Investing Insights: Earnings, RMDs, and Core Funds
We examine Gold-rated ETFs, new investment themes, and the debt ceiling on this week's episode.
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Damien Conover: Johnson & Johnson reported fourth-quarter earnings that were largely in line with our expectations, and we came away with not making any change to our fair value. We continue to believe Johnson & Johnson is worth $130 per share and continues to have a wide economic moat.
I think there's three important takeaways from the results. First off, the results were in line with our expectations, again driven by strong drug sales. So these drug sales really offset some of the more slow growth that we see out of the consumer goods and the medical device product group.
The second key takeaway here is the guidance for 2019 was a little bit softer than we were anticipating on the top line but stronger with other income. What other income is, is largely divestitures that the company plans to make to help grow the earnings. The net impact of those two things largely doesn't change our fair value.
Then the last point that I'd make about the call that they hosted earlier today was that they talked about the talcum powder litigation concerns that have been really over the stock, really over the last couple months, and they continue to believe in the safety of this product. We continue to believe that this litigation overhang will not cause a significant impact to our fair value. We currently model in close to $2 billion in litigation concerns revolving around the litigation for the talcum powder, but again we don't anticipate that to have a material impact on our overall valuation.
The net take away from our perspective is, the fourth-quarter results were largely in line with our expectations; the 2019 outlook is a little softer than we thought, but it doesn't impact our fair value; and we continue to believe the stock is fairly valued.
Erin Lash: Over the last several years, much focus has resided within P&G's top-line trajectory, and the second-quarter results highlight that efforts to shed more than 100 brands from its mix and focus its investments behind its key brands are beginning to gain traction. More specifically, organic sales popped 4% in the quarter, similar to the gains reported in the prior quarter and on top of 2% growth in the year-ago period. Even more impressive is the fact that this growth was balanced and driven by both gains in price as well as volume.
Despite this improving performance that we anticipate will persist over the longer term, the firm is fairly valued at current levels after popping at a mid-single digit clip on the results. We would suggest that investors await a more attractive risk-reward opportunity before building a position in this wide-moat name.
Neil Macker: Netflix ended 2018 on a strong note as international subs beat guidance by a handily amount. The company continues to expand, both in the U.S. and internationally. But, the problem for the company is the cash burden continues with a free cash flow burn of $3 billion in 2018 and a similar level expected in 2019.
In our view, Netflix will face increasing competition over the next 18 months as NBC, Universal, Warner Media, and Disney all launch services. These services will all contain content from these large media firms, forcing Netflix to increase its content spend on original content. As a result of this increased content spend, we expect cash flow burn to remain at elevated levels over the next five years. This increased content spend will also limit margin expansion, both here in the U.S. and internationally.
As a result, we continue to believe that Netflix shares are overvalued. Our new fair value estimate is $135. We believe that investors should stay off the roller coaster that is Netflix for the foreseeable future.
Andrew Lange: Overall, our expectations leading into IBM's fourth quarter were anything but stellar. However, the company managed to surprise us with slightly better than expected revenue growth.
A couple of bright spots were apparent, with global business services, or GBS, outperforming sales expectations and the company's systems business managing to decline slower than we had forecast. We think the performance from GBS was particularly notable and supports our opinion that IBM as well as Accenture, remain the premier global IT services firms. We believe IBM's consulting and digital transformation skills are key assets for the firm, and we continue to see midterm growth tailwinds for this business after prior years of restructuring.
The firm provided an in-line outlook for fiscal 2019, and while it was a solid end to the year, our fair value estimate remains unchanged at $158 per share. Systems revenue was down significantly, but this was expected due to the highly cyclical nature of this business and the fact that the z14 mainframe is now at the tail end of its cycle.
Analytics and artificial intelligence software helped boost cognitive solutions, and as we look at the next year and beyond, we think IBM's recent $1.8 billion software sale to HCL will help to lessen IBM's legacy exposure and reinvigorate the subsequent growth profile of the cognitive solutions business.
