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5 Planning for the Next Round of TaxesTaxes are going up sooner or later— sooner ifyou’re well-off and Democrats take the WhiteHouse. By Janet Novack

7 Shift That Wealth NowStock prices and interest rates are down andthe estate tax is her to stay. Time to thinkabout gifts and GRATS. By Ashlea Ebeling

9 How to Build a Winning FundPortfolioFads and fears are merely distractions. The twomost important things about constructing aportfolio: having a reasonable allocation ofyour assets and keeping your costs down. ByMichael Maiello

12 Inside TrackExecutives trading their company’s stock don’talways have the right answers. But think twicebefore betting against them. By Megha Bahree

14Max Out Your Muni BondsConventional wisdom says buy muni bonds incautiously staggered maturities. Jimmy Klotzsays put everything into long bonds. ByBernard Condon

15High Yield, High RiskJunk bonds are perilous in the best of times,which these are not. Funds like BlackRockoffer those with the stomach for it at least achance of survival. By Robert Lenzner

17The Government Oil PlayNational governments hog the world’s most accessible petroleum. Get a piece with StatoilHydro. By Christopher Helman with Emily Schmall

19Cheap Green StocksIt’s not too late to find cheap “green” stocks. Justlook beyond the obvious. By Erika Brown

20Tax Shelters 2.0Bad tax ideas, like viruses, tend to mutate and claim new victims. By Janet Novack

21Penalty-Free IRA WithdrawalsThere is a way to get at your retirement accountearly without paying a fat penalty. But there’s a catch. By Christopher Steiner

22Safe Plays in Real EstateFinancial troubles have turned net leases into ahigh-yield way to get into commercial real estate. By Matthew Swibel

24Crash-Proof Oil StocksYou want a piece of the energy business that won’t get hurt if oil crashes? Take GabrielHammond’s advice and own some buried steel. By Zack O’Malley Greenburg

25Choosing the Right Long-Term-CareInsuranceWant to live out your last years in your own home? Long-term-care insurance canhelp. By Carrie Coolidge

27This Home Boom Is Still AliveBrazil is enjoying a residential building bonanza,for all the right reasons. Foreign investors are welcome. By Kerry A. Dolan

28Create Your Own Tropical ParadiseDavid Schnittlich dreamed of a Caribbeanretirement. So he bought his favorite restaurantthere and became Mango Dave. By Carrie Coolidge

MONEY PHOTOGRAPH BY STEPHEN WEBSTER FOR FORBESS

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AS PRESIDENT, SENATOR JOHN

McCain (R–Ariz.) aimsto balance the budgetwhile extending theBush-era income tax cuts,

doubling the personal exemption andeliminating the alternative minimumtax. The Democratic candidates saythey’ll raise taxes only on the well-off—those making over $200,000 for SenatorBarack Obama (D–Ill.) and $250,000for Senator Hillary Clinton (D–N.Y.)—while showering tax breaks and healthinsurance on working families. (At presstime Clinton is still hanging in.)

Anyone who believes any of thislikely already owns Florida swampland.

“We’re in silly season. None of thenumbers add up,” sighs Lindy Paull, amanaging partner of Pricewaterhouse-Coopers and former chief of staff forCongress’ Joint Committee on Taxation.“Taxes are going to go up one way oranother. The first to get hit will behigher-income people.”

It’s hard to argue with that view longterm, when you consider the state of gov-ernment finances. But given that the Bushtax cuts don’t expire until the end of 2010,politicians may avoid wrestling with theproblem until the year after next. The out-lier is the estate tax; it’s set to go away al-together in January 2010 and then reap-pear a year later with a mere $1 millionexempt from taxes on inheritances left tononspousal heirs.

“The only thing they [politicians]have to do next year is the estate andgift tax. Otherwise we get to 2010 andpeople start taking their parents outfor hunting accidents,” says Clint

Stretch, managing principal of taxpolicy at Deloitte Tax.

Although it appears likely that Con-gress will settle on a permanent estatetax exemption of $3.5 million (the levelfor 2009, under current law) or higher,it still pays for wealthy individuals toconsider giving away assets now (seestory, p. 7).

What about income taxes? ADemocratic President is likely to returnthe top stated rate on ordinaryincome—salary and interest—to the39.6% that Bill Clinton’s presidencyended with, says Mark Weinberger, theTreasury’s top tax official when the Bushtax cuts went through and now head ofErnst & Young’s Americas’ tax practice.

That would put the real salary taxbite at around 50% if, as Obama hassuggested, the 6.2% Social Security taxis applied to wages above the current

$102,000 cap and two sneaky provisionsmake a comeback—the phaseout ofpersonal exemptions and a haircut toitemized deductions. Under a Democ-rat, the top capital gains tax rate, now ahistorically low 15%, will likely rise to20% or higher. Given the budget gap,even Republican McCain may wellresort to closing loopholes and curbingdeductions.

“We don’t want high marginal rates.But there’s nothing about that that rulesout sensible base-broadening,”says Doug-las Holtz-Eakin, McCain’s top economicadviser, as if it makes much difference tomost taxpayers why their tax bills go up.

None of this is cause for panic, butwith higher taxes on the horizon it doesmake sense to prepare now.1) Contribute to a Roth. A Roth Indi-vidual Retirement Account or Roth401(k) can be a great hedge against

WWW.FORBESMAGAZINE.COM INVESTORS’ GUIDE F O R B E S 5

STRATEGYwINVESTORS’ GUIDE

READ MY LIPSTaxes are going up sooner or later—sooner if you’re well-off and Democrats

take the White House. Here’s what to do now.BY JANET NOVACK

SCOTT OLSON / GETTY IMAGES; DANIEL BARRY / BLOOMBERG NEWS; BRADLEY BOWER / BLOOMBERG NEWS

higher rates. You put in aftertax dollars,the money grows untaxed and all with-drawals in retirement are tax free.

In contrast, with a traditional de-ductible IRA or 401(k), you put pretax

dollars in and every dollar you takeout in retirement is taxed as ordinaryincome—at what are likely to behigher rates than now.

With the Roth IRA, couples withadjusted gross income up to $159,000,and singles earning up to $101,000, canthis year contribute $5,000 each ($6,000for those 50 or older). Regardless ofincome, anyone whose employer offersit can use the newer Roth 401(k)option. For 2008 you can contribute upto $15,500 in after-tax salary ($20,500 ifyou’re 50 or older).

A pretax 401(k) rather than a Rothstill makes sense if your combined fed-eral and local income tax rate is likely tofall. Candidates include New York Cityresidents retiring to Florida and execu-tives intending to quit to work for charity.2) Do a Roth conversion. This strategyinvolves taking money out of a tradi-tional IRA, declaring the taxable incomeand depositing it in a Roth, where allfuture growth is tax free. Only taxpay-ers with gross income below $100,000are eligible, but that limit will end in2010—unless Congress reneges.

Another rule that makes a conver-sion attractive for affluent families: Witha pretax IRA you must take money outfrom age 701/2; with the Roth you canlet it ride and become a tax-free kitty foryour kids.3) Think twice about deferring pay.The prospect of higher rates, on top of a2004 congressional crackdown ondeferred-compensation plans, makes

this perk less alluring. (Deferredcomp grows tax deferred, and allincome, including gains, is taxed as

ordinary income when received.) It’shard to get at your money early if a bigtax-rate hike looms or your company

tanks, putting your deferred pot at risk,notes Mel Schwarz, Grant Thornton’sdirector of tax legislative affairs. He addsthat deferring comp still makes sense insome cases—say for someone who is inthe top tax bracket now but likely won’tbe when he withdraws the cash.4) Relocate assets. Investors may havebeen lulled into complacency over capi-tal gains taxes in the three years through2005 as their mutual funds used lossesbooked over the previous couple ofyears to offset gains. The holiday’s over.Last year funds distributed $393 billionin long- and short-term gains to taxableshareholders, up 270% from 2005, esti-mates Thomas Roseen, a senior analystat Lipper.

With the capital gains likely to keepon coming, you can minimize your taxbite by strategically deploying assetsamong taxable and tax-deferredaccounts. Tax-efficient index funds,exchange-traded funds and “tax-man-aged” funds belong in taxable accounts.Small-cap growth funds, whose man-agers trade a lot, belong in tax-deferredaccounts. Don’t rush to sell, and thusrealize costly gains, but use new moneyand any asset-reallocation moves toimprove the location of holdings. Giventhe market’s recent volatility, now mayalso be a good time to harvest losses thatcan be used to offset gains as you moveassets around to strike a tax-efficientbalance.5) Track your cost basis. Keepingdetailed records of your cost basis—thatis, what you paid for each block ofshares in a taxable account—is morecrucial than ever. That’s becauseCongress is likely to require that brokersand fund firms begin reporting yourbasis to the Internal Revenue Service.There’s no guarantee they’ll calculateyour basis in a way that minimizes yourtax bite. As is, unless you specifyotherwise, when you sell a part of yourshares, your fund will report the average

6 F O R B E S INVESTORS’ GUIDE WWW.FORBESMAGAZINE.COM

INVESTORS’ GUIDEq STRATEGY

Estate taxMcCain: $10 millionexemption, 15% top rate.Obama: $3.5 million exemption, 45% toprate.Clinton: $3.5 millionexemption, 45% toprate.

Ordinary incometax ratesMcCain: top rate of 35%.Obama: top rate of 39.6%.Clinton: top rate of 39.6%.

Long-termcapital gainsand dividendsMcCain: permanent rate of

15% for both.Obama: around 25% for

both gains anddividends.Clinton: top rates of

20% for gains and39.6% for dividends.

New tax cutsMcCain: Eliminate alternativeminimum tax. Double personalexemption for dependents from$3,500 to $7,000. Cut corporatetax rate from 35% to 25%.Obama: Give $500 per workercredit to offset payroll tax. Exempt from income tax seniorswho make less than $50,000. Expand credits for college and retirement savings. Give 10%mortgage credit to nonitemizers.Clinton: Expand credits for college and retirementsavings. Expandearned income taxcredit for big fami-lies. Add $3,000 taxcredit for long-termcare and caregivers.

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CONtrolled Congress,the estate tax seemedto be doomed to anearly demise. Lawyers

specializing in wealth transfer found theirservices a tough sell. Clients were reluc-tant to shell out fat fees and certainly did-n’t want schemes that involved paying gifttaxes now in lieu of estate taxes later ifthere was a chance there wouldn’t be anestate tax when the time came.

But busy days are here again for thelawyers, and not just because of thechanged political outlook. Certain tech-niques that let you move big bucks toyour kids while you’re alive at reducedor no gift tax cost—for example, grantorretained annuity trusts—work bestwhen both interest rates and asset val-ues are depressed. “GRATs are smokinghot right now. Not only do we have lowinterest rates, but we have depressed realestate values,” exults Jeffrey Baskies, aBoca Raton estate planning lawyer.

How rich do you have to be to thinkabout transferring wealth early? Not very,particularly if you live in certain states.Someone who dies this year can pass $2million to nonspousal heirs free of federalestate tax. That rises to $3.5 million nextyear and is likely to settle there or higher

(see story, p. 5). But 23 statesimpose their own estate or in-heritance taxes, some at farlower wealth levels; New Jer-sey and Rhode Island exemptonly the first $675,000 goingto nonspousal heirs. (You cantransfer an unlimited amountto a spouse who is a U.S. cit-izen without federal or stategift or estate tax.)

The good news is thatmost affluent folks don’tneedtodo fancystuff; they can giveawayenoughassets using theannual gift tax exclusion. Anyone can give$12,000 a year in cash, stock or propertyto any other person, without worryingabout federal or state transfer taxes. A hus-band and wife can give their two grownchildren, and their kids’ spouses, $96,000a year. Cut in four grandchildren and$192,000 can be passed between genera-tions every year. Noncash gifts—say, a fam-ily cruise—count against the $12,000. Butif you pay someone’stuition or medical billsand send the check directly to the schoolor health provider, it doesn’t eat into the$12,000 exclusion.

What if you want to transfer a biggerchunk at once? You also get a single life-time gift tax exclusion of $1 million,

which, when used, reduces dollar for dol-lar the amount you can pass to heirs freeof federal estate tax.

Deciding which assets to give away canbe tricky. You must consider both estate andcapital gains taxes and make some educatedguesses. Under current law—and likely inthe future too—an asset passed on at yourdeath gets a “step-up” in value to what it isworth at that time. So your heirs can sell itright away without owing capital gains tax.That means if your estate isn’t likely to betaxed, you probably don’twant to give awaya highly appreciated asset. On the otherhand, when you give an asset during yourlife, the recipient takes on your basis in it,or its current market value, whichever is


cost for all of them. If instead you statebeforehand which shares you’re selling,you can minimize gains one year andrecognize them later when you haveoffsetting losses.6) Buy munis. If you’re in a high tax

bracket, tax-exempt municipal bondsare a buy, says Robert Gordon, presidentof Twenty-First Securities. While offtheir peak of this year, muni yields arestill high relative to Treasurys, even atcurrent tax rates (see story, p. 14). Avoid

private-purpose bonds—the kindwhose income is taxable in the AMT.Vanguard, which offers some of thelowest-cost funds around, eliminatedmost of these bonds from its munifunds last year a

SHIFT THAT WEALTH NOWStock prices and interest rates are down and the estate tax is here to stay.

