Where to Invest in 2011

Featured in this booklet

The Error-Proof Portfolio 3
Core Anchors for Any Portfolio 5
Steady-Eddie Stock Funds 8
Tips and Traps for Short-Term Income-Oriented Investors 10
Create a Paycheck in Retirement With a Total-Return Approach 12
Topnotch Bargain-Hunting Funds 15
Our Picks for Inflation Protection 17
Ideas in Emerging Markets Beyond the Broad Indexes 20

Compliments of Morningstar
Where to Invest in 2011:
Morningstar’s Top Ideas for the New Year and Beyond

Although we’ve come a long way from the abyss of 2008, most investors would be hard-pressed to say
we’re completely out of the woods just yet. Lingering European debt concerns, a possible slowdown in
China, a still-high unemployment rate, a troublesome low-yield environment, and a cloudy outlook for fixed
income are casting some shadows on the path ahead.

In this special report, Morningstar’s own strategists, directors, and analysts will tackle the major concerns
going into 2011 with actionable tips, insights, and investment picks. You’ll also hear from Morningstar’s
director of personal finance Christine Benz on how to deal with today’s bigger-picture portfolio dilemmas,
including the possibility for rising rates and inflation.

In addition to the ideas in this report, I hope you’ll check out “Three Takes on Today’s Market,” our first-ever
roundtable webcast, http://www.morningstar.com/goto/webcast2010. Morningstar director of equity
research Pat Dorsey sat down with Ariel’s vice chairman, director of research and Ariel Focus (ARFFX) co-
manager Charlie Bobrinskoy; Tom Forester of Forester Value Fund (FVALX); and Leuthold director of research
and Leuthold Global (GLBLX) co-manager Doug Ramsey to discuss the opportunities and risks in the stock
and bond markets today.

Thanks again for subscribing, and here’s to many happy returns.

Best Regards,

Jason Stipp
Site Editor
Morningstar.com

Where to Invest in 2011 2


By Christine Benz
Morningstar.com Director of
Personal Finance
The Error-Proof Portfolio:
How to Hedge Against the Market’s Many Wild Cards
Although it’s shaping up to be a pretty decent year
for stocks and bonds, it’s hard to blame investors for
feeling like they’re walking a tightrope. Current
stock prices are factoring in continued economic
expansion, and if it fails to materialize, things could
get very ugly very fast. On the other hand, if the
economy grows too spritely, rising inflation or rising
interest rates could quickly shoot to the top of
investors’ worry lists.
True, investors have no power to control those
macroeconomic risk factors, but it’s also possible to
inoculate your portfolio against some of them in
case they materialize.
There are some of the biggest wild cards currently
facing the economy and the market, along with
some concrete ways to hedge against them. The
good news is that if you’ve done a good job of
diversifying, you probably already have some of
these hedges in place.
The Wild Card
Continued economic growth could lead to a spike
in interest rates, crushing bonds.
How to Seize Control
Keep risk in perspective: Even if we do see a
calamitous rise in interest rates, the magnitude
of losses for bond and bond-fund investors would
very likely be much less than stock investors have
faced during large equity-market sell-offs. This
article discusses how to keep worries about rising
rates in perspective, and it links to a Fidelity
study chronicling how bonds have performed during
sustained periods of rising rates.
Where to Invest in 2011
Avoid long-term bonds: If you’re looking at
returns during the past decade, long-term bonds,
especially Treasuries, look like a slam-dunk missed
investment. (The long-term bond fund category
has gained about 8% on average during the past
decade, versus 6% for intermediate-term bond
funds.) If the economy continues to sputter along in
fits and starts, long-term bonds could continue to
prosper. But the volatility in long-term bonds has
also been nearly twice as high as has been the case
for intermediate-term bonds. For that reason, I think
it makes sense to downplay long-term bonds if the
goal of your fixed-income portfolio is income and
capital preservation. Esteemed investors such as
Jack Bogle and Bill Bernstein are on the same page.
Stress-test your bond portfolio: Even if you
don’t own long-term bonds, it’s still a good idea to
investigate just how sensitive your portfolio would
be to an increase in interest rates. This article
outlines a concrete way to simulate how much your
portfolio could lose if interest rates bumped up by 1
or 2 percentage points.
The Wild Card
Inflation takes off, cutting into the future purchas-
ing power of invested dollars.
How to Seize Control
Check to see whether you already have some
protection: Yes, there are direct ways to inflation-
proof your portfolio (more on these in a second).
But before you layer on any investments dedicated to
inflation control, use Morningstar’s Instant X-Ray
tool, http://portfolio.morningstar.com/RtPort/Free/
InstantXRayDEntry.aspx?dt=0.7055475, to see
3
The Error-Proof Portfolio
whether you’re already holding investments that
may indirectly benefit from inflation. For example,
emerging markets tend to be heavy on basic-
materials producers, and they in turn are beneficia-
ries of higher demand and prices; check your
portfolio’s exposure to Latin America and developing
Asian markets.
Include inflation protection in your portfolio:
Regardless of the current inflation rate, a position
in Treasury Inflation Protected Securities helps
provide insurance against an unexpected spike in
inflation. This article, http://news.morningstar.
com/articlenet/article.aspx?id=330149, discusses
some simple ways to add explicit inflation protection
to your portfolio, including TIPS and commodities.
Include inflation when making return
assumptions: I recently wrote about the dangers
of having overly rosy expectations for stocks,
http://news.morningstar.com/articlenet/article.
aspx?id=361242. A related pitfall is failing to factor
taxes and inflation into those return assumptions.
If you’re using a
calculator to help estimate whether you’re on track
to meet your financial goals, make sure it’s giving
your returns a realistic haircut to account for
inflation. Factoring in a long-term inflation rate of
2.5% or 3% is realistic.
Add inflation protection when purchasing
products such as annuities and long-term
care insurance: If you’re purchasing annuities or
long-term care insurance, don’t just settle for a
fixed benefit, which will be worth less and less if
inflation takes off. Yes, you’ll pay extra for adding
Where to Invest in 2011
an inflation-adjustment feature, but it could be
well worth it in a sustained period of rising prices.
The Wild Card
Stocks will take a breather (or worse) if economy
doesn’t continue to grow.
How to Seize Control
Make sure your investment mix include stable,
non-economically sensitive companies: Investors
appear to be betting that the economy will continue
to do well, given the highly economically sensitive
firms (retail, basic materials, industrial companies)
that have recently fared best. But if the economy
takes a timeout, those more cyclical firms will hand
the baton to stable companies that do well in myriad
economic environments; think consumer staples and
pharmaceuticals, whose products consumers will buy
regardless of what the economy’s doing. The good
news is that you probably already have plenty of
exposure to such names if you own a well-diversified
large-cap U.S. stock fund.
Dribble new money into the market: In
contrast with two years ago, few consider stocks a
screaming buy right now. To help hedge against the
risk of putting a lot of new money into the market
just in time to see stocks sell off, plan to add to your
positions during a period of several months or even
more. Yes, such a strategy will mute your gains
if stocks take off from here, but it will also greatly
reduce your downside risk if stocks see a perfor-
mance hiccup in the months ahead.
4

