Fund Times: 2007 Morningstar Conference Highlights

Conference Kicked Off with Concern Over Subprime Woes
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 , 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 , 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."

"When you test a fundamentally weighted index against a cap-weighted index, not only is the return higher, but the volatility of these indexes in general is less, and in some cases far less, than the cap-weighted indexes," Siegel said. "Now, I think there is a better mousetrap out there."

Sauter, chief investment officer and managing director for the Vanguard Group, countered that nontraditional indexing costs more, and that traditional index funds give investors a better chance of staying with the market. "The value of a market-cap-weighted index is that before costs investors are getting the market rate of return, because they own the market," he said. "After costs, most investors will get less than the market rate of return."

Sauter said that many investors dramatically underestimate transaction costs, meaning that in the end, a traditional index fund makes it more likely for investors to earn the market rate of return.

Capital Research Head Provides Investment Perspective
Finally, despite having 14 illuminating and varied panel discussions from which to choose in the first two days of the conference, a highlight certainly was a look inside some of the thinking behind the American Funds, which are run by Capital Research and Management. Jim Rothenberg, chairman and principal executive officer of publicity-shy Capital Research, ranged over many topics.

Rothenberg urged advisors to change their thinking about retirement planning, particularly with the increased longevity facing Americans today. "At age 65, a couple should have a planning horizon of at least 20 years, which for most in the financial world is an awfully long time frame," he said.

Rothenberg said that Capital is creating new retirement strategies that include a transition phase, between the traditional phases of accumulation and distribution. This transition stage seeks to provide both income and growth. "My message here is really twofold," he said. "First of all, there is an extraordinarily important role for advisors to help individuals with retirement, and secondly, most conventional wisdom does not capture the risk of longevity on cash flows."

Secondly, Rothenberg encouraged advisors to look globally for opportunities and supported his advice with some statistics. "Today, the developing world represents 29% of the world's gross domestic product, with 12% of that in Brazil, Russia, India, and China," he said. "That 29% of the world is estimated to be growing at 6%, while the developed West grows at 2% to 3%."

"The United States' position in the world has changed, whether we like it or not. The ability of the our government's Federal Reserve to implement policies that affect the U.S.--and thereby the global economy--has been dampened materially," he said, citing factors such as China's monetary reserves and petrodollars that make the world "far more competitive and much less U.S.-centric."

Rothenberg said that in the short term, he's hesitant about dramatic asset-allocation shifts into international and emerging markets, but the long-term story is different. "A 10-year timeframe suggests that asset allocation needs to take on a more global perspective," he said. "Undoubtedly, there are risks, but there are also much faster growth rates," as the developing world gains considerable economic ground on the West.

The need to focus a greater amount of assets in international markets was echoed by  Oakmark International (OAKIX) manager David Herro. That said, both he and Rothenberg argued for more modest expectations for international equity returns, as certain macroeconomic tailwinds that have aided these markets in recent years may subside.

Marsico to Buy Back Firm
Tom Marsico, investment head and chief executive from Bank of America's Marsico Capital Management, recently announced his intention to buy back the asset-management unit seven years after selling to that firm. The main impetus behind the deal, which needs to be approved by fund shareholders and is expected to close in 2007's fourth quarter, is to spread firm equity ownership more broadly amongst the investment staff. We've seen firm equity act as a powerful tool for attracting and retaining investment talent at other shops, and we expect it could also be so here. The firm doesn't expect any changes in mutual fund expenses or subadvisory arrangements to result from the deal.

Hancock Settles with SEC
Manulife Financial Corp., and its subsidiary John Hancock, reached a $19 million settlement with the Securities and Exchange Commission after the firm allegedly paid brokers with fund assets in a revenue-sharing arrangement not disclosed to fund boards. As is typical, the firm admitted no wrongdoing.

Growth Seen in Number of Fixed-Income ETFs
SSgA Funds Management has filed to offer the first international bond ETFs on the market with the proposed addition of SPDR Lehman International Treasury Bond and SPDR Barclays Capital Global TIPS ETFs. As the respective names imply, the first of this duo seeks to provide investors exposure to the local currency sovereign debt of non-U.S. investment grade countries, and the second focuses on the global inflation-protected bond markets.

At the start of 2007 only six bond ETFs were available in the marketplace, but the market has grown to 25 funds, with even more on the way.

Elizabeth Bushman, Ryun Patterson, and Jerry Kerns contributed to this article.