IBF - Updates - 2008 (Q2 v1.0)

Copyright © 2008 by Institute of Business & Finance. All rights reserved. v1.0

INSTITUTE OF BUSINESS & FINANCE

QUARTERLY UPDATES

Q2 2008

Quarterly Updates

Table of Contents

BONDS AND CONVERTIBLES

BOND YIELD SPREADS 1.1

T-BILL YIELD GAP 1.1

FIXED INCOME 1.1

HIGH-YIELD BONDS 1.3

EMERGING MARKET DEBT 1.3

COUNTRIES HOLDING U.S. DEBT 1.4

SAVINGS BONDS 1.5

MUNICIPAL BOND INSURANCE 1.7

CONVERTIBLES 1.7

CLOSED-END FUNDS

AUCTION-RATE SECURITIES 2.1

PREFERRED STOCK AND CLOSED-END FUNDS 2.1

CLOSED-END FUND 2008 DISCOUNTS 2.2

COMMODITIES

PENSION FUNDS AND COMMODITY INVESTMENTS 3.1

COMMODITIES 3.1

ECONOMICS

FDIC COVERAGE 4.1

U.S. RECEIPTS AND DISPERSEMENTS 4.2

GLOBAL ECONOMICS 4.2

ENHANCED APPRECIATION NOTES

EANS 5.1

COMMENTARY 5.3

GLOBAL / FOREIGN

MEASURING ECONOMIC GROWTH 6.1

INTERNATIONAL STOCKS 6.2

CATEGORIZING GLOBAL MARKETS 6.2

EMERGING MARKETS 6.3

FOREIGN VALUE STOCKS 6.4

HEDGE FUNDS

HEDGE FUND SHAKEOUT 7.1

MODERN PORTFOLIO THEORY

ASSET ALLOCATION 8.1

ACADEMIC STUDIES 8.1

T-BILL RETURNS AFTER TAXES AND INFLATION 8.1

VOLATILITY AS RISK 8.2

BRIEF HISTORY OF ASSET ALLOCATION 8.2

REBALANCING 8.2

CORRELATION EXPLAINED 8.2

CORRELATION EXPLAINED 8.3

STANDARD DEVIATION 8.5

TAXABLE FIXED-INCOME ALLOCATION 8.6

MUTUAL FUNDS

FUNDAMENTAL INDEXING 9.1

130/30 FUNDS 9.1

TOP PERFORMING STOCK FUNDS 9.1

TOP PERFORMING BOND FUNDS 9.2

STYLE DRIFT 9.2

ULTRA-SHORT BOND FUNDS 9.3

FRONTIER FUNDS 9.3

FRONTIER INDEX 9.4

TRANSACTION COSTS 9.4

MUTUAL FUND INDUSTRY GROWTH FUND BIAS 9.5

MICROCAP ADVANTAGE 9.5

EQUITY STYLE PERFORMANCE 9.6

PREFERREDS

PREFERRED STOCK 10.1

REAL ESTATE

S&P/CASE-SHILLER HOME-PRICE INDEX [2000-2008] 11.1

HARVARD REAL ESTATE STUDY 11.3

REAL ESTATE INVESTMENTS 11.3

MORTGAGE SAVINGS 11.5

MORTGAGE IMPACT REDUCTION 11.5

FOREIGN REAL ESTATE FUNDS 11.5

RETIREMENT

STANDARD OF LIVING PERSPECTIVE 12.1

RETIREMENT PAYOUT FUNDS 12.2

RETIREMENT INCOME STRATEGIES 12.2

PROJECTED PROBABILITY OF SUCCESS 12.5

RETIREMENT SURVEY RESULTS 12.6

SOCIAL SECURITY SPOUSAL BENEFITS 12.7

GIFTS AND QUALIFYING FOR MEDICAID 12.8

HOME OWNERSHIP AS AN INVESTMENT 12.8

NURSING HOME RATING SYSTEM 12.9

HSA ACCOUNTS 12.9

RETIREMENT STATISTICS 12.10

STOCKS

HOW TO LOVE A BEAR MARKETS 13.1

S&P SECTOR WEIGHTINGS 13.2

2007 DOW JONES INVESTMENT SCOREBOARD 13.2

2007 DOW JONES GLOBAL INDEXES 13.3

U.S. STOCK MARKET VOLATILITY 13.4

THE 20 LARGEST U.S. COMPANIES 13.6

DOW JONES INDUSTRIAL AVERAGE 13.6

TAXES

TOP PERFORMING FUNDS AND TAX EFFICIENCY 14.1

QUARTERLY UPDATES

BONDS AND CONVERTIBLES

THE ECONOMY 1.1

QUARTERLY UPDATES

IBF | GRADUATE SERIES

1.BOND YIELD SPREADS

From 1998 to the middle of 2008, the yield spread between intermediate-term U.S.

Treasury bonds and intermediate-term municipal bonds has ranged from -1.0% to over

1.7%, averaging 0.7% over the entire period (note: -1.0% means that the yield for

municipals was a full point higher than similar-maturing treasuries). In the case of high-

yield corporate bonds and intermediate-term treasuries, the yield spread has ranged from

a low of 2.0% up to a high of 6.3%, with an average of 3.5% over the 1998-2008 period.

T-BILL YIELD GAP

Over the past 26 years (1983-2008), yields on three-month U.S. Treasury bills have been

lower than yields on 10-year Treasury notes only 22 months out of 313, or about 7% of

the time, according to The Wall Street Journal.

FIXED INCOME

It is a sad fact that fixed-income asset allocation is often overlooked by advisors and

the financial services industry. Bonds are issued by governments and corporations with

differing maturity dates. Short-term bonds have an average maturity of three years or

less, intermediate-term average 4-9 years and long-term bonds have maturities averaging

10 or more years. Historically, the average yield spread between one-year and 10-year

Treasuries has been about 0.9%. From the beginning of 1953 to the end of 2005, these

yield spreads have ranged from a negative 2% (1980) to over 3% (2002 and 2004). The

yield spread between BBB-rated and AAA-rated corporate bonds has ranged from a little

less than 0.5% to about 2.5% over the same period.

The Lehman Brothers U.S. Aggregate Bond Index tracks more than 6,600 U.S. Treasury,

government agency, investment grade corporate and Yankee bonds; the index does not

include TIPS. The average maturity for this Lehman index is about 7.5 years. Over 70%

of the holdings are in U.S. Treasuries, government agency and government-backed

mortgage bonds; 100% of the index is comprised of investment grade debt instruments,

as shown in the table below.

THE ECONOMY 1.2

QUARTERLY UPDATES


Lehman Bros. Aggregate Bond Composition

Issuer % of Index Quality % of

Index

Treasuries 23% AAA 77%

Government agencies 12% AA 3%

Mortgage-backed 35% A 10%

Corporate & asset-

backed

26% BBB 10%

Yankee bonds (foreign) 4% BB 0%

In recent years, there has been tremendous excitement about the inflation-adjustment

aspect of TIPS. It should be kept in mind that all bonds already include an inflation

forecast built into their expected return; part of the daily price movements of bonds

reflects current projections about inflation. One method used to calculate the expected

future rate of inflation is to subtract the yield on a current TIPS from a traditional U.S.

Treasury with a similar maturity.

From the end of 1998 to the end of 2004, the expected 20-year rate of inflation (as

measured by the formula above) has ranged from about 1.25% to about 3.1%. A strong

argument could be made that the real return on TIPS of the same maturity would be

constant over time because U.S. Treasuries have no credit risk. However, when inflation

expectations are high, the real return on TIPS tends to be higher than when inflation

projections are low. There are two possible reasons for this disparity. First, when

inflation concerns become great, a certain level of panic sets in. Second, income taxes

must be paid on both the real return and the inflation portion of the TIPS; investors need

to make more money to pay the extra taxes on the inflation portion of the appreciation.