By Christine Benz
Director of Personal Finance
Morningstar.com
Core Anchors for Any Portfolio
Question: I have been trying to streamline
and upgrade my portfolio. Can you name some
favorites?
Answer: As I noted in my recent article, http://
news.morningstar.com/articlenet/article.
aspx?id=351716, there’s no clear-cut definition of
what constitutes a core holding. An investment
that may be a perfectly legitimate linchpin holding
for one investor, such as the aggressive bond
fund Loomis Sayles Bond (LSBRX), might be far
too volatile, and decidedly noncore, for another.
A key first step, then, in finding the right core
holding for you is to consider what type of investor
you are. Do you like to get your hands dirty
overseeing your investments, or are you comfort-
able outsourcing your asset management to a
professional? Are you a believer in the long-term
benefits of an indexing approach, or do you believe
that hands-on security selection has the power to
beat passive management?
What follows are a few key investor profiles, fol-
lowed by appropriate core holding ideas for each.
Many investors may choose to mix and match
investments from each of these bins.
The Delegator
Are you looking to create a sane investment mix with
few moving parts to oversee on an ongoing basis?
Is your ideal holding period, like Warren Buffett’s,
“forever”? If so, the right core holding for you is apt
to be an investment that includes a lot of diversifica-
tion—in terms of asset class, geography, and
investment style—under the hood of a single fund.
Where to Invest in 2011
Target-date funds are the ideal vehicles for set-
it-and-forget-it types, in that they aim to deliver an
age-appropriate asset-allocation mix that gradually
gets more conservative as the investor nears
retirement. Of course, not all of these funds are
worthwhile: Some featured too-aggressive asset
allocations coming into the bear market, which led
to outsized losses for shareholders who were
nearing retirement. Others, meanwhile, simply
don’t have the raw materials necessary to be top-
notch all-in-one offerings; namely, they lack
standout offerings in all of the major asset classes.
But a few target-date series tick all the boxes:
Vanguard’s target retirement funds (middle-of-the-
road stock/bond mixes) and T. Rowe Price’s Target
Retirement offerings (more equity-heavy asset
allocations) are Morningstar analysts’ favorites.
The Asset Allocator
Would you like more hands-on oversight of your
asset allocation than a target-date fund affords?
Are you seeking to assemble a portfolio of very
low-cost investments?
If so, broad-market index funds and exchange-
traded funds make ideal core-holding building
blocks for your portfolio; you can then customize
your allocations to suit your own needs. (I’ve often
recommended using Morningstar’s Lifetime
Allocation Indexes as a starting point for that
important part of the investment decision-making
process.) Index funds and ETFs give investors a
high level of control over their asset mixes. There’s
no chance that a domestic-stock ETF will suddenly
show up with 20% in cash, and a small-cap index
fund won’t begin buying large-cap stocks. And
5
Core Anchors for Any Portfolio
thanks in part to the advent of very low-cost ETFs,
index-fund and ETF purveyors have been vying for
cheapest index-fund rights for the past several
years, slashing expense ratios and also cutting out
brokerage charges for ETF trades.
On the domestic-stock front, Morningstar’s large-
blend category is the place to go for broadly
diversified total stock-market index funds and ETFs;
our analysts’ core index pick is Vanguard Total
Stock Market, available in both conventional
mutual fund (VTSAX) and ETF (VTI) format. For broad
international-stock exposure via index funds,
Fidelity Spartan International Index (FSIIX),
Vanguard Total International Stock Market
Index (VGTSX), and Vanguard FTSE All-World
ex-US (VEU), an ETF, are the favorite index funds
of Morningstar’s analysts. For core fixed-income
exposure, Morningstar’s analysts recommend
Vanguard Total Bond Market Index, available in
both conventional mutual fund (VBMFX) and ETF
(BND) formats, as well as iShares Barclays
Aggregate Bond (AGG).
The Active Management Enthusiast
Do you believe in the power of active managers to
beat their benchmarks? Do you have the patience
to stick with truly active managers through what
will be inevitable weak patches? Are you comfort-
able with the fact that your portfolio—and in turn
its performance—will at times be out of step with
the broad market?
Morningstar’s Fund Analyst Picks feature a number
of the aforementioned index funds, but they also
include many topnotch active funds. Among our
team’s longtime favorites are Sequoia (SEQUX),
Where to Invest in 2011
Oakmark (OAKMX) and Oakmark Select (OAKLX),
Fairholme (FAIRX), and T. Rowe Price Equity-
Income (PRFDX). Active international offerings can
also serve as worthwhile core holdings; Dodge &
Cox International (DODFX), Scout International
(UMBWX), and Harbor International (HAINX) rate
among the analysts’ “best ideas.” On the fixed-
income side, the teams at PIMCO Total Return
(PTTRX), Harbor Bond (HABDX), Dodge & Cox
Income (DODIX), and Metropolitan West Total
Return (MWTRX) have all demonstrated a strong
aptitude for beating their benchmarks over time.
The Taxable Investor
If you’re building a portfolio for a taxable account,
you’ll need to be more choosey than when you’re
selecting investments for an IRA or other tax-shel-
tered vehicle. You’ll be on the hook for dividend
and capital gains taxes on an ongoing basis, so it
pays to focus on funds that have the ability to
reduce the tax collector’s cut of their returns on an
ongoing basis.
My recent article series that highlighted tax-effi-
cient model portfolios for retirees, http://news.
morningstar.com/articlenet/article.aspx?id=361184,
featured core tax-efficient holdings. My model
portfolios featured tax-managed funds such as
Vanguard Capital Appreciation (VMCAX) and
Tax-Managed International (VTMGX) on the
equity side, primarily because of their ability to
adjust their strategies to adapt to current tax
policy. But broad-market index funds and ETFs are
also solid core options with a history of good tax
efficiency (see the “Asset Allocator” section above
for a few favorites). On the fixed-income side,
6
Core Anchors for Any Portfolio

