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Jewish World Review July 15, 2002 / 6 Menachem-Av, 5762

James K. Glassman

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Have your cake

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Let's be clear. The best place for long-term investors to put their money is a diversified portfolio of stocks. Period.

Still, these are frightening times, and investors are searching for sensible alternatives. This week, I'll discuss several decent choices and then, at the end, a spectacular one that lets you have it both ways. You get the safety of a no-loss guarantee plus the chance for big gains when (some would say "if") the stock market takes off again.

But first, some of the more conventional ways to diversify away from stocks:

? Bonds. A bond is an IOU. When you buy a bond, you make a loan, usually to a large corporation or a government agency. The lender pledges to pay you back on a specific date and send interest checks twice a year.

If you are so worried about terrorism, accounting scandals and the economy that you want to get out of stocks, then you should probably stick to Treasurys. While debtholders stand in front of shareholders in a corporate bankruptcy, there may not be much left to hand out, as owners of WorldCom bonds now suspect. But even in a disaster, the U.S. government, if it's still around, will meet the interest payments of Treasury bonds and give you the principal back at maturity.

With bonds, however, you're faced with more than just credit risk. There's the chance that your principal will be seriously eroded by inflation and that your interest payments won't compensate. For example, long-term government bonds lost ground to inflation in 10 of the 15 years from 1967 through 1981.

Overall, intermediate- and long-term T-bonds have returned an average of 5.3 percent since 1926, according to Ibbotson Associates, while large-cap stocks, represented by the benchmark Standard & Poor's 500 index, have returned 10.7 percent. After inflation, the difference in "real" returns is even more dramatic: 2.2 percent returns for bonds, 7.6 percent for stocks.

Normally, bonds are not a good buy for long-term investors. They have beaten stocks in only one of the 23 five-year overlapping periods since 1975 (i.e., 1975-1980, 1976-1981, etc.). Looking at overlapping 10-year periods, I found that the last time bonds beat stocks was from 1969 to 1979. This time, however, could be different, and there's no doubt that owning U.S. bonds -- which you can buy from banks, brokers, straight from the Treasury or through mutual funds -- gives investors a feeling of confidence. Currently, 10-year bonds pay a little less than 5 percent, but if inflation continues low, real returns could exceed 3 percent. (Another way to guarantee real returns is to buy Treasury Inflation Protection Securities, or TIPS.)

Treasurys are liquid -- that is, they are traded on exchanges after they're issued, just like stocks, and buyers and sellers abound. Municipal bonds, whose interest is tax-exempt, come in thousands of varieties, and individual issues can lack liquidity. Still, muni rates right now are tempting. A 10-year muni with a AAA (tops) credit rating was recently yielding 3.8 percent. That's the equivalent, for someone in a 38 percent tax bracket, of a Treasury that pays 6.3 percent.

Treasurys, corporates and munis can all be bought in portfolios -- either as mutual funds (where the manager has discretion over the bonds bought and sold) or as unit trusts (where the holdings are locked in for a specific time). Be sure to check the expenses on a bond mutual fund. They should be less than half a percentage point a year.

? Cash. What financial professionals call "cash" isn't the green stuff. It's very short-term debt: typically, checking and savings accounts (you are actually lending money to your bank, which, with a federal guarantee, agrees to pay you back); certificates of deposit (savings accounts with a fixed term); money-market funds (mutual funds that own short-term loans, often in the form of commercial paper issued by corporations); and Treasury bills, which are sold by the U.S. government to finance the national debt, in maturities as short as four weeks. Short-term rates change day by day, and the interest yield on a T-bill is usually the benchmark. Right now, it's 1.7 percent on a six-month bill, which is roughly the rate of inflation.

In between bonds and cash are CDs with maturities of a few years. Last week, certificates that mature in two years were yielding 2.5 percent to 3 percent. These are not inspiring numbers. History shows that a T-bill usually pays a half-point to a full point more than inflation. But, for fearful investors, returns are not the point. If you crave safety, cash provides it.

? Precious metals. In turbulent times, especially when the dollar is weakening, many people turn to gold, silver, platinum and other precious metals and gems as a store of value -- that is, an investment that will be worth something when currency, bonds and stocks aren't. Precious metals are usually considered a hedge against inflation, since the value of "things" -- and gold is the ultimate thing -- rises with prices. Right now, inflation isn't the problem, but it could be.

If utter disaster strikes, some people believe that precious metals and jewels will become substitutes for currency, but it is hard to imagine buying coffee and bread at the local 7-Eleven, handing over an investment-grade diamond worth $100,000 and asking for change. Also, what good would the change be? And how would the clerk tell a diamond from a piece of glass?