The performance data on TIPS is somewhat suspect for two reasons: [1] they have only

been around since 1997 and [2] TIPS prices went up artificially too much (high demand)

when mutual fund companies started adding them to their portfolios—an event that is not

expected to be repeated in the future.

THE ECONOMY 1.3

QUARTERLY UPDATES


An often overlooked alternative to TIPS are U.S. Treasury iBonds, another type of

inflation-protected government security. Just like TIPS, the interest and inflation gain

from iBonds is exempt from state and any local income taxes. There are two features that

make this security somewhat unique. First, they are sold in face value denominations of

$50, $75, $100, $200, $500, $1,000, $5,000 and $10,000 (with a maximum purchase of

$30,000 per year). Second, federal income taxes on all earnings can be deferred for up to

30 years; iBonds cashed in before five years are subject to a three-month earnings

penalty. Since bond indices do not generally include inflation-protected securities, adding

iBonds and/or TIPS to a client‘s portfolio can provide an additional layer of protection

and diversification.

HIGH-YIELD BONDS

Because of the historical inconsistency between bond default risk premiums and equity

risk premiums, adding BB- or B-rated corporate bonds can increase the diversity of a

fixed-income portfolio. Lower rated bonds (CCC or less) have a higher correlation with

equity returns. Therefore, if you are going to invest part of the client‘s holdings into very

low quality bonds, expect that about 40% of such allocation should be counted as part of

the equity portion.

EMERGING MARKET DEBT

The first emerging market bond funds were introduced in 1993. The table below

compares the Lehman Brothers Aggregate Bond Index (which is 100% investment grade)

with emerging market bond funds. As you can see, the correlation between the two is

positive (+0.5) but still low enough to make emerging market debt a strong contender for

a portion of the fixed-income allocation.

Emerging Market Bond Funds

1993-2004

LB Aggregate

Bond Index

Emerging Market

Bond Funds

Annualized return 7.4% 12.2%

Standard deviation 6.3% 18.5%

Correlation to LB +0.5%

THE ECONOMY 1.4

QUARTERLY UPDATES


COUNTRIES HOLDING U.S. DEBT

As of June 2007, the major foreign holders of U.S. Treasury securities were: Japan

($612b), China ($405b), U.K. ($190b), oil exporting countries ($122b), and Caribbean

banking centers ($49b).

THE ECONOMY 1.5

QUARTERLY UPDATES


SAVINGS BONDS

Savings bonds are issued by the U.S. Treasury and are only payable to the registered

owner; they are not negotiable (zero marketability). Savings bonds can be purchased for

as little as $25 and can earn interest for up to 30 years. The bonds can also be cashed in

12 months (or later) after purchase. There are three types of savings bonds: Series E/EE

Bonds, I Bonds and Series H/HH Bonds. The treasury no longer issues E Bonds, H Bonds

or HH Bonds. The table below compares I Bonds and EE Bonds, the two types of savings

bonds still issued by the U.S. Treasury (source: www.treasurydirect.gov.com). While

reviewing the table, keep in mind the following points:

[a] Both I Bonds and EE Bonds are issued in two different formats and one of the formats

is a physical certificate (paper), similar in size to the old punch card used by computers

well over 20 years ago.

[b] The annual purchase limit for both I Bonds and EE Bonds is $30,000 per Social

Security number per year. However, these amounts double if the investor makes the

second purchase as ―paper‖ (physical certificate). Thus, in theory, a single investor could

buy $60,000 worth of I Bonds each year and an additional $60,000 in EE Bonds the same

year(s).

[c] In the case of EE Bonds, interest payments are only fixed if the EE Bonds were

purchased after May 2005; for EE Bonds bought between May 1997 and April 2005, the

interest payment is based on 90% of the six-month averages of five-year Treasuries.

[d] Finally, the financial institution that initiated the purchase for the investor reports

interest earnings to the federal government each year the bond is owned.

http://www.treasurydirect.gov.com/

THE ECONOMY 1.6

QUARTERLY UPDATES


I Bonds vs. EE Bonds

I Bonds EE Bonds

Denominations Any amount over $25 Any amount over $25

Denominations (paper) $50, $75, $100, $200,

$500, $1,000, $5,000 and

$10,000

$50, $75, $100, $200,

$500, $1,000, $5,000 and

$10,000

Purchase Price Face value Face value

Purchase Price (paper) 50% of face value*

Annual Purchase Limit $30,000 per SS# $30,000 per SS#

Annual Limit (paper) $30,000 per SS# $30,000 per SS#

Interest Earnings [1] Fixed rate of return

and semiannual CPI

increase

[2] interest compounds

semiannually for 30 years

[1] Fixed rate of return

[2] interest compounds

semiannually for 30 years

Redemption Can be redeemed as early

as 12 months after

purchase

Can be redeemed as early

as 12 months after

purchase

Early Redemption

Penalties

3-months of interest if

redeemed w/in 1st 5 years

3-months of interest if

redeemed w/in 1st 5 years

Taxes [1] exempt from state and

local income taxes

[2] other tax benefits if

used for education

expenses

exempt from state and

local income taxes

* guaranteed to reach face value in 20 years

THE ECONOMY 1.7

QUARTERLY UPDATES


MUNICIPAL BOND INSURANCE

Roughly half of the $2.6 trillion municipal bond market is insured by firms such as

MBIA, Ambac Financial Group and Financial Guarantee Insurance. If there is a default,

the insurer guarantees repayment. Fortunately, few municipal bonds ever default. For

example, municipal bonds with a BB rating have a cumulative average 10-year default

rate of 1.74% since 1970 (meaning an average of just 0.74% per year); BB rated

corporate bonds have a 29.93% 10-year cumulative default rate (meaning an average of

2.99% per year), according to Municipal Market Advisors.

The security of municipal bonds becomes much greater when looking at BBB rated

bonds by S&P, a mere 0.32% cumulative average over 10 years (or 0.03% per year),

versus 0.6% cumulative 10-year average for AAA rated corporate bonds (or 0.06% per

year).

Before the 2007-2008 bond-insurer crisis, bond insurers charged about 30% of the

interest-rate savings an issuer would get; during the early parts of 2008, that figure rose to

80-90%. In some cases, the need for bond insurance seems weak; California takes in over

$100 billion of revenue each year (posing the question, ―Would you rather be exposed to

the state of California for 30 years or the credit of a bond insurer for the next 30 years?‖).

CONVERTIBLES

The interest rate on convertible bonds is generally a few percentage points lower than that

paid by the same issuer‘s regular bonds, your clients have the potential to make money

off the stock price. Typically, the trigger point where an investor can convert to common

stock is 15-25% higher than the current stock price. Roughly $11 billion is invested in

mutual funds that specialize in convertibles. Some funds are careful about how much is

invested in convertible preferreds because it is believed that this kind of a convertible is

riskier than its convertible bond counterpart. Some convertible funds like common stocks

when such equities have yields higher than their convertible counterparts.

QUARTERLY UPDATES

CLOSED-END FUNDS

CLOSED-END FUNDS 2.1

QUARTERLY UPDATES


2.AUCTION-RATE SECURITIES

Individuals and institutions own auction-rate securities. Municipalities, charities, student

lenders and closed-end mutual funds issue these securities. Auction-rate securities are

long-term debt that has short-term debt features. Their interest rates supposed to be reset

via weekly or monthly auctions conducted by Wall Street brokers. Investors found the

securities appealing because they were told that the yields were comparatively high (they

were and are) and they can be easily sold (not necessarily true).

