Morningstar Advisor - Summer 2008 - 19

asset classes that have exhibited higher returns in the past can cause an investor’s original asset allocation to become unbalanced over time. And a portfolio that is not rebalanced periodically may become more volatile. As shown in the charts below, after 20 years of great performance, what was once a 10% allocation to emerging-markets stocks has more than doubled to 23%. The portfolio’s fixed-income component was reduced to 26% from 40%. Moreover, not only does the portfolio’s allocation change, but its risk does as well. The portfolio’s standard deviation rose to 11.4% from 10.1%. And to make matter worse, the portfolio’s annual return stayed at 11.7%. For taking on additional risk, the investor was not compensated. Brown says that while there is a disappointing scarcity of investable options in the micro-cap space, there are some bright spots, including: Royce Micro-Cap RYOTX This recently reopened fund has been around since 1991, making it an elder statesman among micro-caps funds. Manager Whitney George, who’s been in charge since 2001, has been outstanding. George’s insistence on healthy balance sheets and an aversion to pricey stocks has helped the fund’s performance. value estimates. Valuations rose after hitting a median price/fair value estimate ratio of 0.83 in March (a price/fair value estimate ratio below 1.00 is considered undervalued), but prices have fallen and again are approaching October 2002 levels, when the ratio hit 0.78. Although the 2001-02 period turned out to be a good time to invest, Bergman says, a turnaround this time might require patience. A prolonged economic downturn could mean revisions in Morningstar’s fair value estimates. “We’ve been shaving expectations for revenue and cash flow in 2008 for many of our companies, but our forecasts could still be too high,” Bergman says. “In turn, persistently higher inflation could mean that our discount rates are too low, and our fair value estimates too high.” (To see the most recent market valuation graph, go to Morningstar.com.) Looking across Morningstar’s coverage universe, each of the 12 sectors appeared undervalued on a median basis in June, just as they did in March. In other words, Morningstar analysts still think there is a lot of value out there in a lot of places. Aegis Value AVALX For value hounds, this fund is a solid choice. It has a good long-term record, and its manager has been in charge since the fund’s 1998 inception. Lead manager Scott Barbee follows Change of Portfolio Allocation: a deep-value approach inspired by Ben Graham, January 1988–December 2007 which is reflected in the fund’s low price/book Rebalanced Portfolio Non-Rebalanced Portfolio and price/cash flow metrics. The fund Annual Ret: 11.7% Annual Ret: 11.7% slipped up from 2003 through 2005 but has Standard Dev: 10.1% Standard Dev: 11.4% since regained its footing. Emerging market stocks Emerging market stocks 10% 50% Bonds Domestic 22.6% stocks 51.5% 25.9% Bonds Domestic stocks Bridgeway Ultra-Small Company Market 40% BRSIX Domestic Stocks Rebalanced portfolio Bonds Not rebalanced portfolio EmergingMarkets Stocks Domestic stocks are represented by the Standard & Poor’s 500®, which is an unmanaged group of securities and considered to be representative of the stock market in general, bonds by the 20-year U.S. government bond, and emerging-markets stocks by the Morgan Stanley Capital International Emerging Markets Index. This fund is distinct. For one, it tracks the growth-leaning CRSP Cap-Based Portfolio 10 Index. It keeps its expenses significantly below those of other micro-cap funds, and its advisor donates part of its profits to charity. Owing to its index approach, the fund has a turnover rate well below that of its micro-cap peers. Since its 1997 inception, the fund has returned an average of 15.6% annually, crushing nearly every other micro-cap fund. Sector Valuation Changes Sector Current Median Three Months Change Price/Fair Value Prior % Business Services Consumer Goods Consumer Services Energy Financial Services Hardware Health Care Industrial Materials Media Software Telecommunications Utilities Data as of June 30, 2008. 0.93 0.88 0.83 0.87 0.88 0.91 0.88 0.91 0.98 0.92 0.86 0.98 0.88 0.89 0.78 0.93 0.88 0.85 0.90 0.90 0.91 0.88 0.90 0.93 6.2 –1.4 6.6 –6.0 –0.5 6.7 –2.3 1.4 7.6 4.1 –4.3 5.4 Opportunities in Micro-Cap Funds The market downturn has taken a big toll on small firms, and micro-cap funds have struggled as a result. But Morningstar mutual fund analyst Greg Brown notes that as investors flee these funds, an opportunity has been created for those wanting to add some micro-cap diversification to their holdings. Market Outlook: Stocks Still Undervalued Morningstar stock analyst Bill Bergman says that stocks still look cheap, comparing the market valuations in June with those seen in 2001-02. Bergman’s assertion is grounded in a comparison between the market values of the 2,000 stocks on which Morningstar publishes fair MorningstarAdvisor.com 19

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Morningstar Advisor - Summer 2008

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