Morningstar’s Fund Analyst Picks in the short- and

intermediate-term municipal national categories
make worthwhile core holdings; the muni lineups
from Fidelity and Vanguard are hard to beat.

Disclosure: Christine Benz has a position in the fol-

lowing securities mentioned above: OAKLX

Where to Invest in 2011 7

 Steady-Eddie Stock Funds
By Esther Pak When the market looks anemic and the economic
Assistant Site Editor
outlook uncertain, you want to make sure the
Morningstar.com
investments in your portfolio don’t follow suit. So
what are some dependable, high-conviction stock
funds that investors can rely on to hold steady
even when the going gets tough?
Using the Premium Fund Screener, http://screen.
morningstar.com/AdvFunds/Selector.html, we
featured our tool’s newest screenable data point—
Average Moat Rating—to home in on funds that
emphasize companies with competitive advantages.
(Currently, this data point is only available in our the
Premium Fund Screener tool, but we are working on
adding it to our individual report pages soon.)
Investors should note that while wide-moat compa-
nies won’t necessarily outperform narrow-moat
firms during periods of market euphoria, they tend
to hold up well during storms. For example,
Morningstar’s calculations revealed that domestic
large-cap stock funds with the highest average
moat ratings were the best category performers in
2008, whereas the reverse held true in 2009 with
the widest-moat funds largely underperforming the
narrow-moat funds by a long shot.
For this screener, we kept the focus on domestic
stock funds with below-average expenses and at
least a moderately wide average moat rating. And
to keep a lid on risk, we eliminated any funds with
a Morningstar Risk rating higher than “below aver-
age” and with a Morningstar Rating for funds of
less than 4. (It’s important to note that in contrast
with Morningstar’s moat ratings for stocks, which
are qualitative and forward-looking, Morningstar’s
Where to Invest in 2011
star ratings and risk ratings are quantitative mea-
sures based on a backward-looking view of risk
and return.)
We also required that managers have at least a
decade of experience at the helm. Finally, we
called up distinct portfolios and funds that were
open to new money. When we ran the screen in
early December, it yielded six funds, three of which
we highlight below.
Amana Trust Income (AMANX)
This fund is geared toward Muslim investors, and
as such, it must follow the tenets of Islam. For
example, it can’t engage in excessive stock trading
or invest in financial stocks as well as debt-ridden
companies. That may sound exceedingly restrictive,
but in the hands of a talented and experienced
manager, the fund has managed to soar above its
more flexible peers. Half of the most recently
available portfolio’s 10 top holdings were wide-
moat stocks, with familiar names such as Procter
& Gamble (PG), Nike (NKE), and ExxonMobil
(XOM) leading the way. And the fund’s strictures
have actually worked in investors’ favor in the past.
The microscopic turnover promotes tax efficiency,
and the fund held up extremely well in the bear
market of 2008 when financials, which it avoids,
were hit. While these same restrictions held this
fund back during the 2009 rally, the fund didn’t trail
its large-value peers. For the buy-and-hold investor
with a long-term investing approach, this fund
comfortably fits the bill.
Aston/Montag & Caldwell Growth (MCGFX)
Investors should not be deterred by this fund’s
8
Steady-Eddie Stock Funds