Starting in February 2008, the marketplace began to see that Wall Street was no longer

supporting auction-rate securities, causing the marketplace for these securities to freeze

up. Sellers have taken discounts ranging from 2% for municipal securities up to 30% for

student loan backed securities (that were rated AAA just a few months before February

2000). Some institutions have sold their auction-rate securities for a 43% discount.

PREFERRED STOCK AND CLOSED-END FUNDS

Preferred stock is often issued by a closed-end fund (CEF) to buy more securities with

the expectation of juicing up returns. The preferreds act like a short-term debt with a

dividend rate that is reset periodically by auction. During the middle of February 2008,

the marketplace for these kinds of preferreds froze due to concerns about the mortgage

market and unfamiliar types of securities. The SEC requires CEFs to have $3 of assets for

every $1 of leveraged debt, but only $2 of assets for every $1 of preferred stock or other

senior securities.

CLOSED-END FUNDS 2.2

QUARTERLY UPDATES


CLOSED-END FUND 2008 DISCOUNTS

As of the middle of January 2008, closed-end funds (CEFs) were trading at an average

discount to NAV of just under 7% (reaching almost an 11% discount in November 2007).

Over the past 10 years (ending 12-31-2007), shares usually sold for 4% below NAV,

according to Wachovia Securities. The larger than normal gap represents investor

concerns over the credit markets and, to a lesser degree, tax-related trading.

During January of 2007, a record for the largest CEF was set by Alpine Total Dynamic

Dividend Fund, when it raised $3.5 billion; a month later, Eaton Vance raised $5.5 billion

for its Tax-Managed Global Diversified Equity Income Fund. Less than a year later, the

Eaton Vance investors had experienced a cumulative loss of over 8%, even though the

fund‘s assets had appreciated over 7%. Of the seven $1+ billion CEFs that hit the market

in 2007, all but one are trading at discounts of more than 5%. It appears that the

marketplace has viewed all of these CEFs the same, regardless of their portfolio

composition.

QUARTERLY UPDATES

COMMODITIES

COMMODITIES 3.1

QUARTERLY UPDATES


3.PENSION FUNDS AND COMMODITY INVESTMENTS

Over the past several years, pension funds have poured billions of dollars into

commodities-futures indexes. A number of years ago, pension plans discovered that

major commodity indexes tend to do well during periods of inflation and when there are

sell offs in the U.S. stock market. PIMCO manages about $15 billion in commodity index

funds. California Employees’ Retirement System (Calpers), which oversaw $247

billion as of June 2008, has about $1.1 billion in commodity holdings.

According to Wilshire Trust Universe Comparison Service, the median returns for public

pension plans, fiscal years ending June 30th

were:

Median Returns of Public Pension Plans

[fiscal year ending 6-30]

Year Return Year Return

2000 10% 2004 15%

2001 -5% 2005 10%

2002 -6% 2006 10%

2003 4% 2007 16%

COMMODITIES

The global market for commodities is not only huge, trading takes place 24 hours a day.

The Money and Investing section of The Wall Street Journal provides both spot and

futures prices for a number of commodities daily. The spot price shows what the physical

commodity is selling for today, while the futures price reflects the contractual price for

delivery of the commodity at some time in the future. The Commodity Research Bureau

(CRB) Spot Market Price Index (published daily in the WSJ) shows the price changes in

close to two dozen actively traded commodities:

COMMODITIES 3.2

QUARTERLY UPDATES


CRB Index Components

cocoa beans copper scrap rubber lard

corn burlap steel scrap rosin

steers cotton wool tops tallow

sugar lead scrap butter tin zinc

wheat print cloth hides hogs

hogs energy-related items

From 1956 to 1980, commodity prices generally kept pace with inflation; prices then

moved sideways for the following 23 years (meaning commodity prices did not keep

pace with inflation)—since 2003 there has been a jump in such pricing.

Advisors need to know the leverage that can be used for futures contracts. Payment for

futures contracts is a down payment, referred as margin. The margin ranges from 2% to

7% of the contract‘s value; the margin is placed in escrow until the contract expires. With

such a high level of leverage, it is easy to imagine the past and future volatility of this

investment vehicle.

The rolling 36-month correlation between the CRB Total Return Index (commodities)

and intermediate-term Treasury bonds from 1985 to the end of 2004 was almost random,

rarely deviating from a range of -0.3 to +0.3. The same can be said for the CRB and U.S.

stocks during the same period. The main difference between the use of stocks and bonds

was that in the case of bonds, the correlation was mostly in the 0.0 to -0.3 range; when

stocks were correlated with commodities the relationship was still random but roughly

half the time the range was 0.0 to -0.3 and the other half of the time it was in the 0.3 to

+0.3 range. Historically, these correlations show that adding a commodities index fund or

ETF would have been a very good risk-reduction tool.

COMMODITIES 3.3

QUARTERLY UPDATES


Generally, commodity mutual funds invest in derivatives of commodity total return

indexes. The three most popular indexes are the CRB (previously discussed), the

Goldman Sachs Commodity Index (GSCI) and the Dow Jones-AIG Commodity Index

(DJ-AIGCI):

Reuters-CRB Index—22 commodities equally weighted. This is also the oldest of these

three indexes, having begun in 1940.

GSCI Index—weighting of 24 commodities based on market value (a high oil price

means that there is a very large energy weighting)

DJ-AIGCI Index—weighting of 19 commodities that is also market-weighted; however,

no commodity group starts at more than 33% (e.g., energy) and no single component

(e.g., crude oil) may ever represent more than 15% of the overall index. This index is

annually reweighted and rebalanced.

The table below summarizes the annualized returns and standard deviations of these three

total return commodity indexes (plus T-bills) from 1991 through 2004.

Commodity Index Returns [1991-2004]

Reuters-CRB GSCI DJ-

AIGCI

T-Bills

Annualized Return 3.6% 5.7% 6.8% 3.9%

Standard Deviation 15.9% 17.2% 17.5% 0.5%

Potential downsides to using commodity mutual funds include: [1] potentially high

annual expense ratio plus initial sales charge and [2] tax inefficiency. The relatively

recent popularity of such funds means that some offerings including commodity-based

ETFs can have very competitive pricing.

QUARTERLY UPDATES

ECONOMICS

ECONOMICS 4.1

QUARTERLY UPDATES


4.FDIC COVERAGE

The Federal Deposit Insurance Corporation (FDIC) covers individual accounts up to

$100,000 per deposit per bank plus up to $250,000 for most retirement accounts. The

dollar figures include any accrued interest. For investors who have liquid assets in excess

of the coverage limits, they have three choices: [1] transfer money to a brokerage firm

that has SIPC coverage, [2] dividing the money up and using different banks or [3] use

the same bank but set up multiple, but different accounts.

Depositors who want to use the same institution for convenience purposes (or perhaps the

bank is offering a higher return) will want to make sure that any multiple accounts set up

are properly titled so that coverage extends to each account.

For example, a married couple could have a joint account, an individual account for each

spouse, two different retirement accounts and two revocable trust accounts payable on

death, naming each other as beneficiaries. Together, the couple would have combined

coverage of $1 million ($100,000 for each non-retirement account plus $250,000 for each

retirement account). In this example, coverage could be extended by adding additional

revocable trust accounts that listed other people as beneficiaries (e.g., children, siblings,

parents, etc.).

