Morningstar Advisor - April/May 2009 - 9

Letter from the Editor Dangerous Creatures In this issue’s Morningstar Conversation with Bob Rodriguez (page 42), Jeffrey Gundlach talks about bond managers failing to adapt to an economy that has been transformed by the financial crisis. Managers are too used to operating in an environment of heavy leverage and increasing debt, he says. “Most bond managers just don’t understand that they have to go back to a cash-flow-based investment program in credit and not the price-based investment program of the past,” Gundlach says. For shareholders of many bond funds, that return to fundamentals can’t come soon enough. Like a midwinter warm-up melting weeks of Chicago snowpack, the financial crisis is revealing some interesting things. It appears that scores of bond-fund managers took heavily leveraged positions in their portfolios. In steadier times, these strategies might have worked out and gone largely unnoticed. But in a financial meltdown, they became exposed, as Morningstar analysts began noticing that funds were piling up disastrous losses that could not be explained by a bad sector call or two. The worst part, however, is that shareholders had little way of knowing what was going on at their funds. Managers didn’t reveal their tactics to analysts in interviews. In many cases, fund documentation lacked specific mention of leverage or even hinted that it was being done. Even someone with an experienced eye for accounting would have a hard time reconciling a leveraged fund’s balance sheet and determining the levels of risk a manager was building up. Much of derivative leverage occurs off the balance sheet. Fixed-income specialist Eric Jacobson has all the sordid details in “Where Leverage Lurks” (page 32). He also details, in a step-by-step guide (page 36), how to go through a fund’s balance sheet and Schedule of Investments to determine if a manager is taking heavily leveraged positions. Unfortunately, our lesson on the dangers of leverage doesn’t end there. ETF specialist, and contributing editor, Paul Justice is disturbed by the popularity of leveraged ETFs. Unlike the above-mentioned bond funds, however, these funds are very up front about their practices. The problem is that investors are not using the instruments correctly. Built for institutions looking to offset some risks for a day or two, leverage ETFs compound their returns daily. As Justice explains in his article, “How Leveraged ETFs Compound the Misery” (page 40), simple math shows that holding these instruments for longer time periods could lead to financial pain. This issue’s look at leverage serves to highlight a point Morningstar preaches to investors of all stripes, sophisticated or not. It’s critical to intimately know what you’re investing in and understand your risks. If an investment’s accounting is opaque or raises red flags, ask questions. Information will be key in the rough-and-tumble markets of the foreseeable future. Please e-mail me your comments about the magazine to magazine_editor@morningstar.com. Jerry Kerns MorningstarAdvisor.com 9

http://www.MorningstarAdvisor.com

Morningstar Advisor - April/May 2009

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2009