MIIC Exclusive: Top Picks for Income and Growth

Jeremy Glaser: Good afternoon. I am Jeremy Glaser and welcome to our final panel, "Best Ideas for Income and Growth." Before we get started, just a few quick housekeeping notes. If you haven't already turned off your cell phones or other electronic devices, now would be a great time to do this, and also we will be taking questions at the end of the panel, leaving plenty of time. So if you're in-house, please think of some questions, and we will have people with microphones to take them. If you are watching us online, click Ask a Question, and we are moderating them. We will be sure to get to a lot of those, as well.

Without further ado, I'd like to introduce our panelists today. I'll start off with Scott Burns; he is the head of our exchange-traded fund, closed-end fund, and other traded products research. Russ Kinnel is the director of mutual fund research and editor of Morningstar FundInvestor. Paul Larson is an equities strategist and editor of Morningstar StockInvestor. And Josh Peter is our dividend strategist and the editor of Morningstar DividendInvestor. Gentlemen, thanks so much for joining me today.

So Josh, I am actually going to start with you. Dividends have been a big topic of conversation all day today. But they are difficult to find; it's hard to find really good yielding stocks right now. Why is that? Are dividend stocks just too expensive today?

Josh Peters: I think there is a certain scarcity premium associated with them right now. I mean, the yield on the stock market as a whole right now is about 2%. That's better than the 1% you had back in the dot-com bubble era. That's improved somewhat, but historically, it's still very low. It was interesting this morning before coming in, I took a quick peek at Barron's and it turned out their cover story was all about the search for yield and it talked about how many more companies should be paying larger dividends.

And there was one quote in there, I think from a technology sector analyst, and he described dividend-paying stocks, higher-yielding stocks as being almost their own asset class. I think that's actually a pretty sharp observation. They are not entirely like the rest of the stock market with the absence of yield. They are not the bond market obviously because they don't have that fixed-income perspective. So you are talking about a pretty small piece of overlap there, and there's not a lot of income to go around. I mean, you put all of the companies in the S&P 500 together. There's maybe $250 billion worth of income. It's about $15 trillion market. It's just very tough. So the companies that are providing a lot of stability, that are providing those relatively high current yields tend to be pretty fairly to fully priced in this kind of environment. I think you can still do well, but you certainly can't go in looking for bargains like you could have a couple of years ago.

Glaser: So is there nothing to buy or are there dividend-paying stocks that you load up on today?

Peters: It depends on your time horizon. I don't think it's too late. I don't think that dividends are a bandwagon. I don't think they're a fad. Certainly, if interest rates go up, the economy takes off, or the market goes into another big speculative phase, we could see dividend payers underperform on a relative basis. But I think unless we're talking about severe overvaluation, and I really don't think we're there yet and may never get there in fact, the idea of buying fairly priced high-yielding stocks is really not that bad. It's more about the investor than the investment; what are you trying to accomplish? And what I do in DividendInvestor for the two model portfolios is, say, I can't make the stocks go up. I can't control the market value at any point in time. I'm putting together a stream of income. If I have $100,000 I can build the stream of income say $4,000 or $4,500 a year. Then the question is, secure that, and grow it as fast as possible.

If I can accomplish those things and then I have got something that's behaving in an almost an annuitylike fashion, throwing off a growing stream of cash flow, I don't have to worry so much about what the market is going to do. You really, I think, need to have that mind-set. You need to think in terms of the income being your reward, how you measure your performance, what you use for your returns, and have that long-term time horizon. Now couple of years ago you could have just said they are cheap, like everything was cheap. That's not really the case today. So it's a more nuanced question but one I think that still leaves some success out there for people.

W. Scott Burns: You know, Jeremy, to Josh's point about how we've really seen that yield compress in the United States, outside the U.S, I think there are a lot more attractive yields out there. And there are various pockets of risk when you look, especially in the European space, but the dividend yield on the international or MSCI EAFE space is about 1.5-2 percentage points higher than what the S&P 500 is offering right on aggregate. So, we are starting to see flows around that in the ETF space, as well as when you asked the question, "Are there any good dividends out there to buy?" I think there are. But they are just not in that usual backyard that people are playing in.

Glaser: So those are going to be hard to get to. What funds out there are looking at international dividends? How can investors get a hold of those?