FDIC does not insure mutual funds, individual securities, life insurance policies or other

products purchased through the bank. In the case of a bank failure, depositors with more

than $100,000 per account (which would include any accrued interest) the amount of

reimbursement on the excess above $100,000 ($250,000 for retirement accounts) will be

based on the sale of the failed bank‘s assets. In general, depositors eventually get 70-80%

of the excess back.

If a bank has financial problems but is taken over by another bank, depositors have

nothing to worry about as long as the new bank has FDIC coverage. In such instances, it

is almost as if the original bank never failed.

FDIC coverage may increase in the future, but by law, this cannot happen until 2011. For

additional information, contact the FDIC consumer hot line at (877-275-3342); you may

also want to use the deposit insurance calculator at www.fdic.gov.

http://www.fdic.gov/

ECONOMICS 4.2

QUARTERLY UPDATES


U.S. RECEIPTS AND DISPERSEMENTS

For fiscal year 2008, total receipts collected by the U.S. Government are expected to be

$2.7 trillion. The largest source, $1.26 trillion, will come from individual income taxes,

followed by $949 from Social Security and Medicare payroll taxes, $339 from corporate

income taxes and $152 billion from excise and other taxes.

The proposed $3.1 trillion outlays for fiscal year 2009 are: $992 billion paid to Medicare,

Medicaid and similar beneficiaries, $644 billion paid to Social Security recipients, $671

billion to defense, $541 billion to nondefense spending and $260 billion of net interest

payments.

GLOBAL ECONOMICS

During 2007, the developing countries produced over 52% of global growth, compared to

37% during the late 1990s; China alone produced 18% of global GDP, compared to 15%

for the U.S. Developing countries now represent 29% of the total world‘s output,

compared to 18% in 1995. For 2008, the World Bank forecasts that the economies of

developing countries will grow over 7%, compared to 3% in older industrialized nations.

As of the beginning of 2008, the capitalization o the U.S. stock market was $17.5 trillion,

versus $17.8 trillion for all of the developing countries (which was just $2.2 trillion in

2000). In 2000, consumer spending for the 17 largest emerging economies was equal to

48% of U.S. consumer spending; in 2007 that number increased to 65%. The United

States‘ share of global imports fell from over 20% in 2000 to 14% in 2007. The import

share of the developing countries has grown from 33% in 2000 to 41% in 2007.

QUARTERLY UPDATES

ENHANCED APPRECIATION

NOTES

ENHANCED APPRECIATION NOTES 5.1

QUARTERLY UPDATES


5.EANS

Enhanced appreciation notes (EANs) are designed to provide some or all of the stock

market’s upside potential, while partially or fully insulating the investor from

downside risk (note: some of these securities have no downside protection—see table at

the end of this section). EANs are usually linked to major indexes and provide an

enhanced participation on the upside—up to a limit, or cap (note: index returns for

EANs never include dividends). For example, an EAN may be structured so that the

investor gets 1.25% to 3% for every 1% increase in the index. If the ratio is 1.25-to-1 and

the index went up 10% (excluding any dividend) during the life of the EAN, the investor

would receive a total return of 12.5%.

Issuers usually cap the upside potential of EANs. As an example, if the participation

rate is 200% or 300% on the upside, the cap for the year may be 13-20%. Some EANs

provide a level of downside protection, described as a percentage of the investor‘s

principal. For example, the first 10-20% of the loss may be fully absorbed by the issuer;

the investor would then incur any loss in excess of this figure. This means that the

investor has no chance of loss provided the index never exceeds the level of downside

protection provided by the issuer.

Typically, the barrier is set at 70-75% of the initial level (the value of the index when the

investor buys the EAN). If the covered loss is ever breached (20% or 25% in this

example), the investor would have full downside exposure past the point of protection. A

real world example will better illustrate the pros and cons of EANs.

A few months ago, Goldman Sachs issued a note linked to the iShares MSCI Emerging

Markets Index. The note had a 14-month maturity and offered investors a 200%

participation rate in the index, subject to a maximum total return of 28% over the 14-

month life of the note.

The note also included downside protection of 10%; meaning if the MSCI index fell by

10% or less, investors were still guaranteed to receive 100% of their principal at the end

of 14 months. If the decline were greater than 10%, investors suffered everything past the

-10% return (e.g., if the index dropped 17%, the investor would receive back 93% of

principal—the issuer incurred the first 10% and the investor the balance).

Continuing with the example above, as long as the cumulative return on the MSCI

Emerging Markets Index is positive but below 28%, the note can end up being a good

investment. Thus, if the index has a gain of 14%, an investor in the note will receive 28%

(remember, the note has a 200% participation rate).


QUARTERLY UPDATES


If the index has increased by over 28%, an investor would have been better off buying the

iShares directly (note: these iShares were up over 31% in 2005 and 29% in 2006). And, if

the index‘s return is just 1-2% (or some negative number) over the 14 months, an investor

would have done better in some type of conservative instrument (assuming it would have

returned 2-4% or more over the same period).

In general, if the market outlook is moderate, investors may consider a note with a 200-

300% participation rate that is tied to an index they feel comfortable with. EANs can be

used with a wide range of indexes and with time horizons that are in the 1-2 or 3-7 year

range. Some notes can be used to reduce risk (see downside ―Protection‖ below) with

possible limited upside potential—see ―Cap‖ below).

Examples of Enhanced Appreciation Notes [EANs]

Issuer Index Name Maturity Upside Cap Protection

Merrill

Lynch

Energy

Select

Sector

Accelerated

Return

Notes

14

months

300% 22.7% none

UBS Rogers

Intern‘l

Commodity

Return

Optimization

Securities

18

months

300% 28.5% none

Citigroup Hang Seng

China

Enterprises

Index

Stock Market

Upturn Notes

18

months

300% 30% none

Wachovia Nikkei 225 Enhanced

Growth

Securities

18

months

125% none none

BNP

Paribas

Basket of

global

indexes

Enhanced Index

Notes

3 years 135% none 25%

Morgan

Stanley

Basket of

five Asian

Indexes

Performance

Enhanced

Indexed-Linked

Securities

7 years 140% none 25%


QUARTERLY UPDATES


COMMENTARY

The desire for higher equity returns has led Wall Street to create a new class of products

generally known as "enhanced appreciation notes." (Different issuers may vary the

names.) These products are designed to provide investors with higher returns on the

upside (although they're often capped), while retaining the downside risk of the equity

investment.

Enhanced appreciation notes are typically linked to major indices and provide an

enhanced participation on the upside. So, instead of investors receiving 1% for every 1%

increase of the index, they may get 1.25% to 3% for every 1% uptick.

The benefits, however, aren't unlimited. Providing a participation of 200% to 300% on

the upside usually leads to introducing some kind of cap on the return. That may be

around 13% to 20% per annum--depending on the underlying index.

In addition, some of these enhanced appreciation notes provide investors with limited

downside protection. This could take a variety of forms. For instance, the first 10% to

20% of the loss could be fully covered by the note's issuer. Or there could be a kind of

contingent protection. This means that investors are fully protected as long as the

underlying index (or basket of indices) never breaches the downside protection barrier

during the life of the note. (The barrier is usually set at 70% to 75% of the initial level.) If

the protection barrier is ever breached, then investors have full downside exposure.

Let's take a close look at one recently issued enhanced appreciation note to understand

the types of enhancement (and downside protection, if any) that may be available to

investors looking to spice up their portfolio returns.

In November, Goldman Sachs issued a $75 million note (which the firm calls an

Enhanced Participation Note) linked to the iShares MSCI Emerging Markets Index Fund.

The note's maturity was approximately 14 months, and it provided investors with 200%

participation on the upside of the underlying index, subject to a maximum return of

28.2% over 14 months.

