Let’s start with cash. Today, the net return on a money market fund is practically nil. If you deposit your savings in a one-year GIC, you’ll be lucky to get 1.25%. With inflation running at about 3% so far this year, you are losing close to 2% in purchasing power each year. That’s a high price to pay for safety.

What about government bonds? The benchmark 10-year Government of Canada bond yield as of early November was 2.15%. Again, with inflation at about 3%, your net annual purchasing power loss is almost a full percentage point. And that doesn’t include fund fees.

These low yields might be a fair price if they came with peace of mind. They don’t. The important thing to remember with bonds is that your long-term return is mostly determined by the prevailing yield at the time of buying. Yes, you may have temporary capital gains if yields decline, or capital losses if they rise. However, those gains or losses disappear as you approach maturity. The major risk with bonds today is that if inflation stays high or rises further, you will be stuck with negative real returns.

There is one investment that gives you the best of both worlds: safety and inflation protection. It’s called a real-return bond (RRB), or inflation-protected bond.

Before I elaborate, let me explain how RRBs work. Traditional bonds have a “coupon,” which is the annual interest rate you receive on the principal. If the bond’s principal is $100 and the coupon is 1%, you’ll receive $1 in interest every year. (More properly, you’ll receive 0.5%, or 50 cents, every six months.) When the bond matures, you get your $100 returned to you.

With RRBs, the coupon always stays the same, but the principal gets adjusted every six months based on the rate of inflation, as measured by the Consumer Price Index. For example, if you invest $100 in an RRB and inflation is 2% during the period, the principal grows to $102. Your semiannual interest payment is based on that adjusted amount: you’d receive a payment of 0.5% of $102, or 51 cents. That goes on until the bond matures, at which point you receive the inflation-adjusted principal.

To me, RRBs are a plausible alternative for investors who want the safety of bonds combined with inflation protection. Unfortunately, there’s no such thing as a free lunch. Today, the average yield on Canadian RRBs is 0.85% or so, excluding the inflation adjustment. In other words, 0.85% is your expected real return after inflation, but before management fees. Problem is, the cheapest RRB fund in Canada carries a 0.29% annual fee. So after paying fees, your real return on a bond held to maturity in this fund can’t exceed a paltry 0.56% per year.

That’s not all. The shortest RRB maturity available in today’s market is 10 years, and the average term to maturity of your typical fund is 20 years. Thus, by investing in one you will have condemned part of your portfolio to mediocrity for 20 years or so.

For those reasons, most analysts and advisors have stopped recommending RRBs to their clients. Their argument is simple. Not only is the return mediocre, but the risk, in their view, is high. Over the past 10 years or so, the yield on RRBs has gradually dropped from 4% to 0.85%. If yields revert back to the historical mean, capital losses could be significant. By significant, I mean that each 1% increase in RRB yields would reduce your fund’s market value by 16%.

Okay, that’s the downside. Stay with me though, because there’s an upside too. I personally am willing to live with the risk inherent in RBBs for several reasons.

First, an inflation-safe bond with mediocre returns is better than one exposed to inflation risk. Every investor needs some bonds in his or her portfolio, and I’d rather have the former.

Second, RRBs have an inherent stability mechanism and are therefore not as risky as people fear. The probability of RRB yields rising again is very low in the foreseeable future. Remember that bond yields rise for two reasons: when inflation expectations rise, or when the credit risk of the issuer worsens. With RRBs, the inflation adjustment takes care of the former. As for credit risk, RRBs are primarily issued by the federal (and to a much lesser extent, provincial) governments, all with good credit standing.

Third, bond yields are subject to the laws of supply and demand. Here is the key point: RRB supply is scarce, and when supply is short of demand, prices remain high (and yields remain low). Currently, RRBs represent no more than 5% of the total supply of government bonds. The Canadian government projects this to increase to 10%, but I still believe supply will remain tight.

The fact is, governments have a disincentive to issue RRBs unless they believe future inflation will stay very low. And barring a European-induced financial meltdown, global inflation is here to stay. While they won’t admit it, governments like this combination of low interest rates and moderate inflation because it lightens their debt burden significantly. If you’re paying 2% interest on your bonds and inflation is 3%, your real cost of borrowing cost is negative. If governments can borrow today at negative cost, why would they issue RRBs that close that gap and make borrowing more expensive?

With all of this in mind, putting some of your portfolio in an RRB fund is not a bad idea. But don’t go for the kill. The risk of higher yields—and therefore falling prices—cannot be completely ruled out. More importantly, don’t put in any money that you may need in the next five years. RRBs have very long maturities, and rising interest rates may force you to sell the bonds at a loss.

How much should one invest in RRBs versus regular bonds? Before you decide, understand that RRBs have a built-in inflation expectation. As I mentioned earlier, RRBs yield about 0.85% today, while regular government bonds with comparable maturities yield roughly 2.9%. The difference between those two yields (just over 2%) is what the market expects inflation to be. How much you allocate to RRBs and regular bonds depends on whether you agree with the market. If you expect inflation to be more than 2%, add more RRBs. If you expect inflation will be lower than that, you may want to favour traditional bonds. A balanced approach would include equal amounts of each.