Burns: Well, on the ETF side, one of our favorites is the WisdomTree International, I may be mangling the name a little bit, International Dividend fund, and the ticker on that is DEFA. That's one of our favorites. There's also another WisdomTree product that does emerging-markets small-cap dividends. We really like that fund because when you're looking at emerging markets right now, the composition of those indexes have large-market-cap companies like Petrobras or China Mobile. That's the same as buying an Exxon or a Verizon in a lot of ways, and you are not really getting access to that growing emerging-markets gross domestic product story out there. So, ticker on that is DGS. It's something that we've owned in our portfolios for a while in Morningstar ETF Investor. So, on the ETF side, there are a couple of very low-cost passive, but dividend-skewing funds out there that we like.

Russ Kinnel: I would add, a couple of actively managed foreign dividend plays. One is Matthews Asian Growth and Income. Again, like Scott says, having dividends in an emerging-markets fund tends to moderate the risk a little, but it's still risky for sure. Another one we like is a Tweedy, Browne Worldwide High Dividend Yield. That's TBHDX. That's more global, but again I think, as Scott mentioned, overseas there are little better dividends to be had out there.

Glaser: Sure.

Burns: I think when you look overseas, too, especially in some of the emerging markets, the culture around dividends is a lot different than in the U.S. I think Josh has railed on this for a lot of years that companies should pay more dividends. In emerging markets, investors there want that capital back, and it's much more pronounced. The payout ratios at firms are a lot larger as well as the ability to find dividends across the spectrum. So you do see some of those, kind of, intermarket differences when it comes to commitment to dividend.

Glaser: Paul, I know that you've looked at other income-producing equities such as master limited partnerships before. Can you talk to us a little bit about that space and if it looks attractively priced today?

Paul Larson: Sure. I own a number of MLPs in the StockInvestor portfolio, as does Josh in DividendInvestor. The one that's looking attractive to me right now is one called Energy Transfer Equity, ticker ETE. This is an MLP that actually owns the general partner of a couple of other MLPs. The yield is close to 6% right now. It has very modest expectations right now regarding distribution growth from this point forward because it is in the midst of a merger, and the firm has raised that distribution trying to entice the other shareholders of a company called Southern Union. So there's probably not going to be any distribution growth for probably a good year.

But after Southern Union is integrated, I expect this firm to continue to raise its distributions. Again, while we're waiting, we're getting a nice 6% yield. Another relatively high-yielding stock that I own, that Josh does not, is a utility or technically a utility. In reality, it's more of a wholesaler. But it's Exelon, ticker EXC. This one has a yield slightly in excess of 5%. It's the only wide-moat firm in the utilities sector that we have. It's the largest nuclear plant operator here in the country. Our fair value estimate there is about $58 and the stock is trading near $40 today.

Peters: I think I've got to throw out a couple ideas, too, since everybody has been going down the line. As I said earlier, there are not a whole lot of high-yielding stocks that are real bargains, but there are a few that I think do still stand out as being more attractive in this environment than others. One is General Electric, a name that's certainly for many, many years disappointed a lot of investors. This was a $60 stock 12 years ago; today it's about $19. The dividend was cut during the crash because of some of the problems that they had at their financial-services operations, but I think the turnaround has really been quite dramatic for GE. The industrial side of the business is doing well, and it's getting more emphasis, it's getting more attention on the part of management, it's getting a greater allocation of GE's capital. Those are all pluses.

The turn in the financial-services operations could hardly be more dramatic from a balance sheet that was much more highly leveraged and frankly illiquid to one now that is very, very strong in terms of the capital and a liquidity position. And it's continuing to shrink, and it's growing earnings as it's shrinking because it's doing more with the capital it has left. That stock right now yields about 3.6% to 3.7%. I think you're going to see double-digit dividend growth for another couple of years as the management really tries to bring that dividend back. I think they feel very bad and very put upon about having had to cut the dividend, and that's going to remain a top priority for them going forward.

The other company is National Grid, which is a transatlantic utility about 60-40 split between the United Kingdom and the United States. ADRs trade here under the symbol NGG. It yields around 6% right now. The dividend is paid in British pounds, so there is some currency exposure there. But it's very cheap, especially compared with regulated utilities in United States. You have got a big regulatory rate review going on in the U.K. operations, but in those, we are expecting favorable outcomes and expect that the dividend will be able to continue growing, at least as fast as inflation, even under kind of a muted response from regulators. So, potentially it's 5%-6% a year, going forward. Over the last couple of years, dividends have been growing 8% a year, which shows very good metrics for a regulated utility.

So that's one that I think would be well worth considering, as well.

Burns: On the GE call there, I think the fact that they have been able to generate that kind of income growth in the current economic conditions, I don't think you give enough credit in that pick there to the call option that you kind of have on an economic turnaround with that. I think they have been able to kind of slog through this, but aircraft orders are down as well as power plant generation. The firm has all these things that even the slightest economic uptick is going to be just a real boon for that firm right now. So I love that pick.