The note also included limited downside protection of 10%. This means that if the

underlying index declines by 10% or less, investors are still guaranteed to receive 100%

of their principal back. But, if the decline is more than 10%, investors are only on the

hook for any additional loss in excess of the first 10%. Thus, if the index declines by

15%, investors only lose 5% of their invested principal.


QUARTERLY UPDATES


To understand if such a product is an attractive substitute for a direct investment in the

iShares MSCI Emerging Markets Index Fund, let's examine the advantages and

disadvantages of investing in it. For the sake of simplicity, we'll disregard the dividends,

which are about 1.4% per annum and are paid to the holders of the iShares MSCI

Emerging Markets Index Fund, but aren't passed on to holders of the note.

If the return on the underlying index is positive, but below 28.2%, then investors are

better off holding a note. For example, if the return on the underlying index is only 10%,

investors in the note will realize a return of 20%.

Similarly, if the return on the underlying index is negative, investors are better off

holding a note as well. For example, if the underlying index declines by 25%, investors

will lose only 15%, thanks to the buffer built into the note. The only scenario in which

they are better off holding the underlying iShares MSCI Emerging Markets Index Fund is

when it generates more than 28.2%. That's quite possible, since the price returns on this

fund were 31.16% in 2005 and 29.37% last year.

Nevertheless, if investors are expecting a moderately bullish market with single-digit or

low-double-digit returns, then such Enhanced Participation Notes like the Goldman Sachs

one may well be a more attractive alternative than a direct investment in the iShares

MSCI Emerging Markets Index Fund.

We could use the same analysis to understand the potential value of any enhanced

appreciation note and to see whether it would fit into an investor's portfolio. Such an

analysis should typically follow the market view's lead. For example, if the market

outlook is for strong growth, then investors may want to select a note with no cap and

participation of 125% to 150%.

But, if the outlook is for moderate growth, then investors may opt for a note with a

greater participation of 200% to 300% and a cap that they're comfortable with. (This

means that within their market views, they're not giving up a significant portion of the

upside.)

It should be noted that underlying indices with high volatility (such as commodity or

emerging-markets indices) may allow note issuers to provide greater caps than they

would by linking their products to indices with lower volatility (such as the S&P 500

index).


QUARTERLY UPDATES


In either case, when deciding between a direct investment and an enhanced appreciation

note for clients, advisors may want to examine back-testing results over a predetermined

period, such as 15 years. (The test period should include both bull and bear markets.) If it

can be determined that the note adds value in most of the cases in different market

environments, then this product makes a strong case for itself. Otherwise, investors may

prefer to stick with a simple direct investment.

Enhanced appreciation notes have been purchased by a wide variety of investors, ranging

from retail investors to money managers to institutional clients. These products can be

used for strategic asset allocation to any particular market with investment horizons of

three to five years, as well as for shorter-dated tactical allocations of 12 to 24 months.

So in a nutshell, the added value of enhanced appreciation notes comes from

multiplicative returns within the investment forecast range. In some cases, such notes also

include partial or contingent downside protection, which aim to offset certain risks in

bear markets. It's up to the advisor and his client to determine if these products are a good

fit.

QUARTERLY UPDATES

GLOBAL / FOREIGN


QUARTERLY UPDATES


6.MEASURING ECONOMIC GROWTH

Nobel Prize winner in economics, Michael Spence, spent two years trying to figure out

why some counties get rich while the vast majority do no. The 2008 study, funded by the

World Bank showed the following:

[1] governments have played a large role in the development process;

[2] democracy is not essential for growth;

[3] free trade is not a prerequisite;

[4] some countries kept high barriers to imports, even while they were promoting exports;

[5] the successful countries have high levels of savings and investment;

[6] the successful countries ad flexible domestic markets and ―credible‖ governments;

The table below shows 13 countries that have grown at least 7% a year for at least 25

years during some period starting in 1950 or later (source: Commission on Growth and

Development).

Countries That Had 7%+ Growth Rates Since 1950

Country Growth Period Per Capita Income

Botswana 1960-2005 $5,000

Brazil 1950-1980 $5,000

China 1961-2005 $1,000

Hong Kong 1960-1997 $30,000

Indonesia 1966-1997 $500

Japan 1950-1983 $39,000

South Korea 1960-2001 $13,000

Malaysia 1967-1997 $6,000

Malta 1963-1994 $9,000

Oman 1960-1999 $8,000

Singapore 1967-2002 $26,000

Taiwan 1965-2002 $17,000

Thailand 1960-1997 $3,000


QUARTERLY UPDATES


INTERNATIONAL STOCKS

Foreign stocks tend to be more volatile than their U.S. counterparts for five reasons: [1]

currency risk, [2] political risk, [3] trading and custody risk caused by exchange

restrictions on outside investors, [4] weak judicial and regulatory oversight, and [5]

information risk caused by a lack of disclosure by foreign companies. For example, the

value of the U.S. dollar versus other major currencies rose from a level of 100 to 145 (a

45% increase) from 1973 to late 1986 and then dropped to a level of about 80-85 until

early 1995, increasing again to a level of about 110-115 in 2002, falling to a level of

about 80 by the beginning of 2005.

CATEGORIZING GLOBAL MARKETS

The world is divided into two markets: developed and emerging. The difference between

the two categories is based on both the size of the economy per capita and the level of

development in a country‘s public stock and bond markets. Developed markets have a

per capita GDP that exceeds $10,000 per year and a deep and mature securities

marketplace. Emerging markets can be divided into early-stage and late-stage,

depending on the countries progress toward a free-market economy. Examples of early-

stage emerging markets include Russia, Turkey, Poland, Indonesia and China. Late-

stage markets include Mexico, Taiwan, South Africa and South Korea. Emerging

market mutual funds concentrate their holdings on late-stage markets because those

countries generally have the largest percentage of market capitalization.

The EAFE index is comprised of approximately 1,000 stocks from 21 developed markets

located in Europe and the Pacific Rim. This index is designed to include at least 85% of

the market value of each industry group within those 21 countries. MSCI has

published returns on EAFE and its components since 1970. Index methodology and

return information can be found by going to www.MSCI.com. Since 1998, the correlation

between the EAFE Index and U.S. markets has increased from about +0.5 to +0.9. As

noted elsewhere, since correlations can change abruptly, international equity exposure is

still recommended by most advisors.

Over the years, changes in exchange rates and local stock market valuations have caused

EAFE country weighting to swing wildly. In the early 1970s, Europe represented 78%

market share; by 1988, due to a huge run-up in Japanese stocks, the Pacific Rim came to

make up 70% of the EAFE. A 1990s bear market in Japan pushed Europe‘s exposure

back up to a 70% market share. From the beginning of 1973 to the end of 2004, the

correlation between European and Pacific Rim indexes (using 36-month rolling periods)

in U.S. dollars has ranged from 0.25 up to 0.75.

http://www.msci.com/


QUARTERLY UPDATES


Since there is no rebalancing in the EAFE Index, there are considerable swings in the

weighting of the geographical regions (as noted above). Developed markets can be

divided into two broad regions, Europe and the Pacific Rim. Buying an EAFE Index fund

or ETF may be the most convenient way to gain large cap foreign stock exposure, but it

may not be the best approach. IBF studies show that by putting an equal amount in

Europe and the Pacific Rim and then annually rebalancing such positions should

produce better returns and less risk compared to just investing in the EAFE.

