The Subprime Mess and Your Portfolio, Part 2

The biggest financial story of 2007 has undoubtedly been the subprime-mortgage crisis and its increasingly widespread fallout. The first rumblings of the problem started last year, then the crisis exploded in February and March of this year as defaults spiked in subprime mortgages and mortgage lenders such as New Century Financial started going bankrupt. Since then, the situation has only continued to get worse, and the crisis has spread throughout the financial world, ensnaring such Wall Street heavyweights as  Citigroup (C),  Merrill Lynch & Company  , and  Goldman Sachs (GS).

Back in early May, we took a look at the effect of the subprime crisis on mutual funds up to that point, and we suggested some ways for fund investors to judge how their portfolio might be affected. At the time, few people had any idea how bad things would get, and there have been a lot of new developments in the past seven months. We've written about many of these specific developments already, but we thought it would be a good idea to take another broad look at the impact of the crisis on mutual funds, including how things have changed since May and what you can do now.

The Effect on Bond Funds
The subprime meltdown has had a significant effect on many bond funds. Most mortgages in the U.S., including subprime ones, get packaged into bonds and sold to investors through mortgage-backed securities and asset-backed securities. In theory, at least, investors can choose how much risk they want to take on, from very safe, AAA rated mortgage-backed securities down to much riskier, lower-rated asset-backed securities based on subprime mortgages. In practice, it hasn't been quite that simple. As the effects of the crisis have spread, bond-rating agencies such as Standard & Poor's and Moody's have downgraded increasing numbers of formerly high-rated securities after it became apparent that they had more subprime exposure than previously thought. That, in turn, has caused pain for some bond funds, including some you wouldn't necessarily expect.

As we noted in May, most funds get their mortgage exposure through MBS issued by  Fannie Mae (FNM) and  Freddie Mac (FRE), and these are unlikely to be significantly affected in more than a temporary way. While Fannie- and Freddie-issued MBS have taken some price hits due to a general fear of anything mortgage-related, the effect has not been dramatic. On the other hand, quite a few ABS have been hurt by subprime-related downgrades or the threat of downgrades, as Paul Herbert described in this article back in August. One of the funds highlighted in that article is also one we also mentioned back in May,  Regions Morgan Keegan Select High Income . The fund's 15% stake in subprime ABS and MBS dinged its returns significantly when the first stage of the subprime mess hit in March, but it still remained in positive territory for the year to date. When the next stage hit in July and August, those holdings got slammed even more, and redemptions forced manager James Kelsoe to sell some of these illiquid securities at fire-sale prices, making the problem far worse. By Aug. 9, the fund was down 27% for the year to date, and as of Dec. 4, it was down an incredible 55% and fighting for its life.

The Regions Morgan Keegan fund is an extreme example of what can go wrong with a fund that takes too many risks, but subprime fallout has also hit some funds usually considered safe. For example,  Fidelity Ultra-Short Bond  has been hit hard because of its very short-term subprime holdings, some of which made it into the portfolios of other Fidelity bond funds. There were already rumblings of trouble for Ultra-Short Bond back in August, as Paul Herbert's article and this one by Russel Kinnel noted, and things have continued to deteriorate since then. As of Dec. 5, the fund had lost 5.55% for the year to date, a remarkable amount for an ultrashort bond fund. Another ultrashort fund,  SSgA Yield Plus , has lost an even more astonishing 12.87% over the same period. Those are extreme examples, but a surprising number of ultrashort bond funds and even money-market funds have been caught in subprime fallout.

More broadly, the crisis has caused bond investors to flee from credit risk, regardless of whether there's any actual subprime exposure, and embrace bonds seen as safe, such as Treasuries. Of the 13 taxable fixed-income categories that Morningstar tracks, the best-performing this year (as of Dec. 5) has been long government, followed by inflation-protected bond. Over the trailing three months, long government is out in front by an even wider margin. The worst-performing categories have been bank loan, high-yield, and ultrashort bond, all of which are exposed to credit risk in various ways. This is a reversal from the previous five years, when credit risk was amply rewarded by the market. Even after this year's troubles, the high-yield bond category still has the second-highest five-year returns, after emerging-markets bond.