Note that RRBs are not suitable for retired investors who rely on capital withdrawals to supplement their income. The income RRBs spin off is not that rich to start with, because the inflation adjustment is added to the principal, not paid out in cash. RRBs are most suitable for middle-aged investors who are saving for retirement and want to ensure their fixed-income investments keep pace with long-term inflation.

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The “Keeping it real” chart lists RRB funds available to Canadian investors. As you can see, most of them are way too expensive. To begin with, there is no value added from active management, because all the fund managers have only a handful of bond issues to choose from. Therefore, the underlying portfolios in these funds are nearly identical. The best choice, therefore, is one of the less expensive exchange-traded funds, such as the BMO or iShares offering.

Both ETFs have very similar portfolios, with an average maturity of 20 years or so. The BMO ETF is entirely composed of federal government bonds, whereas the iShares ETF has a small component of provincial bonds with a slightly higher yield. I expect the two funds to deliver very similar returns over the long term. For the first half of 2011, both have reported a nominal annual income of 2%, made up of coupon payments with the inflation adjustment. I expect that to improve slightly to 2.5% or so in the second half due to higher inflation.

You’ll notice that the total returns on real-return bonds (that is, interest payments plus price increases) have been extremely good in recent years. But please do not be fooled. This is history that is not likely to repeat itself any time soon. As RRB yields kept dropping, bond prices climbed up. But yields have now reached very low levels and have limited room to drop further, unless people decide to start lending to the government for free. Therefore, the potential for any capital gains is much lower. You do not buy an RRB fund in order to make big bucks, but rather to protect your wealth from inflation while earning a small income.

First, emerging economies will continue to grow rapidly compared to developed economies. In fact, with developed countries on the verge of another economic slowdown—possibly even another recession—emerging markets are the only place where you can expect to see any significant growth.

Second, most emerging countries are no longer plagued with debt problems. Their international trade balances have massive surpluses and their central banks are flush with foreign reserves. Unlike in Europe, North America and Japan, where governments are burdened with budget deficits, the governments of leading emerging countries have put their fiscal houses perfectly in order.

Third, valuations are now attractive, relative to the rest of the world. The average forward price-to-earnings (P/E) ratio of emerging market equities is currently in the range of 12 to 13, compared with 14 to 15 for global equities. In China, Brazil and South Korea, for example, stocks are currently trading at forward P/E ratios of 10 or less (a forward P/E ratio expresses the company’s stock price as a multiple of its expected earnings for the next year).

Fourth, dividend yields are attractive. Unlike the old days when you bought emerging markets purely for rapid growth, you can now count on growth and decent dividend income. This is good, because dividends represent an objective measure of a company’s financial health. Stated earnings can be manipulated (particularly in some emerging countries; I won’t name names), but dividends are real cash in your hands. Companies that pay high dividends have less room to engage in accounting games.

Fifth, the banks in the emerging countries are the least exposed to Europe. A healthy banking system is critical for economic growth. With all that’s happening now in the Eurozone, the impending crisis is bound to affect banks exposed to European debt. In this respect, the Asian and Latin American banks, which represent the highest component of emerging market indexes, will be less affected than American and European banks.

Finally, the emerging currencies are strong. This is both good and bad: currency appreciation has the potential to offset some of your losses and add to your gains when markets rebound. However, currency strength is also related to inflation and high interest rates, which are not good for stocks, and this largely explains the recent 25% dip in the markets.

Indeed, inflation is the major risk currently surrounding emerging market equities. Some economies, such as those in Brazil, China and India, are now truly overheating, with inflation rates in the 6% to 8% range. As a result, interest rates are becoming dangerously high. In Brazil, for example, short-term rates are currently north of 10%.

It is all but certain that high interest rates will quell economic growth eventually. The objective of governments and central banks is to manage a soft landing where economies cool down enough to control inflation, but not so much that they induce a recession. The danger is that if they press too hard on the brakes, economic growth will come to a grinding halt.

Moreover, emerging economies are not isolated islands: many depend heavily on exports to the West and Japan. That means a major slowdown in global economic growth will result in reduced demand for their exports. There are already signs that this is starting to happen, as China’s fourth-quarter growth is now forecasted to slow to (a still whopping) 8.5% from nearly 10%.

There is also the nagging issue of governance and transparency. In many emerging countries, the law is still applied selectively. Corporate governance and accounting standards are not as strict as in developed markets, and therefore financial statements and earnings reports are not always reliable. This problem occasionally spills over to companies listed on western stock exchanges, as we recently saw with the Sino-Forest case. Moreover, despite their relentless economic growth, countries such as China and Russia still have major structural economic problems that remain to be resolved.

