces of supply and demand control the long-term price of oil. And with no apparent destruction of supply, the market should return to its earlier trajectory.

Investors can expect long term supply-and-demand fundamentals to remain positive for energy and resources. Urbanization and industrialization trends in emerging market economies continue to drive long-term growth in the energy and resources space.

After oil, the next popular choice is coal. Coal demand has soared in emerging economies as a cheap source of electricity. China became a net importer of coal in 2009, a notable change from its previous status as the world's third-largest exporter. Australia is the principal source of coal exports to China, and because its port capacity is limited, it will be extremely difficult for it to keep up with China's increasing demand, even if it had unlimited supply. Other major exporters, South Africa and Colombia, could help fill China's demand, but this would mean redirecting coal normally shipped to Europe, leaving Europe short on supply.

Factoring in short-term weather-related incidents, like the flooding in Australian mines in late 2010, makes it more apparent that coal cannot be the only answer to the world's increasing energy demand.

Natural gas is a more likely option to fill the gap between expected energy demand and supply. The U.S. now has the energy equivalent of Saudi Arabia in its shale gas resource potential at a cost base that is 60% cheaper than oil, 20% cheaper than coal, 60% cheaper than wind and 80% cheaper than solar power. Shale gas represents the best option the U.S. has for both increasing its energy independence and reducing pollution.

This will take the form of substitution of natural gas for gasoline in car engines, diesel in truck engines and coal in electricity. Natural gas prices are currently at depressed levels due to the near-term glut of supply in the U.S. from highly prolific shales. Prices for both oil and coal are at a point at which gas is a more attractive substitute, and the appropriate infrastructure should be built out. When this happens, the economic relationship between gas and oil and coal should be partially restored, pushing gas prices up to reflect its value as a substitute energy source.

Even in a stable world environment, there will be increasing pressure to meet the world's growing energy demands with alternative energy sources and investors should benefit from these long term trends. Commodity-related investments provide a good source of diversification given their lack of correlation to other financial markets — an important reason for investors to maintain an allocation to the sector, regardless of headlines.

 — Dan J. Rice III, Blackrock


ANNUITIES: The Investor Demand for Guaranteed Retirement Income


For some people, age 65 represents the retirement age they have been planning for throughout their adult life. For others, it will serve as an unwelcome reminder of how unprepared they really are. Either way, this year will be the beginning of the "great awakening" in terms of retirement planning and preparedness.

This year also marks a time of unprecedented opportunity for the financial industry to help millions of Americans attain the secure financial future they are urgently seeking. Of the baby boomers who are within five years of retirement, just slightly more than one-third have a fully vested pension, and given the uncertain long-term viability Social Security, they are understandably concerned.

Annuities are the only financial instruments available today, other than Social Security and pensions, that can guarantee a lifetime stream of income during retirement. Along with giving retirees the peace of mind that comes from knowing that they will not outlive their assets, annuities provide another important benefit through the tax deferral of earnings.

For all these reasons, 2010 was an historic one for the annuity industry, with variable annuity assets reaching an all-time record of $1.5 trillion. In addition, the industry ended the year on strong footing, with fourth quarter sales reaching the highest levels of the entire year.

On the fixed side, sales settled somewhat, after a record 2009, but remained strong. Over the course of that time, indexed annuities have emerged as the product of choice, representing nearly half of all fixed annuity sales for 2010. Indexed annuities can be attractive to investors who are reexamining their risk tolerance and are looking to protect their principal investment from losses in the equity market, while still benefitting from gains.

Product development in 2010 was underscored by innovation and continued demand for lifetime benefits. Throughout the year, the industry continued to transform its guaranteed lifetime income offerings. Nearly 350 changes were filed last year, and among them, more than half were either new benefits, new products or revisions to products. Notably, a swing toward more generous benefit offerings for investors were made available, as nearly all of the new benefits released were lifetime withdrawal benefits.

Earnings in all types of annuities compound tax-deferred until an investor begins to take money out. So investors can build a larger retirement savings account than they would be able to if some of their earnings went to pay income tax every year. And while IRAs and 401(k)s also offer tax-deferred status, contributions made to these investments have a yearly cap. Annuities have no annual contribution limit, allowing those nearing retirement age to catch-up by saving more.

In addition, the tax deferral of annuity earnings is one of the most highly regarded attributes of the products. A recent Insured Retirement Institute report found that the deferral of taxes on the inside buildup of annuity contracts is a key selling point for advisors and investors, as noted by 37% of advisors and 56% of annuity owners.

The baby boomer tsunami has arrived, pushing the consumer need for retirement income to historic levels. The need for investment protection and the value of a guarantee have never been greater, as consumers strive to achieve a financially secure retirement. Through innovative products and historic performance levels, the industry is primed to play a pivotal role in the retirement plans of millions of Americans looking for the peace of mind that only an annuity can bring.

 — Cathy Weatherford, Insured Retirement Institute

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