Technology services and cloud platforms remain mixed, and we think this will be the case for at least the near term, with IBM looking to exit lower value infrastructure work.***
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Despite their best intentions, retirees sometimes miss their required minimum distributions. Joining me to share some steps to take in this situation is Ed Slott, he is a retirement expert.
Ed, thank you so much for being here.
Ed Slott: Great to be back here. Thanks.
Benz: Ed, let's discuss required minimum distributions briefly--which accounts are subject to them and who is subject to them.
Slott: This is great to start off the year knowing all of your accounts that are subject to RMDs, because we find at tax time that's when we hear, oh, I missed, I forgot that account, I forgot this account, I took the wrong amount. This is when we see all the errors. In general, IRAs after 70 1/2 are subject to required minimum distribution. So are 401(k)s if you are not still working. If you are still working, there are exceptions for some people. So, or any other plan, except Roth IRAs; Roth IRAs, that's sort of a big advantage--they are not subject to lifetime RMDs. But your 403(b)s, 457, your 401(k)s and your IRAs are subject to RMDs. Especially, when people start, that's when the confusion sets in, but every year in the beginning of the year that's when we hear, oh, I missed it.
Benz: Right. So, let's discuss what happens if you miss it, because it's not something you want to mess around with. There is a big penalty, right?
Slott: Yeah, it's a 50--and I always say, 5-0 because it sounds like 15, because 50 doesn't sound believable--50, 50% penalty on the amount you should have taken but didn't or any shortfall, let's say. But that penalty can be waived if you do take the right steps.
Benz: We're going to talk about those steps. Say, it's the new year and I realized I didn't take my distribution for last year, what process should I go through, first of all, to let the authorities know and also try to make a case about why I missed it? Actually, there is some leniency ... so let's talk about that.
Slott: The first thing you have to know, people always ask, should I go back last year and take it? Only if you have a time machine. You can't go back to a year and take, and say, I took it that year. So, you can't go back. It has nothing to do with the prior year. And some people say, but don't I have unreported income? No. Unreported income is income you took, but didn't report; you never took this income.
There is no effect on the prior year other than you have a potential 50% penalty. You have to make it up. Currently, as soon as you discover it, you should figure out the amount you were short or whatever the RMD that was missed, and take the makeup distribution immediately. Then, of course, take you regular distribution for the year so you stay on track. And then you report that on what's called Form 5329. It's a tax form where you report the 50% penalty. You tell IRS this was my required amount, this is how much I didn't take, how much I was short, but you don't pay the penalty. Years ago you had to pay and then ask for an abatement …
Benz: Ask for it back. You just show zero, but you must attach a statement saying two thing: number one, that I made up the shortfall, you have to show good faith that whatever I missed, I took immediately upon discovery. Then give a short explanation of why, and IRS waives the penalty in almost every case. They know they are talking about seniors, people over 70 1/2, they got confused, they had a medical issue, a death in the family, bad information from a bank or financial advisor. You just put whatever reason it was and take the missed--well you have already taken the missed distribution--and file that form with your regular tax return.
Benz: There is some leniency, would you say, in terms of getting these penalties waived?
Slott: Oh, yeah. Almost everybody gets the penalties waived. I can't even think of somebody I have ever seen declined. I have seen one case, and it was an oddball case because they didn't understand the rules and they actually asked IRS if they would assess the penalty. It's a long story, but don't ever do that.
Benz: In terms of the paper trail that I want to maintain to try to keep my taxes clear and straight, what should I do in terms of--I'm addressing this missed RMD, but then I also have another RMD coming due for this year ahead. How do I handle that?
Slott: There is no requirement. But what I do on a practical level, I tell people take separate distributions. Take the makeup distribution separately, so it can be better traced if it's ever a question--there is that one. You could mix it in with your current one, but then somebody would have to figure out, well, did they just take too much of the current one and not the other one. Separate them. Take the missed distribution separately and the current one separately so they can be traced.
Benz: Then in terms of avoiding this problem altogether, do you have any tips on that front of things that people who are subject to RMDs can do to avoid falling into this trap?