If economic concerns materialize into a full-blown recession, we may see further market weakening. You will also feel the heat of currency volatility, as exchange rates will strongly (but temporarily, I believe) favour the U.S. dollar as a safe haven during periods of market turmoil. But as I said, investing is not about market timing. It’s about buying low and selling high, which means you add to your positions when the news is bad and prices are down.

So what is the best way to invest in emerging markets? Certainly picking individual stocks is out of the question for most investors, so mutual funds are the most sensible choice. “The passive route” table provides a list of exchange-traded funds (ETFs) with low management expense ratios. The Vanguard MSCI Emerging Markets ETF (NYSE:VWO), for example, charges just 0.22%.

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The beauty of ETFs is that they give you exposure to hundreds of individual stocks in many emerging countries. They are fully invested at all times, so you will fully benefit from a market rebound when that happens. On the flip side, however, you will take the full brunt of any further downturn.

The two WisdomTree ETFs offer an interesting approach. Unlike most emerging markets indexes, which are dominated by large-cap companies, the WisdomTree indexes focus on dividends and have whopping yields in the 6% to 7% range. Both funds have a high allocation to Taiwan and little exposure to China, India and Russia. Exposure to banks is high, which is typical of dividend funds. This means the waters will be choppy in the short term, particularly if we have a full-blown credit crisis. However, dividend yields will provide good support in the long term.

The other table provides a list of actively managed funds for you to consider. The major problem with these funds is their high cost. The moment you steer away from index funds, your annual management fees jump by a lumpy two percentage points or more. In most cases, these costs are more than enough to offset the fund’s dividend income. Still, this is a category where risk is high, so the comfort of having a skilled manager is, for many investors, worth the cost.

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AGF Emerging Markets has been a good performer. For the past three years, the fund has beaten its benchmark, and its average annual return over the last five years is almost 10%. It follows a bottom-up approach: in other words, the manager’s strategy is based on individual stocks rather than sectors or countries. Against that backdrop, no single sector or country represents more than 15% of the total portfolio. My major concern with this fund is the very high management expense ratio (MER), which is more than 3%. That said, one must recognize that the extremely low portfolio turnover (10% to 15%) partly compensates for that.

Brandes Emerging Markets Equity also has one of the best long-term records, with an 8.8% average five-year return. It has recently been hurt by its exposure to financials and some other individual holdings in the consumer sector. However, on balance, the fund presents some advantages in the form of broad diversification across sectors. This can help smooth out the ride in this highly volatile space. Again, the low turnover compensates for the high MER.

If you truly believe in buying low and selling high, you need to tolerate short-term volatility. That’s why investing in bad times takes so much courage and discipline.

You don’t need to do a lot of research to conclude that if two funds invest in similar securities, the one that charges less will deliver better results. Some will argue that funds that have delivered good performance deserve higher fees, but let the numbers speak for themselves. In the table “Costs matter” I have sorted funds from four major investing categories—Canada’s cheapest Canadian fixed-income mutual funds, Canada’s cheapest Canadian neutral balanced mutual funds, Canada’s cheapest international equity funds, Canada’s cheapest Canadian equity funds—into management expense ratio (MER) quartiles. (The MER is the total annual fee you pay for each fund.)

The first quartile contains the cheapest 25% of funds and the fourth quartile contains the most expensive. For each quartile, I calculated the average five-year return to see how the MER affects returns. (Since I’m assessing whether manager performance justifies higher fees, I’ve excluded index funds. To compare apples to apples, I’ve also left out institutional funds, U.S. dollar series, and Series F funds.)

The table provides compelling evidence that management expenses have a direct, negative impact on long-term returns: the cheapest quartiles have the highest returns, and vice-versa.

Why is a fund manager’s ability to add value so limited? In the case of fixed-income funds, there is simply a limited supply of investment-grade bonds, so most managers end up in the same issues. Some may use tactics such as buying longer maturities when they believe interest rates will go down, or keeping their bonds shorter when they expect rates to rise. Sometimes they get it right, sometimes they don’t. Over the long term, bond funds tend to perform quite similarly to their indexes, less management expenses, so keeping fees low is essential. The same applies to balanced funds, which usually include 35% to 40% bonds.

What about equity funds? Since there are so many more investment choices, you would expect your fund manager to earn his or her fees by picking stocks that will outperform the market. In reality, it’s not that simple. Managers do not have free rein: they have to invest in a prescribed set of assets, as determined in the fund’s objectives. They also have other limitations that prevent them from concentrating too heavily in any particular company or sector.

Even if they are permitted to make concentrated bets, most managers are reluctant to do so, because they have too much to lose if they get it wrong. When things don’t work out, both investors and the fund’s sponsor will blame the manager: money will flow out of the fund and the manager may lose his or her job. But if the fund cuddles up to the index, the manager can always blame the market if performance is poor. As a result, many fund managers end up sticking closely to the securities in their benchmark.