Peters: That's one of the tougher things to do. I mean, you start thinking in terms of relative performance or just how do I make money from some rebound in the economy at some point, you are not going to get it from a packaged-food company. You are not going to get it from Southern or a traditional regulated utility. You are not going to get it from Johnson and Johnson. You can get it from GE. But I think there was a big takeaway Jan. 20 in that, their earnings report seemed disappointing initially, before the market opened the stock was down I think 3%-4%. The stock closed unchanged on the day, all of a sudden. Well, this doesn't need to be so dramatic about a penny a share over or under on the quarterly earnings. Look at that yield, look at how they are growing the dividend. Four dividend increases in the last two years. That's the priority of management. I think people are now finally starting to understand, GE is a dividend company with an economic upside and a good valuation. It's not the old drama about they have to beat earnings every quarter or somehow it's going to be a disaster.

Glaser: So this is certainly an interesting point of this tension of "Do you have to choose between getting current income or getting future growth?" Can you find a mix between those? And if so, what would be some good ways to find that in the marketplace today?

Peters: GE's one of the best.

Burns: I think, when you think about sectors, utilities are going to give you that dividend, but right now our analysts aggregate the fair value estimates off the equities team. We're looking at utilities as fairly valued. So there you can use tools from Morningstar to kind of understand that the upside on the capital appreciation isn't going to be there even if the dividend's there. But if you can think that the economy is going to stay sideways for a year or two longer, then getting paid to wait is not a bad idea. I mean, there will be time along the curve to set your portfolio up for that capital appreciation. But, there's a lot of other ways out there like a GE, other stories like that where you can look at the call option to the upside--like if they are muddling along now and things get a lot better--we are talking about a call option on an economic recovery in GE that pays you 3.6%. That is going to be kind of hard to beat I think.

Glaser: So you mentioned that the economy could be going sideways. Where is there growth then? What stocks are out there? What funds are out there that are really trying to capitalize on growth? Is it in emerging markets? Is it in the tech sector in the United States? Where are investors placing their bets and are those bets well-placed?

Kinnel: Really, I don't think there is one particular sector that's a draw. What I particularly like are some of the world-stock funds just because they have that flexibility to look for the best valuations. I already mentioned the Tweedy, Browne fund. I like funds like PIMCO EqS Pathfinder run by two former mutual series managers, ticker PTHDX. I like Artisan Global Value, run by David Samra and Daniel O'Keefe, ticker ARTGX. So I like a world-stock fund just because it's hard to really find the values out there, and you want to give them that flexibility.

Larson: Well, one of the interesting things that I think when you look at the sector valuations, and Scott alluded to this that you can get this data on Morningstar.com, you can look at our median price/fair value ratio by each sector. And we've seen a compression of the ratios where a year ago we saw that health care was quite significantly undervalued, and that is no longer the case. Also, we showed that real estate was quite overvalued. That is no longer the case. Another interesting thing that has happened is a year ago, we were saying the action is with wide-moat stocks. The high-quality stocks are where the best value is. But these days, there's really not a whole lot of difference between wide-moat, narrow-moat, and no-moat stocks. They are all about, if you use this ratio, 7% or 8% undervalued, which is a significant difference than what we saw early in 2011.

Burns: If that's true, then given the moat methodology and the fact you're getting all the same kind of discounts, then large value, which is predominately what the wide-moat areas would look like, would be the most attractive area on a risk/reward basis.

Larson: Exactly. The price/fair value ratio says nothing about uncertainty. So, these wide-moat large stocks are going to be less uncertain all else equal.

Burns: Like you said, I still like the emerging-markets story. I think China is losing a little bit of its luster. What goes up must eventually come down, but I still think there's a tremendous amount of opportunity in Latin America and other parts ofAsia to continue growing. At some point in time, and I think it will be fairly soon, they are going to turn from this predominantly or supermajority export-type situation to where demand for products is going to come internally that the population, that the GDP will rise, and grow with that. So again we like small-cap emerging markets. We think there's a lot of value there and still a lot of potential for growth. I mean you just can look at things like population curves. I think the average age in Brazil is like 22 years old, right, and so you can do the math on that. That puts you in an even better situation than say the U.S. had in the '50s with the baby boom and how that affected demographics.

Glaser: So what are the best ETFs to access in those emerging markets?

