Eight Burning Questions for the Mutual Fund World

It's time once more for the annual Morningstar Investment Conference, and there are quite a few burning issues on which we hope to shed light. I'll let you know what we learned next week.

1. How Bad Is the Subprime Mess, and What Will It Do to the Economy?
The housing market is in a slump that most people say will get much worse before it gets better. Less clear, though, is where the subprime-lending mess will lead. Some, including PIMCO's Bill Gross, say that the Fed will have to ease to reduce pressure on the subprime market. Gross argues that the real threat is not in hedge funds blowing up, but that huge numbers of mortgages will reset their interest rates at a much higher rate, thus spurring delinquencies. "A recent research piece by Bank of America estimates that approximately $500 billion of adjustable rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises with nearly $700 billion ARMS subject to reset, nearly � of which are subprimes," he writes.

At our conference, the first to offer his take on the subprime world will be Jeffrey Gundlach of TCW. Gundlach won our Fixed-Income Manager of the Year award and should have some good insights to share. I expect to hear more on it from any number of stock-fund managers, but the final word will go to a trio of bond-fund managers who will wrap things up for us: Keith Anderson of BlackRock, Bob Rodriguez of FPA, and Steve Walsh of Western Asset Management. Including Gundlach, that means four of the very best minds in bond investing. Three of them work in Southern California and therefore have a great vantage point to the housing mess. I just hope we can get Bob Rodriguez to come out of his shell and tell us what he really thinks. Rodriguez was an early detractor of subprime lending, so I'm sure he'll not mince words in telling us how bad it really is and why.

2. What Does the Private Equity Boom Mean for Investors and the Economy?
A couple of years ago hedge funds and their super-short-term time horizon were creating a lot of buzz at our conference. This year, it will be about private equity. The good news is that the time horizons of private equity are much longer and they truly are looking at the value of the overall business--not just trading blips on a screen. However, they are loading massive amounts of debt onto companies and that may force more into bankruptcy down the road. I'm sure many of the managers at the conference will weigh in on that subject. One thing is for sure, the bond-fund managers hate the trend because it can instantly turn a high-quality credit into a junk bond because of the massive increase in debt.

3. Is This the Moment for Large-Cap Stocks?
I'll put that question to three large-cap fund managers: Ken Feinberg of  Selected American (SLADX), David Katz of  Matrix Advisors Value (MAVFX), and Ron Canakaris of  Aston/Montag & Caldwell Growth  (MCGFX). I know what Canakaris' view will be. He recently wrote to shareholders and told them that "Now's the time!" He argued that after a very long run for small caps, the tide would turn: "The outperformance of large cap value over large cap growth has continued for an unprecedented seven years. As investment returns normalize for these two asset categories, relative returns should favor growth by a substantial margin. As a result of these performance differences, significant valuation gaps have developed. For example, the relative price to earnings multiple of the largest twenty-five companies in the S&P 500 is at one of its lowest points in twenty years and the Russell 1000 Growth's price to sales ratio relative to the Russell 1000 Value's ratio is at its lowest point since 1980. Furthermore, your equity holdings are particularly attractive at this time. As of 12/31/06 your equities were selling at a median price to present value ratio of 76%, or at a 24% discount to our calculated intrinsic value."

4. What's Next in Mutual Fund Research?
There are a few places to go for that answer, but we'll hear academia's answer in two breakout presentations. We've asked two of the people behind two of the most exciting research efforts relating to mutual funds to present their work. Greg Kadlec, a professor at Virginia Tech, will share his thoughts on some fascinating work he's done on trading costs. (Click here to see the paper by Roger Edelen, Richard Evans, and Kadlec.) The paper found that trading costs at mutual funds were a powerful negative predictor of mutual fund returns. In short, they act much like expense ratios in that they are sizable costs that are generally not recouped by management. In the fund world there are very few data points that have predictive power, and this one seems like a big one. Two interesting details are that they found not all trades are created equal. Specifically, they found that trades made in order to accommodate inflows or outflows were much more damaging than other trades because the trades are not based on information. In addition, they found that big trades are more damaging of a sign that funds need to be careful about growing too big to execute their strategy properly.

In addition, Antti Petajisto of Yale will present a paper on a new measure called active share. The paper, co-authored by Martijn Cremers, has fast become a favorite of focused-fund managers. The measure attempts to see if a fund is boldly different from its benchmark or is simply hugging the benchmark by comparing a fund portfolio with its closest index. The authors found that funds with higher active shares are more likely to outperform their benchmarks. It's great stuff.

5. Which Emerging Markets, If Any, Should You Buy Now?
We have three experts in the field presenting their takes on three separate regions. Given the rally across the board you might assume it's all pricey, but I doubt that Thailand, Poland, and Brazil are all that similar. We'll hear about Asia from Mark Headley of Matthews Funds, Eastern Europe from Templeton analyst Michael Hasenstab, and Latin America from T. Rowe Price manager Gonzalo Pongaro.

6. What Does a Drop in Volatility Mean for Different Asset Classes?
AllianceBernstein growth chief investment officer Ranji Nagaswami will share some intriguing research that AllianceBernstein has done on the subject. She will give us her take on which asset classes are pricey and which are attractive.

Earlier in the conference we'll hear from some excellent foreign stock fund managers and commodity managers, who should have interesting perspectives on the attractiveness of assets in their necks of the woods. Included in that group will be Jean-Marie Eveillard, who has returned to the fund world to run  First Eagle Overseas (SGOVX),  First Eagle Global (SGENX), and  First Eagle Fund of America .

7. Which Stocks Are Buys?
Okay, I've spent a lot of time on macro issues, but many of the best managers focus solely on sniffing out the best investments with little concern for macro trends. I'm eager to hear what people such as Mason Hawkins, Peter Langerman, John Rogers, Brian Posner, Bob Doll, and Steve Romick (to name just a few) are buying.

8. What's on Jim Rothenberg's Mind?
Although they are among the brightest long-term investors around, we rarely get to hear from the investors at American Funds. Jim Rothenberg, chairman of Capital Research and Management Company, will share his insights on the market. I'm expecting a packed house for that one.