Even fund managers who outperform do so for a limited period of time. They may enjoy success as the result of a good call on some individual securities or sectors. More often than not, unfortunately, their success is short-lived. Markets are largely efficient and very difficult to outguess consistently.

All of which brings us back to cost. If a fund manager’s ability to add value is so limited, charging higher fees is hardly justified. Look at the tables on the opposite page, which list the cheapest funds in each of four categories: Canadian fixed income, Canadian neutral balanced, international equity and Canadian equity. As you can see, the vast majority of these funds report above-average returns. My intention here is not to endorse any specific fund (although a low MER is a good starting point), but rather to prove that paying higher fees to your manager will not necessarily reward you with higher returns.

Armed with this evidence, should you just go and buy the cheapest funds to maximize your returns? Not so fast. First, you need to select the funds that suit you best in terms of your financial objectives and risk tolerance. After excluding consistently poor performers, determine if you like the fund’s investment style (value or growth) and portfolio composition. After you’ve whittled down your choices to a short list of suitable funds, then you can select the cheaper ones.

You also need to look at the big picture. Management expenses are not the only cost component. You need to factor in commissions, such as front-end loads or deferred sales charges. Trading costs can also cut into returns, and these are directly related to portfolio turnover. Brokers always take their cut when fund managers buy and sell securities, so the higher the turnover, the greater the fund’s costs. And if you’re investing outside an RRSP, you’ll pay capital gains taxes on any trade that turns a profit.

Imagine what impact this can have if your fund manager buys and sells too often: A fund with 200% portfolio turnover and a 2% MER may be more expensive than a fund with 30% turnover and 2.5% MER.

An excellent resource is the fund’s semi-annual Management Report of Fund Performance, which details all costs as well as portfolio turnover. (You can find this document at www.sedar.com.)

Finally, don’t forget the price of advice. Your fund MER includes two major components: management fees paid to the portfolio manager and trailer fees (usually 0.5% to 1%) paid to the adviser or broker who sells you the fund.

If you do not need investment advice, you can reduce your costs by buying funds that do not charge trailer fees. Some fund companies (including Mawer, Phillips Hager & North, Steadyhand and RBC) sell funds directly to do-it-yourself investors, with no advice fee built in. (These are often called “D Series” funds.) However, to open an account you will typically need a starting investment of $10,000 or more, depending on the company. Another option is to buy no-load, no-trailer funds from a discount brokerage, which will often require a lower minimum investment.

If you need investment advice, your overall cost will be higher. Still, one option is to buy “F series” funds, which have much lower MERs because they do not pay trailer fees. F Series funds are sold by advisers who then add their own fee separately. Usually these advisers charge a minimum annual fee of at least $1,000, however, so this option is suitable for investors with large accounts. For example, if you have only $10,000 to invest and your adviser charges a fee of $1,000 per year, that represents 10% of your total investment, which makes “F series” funds uneconomical.

For investors who need advice but have smaller amounts to invest, there may be no other choice but to go with the more expensive funds. If this is your only option, make sure that your fund’s MER does not exceed 2.5% (1.5% for fixed income). If you’re happy with the quality of service and advice that you get from your adviser, the embedded trailer fee will be well deserved.

Since the beginning of the year, several key developments have helped to boost the outlook for oil and gas prices. First and foremost is the recurring risk of inflation.

The unwillingness of governments to cut their budget deficits has made higher prices all but certain in most developed countries. In the U.S. in particular, the mounting deficits and debt are untenable. But instead of cutting expenditures and raising taxes, which is politically suicidal, governments seem to be inducing inflation to make debt easier to repay.

For the same reason that inflation is harmful to savers, it’s good for long-term debtors, because it lowers the real value of the interest payments. That’s why governments with high debt have an incentive to encourage inflation. In his book The Age of Turbulence, Alan Greenspan forecast a 4% inflation rate for this decade, mostly due to structural budget deficits. (A structural deficit is one that cannot be eliminated without major taxing and spending policy changes.) But that was before the crisis of 2008. With the binge spending and loose monetary policy of the past three years, inflation is likely to get worse than 4%. Prices are currently moderate on most consumer items, so this sounds like next year’s problem. But markets anticipate what will happen next.

The problem is, inflation and high commodity prices — including oil and gas prices — tend to feed on each other in a vicious circle: people stock up on commodities to hedge against inflation, which leads to even higher prices, and thus inflation continues to rise.

The second development that bodes well for energy stocks is Japan’s nuclear crisis. After what happened in Fukushima, nuclear energy has suddenly become unattractive, both politically and environmentally. The obvious alternative is natural gas, which will increasingly replace nuclear reactors for generating electricity.

The third development is political uncertainty in the Middle East. Recent events in this region, which produces about one third of the world’s oil supply, have pushed oil prices above $120 per barrel.

Needless to say, higher prices do wonders to the profitability and cash flows of oil and gas companies. For these companies, the cost of production is pretty much constant, so every extra dollar in the selling price goes straight in their coffers.

