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Investing Insights: Retirement Buckets and Vanguard Changes

Morningstar.com

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Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. Dividend growth funds focus on companies that have a history of increasing their dividends. Companies that regularly boost their dividends often have sustainable competitive advantages. A collection of such high-quality companies can make an excellent core holding. As such, even investors who aren't yield seekers may find plenty to like among dividend growth funds. We asked our analysts to share some of their favorites.

Katie Reichart: T. Rowe Price Dividend Growth receives a Morningstar Analyst Rating of Silver. Tom Huber has run the fund since 2000. He emphasizes free cash flow and capital allocation by management teams to ensure that his holdings will continue to pay dividend and grow them. The fund's diversified portfolio and focus on financially stable companies has given it a tame risk profile. During Huber's tenure it's lost just 79%, as much as the S&P 500 Index in market downturns. Growth-led markets aren't its strong suit; it lagged in 2017, for instance. However, long-term risk-adjusted results are solid, and the fund also has below-average expenses.

Adam McCullough: Vanguard Dividend Appreciation Fund is an excellent choice for investors looking for a broadly diversified portfolio of stocks with the potential to raise their dividend payments in the future. This fund earns a Morningstar Analyst Rating of Gold. This fund starts with all the stocks in the U.S. market that pay dividends and screens out for only those that have raised their dividends consistently for the past 10 years. This is a high hurdle. This fund excludes stocks like Apple that have only started paying their dividend in the past 10 years. Next, it applies proprietary quality screens to look for names that have the potential to raise their dividend payments in the future. Because the fund is more focused on dividend growth and dividend yield, its yield is about the same as the Russel 1000 Index. But this leads to a more defensive portfolio that holds up better during market downturns. For example, this fund drew down 8% less than the Russel 1000 Index during the financial crisis from October 2007 through March 2009. It's a great fund option for investors looking for a stable portfolio of dividend-paying stocks with the potential to raise their dividend payments in the future. It's also a very cheap fund. Vanguard only charges 8 basis points for the Admiral share class of the fund and charges the same price for the ETF share class of the fund as well.

Alec Lucas: Hartford Dividend and Growth is a good option for investors who want companies that pay dividends as well as have above-average growth prospects. Lead manager Edward Bousa roots the portfolio in stocks that pay above-average dividends; Bank of America, for example, fits that bill. He also pays attention to supply/demand dynamics and will invest in companies poised to benefit from supply/demand imbalances. Chevron is the company that he holds for that reason. He will also buy growth-oriented companies when they fall out of favor. He bought Alphabet, for example, a few years ago. The fund has a consistent record. Fees could be a bit lower than they are currently, but Bousa's skill and a strong management team are good enough to overcome the fund's fee hurdle, and it's a very reliable option.

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We've talked a lot about the Bucket approach to retirement investing. I'm here with Christine Benz, she is our director of personal finance, to talk about how many buckets retirees really need.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: Let's start with just definitions about what this approach is. How would you describe it to someone who is not familiar?

Benz: I sometimes see the Bucket approach referred to as a time segmentation approach, and I think that's a nice way of putting it. The basic idea is that you are thinking about your spending horizon from your portfolio and using that to structure the portfolio. For assets that I'm going to need to spend right away, I want to keep that money very safe. I'd keep six months' to two years' worth of my portfolio expenditures in cash. From there I can step out on the risk spectrum. If I have a time horizon of, say, three to eight or three to 10 years, I can take a little bit more risk with that portion of the portfolio in the hope of earning higher return, and I can venture into bonds, maybe focus on high-quality short and intermediate-term bonds.

If I have a very long-term spending horizon for a component of my portfolio, I can think about venturing into higher-returning assets that have this potential for significant volatility along the way. I wouldn't want to earmark them for near-term spending, but if my time horizon is longer, like eight or 10 years, I can afford to be in the higher-growth investments.

Glaser: You've described three buckets there. But what if you wanted to simplify and go to two buckets? Is that something that's feasible?

Benz: Well, the person who really influenced my thinking in terms of this Bucket approach is Harold Evensky, the great financial planner. He talked about simply bolting on a cash bucket alongside the total return portfolios that he maintains for his clients. There certainly is a benefit of simplicity of saying, this is my intermediate and long-term, all-in-one component to my portfolio, and the rest is very near-term reserves. That makes a lot of sense.

The downside potentially, and the reason I have typically structured my model portfolios in terms of three buckets is that if you are using rebalancing to help meet your cash flow needs and to help refill Bucket 1 as it becomes depleted as you spend through your cash, well, the advantage of having discrete bond and stock holdings is that you can really see where do I need to go if I need to replenish that Bucket 1. In a year like 2017, for example, the answer is probably pretty obvious; it's that third bucket, the equity bucket, because stocks performed so well. In other years, maybe the bond piece will be the piece that grows, and you'd want to leave stocks alone.

