Now that a major uncertainty in the 2011 economic outlook—income tax rates for individual taxpayers—is resolved, you are better able to focus your year-end financial planning on the prospects for the stock, bond, and money markets—and on how your mutual funds are invested in them.
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What, if any, funds should you sell? How should you reinvest the proceeds? What, if any, changes should you make in how you invest fresh cash?
Figure out how your fund portfolio’s assets are allocated among stock, bond, hybrid and money market funds, and you may discover your portfolio is not as balanced as it should be for someone of your age.
Given that the Standard & Poor’s 500 Index, the principal benchmark for the broad U.S. stock market, has gone up 86 percent since its March 2009 low—and given that your equity funds may have gone up a lot, too—your portfolio could have become over weighted in stocks. In that case, you might be too exposed to stock market risk and should re-balance by lifting your bond fund holdings.
On the other hand, you may be among those who were frightened by the stock market and contributed to the net flow of over $600 billion into bond funds—and to the net flow of around $80 billion out of domestic equity funds—during the last 20 months, according to estimates from the Investment Company Institute. You may now be too exposed to the under-performing taxable and tax-free bond markets and need to re-balance by adding to stock funds.
Whatever the circumstances, suitability is something you always have to remember when buying or selling mutual funds. Either transaction could tilt a well-diversified fund portfolio towards too much risk if you are near or in retirement—or not enough risk, if you are younger and have years to grow your portfolio before you need the money.
As you do your planning, here are a few points to consider about your funds:
As pre-tax yields on money market securities start their third year around zero—thanks to the Federal Reserve’s policy of boosting the economy—these funds have little appeal beyond being places to park cash. Even when rates rise, they may not provide meaningful after-tax income. They, are, however, comparatively stable places to park cash.
Taxable and federally tax-exempt bond funds share a risk and two major benefits.
The risk: Prices of bonds, including Treasuries, will fall if the overdue economic expansion ignites inflation and drives interest rates up—the longer the bonds’ maturities, the greater the fall.
The benefits: Diversification, which paid off when the S&P 500 fell 57 percent to March 2009’s low, and management, which eliminates your need to pick—and monitor—creditworthy bonds from some 8,000 taxable investment grade issues or six times as many municipals.
Taxable bond funds provide at least a little after-tax income, now that intermediate-term government and investment-grade corporate securities yield around 2 and 3 percent pre-tax, respectively, and long-term issues yield around 4 and 6 percent, respectively. Lower-grade corporates, owned by high-yield funds, may pay 8 percent or more.
Because federally tax-free, long-term state and local government securities are also yielding around 4 percent, municipal bond funds offer higher net income. If you’re in the 25 percent tax bracket, a 4 percent yield is equivalent to a taxable 5.3 percent; if your bracket is higher, your taxable equivalent yield is, too. Credit quality problems in some of the over 46,000 state and local issues underscore the importance of using well-managed funds for tax-free investing.
As the economy lurches upward, inflation remains low and the recession is beginning to recede in memory, notwithstanding unemployment at nearly 10 percent and industrial capacity utilization at 75 percent. The stock market continues to rise in anticipation of better times.
Forecasters at T. Rowe Price, Bank of America’s Merrill Lynch and elsewhere expect 2011 economic growth to run slightly higher than the inflation-adjusted rate of 2.6 percent that was logged in the third quarter of 2010. S&P analysts are predicting a 14.9 percent increase in earnings per share for the S&P 500’s stocks in 2011. Though that is far less than this year’s estimated 48 percent increase, well-managed funds could select stocks whose earnings could grow faster.
The 500 may be selling at a “historically low” ratio of 14.5 times next year’s estimated earnings (compared to 16.6 times this year’s), said S&P senior index analyst Howard Silverblatt. But “it appears to fairly value the fact that the actual 2011 earnings could be short of what’s hoped for.”
Need thoughts about the market sectors in which your funds ought now to be invested?
At recent press briefings, some fund managers and strategists cited a few that warrant consideration, including domestic large-cap growth, large-cap multinationals and capital goods (Larry Puglia, T. Rowe Price), large-cap dividend-paying companies, utilities, and technology (James Swanson, MFS), and technology and energy (David Bianco, Bank of America Merrill Lynch).