Right now large oil and gas companies are trading at cash flow multiples of 9 to 10 times, which is on the high side. However, when recent price increases are factored into this year’s results, those multiples will suddenly look much more attractive.

As Canadian investors, our options for getting oil and gas exposure abound. To start with, the S&P/TSX Composite Index is more than 25% energy stocks. So even a broad-market Canadian mutual fund may have more than enough oil and gas exposure for a regular investor. But if you want more, you can always buy an energy fund.

There is no separate investment category for energy funds: they’re typically included with natural resources funds. But in the graph Cooking with gas I have provided a list of pure, actively managed energy funds for you. In order to select a suitable one, first consider whether you want purely Canadian exposure, or whether you prefer to diversify into global energy funds.

Keep in mind that the moment you go global, some additional risk factors come into the equation, including foreign currency fluctuations. Historically, the Canadian dollar tends to appreciate with higher commodity prices, as Canada is largely a resource-based economy. Therefore, investing in a fund with exposure to foreign energy stocks is a bit like a tug-of-war: some of your gains may be offset by currency depreciation.

Your second consideration is whether you want a fund with small-cap or large-cap focus. Small energy companies produce less and have fewer exploration fields, so when they have a major strike, their price skyrockets. They also tend to benefit more from higher prices. On the other hand, those companies have limited access to financing, and less capacity to withstand long cyclical
downturns. In summary, investing in small-cap producers can be very rewarding, but it’s not for the faint of heart.

Looking closer at Cooking with gas, you will see that CIBC Energy and Bissett Energy have scored the best results, buoyed by high exposure to Canadian small- and mid-cap companies. RBC Global Energy also has some focus on smaller companies, but the non-Canadian component of its portfolio has suffered from the rising Canadian dollar. The fourth-best performer, Altamira Energy, places more emphasis on mature, large-cap Canadian producers. For that reason, it is slightly less volatile than the other two.

No matter what you choose, keep in mind that energy funds are almost twice as volatile as regular equity funds. Even though the long-term outlook remains promising, you can never ignore the risk of a cyclical downturn. Energy funds lost 40% or more of their value between June 2008 and March 2009. That’s an indicator of how bad things can get when the market turns against you.

For the risk-conscious investor, the ideal alternative is a fund that invests in high-yield energy stocks. The beauty of these funds is that they can cope with most economic situations. When the economy is strong and inflation is high, interest rates go up, but so do oil and gas prices. That strengthens the balance sheets and cash flows of energy companies. When the economy is weak and inflation is under control, lower commodity prices negatively affect cash flows and may result in dividend cuts. However, this risk is mitigated by the likelihood of lower interest rates, which makes dividend yields more attractive. Either way, financially sound, high-yield energy stocks tend to fare well.

In the good old days, when income trust funds were still around, it was easy to find one with exposure to high-yield energy stocks. Until last year, we had a respectable number of income trusts with high energy exposure yielding 7% or more. When the new tax laws came into effect, those trusts converted into corporations. Meanwhile, income tax and higher share prices have reduced dividend yields by half (when the share price goes up, the dividend yield goes down), but those yields are still attractive.

As a result of the mass conversion of income trusts into corporations, the former income trust funds have now morphed into balanced funds, high-yield funds, or small-cap funds. So you need to dig deep to find those with significant exposure to high-yield energy corporations.

For that, you have to look at the portfolio holdings as well as the dividend distributions of each fund. I stress the word dividend here because mutual fund distributions include several components: dividends, capital gains and return of capital. What matters most is the dividend income, because these payments come from surplus cash flow. Capital gains are more unpredictable, and return of capital is simply your money being handed back to you.

Separating out the dividend distributions from the others sounds tedious, and it is. However, you don’t need to worry, because I’ve done the work for you. In the graph “A safer bet,” I have listed six options with a healthy exposure to high-yield energy stocks. I selected funds with a minimum estimated portfolio yield of 2% and a minimum exposure of 30% to the energy sector. This is to ensure that a substantial portion of the dividend income is derived from energy stocks, which makes the fund less vulnerable to inflation.

If you want a lower-risk alternative to hedge against high energy prices, I would suggest that putting some money (say 10% or 15% of your portfolio) in one of these funds is a suitable choice.

We calculate RAR in two steps: First, we adjust the fund’s risk to a level
comparable to that of its respective benchmark index. Then, we calculate
the rate of return that the fund would have posted under that assumption.
In other words, RAR gives us the rate of return that the fund manager
would have obtained, had he/she been prepared to assume the same risk
level as the index.

But it’s different now. Really. Technology stocks are no longer grossly over-valued, for starters. The whole sector has come crashing down to earth. Not only is the sector more attractive by historical standards, but arguably, compared to most other market sectors as well.