Time to think about gifts and GRATs.BY ASHLEA EBELING

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lower.That means you can’ttransfer an un-realized loss and usually shouldn’t be giv-ing away property that’sworth less than youpaid for it. Sell it, book the loss yourself andgive the cash.

What assets should you give away? Ifyou have appreciated stock you want to sellnow, you might do well giving it to an adultgrandchild and letting him or her sell it.That’s because folks at or below the 15%ordinary income tax bracket—for exam-ple, a single with $40,000 in gross income—qualify this year for a new 0% capital gainsrate. (Caution: Full-time students don’tqual-ify for the 0% rate unless they’re marriedor 24 or older.)

What if your estate is likely to be tax-able? Then you want to give assets withgrowth potential to get that growth out ofyour estate. Jonathan Forster, a tax lawyerwith Greenberg Traurig in McLean, Va., re-ports that a client worth $80 million justput her shopping center interests into a fam-ily limited partnership and gave some sharesin the partnership to her kids. “She wrotea check to the IRS for $200,000 in gift tax,”he says. “She believes it’s in her best inter-esttomoveassets, particularly at today’s de-pressed values.”

It’s not just the sagging real estatemarket that made this transfer smart.Putting the real estate in the partnershipreduced the appraised value of her gift;this “discount” is legit because the kidscan’t easily sell their minority partner-ships or force Mom to sell the real es-tate and distribute cash.

Also, while estate and gift taxes carrythe same nominal 45% tax rate, the gift taxworks out to be cheaper. Why? If you givea$1million gift to your daughter, you haveto send a check for $450,000 in gift tax tothe government. But if you leave that same$1.45 million in your estate, the 45% tax islevied on the whole amount. So the IRSgets$652,500 and your daughter only $797,500.

While the gift tax may be cheaper, mostfolks would still rather not pay it, which iswhy grantor retained annuity trusts are pop-

ular. You put assets like stocks, commer-cial real estate or shares of a family busi-ness in a trust that pays you a fixed annualannuity for a set number of years. At theend of that term what’s left in the GRATgoesto your kids.

The key is this: The value of what’s leftfor the kids, for gift tax purposes, is calcu-lated by subtracting from the trust’s valuethe discounted present value of your an-nuity. The discount rate (known as the Sec-tion7520 rate) comes fromaformula basedon Treasury note yields. At the moment,Treasury yields are low, and Section 7520spits out3.2%. Thatmakes the annuity lookvaluable and the remainder look small. Ifyour assets earn more than 3.2%, you willhave got a break on gift taxes.

Say you put $1 million of assets in aGRAT paying you an annuity of $355,000a year for three years. As far as the IRS isconcerned, you haven’t given the kids any-thing at all, since that annuity will exhaustall the principal and earnings. Yet if theGRAT assets grow at 8% a year, there willbe $110,000 left for your kids. By contrast,to set up a zero gift tax value GRAT in Au-gust 2007, when the 7520 rate was 6.2%,you would have had to pay yourself a$375,000 a year annuity, leaving only$42,000 for the kids, assuming the same8% return. (One catch: You need to sur-vive the term of the trust or else everything

ends up back in your estate.)“Capturing a change in the rates

makes a difference, but the bigger play isby putting in assets where you expect asudden spike in value,” says JanineRacanelli, head of JPMorgan Private Bank’sAdvice Lab. Recently she’sseen executivesof financial firms whose stock has takenadrubbing funding GRATswith their com-pany stock.

What if you bet wrong and the de-pressed assets you stick in a GRAT headfurther south? There will be nothing leftfor the kids and you’ll be out the setupfees ($5,000 and up for a lawyer and$5,000 and up for an appraiser, ifneeded), plus annual accounting fees.“Some see GRATs as a lawyer/CPA/ ap-praiser annuity,” concedes Baskies.

If you’d like to help charity as well asyour kids (and your lawyers), there’s an-other GRAT-like ploy that benefits from lowinterest rates: the charitable lead annuitytrust. The annuity payments go to charity,instead of to you, and your kids get what’sleft. Vaughn W. Henry, a Springfield, Ill.charitable gift planner, recently helped adoctor set up a charitable lead trust hold-ing$1.5 millionin stock. The trustwill pay$105,000 a year for 15 years to good causes.Thedoc’s threekidsget what’s left. The lowdiscounting rate tells the IRS that the doc-tor has given his kids the equivalent of only$264,000 in immediate cash. But if theportfolio earns 8% a year, they’ll get $1.9million, better than double what theywould get if he were to hand over $264,000and they invested it at 8%.

The tax treatment of this kind ofcharitable trust? The doctor doesn’t getan immediate income tax deduction forthe present value of the income streamgiven away or a deduction for the pay-ments to charity over the years. Insteadthe trust declares capital gains and div-idends as its own income, while claim-ing the $105,000 payments as charita-ble deductions. Usually, the trust windsup with little or no income tax due. a


INVESTORS’ GUIDEq STRATEGY

The State of TheEstate Tax

Under the current wacky federallaw, which will likely change before it takes effect, the estatetax disappears and then reappears.

EXEMPTIONAMOUNT

YEAR ($MIL) RATE

2008 $2.0 45%

2009 3.5 45

2010 0.0 0

2011 1.0 41 to 60Source: CCH, a Wolters Kluwer business.

THE DOLLAR IS LOWER THAN EVER

against the euro, gas prices arehigher than ever, Egyptians arerioting over food shortages and

Sam’sClub is rationing rice. Such upheavalaside, it’s business as usual on Wall Street:Small investors are repeating past mistakesby focusing on the market’s short-termtroubles rather than on their own long-term objectives.

Instead of diving into tech stocks orhousing near the peak, the masses are thistime pouring into Treasurys and com-modities, says Christine Benz, personal fi-nance director at Morningstar in Chicago.Small investors pumped $10.4 billion intomutual funds and exchange-traded fundsspecializing in Treasury Inflation-Pro-tected Securities over the last year, driv-ing up the price of TIPS and thereby low-ering future returns. Buy one now, at leastin a taxable account, and you are just aboutguaranteed to be a loser.

In January the government issued aten-year TIPS at $99.14 per $100 with anafterinflation yield of 1.7%. It now sells for$101.05, and the yield is down to 1.5%.The bond protects you against inflation,but still, this is a very bad deal. Ifthe cost of living goes up 3%,the bond gives you a totalreturn of 4.5%, and all ofthat return is

taxable immediately. If your tax bracketis 35%, you lose more than 1.5 percent-age points to taxes. Subtract inflation andyour real, aftertax return is negative.

That’s not all. If you buy the Treasurythrough a fund, you’ll be even worse offbecause funds have overhead.

Putting the TIPS in a 401(k) postpones,but does not eliminate, the tax punish-ment. When the money comes out, it willbe subject to post-2009 federal tax rates(all but certain to be higher than today’s)and, somewhat surprisingly, state incometax as well.

Why are retail investors falling all overthemselves to buy TIPS? Because they arein a panic. The price of gasoline is goingup, and TIPS have the specious appeal ofbeating the cost of living. They are miss-ing the big picture.

“Investors, as usual, are gettingin at the worst time andignoring stocks,” saysMorningstar’s Benz.

Whatever happensto bonds and

commodities from here, the rush from onehot sector to another is usually far moreprofitable to the brokers clipping commis-sions off each buy-and-sell order than topeople aiming to pay for college and re-tirement.

What investors should be doing whenpanic is in the air is tuning out the mar-ket’s day-to-day distractions and focusingon multidecade goals. That means stick-ing to two basics: deciding what asset cat-egories to own and finding ways to ownthem cheaply. We’ll restate this simple phi-losophy as four rules.

Think About Allocation. Most peopledon’t give any thought at all to how theyallocate between stocks, bonds, cashand commodities. They just buy what’sworked lately.

What Wall Street refers to as a“flight to quality” amid short-termtroubles often turns out to be a flightto mediocrity over the long haul.Lately that flight has been a stampedeinto bonds, especially Treasurys, fortheir safe-haven status. True, theydon’t default. But they do somethingelse bad. They


CPI

Vanguard Prime Money Market

Lehman Aggregate Bond Index

Take the Long ViewOver the last three decades the S&P 500 has easily

beaten bonds, cash and inflation.

3/31/78=100

Sources: Lipper; U.S. Bureau of Labor Statistics.

THE BIG PICTUREDon’t let fads, fears and hot products distract you from

the two most important things about constructing aportfolio: having a reasonable allocation of your assets

and keeping your costs down.BY MICHAEL MAIELLO

MUTUAL FUNDSwINVESTORS’ GUIDE

eat away yourpurchasing power.

We can’t prove it, butwe suspect that most ofthe people buying ten-year Treasurys todayaren’t buying becausethey expect terrificreturns over the nextdecade. They are buyingbecause they witnessedgreat returns over thepast year (greatcompared to stocks, atany rate). As investorsbid up bonds over thelast year, Vanguard’sIntermediate-Term Treasury Fundposted a 10.5% total return. Meanwhile,its yield has fallen to 3.1%. That’s a prettygood forecast of what you’ll get owningthis fund for the next decade.

That’s a terrible return. It’s highlylikely to be negative after inflation andtaxes. See the arithmetic above, wherewe showed how a 4.5% yield is likely tonet a negative real return, too. You haveto expect extraordinarily good things onthe inflation front to like a 3.3% return.Indeed, our 3% assumption for inflationis pretty conservative. In the past yearthe cost of living went up 4%.

Could stocks do worse than 3.3%?Sure. They are, after all, risky. But whatis likely?

During one-year periods over the pasttwo centuries stocks have outperformedgovernment and corporate bonds 60% ofthe time, according to an updated editionof Stocks for the Long Run, by Whartonfinance professor Jeremy Siegel. Stretch thetime frame to five-year periods and stocksexcel 70% of the time, with their winingpercentage rising to 95% for periods longerthan 20 years.

The moral of this story is that in-vestors who can sleep through the bumpsshould weight their holdings heavily to-ward stocks, argues Edmund (Ned) Not-

zon, chairman of the asset allocation com-mittee for fund vendor T. Rowe Price.Under his direction, T. Rowe’s target-dateretirement and college savings funds arethe most equities-laden in the business.

Investors in their 20s and 30s shouldhold at least 90% of assets in stocks andcut that only to 55% at age 65, he recom-mends. Given inflation’s corrosive effects,even octogenarians should hold 40% oftheir stashin stocks, throttling back to 20%atage95, andthen only if they don’tmuchcare about what’s left for their heirs, he says.

If you’re working with a blank slate,or tax-deferred account, the simplestway to diversify is through a single fundthat covers the earth and relieves you ofthe temptation to load up on hot regionsor sectors or abandon out-of-favorones. Vanguard launched a GlobalStock Index Fund and ETF last monththat tracks the FTSE All-World Index of2,800 companies and includes a 55%weighting outside the U.S. At 0.25% ayear in fees, it’s the cheapest global indexaround.

A second way to own the world is tobuy country- or sector-specific mutualfunds or ETFs. Then when one gets beatenup, harvest the losses to offset gains else-where when you rebalance. The key isreinvesting by the original plan, regard-

less of the market’s swings.Beware of overlap,

too. Gazprom, forexample, is the top hold-ing in Fidelity’s EmergingMarkets and AggressiveInternational funds. Sim-ilarly, before buying anenergy fund, note that en-ergy stocks already com-pose 13% of the market-cap-weighted S&P 500.Many fund Web sites up-date holdings monthly,versus semiannually inSecurities & ExchangeCommission filings.

Be a Cheapskate. As Vanguard founderJohn C. Bogle put it, investing is one busi-ness where you get what you don’tpay for.Pony up the average 1.5% of assets thatU.S. equity no-load funds charge and overtime you’re likely to lag the market byabout that much.

More, actually, according to Madrid’sUniversidad Carlos III professors JavierGil-Bazo andPablo Ruiz-Verdú. That’sbe-causemanagers keep fees high in preciselythose funds whose investors are inatten-tive, theyconcluded after studying activelymanaged funds in business for at least twoyears. “A significant fraction of investorsresponds at best sluggishly to differencesin afterfee performance,” the professorswrote in a working paper. “Funds exploitthat fact and charge high fees.”

The flip side is that sophisticated in-vestors care dearly about performance, andtherefore fees, so the best managers keepthem low. Postscript: The ten cheapest ac-tively managed funds are all from Vanguard.

What about all those broker-sold loadfunds? They’re hardly ever worth themoney. On average they clip 5.5% off sav-ings before they go to work and charge1.3% in management fees versus 1% forno-load equity funds. If you really needhand-holding, consider using a financial


INVESTORS’ GUIDEqMUTUAL FUNDS

Best of the BunchOnly 29% of actively managed funds have beaten Vanguard’s S&P 500 Index since it wasoffered to small investors in 1976. These ten have performed best. All have below-average fees.