Burns: Again, you can go with a direct-country fund that's out there. So we like iShares Brazil, ticker EWZ. Again, there is also small-cap Brazil that you can get out there. I think we're a little less certain about East Asia. I think we're still digging around in there, but I think South Korea is an area that we consistently see kind of bouncing in and out of a nice valuation right there. So those would be two of the areas that we're really looking at where you've got a lot of political stability and got really good demographic trends. And the valuations are seesawing enough that you get good opportunities to get in and get not only that dividend stream but also kind of buy things on that nice valuation dip.

Glaser: Now if we switch our focus a little bit to bonds which is obviously a scenario where a lot investors are also looking for income. There's a huge inflows into bond funds.

Burns: More and more everyday it seems.

Glaser: Yeah and certainly it's an area people are putting money and hoping for good returns. Are those hopes justified? Are bond investors during the next 10 years going to see the kind of experience they had during the last 10 years? Or are they in for a rude awakening.

Peters: Is that mathematically impossible?

Burns: Never say never. I was on a panel once, and someone said, "It's not like interest rates can go lower." And I was like, "What? They can go negative. It's been like 10 years in Japan." You can't say never, though it is still unlikely.

Kinnel: GMO had an interesting forecast. They are projecting out the next seven years. For them, most equities are going to be between 6% and 7% annualized return, and almost all bonds around 0%. It's a really sobering thought, and I think you just have to recognize that there's not a lot of potential there in bonds. I think munis are among the more attractive area. If we can just get Meredith Whitney to make another doomsday prediction based on very little fact, we might get another buying opportunity, but she predicted massive defaults. But there were actually very low defaults, much lower than previous years. So I still think municipal bonds are a pretty good investment, but obviously they are not real exciting. Fidelity and Vanguard are hands-down the best places to go for munis. They're low-cost portfolios with very good management. So, I think that's one of the few areas that's relatively attractive, but even there I don't know that we are going to see a performance as good as the last 10 years.

Glaser: I guess, we can hope a 60 Minutes producer is watching today, but when you're looking at your core bond exposure, certainly, even if bond returns aren't going to look great, it's still an important part of the portfolio, particularly for retirees, where it can be a very large part of the portfolio. Where does it make sense to have the money? What are some of the best core bond funds?

Kinnel: Well, I like Dodge & Cox income because it's got a fair amount in corporate bonds. I think good old PIMCO Total Return or Harbor Bond are still very good funds. Obviously manager Bill Gross made a pretty bad call. People have asked, "Well, is that because it's too big?" And I think well he was wrong. So whether he was small or really big, it doesn't really matter if you are just really wrong. So I think it had to much more to do with the fact that it's tough to make those macro forecasts. He is right pretty often but not every time. But I still think it's a good investment; Harbor Bond is usually more attractive for retail investors.

Glaser: Scott, I know there has been a proliferation of exchange-traded bond products. Do any of those stand out for you?

Burns: To follow on the muni idea, there is a new set of products out there that are target-date municipal fund ETFs from iShares. What's interesting about these is that, I think there are going to be a lot of folks who are looking to do traditional things like bond laddering and stuff like that. And these funds will buy that basket of bonds, but it will mature, say in 2015, 2016, or 2017. So for low cost, I think credit is going to become very important in the muni space, which means diversification. So if your choice is an individual muni-bond type laddering product versus these, I think these win hands down. The cost is low enough.

The other benefit, and why I had mention that is so people look at these, is that, traditional bond funds have a lot of turnover. Things mature, and then they have to come out. That transaction friction in a world where you are looking at 5% Treasury rates, is often overwhelmed by that yield that you are getting. But in this low-return world, that kind of transaction friction, in a bond fund, that kind of 300% turnover, 1,000% turnover is going to take, I think, a huge chunk out of whatever yields are there and whatever returns are. So the nice thing, you know, the way these ETF products are structured, is they buy their basket and then when it matures, you can roll it into a new one. So you actually hold the bonds all the way to maturity, and therefore you don't collect any of that turnover, kind of transaction friction.

The other area we're finding very interesting is, again, in emerging-markets bonds and Asian debt out there. I think with a lot of international-bond funds the problem is that they own a lot of European bonds and that is becoming a dicier and more uncertain proposition. But the yields that we're getting from emerging-markets debt right now are tremendous. They are good 300 percentage points over what the Treasury equivalents would be. They're basically priced like junk bonds, exceptBrazil's balance sheet is clearly not junk, right?