recent slip in performance. While it tends to under-

perform during the early stages of market rallies,
its performance has been exceptional over full
market cycles. Manager Ron Canakaris and his
investment team employ a combination of
top-down analysis and fundamental bottom-up
research. And they keep a fairly concentrated
portfolio of just more than 30 large-cap names
with earnings-growth rates of at least 10%. At the
same time, the team keeps price in the picture;
they will consider selling a stock when it reaches a
20% premium to their calculation of fair value.
Its top seven holdings were recently wide-moat,
low-uncertainty stocks such as Coca-Cola (KO) and
Google (GOOG). All in all, this fund merits
consideration as a core holding in a portfolio.

T. Rowe Price Dividend Growth (PRDGX)

Manager Tom Huber takes a measured approach to
stock selection and portfolio management. Rather
than solely reaching for yield, Huber focuses on
a company’s ability to increase its dividend and kick
off free cash flow. He also considers a stock’s
valuation before making purchases or trimming
shares. Although the portfolio’s top holdings are not
as heavy on wide-moat companies as the preceding
two funds, this offering has still managed to
effectively temper risk in comparison to its rivals.
It has beaten 86% of its peers and the S&P 500
index during Huber’s 10-year watch. His confidence
in his stock selection and long-term outlook is
evident in the fund’s low turnover rate. With its
diversified portfolio of large-cap stocks, this fund is
a solid option for conservative investors.

Where to Invest in 2011 9

 Tips and Traps for Short-Term Income-
Oriented Investors
Christine Benz Talk about a rock and a hard place. That’s where
Director of Personal Finance
investors in search of a modicum of income from
Morningstar.com
their cash and other short-term assets have found
themselves during the past few years.
On the one hand, you’ve been lucky to earn 1% from
true cash. On the other, by venturing into riskier
assets in search of a bit of extra yield, you risk
getting singed by rising interest rates or faltering
credits in a still-shaky economic environment.
So what’s a yield-starved, safety-loving investor to
do? And just as important, what shouldn’t they do?
Here are some tips.
Beware of Interest-Rate Risk
In years past, one layup move for cash investors
looking to pick up a bit of extra yield was to
venture beyond true cash and into short-term
bonds and bond funds. With the exception of a few
big blowups, as when credit-sensitive ultrashort
funds imploded during the 2008 credit crisis,
venturing beyond certificates of deposit and money
market funds has worked out pretty well, as
interest rates have trended lower for the better
part of two decades. That tailwind has provided for
stable or even increasing principal levels.
At this point, however, the risks of getting too
aggressive in search of extra yield far outweigh the
opportunity cost of sticking with relatively safe
investments. While it’s possible that interest rates
could go even lower from here, it’s not especially
probable. As I outlined in this article, http://news.
morningstar.com/articlenet/article.aspx?id=351733,
investors for whom capital preservation is key are
Where to Invest in 2011
better off being patient, even though CD and
money market yields are unattractive right now. If
and when
prevailing yields trend up, you’ll get your chance to
pick up extra income without sacrificing the safe-
guards that come with true cash investments.
Build a Two-Part Emergency Fund
While it’s a mistake to venture beyond true cash
if you’re investing money you can’t afford to lose,
it’s also unwise to hold more in cash instruments
than you need to cover your emergency fund or
meet your household’s near-term cash needs if
you’re retired.
As I discussed in this article, http://news.morning-
star.com/articlenet/article.aspx?id=351318, I
like the idea of building a two-part safety fund that
consists of true cash as well as a high-quality
short-term bond fund. T. Rowe Price Short-Term
Bond (PRWBX) is a favorite for the second part
of a two-part emergency fund.
Don’t Reflexively Avoid CDs, Even Those With
Longer Terms
Certificates of deposit typically offer higher yields
than money market funds because of the liquidity
you give up. If you need to break the CD, either
because you need your money sooner or you want
to take advantage of newly issued CDs with higher
rates, you’ll pay a penalty that might amount to 90
or 180 days’ worth of interest.
That seems like an unattractive stricture, but do
the math before settling for a money market fund
rather than a CD. If you’re able to pick up a higher
10
Tips and Traps for Short-Term Income-Oriented Investors

yield with a longer-term CD, that may offset the cash, you’re better off using a just-in-time
penalty you’ll pay to tap your money prematurely. approach, Keep your cash elsewhere and move it in
The same holds true for longer-term CDs. Even only when you plan to put it to work in longer-term
if you plan to need your money in a short period of investments.
time, the yield pickup may warrant opting for a
longer-term CD versus one that matches your time
horizon perfectly.

Investigate Credit Unions

Morningstar.com users love their credit unions, as
the many enthusiastic comments below this article
illustrate. Although yields everywhere have been
compressed during the past few years, short-term
savings vehicles available through credit unions
may deliver a yield pickup of 0.25% or even more
relative to comparable savings instruments offered
through banks. How are credit unions able to
deliver relatively high payouts? First, they’re non-
profit entities owned and controlled by their
members; they don’t have to deliver a slice of
profits to their shareholders. Nor do credit unions
typically advertise, and they may not provide all
of the amenities available to individuals who use
traditional bank. Both attributes further boost take-
home yields.

