My 1st Million At 33 – yes, you can do it too

In the two previous posts in this series (here and here), I discussed a basic allocation plan using stocks and bonds. The current article examines some alternative asset classes that may boost the return without much additional risk.

REITs
Real estate investment trusts are a very popular sector in the past five years along with the bubblicious housing market. REITs (and other income trusts, MLPs) can be thought of as straddling both stocks and bonds. They are ultra long maturity fixed income plays that also reflect the value of the underlying assets. You will not find them in the portfolios at Fund Advice, but they are included in many other plans including that of Index Fund Advisor. A typical allocation would be in the range of 5-10%. There are at least four ETFs of REITs (IYR, ICF, VNQ and RWR) as well as numerous mutual funds available. Current yields of the ETFs are 3-4%.

My thinking on REITs has been evolving. I have been wary of the housing bubble as I have written elsewhere; therefore, it was natural to be concerned about the value of the underlying real estate. On the other hand, REITs are not the same as residential housing, there are apartment/commercial/nursing home/forestry REITs that may be quite resilient. The price action certainly supports the latter view. The chart below compares IYR (iShares DJ Real Esteat Index ETF) with ^HGX (Philly housing index, mostly home builders). You can see that IYR has been steadily increasing with little volatility since 2003 even as the home builders peaked last summer and the apparent deflation of the housing bubble.

More information on REITs can be found here and here.

MLPs and CANROYs
Master Limited Partnerships (MLPs) are similar to REITs in that they do not pay income taxes, and their shares trade on the major stock exchanges just like regular stocks. However, REITs and MLPs are different in structure. Unlike REITs, which are a special type of corporation, MLPs are partnerships. MLPs get special tax treatment. An MLP does not incur income taxes. Its income is allocated among all partners in proportion to their ownership interest. To qualify for the tax benefit, 90 percent of an MLP’s income must come from activities in real estate, commodities, or natural resources such as mining, timber or energy production and related activities. However, MLPs may not be suitable for IRAs and other tax-sheltered accounts.

CANROYs stands for Canadian royalty trusts. More often than not they are oil/gas operators which ties into the commodity theme below. They grabbed dividend investors’ attention during 2003/2004 because many of their payouts were equating to 15% to 20% yields. Now, because so many investors are on to them, share prices have gone up, dropping yields for most to the 6% to 12% range.

Frugal has written on both topics:
Master Limited Partnership – Great Dividend Savers
List of High Yield Dividend Stocks (Up to 18.6%)
Royalty Trusts – Get Paid Royalties w/o Paying (Much) Taxes

Commodities
“Commodity” is a wide-ranging term encompassing hydrocarbon fuels (oil, gas, coal), metals (precious and base), soft goods (grains, sugar), etc. They tracked by at least three major indices: the Commodity Research Bureau (CRB) index, the DJ/AIG commodity index and the Goldman Sachs Commodity indices. All have shown tremendous appreciation since1999.

If you have been following my other articles, you would have known that I’m heavily over weighted in precious metals (PMs) and the energy complex. One attraction of PMs is their lack of correlation to either general equities or bonds according to this study by the highly regarded Ibbotson Associates. I have yet to write a big picture overview for the PM sector, but I urge readers to visit the PM related sites I have linked to in the side bar.

Anyone had to fill up gas in the last two years would understand my preoccupation with the energy sector. I subscribe to the “peak oil” theory which basically states that the world’s reserve of cheap oil has already/is going to run out soon. Again, this is a topic deserving of at least several posts of its own, and I won’t go into much details here.

Hot Commodities : How Anyone Can Invest Profitably in the World’s Best Market Jim Rogers was the best selling author of Adventure Capitalist and Investment Biker. He was also partner to Soros in the legendary Quantum fund. “Rogers also offers practical advice and information for beginners, including the best resources, how to read the commodities reports in the newspaper or on television, the various ways to open an account, information on index funds (such as Rogers’ own index fund that he started in 1998), mechanisms, terminology, and other vital details people must know before investing. Clearly written and entertaining.” — Amazon review

There are two ways to gain exposure to commodities: buy the commodities themselves, or buy stocks in the commodity producing (including exploration) companies. In the first category, the Pimco commodity real return strategy fund (PCRDX and family), the newly launched Deutsch Bank commodity index ETF (DBC) and the more recent iSharies GSCI trust (GSG) are convenient ways for participating through the commodity futures market. For PMs specifically, there are three index ETFs (GLD and IAU for gold, SLV for silver), and a close end fund (CEF, the Central Canada Fund) for both gold and silver. For crude oil, there is USO. Buying the actual commodity eschews individual company risks and may offer short term trading opportunities.

Stocks in the commodity producing (or exploration) companies are more volatile, usually carry some political and management risk, but also offer a healthy leverage to the underlying commodity as they come to be more and more valued on their secure reserves. There are many mutual funds and ETFs available in this area. For precious metals, ASA, GDX and GGN are traded on US exchanges; XGD is traded in Toronto. Gold mutual fund performances in various time periods can be viewed here.

I have spill the most ink in this section because in my view its lack of representation is the biggest weakness in Merriman’s portfolios. Currently, my own target allocation is 30% general domestic equities, 30% general international equities, 10% commodities and 30% bonds. In my actively managed accounts however, PM and energy shares are weighted much more heavily.

Municipal bonds, foreign bonds/currencies, income producing closed-end funds
I’m lumping all these together under the big umbrella as alternatives in the fixed income category. A great site to do research on them is ETFconnect.com.

For individuals in high tax brackets and whose bond allocation are in taxable accounts, municipal bonds offer superior return as the income is tax free at the federal and state (if bonds are from the state you reside in) level. There are closed-end funds that offer very respectable yields (5-6% with leverage).

The US$ has been trending downward since 2000, although the decline was interrupted since the beginning of 2005, longer term it would have to lose value (against gold and Asian currencies most probably) in order to pay for the Social Security and Medicare obligations. It won’t happen in a linear fashion or overnight, but diversification into foreigh bonds or currencies seems prudent and consistent with the basic tenets of asset allocation.

The Dollar Crisis: Causes, Consequences, Cures , Revised and Updated Posterity may remember The Dollar Crisis as a seminal book in the field of 21st century economics. Indeed, rarely has a book offered such a grim yet, well argued view of the current economic situation facing the world.”– Steven Irvine, FinanceAsia

“Duncan writes like a man who’s already seen tomorrow.” — James Grant, Grant’s Interest Rate Observer

One can purshase foreign bond mutual funds. I currently own OIBAX ( it has a front load). Some no load alternatives are PSAFX (has ~15% PM, my wife owns), BEGBX, PFBDX, PEMDX, LSGLX, etc. There are plenty of closed-end funds in this area, again the best bet is to do a search on ETFconnect.com. Yields of high single digit can be expected. On the currency side, Everbank offers foreign currency CD’s (single currency CD’s with a minimum of $10k, index CD’s from 20k) that are worth looking into.