So you will have currency risk if you look at some of these products, and if you think the U.S. dollar is overvalued then its currency opportunity, right? If you don't or you don't know, then it's uncertainty. But you're getting a great yield. I think the balance sheets on most of these emerging-markets countries are better than what we're looking at the U.S., and better than the balance sheet in Europe for certain. So there is a great opportunity there. Again, WisdomTree has a product in emerging-markets debt, so ELD would be the ticker on that one. It sounds like I'm mentioning WisdomTree a lot. They've done a lot of work in the emerging-markets space both in fixed income and equities. So for that they get mentioned.

Glaser: So before we jump into questions from the audience, I have one last one about what's keeping you up at night and what have you bought to try to make yourself sleep a little bit easier for 2012?

Burns: Well, my 15-month old is teething, so that's what usually keeps me up at night.

Larson: I know what keeps me up at night is Europe, and I think we have a real tug-of-war right now where if you look at the economic data that we have here in the United States, it's fairly obvious that we have a relatively strong recovery that is starting to gain steam. But I do worry about Europe kind of upsetting that entire applecart, some sort of credit crisis coming from default contagion emanating fromGreece and then to the other so-called PIIGS countries (Portugal, Italy, Ireland,Greece, and Spain). That's what I worry about.

Burns: I think that's a really interesting situation going on around here, and the media asks me all the time "Why is there so much volatility? Is it because of the ETFs?" To which we say "No." But I think when you look at the volatility that's out there and the source of it is Europe, I mean don't you guys feel like when you look at Europe you almost need a political science degree in addition to all your investing expertise?

Peters: I don't think that would help. There's nothing scientific about politics that's going on there.

Burns: At least be able to handicap policy and things like that, and I think that's the real challenge and why there's so much volatility. You have financial analysts out there trying to decide will the troubled countries default. Will German chancellor Angela Merkel and Germany approve the next bailout? And so we're getting these huge swings because people who are used to estimating future cash flows or looking at credit risk and things like that are now all of a sudden having to bring in European parliamentary procedures. And there's just no way for people in the finance world to handicap that.

Glaser: You thought no one would care about the Slovakian Parliament.

Burns: Right, all of a sudden, where was that in your cash flow model, right?

Kinnel: To me that is, again, part of appeal of a world-stock fund is that Europeand emerging markets have kind of flipped. Europe is now the high-risk, high-reward area, and emerging markets are a lower-risk, a little lower-reward. And Europe if actually for a change were to be a little less of a mess and do a little better job of resolving its problems, then it's priced in. Right now the stocks are really attractive. So there's certainly some potential there for really nice returns, but obviously there's also massive risk.

Glaser: So Europe is the biggest worry for everyone?

Burns: Yeah, I mean I would say Operation Twist is worrisome, as well, to the extent that the Federal Reserve keeps the rates as low as they are doing and has that curve. I think when you look at the fund flows and the amount of money that's been really piling into Treasuries whether people know it or not, especially the short end, the decision to unwind that could have some dramatic consequences. I mean, short-term Treasury rates going from zero to 50 basis points isn't a lot on any single invested dollar, but I think for the aggregate amount of dollars, that could have some serious potential ramifications enough through the financial system.

Glaser: There should be some folks with microphones. We'll be able to take your questions if you just want to raise your hand. I'll start with one from online. We have a question from John Adams, who is wondering about convertible bonds. That's an asset class. Do any of you think about it? Do you have any picks in that space, or do you think it's an area to avoid?

Kinnel: Well, a fund I'll recommend, Vanguard Convertible, ticker VCVSX, is a great play on convertibles. You have to recognize convertibles are kind of like high yield plus equity, and obviously high yield's been bit up quite a bit. So the convertible is not thrilling and you have a bit of exposure there. If the U.S.economy keeps improving, great. If we go back into a recession, you're not going to be happy.

Speaker 1: The PIMCO and Harbor Bond fund have come up a lot today in all these discussions, and a lot of the ones that have been mentioned are run by Bill Gross. He's getting on up there in age, and there has never been any mention as to what his long-term plans are with managing these funds, such as if he's going to be around forever or if he has any plans to bail out at some point. There has never been any mention that I know of about any successorship for the funds that are in place. Do you have any information on that?

Kinnel: Yeah, I don't know that they've necessarily named a successor on the funds. Mohamed El-Erian is co-chief investment officer, and so, I think, in many ways the likely successor could take over a lot of Bill Gross' work. We visit PIMCO pretty regularly and they've built in a lot of really people around Bill Gross. So, we feel really good that there are a lot of very good people behind Bill Gross. Obviously, he has a remarkable touch at managing all that information and turning it into a coherent and savvy way of running funds, and that's not easy. But I think people like Mohamed El-Erian will put it in good shape. One concern we see with PIMCO is they seem to churn a lot of people, so they lose some really talented, really experienced people. But they replace them with a bunch of more really talented, really experienced people. It's kind of unusual. We don't see that a lot. I think it's a tough place to work, but it seems like they've got a lot of good people in place.

