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Fund Times: 2007 Morningstar Conference Highlights

Plus, news on Marsico firm buyback, Hancock settles with SEC, and more.

Morningstar Analysts, 07/02/2007

Morningstar held its annual investment conference in Chicago this week. Jeffrey Gundlach, TCW Group chief investment officer, and recipient of Morningstar's 2006 Fixed-Income Manager of the Year award, opened Wednesday by giving his insights into the subprime mortgage crisis. He thinks the situation could get considerably worse before it gets better. The subprime trouble "has to do with people getting loans who wouldn't normally get loans," Gundlach said. "Subprime is a total unmitigated disaster, and it's only going to get worse."

Part of the problem is that "people didn't understand the risks" involved in investing in these securities, Gundlach said. "Now that the tide's going out, all the wreckage is showing up at the bottom of the sea," he said. "The delinquency rate is climbing, and it should climb at a very high rate."

Of course, what this means for mutual fund investors is less clear. Gundlach notes, for example, that his own fund, TCW Total Return Bond TGLMX, does not invest in subprime-exposed mortgage- or asset-backed security collateralized debt obligations (CDOs), a main vehicle of subprime exposure. Rather, Gundlach plies primarily the high-quality mortgage-backed bonds (and collateralized mortgage obligations, which are essentially segmented parts of these bonds) issued by the federal agency Ginnie Mae or the government-sponsored agencies Fannie Mae and Freddie Mac. These bonds are high quality and hold explicit and implied government backing.

Clearly, however, the easy lending standards that facilitated the current crisis in subprime, combined with huge amounts of capital searching for added yield, has created a troublesome environment. Gundlach suggested that those who stand the greatest chance of being hit hardest by subprime-exposed CDO losses are less experienced investors, the proverbial "two-guys-and-a-Bloomberg," as well as those who were late entrants to the market, and holders of 2006 subprime bond pools (the most troubled group).

Following Gundlach's talk, Scott Berry, Morningstar's associate director of mutual fund analysis, said that fixed-income mutual funds haven't sustained much damage thus far from subprime exposure, and most bond-fund managers have limited subprime exposure. A few of the exceptions are Fidelity Short-Term Bond FSHBX, which has been modestly impacted by its subprime exposure, and Regions Morgan Keegan Select High Income MKHIX, which has taken a greater hit.

Of course, some enterprising managers have been able to profit from the subprime decline. The team at Dreyfus Premier Core Bond DSINX, for example, purchased a derivatives position with insurance-policy-like qualities that was tied to subprime home equity asset-backed securities. When the subprime sector began collapsing in early 2007, the value of the position appreciated greatly. By March, the team had exited the position and searched out opportunities in beaten-down issues of stronger subprime lenders where it saw value. Investors should keep a close eye on their portfolios as the subprime crisis unfolds, though panic would be a mistake.

Indexing Gurus Debate Fundamental vs. Traditional Methods
While the terms "indexing" and "spirited debate" aren't normally spoken in the same breath, they were appropriate when referring to Thursday morning's panel discussion where Jeremy Siegel and Gus Sauter squared off over two very different styles of indexing.

Siegel, a professor at the Wharton School of the University of Pennsylvania and author of the classic investing book Stocks for the Long Run, said he's found that a fundamental approach to indexing--weighting stocks based on metrics like book value, sales, profits, or dividends--is optimal for investors. "One very important point that has to be understood about cap-weighted indexing is that it is only optimal for investors under one circumstance: if the prices for all stocks are efficiently set," he said. "The more that I study the economy, the more I see cracks in the efficient market theory."

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