Today’s Investment Opportunities – April 1, 2007

With the economy slowing and sector leadership waning, investor interests may be best served by considering funds, and management teams, that have shown a knack for good, old-fashioned stock-picking. Here’s an updated list of what we find attractive at present and a few thoughts as to why these funds might make sense in your portfolio.

If you recall, we added “bear market” and “market neutral” investment options to our list at the beginning of July 2006. Not the most auspicious time to do so, but we’re not just looking for funds that “zig when the market zags”. In order to make the list, these funds have to provide not only downside protection to a portfolio, but also a modest level of risk-adjusted excess return, or alpha. So, even if we get the ensuing market direction wrong, our market neutral and bear market funds have a good probability of mitigating directional bias.

As it turns out, a good example of a fund with these characteristics is the Prudent Bear fund we mentioned in July. From our work, the fund’s beta relative to the U.S. market was roughly -0.75 over the past year (through March 31, 2007). Given the broad U.S. stock market returned positive 11.28% over the last 12-months, one would expect Prudent Bear to have lost roughly 8.4%. Yet the fund generated positive returns of 7.4%. This difference of 15.9% would have allowed one to both insulate an investment portfolio to short-term moves on the downside while capturing a good deal of the market’s upside. We like that.

We present all three of the market neutral and bear market funds we recommended last July in the table below along with two funds we’d be unlikely to hold in either model portfolios, or client accounts, namely the Rydex Inverse S&P 500 and ProFunds Bear funds. The column marked “Beta Implied 1-year Return” is an estimate of the return an investor should have expected from just fund’s beta exposure to the broad market. The fund’s “Excess Return” is simply the difference between the fund’s total return and its Beta Implied 1-year Return.

A logical question that might arise – why do both the Rydex and ProFunds offerings show any positive “Excess Return”, given that they both attempt to mirror the overall market in the opposite direction? The answer stems from two sources. First, part of this benefit is due to the strategy that each employs - investing the proceeds from shorting futures in risk-free short-term obligations. This accounts for maybe 5% of each fund’s total returns and, given that Prudent Bear is roughly 75% short, about 3.75% of the excess return generated by this fund as well. The remainder of the excess return generated by Rydex and ProFunds can be attributed to the mis-match between the S&P 500 Index and the Russell 3000 index.

We’d be unlikely to recommend, much less hold, either the Rydex or ProFunds offerings simply because we don’t place much faith in our abilities at accurately calling the direction of the overall market over the short term – and that’s what benefiting from these funds requires. Yet in cases where an active market neutral or bear fund manager shows an adept ability to add modestly consistent excess return we’re more interested, as that excess return (assuming it persists) actually mitigates the risk if our directional biases are wrong.

Our opportunity list, shown below, is comprised solely of actively managed mutual funds that should be available through the Fidelity, Charles Schwab and TD Ameritrade fund platforms as “no-transaction fee” options. However, if you find an error in availability, let us know and we’ll be sure to correct it next quarter.

Changes in Fund Recommendations

Deletions

Chase Growth, Hillman Focused Advantage (CHASX & HCMAX) – both fund’s risk-adjusted returns have fallen off markedly since last July. We recommend swapping out of each into Janus Contrarian (JSVAX) and/or Allianz NFJ Dividend Value – D (PEIDX).

Fidelity Value Discovery (FVDFX) – still producing solid returns, we recommend continuing to hold in taxable accounts, but we’d rather dedicate new money to either Kinetics Paradigm (WWNPX), Kinetics Small Cap Opportunities (KSCOX), or Delafield (DEFIX). Realize the overlap between Kinetics Paradigm and Small Cap Opportunities is sizeable, so we’d select either one or the other.

James Equity & James Small Cap (JALCX, JASCX) – deterioration in both funds merit a move to greener pastures. We suggest Delafied (DEFIX) for owners of James Equity and Cambiar Conquistador Inv. (CAMSX) for James Small Cap holders.

Touchstone Small Cap Value Opportunities (TSVOX) – Shorter term prospects might be brighter with Cambiar Conquistador Inv. (CAMSX) or Royce Value Plus Service (RYVPX).

Fidelity International Discovery (FIGRX) – fund has closed. We’d recommend continuing to hold but new money is advised to look to Quant Foreign Value (QFVOX).

Additions

Janus Contrarian (JSVAX) – it looks like Janus is getting its groove back, and Contrarian is one of the timeliest of their offerings. Solid risk-adjusted returns for the past few years add to its attractiveness.

Allianz NFJ Dividend Value – D (PEIDX) – steady, consistent performance along with a modest expense ratio make this fund attractive in the large-cap value sector.

Delafield (DEFIX) – a solid way to get mid-cap value exposure. Much more cyclically positioned than either Kinetics Paradigm (WWNPX) or Kinetics Small Cap Opportunities (KSCOX) and hence a likely complement to either.

Royce Value Plus Service (RYVPX) – a nice small cap opportunity, Royce has done a great job with many of their small cap offerings and Value Plus Service is both well diversified and most timely.

Cambiar Conquistador Inv (CAMSX) – a relatively unknown fund with only $63MM under management, he performance has been solid since inception. This looks like a good opportunity to get in on the ground floor though the ride may be bumpy at times.

Fidelity Real Estate Income (FRIFX) – a nice conservative offering that seems to be completely misunderstood by Morningstar, who give it a one-star rating. The fund invests in preferred shares of real estate companies (REITs and operating companies) and is much more comparable to fixed income offerings than other REIT funds. A good fund for those seeking retirement income with some upside.

Alpine International Real Estate (EGRLX) – in our opinion the U.S. REIT sector is both picked-over and over-priced relative to the risk inherent in the sector. However, international REITs are in their infancy and, as the market develops, we’d expect a lot of opportunities for early investors. The yields are currently low, but expected to rise over the next few years as the REIT structure matures overseas. Funds in this sector are not without risk, but tuck this fund away for five years and we think you’ll be well rewarded.