Imagining less dire circumstances, I can understand the value of precious metals as a financial investment, and there are dozens of mutual funds that own shares in mining companies. Their common characteristic, however, is wild volatility. For example, the No. 1 fund of this type so far in 2002 (through July 2) is USGI Gold. It's returned a whopping 86 percent. Despite that recent gain, the fund has fallen a total of 37 percent over the past five years.

A more stable fund is First Eagle SoGen Gold, run by Jean-Marie Eveillard, a successful global value-stock manager. Eveillard's top holdings include Newmont Mining Corp., with operations in the United States, Peru, Uzbekistan and elsewhere, and two South African firms, Gold Mines Ltd. and Harmony Gold Mining Ltd. (By the way, thanks to gold, the South African stock market has been one of the world's best this year, up 27 percent.)

A more general natural-resources fund with a solid track record is T. Rowe Price New Era, founded in 1969. Its holdings are currently weighted heavily toward oil stocks, the prices of which would probably soar if supplies were cut off in a war -- although manager Charles Ober also owns Newmont and Phelps Dodge (copper), Alcoa (aluminum) and Inco (nickel, cobalt and precious metals), that last one being a stock that has doubled since September. Over the past five years, New Era has returned an annual average of 5 percent, beating the S&P by nearly three points. Over 10 years, the fund has averaged 10.8 percent, a little less than the S&P. There's no load, or upfront charge, and the expense ratio is a mere 0.72 percent, or half that of the typical fund.

? REITs. As I wrote recently, many investors have discovered real estate stocks over the past couple of years -- and for the obvious reason. They were going up while almost everything else was going down. During 2000 and 2001, the Vanguard REIT Index fund, which tracks the Morgan Stanley index of real estate investment trusts, or REITs, returned a whopping 42 percent. Meanwhile, the Vanguard 500 Index fund, which tracks the benchmark index of the broader stock market, fell 20 percent.

Of course, real estate stocks don't always go up. They plunged, for instance, in 1998 and fell slightly in 1999, years in which the rest of the market zoomed upward. But that's the whole point. REITs can offer balance and stability for portfolios because they have what economists call "low correlation" with other stocks.

Long ago, REITs had a well-deserved reputation as volatile companies, deep in debt and run by risk-loving property jocks. No more. As of May 31 there were 179 publicly traded REITs identified by their trade association (www.nareit.org), with a market capitalization (or value according to investors) of about $950 million each. The best of them are good citizens, slowly and consistently raising their dividends. Despite the slowdown in the economy, their fundamentals have remained sound. And as interest rates on bonds have dwindled, REIT dividend yields have remained enticingly high.

Consider Duke Realty Corp., one of the sturdiest of the REITs. Over the past five years, it has returned a total of 89 percent, including price increases and dividends. Duke, based in Indianapolis, owns nearly 1,000 properties -- mainly industrial and suburban office and retail space in the Midwest and Southeast -- worth about $5 billion. Duke currently pays an annual dividend of $1.80 a share. The stock closed on Friday at $27.18, so its yield ($1.80 divided by $27.18) was 6.62 percent, which compares favorably with the 4.85 percent yield on 10-year Treasury bonds on that date.

Of course, one of the differences between Treasury interest payments and REIT dividends is that the latter aren't guaranteed by the U.S. government. REIT dividends can fluctuate or disappear altogether. But they rarely disappear.

The safest way to buy REITs is through mutual funds, which typically package about two dozen of them in a single portfolio. The analysts at Morningstar pick two in particular: Security Capital U.S. Real Estate, which produced average annual returns of an attractive 10 percent for the five years that ended 2001, and Columbia Real Estate Equity, which had lower returns (8.3 percent) but also lower expenses and a lower risk rating. The largest REIT fund, Cohen & Steers Realty Shares, has assets of more than $2 billion and average annual returns over the past 10 years of more than 12 percent.

Whichever fund you choose, get yourself some REITs. Investors close to retirement can comfortably buy enough REITs to represent 10 percent of a portfolio.

? Guaranteed stocks. How would you like to own an investment that rises when stocks rise but guarantees you won't lose money when stocks fall?

There are dozens of these securities, which are a cross between stocks and bonds. Packaged by such investment firms as Merrill Lynch & Co., Lehman Brothers, Morgan Stanley and Salomon Smith Barney, they trade on the major exchanges just like individual shares.