Today, the average price-to-earnings (P/E) ratio of a typical U.S. technology mutual fund is 21 times. That’s approximately half of what it was 10 years ago. In March of 2000, at the crest of the dot-com bubble, the NASDAQ Index average P/E ratio peaked at an absurd 47 times earnings. It’s true that a P/E ratio of 21 is still high compared to the overall S&P 500 average of 16. However, technology stocks have always commanded a sizeable valuation premium over other sectors, and there are some good reasons for that. You might not want to jump in with both feet, but here are five good reasons why it’s time to give tech stocks another chance:

Tech is growing fast
Forrester Research estimates IT spending will grow by 9% this year and 7% next year. Compare that to the expected GDP growth of 2% or 3% for the overall economy. As well, technology companies are projecting an average earnings growth of 15% to 20% next year, versus 7% or so for the broad market. Investors expect the faster growing earnings to catch up with higher stock prices, which justifies the higher P/E multiple.

Even better, that valuation premium isn’t as high as it appears to be. These days many technology companies have tons of cash on their balance sheets, averaging between 10% and 20% of their market capitalization. Microsoft, for example, has cash assets representing some $4 per share. That means if you bought the company’s stock today at $25, you’re really only paying $21. After adjusting the price of the shares for the value of the cash on hand, Microsoft’s P/E ratio drops from 12 times to 10 times. Several technology stocks have become so cheap that they are now considered true value picks. Because of all that cash, the average technology P/E ratio is actually more like 18 or 19 times, not 21.

Tech is transparent
Tech companies got a bad rap during the dot-com bubble for promising the moon before they even had a penny in earnings. Internet darlings that actually lost money on most of their sales still saw their stock prices shoot up (remember Pets.com?). But today it’s easier to understand a tech company’s earnings reports and balance sheets than those from companies in other sectors. Some five years ago, new accounting rules paved the way for cleaning up the stock options fiasco. Since then, earnings reports have become more transparent, with less room for accounting shenanigans. Unlike banks, which have a zillion ways to hide bad loans, or commodity-based companies, which use complex models to estimate the value of their reserves, technology companies’ earnings are largely made up of simple, pure cash flow.

Tech is (almost) recession-proof
Technology products have increasingly become part of our daily life. These are no longer discretionary spending items: in many businesses, if you don’t have a BlackBerry or an iPhone you can’t compete. Our unwillingness to give up such technology once we’ve grown accustomed to it has made the sector more defensive in nature, and more resistant to economic down cycles.

Yes, companies may put off upgrading their computers, software, routers and servers during times of hardship, but they won’t give them up altogether. Besides, corporate balance sheets are flush with cash right now—unlike debt-laden consumers and governments. Right now corporations are capable of spending big bucks on technology to improve productivity, making tech one of the few sectors that could see above-average growth despite the current hard times.

Tech is global
Technology has innovation on its side, and that boosts both productivity and demand. (How many people do you see lining up for a new detergent or soft drink formula the way they do for the latest iPhone or iPad?) That excitement is spreading around the world. In fact, the sector is now considered a second-tier play on emerging markets growth. As consumers in India and China become wealthier, they’re quick to upgrade the technology they use. Those markets present a phenomenal opportunity for many sub-sectors, particularly telecommunications equipment. Despite cut-throat competition between Apple, Research in Motion and Google, all three of them are enjoying strong growth in global smart phones sales.

Tech pays dividends
Believe it or not, some tech stocks are becoming dividend cash cows. Distributing surplus cash—as opposed to retaining it for growth—is becoming increasingly engrained in the corporate culture of the larger, more mature technology players. Microsoft’s dividend yield is currently 2%, similar to the overall market yield. Intel is yielding a juicy 3%. Other high-tech companies that used to pour all of their surplus cash into research and product development are likely to follow suit.

Of course there are risks too. You probably don’t want to invest too heavily in tech if diversification is important to you. Just a few large players make up the bulk of the sector’s market capitalization. Apple, for instance, currently represents a full 20% of the NASDAQ Index. The Dow Jones U.S. Technology Sector Index is also top-heavy, with the five largest member companies representing nearly half of the portfolio. Similarly, in Canada pretty much all of the S&P/TSX Capped Information Technology Index is made up of just five companies, no more.

So while the long-term prospects of the big technology indexes are good, short-term, investors could be in for some serious volatility. If you don’t have the stomach for wild roller coaster rides, a more diversified, actively managed mutual fund might serve you better than a passive index fund, as the fund manager can help to smooth things out.

In the “Tempting Technology,” chart below, I list some actively managed technology funds that have managed to report positive returns over the past five years—despite the massive losses incurred in 2008. If you look at their top holdings you will see the same index heavyweights: Apple, Google, Microsoft and Cisco. I recommend them as a good way to get some technology exposure, as they are more diversified than the index funds. Keep in mind, though, that higher growth always comes at a cost—so even the best technology mutual funds will have a tumble or two along the way.

Tempting Technology

These funds are a great way to increase your tech exposure.

As you wait for time to tell which camp is right, one investment category is screaming “buy me.” I am referring to dividend mutual funds. Right now, you can’t go wrong with them. That is, as long as you can prevent the fund companies from clawing back your gains in the form of high fees.

