Investors hoping for 5% to 6% yields in income-generating equity and bond funds will likely have to lower expectations over the long term.

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John Rekenthaler, Morningstar's vice president of research, compares the current investment climate to 20 years ago, when he first started tracking mutual funds. "In late 1993 and in 1994, bond, utility and equity income instruments were doing fabulously well, generating 10% to 15% returns," he recalls. "Then interest rates rose, and they hit the wall."

Rekenthaler is now experiencing a sense of deja  vu, as low-volatility strategies seem once again to be on a collision course with rising rates. "Now we've had a 30-year period basically where rates have come down, and [then] have started to rise" again, he says. "Low-volatility strategies are being promoted, but the timing feels wrong to me. This is not the time I would be enthusiastic about them."

Though he hesitates to use the term "bond bubble," Rekenthaler notes bond fund yields have slipped significantly with increased rates. "The relatively low current yields are likely to continue into the future," he says. "Over the next 10 years, bond funds are not going to earn what they earned over the past 20."

Rekenthaler dismisses a couple of popular strategies, including dividend stock funds, as fads. "I'm not wildly against the notion of these types of funds, but I think the timing is off and they sound a little narrow and specialized," he says, adding: "I suspect they won't do very well over the next three to five years on a relative basis."

Rekenthaler is also skeptical about tactical allocation funds, which balance the major asset classes. "These things typically come out after market crashes, when investors want to get tactical after they've lost money. They're marketed as a means of dodging the next downturn - of course, there isn't a downturn for a while because prices are cheap."

These funds are also expensive, Rekenthaler says, and their timing is often poor. "They tend to be launched at the wrong time, and when you do really need them for the next crash, they won't be around."

Another pricey strategy, Rekenthaler says, uses specialized alternative strategy funds, which may be trading leveraged commodities or taking concurrent long and short equity positions. "They adapt hedge fund strategies, and charge 2%."

A better way to achieve long-term performance is to focus on broad, solution-based funds or multi-asset balanced funds that diversify risk, Rekenthaler says. "You're probably better off as an advisor using a broad solution-based fund, rather than taking a brick-by-brick approach and assembling the individual pieces from various sector funds."

Even advisors can fall prey to performance chasing, he says. "The temptation becomes too strong at the end of the year, or the end of a three-year period, to look at the individual bricks and get upset at the ones that performed the worst and clear them out. You tend to be clearing out not your worst fund but your lowest-performing asset class - which may be your best-performing asset class next time around." But by then the advisor no longer owns it, he notes.

Rekenthaler does have one bullish notion, given recent trends: international stocks. "Today, international stocks and bonds are more attractive than their U.S. counterparts," he asserts. He also wouldn't be adverse to adding some emerging country stocks into the mix, even at a time when many emerging market funds have incurred double-digit drops in returns.

 

Laton McCartney is a New York writer who's contributed to Money Management Executive and Information Management.