TOTAL RETURN ANNUALANNUALIZED EXPENSES

YEAR– 8/31/97– PERFUND TO–DATE 5-YEAR 4/30/08 $100

FIDELITY MAGELLAN –6.7% 10.1% 17.8% $0.54

CGM CAPITAL DEVELOPMENT –0.4 24.2 16.8 1.091

COLUMBIA ACORN-Z –4.6 17.3 16.6 0.74

SEQUOIA –1.4 9.0 16.2 1.00

AMERICAN GROWTH OF AMERICA-A –3.2 13.9 15.8 0.622

DAVIS NEW YORK VENTURE-A –3.8 13.2 15.8 0.853

MUTUAL SHARES-Z –6.1 12.0 15.2 0.741

HARTFORD GROWTH OPPORTUNITIES-L –10.2 18.1 15.2 1.043

ROYCE PENNSYLVANIA MUTUAL-INV –2.9 16.3 15.1 0.89

AMERICAN CENTURY GROWTH-INV –4.8 10.8 15.1 1.00

S&P 500 –5.0 10.6 12.0Performance through Apr. 30. 1Closed to new investors. 2Fund may impose sales charge of up to 5.75%. 3Fundmay impose sales charge of up to 4.75%. Source: Lipper.

planner who charges a flat fee or 1% orso of assets a year to put you into low-costmutual funds or ETFs.

One cost not captured in most feetables is the brokerage commissionsfunds run up buying and selling. Wherethe fees do turn up is in reduced per-formance. The best way to minimizethem is to buy ETFs, index funds or oth-ers with low turnover ratios. You canalso gauge the net effects of brokeragecosts by reviewing FORBES’ fund tables,which include them in fees. We don’t,however, include the effect of bid-askspreads, which are significant but hardto quantify. Our advice on this score isto be leery of high-turnover funds.

Think About Risk.We’re not averse to tak-ing risks, or we wouldn’t be saying kindthings about the stock market. But we dothink you should be contemplating it be-fore putting your money down. If youdon’t, you might react badly to a marketspill. You might, in short, buy high andsell low. That’s what befell a lot of the in-vestors who stampeded into tech funds in1999 and 2000.

One way to measure risk for a stockfund is to evaluate its performanceseparately in bull and bear markets.FORBES does that for you with its fundgrading system, available atwww.forbes.com/finance/funds. Risky

funds tend to get As and Bs in bullmarkets and Ds and Fs in bear markets.Example: Fidelity Select Electronics.Conservative funds have the reverseprofile, like Fidelity Select Insurance.

Another measure, available for any in-vestment with a performance history, ishow widely the returns have strayedfrom their long-term average. For exam-ple, you look at how monthly returns overthe past three or five years have dancedaround the monthly average. The analy-sis is usually presented as an annualizedstandard deviation. For the Vanguard S&P

500 Index Fund, the standard deviationover five years is 8.9%. Pimco’sCommodi-ties Real Return Strategies Fund far out-performed the Vanguard index fund overthat period but took big chances; its an-nualized standard deviation was 17.8%.You can find standard deviation figureson Morningstar’s Web site.

Don’t Buy Past Performance. At anygiven moment there will be funds thathave done well in the past five or ten yearsand trumpet their results in ads. Don’tbuythinkingthat future returns will be as goodas past ones. You should, to be sure, buya fund with a good history rather than abad one, but past performance is a prettyweak indicator.

In 1976 Vanguard’s S&P 500 Index of-fered retail investors their first chance to

passively track stocks. At the time therewere 308 U.S. stock funds big enough tobe listed in the FORBES Mutual Fund Sur-vey. Over the succeeding 32 years 89 ofthese funds, or 29%, have beaten the Van-guard index fund. This is a decent meas-ure of how likely it is that a managed fundwill beat the index over such spans.

Over the years a lot of the stinkerfunds have been merged out of exis-tence. Only 205 of the 308 at the start-ing line are still in the race. Were youfoolish enough to use 205 as your de-nominator, you would erroneously con-clude that 43% of actively managedfunds beat the passive one.

Among the ten best-performing ac-tively managed funds (see table, below) thatbeat Vanguard’s index over 32 years, sevenare no-loads and all have below-averagefees. (Loads aren’t figured into our perform-ance numbers; expenses are.) Only onetop-ten fund is a small-cap, although smallstocks supposedly outperform large onesover time. Topping the list: Fidelity’s re-cently reopened Magellan, with a 17.8%annual return to the Vanguard index’s 12%.That includes market-beating results for 9years when Magellan was closed.

Bottom line: Getting a hot fundmay win a sprint or two, but nothingtrumps a diverse portfolio and steadyhand over time. aResearch by John Chamberlain.


The World for Pennies a DayThese index funds and ETFs are the cheapest in their sectors. They’re also a good bet to beat most actively managed funds.

TOTAL RETURN ASSETS ANNUALYEAR– 3-YEAR 3/31/08 EXPENSES

FUND | CATEGORY TO–DATE ANNUALIZED ($MIL) PER $100

VANGUARD LARGE-CAP INDEX-ETF | U.S. Equity –4.9% 8.9% $2,164 $0.07

E-TRADE INTERNATIONAL INDEX | International –3.9 16.0 169 0.09

VANGUARD EUROPEAN STOCK INDEX-INV | Europe –4.5 17.2 33,930 0.22

VANGUARD PACIFIC STOCK INDEX-INV | Asia –1.5 13.7 15,399 0.22

ISHARES MSCI KOKUSAI INDEX | Global –4.4 NA 9 0.25

BLDRS EMERGING MARKETS 50 ADR INDEX | Emerging Markets –1.1 41.9 779 0.30Performance through Apr. 30. NA: Not available. Source: Lipper.

BENJAMIN SILVERMAN, THE

head of research at Insider-Score, doesn’t break out ina cold sweat at every head-line reporting another

writedown or missed quarterly earn-ings forecast. Not that he doesn’t takethe investment temperature of theeconomy; he just takes his readingsfrom the people in the know: the onesrunning the companies whose stockprices flick across our screens, theinsiders.

When executives and directors ofcompanies and those who own 10% ormore of a stock buy or sell their sharesin the company or any of their optionsor restricted stock awards, the Securi-ties & Exchange Commission requiresthat they disclose the transactionwithin 48 hours. Mandatory disclosurewas put in place after the Enron melt-down. “A CEO can no longer tellinvestors that the company is doinggreat and continue to dump his stockquietly on the side,” says Silverman.

Between January 2006 and April2008 there were 1.2 million suchtransactions, in which 18.5 billionshares were bought and 16.2 billionshares sold across 9,300 firms. Insid-erScore has formulas to assess eachtrade. It takes into account the posi-tion of the insider, the number ofshares, the price paid, how the buy (orsell) changed the executive’s overallholding and how the stock performedin the previous week, month and year.By looking for patterns specific to aninsider and also for those that range

across a company, anindustry or the entiremarket, InsiderScoredivines if a trade is abuy or sell signal.

“Insiders’ behav-ior is predictive,” saysNejat Seyhun, afinance professor atthe University ofMichigan and authorof Investment Intelli-gence From InsiderTrading. When theequities marketstarted dipping lastAugust on subprimewoes, insidersbecame bullish, hesays. Silvermanagrees: “Insiderswere buying at a levelwe had not seen inclose to a decade.”True to the twomen’s expectations,the market rallied;the S&P 500 rosefrom 1,406 to 1,554by mid-October.

The index has since slipped backto its August 2007 level. And how arethe insiders reacting now? Just as bull-ishly as they did then, according toSilverman.

For investors who like the insiderplay but want to avoid the slog ofkeeping track of the transactions,Claymore Securities offers the Clay-more/Sabrient Insider exchange-

traded fund. This tracks the SabrientInsider Sentiment Index developed bySabrient Systems, an equity researchfirm in Santa Barbara, Calif. Theindex comprises 100 stocks in whichthere has been a trend of insider buy-ing plus recent earnings estimateincreases by Wall Street analysts. Sincebeing launched in September 2006,the index has shown a cumulativegain of 9.45%, outstripping its


INVESTORS’ GUIDEq STOCKS & BONDS

INSIDE TRACKExecutives trading their company’s stock don’t always have the right answers.

But you should think twice before betting against them.BY MEGHA BAHREE

EVAN KAFKA FOR FORBES

Benjamin Silverman: opening the doorsto insiders’ outlooks.

benchmark, the S&P MidCap 400, by2.8 percentage points.

In its current basket of 100 stocks,computer stocks account for 18.2% ofthe total (versus 16.7% of the S&P

500), financials 17.1% (versus 17.6%),industrials 16.4% (versus 11.5%) andconsumer discretionary 14.8%(versus 8.5%).

The last may come as a surprise,given the daily announcements ofsluggish consumer sales. Is thisanother case of insiders knowing bet-ter? “Some of these industries arecyclical, and people working in thoseindustries understand that more sothan the average investor,” says Chris-tian Magoon, Claymore’s president.“They’ve seen there are times you buyin the downturn.” Moreover, the hold-ing time for insiders is a lot longerthan for the average investor. “Insidersaren’t trailing indicators, they are lead-ing indicators,” says Magoon. “Theyget in before things get good.”

The top five positions in the Clay-more/Sabrient Insider ETF are in

SunPower, First Solar, AnthraciteCapital, Redwood Trust and CashAmerica International, with weight-ings in the portfolio ranging from1.2% to 1.3%. The ETF was launchedalong with the index in September2006 at $25 a share and now has $29million of managed assets. It wasrecently trading at $27.61, a three-centpremium to its net asset value.

Since its inception the ETF has hadan annualized return of 7.25%, to themarket’s 5.43%. “We’re trying to investlike the people who know the mostabout the company,” says Magoon.The return is net of expenses—fairlyhigh as ETFs of U.S. stocks go, at 0.6%a year.

If you’d prefer to pick off individ-ual stocks, consider these: One com-pany that saw insiders scooping upmore equity was Chesapeake Energy.Chief Executive Aubrey McClendonbought $70 million in stock in thefirst three months of this year (andanother $22.9 million since the begin-ning of April). That is more than he

bought in all of 2007.At McMoran Exploration, Robert

Day, a director and the founder ofTrust Co. of the West, bought $23.4million of stock. In 2007 he bought$57 million of stock of its former sis-ter company, Freeport-McMoran, inthe range of $53 to $63 per share.Today that one is trading at $114. “Heknows cyclical industries,” says Silver-man. “His grandfather was thefounder of Superior Oil. He’s got someoil in his veins. He’s the kind of insideryou look to follow.”

Another industry that has seenactive insider buying is homebuilding. Hovnanian Enterprises isup 107% since its founder upped hisstake from 27.2% to 29.2% inJanuary. Real estate developmentfirm Amrep is up 87% since its vicechairman and majority shareholderupped his stake from 58% to 60% inDecember. Insiders are stirring intelecoms, too. In May RichardLynch, Verizon’s chief technologyofficer, boosted his stake to 26,000shares from 6,000 shares, eventhough the company’s earnings hadtaken a hit from its $18 billioninvestment in a new fiber network.This was the largest insider buy byan executive in a large telecomcompany in the past five years.

There have been insider sales, too.John Hess, chief executive of oilproducer and refiner Hess Corp., sold$173 million worth of stock in March.Maybe he’s been around long enoughto know that commodity price spikesdon’t last more than a few years. AtGoldman Sachs the vice chairman andthe president sold stock worth acombined 14 million in January andMarch. At Vornado Realty Trust $30million of smart money has left in thepast month. Think twice before you buyany of these. a


Leading IndicatorsFive companies where insiders are buying, and five where they are off-loading.

NET SHARESRECENT PAST 3 MONTHS

COMPANY PRICE P/E (THOU)INSIDER BUYS

AMREP $54.80 18 811

CHESAPEAKE ENERGY 56.12 32 1,583

COACH 35.11 18 47

MCMORAN EXPLORATION 30.51 NA 506

NORTEL NETWORKS 8.31 NA 946INSIDER SELLS

BLACKROCK 212.15 27 –136

FLEXTRONICS INTERNATIONAL 10.58 NA –2,483

GOLDMAN SACHS GROUP 189.76 9 –47

HESS 112.79 16 –177

VORNADO REALTY TRUST 94.46 20 –240Price as of May 7. 1Six-month figure. NA: Not applicable. Sources: FT Interactive Data, Lion-Shares and Reuters Fundamentals via FactSet Research Systems; Bloomberg Financial Markets.

POPULAR TACTIC WITH BRO-KERS selling municipal bonds:ladder your portfolio. Youbuy a bond due in a year, an-other due in three, then six

and end with one due in nine years. Aseach matures, you put the principal intoa nine-year bond. The rolling redemptions provide some protectionagainst rising interest rates, which ofcourse kill the market value of bonds. Asbonds are redeemed, you redeploy themoney at the new higher rates.