Slott: First thing, in the beginning of the year, take an inventory of every retirement account you have subject to required minimum distributions. It might be a first year, so you just turned 70 1/2 and you didn't know, or maybe you have that old 401(k) or a 403(b)--you should have an inventory of all the RMDs. That includes if you are a beneficiary. Remember this 50% penalty also applies to beneficiaries. So if you just inherited, you have a required minimum distribution probably starting in the year after you inherited. You should know all the accounts that are subject to RMDs.
But before you take them, going back to something we've talked about on other programs, if you're going to do the qualified charitable distribution, which applies to IRA owners over 70 1/2, do that at the beginning of the year so it can offset the income from your required minimum distribution, because the first dollars out are deemed to satisfy your required minimum distribution.
Benz: Ed, useful discussion. I know this problem crops up for some retirees. Thank you so much for being here.
Slott: Thanks, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Aron Szaprio: As the shutdown stretches into its fourth week, I've been getting a lot of questions about whether anything has changed. I wrote a column earlier in the shutdown explaining that we've got a lot of experience with these, and longer ones of course slightly ding the economy. But the big story is that shutdowns are really a lagging indicator of governmental dysfunction and a leading indicator that it will be hard for Congress to accomplish much going forward.
Shutdowns have been a regular feature of American government ever since Congress set up the modern appropriations process way back in 1974. If I can paraphrase "Casablanca": This is just like any other shutdown, only moreso.
The window for this Congress to pass bipartisan legislation that could help ordinary investors was always going to be pretty limited, given the realities of divided government. These efforts might have included cleaning up the tax bill to fix technical errors, making it easier for 401(k) savers to access guaranteed income, or adjusting required minimum distributions—to name a few things Congress is pursuing. Obviously, this shutdown makes doing any of those things more difficult.
This shutdown also raises some questions about Congress' ability to deal with something even more important for ordinary investors and potentially the entire U.S. economy: the debt ceiling. The media often conflates shutdowns and the debt ceiling, but they are very different, and I want to explain that. The shutdown simply means Congress has not appropriated funds to keep federal agencies running. In contrast, failing to raise the debit limit could lead to a financial catastrophe--that's not my analysis, that's the official line form the U.S. Treasury Department, U.S. Government Accountability Office, and basically every other expert who has looked at the U.S. defaulting on its obligations.
So coming back to the shutdown and investing, after March 1, the government will need to take "extraordinary measures" to avoid defaulting, and those measures will last for a few months. Ordinary investors should be aware that in 2013, the last time it looked as though Congress might not raise the limit, the market avoided Treasury securities that matured around the dates when the government projected it would exhaust the extraordinary measures.
So, looking ahead, ordinary investors shouldn't be surprised if we see an increase in rates and a decline in liquidity if it looks like the debt ceiling fight is going to be dramatic again. The current state of the shutdown may presage such drama.
In terms of when this might end, no one knows for sure. But there is an unusual dynamic that is not that encouraging. Previous shutdowns have been due to Congress adding riders to appropriations bills the president deemed unacceptable. The president then has an incentive to make the shutdown hard for ordinary Americans, to push for an end to the impasse. This shutdown is reversed: The president wants the policy riders, and he has an incentive to make the shutdown as painless as possible by taking a broad view of what government can do. For example the president has tried to keep parks open and has said he will try to send tax refunds during a shutdown. That may mean things go on for longer than they otherwise would have.
For Morningstar, I'm Aron Szapiro.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The turning of the calendar page provides an opportunity to reassess your portfolio. Joining me to discuss a few investment themes that could be worthy of further research is Russ Kinnel. He is director of manager research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Glad to be here.
Benz: Russ, in the most recent issue of Morningstar FundInvestor you looked at some investment ideas, some themes to investigate in 2019. But before we get into that, let's just talk about 2018. It was not a great year for stock or bond investors, right?
Kinnel: That's right. Just about everything was in the red. Bonds were about flat, but equities lost between 5% and 20% depending on what area you were invested in. Definitely, a really volatile year and certainly could have really altered your portfolio mix.
