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Fund Managers Foresee Subprime Crisis Blowing Over

NEW YORK-While the subprime crisis battered the stock market in the third quarter and the fourth quarter isn't expected to be any better, mutual fund portfolio managers and analysts believe the credit market turmoil will blow over. They spoke earlier this month at a media conference co-sponsored by Lipper and SunStar.

There is no question that the overall S&P 500 has taken a hit to its earnings, said Ashwani Kaul, an analyst with Reuters.

While the technology and healthcare sectors performed very well in the third quarter, with earnings increasing 15% and 12%, respectively, the S&P's anguish has been largely driven by the meltdown of the financial sector, segments of which saw their earnings dive between 26% and 33% in the third quarter, he said.

Earnings for the collective S&P 500 in the third quarter are in negative territory-the first time earnings have been down since the first quarter of 2002.

There will likely be more bad news during the fourth quarter, as the expectation is that there will be even more writedowns of subprime mortgage-linked securities, Kaul said.

"Wall Street wants everyone to write off the losses and move on," he said.

It's too early to predict whether there will be a full-blown earnings recession, Kaul continued, although most analysts are predicting that earnings should recover sometime within the first or second quarter of 2008. In fact, Reuters projects the S&P's annual earnings to weigh in at about 14.4% in 2008. But for the short term, "the outlook is tepid," Kaul said.

Although not directly impacted by the subprime mortgage meltdown, the high-yield bond market has definitely felt ripples.

"The sub-prime situation is bothering the high-yield [market], even though high yield is not a structured product like a CDO [collateralized debt obligation]," confirmed Greg Hopper, portfolio manager at Julius Baer in New York. "While high yield isn't subprime, there have been some excesses, including high-yield [over]issuance," he added.

Still, investors' fears that the two unrelated markets are somehow linked has many throwing out the baby with the bathwater, Hopper said.

The credit market turmoil hasn't produced all bad news. Fund managers are finding ways to capitalize on opportunities.

James Rogers, managing director of The Roosevelt Investment Group in New York, which manages the $30 million Roosevelt Anti-Terror Multi-Cap Fund, has invested in the ProShares UltraShort Financials exchange-traded fund, which aims to produce a positive return when its sector dives.

This leveraged ETF seeks to provide 200% of the inverse return of the sector index it tracks and has posted a 14% return since its inception on Jan. 30.

Another fund manager taking an opportunistic approach to the credit crisis is Michael Corelli, portfolio manager of the $260 million Allianz OCC Opportunity Fund, a diversified small-cap growth fund that takes a secular, thematic approach. Corelli seeks to profit from growth in litigation, legislation and regulation due to the credit market meltdown.

One stock Corelli likes right now, for instance, is Huron Consulting Group of Chicago, which assists companies in financial distress.

The credit market crunch of this past August also offered some hard lessons for investment managers.

One lesson: "Things are a lot more correlated than you think they are," said Gita R. Rao, quantitative equity portfolio manager at MFS Investments of Boston, which recently held its own media conference here.

The second lesson is that sticking to your discipline is very important, Rao added.

MFS, which combines both a fundamental investment process with a models-based quantitative investment approach, found that many of its quant models simply didn't work in early August when the losses in credit-sensitive securities were being covered by hedge fund managers. Instead, the credit crisis produced a domino effect of troubles.

While a team of MFS fundamental analysts are busy picking the stocks they like and dislike based upon their own criteria, MFS' quant team simultaneously runs its models to select stocks found to be attractive based upon the broader markets' metrics and those found to be unattractive. The two sides then collaborate on winners in which to invest and losers in which to take short positions.

So, just how uncorrelated are the fundamental and quantitative investment approaches at MFS? "That's hard to say," Rao noted. "In times of dislocation, they tend to become more correlated. Over the long term, correlation is under 50% and closer to 30%."

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