This is Wall Street propaganda, saysJames A. Klotz, 60, the president of bro-kers FMSbonds of Boca Raton, Fla. Rea-son: Your yield will be less than it couldbe. Better to put all your money in longbonds, he says, and take your chances oninterest rates.

“Everyone wants to tell you howthey’re so sophisticated,” says Klotz. “Butbonds don’t need to be managed. Just buyand hold.”

As a 35-year veteran of the bondbusiness, Klotz knows all the tricks. Bro-kers love laddering for two reasons, hesays: It gives them a lot of work scaringup medium-term bonds every two years;and it protects them—against angryphone calls. If interest rates shoot up, peo-ple holding long-maturity bonds can see20% or even 40% losses in market value.Indeed, Klotz remembers the bond col-lapse of the early 1980s, when munisfrom some solid issuers traded at 50 centson the dollar.

What makes him so sure that won’thappen again? The interest rate spike ofa generation ago, he says, was due tothe Fed’s desperate battle against infla-tion. Next time it will tame inflation early,Klotz figures.

The problem with a ladder thatreaches out only nine years is its skimpyyield. A California general-obligationmuni due in 2017 yields 4%, versus 5.1%on a GO due in 30 years. (Both of theseget A+ ratings from Standard andPoor’s—good, but not great.) If youwon’t need the money until 2038—ifyou are 40 and investing for retirement,or 65 and planning bequests—youand/or your heirs can afford a stretchof high interest rates. Provided theagency borrowing the money doesn’tdefault, the full principal will come backin 2038, even if it has had a bumpy ridein the meantime.

“If you’re going to panic when yousee the monthly statement, you should-n’t buy munis,” Klotz says. “Buy a moneymarket fund.”

Klotz says laddering might makesense with U.S. Treasurys: These (taxable)bonds have a flatter yield curve, so youdon’t give up as much by going short.The muni yield curve is steeper. Time di-versity costs real money there. Klotz does,to be sure, advocate diversifying acrossissuers by putting, say, $100,000 into fourdifferent tax-free bonds.

What if inflation creeps up andmuni interest rates climb by two points?That would take the market value of a$100,000 bond due in 2038 down to$78,000. You could sell and take a$22,000 long-term capital loss, usableagainst any amount of capital gains andagainst up to $3,000 a year of salary andother income. (Unused losses carry for-ward.) But do get back into the marketfor the new 7% rate.

There are two ways to do that. Putyour $78,000 into newly issued 7%bonds at 100 cents on the dollar. Theywould return only $78,000 of principalat maturity but pay $5,460 a year, insteadof $5,000. Or you could, with the same$78,000, buy $100,000 (par value) of a 5%bond trading at 78 cents on the dollar.These would pay $5,000 a year but repay$100,000 in principal in 2038.

The risk with the former strategy isthat the new, high-coupon bonds couldget called. That is, if rates fall again to 5%,the sewer authority that has your $78,000could force an early redemption and endyour $5,460 income stream. You can pre-vent that by putting cash from a tax-losssale into discounted bonds.

That’s what Klotz and his partner,Paul Finesilver, did for clients when theFed was working its magic in 1982. Theysold 6% bonds trading at 50 cents on thedollar and reinvested in different 6%bonds trading at 50 cents. Their clientscame out even, earning over time the



SUPERCHARGEDMUNIS

Conventional wisdom says buy muni bonds in cautiouslystaggered maturities. Jimmy Klotz says put everything

into long bonds—and get an extra point of yield.BY BERNARD CONDON

CH

RIS

GA

SHFO

RFO

RB

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JAMES KEENAN, COMANAGER OF

the BlackRock High Yield Bondfund, loves disarray in the mar-kets. “It’s a risky time, but I’mgetting paid for it,” says the Notre

Dame graduate and son of an FBI agent.In January Keenan shied off investing

in the $29.7 billion buyout of Harrah’s En-

tertainment by private equity giants TPGandApollo Management, even though 133/8%debentures were on offer and he reckonedthat Harrah’scould weather a prolonged re-cession without defaulting on its paper. Al-most immediately, with the subprimemortgage crisis swirling and lots of lever-aged buyout debt overhanging balance

sheets, the bonds fell precipitously. Keenanbought the bonds at around 85 cents onthe dollar, for a yield to maturity of 15%.He’ll buy more if the price falls further. “Debtis more attractive than equity right now,”he says. “I like bonds. They are senior inthe capital structure and are trading at a sig-nificant discount to parity.”

same 6% they had bargained for. Hadthey switched into new bonds payingmore like 12%, those bonds would havebeen called away as interest rates subsidedin the late 1980s, and the investorswould have suffered a permanent erosionof capital.

Alas, the tax-loss game has got a lit-tle trickier because of a law change. Nowif you buy a “tax-exempt” muni at a dis-count the capital gain realized at matu-rity is taxed as ordinary interest income.

(It’s not fair, but that’s how the tax lawswork.) Switching to higher-couponbonds finesses this problem but at the riskthat rates subside and you get whipsawedby a bond call. Klotz’s advice: Don’t takethat tax loss unless it’s really big and youcan make use of it. Otherwise sit tight.

If you don’t need the coupon pay-ments to live, reinvest income from goinglong in new 30-year bonds, Klotz advises.Make sure you have 10-year call protec-tion and consider possible tax changes.

Don’t buy double-tax-free bonds if youplan a move across state lines.

Before buying, it also pays to checkprice quotes against the securities indus-try Web site, www.investinginbonds.com,to avoid getting gouged by brokers. Orbuy newly issued bonds. The table onpage 114 displays a sampling of high-quality munis that Klotz likes.

If you have less than $100,000 to in-vest, or need liquidity, you’re better offin a muni bond fund. a


Going LongVeteran trader Klotz says buy long-term munis from solid issuers like these, and forget about the short stuff. If interest ratesrise, you can use the extra income you’ll be earning to buy new bonds at higher yields.

NAME RATING PRICE COUPON MATURITY YIELD1

CALIFORNIA A+ $98.78 5.0% 2038 5.1%

ILLINOIS FINANCE AUTHORITY EDWARD HOSPITAL AAA 102.77 5.5 2040 5.1

LONG BEACH, CALIF. BUILDING FINANCE AUTHORITY AAA 99.85 5.0 2035 5.0

METROPOLITAN TRANSPORTATION AUTHORITY (NY) A 100.34 5.0 2035 4.9

NEW YORK CITY HOUSING DEVELOPMENT CORP. AA 100.00 5.0 2033 5.0

NEW YORK THRUWAY AUTHORITY AA– 101.08 5.0 2037 4.91To maturity or, if lower, to first call. Sources: Bloomberg; Standard & Poor’s.

HIGH YIELDHIGH RISK

Junk bonds are perilous in the best of times, whichthese are not. Funds like BlackRock offer those with the

stomach for it at least a chance of survival.BY ROBERT LENZNER James Keenan

PETE

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Keenan, 31, and his associates havetheir $1.7 billion fund deep into junkterritory. The portfolio is 35% in BB-rated issues, 35% in Bs, 15% in CCCs and10% in bank debt. The fund’s yield of9%, which is net of expenses and the di-lution caused by uninvested cash, im-plies that Keenan’s junk is yielding morethan 10%. That’s almost seven percent-age points above the yield on ten-yearTreasurys. Since its inception in 1998,the fund’s investor share class has re-turned a compound 5.7%, versus 5.9%for its benchmark, Lehman Brothers’U.S. Corporate High-Yield Index. Thecase for buying junk now: Lenders arefrightened and junk is cheap.

Many bonds in the BlackRock fundare the by-product of leveraged buyouts.This makes High Yield a way for low-budget investors to invest alongside pri-vate equity and hedge funds without theusual rapacious fees of those categories. TheBlackRock fund has an expense ratio of 1%and an upfront load of up to 4%.

Like equity analysts, Keenan’s staff of24 do bottom-up research, monitoringand modeling free cash flow estimates tocreate their own credit ratings for bor-rowers. They need to be sure that thecash an issuer has left after covering itscapital expenditures can comfortably

cover the interest bills and, it’s hoped,retire some of the principal. Keenanscrutinizes the expense accounts of hisanalysts “to make sure they’re on theroad visiting companies.”

After a leveraged buyout a borrowerwill typically have debt (bonds plus bankdebt) equal to four to seven times oper-ating profit (in the sense of earnings be-fore interest, taxes and depreciation). Thatratio of debt to profit doesn’t look tooscary. But two cautions are in order. Oneis that a certain level of capital expendi-tures is necessary just to stay in business—cement kilns and airplanes and printingpresses have to be replaced. The other isthat when the denominator collapses, asit has a habit of doing in recessions, theratio goes skyward.

Arecent mistake BlackRock made wasto buy bonds used to finance a buyout ofYellow Pages publisher R.H. Donnelley.That seemingly stable advertising businesshas taken a blow from the Internet. Thebonds were issued at par value. At the time,the ratio of debt to Ebitda was seven times.Keenan bought some bonds at 100 centson the dollar. The debt ratio is still seven,and the bonds are trading at 70 cents onthe dollar.

Keenan’sportfolio leans toward sectorsthat he thinks will outperform the econ-

omy as a whole. It’s 5.0% in metal minersand processors, versus 3.8% for theLehman junk index; 6.1% in wirelessphone companies versus 1.7% for theindex. He is avoiding food and beverageproducers and retailers. “The consumer isweak. I see a slowdown in consumerspending coming, so I’m underweight re-tail,” Keenan explains.

He likes the Freeport-McMoran Cop-per & Gold 83/8% bond due in 2017, trad-ing at 110 for a 6.5% yield. With copper push-ing close to $4 a pound, Freeport has beenable to pay down faster than expected the$11.5 billion it borrowed to acquire PhelpsDodge. Freeport’sratio of debt to Ebitda hasdropped from 4 to 0.5. If metal prices holdup, Keenan says, Freeport will enjoy $5 bil-lion a year in profits before taxes and depre-ciation but after interest and cap-ex.

Since many of the fund’s holdings arethe result of private equity LBOs, Keenanoften finds himself in tricky negotiationswith the likes of Blackstone and Apollo. Heprefers not to buy securities unless Black-Rock is covered by covenants that protectits position in the debt structure.

Keenanhasset himself two guidelines:Theissuer can’ttake its money out in a cashdividend or add debt senior to BlackRock’s,withoutpermission from the bondholders.Those provisos protected him from theworst of two troubled Apollo LBOs, Linens’n Things and Claire’s Stores.

Keenan isn’t sure we’ve seen the bot-tom of the credit bubble. He has an 8%cash cushion to take advantage of whathe calls “a default environment.” If U.S.earnings weaken, he says, “Equities willtrade down, and the spread [of junkyields] over Treasurys will widen.”

If you have at least $5 million to putinto junk debt, you could buy individualbonds. With less, you probably shouldn’t:You’ll get killed either by bid/ask spreadsor a lack of diversification. To smaller in-vestors we recommend buying no-loadfunds with reasonable expense ratios. Thetable shows eight. a



5-YEAR ANNUALAVERAGE EXPENSES

FUND TOTAL RETURN YIELD PER $100

FEDERATED HIGH-YIELD TRUST 8.0% 7.7% $0.99

FIDELITY CAPITAL & INCOME 10.0 6.5 0.76

FIDELITY HIGH INCOME 8.3 7.6 0.75

NORTHERN HIGH YIELD FIXED INCOME 6.4 7.8 0.90

PAYDEN HIGH INCOME 6.6 7.7 0.61

T ROWE PRICE HIGH-YIELD 7.6 7.9 0.77

USAA HIGH-YIELD OPPORTUNITIES 7.6 7.8 0.90

VANGUARD HIGH-YIELD CORP-INV 6.2 7.7 0.26Performance through Apr. 30. Sources: Forbes; Lipper; Morningstar.

Junk SaleTo avoid a load like BlackRock’s, consider these eight junk funds, which FORBESrates as Best Buys. All have an average credit quality of B, except Vanguard’s BB.

THE JACK 2 WELL DRILLED IN

THE deep waters of the Gulfof Mexico in 2006 was her-alded as opening up 15 bil-lion barrels of untouched oil

reserves. Do you want a piece of it? Youcould buy into Chevron or Devon En-ergy, partners in the project. Or you couldbuy shares in a mostly government-owned oil company that is also partici-pating, the Norwegian firm StatoilHydro.

Øivind Reinertsen, who runs oper-ations in the gulf for StatoilHydro, has-tens to dampen expectations. “There’s alot of oil there, but nobody talks aboutthe cost. If we started today without de-veloping new technology, the econom-ics would not be robust even at today’soil prices,” he says. Even so, StatoilHydrolooks intriguing. It’s making good moneyoff oil projects that are already pumping:$8.7 billion last year, or $2.70 per ADR.Of that, $5.3 billion was paid out in div-idends, for a 4.5% yield on the recent $39share price.