Put Your Dead Money to Work

Last but not least, with cash yields as low as they
are, it pays to cull your investment accounts for
extra cash that may not be yielding much at all,
once fees are factored in. The default cash option
may not be the most attractive option at your
brokerage firm or mutual fund company, or that
particular firm may not be a good option for your
cash, period. If your brokerage firm or fund
company can’t offer you a competitive yield on your

Where to Invest in 2011 11

 Create a Paycheck in Retirement With a
Total-Return Approach
Christine Benz We’ve frequently debated income versus total-
Director of Personal Finance
return approaches on Morningstar.com during the
Morningstar.com
past few years, with partisans weighing in on both
sides of the debate, http://news.morningstar.com/
articlenet/article.aspx?id=344236. I’ve made no
secret of my own “totalnik” leanings, noting that
investors who are fixated on generating current
income from their portfolios are often taking on
disproportionate risks, http://news.morningstar.
com/articlenet/article.aspx?id=360790.
But there’s an area in which “incomeniks” have it
all over the totalniks, and that’s in ease of
implementation in retirement. By using an income-
oriented approach, you can create the equivalent of
a steady paycheck in retirement (or attempt to,
anyway). But tapping your principal periodically, as
you’re required to do with a total-return approach,
isn’t just psychologically difficult. It’s also a
logistical headache. You have to figure out which
accounts to tap for cash, which in turn affects
where you’re holding liquid assets, and you also
have to figure out how to tap your accounts in the
most tax-efficient manner possible. Given that, it’s
no wonder that so many retirees are attracted to
investments that kick off current income.
Of course, annuities have long held appeal to those
seeking to generate a paycheck in retirement. But
with interest rates as low as they are now, annuity
payouts are also depressed. Financial-services
firms have been busy cooking up new investment
products to help retirees generate a paycheck in
retirement; many of them combine investments
with insurance features. It’s early days for most of
these vehicles, however, and at this point, it’s
Where to Invest in 2011
tough to give a ringing endorsement to any one
option within this relatively untested group.
Moreover, many investors are satisfied with their
current investment portfolios; they’re just not sure
where to turn for cash when they need it.
That’s where the bucket approach to retirement
planning can be so effective. Retirement theoreti-
cians often consider bucket strategies as too
simplistic, but the concept resonates with many
real-life retirees and the financial advisors who
work with them. The basic idea is that you create a
dedicated pool of assets, composed of cash and
other very liquid holdings, to meet your near-term
income needs. Once you’ve done that, you can hold
those assets that you don’t need to fulfill near-term
living expenses in progressively more aggressive
investment vehicles.
Such a strategy helps ensure that you’re taking
money from your most stable pool of assets first,
and therefore you won’t have to withdraw from
your higher-risk/higher-return accounts (for
example, those that hold stocks or more-risky
bonds) when your account is at a low ebb. That
strategy also gives your stock assets, which have
the potential for the highest long-term returns,
more time to grow.
Here’s how to use a total return “bucket” approach
to meet your own in-retirement cash needs.
1. Determine the Paycheck You Need From
Your Portfolio
If you’re attempting to create the equivalent of a
paycheck from your portfolio, the first step is to
12
Create a Paycheck in Retirement With a Total-Return Approach
gauge your income needs during retirement, either
on an annual or a monthly basis. Start by tallying
your total expenditures, then subtract steady
sources of income that you can rely on, including
Social Security and pension income. What’s left
over is the amount that you’ll need to extract from
your portfolio each month or each year.
2. Make Sure Your Withdrawal Rate Is
Sustainable
The next step is to evaluate whether your desired
portfolio withdrawal amount is too large or just
about right. Most financial planners consider a 4%
annual withdrawal rate, combined with annual
upward adjustments to accommodate inflation, a
safe withdrawal amount. For another check,
Morningstar’s Asset Allocator tool can help you
determine whether your current portfolio puts you
on track to meet your retirement-income needs.
(Just bear in mind that it’s using fairly rosy return
expectations for stocks.)
3. Put in Place a Short-Term Bucket Holding
of at Least Two Years’ Worth of Living
Expenses
Assuming your desired withdrawal rate is sustain-
able, set up a short-term bucket consisting of at
least two years’ worth of living expenses set aside
in highly liquid (that is, checking, savings, money
market, and certificate of deposit) investments.
Where you hold these assets depends on where
you are in retirement as well as where you’re
holding the bulk of your retirement savings.
Being strategic about where you take withdrawals
from can help you stretch out the tax-savings
benefits from your tax-sheltered accounts. This
Where to Invest in 2011
article provides more detail on sequencing
withdrawals to maximize your long-term tax
savings, but here’s a quick overview:
u If you’re older than 70 1/2 and taking required
minimum distributions from your IRA or the
retirement plan of your former employer, some
or all of your near-term paycheck should come
from those accounts. (Bear in mind that the
amount of your RMD will vary from year to year,
based on your account balances as well as your
age.)
u If you’re not 70 1/2 or your RMDs won’t cover
your cash needs, turn to your taxable accounts
to see if they will cover your cash needs during
the next two years.
u If your RMDs and taxable accounts won’t cover
at least two years’ worth of living expenses,
carve out any additional amount of living
expenses from your IRA or company retirement
plan assets using the sequence outlined above.
Save Roth accounts for last because they offer
the most flexibility and long-term tax-savings
benefits.
4. Put It on Autopilot
Once you’ve identified where your cash will be
coming from during the next few years, contact
your financial-service provider to see if it can help
automate your withdrawals, sending you the
equivalent of a paycheck at preset intervals. (Better
yet, your firm should be able to deposit the
paycheck directly into your account.) The larger
your fund company or brokerage firm, the more
likely it is to offer such an option.
13
Create a Paycheck in Retirement With a Total-Return Approach