Burns: Yeah, we were just out in California in December, and I'm pretty sure he is in better shape than I am. So, I don't think that's an issue.

Peters: It's all that yoga.

Burns: Exactly. We stayed at the hotel where his gym is. So, they said, he was there every day. So we offer due diligence to his workouts.

Glaser: And we have a question over here. Just raise your hand we'll come and bring a microphone to you. I think right here in front row.

Speaker 2: This question goes back again to Bill Gross, who we all keep talking about. And, I get this sinking feeling that he wasn't wrong, but he was early. It affects a lot of things and a question about our long-term debt in the U.S. I mean, right now our debt is 100% of GDP. The biggest drivers of it are entitlements which, there isn't politician in Washington who is fixing it, and I'm not picking on one party or another, it's just the facts politicians don't like taking things away from people. No one has a good way of dealing with that. At what point are we potentially going to become Greece with 100% of GDP? What happens if that happens, and what if the dollar collapses and those sorts of things? So I am just wondering about that because I think you guys are a little easy on U.S. Everybody piles on Europe. I don't think we are any better off. I think we are doing the same things, and like I said, I think Bill Gross is actually right, but for some reason, we are getting a pass right now. But unfortunately, as you guys know, you don't go from a pass to slowly getting warned. It goes from everything's fine to holy you know what, and just what your thoughts on that?

Burns: Here in Chicago we are already Greece in the state of Illinois. So I mean, we have modeled our economy off of that I am assuming.

Peters: There is a huge difference in that. In Europe, the countries don't control the currency. We would have a real problem in this country, if we didn't have the ability to borrow on our own currency and manage that relationship. That it's just a huge difference structurally between the two, and from everything I have been able to read about the Greek economy, I mean, it really is an outlier just in terms of how incompetent its government has been in terms of managing the economy, it's very inflexible with a lot of black-market-type of transactions and gray-market transactions. I don't think that that's the template for where we are going. But the rising debt level in this country is a concern, and it's a fair question. How high do we have to try to turn up the temperature in this situation before the politics will respond and see some sort of affirmative change, that takes us off of the trajectory we are on?

I don't know how long it's going to take to get there, but I think that you have to incorporate some scenarios in terms of taking a toll on economic growth, as the debt burden continues to rise, as well as the possibility for accelerated inflation. So, I don't know which outcome it might be. I mean, look at Japan, their debt/GDP ratio I think might be even higher than Greece's. It's somewhere up in 140%-150% of GDP. But they have their own currency. They still a very productive economy with a lot of inherent advantages, while I think the United States is kind of similar.Japan has been deflating for a long time. So you have to be willing to design your portfolio around that. Here is where we are going to go because you might even have the right problem, but a variety of different outcomes come from that.

Glaser: So talking about inflation, we have a question online from Ken, who is talking a little bit about what happens when rates do start to rise again, maybe in response to higher inflation. What do you do in the fixed-income market? How do you protect yourself against rising rates?

Kinnel: One problem obviously is Treasury Inflation-Protected Securities have now been so bit up that some of that protection is gone, I think bank-loan funds are a good option. You take on greater credit risk, but you have got that markup as interest rates go up. I think having a bit in commodities is another way of protecting way of protecting yourself against inflation, so you put the two together, and you have got some rising-rate protection and some inflation protection. But unfortunately, aren't any great answers, especially with TIPS as bit up as they are.

Burns: The real risk with TIPS is that you get rising rates without a rising Consumer Price Index. So then, the two components of the TIPS return are the interest rate and then the CPI adjustment. So if rates rise, because the Fed has decided to end easing, that will be bad for the interest rate. But if CPI doesn't go up as well, or ratably, you are not going to get that benefit. So, interest rates can move without inflation and so that is a risk and tips right now. So, they will protect you against inflation, but not from other interest-rate-changing monetary policy actions or even a rise in U.S. credit risk to the extent that it doesn't relate back to the CPI, though it presumably would.

Kinnel: One of our favorite bank-loans funds is Fidelity Floating Rate High Income, ticker FFRHX?

