About the Editor
Samuel Lee is an ETF strategist for Morningstar and editor of Morningstar ETFInvestor, a monthly investment newsletter. Prior to becoming editor, Lee was a fund analyst on Morningstar's passive funds research team, where he covered alternative, dividend, and actively managed ETFs and performed quantitative modeling of ETF strategies.

Lee joined Morningstar in 2008 as a data analyst, where he evaluated ways to measure and improve the firm's data quality.

Lee holds a bachelor's degree in economics, with honors, from Grinnell College.


Investment Strategy
Morningstar ETFInvestor scans the globe for value and improving fundamentals across virtually all asset classes. Editor Samuel Lee draws upon academic and practitioner research — including Morningstar's sizeable bench of stock, bond and fund analysts — to find reliable drivers of outperformance.

Morningstar ETFInvestor features two real-money portfolios.

The ETF Income Portfolio assembles a high-quality collection of income-generating ETFs with the goal of earning 5% in excess of the 30-day T-bill rate over a full business cycle. The portfolio adheres to a benchmark-agnostic strategy in its search for absolute returns.

The ETF Global Asset Allocation Portfolio, on the other hand, is more benchmark sensitive. It seeks undervalued asset classes with improving fundamentals. The strategy seeks to beat the 60/40 MSCI ACWI/Barclays US Aggregate benchmark over a full business cycle, with the least risk possible.

 
 
Nov 28, 2014
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Samuel Lee,
Editor, Morningstar ETFInvestor
Samuel Lee is an ETF strategist for Morningstar and editor of Morningstar ETFInvestor, a monthly investment newsletter. Prior to becoming editor, Lee was a fund analyst on Morningstar's
Featured Posts
Some Closed-End Funds Offer Compelling Value Relative to Stocks
The S&P 500 continues its inexorable march up. At today’s price of around 2,050, cyclically adjusted earnings yield is around 4%, consistent with a 3%-4% expected real return. Investors tolerate low expected returns because interest rates are so low: 10-year Treasury Inflation-Protected Securities yield 0.5%. Despite high valuations across the board, closed-end fund discounts remain close to the lows reached during the taper tantrum panic last summer. It’s not hard to find CEFs earning 8% or more on market price. Some CEFs offer 4% expected real returns with lower fundamental volatility than the stock market. The recent sell-off has made them even more attractive.

The irony is that some investors are fleeing leveraged fixed-income CEFs because they fear rising interest rates, when many beaten-down CEFs have lower duration than the market. The stock market can be thought of as a perpetual, inflation-linked bond with a growing coupon that fluctuates with the business cycle. Because the bulk of the stock market’s value owes to big cash flows in the distant future, small changes in interest rates should create big changes in present value—that is, stocks have a very long theoretical duration. However, the contemporaneous relationship is the opposite of what our naive theory predicts: Interest-rate hikes tend to be associated with higher returns, and interest-rate drops tend to be associated with lower returns. Central banks hike rates when economic growth is strong (and profits are booming) in order to forestall inflation, and they lower rates when growth is weak (and profits are declining) to forestall recession and deflation. However, over the long run, stock prices tend to converge to a level where their expected returns offer a reasonable spread over the expected returns of high-quality bonds. In a secular rising-rate environment, stocks eventually fall--a lot.

This process can take years to occur because no one can make money shorting stocks and going long bonds and vice versa. In 1995, the U.S. stock market’s cyclically adjusted earnings yield was a little higher than 4% and the real yield on 10-year Treasuries was about 3%, for a 1% expected return spread in favor of stocks, a multidecade low. At the time, a clever man named Jeff Vinik, who managed a fund called Fidelity Magellan FMAGX, observed the extreme dislocation and cut stocks to load up on long-duration Treasuries. Unfortunately for him, the dot-com bubble inflated right in his face, causing Magellan to lag the market badly. Vinik was out of a job within a year. He was right, though: Long-duration Treasuries ended up providing superior absolute and risk-adjusted returns over the subsequent seven to 10 years.

The moral of the story: It is extremely hard to profit from asset-class-level misvaluations; stock prices can stay crazy for years on end. Investors eventually notice when stock prices are too high in relation to bond prices and vice versa, and they reallocate their portfolios accordingly. In a secular rising real rate environment, stocks will likely be devastated as their far-off cash flows become discounted at higher rates. Short-duration, high-yield bond CEFs will likely hold up better.

Here are a few I have my eye on:

BlackRock Debt Strategies Fund DSU

Prudential Short Duration High Yield ISD

Prudential Global Short Duration High Yield GHY

This isn’t an exhaustive list. The recent discount widening has created a lot of interesting CEF opportunities.

The funds I've highlighted focus on higher-quality junk, BB and B rated bonds, have wide absolute and relative discounts, and charge relatively low fees. The Prudential funds are not covering their distributions and are returning capital to investors. That’s OK. When a CEF trades at a discount, higher distributions allow you to reinvest the excess in discounted shares. However, if the funds cut their distributions, their discounts can widen further. Despite this risk, the funds are dirt cheap and further discount widening simply deepens the relative value opportunity. I think they’re great substitutes for junk-bond exchange-traded funds.

Of course, PIMCO Dynamic Credit Income PCI and PIMCO Dynamic Income PDI remain my top CEF picks, otherwise I’d have sold them to buy up these new CEFs. I’ve treated the recent discount widening in Dynamic Credit as a personal buying opportunity.

Regards,
Samuel Lee
Strategist
Editor, ETFInvestor

P.S. I’m interested in writing an article analyzing a subscriber’s personal portfolio. If you’re interested in subjecting your portfolio to public scrutiny, please email me at samuel.lee@morningstar.com. Readers with sprawling portfolios welcome.

Portfolio Holdings
Income Portfolio
ETF
YTD Ret %
Price $
4.9
108.9
CASH$
N/A
1.0
1.8
59.3
3.4
63.7
-3.3
11.3
-6.3
22.1
15.6
33.0
4.9
40.5
11.6
24.4
Global Asset Allocation Portfolio
ETF
YTD Ret %
Price $
4.0
108.9
CASH$
N/A
1.0
1.8
59.3
-2.5
22.1
12.5
33.0
4.9
40.5
-5.0
39.6
6.4
81.1
11.6
24.4
Most Popular ETFs
ETF Name
YTD Rtn %
3 Yr Rtn %
Trading Vol.
NASDAQ 100 Trust Shares
-10.76
1.45
125,000,944
SPDRs
-3.64
2.68
87,466,496
Semiconductor HOLDRs
-6.23
-11.66
26,838,700
iShares MSCI Japan Index
-6.59
7.18
17,256,500
iShares Russell 2000 Index
-7.46
6.43
16,210,700
Energy Select Sector SPDR
15.88
15.50
14,900,000
Financial Select Sector SPDR
-8.42
2.61
11,612,800
DIAMONDS Trust, Series 1
-3.75
2.21
7,350,600
Utilities Select Sector SPDR
6.84
6.82
3,848,200
Materials Select Sector SPDR
-4.31
8.50
2,179,300
 
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