THE OAKMARK EQUITY AND INCOME FUND Report from Clyde S. McGregor and Edward A. Studzinski, Portfolio Managers

THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK EQUITY AND INCOME FUND FROM ITS INCEPTION (11/1/95) TO PRESENT (6/30/07) AS COMPARED TO THE LIPPER BALANCED FUND INDEX9
		Average Annual Total Returns (as of 6/30/07)
	Total Return Last 3 Months*	1-year	5-year	10-year	Since Inception (11/1/95)
Oakmark Equity & Income Fund (Class I)	4.04%	14.86%	11.26%	12.62%	13.57%
Lipper Balanced Fund Index	4.11%	15.41%	9.05%	6.88%	8.37%
S&P 5005	6.28%	20.59%	10.71%	7.13%	10.27%
Lehman Govt./Corp. Bond10	-0.49%	6.00%	4.69%	6.08%	5.95%
The graph and table do not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares.
Expense Ratio as of 9/30/06 was 0.86%.
The performance data quoted represents past performance. The above performance information for the Fund does not reflect the imposition of a 2% redemption fee on shares held for 90 days or less to deter market timers. If reflected, the fee would reduce the performance quoted. Past performance does not guarantee future results. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Average annual total return measures annualized change, while total return measures aggregate change. To obtain most recent month-end performance data, visit oakmark.com.
* Not annualized

“Life can only be understood backwards; but it must be lived forwards.”
Kierkegaard

Quarter Review

The Equity and Income Fund achieved a return of 4% in the quarter ended June 30, 2007, matching the 4% return that Lipper reported for its Balanced Fund Index. For the first six months of the current calendar year, the Fund earned 7% and the Lipper Balanced Fund Index returned 6%. Moreover, we are pleased to report a return of 14% compounded annually since the inception of the Equity and Income Fund. Strong contributors to performance during this quarter were MedImmune (acquired by AstraZeneca); EnCana (strong long-term fundamentals and rebound in energy prices); XTO Energy (continuation of outstanding fundamental results coupled with potential restructuring); ConocoPhillips (rebound in energy prices and strong refining margins); Ingersoll-Rand (restructuring). Detractors from returns for the quarter were SAFECO (concern about pricing competition in personal auto); News Corporation (uncertainty surrounding the potential acquisition of Dow Jones); and UST (Altria entered into the smokeless tobacco arena).

As value investors, we are especially happy when merger and acquisition activity confirms that we have been searching for value in the right places. During the quarter, your Fund benefited from this activity in a number of its holdings. As mentioned above, MedImmune was acquired by AstraZeneca at a significant premium to its then market value and at a price at the high end of most assessments of the firm’s private market value. Another long-term holding in the Equity and Income Fund, Ceridian, received a buy-out offer of $36 per share from a combination of private and public equity investors. Finally, CDW Corporation is being taken private at a price of $87.75 per share by private equity firm Madison Dearborn Partners, LLC. On balance, we are pleased with this buyout activity. We will confess to a certain sadness, however, where we understood the valuation parameters and prospects of a business and it is called away from us. In all three of the above instances, a major factor in this activity was the arbitrage opportunity available in the longer end of the high-yield debt markets. Put simply, buyout companies are able to obtain “junk” financing at a spread roughly 300 basis points over the equivalent maturity risk-free U.S. Treasury; the historic pricing for such debt has typically been between 600 to 800 basis points above the risk-free U.S. Treasury. One of the current market mysteries is why high-yield investors have accepted such low compensation for their risk. It also indicates why we have been unable to find acceptable investments in the high-yield marketplace.

The quarter’s merger and acquisition activity also spurred more portfolio activity than usual. We eliminated MedImmune from the portfolio and initiated positions in Apache Corporation, Carter’s Incorporated, Mohawk Industries, and Newfield Exploration. We also used the drop in interest rates in June to manage our tax position and to lower the duration on our fixed income portfolio to 2.1. This is a somewhat more defensive position, but we feel it is appropriate in a rising rate scenario. We confess that we are agnostic as to what happens to short-term rates. We believe the Federal Reserve is in the unenviable position of being unable to raise or lower rates, given food and energy inflation on the one hand and real estate deflation on the other. As a major underpinning of our fixed income philosophy is capital preservation, we are comfortable with the current portfolio.