Benz: You do think that as investors are sort of looking at their portfolios, surveying the damage, it's time to take a look at that baseline asset allocation, see where you stand relative to your goals, relative to your spending horizon.
Kinnel: Exactly. I think the main thing you want to think about is making sure you are still on your plan and making whatever changes are needed to get back on that plan. Because obviously when you have some big moves, that can change your portfolio mix.
Benz: One area that you highlighted in the most recent issue of FundInvestor was the small-value space. It's an area where even if investors haven't been actively pulling away from it, their positions there have probably shrunk. Let's talk about what's going on with that category.
Kinnel: Small-value is an area that just keeps underperforming for a number of years, and usually that's a trend that reverses very nicely and you then have a multiyear rally in small-value or at least outperformance. There's certainly a lot of potential positives and you can see some reasons why if you think about large-growth doing well, well some of the FAANGs are eating some of those small-value companies' lunch. It's tough to compete with the Googles and Amazons of the world, but not all of small-value companies are in their target area and some of that sell-off may be overdone.
Benz: You highlighted a few funds that you like in this space, and I'd like to talk about a couple of them. One of them, I think, will probably be familiar to people who have watched you talk about the small-value space, Royce Special Equity. Let's talk about what you like about it. It's Silver-rated, very long-tenured, senior manager on the fund. Let's talk about what's to like about it.
Kinnel: I really like Charlie Dreifus and his approach that really focuses on accounting and quality balance sheets. It's a strategy that leads them into good, relatively safe names, and in downturns it really stands out nicely. If you look at the long-term record of Dreifus, he has got a very strong record, and a lot of that is built in losing less in downturns because of that emphasis on accounting. I think it's a little different from anything you see anywhere else. And again, when I look for a fund, I want a competitive advantage and I think this fund has a genuine competitive advantage.
Benz: It has a comanager now. So, Charlie Dreifus is not flying this fund solo. He has been on the fund for a number of years, but he has a comanager.
Kinnel: That's right. No retirement date has been announced for Charlie, but obviously the successor is there, someone who really buys into Dreifus' way of investing. We feel pretty good about where the fund is going.
Benz: Another small-value fund you like, also Silver-rated, might be a little bit less familiar, LSV Small Cap Value. Let's talk about that one.
Kinnel: Right. Fairly different fund. This is a quantitative fund. LSV is a shop that has an academic grounding, lots of Ph.D.s and quants running their funds. It's a quantitative fund looking for good value names, good companies that are slightly beaten down. If you look at their long-term record, they have done a very good job across the board at their funds, and we just like that academic grounding and the fact that they are always willing to update their models but at the same time they don't drastically overhaul. It doesn't feel like the momentum version of a quant fund. We think that they are really well-designed funds.
Benz: Another theme that you hit on--and this might seem a little perhaps counterintuitive because investors are really moving away from active managers in general and to the extent that they have active managers, they tend to want the very seasoned ones--but you actually say that rising-star managers are people to take a look at or funds to take a look at. Why is that?
Kinnel: Well, I think, if you find a manager who has got some experience but not, say, 30 years, you've got someone who may have a very long runway. They may have a lot of years ahead of them of doing well, and yet, many of these funds are ones that are not that big. You really kind of have potentially a sweet spot of a manager who is really hitting their stride but is not overwhelmed with assets. That's really the ideal, to get to these funds a little ahead of the curve. I think it's worth paying attention to funds. Not that I would avoid the seasoned managers. Obviously, I like Charlie Dreifus, who's got a very long track record. But I think some of these managers are worth investigating, putting on your watchlist.
Benz: You did compile a more detailed watchlist in FundInvestor, but let's talk about a couple of ones that you especially like. One is Vincent Montemaggiore at Fidelity Overseas. Let's talk about that one.
Kinnel: He is a very interesting investor at Fidelity. He has kind of got a Buffett influence and you see that emphasis on high-quality moats, a little willingness to pay up. He fits in the foreign large growth, though there's a lot of large blend names in the portfolio, too. But just a very thoughtful investor who really thinks long term and has built a good record yet hasn't gotten overwhelmed with assets yet. We raised that to Silver not too long ago, and we really have a high opinion of Montemaggiore.