5. Other Important Tasks

In addition to getting your paycheck plan up and
running, it’s important to periodically replenish your
cash assets as they become depleted. Once you’ve
set aside your cash position, put in place a plan to
periodically refill your cash stake so that it always
will cover at least two years’ worth of living
expenses. Plan to incorporate this step into your
rebalancing process. Ideally, you’d fill up your most
liquid bucket with proceeds from rebalancing-
related sales or with money from your next most
liquid pool of assets (for example, intermediate-
term bonds).

Where to Invest in 2011 14

 Topnotch Bargain-Hunting Funds
By Esther Pak Uncertain market conditions drive some investment
Assistant Site Editor
managers to amp up their cash stakes and wait by
Morningstar.com
the sidelines. Other managers, meanwhile, use peri-
ods of market uncertainty as an impetus to go shop-
ping, buying what other investors are dropping.
To help identify truly active bargain-hunting man-
agers who have successfully found opportunities
amid market turbulence and company-specific
problems, we turned to our Premium Fund
Screener, http://screen.morningstar.com/AdvFunds/
Selector.html. We homed in on both the domestic
and foreign value fund categories with underlying
stocks of small, medium, and large market capital-
izations. To winnow our list to funds run by the
most talented and veteran managers, we required
that managers have more than a decade of experi-
ence at the helm and that their funds rank in the
top quartile of their categories for the trailing
10-year period.
On the fees front, we eliminated load funds with
expense ratios above the category average. And to
further weed out funds that move in lock step with
their indexes, we called up funds with lower-than-
average R-squared figures. (R-squared measures an
investment’s correlation with an index or other
investment.) Finally, to whittle the list down even fur-
ther, we screened for distinct portfolios of each fund.
This screen yielded seven bargain-hunting funds,
three of which we highlight below.
American Century Value (TWVLX)
Managers Phil Davidson, Michael Liss, and Kevin
Toney look for healthy companies that are trading
Where to Invest in 2011
below their estimate of fair value as a result of
short-term concerns. For example, they bought
asset-management companies that investors found
unattractive because of market conditions. They
also hung on to top holding Johnson & Johnson
(JNJ), noting that its recent string of product
recalls doesn’t diminish the company’s core
strengths. Armed with this strategy, the managers
strive to achieve a moderate return in rising mar-
kets while limiting downside losses, a balance that
they have achieved successfully. During the bear
market from late 2007 through early 2009, the fund
held up much better than its category peers, and it
went on to post respectable absolute returns dur-
ing 2009’s rally.
Oakmark International (OAKIX)
Manager David Herro subscribes to a decidedly
contrarian style. He invests in beaten-up stocks that
trade at discounts of at least 40% to his
estimates of their intrinsic value; this strategy is
based on his belief that over the long haul, these
stocks are bound to recover. Investors should keep
in mind that Herro does not shy away from
emerging markets and some smaller-cap names;
he’ll also make sizable sector and country bets
when they seem profitable. All of these qualities
have the potential to court additional risk, but Herro
has managed this fund’s risks successfully. Due in
part to his standout results here, Oakmark
International ranks as one of Morningstar’s Analyst
Picks, and the analyst team also named him
Morningstar’s International Manager of the Decade
for 2000-09, http://news.morningstar.com/arti-
clenet/article.aspx?id=321713. This manager eats
his own cooking, too, with more than $1 million
15
Topnotch Bargain-Hunting Funds

invested in this fund. Investors can therefore rest

assured that his incentives are aligned with those
of the shareholders.

Tweedy Browne Global Value (TBGVX)

Comanagers William Browne, John Spears, Tom
Shrager, and Bob Wyckoff are experienced
investors with an eye for value across the market-
cap spectrum and geographic borders. This foreign
large-cap value fund sticks to a value discipline,
investing in companies with healthy balance sheets
whose prices are below their estimates of fair
value. As Morningstar fund analyst Kevin McDevitt
notes, “[management] would rather pay a fair price
for a good business, than a low price for a
mediocre one.” Management hedges its foreign-
currency exposure back into U.S. dollars, and that
can hold the fund back during times that foreign
currencies gain an edge over the dollar. But for
low-risk exposure to global stocks, this fund merits
a place on investors’ radars.

