A Goldilocks market, falling investment costs, and a few remaining pockets of value make the list this year.
Video Transcript
Jason Stipp: I’m Jason Stipp for Morningstar. We hope you’ve had a lot to be thankful for in 2014 if you’ve been invested in the market. Morningstar’s Christine Benz says there are a few things that should make that list. She is here with me today. Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: It has been a decent year in the market for investors, better than maybe we would have thought coming into the year after the rally that we’ve seen. You have five things that investors really should be thankful for so far this year. The first one is that the market has been kind of in a sweet spot.
Benz: It has. I think it’s due to the fact that the U.S. economy has been chugging along but not at such a strong rate that we’re concerned about interest rates rising imminently. So, we’ve been in this terrific year, so far, where U.S. large-cap stocks have small double-digit gains coming into December and bonds have performed pretty well as well. And I think few would have expected both of those things to play out exactly as they have so far this year, but we’ve seen a relatively strong performance from bonds. Long-term bonds have performed exceptionally well. But even if you’ve been in some sort of core intermediate-term fund, you probably have a positive gain from your bond portfolio so far this year.
Stipp: Although we have seen several assets move up in value, not everything has been moving exactly in lockstep. We have seen some differentiated performance, which means some opportunities to rebalance.
Benz: That’s right. I often look at our market fair value graph on the Markets page of Morningstar.com, just for sort of a temperature check on the overall market. The typical stock in our global coverage universe is trading a hair above fair value, currently. But when you drill in on a style box basis--and this is something I like to do using our Morningstar Direct software--you can see that the average price/fair value for large-cap value stocks is slightly below 1.0. So, there could be some pockets of opportunity for investors who want to perhaps steer more toward that part of their portfolio.
When you go overseas, developed foreign markets--particularly European equities--look to be relatively inexpensive to our analysts. And then when you take the sector view of things, there are a couple of pockets of opportunity. One is the energy sector; this looks to be the biggest pocket of opportunity in our global coverage universe, currently. Also, precious-metals equities, those who dare to take a look at this deeply unloved asset class could potentially see that as a pocket of value if they are thinking about moving parts of their portfolios around to redistribute the wealth, pull away from things that have performed really well for you and perhaps steer money to some unloved areas.
Stipp: We interviewed Oakmark’s David Herro last week, and he echoes that sentiment about European equities looking attractive. So, it might be an interesting area for investors to explore. Number three [on the list of] things investors should be thankful for is a trend we’ve seen for a while, and that’s the fact that investment costs are continuing to come down.
Benz: That’s right. This is, in large part, because we have seen very strong inflows into index mutual funds as well as exchange-traded funds. There has been a lot of competition in that space. Now, it’s possible for investors to build an all-in portfolio with exposure to all of the major asset classes for less than 10 basis points. So, these very low costs in index fund land and exchange-traded fund land, by extension, have been putting some pressure on active fund managers to keep their costs low, too. So, we’ve also seen some positive momentum toward cost-lowering among active funds, although some active funds have been seeing outflows. It’s going to be difficult for them to keep their costs down, but there has been pressure all around to keep costs low. This is a real win for investors.
Stipp: With the market rallying, one potential downside is tax liabilities. Though, you say investors should be thankful because long-term capital gains rates are still quite low by historical standards.
Benz: That’s right. So, first off, I do expect to see that it will be maybe a tough season for holders of active mutual funds, from the standpoint of capital gains distributions, and there are two reasons. One is that we’ve had pretty strong market performance, so funds have substantial capital gains on their books that have to get distributed. The second thing is that some active funds have seen redemptions, and that means that those funds that are paying out distributions will be paying them out over a smaller shareholder base.
So, that’s one reason why I think people need to be on the lookout for these distributions; they need to find ways that they might offset those capital gains by finding losers in their portfolios. But certainly, when you take a step back and look at long-term capital gains rates relative to historical norms, they are pretty low. So, people who are in the 10% and 15% income tax bracket now pay a 0% rate on long-term capital gains. People who are between the 25% and 33% income tax brackets pay a 15% rate.
When you look across the past several decades, the long-term capital gains rate for most taxpayers over that timeframe was in the realm of 20% or thereabout. So, we’re in a pretty good position from the standpoint of capital gains rates relative to, certainly, the past several decades.
Stipp: So, folks in that lower income tax bracket who won’t face any long-term capital gains rates also have an opportunity, as well, where they could step up the basis of their investments while they are in that 0% capital gains rate.
Benz: This is such a great point, Jason. If you are in those 10% and 15% income tax brackets and you are paying that 0% capital gains rate, I think it could make a lot of sense to just take your winning holdings, sell them, and--assuming that you want to hang on to your positions in them--rebuy them shortly thereafter. So, you will incur no taxes on that transaction because you are in that 0% capital gains band, but you will have reset you cost basis to the new higher level.
So, if at some point in the future when you sell those securities and you are, in fact, on the hook for capital gains taxes, you will pay taxes on the higher cost basis. So, I think that is a really attractive opportunity for people who are in this position.
Stipp: And on the topic of taxes, you say investors should really be thankful for ETFs because they solve some of those problems that we’ve seen with mutual funds paying out capital gains distributions.
Benz: They do. I'd still like to see the tax system fix the taxation on mutual funds, where you are, in some cases, on the hook for these capital gains taxes even if you haven’t sold a share. But until then, I do think that exchange-traded funds and--to a lesser extent but certainly to an extent--index mutual funds do allow you to really limit those ongoing capital gains taxes. So, if you do hold stocks in a taxable account, ETFs and index mutual funds very nicely reduce the drag of capital gains taxes on your portfolio’s return.
Stipp: Number five: In the current low-yield environment, you say you should be thankful for online savings accounts.
Benz: That’s right. So, yields are very, very low. I don’t want to overplay this because you are not going to be able to earn a yield of over 1% on an online savings account today. But still, when you look at the yields from firms like Ally Bank, for example, you can see that you can lock in a rate that is substantially higher than what you are able to get on a money market account at your bank or a money market mutual fund. So, I think the fact that these banks don’t have those brick-and-mortar locations, which incur costs, is one benefit that has allowed these online savings banks to offer very, very strong yields--certainly, relative to competing vehicles.
Stipp: Not a bad list for investors to be thankful for. Christine, thanks for joining me.
Benz: Jason, great to be here.
Stipp: I’m Jason Stipp for Morningstar. Happy Thanksgiving.
*Image of “savings“ via Shutterstock 