It costs $200 million to drill and com-plete a single well at Jack’s 30,000-footdepths. But StatoilHydro is dedicated tothe gulf. It has invested $8.5 billion thereover six years. Reinertsen expects to drill25 new wells by 2012.

StatoilHydro was formed last Octo-ber in the merger of Norway’s biggestcompany, Statoil, with the oil and gas op-erations of Norsk Hydro. Norway’s $400billion state pension fund owns 63% ofthe company’s shares. With $102 billionin combined annual sales, StatoilHydrois among the world’s ten largest publiclytraded oil companies.

National oil companies hold morethan 70% of the world’s easily recoveredoil and natural gas. But you can’t buyshares in 100% state-owned giants likeSaudi Aramco, Petróleos Mexicanos(Pemex), or Petróleos de Venezuela.StatoilHydro is one of a handful of hy-brid state-controlled oil companies (seetable, p. 18) in which you can.


THE GOVERNMENT

OIL PLAYNational governments are hogging 70% of the world’smost accessible petroleum. You can get a piece of the

action by buying shares of companies like Statoil.BY CHRISTOPHER HELMAN WITH EMILY SCHMALL

KJE

TIL

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Deepwater expertise:drilling the Jack 2 well in

the Gulf of Mexico.

These hybrids are decent invest-ments for outsiders. They enjoy prefer-ential access to large, low-cost reservesat home. By dint of being listed on in-ternational exchanges, they have somemotivation to be transparent to outsideshareholders. That said, “Gazprom is adirect instrument of Russian state pol-icy, while the Chinese [PetroChina andCnooc] are just a shambles, with thegovernment telling them what to do,”says Charles Maxwell, oil analyst withWeeden & Co. Still, Maxwell believesthat over time access to resources willcompensate investors throwing in withautocrats.

StatoilHydro’s political risk is low. Un-like the backlash that China’s Cnooc gotin 2005 when it attempted to buy the Cal-ifornia firm Unocal, the Norwegianshaven’t elicited a peep from U.S. politi-cians for their viking thrust into the Gulfof Mexico. “I don’t think Congress wouldhave been upset if it was Statoil thatbought Unocal,” says Reinertsen.

The company gets 80% of its 1.9 mil-lion barrels of daily production fromhome waters. The rest comes from spotslike Azerbaijan, Angola, Algeria and Iran,where it weathered a bribery scandal in

2004 and is developing the giant SouthPars gas field. Next year it will drill foroil in Cuba, 50 miles from Key West,with Spain’s Repsol and India’s 74%-state-owned Oil & Natural Gas Co.

U.S. oil companies aren’t allowed tooperate in Cuba or Iran and have had ahard time cracking Russia, too. But ear-lier this year Gazprom finalized a dealwith StatoilHydro and France’s Total todevelop the Shtokman field’s 130 trillioncubic feet of gas under the icy BarentsSea. “We have a very close relationshipwith national oil companies around theworld,” says StatoilHydro Chief Execu-tive Helge Lund. In Venezuela, whereExxonMobil is deep in a legal fight overconfiscated projects, Lund reportedly ne-gotiated $230 million in compensationfor an expropriated field and signed anew development deal.

Charles Ober, manager of the T.Rowe Price New Era Fund, likes Statoil-Hydro—and also Petróleo Brasileiro(Petrobras), which has recently found whatcould amount to 30 billion barrels of oilin the Tupi and Carioca discoveries off theshore of Brazil. The two companies haveatechnology-sharing alliance, a pact to co-operate on biofuels development and joint

ventures to develop offshore fields. InMarch the Norwegians acquired fromAnadarko Petroleum the remaining 50%it didn’t own in an offshore Brazilian fieldcalled Peregrino.

Petrobras has great growth poten-tial, with one caveat. Elizabeth Collins,an analyst at Morningstar, points out thatPetrobras, which is 32% government-owned, has a mandate to help keep pe-troleum affordable for Brazilians, so thecompany’s profits won’t be as high as ifBrazil let prices float freely.

StatoilHydro and Petrobras are bothworking the diplomatic shoe leather toget on better terms with Pemex, a state-owned oil company famous for politicsand ineptitude. Mexico’s constitutionbars non-Mexicans from owning its oil.

But with output declining, Pemex hopesto find some way to bring in foreign cap-ital and expertise. The presidents of Mex-ico and Brazil have discussed Petrobrasand Pemex’s jointly exploring Mexico’stechnically challenging deepwater fields.

It’s something StatoilHydro wouldlike to get in on. Last year it initiated aproject to cut natural gas flaring atPemex’s Tres Hermanos field, using Sta-toilHydro technology to capture the gasand bring it to market. In a nice twist,StatoilHydro gains emissions-reductioncredits it can apply to other effortsworldwide.

A bigger idea: Reinertsen foresees atime when StatoilHydro could helpPemex recover oil from the middle of thegulf, where the Norwegians have leasedexploration blocks nearly flush with theU.S.-Mexico maritime border. Pipelineinfrastructure already reaches nearlythat far from the U.S. coast. Deepwaterwells could be drilled in Mexican watersand their output tied in with the subseapipelines on the U.S. side. Says Reinert-sen: “A part of being a small country withfew people is that you have to look forthese possibilities. And when you findthem, you grab them.” a



Oil the World’s a StageThese seven state-controlled sisters have access to massive, low-cost reserves ofoil and gas at home and handy political connections to help expand abroad.

5-YEARANNUALIZED MARKET

% STATE- TOTAL VALUECOMPANY OWNED P/E RETURN ($BIL) RESERVES1

CNOOC 65% 18 52.5% $81 2.6

ENI 30 8 27.3 154 6.4

GAZPROM 50 12 56.3 312 120.0

OMV GROUP 32 9 47.6 22 1.2

PETROBRAS 32 21 75.9 243 13.8

PETROCHINA 86 11 54.4 427 19.6

STATOILHYDRO 63 13 39.1 114 6.0Return and market value as of May 6. All companies trade in the U.S. as American DepositaryReceipts. All figures in U.S. dollars. 1Billions of barrels of oil equivalents. Sources: FT InteractiveData, LionShares and Worldscope via FactSet Research Systems; Bloomberg Financial Markets.

SAY WHAT YOU WILL ABOUT

global warming, there’s nodenying that “green” stocks—the ones promising to help theworld burn less fossil fuel—are

hotter than a July day. SunPower, a makerof solar cells and panels, is trading at $82,or 326 times trailing earnings.That makesFirst Solar, at $275 a share but only 110 timesearnings, a relative bargain.

If you’d like some exposure to greenstocks but fear getting scorched by suchmultiples, look around—beyond the bill-board players. “When your average investorthinks of renewable energy, he thinks ofsolar,wind and biofuels,” says Shez K. Ban-dukwala, “but there is so much more op-portunity hidden in the green tech sector.”

Bandukwala, 42, worked on public of-ferings at William Blair & Co.before mov-ing in 2005 to what is now the San Fran-cisco investment bank ThinkPanmure. Asthe Chicago partner in charge of alterna-tive energy, he has done offerings for FirstSolar, SunPower, Evergreen Solar and RealGoods Solar.

You have to be a true believer to findstocks like these appealing; companies avail-able at low multiples of their sales or earn-ings are pretty scarce (see table). One Ban-dukwala favorite is New Age carbon fibermaker Zoltek. Headquartered in Bridgeton,Mo., and a ThinkPanmure client, it origi-

nally designed carbon fiber for car brakes.These days it sells the lightweight materialto wind-power generators like Gamesa tomake huge windmill blades. Despite Zoltek’sstratospheric price/earnings multiple (135),Bandukwala says it can’t make its productfast enough to meet demand.

Xantrex Technology makescomponents that help convert—or, more specifically, invert—power from direct to alternatingcurrent. That process is necessaryto turn DC power collected insolar panels into ACpower usableinside homes. The Toronto-listed sharestrade at $8.08, giving a $234 million mar-ket value to a firm that had but $234 millionin revenue last year.

Metalico is a Cranford, N.J. companythat recycles copper, aluminum and othermetals. With commodity prices rising, itssales rose 61% in 2007 to $334 million. Thisone is cheap, after a fashion; its shares gofor 15 times the earnings that analysts ex-pect this year.

Fuel Tech, a firm in Batavia, Ill., producesachemical spray that cuts down the acid-rain-producing nitric oxide spewed by powerplants. Fuel Tech is one of the few firms ad-dressing this problem, says Bandukwala.

Sanghvi Movers, which trades on theBombay exchange, rents out heavy equip-ment, including 300 cranes. Most of its growth

is coming from Indian wind farms and otheralternative energy projects. It also leases gearto chemical plants and refineries.

Westport Innovations, listed in Toronto,has partnered with enginemaker Cumminsto develop technology to shoot clean natu-

ral gas into diesel truck engines.This could be a reasonable busi-ness if states and cities mandateor subsidize natural gas engines.Itron, of Liberty Lake, Wash., sellsmeters to utilities to monitor(and to prevent wasting) water,gas, electricity and heat. “From

the substations, where energy is created, tothe premises, where it’s used, there are a lotof opportunities to minimize waste,” saysBandukwala. “Meter readings are a key com-ponent in that process.”

American Superconductor sells powerconverters and superconductor wires to en-ergy companies, including wind energyproducer Sinovel Wind. Its parts help con-nect wind turbines to power grids. Thecompany, whose sales are expected to rise52% this fiscal year to $170 million, also de-signs wind turbines.

“What I like about these companies isthattheycan be successful no matter whichsolar or wind companies win,” says Ban-dukwala. “Outofthe PCindustrycameMi-crosoft. Out of e-commerce came infra-structure company Cisco.” a


SUBTLESHADES

OF GREENIt’s not too late to findcheap “green” stocks.

Look beyond the obviousto companies quietlyboosting the sector’s

growth.BY ERIKA BROWN

The Color of MoneyValue investors aren’t going to love these stocks. But for those seeking growth,and confident in green technology, here are some little-known plays.

PRICE 3-YR ANNUAL52-WEEK PRICE/ SALES-PER-

COMPANY RECENT HIGH SALES SHARE GROWTH

AMERICAN SUPERCONDUCTOR $25.50 $32.74 11.0 –5%

FUEL TECH 24.51 38.20 7.0 32

ITRON 102.78 112.92 1.9 34

METALICO 12.91 14.24 0.9 22

SANGHVI MOVERS 6.09 8.55 5.0 60

WESTPORT INNOVATIONS 2.76 3.42 4.5 14

XANTREX TECHNOLOGY 8.08 13.54 1.1 10

ZOLTEK 27.50 51.77 5.6 36Prices as of Apr. 29, in U.S. dollars. Source: Worldscope via FactSet Research Systems.

GA

BR

IELA

HA

SBU

NFO

RFO

RB

ES

IF YOU NEED A REMINDER THAT

MONEY doesn’t buy happiness, con-sider the sad case of Henry T.Nicholas III. The billionaire co-founder of Broadcom has made

the news lately over a nasty child-cus-tody battle, a stock-options-backdatingscandal in which he’s been identified asan unindicted potential co-conspirator,allegations of drug use and the indict-ment of the former manager of his fam-ily holding company for hiding cashtransactions. Nicholas checked into theBetty Ford Center in April.

One Nicholas nightmare that’s goneunnoticed is his fight with the InternalRevenue Service over whether his familycan claim $290 million in tax losses froma$6 million investment in junk Asian debtand securities.

The ploy—which the IRS calls a “dis-tressedasset/debt,” orDAD,shelter—was soldto Nicholas and other tech high rollers in2001 by Chenery Associates and MyCFO,afinancial advice firm backed by Netscapecofounder James H. Clark and venture cap-italist John Doerr. Three years later Con-gress changed the tax code to bar partner-ships from being used to transfer foreignlosses to U.S. taxpayers. Even though thatlaw doesn’t apply retroactively to Nicholas’2001 shelters, the IRS sent his family’s part-nerships notices declaring them illegitimateeconomic shams. In March the partnershipsfiled five lawsuits challenging the IRS’ de-nial of their losses and its imposition ofpenalties.

You might think that congressional ac-tion, vigorous enforcement and complica-tions like Nicholas’ would have killed offDAD and the rest of the tax shelter racket.But that would be to underestimate the

tenacity of sheltersalesmen and thegreed and gullibilityof their marks.Instead, like sheltersthat garneredunwanted attention

in the past, DAD has mutated—in its caseintoDAT,or the “distressed asset trust,”whichreplaces partnerships with trusts to trans-fer losses.

“Once you find one type of tax shelterand list it [as abusive], you will get a cre-ative accountant, tax lawyer or other typeof promotional salesperson tweaking theshelter,” says Nathan J. Hochman, head ofthe Department of Justice’s Tax Division.

All this comes on the heels of the gov-ernment’s efforts earlier this decade tosquash tax shelters. It indicted lawyers andaccountants, extracted $456 million in fines,penalties and restitution from KPMG andsqueezed billions in back taxes, interest andpenalties from individual shelter users.