Leverage, What Leverage?

Recent stories in both the financial and general press have centered on the debacle surrounding the subprime mortgage debt hedge funds managed by an asset management subsidiary of Bear Stearns. At this point, it appears that the injection of capital (apparently borrowed) by Bear Stearns will keep one of these funds afloat. The other one appears to be a candidate for liquidation. What concerns us is that to date the problems of both of these funds have been compounded by an apparent paucity of acceptable bids when some of the positions were apparently put up for sale. In a marketplace of sophisticated players, one would expect opportunistic bidders to emerge if easy profits were available. The fact that they did not suggests that all of the sub-prime problems are not as yet known and fully priced into the market. In the second half of 2007, according to Stephanie Pomboy of MacroMavens, the volume of subprime Adjustable Rate Mortgages (“ARMs”) due to reset to higher rates is more than double the amount that reset in the first half. In the past, new homeowners could use their minimal equity to refinance into a fixed-rate mortgage. At this point, it would appear that many of these borrowers have little or no equity and will be faced with some not very appetizing choices when their mortgages reset. From Fannie Mae and LoanPerformance (FARES) data, Stephanie Pomboy says: “Based on the share of ARMs in some state of negative equity at the end of last year and the decline in home prices thus far in 2007, a stunning $693B in mortgage loans are already in the red.”11 These figures indicate that, at a minimum, volatility in this area will continue for a while. While many institutions have limited their exposure to this storm, those with weaker balance sheets, insecure funding sources and/or high exposure to low quality mortgages will likely face substantial risk.

Hedge Funds Redux?

The other part of this story that has perplexed us for some time is the attractiveness of hedge funds to so-called sophisticated investors. For the longest time, it seemed that the only explanation for these funds’ obscenely high fees (typically 2% a year plus 20% of the excess return once a certain threshold return was achieved) had to be superior performance. In that vein, we commend to you an article in the July 2, 2007 issue of The New Yorker titled “Hedge Clipping” by John Cassidy, which suggests that the fee-adjusted returns of many hedge funds do not outperform their benchmarks that have a similar risk profile. Indeed, an increasing body of research demonstrates that (a) the fees often negate the excess returns generated by many hedge funds and (b) a large part of the variation among hedge fund returns is driven by broad market movements in various asset classes, rather than the investment skills of the hedge fund managers. There is also the question of proper attribution to account for the problem of survivorship bias in return calculations. That is, when hedge funds go out of business, their returns vanish from the databases. When all is said and done, we suspect that much of hedge funds’ deemed attractiveness is the result of a combination of superior marketing, cocktail party cachet, and herd-like institutional behavior.

Going Forward

At the end of this quarter, 60.3% of the Equity and Income Fund was in equities, 36.2% in fixed income, and the balance held in cash. Although we continue to search for undervalued investment opportunities, as the market has moved upward, they have become more difficult to find. While we do not usually take minimalist positions in individual stocks, in this market, it may appear that we are so doing. In fact, however, it is simply that a security’s price has moved very quickly away from the price at which we were willing to make an investment. The short time horizon of many of our competitors (driven we suspect by the incentives of their fee structures) is a major contributor to that short-term price volatility. That said, we are extremely comfortable sitting where we are and waiting for our price to come around again. We believe our competitive advantages are our long-term time horizon and our focus on business valuation. We consider the portfolio to be defensively postured at this point. Given that our perspective is that there is a paucity of new situations presenting out-sized risk-adjusted returns at present, this defensive posture will most likely continue for the foreseeable future. Should opportunities present themselves that warrant a different posture, we look to react accordingly. We will write to you again after the end of the next quarter.

Schedule of Investments—June 30, 2007 (Unaudited)