IBF estimates that over the long-term, the EAFE should have the same returns as the U.S.

markets, plus or minus currency swings. There is no reason to believe that one mature

industry or market is going to produce higher returns in one country versus another. For

example, large banks around the world make loans. It seems unlikely that the banking

skills of one country would exceed those of another for an extended number of years.

Canada

Canadian stocks account for about 6% of foreign stock market capitalization and about

3% of the global marketplace. Adding a Canadian index fund or ETF can increase

currency diversification and one‘s allocation to natural resources since Canada‘s

economy largely consists of three industries: finance, oil and gas, and basic materials

such as mining and timber.

EMERGING MARKETS

The MSCI Emerging Market Index covers 25 investable countries. The index is market

weighted and is dominated by a handful of countries: South Korea, South Africa and

Taiwan.

2008 MSCI Emerging Market Index Country Composition

Argentina Egypt Korea Philippines

Brazil Hungary Malaysia Poland

Chile India Mexico Russia

China Indonesia Morocco South Africa

Columbia Israel Pakistan Taiwan

Czech Republic Jordan Peru Thailand

Turkey


QUARTERLY UPDATES


FOREIGN VALUE STOCKS

A number of independent studies have confirmed that the behavior of a widely

diversified foreign stock portfolio is consistent with the three factors detailed by Fama

and French (beta, market capitalization, and weighting of value stocks). The table below

uses two different data sources, MSCI an DFA (Dimensional Fund Advisors), for the

period 1975 through 2004. Based on DFA data, foreign small stocks outperformed their

large cap counterparts by about 2.5% per year. MSCI data shows that EAFE value stocks

outperformed EAFE growth stocks by 2.2% per year.

International Size and Value Performance [1975-2004]

DFA Foreign Large Cap DFA Foreign Small

Cap

Annualized Return 15.0% 17.6%

Standard Deviation 18.4% 17.7%

EAFE Growth* EAFE Value*

Annualized Return 12.1% 14.3%

Standard Deviation 16.9% 16.8%

* net of dividends

From the end of 1972 to the end of 2004, the rolling 36-month correlation of the DFA

International Large Cap Index and the DFA International Small Cap Index in U.S. dollar

terms has ranged from just above 0.75 to about 0.90. From the end of 1977 to the end of

2003, the rolling 36-month correlation of the MSCI EAFE Index and the MSCI Value

Index in U.S. dollar terms has ranged from about 0.95 to 0.99.

QUARTERLY UPDATES

HEDGE FUNDS

HEDGE FUNDS 7.1

QUARTERLY UPDATES


7.HEDGE FUND SHAKEOUT

During 2007, 1,152 new hedge funds were launched, down almost 50% from a 2005,

according to Hedge Fund Research, Inc. Because so many hedge funds went under or

merged into others, the industry increased by 589 (meaning 563 hedge funds either went

under or merged). The largest hedge funds (e.g., Och-Ziff Capital Management, D.E.

Shaw & Co. and Paulson & Co.) are attracting more and more of the industry‘s assts. As

of the very beginning of 2008, 87% of all the money in hedge funds was handled by

funds managing $1 billion or more; 60% of hedge fund assets were held by funds worth

$5 billion or more.

QUARTERLY UPDATES

MODERN PORTFOLIO

THEORY

MODERN PORTFOLIO THEORY 8.1

QUARTERLY UPDATES


8.ASSET ALLOCATION

You cannot build a house without blueprints, and you cannot build a portfolio without an

asset allocation policy.

Strategic asset allocation focuses on designing a portfolio of investments that is suitable

for your needs and sticking with that allocation through all market conditions. Tactical

asset allocation is a portfolio strategy that allows active departures from a static asset

allocation based upon some measure of market valuation. Often called active portfolio

management, tactical asset allocation involves forecasting asset class returns and

increasing or decreasing such positions based on the forecast. Return predictions may be

a function of fundamental variables, such as a forecast of inflation, technical variables,

such as recent price trends, or a combination of several variables. Tactical asset allocation

means overweighting one asset class and underweighting another based on these

predictions.

ACADEMIC STUDIES

The Ibbotson/Kaplan report builds on two studies by Gary Brinson, L. Randolph Hood,

and Gilbert Beebower, who looked at the same question 15 years earlier. In 1986, the

three analyzed the returns of 91 large U.S. pension plans between 1974 and 1983,

concluding that asset allocation explained a significant portion of portfolio performance.

A 1991 follow-up study by Brinson, Hood and Beebower confirmed results of their

earlier study—more than 90% of a portfolio’s long-term return characteristics and

risk level are determined by the asset allocation. Both of these studies were also

published in the Financial Analysts Journal.

T-BILL RETURNS AFTER TAXES AND INFLATION

According to the Federal Reserve, from 1955 through 2004, returns from 30-day

Treasury bills continuously reinvested and assuming a 25% federal income tax ranged

from more than -6% (1974) to a positive +4% (1981). Over the entire 50-year period, the

buying power of $100 invested in 30-day T-bills fell to $96.44, hitting a low of $75.26 in

1980 (and then taking 21 years to recover back to $100) and a high of just over $100 in

the mid-to-late 1980s.


QUARTERLY UPDATES


VOLATILITY AS RISK

The reason small stocks have a wider spread between their simple and compounded

(annualized) returns is their higher standard deviation. Greater variation in returns

reduces long-term compound returns. One way to view standard deviation is that it

represents the ―average miss‖ from the portfolio‘s (or asset‘s) simple average return.

BRIEF HISTORY OF ASSET ALLOCATION

In 1952, University of Chicago graduate student Harry Markowitz wrote a 14-page paper

titled, ―Portfolio Selection,‖ that later changed the way portfolio managers think. In 1952,

Markowitz expanded his work in his book, ―Portfolio Selection: Efficient Diversification

of Investments.‖ This book eventually earned him a Nobel Prize in Economics.

Markowitz‘s idea was called ―modern portfolio theory.‖ His beliefs gained little

following until the 1970s when computing power became more affordable.

REBALANCING

One thing that separates asset allocation from simple diversification is rebalancing,

which is based on the theory of regression to the mean. This theory believes that all

investments have a specific risk and return profile and, over time, will exhibit such risk

and return characteristics. An advantage of rebalancing is that it takes advantage of

overly optimistic and overly pessimistic pricing.

CORRELATION EXPLAINED

The table below assumes that each of the three portfolios shown has a simple average

return of 5% per year (note: compound or annualized returns are different because of the

volatility differences each portfolio exhibits). Each portfolio is comprised of just two

assets (A + B, C + D and E + F). As you can see, two perfectly negatively correlated

assets have zero volatility while a portfolio with two randomly correlated assets has

moderate volatility (expected returns that range from 5% +/- 10%) and two perfectly

correlated assets (+1.0 correlation) has fairly high volatility (expected returns of 5% +/-

14%).


QUARTERLY UPDATES


Correlations vs. Volatility

Portfolio

Correlation

Coefficient

Simple

Return

Annualized

Return

Standard

Deviation

[1] ½ in A + ½ in B -1.0 5.0% 5.0% 0%

[2] ½ in C + ½ in D 0.0 5.0% 4.6% 10%

[3] ½ in E + ½ in F +1.0 5.0% 4.2% 14%

CORRELATION EXPLAINED

The ―classic‖ risk-and-return (efficient) frontier is based on a two-asset class portfolio,

stocks represented by the S&P 500 and bonds, represented by five-year U.S. Treasuries.