Here's the easiest way to understand how the investments work: You buy a bond for $1,000. It matures in five years. At the end of that period, you get your $1,000 back. Instead of a fixed rate of interest along the way, you get a lump sum when the five years are up. That lump sum is determined by the performance of a specific index, or basket, of similar stocks. If the index doubles, you get double (more or less) your original $1,000. If the index declines, you still get the $1,000 back. It's hard to think of a better stock investment for people who are scared of the stock market.

But what are these things? They fall under the general rubric "structured products." They are derivatives; that is, their value is derived from something else, in this case the movements of a stock index. Financial engineers patch them together, using other products: bonds, options, index futures and the like. But you really don't need to know how they are built; rather, look at how they perform.

Consider the first series of such investments, created by Merrill Lynch with the overall acronym MITTS (for "Market Index Target-Term Securities"). The original issue, linked to the S&P 500, was launched in January 1992 at a price of $10 per share (or, more precisely, per "unit"). Merrill guaranteed that at the end of five years, investors would, at the very least, get their $10 back. In addition, if the S&P rose, then investors in this particular MITTS issue (its symbol on the American Stock Exchange was MIT) would get the percentage increase over the five years plus a 15 percent kicker, all times the original $10.

Look at what happened: When the MIT units came out, the S&P stood at 412. When MIT expired five years later, the S&P was 925. That's an increase of 125 percent. Add the 15 percent kicker, or premium. So investors received their original $10 plus an extra $14 (that is, $10 times about 140 percent). In other words, $10 grew to $24 -- a nice profit.

Unfortunately, as interest rates have fallen, the delightful premiums provided with some MITTS issues have disappeared and discounts have take their place. Typical is a MITTS that is linked to the Dow Jones industrial average (symbol: MTDW on the Nasdaq). It was issued shortly after Sept. 11, 2001, matures in 2008 and returns 95 percent of increase in the Dow over that period plus $10. On July 2, MTDW was trading at $9.60. It has dropped in price because the Dow has dropped since it was issued. But even if the Dow is at 8,000 -- or less! -- in 2008, MTDW will pay investors $10.

If you invest $9,600 in 1,000 MTDW units, then you'll make a guaranteed $400 profit, minus brokerage commissions, over the next six years. If the Dow doubles from now to then (an annual growth rate of about 12 percent), your $10,000 investment will become nearly $20,000. By the way, guarantees vary with these structured products. In some cases, they are backed by federal deposit insurance; in others, by the investment firm itself, either alone or with support from a bond-insurance company. Even if you aren't worried about the solvency of Merrill or Morgan Stanley (I'm not), be sure to check the basis of the money-back guarantee.

Often, the best deals are securities that are "under water" -- that is, the underlying index has dropped since the units were issued. One example is a series of SUNS (Stock Upside Notes Securities; they all have clever acronyms) underwritten by Lehman. When the series, with the symbol SPJ on the Amex, came out in February, the S&P was trading at 1130. On July 2, the S&P closed at 948, and SPJ has dropped commensurately, to $8.40 a unit from $10.

Buy 1,000 shares and Lehman, as a corporation, guarantees that your $8,400 will be fetch at least $10,000 on expiration date, Feb. 5, 2007. That's a total return of 19 percent or about 4 percent compounded annually, which is more than a Treasury note with the same maturity now pays. And, if the S&P rises above 1130, you get a bonus. (A rise in the S&P of 8 percent a year would bring it to 1341 by expiration.)

You can buy guaranteed securities linked to European stocks (symbol: EFM), energy stocks (XKE), the tech stocks of the Nasdaq 100 (PPV.B, issued by UBS, the Swiss financial firm), the small-caps of the Russell 2000 (RRM), the Japanese stocks of the Nikkei 225 (MNK) and many more issues.

What's the catch? While you can sell these units at any time, some of the series aren't very liquid, and, of course, before expiration, you aren't guaranteed the original $10. In addition, you're giving up all dividends, and some of the issues -- such as the Lehman S&P units -- return a good deal less than 100 percent of the index's increase.

Also, the stock market does not fall very much -- despite the way it seems today. Since 1938, the S&P has declined, after dividends, in only two out of 60 overlapping five-year periods -- just 3 percent of the time. The S&P hasn't dropped in any of the 62 overlapping 10-year periods since 1931. The investment firms that manage these investments have history on their side -- which is precisely why they are offering these deals.

Still, if you believe that something has changed and history won't repeat -- or if you are just plain scared -- ask your broker about these products, which also go by such names as BRIDGES, BULS and PRUDENTS. Find out the precise terms: the index, discount, maturity and guarantees. And be happy you can have your cake and eat it (or at least most of it), too.

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JWR contributor James K. Glassman is the host of Tech Central Station. Comment by clicking here.

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