Mutual Funds Feel Sting
Of Subprime Mortgages

The implosion of some parts of the mortgage market is starting to hit mutual funds.

The latest casualty might seem to be the most obvious: Real-estate funds. Until recently, they have been surprisingly resilient, because their investments tend to be concentrated in commercial properties, not residential. In 2006, real-estate funds ranked as the best-performing U.S. fund category overall, despite the cooling residential-property market nationwide.

But in recent weeks they have slumped sharply as investors fret about whether rising defaults on the riskiest types of mortgages will spread further.

Real-estate funds are down on average 4.7% over the past month, making them the worst-performing category in that period among all fund categories tracked by data firm Morningstar Inc. Still, they remain up 5.16% for the year to date and 25.5% for the year ended Wednesday.

'Knee-Jerk Reaction'?

The funds mostly invest in real-estate investment trusts, which acquire and manage commercial properties such as offices, malls and apartment buildings. Most have relatively little exposure to subprime mortgages, which are home loans to borrowers with weak credit.

"The knee-jerk reaction by the market is to correct anything that is related to real estate," said Jay Rosenberg, co-manager of the First American Real Estate Securities fund, which has almost no exposure to very risky mortgages.

He adds that part of the recent selloff is also because REITs had risen significantly in January for a technical reason: One big REIT was bought out by private-equity investors, which left its investors holding piles of cash, which they put into other REITs in January.

Mr. Rosenberg's $1.27 billion fund is down 6.11% in the past month. It returned 28.50% in the year ended Wednesday, according to Morningstar.

Give It Time

Financial advisers say that fund investors shouldn't make portfolio changes based on extremely short-term performance swings of one month. Still, some analysts said the current downturn could be an early sign of a slowdown in the market.

"There's been a lot of talk on the backburner [about] when is real estate going to cool," said Andrew Gogerty, an analyst at Morningstar. "This could be the trigger."

Among the hardest hit in the past few weeks are some mortgage REITs, which either loan money to owners of property or buy existing mortgages and make money through interest earned. Investors are trying to assess which of these may have exposure to subprime borrowers.

Some apartment REITs -- basically landlords of apartment buildings -- also have been hurt because of fears that growth in rentals has peaked.

That might not be the case, some say. Joe Rodriguez, manager of the $2 billion AIM Real Estate Fund, says low-credit borrowers who default, and may end up losing their homes, may actually be renting apartments, which will be good for apartment REITs such as Equity Residential and Archstone-Smith Trust. His fund owns both of those REITs and hasn't owned mortgage REITs in nearly a decade.

While they are finding pockets of investment opportunities in the market, Mr. Rodriguez warns that investors shouldn't expect the 30%-plus returns from real-estate funds in the recent past. The AIM Real Estate Fund is down 5.20% for the month yet up 27.5% for the year ended Wednesday.

Woes in the mortgage markets are hurting other kinds of funds as well, particularly those that own home-builder companies and stocks of regional banks that had been lending to low-credit borrowers. Home-builder stocks have moved lower in the past month, partly based on worries that they will be left with a high number of unsold homes.

Stocks such as Pulte Homes Inc. and Toll Brothers Inc., are down 13% and around 10% for the month, respectively. Those numbers have hurt funds that own one or the other, including the $20 billion Legg Mason Value Trust and the $2.4 billion Muhlenkamp Fund.

Another source of pain has been mortgage-lender Countrywide Financial Corp., which has some of its portfolio in low-credit loans. Its stock price has fallen 9% in the past month.

Some Managers Hold Firm

But fund managers are sticking with it. "The stock-price reaction is a bit overdone," says Brad Hinton, co-manager of the $3.2 billion Weitz Value Fund. The fund has held Countrywide for several years and invests 7.2% currently.

Stocks of regional banks, such as Wells Fargo & Co. and U.S. Bancorp, which have had some mortgage-related losses, also have declined, pulling down some funds particularly that invest only in the financial sector.

These include Fidelity Select Banking and Fidelity Select Home Finance funds. A Fidelity spokeswoman said the portfolio managers of these funds had been concerned previously about subprime mortgages and had positioned their funds accordingly, and they have managed to beat their benchmarks in the year to date.

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