KPMG is no longer cold-calling shelterprospects. Yet smaller accounting firms,independent CPAs, lawyers and insurancesalesmen continue toflog new—and old—shelter mutations to business owners andthe successfully self-employed.

“After alltheenforcement, I’m surprisedat the level of tax shelter activity that’s stillout there,” says Ian Comisky, a partner atBlank Rome in Philadelphia who defendstaxpayers in civil and criminal cases.

Court records indicate the IRS is inves-tigating whether John E. Rogers, a Chicagopartner in law firm Seyfarth Shaw LLP,pro-moted DAD and later DAT to dozens ofinvestors nationwide. The government as-

serts in court papers that Rogers’ clientsclaimed $223 million in dubious losses fromBrazilian consumer debt in the three yearsthrough 2005. Rogers defends the deals aslegit and accuses the IRSof harassment. Sey-farth Shaw wrote a 104-page opinion be-fore the 2004 law change saying the shel-ters would “more likely than not” withstandIRSand judicial scrutiny. The firm declinedcomment.

Jay D. Adkisson, an attorney who hastracked offshore tax schemes for a decade, saysthat since the IRScrackdown, lawyers and CPAsappear to have become even more central toselling such schemes. “Offshore promotershave become more sophisticated in what theydo,” he says. “People think, ‘If my lawyershowed it to me, it’s okay.’ But if somethinginvolves offshore, get a second opinion.”

Beware: Sanctions have been ratchetedup for shelter buyers. Congress created amandatory $100,000 penalty four years agofor any individual who fails to disclose onhis tax return that he participated in a trans-action that is the same as, or substantiallysimilar to, one the IRS has listed as abusive.A corporation, including one used in anindividual’s tax shelter, faces a mandatory$200,000 penalty for not disclosing a listedtransaction.

Amazingly, even banned shelters arestill being touted. The IRS listed the “abu-sive Roth IRA” five years ago. Yet promot-ers are still encouraging clients to shelterhuge business profits in Roth IRAs, ratherthan stick to the $5,000 or $6,000 limit forlegitimate contributions.

Two partners at Grant Thorntonbegan pushing the Roth ploy in the late1990s. In 2001, after the firm gotsqueamish, they left to promote it fur-ther. (Grant Thornton says its nationaltax practice never approved the shelter.)In February the Justice Department suedthe two seeking to enjoin their activities.

Meanwhile, the bad idea has spread. TheIRSsays it’snow investigating two dozen pro-moters of what it believes may be abusive RothIRAs or similar questionable transactions.a

INVESTORS’ GUIDEq SCAMS

SAFETY TIPSq Stay onshore.q Don’t pay outsize fees.q Don’t do deals with your own IRA.q Get a second opinion.q Be wary of a tax loss bigger than

your investment.

TAX SHELTERS 2.0Bad tax ideas, like viruses, tend to

mutate and claim new victims.BY JANET NOVACK


INDIVIDUAL RETIREMENT ACCOUNTS

are a good deal for people whowant to stash savings away for a fewdecades. A big downside to suchaccounts, however, is that once you

put the money in, taking it out before age591/2 typically means paying a 10% earlywithdrawal penalty on top of ordinary in-come taxes.

There is another way. The IRS al-lows investors to dodge the stan-dard early-withdrawal tax at any age,and for any reason, via a so-called 72(t)distribution. Roth IRA owners can alsowithdraw principal at any time penalty-free without the 72(t).

As with many IRS rules, there’s a

catch. The 72(t) distributions are subjectto ordinary income taxes, and oncestarted they must continue for five yearsor until the beneficiary is 591/2, whicheveris longer. That means a 40-year-old whosigns up must continue taking taxablewithdrawals for at least 19 years. In-vestors can lessen the resulting declinein tax-deferred savings along the way bymaking contributions to a separate IRA

(up to $5,000 a year for those 49 andunder and $6,000 from age 50), even asthey take the 72(t) distributions out. Noteveryone is eligible to make deductible IRA contributions, however.

Who should consider 72(t) distribu-tions? Such withdrawals are best suitedto people with fairly large IRAs who wantto enjoy their money before retiring,while also putting it to productive use,says Harry J. Abrahamsen, a financialplanner in Holmdel, N.J. “Maybe you’re50 and ten years away from a retirementthat you dream will include a Nantucketcottage,” he explains. “Why not use yourIRA to start enjoying the beach housenow, when real estate is cheap and youcan lock in low interest rates?”

Alfonse DeMaria, a 41-year-oldNew Jersey chiropractor, followed Abra-hamsen’s script four years ago when hedrilled into his $700,000 IRA to buy a six-bedroom house on 269 acres in ruralFranklin, N.Y. His $3,000 monthly dis-tribution more than covers his mortgage

payment andreal estate taxes.“My kids and Ican start enjoy-ing the housenow rather than25 years fromnow, and it willstill be here

then, too,” he says. “I’m not throwing the[IRA] income away.”

Matthew Riccardi, 37, films wed-dings, recitals and other events out of hisFranklin Lakes, N.J. videography venture,with ten employees and gear bursting theseams of a 2,000-square-foot office. Ric-cardi started 72(t) distributions last yearfrom the $500,000 IRA he’d amassed byrolling in a profit-sharing plan. The$25,000 annual distribution will ease thecash crunch of spending $700,000 to buyand renovate his own building. “Thisgave me the capital I needed,” he says.

If a 72(t) makes sense for you, thenext step is deciding on one of threeways to calculate distributions. Thesimplest involves dividing the total sizeof the IRA by your remaining life ex-pectancy in years. Under this method,a 50-year-old with a $500,000 IRA wouldbe required to take distributions of$14,620 a year.

A different calculation method is pre-ferred by many financial advisers becauseit yields the largest distribution. Underit, the account balance is amortized overthe IRA owner’s life expectancy, assum-ing an annual growth rate anywhere from80% to 120% of an interest rate knownas the federal midterm. The high-end as-sumption is now at 3.3%. With year-end withdrawals for a half-million-dol-lar account, it would yield annualpayments of $24,572 for a 50-year-old.

The third method divides accountbalances by a factor that is the presentvalue of an annuity worth $1 annuallyto the account owner. A 50-year-old’s factor of 20.44 would yield $24,461yearly from a $500,000 IRA.

Those whose needs are less grand candivide IRAs into two accounts and do 72(t)distributions with only one. a


RETIREMENTwINVESTORS’ GUIDE

TAPPINGYOUR IRA

EARLYThere is a way to get

at your retirementaccount early without

paying a fat penalty. Butonce you take this route

you have to stay on it for years.

BY CHRISTOPHER STEINER

Alfonse DeMaria used his IRA to buy, and enjoy,a retirement retreat while still in his forties.

NATHANIEL WELCH FOR FORBES

THEY’VE GOT INVESTMENT-GRADE

credit, pay your property taxesand insurance and increasetheir rent payments every year.

Meet the typical tenant who hassigned a net lease on a retail, office orindustrial building. If you are the land-lord, you get a pretty well-pro-tected income stream for thenext 20 to 30 years.

It’s a great time to buy thebuilding. Users of space sellproperty and lease it back as away to raise cash. Over the pastsix months SunTrust Banks hasraised $736 million unloading421 branches. Pep Boys, theauto parts chain, closed on asale-leaseback of 23 stores inApril for $74 million.

The average yield on net-leased property rose six basispoints to 7.6% in the fourthquarter of 2007, reports Price-waterhouse-Coopers. Thenumber comes from a surveyof the top seven institutionalnet-lease investors, who trademostly in class A property.What’s the catch? Mainly, thatat the end of the lease term thelandlord may have an emptyfitness club or warehouse onhis hands that needs signifi-cant improvements before itcan be leased again. Another

is that if the tenant goes bankrupt, theproperty may be empty for severalmonths.

The icy residential market offersanother silver lining for net-leasehunters. Until recently, soaring priceswere prompting speculators to dumpinvestment homes and swap intocommercial real estate as a way ofdeferring capital gains taxes via so-called 1031 swaps. Over the pastfew years such deals drove a majorityof net-lease volume and sparked mul-tiple bids for many properties. Notanymore.

“Now’s a good time to be a buyer,”says Michael Houge, a principal atUpland Real Estate Group in Min-neapolis. “I have twice as much retailproperty for sale as six months ago,

with higher-quality tenants, betterlocations and more aggressive sellers.”

Here are ways to get into this mar-ket.

Buy specialized REITs. Equity real es-tate investment trusts (the kindthat own buildings rather than mort-gages) are liquid and average a so-so4.9% yield. Net-lease REITs do consid-erably better by acquiring, owning andmanaging net-leased office, industrialand retail properties (see table).

Among net-lease pure plays, Na-tional Retail Properties and Realty In-come both offer 6.7% yields. Realty,which owns 2,375 properties, acquired106 of them with 100% occupancy ratesin the first quarter of 2008. The aver-age initial yields came in at 8.7% on

leases averaging 20 yearsin length. The company’sfunds from operation(roughly speaking, netincome plusdepreciation minusmaintenance-level capi-tal expenditures) maydip 1% in 2008, but itsdividend should climb4% over the next year,estimates Philip Martin,an analyst with CantorFitzgerald. Even if theeconomy enters a nastydownturn, RealtyIncome should be ableto take care of itself, hav-ing recovered an averageof 97% of prebankruptcyrent in the 16 bankrupt-cies its clients have suf-fered in the past decade.

Two other net-lease


INVESTORS’ GUIDEqREAL ESTATE

BUILDING BOOM

Financial troubles have turned net leases into a

high-yield way to get intocommercial real estate.BY MATTHEW SWIBEL

BOB CROSLIN / AURORA SELECT FOR FORBES

Jack Diamond is earninga tasty yield on his sixnet-lease properties.

REITs offer even juicier yields. LexingtonRealty Trust (9.3%) has had its shareprice bruised by worries that an eco-nomic slowdown will hurt its leaserenewals. CapLease’s dividend (9.9%) iscovered by cash flow (in the sense of netincome plus depreciation), and most ofits portfolio is under fixed-rate financ-ing. Even so, debt market turmoil hasraised fears it will have a hard time rais-ing capital for the future acquisitions itneeds to boost its dividend. Both REITsare trading near 52-week lows.

Piggyback big deals. Most sale-lease-backs involve deals north of $20 mil-lion, which is too pricey for most in-dividuals. They can still participate,however, since REITs and other institu-tional net-lease buyers often sell offsome properties to turn a profit or bal-ance holdings geographically.

That’s how investor Jack A. Dia-mond, 60, became the net-lease holderfor a Checkers drive-through ham-burger joint. Taxi Holdings, a sub-sidiary of private equity firm Well-spring Capital Management, took theburger chain private in 2006 and thenunloaded branches on Trustreet Prop-erties of Orlando, Fla., via a sale-lease-

back deal.Diamond paid Trustreet (now

part of General Electric) $387,000 forone of the Checkers stores in Sarasota,Fla., on a busy intersection sharedwith a Super Wal-Mart. The restau-rant pays $27,000 a year in rent, net ofoperating costs. Rent increases of 2%annually are locked in for the next 20years. “I like the steady income streamand not having day-to-day responsi-bility” for managing the real estate,says Diamond, a retired building sup-ply executive, who co-owns five othernet-lease properties via an S corpora-tion.

Shop solo. A lot like house-hunting,this approach requires lots of legwork,but there’s plenty to choose from. Na-tionwide, 21,000 net-lease properties,worth $60.5 billion, are on the market.That’s up from 7,000 at the end of 2005,Boulder Net Lease Funds estimates.Among them, the most affordable are11,000 single-tenant retail outlets, 60%priced below $2 million. Based on ask-ing prices in the fourth quarter of 2007,one-third of retail properties wereyielding 8% or more.

Brokers peddling net-lease prop-

erties include Boulder,Calkain Cos., Net Lease Cap-ital Advisors and UplandReal Estate Group. They typ-ically represent sellers ofproperties whose tenantsboast investment-grade rat-ings or high net worths—such as Starbucks—ratherthan build-to-suitdevelopers. It is usually up tothe seller to pay the broker-age commissions of 1% ofthe sale price.

It’s well worth paying anexperienced lawyer to reviewa deal before closing since itsvalue depends on the details.

“Make sure the tenant is responsiblefor the parking lot and the roof,” cau-tions Sidney Domb, president ofUnited Trust Fund, a Miami, Fla. net-lease investment shop. “People usethe words ‘net lease’ openly.”

Another red flag: flat rent over 25to 30 years or a series of options atmeager increments. It’s a good idea tocheck out tenants’ credit standing andbusiness strategy. Even if the leaseguarantees a highly rated firm willkeep paying rent after closing abranch, it might not maintain theproperty. Diamond learned that onethe hard way when he acquired a netlease on a central Florida Eckerddrugstore that CVS shuttered, and ne-glected, after acquiring the Eckerdchain.