My reasoning is very simple. Compared to bond yields, dividend yields have rarely been more attractive. How so? Just think about which you would rather buy: a stock that offers a 3% yield right now, plus the possibility of capital gains and yield increase; or a 10-year bond that offers a 3% yield, and… Well, that’s pretty much it. With stocks, you expect corporate earnings to grow. You also expect the dividend payout to improve with higher earnings, leading to share price appreciation. With the bond, you have to be content with the 3% return for the whole 10-year period.

Because of the potential upside with stocks, investors have historically bought equities even when their dividend yields were lower than bond yields. Since the 1950s, the dividend yield on common stocks has averaged just half that of bond yields. When 10-year bonds paid 4%, investors were still happy to buy stocks that paid just 2%.

Right now, however, that yield gap is much narrower. Canadian banks, utilities, and telecommunications stocks are distributing dividends at yields ranging between 3.5% and 5%, while government bonds are offering up 3% or less. In the U.S., even defensive stocks for world-class companies such as Coca-Cola and McDonald’s are now offering amazing yields exceeding 3%—compared to the 1% or so they offered in the past. Why so high? It’s mainly because many investors, stung by their losses in 2008, fear another setback. Therefore, they are demanding higher yields to compensate them for the risk of staying in the market.

Even if our worst fears come true, and we enter phase two of a double-dip recession, I believe that high-yield equities will be fine over the long run. If the recession deepens, interest rates will stay low, keeping dividend yields attractive. On the other hand, if our alternate disaster scenario of out-of-control inflation comes riding into town on the back of a strong economic recovery, corporate earnings will improve. When they do, dividend payouts will increase, paving the way for higher share prices. With dividend funds, you’ll win either way—and collecting a 3% annual dividend while you wait for things to unfold is not a bad proposition.

Of course there is still the risk of dividends being cut, and that’s not a risk to be casually dismissed. Even the best companies have done it (Manulife, how could you?), and often in good times. However, I would say that in the vast majority of cases, corporate balance sheets are strong and dividend payouts fairly safe. You will get the odd case where an individual company slashes dividends. However, if you hold a diversified mutual fund, a few isolated cases of dividend cuts will have minimal impact.

Unfortunately, there’s a bigger problem with funds in the dividend category, and that’s their high average management expense ratio (MER) of 2.2%. If you’re not careful, such high fees could snatch back more than half of the dividend income that you would otherwise expect to collect.

Those high fees lead us directly to a second problem, which you could call mandate drift. By definition, mutual funds in the dividend category should be investing only in high-yield equities. But many managers try to compensate for the high fees by chasing performance—in the form of higher capital gains—even if that means buying equities with lower yields.

Because of this drift away from the dividend mandate, you’ll find that the actual dividend yields of most funds in the category are in the disappointing 0.5% to 1% range. To camouflage this issue, fund companies engage in a somewhat misleading practice: they give you back some of your original investment in the form of a cash distribution referred to as “return of capital.” For example, a fund that is yielding 1% from dividends alone will often distribute 2% to investors—but the additional 1% that you receive is not income. It’s your principal investment returned back to you, to make you feel good.

In the Dividend delight table below, I have listed eight funds with management expense ratios (MER) of 2% or less. All of the funds have a real dividend yield of 2% or more, and a minimum 10-year average annual return of 5%—not bad, considering the recent stock market crash. When calculating the estimated dividend yield of each fund, I ignored the distributions that consist of your own returned capital, and just took the actual dividends into account. Within the “Canadian Dividend Funds” category proper, I only found two candidates that met my requirements. So to compile the list, I had to dig into other categories, such as “Canadian Equity Balanced” and “Balanced.” That said, all the chosen funds have at least two thirds of their portfolio invested in equities.

In addition to the funds listed in the table, there are a couple of exchange-traded funds (ETFs) worthy of your consideration. The iShares Dow Jones Canada Select Dividend Fund (XDV) currently offers a yield of 4% with a cheap management expense ratio of 0.5%. The Claymore S&P/TSX Canadian Dividend ETF has a higher estimated yield of 4.5%, with a 0.6% MER.

The Claymore S&P/TSX Canadian Preferred Share ETF (CPD), which invests solely in preferred shares, currently offers a net yield of nearly 5%. The difference between common and preferred shares is that when it comes to dividend distribution, the preferreds take priority. In other words, if a company has both common and preferred shares, and not enough money to pay out all the dividend cash it promised, it will pay the dividends on the preferred shares first. This makes preferred dividends safer, but the downside is that preferreds offer no significant long-term potential for capital appreciation.

I find the Claymore Preferred Share ETF especially attractive because it strikes a good balance between different types of exposures. In one portfolio, it combines floating-yield issues (50%), perpetual issues (30%) and convertible bonds (20%). The floating-yield preferreds protect you from inflation, and the yield on the perpetual issues becomes attractive when interest rates fall, which tends to happen in recessions. The convertible bonds component rounds out the ETF by offering an opportunity to participate (moderately) in the next bull market.

