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Investing in Funds: A Quarterly Analysis --- Fixed-Income Investing: Going Where Others Fear to Tread --- DoubleLine's Jeffrey Gundlach beats his peers by digging for bargains among private mortgage securities
By Ben Levisohn 1268 words 5 October 2011 The Wall Street Journal J The Wall Street Journal - Print and Online CTGWSJ C12 English (Copyright (c) 2011, Dow Jones & Company, Inc.)

The split verdict in a lawsuit and countersuit between bond-fund manager Jeffrey Gundlach and his former employer, Trust Co. of the West, left neither side a clear-cut winner. The same can't be said for the new fund Mr. Gundlach launched last year, DoubleLine Total Return Bond. The fund trounced competitors over the 12 months through September, returning 10.3%, almost double the Barclays Capital Aggregate Bond index. It beat the average intermediate-maturity bond fund by almost seven percentage points, putting it in the top 1% of that category, according to Morningstar Inc. Adding to the fund's allure: a dividend yield of 8.4%, about five percentage points higher than the category average. How has Mr. Gundlach done it? He has built an intermediate-bond fund that is far from typical. The first hint that Mr. Gundlach is doing something different: DoubleLine Total Return owns almost no traditional bonds. While the average intermediate-bond fund recently had 31% of its assets in corporate bonds and 14.7% in U.S. Treasurys, according to Morningstar, the DoubleLine fund has just 1.2% of its assets invested in corporate bonds and owns no Treasurys. But unlike Pacific Investment Management Co.'s Bill Gross, who famously bet against Treasurys and whose Pimco Total Return now lags behind the average intermediate-bond fund by three percentage points over the past 12 months, Mr. Gundlach hasn't been haunted by his decision to avoid Treasurys. That's because of what he does own: mortgagebacked securities -- and lots of them. Mr. Gundlach has almost 14% of the portfolio invested in agency mortgage pass-through securities, roughly in line with the category average. These are bonds issued by a trust that owns a pool of home loans backed by Fannie Mae, Freddie Mac or Ginnie Mae. The mortgage payments are then funneled to bondholders. But the bulk of Mr. Gundlach's portfolio is invested in a more complex, potentially riskier form of mortgage security known as a collateralized mortgage obligation, or CMO. Rather than simply passing along the cash flow from the underlying mortgages, these trusts split the payments among several classes of securities, each with different payment schedules and designed for various purposes, from floating-rate and inverse floating-rate bonds to "very accurately defined maturity" and "accrual" bonds, each of which has its own payment structure and risks. The average intermediate-bond fund recently had more than 17% of its portfolio invested in these bonds, while DoubleLine Total Return has 64.6%, about half of those in privately issued mortgages not backed by the U.S. government. The typical fund has almost no exposure to privately issued CMOs. Trading in these bonds is what gives Mr. Gundlach his edge, but it also makes it difficult for run-of-the-mill financial professionals, let alone retail investors, to understand what he is doing and how the portfolio will react under different scenarios. "Very few people have the skill set to understand the metrics that drive the credit-exposed mortgage market," Mr. Gundlach says.

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That's not necessarily a problem, says James Shelton, chief investment officer at Kanaly Trust in Houston. Mr. Gundlach built his reputation at Trust Co. of the West, or TCW, on his ability to navigate these complex markets. In 2008, TCW Total Return Bond returned 1.1%, 5.8 percentage points more than the average intermediate-bond fund, and Mr. Gundlach built DoubleLine Capital LP around that know-how. His team analyzes the individual loans in a security down to the ZIP Code, finding bargains where few other funds dare to tread. "They're very experienced in what they do in mortgage-backed securities," says Mr. Shelton, who has invested with Mr. Gundlach since his TCW days. "It's no surprise that the fund's done well." The circumstances surrounding Mr. Gundlach's firing from TCW in 2009 are what led to the trial that ended in last month's split decision. The Los Angeles jury said Mr. Gundlach misappropriated trade secrets and violated his fiduciary duty to his former employer, but it also decided TCW owed him $66.7 million in back wages. Mr. Gundlach says his fund's portfolio is safer than a traditional bond fund because only one-third of the portfolio is exposed to "credit risk" -- the failure of an issuer to pay -- in the privately issued CMOs, while the rest of his bonds have government backing. "If you still believe that the government has no default risk, then 63% has no exposure to credit risk," Mr. Gundlach says. "The risk is greater [in other bond funds] than in a fund like ours." The risks, however, are far different from those in a plain-vanilla bond fund, where the primary concerns are the direction of interest rates and credit quality. For starters, the privately backed CMOs are highly illiquid and their prices fall during periods of risk aversion. The government-issued mortgage-backed securities help balance the risk by gaining in value when investors panic. The fund also recently had more than 17% of its assets in cash, up from about 7% in 2010. But even that isn't a guarantee that Mr. Gundlach will navigate the treacherous landscape unscathed. He is holding more risky assets than he did during other treacherous periods -- and a double-dip recession, a further slide in housing prices or a default in Europe could harm his privately backed securities, says Eric Jacobson , director of fixed-income research for Morningstar. "He's tremendously confident that he can move around this," Mr. Jacobson says. "But it may not matter how nimble he is if we end up with a big selloff too quickly." Complicating matters is the fund's rapid growth. DoubleLine Capital had accumulated $15 billion in assets under management by Aug. 31, up from $500 million at the beginning of 2010. Of that, more than $10 billion is in DoubleLine Total Return Bond. As the fund grows, it will get harder for Mr. Gundlach to find bonds at cheap prices. "More power to DoubleLine for drawing the assets," says Tom Brakke, president of TJB Advisors. "But it will make it harder for them to continue to outperform." One risk is that investors will look at the fund's performance and its hefty yield without understanding what the fund is doing. Investors should take the yield in particular with a healthy dose of skepticism, Mr. Brakke says, because it can change when the manager buys or sells bonds in the portfolio. "People think it will be an 8% yield, and it probably won't be," he says. That's why many advisers spend time trying to understand what Mr. Gundlach does before buying the fund. James Holtzman, a financial adviser at Legend Financial Advisers Inc. in Pittsburgh, for instance, bought the fund about two months ago, after spending months studying the portfolio and how it behaved. Even then, it's just 7% of his clients' portfolios. Too many investors, however, buy the fund on faith, says Mr. Jacobson. "As long as the numbers look good, they don't care what he does," he says. "People need to understand the risk or risk being disappointed." --Mr. Levisohn is a staff reporter for The Wall Street Journal in New York. Email him at ben.levisohn@wsj.com. License this article from Dow Jones Reprint Service [http://www.djreprints.com /link/DJRFactiva.html?FACTIVA=wjco20111005000015]
Dow Jones & Company, Inc.

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