Speaker 3: I'd like to sort of combine what I heard in the previous session on diversification with what you're talking about. A lot of your recommendations are outside of the United States. So we're talking about ADRs, and we're talking about being concerned with currency conversions in what you're buying. They are talking about hedge funds that deal in currencies. It seems to me and I could be totally wrong that the more you think about investing outside of the United States, the more you should be concerned and possibly also investing in these currency funds. Does that make sense? I'm not sure I'm saying it correctly, but if I am buying something that's paying me in pounds, then I should be concerned about rates between dollars and pounds. So, should I be thinking about hedging that with a fund that deals in currency?

Burns: Well, you know you can do that one-off, but there are a lot of products out there whether on the active mutual funds side or even the ETFs that are hedged. So you could buy emerging-markets fixed income hedged to the dollar, so that that rate is always the same. Now, historically, when we look at the returns from emerging markets and international, anywhere to from 25% to 35% of that actual return, the outsized return we used to get from emerging markets was actually due to currency effect, right? So when you're thinking about portfolio diversification, part of that element is not only are these securities outside of the U.S. and based on the company's cash flows or fixed income from the non-U.S. portion, but also the currencies are outside of what's in the core of your portfolio, and so that creates that diversification bubble.

So I think a lot of it kind of depends on how you are looking at your portfolio overall. And I do think as the world becomes more global, and I am sure they talked about this in the alternatives panel, what composes the risk of your portfolio is going to need to evolve, even down at the individual investor level. It's not just "What's my equity risk? What's my fixed income risk? Large-cap or small-cap?" It's going to be "What's my duration risk? What's my currency risk? What's the credit risk?" You need to start thinking about those things holistically around the whole portfolio, which is something institutions have been doing for a decade plus now.

Kinnel: I think a little currency diversification is a good thing. Obviously, if you get a lot outside, then it starts become an issue. There are funds like Tweedy, Browne Global Value that hedge their exposure back, but most funds will just take on that foreign currency exposure and won't do much hedging.

Burns: Yeah. I mean with anything in the portfolio, once it starts to overwhelm your portfolio, it's no longer a diversifier, it is the undiversified risk. If you say it went 80% outside the U.S., now, you have an undiversified currency risk.

Glaser: I think we have question up front here.

Speaker 4: Hi. Is there a way to decouple that euro, or is it the disaster that everybody talks about? I mean, how bad a situation is that euro? And I guess my first question is, is there a way to decouple it?

Kinnel: So you're asking can Europe break up the euro? Yeah, that's obviously one of the possibilities. I've seen some estimates that there will be some pretty great economic harm done by that. So that's why Germany is willing to keep cutting these checks, as that bailing out Greece is still a little less pricy than letting the euro break up. So it's a real mess.

Burns: I think the question should be, "should it?" before "could it?" Something I think the media misses a lot, we talk about how there's a lot of political rhetoric about how China is inflating their currency and fixing their currency. Germany's the greatest currency manipulator out there, by keeping the dog's leg Italy and Greecein the euro. The Deutschemark would be 3-to-1 to the dollar. It would destroyGermany's export business. They are keeping those countries in and when you think about holistically, how that would really impact the Germany economy, these checks are pennies, compared with the option of just shutting their entire export-based economy down.

So Germany, the currency manipulator, will keep the euro together whether the public wants it to or not, I think. Frankly, when the euro was created, it was a political construct and not an economic one. So if you and I were to form a partnership, we would put in the bylaws how we would get out. That was never put into the euro. There is no way out. That was specifically done so that everybody was stuck together.

Larson: Yeah, they're building the plane while they're flying it basically.

Burns: On one hand, your concerns are definitely very valid, and you've got parts of the eurozone in trouble. But the eurozone overall is positive GDP. It's still a growth area overall, and they've got these very problemed children in there. In theU.S., we have our own states that have problems. We're sitting in one of them (Illinois) right now. But, because of the union that we have, we can fix that. We don't have to sit there and let the people of New York vote whether or not they want to bailout the people in California. Instead, it's just going to happen.

Glaser: So we've had a number of questions online about preferred shares. Josh, I know it's an area that you've looked at before. Is there any value there? If so, are there any good managed products that maybe can help you access that?

Peters: I think I'm going to hand the second part of the question off to Scott because he's more familiar with some of the ETFs that are in the sector. But I'll start with sort of the overall question. I actually own a couple of preferred stocks that I purchased in the summer of 2009 for the Harvest Portfolio inDividendInvestor, the higher-yielding portfolio. The reason I did is because at the time, they're yielding 9%-10%, and I thought this was too high for preferreds I thought were good money.