Glaser: Let's talk a little bit about making extra buckets, adding buckets to the strategy. Is there ever a situation in which that would make sense?

Benz: I have heard from some of our Morningstar.com readers who have implemented a Bucket approach in their own in-retirement portfolio strategy. They have talked about a couple of ideas that I think are worth considering. One is simply having a separate emergency fund bucket where, just as they did while they were working, they are holding liquid reserves to meet expenses that arise apart from their anticipated spending. This might be car repairs or a new roof on the house or whatever it might be, they set aside a separate bucket to meet some of those unanticipated expenditures that inevitably arise in our lifetimes.

Another idea that I have heard from some of our users is having a fourth bucket, a very long-term bucket. Retirees have talked to me about using that bucket number four for a variety of different expenditures. Maybe it's someone who is planning to fund long-term care needs out of pocket. They want to segregate those assets from their spendable assets. They have maintained a separate account to meet potentially those unfunded long-term care expenses. Another idea would be for retirees who are very bequest-oriented. They know that they want to leave money behind for their children and grandchildren. They have segregated those assets from their spending assets. I think that those are some interesting ideas. If retirees have very long-term goals or desires for their money that aren't accounted for in their spendable portfolio.

Glaser: And from a practical standpoint, it's good to keep in mind that three buckets doesn't necessarily mean three accounts, that people's financial lives can be messier than that.

Benz: Absolutely. Unfortunately, it's more complicated than the simple three-bucket strategy that I've laid out in my articles on Morningstar.com, because in reality, many retirees will be bringing accounts with different tax characters into retirement. They might have the traditional tax-deferred accounts; they might have Roth accounts; they might have taxable accounts.

From a practical standpoint, it might be not quite as simple as having three accounts. They probably want to think about overlaying the Bucket approach over their different accounts. They'd also want to think about withdrawal sequencing when determining which types of assets to put in which account types. If they are using the standard withdrawal sequencing, they think about maybe making the taxable assets be a little more conservative; the tax-deferred assets potentially somewhere in between; if they have any Roth assets, which are usually the ones you'd want to save to later because they are most valuable to you from a tax standpoint, they'd want to think about making those more growth-oriented. Unfortunately, it's not quite as simple as I've made it look in some of my articles and in some of the model portfolios.

Glaser: Christine, thank you.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching. 

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Karen Wallace: Funds in the emerging-markets bond categories have been pretty volatile so far this year. But emerging-markets bonds in local currency have beaten every other taxable bond category over the trailing 12 months owing to stellar performance in 2017. Here to discuss some of the performance drivers and some of our analyst picks in the category is Karin Anderson. She is an associate director in our fixed-income manager research group.

Karin, thanks so much for being here.

Karin Anderson: No, problem, Karen. Thanks for having me.

Wallace: First, let's discuss a little bit about emerging-markets bonds. It sounds risky. What are some of the risks there?

Anderson: It's definitely one of the more volatile pockets of the fixed-income market. Investors in these types of bonds are going to be going after either credit or currency risk or both. It just depends on which types of bonds you are investing in. The two main areas are hard currency bonds, which are bonds that are denominated in U.S. dollars. There, you are not taking the currency risk, but you are actually going after quite a bit of credit risk because many of the countries in that index are below investment-grade. Some notable ones there would be like Venezuela or Ukraine that have been below investment-grade for quite some time and have gone through defaults in the past five years. While you are not getting currency volatility, you are courting quite a bit of credit risk.

On the other side of the coin are emerging-markets local currency bonds. There, you are actually buying the bond denominated in, say, Mexican pesos or Russian rubles. With that, you are getting a lot of volatility because of that EM currency exposure, typically, on the order of twice as much volatility as the hard currency group. It's a question of how much diversification but also volatility do you want to take through those currencies.

Wallace: Morningstar breaks out emerging-markets bonds in two separate categories, one denominated in local currency and the other denominated in U.S. dollars. Is that correct?

Anderson: Exactly right. For a long time, we had one category, because it was a small category for quite a while. But as the investment landscape has changed, we have seen a lot more EM local bond funds come to the market. We spun out the EM local bond group which makes very good sense for investors because of that volatility that I mentioned earlier. The EM bond group that contain some of the oldest funds in the category are more focused on hard currency denominated sovereign bonds or corporates.

Wallace: An emerging-markets bond allocation might not make sense for every investor. Who should think about an emerging-markets bond fund and how would it sort of fit in with a portfolio?