The Effect on Stock Funds
Stock mutual funds have also been affected by the subprime fallout, in a variety of ways. Most directly affected, as you would expect, are funds that concentrate on mortgage- and housing-related stocks. Back in May we mentioned  FBR Small Cap Financial (FBRSX) and  Fidelity Select Home Finance (FSVLX) as two funds that had been hurt, and they've continued to suffer, having lost 23% and 37%, respectively, for the year to date through Dec. 5. Exchange-traded fund iShares Dow Jones US Home Construction (ITB) fell "only" 19% in the first quarter of this year but is now down 59% for the year. Numerous other funds in the financial and real estate categories have lost more than 20%, including  Franklin Real Estate Securities (FREEX),  AIM Financial Services , and leveraged sector funds from ProFunds focusing on banks ( (BKPIX)), real estate ( (REPIX)), and financials ( (FNPSX)). Those two categories are the worst performing of Morningstar's 18 domestic stock fund categories this year, both with average losses of more than 10%.

It's not just sector funds that have been affected; plenty of diversified funds with significant housing- and mortgage-related holdings have also suffered. As we noted in May, value-investing legend Wally Weitz holds big stakes in such stocks, especially mortgage lender  Countrywide Financial , in four of his funds ( Weitz Hickory ,  Value (WVALX),  Partners Value (WPVLX), and  Partners III Opportunity (WPOPX)). All four funds are still struggling, but Weitz has held his ground, believing that the stocks are still long-term values. Similarly, Analyst Picks  Schneider Value  and  Schneider Small Cap Value  have been slammed by big stakes in Countrywide and other mortgage originators, but we still like the funds long-term. In October, we took a look at which funds had the biggest stakes in homebuilder stocks. Most of these funds ranked near the bottom of their categories for the year to date, but they included some good funds with strong long-term records, such as  Janus Worldwide ,  Legg Mason Opportunity (LMOPX), and  Muhlenkamp (MUHLX).

On the other side of the coin, a few funds have actually benefited from the subprime turmoil. Manager Ken Heebner's  CGM Focus  has gained an eye-popping 70% this year, putting it atop the large-blend category. Among the contributors to those returns is a short position in Countrywide, meaning that the fund has benefited as the stock has gone down.  Longleaf Partners International (LLINX) and  Longleaf Partners Small-Cap (LLSCX) have both generated strong top-decile returns this year, helped by top-10 positions in  Fairfax Financial (FFH). That stock is up more than 50% this year because it owned credit-default swaps that allowed it to benefit when mortgage lenders and bond insurers went down.

As with bond funds, the subprime crisis has caused some broader effects on stock funds, including some that weren't necessarily predictable back in the spring. (Gregg Wolper, in this article, and Christine Benz, in this one, discussed some of these effects after the July-August market swoon.) One notable result is that growth funds have outperformed value funds, especially small- and mid-cap value funds; as of Dec. 5, the average large-growth fund had gained 12% for the year to date, while the average small-value fund had lost 7%. That's exactly the opposite of what happened in the bear market of 2000 through 2002, but it's understandable when you realize that financial stocks are much more prevalent in value portfolios than in growth portfolios. Also, the general aversion to risk resulting from the summer credit crunch has made many investors skittish about small caps and more welcoming of "safe" large caps, just as they've shunned high-yield bonds in favor of Treasuries. However, not all large caps are safe, as the subprime-related travails of Citigroup and Merrill Lynch have illustrated.

What To Do Now
As these examples show, it has been virtually impossible this year to avoid the fallout from the subprime crisis completely. The summer liquidity crisis caused ripple effects in all kinds of investments without direct subprime exposure, including some previously thought to be safe. Still, if you want to find out what kind of exposure your fund might have, there are ways to find out.

To check a given fund's exposure to subprime-related stocks (or anything else that looks suspicious), you can look at its top 25 holdings on Morningstar.com. Just type the fund's name or ticker into the Quotes box at the upper left, click on the Portfolio tab, then click on the Top 25 Holdings tab. You can also find the biggest holders of any given stock (such as Countrywide) by typing in the stock's ticker, clicking on the Insider Trading tab on the left side of the page, and then clicking on the Concentrated Fund Owners or Top Fund Owners tabs at the top. To see how the various fund categories stack up against each other over various trailing periods, go here.

By this point, the most obvious subprime-related risks have already been priced into the market, and about the best you can do is try to avoid areas that seem overly risky. However, completely trying to avoid subprime risk isn't necessarily the best way to go. As we saw above, there are some very good funds out there that have been hammered in the short term by subprime-damaged holdings but which still have great track records and managers who generally know what they're doing. Sometimes the best opportunities come when everyone around you is running for the exits.