Stepping Outside the Box

A 1.7% investment in Jeffrey Gundlach's daring  DoubleLine Total Return (DBLTX) may not  be a particularly dramatic stake--except if that portfolio happens to be another mutual fund, and a world stock fund at that. David Rappa, lead manager of Beck Mack & Oliver Global Equity , believes the mortgage bond market is full of compelling opportunities, but he doesn't presume to have the expertise to identify the best ones. That's where Gundlach comes in.

Rappa's fund is a small portfolio from a small shop, and to put his quirky pick in perspective, it is helpful to consider other instances where fund managers have made similar moves.

To be sure, outside of funds of funds, it is not common for mutual fund managers to take a stake in other funds. For one thing, it could add another layer of expenses (barring a fee waiver), so a large investment in another fund could be a drag on performance. But doing so can be a convenient way to gain exposure to an asset class, particularly given the array of lower-cost ETFs available.  Leuthold Core Investment (LCORX), for example, supplements stock picks with allocations to ETFs such as  Vanguard Total Bond Market (BND).

What's significant about Rappa's move, however, is not that he invested in another mutual fund per se. It's that he thought so far outside his usual box that he stepped completely out of it--even though he needed to outsource to do so. Among the subset of opportunistic, eclectic fund managers, it is not unusual to find portfolios containing other public and private investment vehicles.

Steve Romick's  FPA Crescent (FPACX) is a good example. Romick's wide purview encompasses small-cap stocks, large-cap stocks, high-yield bonds, and convertible bonds, not to mention short-selling. But his ideas range even farther afield: He saw opportunity in farmland and made an investment in a farmland trust.

 Clipper (CFIMX) managers Chris Davis and Ken Feinberg use a concentrated, low-turnover strategy that mixes dominant global franchises with contrarian picks. The portfolio often features financials, a particular area of expertise for the team. (Feinberg also manages  Davis Financial (RPFGX).) They made a private equity investment with Oaktree Capital Group , the asset manager founded by distressed-debt expert Howard Marks, that has grown to more than 9% of assets. (Oaktree went public in April.) They've also invested in SKBHC Holdings, a private bank holding company, to take advantage of opportunities among restructuring regional banks that they could not realize on their own.

Then there's John Osterweis, lead manager of  Osterweis (OSTFX), a wide-ranging but concentrated portfolio. He's willing to amass cash if top-down and bottom-up indicators suggest a retreat. But in 2008, he wasn't content to sit on a stockpile. He invested in Trian Acquisition, a special purpose acquisition corporation, or SPAC, run by activist investor Nelson Peltz. If Peltz made an acquisition, Osterweis would end up with a stake in a company headed by a turnaround master. No deal materialized, and Trian was ultimately liquidated in early 2010, but investors got their cash back, plus interest.

 Federated Equity-Income (LEIFX) is not opportunistic in the manner of the funds above, but manager John Nichol made a move similar to Rappa's. Although he focuses on stocks with healthy and growing dividends, one of his fund's top-10 holdings in 2009 was  Federated High-Yield (FHYTX), a high-yield bond fund. At the time, companies were cutting stock dividends in the face of the credit crisis. Nichols had initiated the position in early 2007, when his concerns about the impact of subprime lending led him to cut exposure to dividend-rich financials and consumer cyclical names. Investing in a ready-made high-yield portfolio allowed him to boost yield without needing to become an expert in the field overnight. The move helped limit the fund's losses in the financial crisis, and high-yield bonds surged in 2009.

Even against this backdrop, Rappa's decision seems extraordinary. But as he sees it, investing in DoubleLine was not much different than his decision to buy Huntingdon Capital , a real estate holding company that is the fund's top holding, and more typical of his strategy. (His portfolio has a lot in common with  Third Avenue Value (TVFVX).) "We're talent scouts," he has said. In both cases, he's confident in management's ability to wisely allocate assets.

Frustration at low interest rates was the force behind Rappa's decision. "It infuriates us to get 0% on cash," he's said. Mortgage bonds are hardly a risk-free alternative, but Rappa's thinking is a very aggressive take on an idea discussed at a panel on cash strategies at the recent Morningstar Investment Conference. While cash needed for near-term liquidity must remain risk-free, investors holding cash for other reasons, such as income or wealth preservation, may want to take on incremental risk.

In this low-interest-rate, high-volatility market, perhaps more mutual fund managers will turn to ETFs and other alternative investments to add value or reduce risk around the edges. As for Rappa, he'll soon be able to stretch even further if he chooses: His fund is undergoing a prospectus change that will allow it to invest more than its current 20% limit in bonds. How this freedom will affect the fund's risk/return profile remains to be seen, but Rappa is worth watching.