Financing the purchase of a net lease presents another challenge. No matterhow highly rated your tenants, virtuallyall lenders will require 30% down pay-ments. A pullback among pension fundsand conduits, which formerly securitizedcommercial mortgages, has made loanstougher to find. Regional and Europeanbanks are stepping in, albeit at higher in-terest rates, says Upland Real Estate’sMichael Houge. a


New Lease on PropertyWant to earn income from a building? Equity real estate investment trusts yieldbelow 5%. Net-lease specialists, like those below, offer considerably more.

3-YEARRECENT DIVIDEND ANNUALIZED GROWTH

REIT PRICE YIELD NAV1 FFO2

CAPLEASE $8.05 9.9% NA 23.0%

WP CAREY & CO3 29.99 6.4 NA NA

LEXINGTON REALTY TRUST 14.23 9.3 1.3% –1.2

NATIONAL RETAIL PROPERTIES 22.31 6.7 13.6 10.1

REALTY INCOME 24.64 6.7 6.0 6.6Prices as of May 7. Growth figures are from 2005 through 2008 estimate. 1Net asset value.2Funds from operations. 3Real estate operating company. NA: Not available. Sources: SNL Financial; Reuters Fundamentals via FactSet Research Systems.

GABRIEL HAMMOND IS A

FUND manager from cen-tral casting. Raised in aposh Washington, D.C.suburb, he got a degree

from Johns Hopkins, spent two years atGoldman Sachs and then set up his ownfund firm (current assets under manage-ment: $250 million). The one kink in hisstory is that Hammond, 29, doesn’t dab-ble in growth stocks or distressed debt.His game is rusty metal tubes buried deepunderground. Hammond’s Dallas firm,Alerian Capital Management, taps intooil and natural gas pipelines via tax-ad-vantaged vehicles called master limited

partnerships, or MLPs.Every day 280,000 miles of pipelines

shuttle 63 billion cubic feet of natural gasaround the U.S. About a quarter of themare held as MLPs. A separate 100,000-milenetwork hauls 20 million barrels of crudedaily, with 70% in MLP hands.

The 50 exchange-listed MLP pipelinesand storage units have a combined valueof $120 billion. There’s more capital enroute. The U.S. is expected to put another$100 billion into its natural gas infra-structure over the next decade. Thepipelines’ income streams should holdup even if energy prices drop. That’s

because they get so much per poundshipped, not per dollar of product.

“These companies are all toll-roadbusiness models,” says Hammond.“They’re agnostic about whether crudeoil is at $30 or $115 a barrel.”

The partnerships are typicallyformed when big companies decide toraise cash by hiving off hard assets. Oncepublic, MLPs trade like stocks. The twistis that they’re partnerships, which meansthey pass on earnings and depreciationto investors. Come tax time, that meansinvestors typically pay ordinary incometaxes on about one-fifth of distributions,which have grown 8% to 10% annually

in recent years.The other 80% of distributions are con-

sidered nontaxable returns of capital thatreduce a partner’s cost basis. That meansthey turn into future capital gains, taxed ei-ther much later (when the investor sells theshares) or never, if it winds up in his estateand enjoys the capital gains step-up at death.There are some further subtleties (the taxtreatment of partnerships is bizarrely com-plicated), but the bottom line is that investorsholding MLPs that own depreciating assets


INVESTORS’ GUIDEqALTERNATIVES

PIPELINE TO PROFITS

You want a piece of theenergy business that won’tget hurt if oil crashes? TakeGabriel Hammond’s adviceand own some buried steel.

BY ZACK O’MALLEYGREENBURG

Climbing the MLP ladder:Gabriel Hammond.

MARKET DISTRIBUTION DISTRIBUTION RETURN OF STATESVALUE PER SHARE GROWTH CAPITAL WITH

NAME ($BIL) PRICE YIELD LAST 12 MONTHS 5-YR AVG 5-YR AVG OPERATIONS1

ATLAS PIPELINE PARTNERS $1.6 $41.85 8.6% $3.50 10.1% 90% 6

COPANO ENERGY 1.8 37.66 5.0 1.73 32.6 90 2 4

ENBRIDGE ENERGY PARTNERS 4.8 49.91 7.5 3.73 0.5 90 42

ENERGY TRANSFER PARTNERS 8.3 49.10 7.3 3.26 6.0 80 34

ENTERPRISE PRODUCT PARTNERS 14.0 32.06 6.1 1.92 7.0 90 42

INERGY 1.5 29.06 8.5 2.32 10.4 85 33

LINN ENERGY 2.5 21.49 10.9 2.18 25.5 100 3 7

MAGELLAN MIDSTREAM HOLDINGS 1.5 24.42 4.8 1.07 24.5 90 3 22

PLAINS ALL AMERICAN PIPELINE 5.5 47.00 7.2 3.28 9.5 90 401MLP shareholders aren’t necessarily taxed in every state in which the partnership operates. Some states have tax thresholds; others, e.g.,Texas, haveno income tax. 2Three-year average. 3Two-year average. Sources: Alerian Capital Management; companies; Bloomberg.

A Nice Set of PipesGabriel Hammond likes pipelines for their high yields and steady growth rates. Here are nine MLPs to gas up your portfolio.

SCOGIN MAYO FOR FORBES

PATRICIA GLASCOM NEVER FELT

so hopeless as when shewatched her parents burnthrough their life savings pay-ing for Alzheimer’s care for

her mother. The elderly couple ended updestitute together in a nursing home paid

for with help from Medicaid. Glascom, a60-year-old retired school teacher, vowsnever to succumb to a similar fate.

To avoid it, she and her husband, Gary,apublic defender in Allentown, Pa., boughtlong-term-care insurance in 2000. Thep-olicy came in handy long before Glascom

ever expected she’d need it when, in 2002,she required back surgery, was laid up athome for ten months and, in the comfortof her own home, received $110 a day tocover an aide and an in-home hospital bed.

“The policy did what it was supposedto do,”she says of the coverage bought fromGenworth, the largest vendor, which tookin $1.8 billion last year in premiums on long-term-care policies. Rival vendor John Han-cock had premium income of $1.4 billion.

As with most Americans, when theGlascoms first contemplated old age,their top priority was to spend as muchof it as possible in their own home.When they started shopping for long-term-care insurance, that meant focus-

are taxed leniently.The downside of investing directly

in MLPs is complexity. Pipeline partner-ships are a particular problem becausethey must calculate, and investors mustreport, gains and losses in each state theytraverse. The resulting K-1 tax forms areso cumbersome that many financial ad-visers suggest bothering with MLPs onlyfor six-figure investments.

A simpler alternative is to own theexchange-traded iShares in one of two in-dustry stalwarts, Kinder Morgan and En-bridge. These trade, and are taxed, like ETFsand require no K-1 filings. Kinder Morganis the largest MLP by market cap at $15.2billion; Enbridge is valued at $4.8 billion.They are precisely the sort of workhorsepipelines that Hammond favors (see table).

In 1997, in Hammond’sfreshman yearat college, he put $2,000 earned as a swim-minginstructor into his first online broker-age account and started trading. The techbust was raging by the time he graduatedin 2001 with a double major in economicsand international relations. Yet Hammond’saccount had ballooned to $17,000, thanksto blue chips like Caterpillar and Altria.

After graduating, Hammond, whomaintains his swimmer’s physique on a diet

that includes a gallon of egg whites a week,took a job as an energy analyst at GoldmanSachs in New York. It turned out to be afront-row seat for Enron’s collapse and theshock waves it sent through the pipeline in-dustry. “Companies were selling assets tostave off bankruptcy,” recalls Hammond.

As firms like El Paso and Dynegy racedto raise capital, some spun off pipelines intoMLPs. When it was over, Hammond wasthe only one in Goldman’s energy andpower group interested in covering the part-nerships.

In the 15 years since tax changes hadpaved the way for modern MLPs, a mere 15had been launched and had a combinedvalue of $20 billion by 2003. In the marketrecovery that followed Enron’s collapse,however, the partnerships started to drawyield-hungry investors. Hammond wasconvinced the MLPbusiness was poised fora growth spurt, like the one REITs had en-joyed a decade and a half earlier.

He began putting together Alerian inJuly 2004 and trading MLPswith $5 millionunder management from Hans Utsch, aportfolio manager at Federated Investors,whomHammondhad met at a luncheon.Hammond struggled just to pay the billsbut earned 15% his first half-year in oper-

ation. That was good enough to lure invest-ments from two Wall Street firms, whichdeclined to be named.

A year after Alerian’s launch Ham-mond had $50 million under management.His timing was outstanding. In the fouryears after he set up Alerian, the MLP sec-tor’s market cap tripled and Alerian’s totalreturns came in at 20% annually. In June2006 Hammond’s little firm launched theAlerian Master Limited Partnership Index,the first to track MLPs. A year later he addedBearLinx Alerian MLPSelect, an exchange-traded note that trades like an ETFand tracksthe firm’s MLP index.

Despite MLPs’ hefty returns over the pastdecade, tax-exempt institutions have shiedaway from investing directly in them be-cause of tax complications. (It’s similarly abad idea to hold MLPshares in a tax-deferredaccount.) But they are a fine choice, he says,for retail investors in high tax brackets whocan stomach the paperwork.

MLPdistributions average 7.5% of mar-ket prices today, or 3.6 percentage pointsmore than yields on ten-year Treasurys.That compares with a historical average ofonly 2.25 points over Treasurys, saysStephen Maresca, an MLPanalystatUBS.Nosurprise, he’s a bull on the sector. a


HOME, BUT NOT ALONE

Want to live out your last years in your own home?Long-term-care insurance can help.

BY CARRIE COOLIDGE

INSURANCEwINVESTORS’ GUIDE

ing on in-home coverage.A decade ago that would have been a

tall order. But policies have evolvedrapidly in recent years, from coveringnursing homes and little else, to pro-viding services at assisted living facil-ities or right at home. Indeed, Gen-worth says that it wrote checks for $240million to cover at-home benefitsfrom its long-term-care policies lastyear; 75% of policyholders chose tohave care at home.

The evolution of the long-term-care market is merely followingbroader demographic trends. Two infive Americans will eventually needlong-term care, which neither health nordisability insurance covers. What’s more,80% of that care is already delivered athome, versus 18% in nursing homes and2% in assisted living homes.

“Insurers have gotten moreprogressive and responsive to themarket,” says Shay Jacobson, presidentof Life Care Innovations, a Chicagogeriatrics consulting firm.

Medicare, for which 65-year-olds areeligible whatever their income, coverslong-termcare only in a nursing home, andthen only for 20 days (with a co-pay afterthat) following a hospital stay for the samecondition. It does not pay for at-home orassisted living care. Medicaid, by contrast,alreadypaysfor44% of total long-term-careservices but covers only the indigent—likePatricia Glascom’sparents in their last days.

“There’s a silent epidemic in the U.S.involving hardworking middle-class citizensgoing broke because of long-term-carecosts,” says Donald Grimes, executive di-rector of Long Term Care Education Spe-cialists, a nonprofit that gets funding fromgovernment agencies and insurance com-panies and educates the public about long-term care.

For most middle-class people, decid-ing what to do presents a tough choice.They can buy costly private insurance orrisk that their savings will expire before

they do. It might pay to take that chanceand self-insure if your retirement incomewill cover $100,000 to $150,000 annuallyin care costs, says Grimes.

Another option is to combine per-sonal savings and insurance. “I tell clientsto have a lump sum stashed away forlong-term care and purchase some baselevel of insurance to cover the rest,” saysGregory Zandlo, a fee-only certifiedfinancial planner in Minneapolis. “Thishelps preserve the estate plan.”

Those interested in at-home orassisted living coverage should shop for a“comprehensive” plan rather than a“facility-only” one. Comprehensive poli-cies typically will cover in-home hospitalbeds and other equipment; skilled nurs-ing services; and help with daily tasks likepreparing meals, housecleaning andlaundry. Benefits extend to hospices andadult day care, if it involves social pro-grams and health-related services.

Just moving into an old-age homewon’t launch benefits. To collect, youmust need substantial assistance with atleast two of six daily activities, likebathing, eating and dressing, or supervi-sion made necessary by cognitive impair-ment. To qualify for benefits outside thehome, a facility must be a state-licensedassisted living or nursing home that has adining room.

Most comprehensive policies offerbenefit periods of two to ten years, as

well as a lifetime benefit optionthat’s most likely to be of use tothose with chronic conditions suchas Alzheimer’s or Parkinson’sdisease. Guardian’s lifetime benefitcosts 22% more than its five-yearplan. When shopping, keep inmind that the average care claim isfor two and a half to three years.Given the long-term nature of thesepolicies, and the short-term natureof most benefit periods, it maymake more sense to opt for aninflation-protection rider than a

lifetime benefit.Payment of benefits can be through

reimbursement plans, which pay actualexpenses, or indemnity plans, which aremore expensive and pay specific dailybenefits regardless of costs. Daily benefitsrange from $100 to $400. When select-ing, consider that nursing homes cur-rently cost $76,000 a year, or $208 a day,on average. Full-time home health aidesrun about $44,000 annually, or $121 eachday you need help. If you are really dis-abled, you’ll keep four full-timers busy.