Long-term, the highest return is from a portfolio that is 100% invested in stocks (12%

annualized return with a standard deviation of 18%); the lowest return is 100% invested

in bonds (6% return with less than a 6% standard deviation). A portfolio with a 20%

stock weighting has the same risk level as a portfolio with 0% in stocks but annualized

returns that are 2% higher (8% vs. 6%). The efficient frontier is the line that connects all

11 points, or portfolios (e.g., 100% bonds, 90% bonds & 10% stocks, 80% bonds & 20%

stocks, etc.). The area above and to the left of this line is sometimes referred to as ―The

Northwest Quadrant‖—a mythical area that does not exist (there is no such thing as a

―super efficient‖ portfolio). Let us now consider the benefits of rebalancing.

An equally weighted portfolio (½ S&P 500 and ½ T-notes) is expected to have long-

term annualized returns of about 9% and a standard deviation of approximately

12%; the same portfolio rebalanced is projected to have a return of roughly 9.2%

and a standard deviation of about 9.5%. The table below shows the exact numbers,

based on risk and return data from 1950 through 2004.

Risk and Return [1950-2004]

Portfolio Annualized Risk

100% five-year T-notes 6.1% 5.6%

100% S&P 500 12.1% 17.4%

1/2 in T-notes & 1/2 in S&P 500 9.1% 11.5%

1/2 in T-notes & 1/2 in S&P 500—

rebalanced

9.5% 9.1%

advantage of rebalancing 0.4% gain reduced by 2.4%


QUARTERLY UPDATES


Over the past 50 years, the rolling 36-month correlation between the S&P 500 and

intermediate-term U.S. Treasury Notes has ranged from -0.6 to +0.7; over the entire

period it has averaged a mere +0.1, powerfully suggesting a strong randomness between

these two asset classes. Perhaps more importantly, this range of correlation coefficients

shows that the price movement relationship between two assets can change frequently

and without warning. However, as the table below shows, regardless of changing

correlations over time, there is still a reduction in portfolio risk and an increase in

annualized returns.

Diversification Benefits—[1955-2004]

50% S&P 500 & 50% T-Notes

Time

Period

Correlation

Coefficient

Risk

Reduction

Annual

Return

Increase

1955-1964 - 0.7 3.5% 0.4%

1965-1974 0.0 2.1% 0.4%

1975-1984 + 0.2 2.4% 0.2%

1985-1994 + 0.7 0.6% 0.1%

1995-2004 - 0.2 3.0% 0.6%

Over the past 50 years, the most common annualized returns for this 50/50 portfolio were

in the 10-15% range. Over the entire period (1950-2004), the lowest year for a 50/50 mix

was -9.6%; the highest return was 27.7% and the overall annualized return was 9.5%.

This compares favorably to what T-notes experienced on their own (lowest year was -

2.1%, highest year was 25.0% and overall annualized return was 6.1%) as well as what

the S&P 500 experienced (-26.5% was the worst year, 52.6% was the highest year and

annualized returns were 12.1%).

The reason why the comparisons for the 50/50 portfolio are so compelling is based on

percentage changes. For example, the 50/50 portfolio‘s worst year represents just 36% of

the S&P 500‘s worst year (-9.6/-26.5); yet, the 50/50 portfolio experienced 79% of the

S&P 500‘s annualized returns (9.5%/12.1%). Perhaps more importantly, few investors

can accept a year when their net worth drops 26.5% (note: even a loss of 9.6% would not

be tolerable by a conservative investor).


QUARTERLY UPDATES


STANDARD DEVIATION

A traditional bell curve is a good way to visualize the concept of an investment‘s returns

over an extended period of time. Assuming returns that are normally distributed,

approximately two-thirds of the time (every two out of three years), returns are expected

to differ from the mean by not more than plus or minus one standard deviation;

approximately 95% of the time (every 19 out of 20 years), returns are expected to differ

from the mean by not more than plus or minus two standard deviations.

As the example below shows, there are six steps involved in computing standard

deviation: [1] calculate the average (mean) annual return, [2] then go back and subtract

from the mean return from the actual return for that period, [3] square that difference (the

deviation) for each period, [4] add up all of the squared deviations, [5] divide the sum by

the number of periods (this is known as the variance)–typically 36 months of

observations, and [6] calculate the square root of the sum of the squared deviations (the

resulting number is the standard deviation).

Calculating Standard Deviation (Std. Dev.)

Period

Annual

Return

Deviation For Each Period

(step #2)

Deviation

Squared

(step #3)

1 -3.4 -9.6 92.0

2 9.9 3.7 13.8

3 -2.0 -8.2 67.1

4 21.7 15.5 240.6

5 -6.2 -12.4 153.5

6 11.0 4.8 23.1

7 -9.1 -15.3 233.8

8 13.1 6.9 47.7

9 -1.5 -7.7 59.1

10 28.6 22.2 493.3

sum

(1-10)

61.9 1,424.0 sum of squared

deviations (step #4)

average

(step #1)

6.2% 142.4 divided by number of

periods (step #5)

11.9% Std. dev. (square root of

variance) (step. #6)


QUARTERLY UPDATES


TAXABLE FIXED-INCOME ALLOCATION

From the end of 1995 to the end of 2004, $10,000 invested in a diversified portfolio of

bonds (1/3rd

med-term Treasuries, 1/3rd

investment-grade corporates and 1/3rd

in

GNMAs—an overall mix that is somewhat similar to the LB Aggregate Bond Index)

grew to $20,000. The same $10,000 invested just in investment-grade corporates grew to

$17,500 and $16,500 in the case of intermediate-term Treasuries. The table below shows

one approach to structuring the taxable fixed-income portion of a portfolio.

Taxable Fixed-Income Allocation

Allocation Category

50% LB Aggregate Bond

Index

20% TIPS or iBonds

20% High-Yield Corporates

10% Emerging Market Debt

QUARTERLY UPDATES

MUTUAL FUNDS


QUARTERLY UPDATES


9.FUNDAMENTAL INDEXING

ETF investor can choose from two approaches to fundamentally-weighted index funds.

One approach selects stock based on cash flow, sales, book value and dividends. The

second approach uses only two yardsticks, either earnings or dividends.

130/30 FUNDS

A 130/30 fund magnifies a manager‘s stock picking skills and mistakes; up to 130% of

the portfolio‘s assets are in stocks, while another 30% is shorting stocks. Shorting

involves selling a borrowed security, with the goal of replacing the borrowing once the

share price falls.

In theory, short-selling allows a manager to profit from stock analysis that would

normally be used to avoid a particular stock. If you buy (―go long‖) a stock, the most you

can lose is 100%; when you short a stock, the possible losses can exceed 100% or even

200% (plus the cost of borrowed money).

TOP PERFORMING STOCK FUNDS

The table below shows the performance of the 10 largest equity funds for a select period

of time, the 10 years ending March 31st, 2008 (source: Lipper). The largest of these

funds, Growth Fund of America, oversees $88 billion; the smallest of the 10 largest,

Vanguard 500 Index, manages $60 billion. It is interesting to note that all of the actively

managed funds below (a total of 8), easily outperformed the two examples of passive

investing (SPDR Trust: 1 and Vanguard 500 Index).

Annualized Returns of the 10 Largest Stock Funds

[3/31/1999—3/31/2008]

Fund 10 Years Fund 10 Years

Growth Fund of America 10.4% Investment Co. of America 6.7%

Capital World Gr. & Income 12.2% American Funds 7.4%

Capital Income Builder 9.2% Washington Mutual 5.7%

Fidelity Contrafund 9.2% EuroPacific Growth 10.5%

SPDR Trust: 1 (S&P 500) 4.1% Vanguard 500 Index 4.1%


QUARTERLY UPDATES


TOP PERFORMING BOND FUNDS

The table below shows the performance of the 10 largest bond funds for a select period of

time, the 10 years ending March 31st, 2008 (source: Lipper). The largest of these funds,

PIMCO Total Return Institutional, oversees $78 billion; the smallest of the 10 largest,

Fidelity Investment Grade Bond, manages $10 billion.