Anderson: An investor with a very U.S.-focused bond portfolio could certainly consider it. If they feel a little bit skittish about the currency volatility that can come with it, a hard currency allocation can make a lot of sense. Investors that are looking for even more diversification--a great example of that is, as you noted, EM local currency has strongly outperformed EM hard currency and other bond categories over the past year, EM local currency is a great way to get it. Still another way is to invest in blended funds that invest across the EM bond spectrum. They will have a bit of USD-denominated exposure, some of that local currency exposure, quasi sovereigns, like Petrobras or Gazprom, and then also, maybe a bit of EM corporate exposure. That gives you a bit of everything.

Now, all that said, investors need to take a hard look at their portfolios to make sure they don't already have a lot of EM bond exposure in, say, their global bond fund, their multisector fund and even some core funds like PIMCO Total Return have smaller allocations to EM bonds these days. It's becoming more and more common. Investors need to take a good look before they actually go out and pick a dedicated EM bond fund.

Wallace: That's a great point. What are some of the analyst picks in the EM bond category? What are some of the interesting approach that people take to mitigating the sort of risk or finding opportunity?

Anderson: One of our top choices in that blended group that I described is TCW Emerging Markets Income. They have invested across the EM bond spectrum for years, and the managers there have done a good job allocating risk and anticipating when it's a good time to take up that EM currency exposure and when to take it down. They navigated difficult period of 2013 to 2015 roughly for those currencies pretty well. They still lost money but lost less than most. They have a good history of picking corporates as well, which is a growing part of that investment landscape. That's one that we like that kind of gives people a broad-based exposure.

More old school funds would be Fidelity New Markets Income, T. Rowe Price Emerging Markets Bond, which are really more anchored in hard currency denominated debt. They are going to have very little currency risk but some significant credit and country risks at times. The T. Rowe Price fund, for example, had a very significant stake in Venezuela, and I believe still continues to do so. There, you are getting more of a U.S. high-yield-type exposure. You might want to think about that too if you already own a high-yield bond fund before adding something like that into the mix.

Wallace: Great. Thanks so much. It is an interesting topic. Thanks so much for being here to discuss it.

Anderson: Thank you.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.

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Damien Conover: President Trump outlined a blueprint to lower prescription drug prices for patients in the United States. A lot of what's been outlined we don't think will impact the moats or the valuations for the majority of the large-cap pharmaceutical and large-cap biotechnology firms. There are some things in the proposal that will create some minor headwinds, but we think the innovation that's coming out of these firms will offset those headwinds. We want to talk a little bit about what some of those headwinds are.

First off in the blueprint, President Trump wants to encourage more generic competition. We think this is a good thing and is something that is more in line with our generic drug companies, which all have no moats, where that industry is a very highly competitive industry, commoditized, very difficult to get returns on invested capital. 

Additionally, the blueprint calls for increased negotiation within Medicare drugs. This is a subsegment of the patient population. Those increased negotiations will put some minor headwinds into the pricing for a lot of drugs that the large-cap pharmaceutical and large-cap biotechnology firms sell. However, to put this in perspective, we only anticipate the increased negotiations for one of the key segments, Part B, to really hit the drugs sales by around 2%. That's not a major impact. Also, we anticipate that drug firms will be able to increase prices to offset some of that pressure in the Medicare Part B segment--so to be able to increase prices in other segments of the market. 

Within this context, we think the innovation and strong pipelines within large-cap pharmaceutical and large-cap biotechnology firms will enable them to strengthen their position over time and continue to have wide economic moats.

On a valuation perspective, we still see these two groups as very well-positioned and undervalued. A couple of names we are highlighting are Roche, Pfizer, Eli Lilly, and Allergan. All of these firms, we think, are undervalued and most of them pay very strong dividends that we think will continue for several years.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Vanguard has recently seen some personnel changes in its fixed-income effort, and that has some implications for fundholders. Joining me to discuss the changes and discuss the implications are two of Morningstar's fixed-income manager research analysts, Emory Zink and Alaina Bompiedi.

Ladies, thank you so much for being here.

Emory Zink and Alaina Bompiedi: Thank you for having us.

Benz: There have been a number of changes at Vanguard. Let's talk about the most immediate one, Alaina, the departure of Greg Nassour. That one sounds like it was somewhat unexpected.

Bompiedi: Greg Nassour was leading Vanguard's corporate bond desk, and he had overseen just over $100 billion in funds for Vanguard, six funds in all, two of which we had under coverage, these being Short-Term Investment-Grade and Intermediate-Term Investment-Grade. The Short-Term Fund is the largest, just over $60 billion.

Benz: Emory, there are also some other changes going on at an even more sort of senior executive leadership level in the fixed-income shop.