But, at the same time, I've always liked Ben Graham's discourse on the topic. He basically said, these are the worst combination of stocks and bonds. If you have a situation where you would rather the security behave like the common stock because the company's doing well, then preferred is going to act like a bond. If the company gets into trouble and you would rather have a real bond be a real creditor, now the preferred is probably going to act like common stock.

The biggest issuers of preferred stocks were Fannie Mae and Freddie Mac. Their holders have essentially been wiped out even though debtholders are being made whole. So I think what you want to do as an investor is think in terms of preferreds as needing to be relatively cheap in order to make them attractive. Right now, your higher-quality issuers are in kind of the 6%-6.5% type of area. To me, that's not a very good risk/reward trade-off considering that they may be called at the issuer's option if it's advantageous to the banker, whoever issued it to call it in. But if interest rates rise and these things go from being expensive forms of long-term capital funding to cheap forms, you could get stuck with something. I'll use an example of the Kansas City Southern Railroad in 1960 issued a preferred stock that's still trading today. They never called it, they never redeemed it, and it paid the going rate of 4%. It's still paying 4%. It still trades at a $25 par value give or take; 4% over 50 odd years and that's not even the rate of inflation. So that's kind of an extreme example of what can happen with the security like that.

I just much rather set my sights just a little bit lower in terms of current yield, maybe looking at something like a General Electric, with yield in the high 3% area. Of some my favorite securities, I mentioned National Grid. Healthcare REIT is another I like with yields in the 6% area, mid-5% area, let's say, but where we expect the dividend to grow faster than inflation. Now, I have got an inflation hedge as opposed to being locked into a fixed-income stream. I have got something that can offset some of the inflation and the risk of higher interest rates over time. So I'll admit that there are some people who really like them, but I'm not a fan unless they're cheap.

Glaser: I think we have time for maybe one or two more questions from the audience.

Burns: You know what I've always loved about, Josh. He can talk about 1960 like he was there and nobody even thinks twice about it. Old soul.

Peters: Heart of a historian. I think you have to learn from history or you're doomed to repeat it. That Kansas City Southern Railroad preferred, I don't want to repeat that.

Burns: That's right.

Speaker 5: I was wondering if there has ever been any consideration by Morningstar in terms of reducing the minimums that need to be put into some of the managed portfolios. I have been really interested in some of them, but haven't got the funds to meet the $100,000 or whatever minimum that, for example, is in Josh's portfolios. Has there any ever been any consideration in Morningstar to have some of those managed portfolios at somewhat smaller minimums?

Peters: I will take that. None of us is employed by the regulated subsidiary, Morningstar Investment Services, so it's kind of hard for us to directly answer that question. I can only say that, I think that for these accounts, typically the minimums are lower than what you will find elsewhere in the industry. But you have to kind of manage a balance. I mean, there is a certain amount of costs that goes into each account regardless of size, and I think hopefully we struck a good balance there. Morningstar is a company that really has a heart to serve individual investors as effectively and efficiently as we can. So, we appreciate your comment and pass it along, I hope I gave you a little bit of context there, but can't really do much more than that.

Glaser: Unfortunately, that's all the time we have today. But I wanted to thank everyone for attending, and we will just have Jason Stipp, who will come back up for some concluding remarks.

Jason Stipp: Hi everyone. I just wanted to thank you again for joining us here. To our Premium members here in Chicago and all of our viewers online, thanks so much for spending your time with us today on this Saturday. We did this for you. This is a benefit of your Premium membership. We were happy to do it for you; we hope you can take some of these ideas that you learned today home and hopefully do some good for your portfolio. One thing I do want to remind you of--I have this starred several times here—we have a survey and are going to email it to you. We would love for you to fill it out. As I said, this conference is for you guys, so we want to hear from you, what you liked, what you didn't like, and what you'd like to see in the future. We do plan to do more events like this so please do take a few moments and fill out that survey for us. We'd be happy to hear from you. Also, I wanted to let you know, that every registrant, all the online registrants and all you folks here in the office will receive an email with links. You can watch all these sessions over again. Anything you missed, any sessions you weren't able to attend, you will be able to watch those as often as you like. We will also have links to most of the slide presentations, so you'd be able to print those out and get that information, as well. So keep an eye on your inbox; those should be coming to you shortly.

Once again, thank you for being here. We certainly look forward to hosting you again. We are planning to do a midyear event, where we will catch you up on all the things we talked about in this seminar and also what's happened in the first half of the year. So certainly stay tuned with us. We want to be back in touch with you very soon. Until then, I am Jason Stipp for Morningstar.com. I look forward to seeing you on the website, and thanks for being here today.