Dividend delight: These eight dividend funds offer low fees and high yields.

Certainly there have been a lot of jittery investors dumping their American greenbacks and flooding into the ultimate currency lately. That influx has prompted gold to roar back to life after its 2008 slide, and it recently topped US$1,200 an ounce. Now, as Europe plunges deeper into debt, some respected analysts are saying it could reach US$3,000.

So should you buy in and ride the wave? It’s hard to say. There are many good reasons why gold could continue its ascent for a while longer. On the other hand, gold is volatile right now and when it does fall, it tends to fall fast. To help you decide, I’ll take you through the cases for and against sprinkling a bit of bullion in your portfolio. Then I’ll take a look at some interesting mutual funds in the precious metals sector (see table on page 2).

The case for gold largely revolves around three current trends in the global economy. The first is the “flight to safety” that tends to occur during uncertain times. Right now, the world is looking for an alternative reserve currency to the faltering American dollar, and thanks to the European debt crisis, it doesn’t look like it will be the Euro. The resulting migration from U.S. dollars to gold has helped push up the price.

The second trend is the slow build of economic forces pushing us towards inflation. The current budget deficits reported by many struggling European countries (not to mention that reported by the U.S.), don’t look sustainable. Yet the drastic cuts required to balance budgets will be extremely unpopular. So what’s the alternative? Some say inflation. By tolerating some moderate inflation (say 4% to 5%), and eroding the value of money by as much every year, Western governments could reduce their debt burdens. This may take another year or two to start happening, but it’s a real possibility. If it does, gold could soar, as it is widely seen as a hedge against the risk of surging inflation.

Thirdly, it’s worth noting that central banks, which were dumping gold in the late 1990s and the early 2000s, are now buying again, mainly in a bid to diversify their foreign reserve holdings. The serious troubles in Europe make me feel that this could continue for some time. If it does, gold still has room to appreciate further.

Before you start burying gold bars in the backyard, though, it’s worth taking a moment to consider the risks. For starters, remember that buying into any investment that’s trading at such a high valuation is dangerous. Dot-com stocks looked just as fantastic in 1999 before the bust, and U.S. real estate was a sure bet in 2006.

Gold is a risky investment because when it loses investors’ interest, there is nothing to support it. Industrial demand for the metal is limited, so its fundamentals are purely based on investors’ appetite. People who invested in gold in the 1980s lost two-thirds of their capital. Those who stayed invested had to wait 30 years to break even. That’s why I don’t recommend that you hold precious metals funds in the core of your portfolio. Instead restrict them to a speculative portion of no more than 10%.

If you do decide to increase your exposure to gold, the first question you will face is whether you should buy pure gold (be it in the form of coins, bars or exchange-traded funds with real gold holdings), or a precious metals equity mutual fund.

When you compare pure gold to a gold equity index fund, you find that there’s not much difference. If at the end of 2001 you invested $10,000 in pure gold, your investment would be worth $27,390 today. That compares to $25,900 if you had invested the same amount in a precious metals equity index fund. Pure gold would have outperformed the index fund by more, but gold prices are denominated in U.S. dollars. Because the U.S. dollar has been falling against the loonie, when you adjust your returns for currency, the returns are pretty similar.

But I think an actively managed precious metals equity fund can do better than either pure gold or the index. As “The gold standard” table underneath shows, several funds in the category have outperformed the S&P/ TSX Global Gold index by a significant margin, and with average returns of 20% per year on a 10-year basis. Such spectacular returns are usually achieved through exposure to junior gold miners. Investing in juniors by yourself is risky, but by investing with a smart fund manager who keeps a diversified portfolio, you can reap handsome short-term benefits while minimizing the risk.

Dynamic Precious Metals is a good example of an actively managed precious metals fund that has achieved above-average results on consistent basis. I attribute this performance to a solid stock selection with an emphasis on small cap issues. This fund was particularly adept at maintaining a liquid portfolio during the 2008-09 plunge in gold prices, which enabled it to contain its losses well below the average category loss.

RBC Global Precious Metals is another good choice. This fund has delivered excellent returns on a 10-year basis, and again, the portfolio manager was good at containing losses during the 2008 fall, this time by maintaining a high cash balance and holding some gold futures.

Still, I must emphasize that if you choose any of the listed funds, be prepared for a drop if the market turns. Losses posted during the 2008 slide ranged from 25% to 55%, and as a rule, precious metals equity funds are twice as volatile as regular equity funds. In short, if you’re an active and bold investor who wants to buy into the gold rush, you need to remain alert to market trends and be ready to exit when you reach your target price. On the other hand, if you’re a buy-and-hold investor looking to add a new asset class, gold may not be an ideal choice.

The gold standard
Precious metals funds have returned 20% a year over the past 10 years

Suzane Abboud, CIM, is president of FundScope Ltd., a mutual fund research company located in Toronto.