Q. I am really puzzled by the confusing factors surrounding investing for income, particularly current interest rates, treasury yields, bond fund performance, bank CD rates, inflation, etc. An inverted Treasury yield curve has historically preceded a recession. Do you believe that is the situation at hand or is this just another historical pattern being invalidated by the "new investment era"?

---R.M., Dallas, TX

 

A. The Treasury yield curve--- the curve made by connecting the yields on Treasury obligations from 3 months to 30 years--- isn't the indicator that it used to be. One reason is that the Treasury has been buying back long-term issues. This has forced yields on long Treasuries lower. Another reason is the prospect of a long period of government surpluses that could result enormous reductions in the amount of Treasury debt outstanding.

Beyond the Treasury arena, yields are much higher. Recently, for instance, the yield to maturity on GNMA issues with an average life around 10 years were about 7.4 percent, a 160 basis point premium over comparable maturity Treasury issues. Similarly, long term tax-free municipal bonds have been providing yields that were 90 percent of comparable taxable Treasury yields. There is also a large premium to Treasury yields on Guaranteed Investment Contracts from insurance companies. Recently, the T. Rowe Price GIC Index showed yields of 6.6 percent for 1-year contracts and 7.18 percent for 5-year contracts.

As a consequence, the Treasury yield curve probably isn't a good tool for economic forecasting.

What's the alternative?

That's what everyone wants to know.

 

Q. Although I was familiar with Exchange Traded Funds previously, your recent description in a column caused me to think there are many similarities between ETF's and closed end funds. If so, do you have any thoughts on why ETF's have been successful during their relatively short lives compared to closed end funds? What is particularly interesting here is that most of the closed end funds sell at a discount and still don't seem too popular with investors.

Or are the ETF's less popular than I think?

---K.W., Dallas, TX

 

A. If you check the most active issues on the Amex on any given day, most of them will be ETFs, usually led by the NASDAQ 100 unit. They are very popular because they can be traded through the day, margined, shorted, and should operate with very low costs. I suspect that one of the reasons ETFs are so popular is that index funds have 'opened the door' to the idea of unmanaged portfolios.

In addition, the very mechanism of their creation means they should never sell at a premium or discount to the underlying asset value. Why is that?

Units are constantly created or undone by market makers, depending on demand. The market markets make a spread between the underlying individual stocks and the unit price. The actual cost of doing this is difficult to determine and means that ETFs aren't as dirt cheap as some represent them to be. On the other hand, once you've got your particular units, you don't have any churn in transaction costs.

 

Q. I am 32 years old and am recently self-employed. I am moving my 401k account from my previous employer to Vanguard. I am investing 50 percent in their GNMA fund. What do you think about investing the other 50 percent into Vanguard Utilities Income fund? Is it too risky?

---R. B., by e-mail

 

A. There are two reasons for you to try something other than the Utilities Income fund. The first is that this is a narrow sector fund that will never provide the long-term return of a broad domestic equity fund.

The second is that--- low expense ratio notwithstanding--- this fund hasn't done well relative to other funds that specialize in utilities. At the end of July it was in the 80th percentile relative to other utilities funds, meaning that 8 out of 10 utilities funds did better.

As an alternative, you should be looking for a broad equity fund. Vanguard Total Market Fund is a good example. A somewhat more narrow choice would be the Schwab 1000 fund.

A 50/50 mixture of Vanguard GNMA and Vanguard Total Market, up 6.3 percent and 3.6 percent year to date, respectively, in early September would have returned 4.95 percent, beating 8 of the 10 largest equity funds over the same period.