The earlier you start paying for a pol-icy, the less it costs. A 55-year-old manwill pay an annual premium of $1,128 fora guaranteed renewable John Hancockpolicy with a $200 daily benefit to be paidfor up to three years (or a total of$219,000 in benefits). If he waits until age65, the yearly premium jumps to $2,200.For $3,948 a year, the 65-year-old can geta policy that doesn’t have the three-yearceiling on benefits. Neither of these poli-cies has an inflation adjustment. That canadd another 65%.

Another advantage of buying early isthat your chances are better of findingcoverage. Only 11% of applicants in their50s are turned down, versus 57% who are80 or older. Once you’re in a policy, theinsurance company can kick you outonly if you stop paying premiums. a


INVESTORS’ GUIDEq INSURANCE

Patricia Glascom vows not to end up old and impoverished, like her parents.

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HYPERINFLATION. POLITICAL

crises. A plummeting cur-rency. For decades some-thing always supported theadage that Brazil is the coun-

try of the future—and always will be.Not anymore. Fueled by low interest

rates, sound fiscal policy and robust de-mand for its commodities, Brazil is a dar-ling of emerging markets these days. Theeconomy grew 5.4% in 2007 and shoulddeliver something close to that again thisyear. Stocks, measured in Brazilian reais, areup 55% since January 2007. Inflation isdown two-thirds in six years to 4.29%,aboutthe same as in the U.S.

As in Mexico four years ago, Brazil’srealestate market has been a prime beneficiaryofthedropin borrowing rates and other goodeconomic news. The difference is that Brazil’smarket is open and drawing in enormousamounts of foreign capital, says CitigroupLatin America strategist Geoffrey Dennis.

U.S. institutions started sniffing out

Brazilian real estate deals a few years ago.The $242 billion California Public Em-ployees’ Retirement System has part-nered with Houston developer Hinestoinvest a reported $1.2 billion in Brazil-ian real estate. Equity International,owned by Chicago tycoon Sam Zell,began investing in Brazilian real estatein 2004.

Is it too late to join the party? Hardly.Decades of capital scarcity have created hugepent-up demand; buyers are ready to soak up7 million houses and apartments. In Rio deJaneiro the vacancy rate for high-end officespace is 3.4% (versus 7.2% in Manhattan).

“Brazil has become the nimble sprinteramong emerging markets,” says Equity In-ternational Chief Executive GaryGarrabrant.

Nor has it stumbled the way the U.S.has. The term “subprime” has yet to enterthe vocabulary in Brazil, where home buy-ers traditionally borrowed from relativesand paid cash. When the mortgage mar-ket started taking off a few years ago, thelongest term on a home loan was 10 years.Now 30-year loans are available, with in-terest rates of 13% to 14%. “In the past noone would get financing. We had inflationof30% a month,” says Fabio Maceira, chiefexecutiveofthe Brazilian subsidiary of prop-ertymanagement firm Jones Lang LaSalle.

Brazilian mortgage originations havemorethanquintupled since 2003 to $22 bil-

lionlast year, accord-ing to Jones Lang.There’splenty moreroom for growth.The total came to2% of gross domes-tic product; the cor-responding ratio forthe U.S. was 14%.

Another bigchange: Propertydevelopers havebeen tapping theequity markets forcapital, with much

of it coming from abroad. All told, 20 Brazil-ian real estate firms, most of them residen-tial home builders, listed shares last year.Consolidation now seems inevitable, withthe smart money betting on the strongestbuilders, says Tomás Awad, senior strate-gist at Itaú Securities in São Paulo.

Equity International began investingfour years ago in Gafisa, which began build-ing high-end homes but has expandeddown-market. With American DepositaryShares at $37.35, Gafisa has a market valueof 37 times projected 2008 earnings of $73million on $869 million in revenues.

The majority of the stocks in the tablebelow trade only on São Paulo’s Bovespaexchange. Even so, buying shares online viaE-Trade is fairly painless. A $10,000 pur-chase will cost $13 or so in commissions.For the ones with dividends but withoutan ADS, there is the added nuisance of con-verting semi-annual payments from reaisinto dollars.

Cyrela Brazil Realty, Brazil’s biggesthome developer, is run by billionaire ElieHorn. It began by building luxury apart-ments in São Paulo and Rio de Janeiro. Ithas since expanded into middle- andlower-income housing in 43 cities. Publicsince late 2005, it expanded revenue 53%last year to $1 billion; profits jumped 74%to $274 million. At a recent $14, it tradesat 17 times expected 2008 earnings.

Construtora Tenda, the largest low-in-come home builder, went public lastOctober and posted a loss of $22 millionon $176 million in revenues in 2007. De-mand is strong for its apartments and townhouses, which sell for an average $43,000.Revenue should more than triple this yearto $590 million, with the firm swinging toa profit of $98 million, estimates Itaú Se-curities’ Awad. At a recent $4.91, Tendatrades at an affordable eight times expected2008 earnings per share.

Says Awad: “Brazil is so behindeverywhere in everything that this is nota short-term boost. It’s a five- to ten-yearcycle we’re entering.” a


THIS HOME BOOMIS STILL ALIVE

Brazil is enjoying a residentialbuilding bonanza for all the right

reasons.And foreign investors are welcome.

BY KERRY A. DOLAN

From the Ground UpWith Brazilian mortgages becoming available only a few yearsago, home builders are capitalizing on huge pent-up demand.

PRICE52-WEEK

COMPANY RECENT HIGH P/E

BR MALLS $9.75 $15.18 NM

CONSTRUTORA TENDA 4.91 6.99 NM

CYRELA BRAZIL REALTY 14.43 17.86 20

EVEN CONSTRUTORA 5.68 10.86 38

GAFISA1 37.35 42.75 NMPrices as of Apr. 28, in U.S. dollars. NM: Not meaningful. 1American Depositary Shares. Source: Worldscope via FactSet Research Systems.

INTERNATIONALwINVESTORS’ GUIDE

DAVID SCHNITTLICH SPENDS

most of his nights min-gling with customers atMango’s Seaside Grill, theopen-air beachside

restaurant he owns in Anguilla.The 65-year-old New Jersey native

is one of those rare people who lives outa lifelong dream. Schnittlich says since

moving to the island 13 years ago, hehas also shed 50 pounds and overcomediabetes, gout and stress. “I’m sure I’ll live longer,” he says.

While tens of thousands ofAmericans with warm-weatherfantasies migrate to Florida andArizona every year, a number opt forexotic destinations. Like Schnittlich,

many buybusinesses for fun and profitonce they arrive and are glad they did.Except that it’s not all fun. Along theway, Schnittlich has lived throughtraumatic changes to his personal life,severed decades-long financial ties andweathered the worst Mother Naturecould throw at him.

The Northeasterner was drawn to


INVESTORS’ GUIDEq FLINGS

FANTASY ISLANDDavid Schnittlich dreamed of retiring to the Caribbean. So he bought his favorite

restaurant there and became Mango Dave.BY CARRIE COOLIDGE

Paradise found: Remote Anguillaattracts the rich and famous.

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Anguilla by the idyllic tropical scenery,English-speaking population, safetyand laid-back atmosphere. The 16-by-3-mile British Overseas Territory ishome to 12,000 people and an intimategetaway for the rich and famous. Itsairport’s only direct flights are to otherCaribbean islands, and no cruise shipsmake port calls. Most visitors either flyin with their own planes or take a 20-minute ferry ride from nearby St.Martin.

Despite, or because of, its difficultyof access, Anguilla has more than itsshare of the Caribbean’s five-starresorts—including the Malliouhana,Cap Juluca and CuisinArt. It also haspristine beaches and gourmetrestaurants. Several resorts are underconstruction, but the island remainslargely undeveloped. The only trafficjams are caused by wandering goats.

Schnittlich saw Anguilla featuredin 1989 on TV’s Lifestyles of the Rich andFamous. The following day he bookeda trip with his wife, Carol. Five yearsand several visits later Schnittlichliquidated Philmour’s, an upscaleclothing store in northern New Jerseythat his father had opened in 1947, andspent a month traveling the Caribbeanwhile considering a move there.

One evening he was sitting inMango’s, his favorite Anguillanrestaurant, when the chef mentionedhe was trying to sell the place and moveto the U.S. so he could be near hisdaughter while she attended school. “Irealized it was the opportunity of alifetime,” Schnittlich says. “I couldn’tjust retire and live down here. I neededsomething to do.”

The next day Schnittlich handedthe owner a nonrefundable deposit for$50,000, a fifth of the asking price. Theysealed the deal with a handshake. Thencame the hard part. After returning toNew Jersey, Schnittlich took threeweeks to summon the courage to

tell his wife about his decision tobecome an Anguillan restaurateur.

“She laughed, but not for long,” he recalls. “She thought it was a stupididea and said I was going through malemenopause. She told me to get therapy.”

Undeterred, Schnittlich arrangedfor the previous owner to run Mango’sfor three months so he could sell offmost of his U.S. assets. Schnittlich soldhis four-bedroom home in EastHampton, cars and several rentalproperties in the Hamptons. He keptone for home visits. Schnittlich’s partnerbought his 50% stake in Goldberg’s, a14-store New Jersey bagel chain.

In late June 1995 Schnittlich paidthe balance of the restaurant tab. His$250,000 bought him a wobblystructure with 13 dining tables andcooking gear. Its best asset was thename Mango’s Seaside Grill, one ofAnguilla’s best-known eateries.

Schnittlich sank another $75,000into new furniture, lighting andflooring. Eleven days shy of Mango’sscheduled reopening, he was in the U.S.on personal business on Sept. 5, 1995,when he heard that a giant storm wasbarreling down on the Leeward Islands.

Hurricane Louis was a category fivemonster with 180mph winds and 25-foot waves. Two days later Schnittlichchartered a small plane to Anguilla.Mango’s was in ruins. “The only thingleft was the toilet,” says Schnittlich, whocried for hours on the beach. It took theisland weeks to restore water, powerand phone service.

He still chokes up at the memory,but Schnittlich now sees theexperience as a blessing in disguise.He’d had the foresight to buy propertyinsurance, and he used it to build amore modern Mango’s, with 36tables. Schnittlich also expanded hismenu and his wine list, from 24 to550 vintages. Reopened in January1996, the restaurant quickly

recaptured its buzz.Five years into their Anguillan

adventure, Schnittlich’s wife of 22years returned to the U.S. and laterfiled for divorce.“My dream cametrue, but it became her nightmare,”he recalls.

Tough as the breakup was,Schnittlich says it didn’t make sensefor either his wife or him to remainperpetually unhappy. Today he is inlove with running a restaurant thatdraws glitterati like Robert De Niro,Al Gore and the Clintons, whowelcomed in 2007 there by dancinglate into the night.

Although Schnittlich had actedquickly when he heard Mango’s wason the market, it had two ingredientshis business experience told him werekey: an established clientele and asolid reputation. Nor did it hurt thatexpenses are reasonable. Schnittlich,who owns his building, pays $78,000annually for the beachfront acre onwhich it sits, plus $13,000 forinsurance.

Schnittlich’s biggest headache islabor. When some employees calledin sick early on, he got stuck servingmeals and clearing tables himself.These days he pads his shifts with20% extra workers to avoid having topitch in. He’s also managed to lureand keep a talented chef whograduated from the Johnson & Wales’College of Culinary Arts inProvidence, R.I., by offering him 20%of the restaurant.

More than anything, Schnittlichattributes Mango’s success to keepingthings local. “If we don’t catch it, wedon’t serve it,” he says. That may betrue of the fish, but he still has toimport wine, dry goods and meatfrom Miami. Mango’s revenues haveincreased from $350,000 to $1.5million a year under Schnittlich, andit’s solidly profitable. He closes the


business and visits the U.S. betweenJuly and September—hurricaneseason.

Schnittlich is still a U.S. citizen,which means that, even thoughAnguilla has no income tax, he’s onthe hook to Uncle Sam. That includespaying the U.S. self-employmenttax—15.3% on his first $102,000 and

2.9% above that.There are some tax benefits for

Americans living overseas.Nonresidents get to exclude up to$87,600 of income earned outside ofthe U.S., if they spend at least 330days every 12 months abroad.Schnittlich doesn’t qualify.

“Islands are nice, but the cost of

living may be higher than youexpect,” warns Leonard Levin, headof the international tax practice atNew York City accounting firmWeiser LLP. “Do your homework,” hesays, “before you go.”

Mere details in the greater schemeof things, insists Schnittlich, who isnow known locally as Mango Dave.“I’m a better person now than I usedto be, inside and outside,” he says. “Iused to work 20 hours a day runningmultiple businesses in New Jersey.Now I only work 4 hours a day.” a


INVESTORS’ GUIDEq FLINGS

Follow your dream: David Schnittlichrelaxes at Mango’s.“I couldn’t just retire and live

down here. I needed something to do.”

JEFFERY SALTER FOR FORBES

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