Zink: Simultaneously, and this is separate from the Nassour departure, but on the municipals team the long-time head of the municipals group, Chris Alwine, he is going to be moving to lead the U.S. fixed-income taxable side. He had led the municipal group of Vanguard for a little over a decade, and his replacement will be an individual by the name of Paul Malloy. He is no stranger to Vanguard. He actually previously had worked on their fixed-income ETFs in the United States. Prior to taking this particular job, he headed up European Credit Research in London. He will be new, and at first, we were kind of curious because he didn't have a background in municipals, but we have a lot of comfort in the fact that Alwine is remaining with Vanguard and is going to help with that transition as Malloy takes over as head of Vanguard's municipal income group.

Benz: Alaina, with Nassour's funds, I know they have named some interim managers, but sounds like the search is still on for permanent managers?

Bompiedi: That's right. The search is still on. Vanguard is looking to hire a portfolio manager to lead their corporate bond desk. In the interim, it named two of its current portfolio managers, Daniel Shaykevich and Samuel Martinez, as lead managers of Nassour's funds in his stead.

Benz: Let's talk about the review process that you and the team undertake when you do see significant manager changes or changes in executive leadership like this. Emory, can you talk about what the team does at that point?

Zink: When we learn that there is going to be a significant change up top, we of course want to take a fund through review and see how it's going to impact its process, whether we think there are going to be any major changes. In the case of the municipal group, they really have a very strategic and systematic way of running their funds. When we looked at that adjustment, which was the head of municipal group, so Chris Alwine, we asked are there going to be any adjustments to the process, are there going to be any changes to the resources. Ultimately, all the support staff in the case of the municipal funds--the portfolio managers, the credit analysts, the traders--they are all going to be very consistent. Given that Alwine was going to provide help with that transition, there really wasn't going to be much of a change. We maintained all of those ratings and ultimately, didn't think that it would impact the process. Part of our job is, we continue to monitor that in case there are eventually any adjustments. It's a little different in the case of the taxable side.

Bompiedi: On the taxable side, Greg Nassour has been overseeing portfolio management and trading more broadly for all of Vanguard's corporate bond investments. That was something that we were considering when we were evaluating the People Pillar there. He just had a lot of responsibility, and because that seat is still unfilled, that was a big factor in our ratings review process.

Benz: A broader question, and Emory, you alluded to this--you both alluded to this really--these funds have always been run in a very disciplined fashion. The managers don't have a lot of leeway by charter to make any crazy bets and the low costs are a main advantage. Broadly speaking, investors in Vanguard's big bond funds that might have been affected or touched by some of these changes, do they have reason for concern?

Zink: I would say one of the reasons that we really have a lot of confidence in a number of Vanguard's funds are these sorts of sources of advantage, and none of these have been impacted by sort of the changes up top. Things that you had mentioned, the low fees, the conservative guardrails, they are very systematic, and Vanguard is known for its very efficient implementation and diversification. All these things still hold. If an investor is looking at their Vanguard funds and wondering, should I make an adjustment based on these changes, we a lot of confidence in those funds. I think that's somewhat reflected in the fact that they all still have medalist ratings on those.

Benz: Alaina, in the case of the funds that you look at, you have maintained them as medalists. They got downgraded a little bit to Bronze, but that still signals the level of conviction?

Bompiedi: That's right. The Bronze is still signaling our conviction there. We just wanted to emphasize our hesitation, just because someone hasn't been named in Nassour's stead just yet, but we'll revisit our review process when someone is named in his place.

Benz: Thank you so much for being here both of you for breaking this down for us. Big funds, investors have a lot of dollars invested in them. It's good to have some clear thinking on what's going on. Thank you for being here.

Zink: Thanks for having us.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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Joe Gemino: With its 4-star rating and narrow moat, TransCanada is one of our best picks in the energy sector. The stock offers 25% upside and an attractive 5% dividend yield. We think that the market continues to overlook the positive impact the growth portfolio will have on future cash flows and the balance sheet, while it places too much emphasis on less important outside factors. The time is right for long-term investors to capitalize on the stock's considerable upside while collecting a steady stream of growing income.

The FERC's proposal that disallows tax recovery from U.S. pipelines that operate under a cost of service contract sent the stock into a downward trajectory. However, we think that the market is overestimating its impact on TransCanada's operations. Currently, the regulations affect only 13% of the company's EBITDA, which we expect it to fall to 8% in the next five years, owing to unaffected growth projects.

Additionally, we expect a healthy pipeline of growth opportunities to drive TransCanada to meet its targeted 8% to 10% annual dividend growth over the next three years. TransCanada boasts 32 billion Canadian in commercially secured capital projects in its growth portfolio, highlighted by the Keystone XL. The widening of the heavy oil discount has given some investors pause as it makes production growth more difficult. But the widening heavy oil discount only shows that new pipelines are needed now more than ever, making TransCanada a good opportunity for investors.