Benz: How are you feeling about managerial stability at Fidelity funds these days? Have they stabilized, would you say? Or what's your view?
Kinnel: Much more so. So, say, versus 10 years ago, where you had musical chairs, but also a lot of people leaving the firm, we really haven't seen that in recent years. It's been much more stability and better handling of manager transitions. We feel a lot better about them. I wouldn't yet put them maybe at the top of the list of stability, but they have improved a lot.
Benz: Another fund you like also, a foreign stock fund, this is T. Rowe Price International Concentrated Equity run by Federico Santilli. Let's talk about that one.
Kinnel: This is a fund that's got about a four-year record on the retail version, about an eight-year record on the institutional. So, we got a little more to go on than you'd see on the retail version. But he has built a really good record with a concentrated strategy. Of course, because it's T. Rowe, it's only kind of concentrated.
Benz: Well, that's what I was going to ask. I don't usually think of them as a concentrated fund shop.
Kinnel: Right. This is not like a Bill Nygren or Sequoia. They have got 60 names, but the top holding isn't even 3%. So, it's not that bold. You are not living or dying on a couple of stocks. But again, a good strategy. Kind of like Montemaggiore's in that they are looking for good companies with competitive advantages trading at a reasonable price, but a little more of value tilt. This fund is in the blend category. It's got a big emphasis on Europe, in particular. You see overweights to German and Swiss companies. A pretty distinctive strategy from T. Rowe Price. But again, I think this is one that's still under people's radar.
Benz: Russ, some interesting themes and some interesting funds. Thank you so much for being here.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Susan Dziubinski: Small-cap stocks have plenty going for them. They can add diversification to a portfolio and offer greater potential return than large-cap stocks albeit with some additional risk. Here to discuss the three highest-rated small-cap ETFs that Morningstar analysts cover is Adam McCullough. He is an analyst in our manager research group focusing on passive strategies.
Adam, thank you for joining us today.
Adam McCullough: Happy to be here today, Susan.
Dziubinski: Now, all three of the funds that we are going to talk about today track well-constructed investable indexes, and they are inexpensive to boot. The three funds do have some differences. The first one is Schwab U.S. Small-Cap ETF.
McCullough: You are right, Susan. Each of these funds do something a little bit different to dampen the impact of trading costs among the small-cap indexes. The first fund is Schwab U.S. Small-Cap ETF. What this fund does, it tracks one of the Dow Jones small-cap indexes, and it uses buffering rules so that it doesn't trade stocks unnecessarily on its reconstitution dates. If a stock graduates to the mid-cap level, it won't trade it into the mid-cap, then out of the mid-cap, then into the mid-cap if it's on the edge. It will wait until it's fully in that mid-cap range before trading.
You get the exposure that you want in small-cap stocks without unnecessarily trading names as they go between different buckets. And so, this fund also charges 5 basis points per year, so it's cheap. Over the past three years through December 2018, it's actually outpaced its benchmark by 2 basis points per year. That kind of shows, one, that it's mitigating the impact of transaction costs, and two, might have some help with securities-lending income that offsets some of the fees that it charges.
Dziubinski: Another one of our Gold-rated ETFs is Vanguard Small-Cap ETF. How is this one a little bit different?
McCullough: The Vanguard fund is a little bit different in that it tracks the CRSP Small Cap Index. So, again, it's looking for small-cap stocks. But the CRSP indexes were built to be investable. Maybe the first generation of indexes were more benchmarks, you know, how is your fund performing. The CRSP suite of indexes is made for investment. What this fund does beyond buffering rules is it actually will spread out trading over five days. So, when the mix changes, instead of trading all the stocks on one day-so buying a bunch of names, selling a bunch of names--it trades that over five days in a week. That will break the impact of the trades by one-fifth because it's trading one over five days.