Where to Invest in 2011 16


By Christine Benz
Director of Personal Finance
Morningstar.com
Our Picks for Inflation Protection
If there’s a small silver lining amid the current
economic malaise, it’s that inflation has been
pretty muted.
But investors ignore inflation at their own peril.
Even if massive amounts of government stimulus
don’t prompt inflation, there’s still the possibility
of price spikes here in the United States as a
result of still-red-hot economic growth in emerg-
ing markets. Widespread rising prices, in turn,
could amount to erosion in the purchasing power
of any assets you’ve managed to save or invest.
By the time you start tapping your portfolio to
meet your income needs, those dollars could be
worth a lot more than they are right now.
That’s why it’s so important to ensure that your
portfolio is adequately protected against inflation.
Some inflation-fighting vehicles have explicit
protection against rising prices, such as Treasury
Inflation-Protected Securities. Others, such as
stocks, protect against inflation indirectly.
Here’s an overview of the key vehicles with
inflation-fighting attributes, as well as some of
Morningstar’s top picks within those groups.
Inflation-Protected Bonds
The Thesis
For holders of nominal (that is, not inflation-pro-
tected) bonds, inflation is a natural enemy, right
up there with rising interest rates. If an invest-
ment is delivering a fixed payout, inflation will
reduce the value of that payout accordingly.
That’s where inflation-protected bonds come into
play. There are two main varieties: I-Bonds and
Where to Invest in 2011
inflation-protected bonds. The former are bonds
for individual investors issued by the Treasury
Department; their yields adjust upward to reflect
changes in the Consumer Price Index. (This article
provides more color on I-Bonds, http://news.morn-
ingstar.com/articlenet/article.aspx?id=341946.)
Inflation-protected bonds, such as TIPS, are simi-
lar, but the inflation adjustment comes at the
principal level, not in the bond’s yield.
Best Bets
There are no funds composed of I-Bonds, but
there are a number of offerings that focus on
inflation-protected bonds. For plain-vanilla TIPS
exposure, it’s tough to beat the low-cost
Vanguard Inflation-Protected Securities
(VIPSX); for ETF enthusiasts, iShares Barclays
TIPS Bond (TIP) is another low-cost, no-nonsense
choice. The PIMCO-managed Harbor Real Return
(HARRX), meanwhile, has successfully employed a
broader toolkit that encompasses non-U.S. infla-
tion-protected bonds and the use of forward con-
tracts to obtain TIPS exposure. While SPDR DB
International Government Inflation-Protected
Bond (WIP) isn’t an official ETF Analyst Pick, but
it provides both inflation protection and diversifi-
cation away from the U.S. dollar.
Bank Loans
The Thesis
Unlike inflation-protected bonds, bank loans don’t
include an explicit mechanism to ward against
inflation. But they stand to be fairly hardy when
inflation is on the move. That’s because bank-
loan payouts fluctuate in line with the London
Interbank Offered Rate (LIBOR)—the rate that
17
Our Picks for Inflation Protection
banks charge one another to borrow money.
When the LIBOR heads up, which is often the
case during inflationary environments, so do
bank-loan coupon payments.
Best Bets
Bank-loan funds might seem to have it all:
imperviousness to rising interest rates plus some
inflation-fighting characteristics. But investors
should tread with caution in this varied category.
Due to credit sensitivity and forced bank-loan
selling from institutional investors, the average
bank-loan fund lost a shocking 29% in 2008.
Morningstar’s favorite fund here is one of the
group’s slow and steady options, Fidelity
Floating Rate High Income (FFRHX), where
manager Christine McConnell assiduously avoids
the market’s riskiest loans.
Commodities/Metals Funds
The Thesis
The premise behind owning commodities invest-
ments for inflation protection is straightforward:
If the prices of goods are going up, an investment
that captures price changes in food, energy, and
basic-materials costs will thrive at the same time.
Best Bets
Although the case for commodities for inflation
protection is straightforward, the implementation
isn’t. Owning the stocks of commodities compa-
nies, as with an offering like T. Rowe Price New
Era (PRNEX), provides indirect exposure to the
prices of stuff. And while commodities futures-
based funds aim to provide broad, and direct,
exposure to the prices of goods, in practice they
Where to Invest in 2011
haven’t been perfect trackers of commodity prices
as a result of a situation called contango. (Read
this article for a discussion of the pros and cons
of these investments, http://news.morningstar.
com/articlenet/article.aspx?id=354373.)
Morningstar’s open-end fund team doesn’t cur-
rently include any commodities offerings among
its Analyst Picks. Our exchange-traded fund team,
meanwhile, has a few commodities picks,
including iPath DJ-UBS Commodity Index (DJP).
Stocks
The Thesis
Stocks are another indirect way to gird your
portfolio against the threat of inflation. Their
returns are variable, in contrast with fixed-rate
investments, giving them the potential for higher
returns than bonds. That means that inflation
could take a smaller bite, in percentage terms,
out of your future purchasing power.
Best Bets
Not all stocks will thrive in an inflationary
environment, and some companies may even see
their profitability flag. To help identify companies
with a strong history of profitability through a
variety of economic environments, screening for
firms with high returns on equity is a good
starting point. Morningstar’s preset Wealth
Creators screen can help you identify such firms,
and layering on an additional screen for wide
moats will further winnow down the universe
to companies with long-term competitive
advantages. Fund investors have a few top
options, including Vanguard Dividend Growth
(VDIGX) and T. Rowe Price Dividend Growth
18
Our Picks for Inflation Protection

(PRDGX) (traditional actively managed funds) and

the index fund Vanguard Dividend Appreciation
(available as a conventional mutual fund (VDAIX)
and ETF (VIG).

