Lead manager Jeffrey Gundlach's "secret sauce" seeks to increase returns while lowering risk. By Nellie S. Huang, Senior Associate Editor January 10, 2013 The managers of DoubleLine Total Return Bond (symbol DLTNX), led by Jeffrey Gundlach, were loading up on government-backed mortgage securities months before the Federal Reserve began buying the bonds last September. "We saw the writing on the wall," says Vitaliy Liberman, a DoubleLine analyst who specializes in mortgage securities. "So we changed the allocation of the fund a bit in anticipation" of the Fed's purchases. As cash flowed into the fund, the managers allotted the lion's share of it to those high-quality debt instruments and devoted less to non-agency mortgage-backed bonds.KIPLINGER 25: Our Favorite No-Load Mutual Funds It was a good move. Over the past 12 months, Total Return, a member of the Kiplinger 25, gained 9.4%, outpacing the Barclays Capital Aggregate Bond index by 5.3 percentage points. It also outdid the average fund in its category -- medium-maturity bond funds -- by 2.5 percentage points. (All results are through January 9, unless otherwise noted.) Mortgage-backed securities are Total Return's bread-and-butter investments. Gundlach and his co-manager, Philip Barach, have been honing their approach to this subset of bonds since they ran TCW Total Return from 1993 to 2009. The fund's 7.2% annualized return over that time beat the Aggregate Bond index, considered a proxy for the high-quality part of the U.S. bond market, by an average of one percentage point per year. They left TCW in 2009 to found DoubleLine Capital, which now runs six mutual funds -- five open-end and one closed-end (closed-end funds trade on exchanges just like stocks). Advertisement By blending two kinds of real estate debt securities, the managers lower the fund's overall risk. It's a combination that Gundlach likes to call the "secret sauce." On the one side, the managers own government-agency mortgage-backed securities, such as those backed by the Government National Mortgage Association, which carry no default risk but a fair amount of interest-rate risk (bond prices typically move in the opposite direction of interest rates). The managers balance the government-backed bonds with non-agency mortgage securities, which have less interest-rate risk but high default risk. The risks offset each other, as does the typical performance of the bonds themselves: When the economy suffers, the agency bonds do well; when the economy does well, typically causing interest rates to rise, the non-agency securities do better. "So we have this zigging and zagging," says Gundlach. The zigging and zagging has worked well for Total Return. And the fund has done especially well over the past year in comparison with funds that invest only in GNMAs. Over that period, for example, Total Return beat Vanguard GNMA by 7.3 points. Of course, the fund isn't always partial to GNMAs. In mid 2011, for instance, concerns about Europe and the U.S. debt ceiling resulted in a big sell-off in non-agency securities, which are pools of mortgage bonds, issued by banks or other lenders, that are not guaranteed by a government agency and are sold to institutional investors. So Gundlach and Barach bought them aggressively, to the point that they accounted for half the fund's assets. These days, with the Federal Reserve engaged in its third quantitative-easing program, which involves the buying of government-backed mortgage securities, the fund tilts more toward GNMAs (about 49% of assets) than non-agency bonds (about 34%). "We're still buying non-agency bonds, but we'd like to see the price come down to make a significant purchase," says Liberman. Meanwhile, the Fed's purchases have pushed GNMA prices up and their yields down. So the fund, which yielded a rich 8% a year ago, now yields 4.3% -- decent by today's standards but not extraordinary. The rest of the fund -- about 17% -- is sitting in cash. Assets have more than doubled, to $37.5 billion, over the past 12 months, so the fund holds about $6.5 billion earning zilch. Big cash stashes are typical for Total Return. A year ago, it had 15% of its assets in cash. Gundlach and Barach like to have a lot of ammunition with which to buy bonds when they go on sale. "It's a volatile environment," says Liberman. "We may have a pivotal event -- say, rising rates -- so it will be very important to be able to maneuver in the unfolding scenario." Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Subscribe now!