And the second thing that it does is it uses a technique called packeting. What this means is, when a stock graduates to the mid-cap bucket, instead of moving everything at once, once it does get fully into that bucket, it will move half of the position. It will move half the position, wait till the next reconstitution; if the stock is still squarely in the mid-cap range, it will move the other half. So, that also breaks the trading in half and so it lowers the market impact cost as well. This fund is rated Gold as you mentioned. It charges 5 basis points per year. Over the past three years through December 2018, it's also topped its benchmark by 2 basis points.
Dziubinski: And our last Gold-rated small-cap ETF is iShares Core S&P Small-Cap ETF. And this one has a market cap that seems to fall somewhere between the other two funds that we've talked about so far.
McCullough: That's right. The iShares Core S&P Small-Cap ETF does fall between those other two funds based on its average market cap. But this fund also uses a little different of a technique to avoid forecasting its trades in the market. While the first two funds follow strict reconstitution schedules, the S&P Small Cap 600 Index is actually run by a committee. It doesn't have a prescheduled reconstitution day and the committee members can actually decide when to add or remove names from the index. You can't forecast out, this is the June reconstitution; it looks like these stocks might graduate to the mid-cap index and will be sold out of this index. They can say, you know what, now it's time to reconstitute, we're going to go ahead and do that. And so, by not forecasting the trades, it lowers the transaction costs for funds such as this fund that track the index.
And this fund is also cheap. It charges 7 basis points per year. It's actually not outpaced its index, unlike the other two funds. It's lagged by 1 basis point over three years, but still very small.
Dziubinski: These all sound like great options for investors. Adam, thank you for your insights today.
Dziubinski: I'm Susan Dziubinski for Morningstar.com. Thank you for watching.
Christine Benz: Hi, I'm Christine Benz from Morningstar.com. How can investors build a solid foundation for their portfolios? Joining me via Skype to discuss that topic is Alex Bryan, he's director of passive research strategies for Morningstar in North America.
Alex, thank you so much for being here.
Alex Bryan: Thank you for having me.
Benz: You dedicated the most recent issue of Morningstar ETFInvestor to the topic of building a strong foundation for investor's portfolios, and you emphasized the importance of asset allocation--deciding what is an appropriate stock, bond, cash mix for you given your life stage. You say that investors spend a lot more time on security selection but ultimately asset allocation is more impactful. How do you know that? What does the research say about that topic?
Bryan: That's a great question. Imagine you had a portfolio that was allocated 40% to U.S. stocks, 20% to international stocks, and 40% to bonds. If you had perfect foresight and could somehow identify the managers that would have gone on to land in the top 5% of their respective Morningstar categories in each of those areas, you would have had a return of about 7.6% over the last 15 years through November. Now if you had instead decided to build that allocation with broad market-cap-weighted indexes your return would have been about 6.8%. So achieving that type of success with manager selection is very difficult, and as you can see from that example the return benefit is relatively modest.
But if I had instead decided to shift the asset allocation from 60% in stocks to 90% in stocks, the return on the portfolio would have climbed from 6.8% to 8%. So shifting the asset allocation has a much bigger impact on your overall portfolio's risk and its returns. That makes sense because stocks and bonds performed quite differently, so how much you decide to allocate to each bucket's going to have a much bigger impact on your overall performance than manager selection within each of those categories.
Benz: I know that's it's one thing that investors really struggle with--this idea of finding an appropriate asset allocation. I hear from a lot of investors that it seems quite black boxy to them. Do you have any thoughts on what factors investors should home in on, when they are trying to think about setting their asset allocation what should they prioritize?
Bryan: I think while we talk about a lot about returns, and that certainly draws our attention, I think more than anything else it's really important to allow your ability and willingness to take risk really dictate what type of asset allocation you have. It's important not to take more risk than you are comfortable with because if you do that you might experience losses that you are not prepared to handle. It can make it more difficult to stay invested through the markets rough patches, which will inevitably happen over time.
Benz: How do investors take their own personal situations and customize that to arrive at some sort of an appropriate asset allocation plan?