Where to Invest in 2011 19

 Ideas in Emerging Markets Beyond the
Broad Indexes
Timothy Strauts Many investors today have some exposure to the
ETF Analyst
emerging-markets asset class, often through one of
Morningstar.com
the broad index funds like iShares MSCI
Emerging Markets (EEM) or Vanguard Emerging
Markets Stock ETF (VWO). Emerging markets have
seen tremendous inflows in the past few years, but
most of the investment has gone to the major
large-cap-focused indexes. The emerging world is
a very large and diverse asset class, and we think
investors willing to look a bit harder can find richer
opportunities beyond the largest exchange-traded
funds. But before we get into the details of our
recommendations, it is important to understand the
macroeconomic factors that are driving interest in
the emerging-markets space.
Changes made by emerging markets in the 1990s
set the stage for the phenomenal investment
performance over the past 10 years. Many develop-
ing countries abandoned fixed exchange rates,
adopted inflation targeting, reduced external debt,
and lowered fiscal deficits. Today, emerging
economies make up one third of global GDP. On
average, they should grow by more than 6% in
2010 compared with the expected growth of only
2% in the United States.
These trends are not expected to reverse anytime
soon either. The developed world’s dramatically
higher debt burden will constrain growth for years
to come, and emerging markets still have plenty of
room for easy productivity gains from adopting
modern infrastructure and technology. The recent
global financial crisis sparked even greater investor
interest in emerging-markets equities because it
showed the strength of the emerging world. Even
Where to Invest in 2011
through the worst of the crisis in 2009, these
economies as a whole still posted positive GDP
growth, whereas every major developed market
contracted dramatically.
With these fundamental economic drivers
explained, let’s look at two promising investments
in the emerging-markets space.
WisdomTree Emerging Markets SmallCap
Dividend (DGS)
With more than 30% of world consumption taking
place in emerging-markets countries, consumers in
those countries are an underappreciated driver of
growth. Most investors think of emerging markets
as the producers of cheap products that are later
bought by people in the developed world. While
this is true, the accelerated growth of emerging
countries has also rapidly increased the income of
the emerging consumer. DGS is best positioned to
take advantage of this growing trend because of its
focus on small-cap stocks. These small companies
get most of their revenue from the local economy
and have very little exposure to external demand.
While the largest positions in VWO are global
multinationals focused in the technology, energy,
and materials sector, DGS has increased exposure
to consumer and industrial sectors that are more
leveraged to domestic growth trends.
Over the past three years, returns to DGS had a
standard deviation (a measure of risk) very close to
the large-cap-focused MSCI Emerging Markets
Index but still 50% higher than the S&P 500. The
portfolio for DGS does not follow a typical market-
cap-weighting methodology but instead weights
20
Ideas in Emerging Markets Beyond the Broad Indexes
the holdings by total dividend yield of the underly-
ing company. Companies with higher dividend pay-
outs get a higher weighting in the fund. This focus
on dividends ensures the companies in the fund
have attained some minimal level of profitability
but tends to underallocate to some countries. For
example, Chinese companies have only a 6%
weighting in DGS, whereas the Emerging Markets
Index has 18% invested in China. Overall, we pre-
fer the dividend-weighting methodology because it
reduces risk and naturally focuses on companies
that already have profitable businesses.
WisdomTree Emerging Markets Local Debt (ELD)
Emerging-markets debt historically has been very
volatile and prone to defaults. Most debt was
issued in U.S. dollars until very recently because
investors refused to take the risk of currency expo-
sure as well as the credit exposure to these unsta-
ble countries. However, this exposed the govern-
ments of developing markets to the volatile swings
of their currencies in comparison to the U.S. dollar.
In the past 10 years, emerging countries have
worked to reduce their reliance on external funding
and the risks of issuing U.S. dollar debt. Their
growing private pension systems, higher savings
rates, sound fiscal policies, and more flexible cur-
rency regimes have created internal demand for
the emerging countries’ government debt, and
macroeconomic changes over the past couple of
decades mean that many emerging markets have
investment-grade credit ratings today. With this
newfound stability, we feel that exposure to local
currency emerging-markets bonds can now act as
a hedge on further U.S. dollar weakness. This
foreign currency risk increases the volatility of ELD,
Where to Invest in 2011
but we think it will add incrementally to returns
over time.
With the sovereign-debt crisis in Europe, investors
are re-evaluating which countries are most
creditworthy. The emerging world has an average
public debt/GDP ratio of less than 50% while the
United States has a ratio close to 100%. The credit
ratings agencies continue to take note of the good
fundamentals, as emerging markets have received
6 times more upgrades than downgrades in 2010.
There is growing belief that, despite emerging
markets’ lower credit ratings, they may actually be
better credit risks than developed markets.
ELD has a current yield of 4.8%, an average credit
rating of A-, and a duration of only 4.0 years. The
fund was launched in August 2010, but because it
is one of the first ETFs to offer access to emerging-
markets local currency bonds, it has seen strong
inflows and currently offers good liquidity. ELD
implements a tiering strategy that attempts to put
more assets in countries that maintain strong fiscal
discipline. Currently, the fund has its highest
weightings in Brazil, Mexico, Malaysia, and
Indonesia. With ELD you’re getting an investment-
grade portfolio with an attractive yield, relatively
low interest-rate risk, and the potential for
increased returns if the U.S. dollar weakens versus
emerging markets.
Disclosure: Morningstar licenses its indexes to cer-
tain ETF and ETN providers, including BlackRock
Asset Management, First Trust, and ELEMENTS, for
use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by
21
Ideas in Emerging Markets Beyond the Broad Indexes

Morningstar. Morningstar does not make any repre-

sentation regarding the advisability of investing in
ETFs or ETNs that are based on Morningstar
indexes.

Where to Invest in 2011 22