Bryan: One of the first things you should do to figure out how much risk you should take is identify the time period for which you have your investment. If I don’t need the money for a long period of time, I can afford to take greater risk with my money, because the risk of losing money actually goes down the longer your investment horizon is. Stocks have a better shot of earning a positive return the longer that you hold them. If I have a really big objective that I need to meet--let's say I am making down payment on a house in the next year or so--I probably shouldn’t allocate a lot of my money to stocks, but there's a good shot I could lose money over a short window of time. The longer your investment horizon the more risk you can take. So it's important to keep that in mind.
It's also important to understand your own willingness to take risk. If you are not comfortable with the prospect of losing money, it's probably not a good idea to allocate a big part of your portfolio to stocks. You need to have a balanced allocation that lets you sleep at night and something that you can stick with over the long term.
Benz: Assuming someone has taken those steps and identified an appropriate asset allocation mix, the next step is to populate that portfolio with some good core building blocks. Are there any categories that you would suggest investors focus on, any investment types that you would suggest that they tend to favor at the expense of others?
Bryan: The most important thing to keep in mind for identifying core investments--these are funds that should be broadly diversified, that should be very low cost, and they should be holdings that you can stick with regardless of what's happening in the market. The types of Morningstar categories that you might look for a core holding in would be the Morningstar large-blend category. This is typically going to be your broadest bucket of stocks; it includes large-cap stocks across the value-growth-style spectrum. You'd also want to look for your exposure to international stocks within the Morningstar foreign large-blend category. Then as far as bonds go it's good to look within the intermediate-term bond category which focuses on U.S. investment grade bonds.
Typically within each of those categories I would want to look for funds that are broadly diversified and funds that are among the lowest cost options within each of those categories. Because over time these are one of the best predicators of fund performance--the less you pay the better your odds are of achieving better returns.
Benz: What you've just talked about, I think, naturally would lead investors to favor perhaps some core-type passively managed funds. Can you talk about some of your favorite funds within each of those categories?
Bryan: As you mentioned these broad index funds are a good starting point; certainly not the only type of fund that would be suitable as its core holding. But I think if you are looking for a good place to start, one of the better options is the Vanguard Total Stock Market ETF, the ticker is VTI. This fund basically owns all U.S. stocks, and then it weights them based on their relative market capitalization. Effectively what this is doing is it's owning the market portfolio, harnessing all investors' collective wisdom, and it's delivering that exposure at a very, very low fee. That low fee allows investors to keep more of their money. This one has a good shot of outperforming relative to its actively managed peers because it charges considerably less. It's also a very tax-efficient option, low turnover, it hasn't made any capital gains distributions over its life. I think this is a really good core option for exposure to U.S. stocks.
If you are looking for exposure to international stocks, the Vanguard Total International Stock ETF, ticker VXUS, is a really great option. It again owns most stocks listed outside the U.S., both foreign developed and emerging-markets stocks and then weights them according to their market capitalization. This is also a very low cost fund that has been very tax efficient. I think it's a good complement to that U.S. stock fund.
Then as for fixed-income exposure, Vanguard Total Bond Market ETF, ticker BND, is a really good option. This fund basically provides broad exposure to the U.S. investment-grade bond market. So it owns Treasuries, corporate bonds, mortgage-backed securities, and it weights each of those bonds according to its market value. It does tend to tilt pretty heavily toward pretty conservative U.S. Treasuries and agency mortgage-backed securities. But that actually makes this a pretty good complement to stocks because those more highly rated conservative bonds tend to provide good downside protection. So in periods when the stock market is selling off this can provide a nice counterbalance to stocks and serve as the defense within your portfolio.
I think between these three funds--the Vanguard Total Stock Market Fund for U.S. stocks; Vanguard Total International Fund; and the Vanguard Total Bond Market ETF--I think these can help you build a really solid core portfolio that you could stick with through thick and thin.
Benz: Great recommendations, Alex. Thank you so much for being here.
Bryan: Thank you for having me.
Benz: Thanks for watching I'm Christine Benz from Morningstar.com.
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