Annualized Returns of the 10 Largest Bond Funds

[3/31/1999—3/31/2008]

Fund 10

Years

Fund 10

Years

PIMCO Total Return Inst 6.7% Vanguard Int-Term Tax-

Ex

n/a

Vanguard Total Bond 5.5% Western Asset Core n/a

Bond Fund of America 5.2% Franklin CA Tax-Free Inc 4.7%

Dodge & Cox Income 5.8% Vanguard Sh-Tm Inv 4.9%

Vanguard GNMA 5.6% Fidelity Investment Grade 5.0%

STYLE DRIFT

Standard & Poor‘s research indicates that investment style drift heightens during market

shifts. For example, about 32% of all U.S. stock funds had ―style drift‖ during the

reasonably calm period in the stock market between March 2004 and March 2007. Style

drift increased to 46% of all U.S. stock funds during the post-technology-bubble period

of June 2000 to June 2003. According to University of Texas finance professor Keith

Brown, style-pure funds beat style drifters by 2.7 percentage points a year over a recent

12-year period.

Although the SEC has had a rule since 2001 that requires funds to have at least 80% of

their holdings in line with the fund name (if it implies or states a style), there is a

loophole. According to the SEC rule, investment companies can take ―temporary

defensive positions to avoid losses in response to adverse market, economic political and

other conditions.‖ Mutual funds can also depart from the SEC rule in ―other limited,

appropriate circumstances, particularly in the case of unusually large cash inflows or

redemptions.‖


QUARTERLY UPDATES


For advisors concerned about style drift, the closest thing to a time read for many funds is

quarterly updates on fund Web sites and in the SEC‘s Edgar database online

(www.sec.gov).

ULTRA-SHORT BOND FUNDS

The objective of an ultra-short bond fund is to provide the investor with a return that is

slightly higher than that offered by traditional money market funds. The portfolios were

considered extremely safe for two reasons: [1] very short maturities and [2] highly-rated

securities. While the funds have always, and still do, typically maintain maturities of just

a year or two, the quality of the paper began to suffer in mid 2007.

A number of ultra-short bond funds own mortgage-backed bonds that appeared to be

safe—until home prices started to fall and mortgage-laden borrowers had difficulty in

trying to make their monthly payments. The problem was compounded when investors in

ultra-short bond funds started to see problems and began making redemption requests.

For example, for every single month starting in August 2007 (-19% net cash flow for the

month) through the first three months of 2008, the Schwab Yield Plus fund experienced

redemptions that ranged from -4% (October 2007) to -48% (March 2008) per month. The

cumulative decrease in assets for this Schwab ultra-short bond fund has been about 90%.

Redemptions of the kinds of cash equivalents found in money market funds (and ultra-

short bond funds to a lesser degree) have never been a problem and is not likely to be a

surprise in the future. However, the forced sale (due to shareholder redemption requests)

of mortgage-backed securities resulted in losses that were greater than what would have

happened during an orderly liquidation. For at least the next couple of years, the lesson is

clear—if you are going to recommend this kinds of funds, stick with ultra-short

government funds.

FRONTIER FUNDS

The rush by investment companies to start frontier funds may be another example of

mainstream investors access to new and risk products only after the easy money has been

made. In November 2007, MSCI Barra unveiled 19 indexes tracking some of the world‘s

most obscure exchanges, including Slovenia, Mauritius and Sri Lanka. ETF and mutual

fund companies with frontier funds offerings include: State Street Global Advisors,

Invesco PowerShares, Claymore Securities, T. Rowe Price, Standard & Poor‘s and

Merrill Lynch.

http://www.sec.gov/


QUARTERLY UPDATES


Five major concerns with this strategy are: inflation (e.g., Zimbabwe‘s inflation

exceeded 100,000% for a period), marketability (a number of index shares in different

countries never trade and many other shares are thinly traded), volatility (Vietnam‘s

stock market more than tripled in recent years but lost over 50% during the first half of

2008), high P/E ratios (in early 2006, Saudi stocks traded for 60 times earnings, a P/E of

just 15 during 2008) and diversification (often a modest number of stocks will comprise

more than half of a country‘s index weighting).

FRONTIER INDEX

The Merrill Lynch Frontier Index tracks 50 of the largest and most highly-traded stocks

in 17 countries, from Kuwait to Kazakhstan; stocks that are so much off the radar screen,

they do not qualify for ―emerging markets‖ status. Roughly half of the index is comprised

of Middle Eastern stocks. The market value of the 50 stocks in the index is $366 (about

the same market capitalization as GE). Other markets represented in the index are

Nigeria, Cyprus, Vietnam and Pakistan.

The two biggest appeals of frontier stocks (and funds) is that the data, so far, shows that

correlations to other markets is random and that returns can be quite attractive (e.g., from

the beginning of 2007 through February of 2008, the Merrill index was up 70%). Another

short-term appeal is the fact that a number of Persian Gulf countries went through a

bubble period that ended in large stock market price drops during 2006.

TRANSACTION COSTS

Different mutual fund companies take different approaches to commissions they pay

when a buy or sell occurs within a fund. The fee may be negotiated with the broker (often

less than one cent a share) or they pay roughly five cents a share—added incentive for the

brokerage firm to conduct research for the fund manager (―soft dollars‖). Some variations

of the “soft dollar” approach may be of questionable value to the fund‘s shareholders.

Some fund managers may rely heavily on brokerage research, thereby reducing

management‘s supposed cost and increasing management profits.


QUARTERLY UPDATES


The implicit transaction costs incurred by mutual funds include timing-delay and

impact costs. A timing-delay cost takes place during the period when the fund places a

buy or sell order and the actual placement price. This delay can be viewed as the ―cost of

seeking liquidity.‖ The good news is that transaction costs have trended downward over

the past five years, according to ITG data. For the 2003 calendar year, large cap two-way

transaction costs totaled 1.46% per 100% fund turnover. In 2006, that number had fallen

to 0.92%—almost a 55% decline.

Brokerage costs have also gotten lower, according to a September 2007 article in ITG

Global Trading Cost Review. Between 2003 and 2006, large cap brokerage costs dropped

13 basis points (0.13%). In the case of small cap equity transactions, annual two-way

transaction costs for 100% turnover averaged 2.26% in 2003, but 1.48% in 2006; of the

78 basis point difference, 22 points were due to lower transaction costs. As a side note,

index funds incur roughly 80% less in transaction costs than actively managed funds.

MUTUAL FUND INDUSTRY GROWTH FUND BIAS

Despite the strong evidence favoring value equity funds over growth, both domestically

and internationally, mutual funds still ―don‘t get it.‖ In 1997, the number of new growth

funds added was 108 vs. 37 for new value funds. This pattern repeats itself in 1998 (134

growth vs. 48 value), 1999 (133 growth vs. 26 value) and 2000 (227 new growth funds

vs. 36 new value funds added). Yet, the industry can clearly see where cash flows from

investors go—mostly to growth funds. For each quarter of 1998, 1999 and the first

quarter of 2000, the amount of money going into growth funds was dramatically higher in

every quarter except the first two quarters of 1998. For example, during the third quarter

of 1999, five billion dollars of new money went into value funds while $27 billion went

into growth funds; during the first quarter of 2000, $39 billion was taken out of value

funds while $90 billion was added to growth.

MICROCAP ADVANTAGE

There are more than 3,000 micro cap stocks that are actively traded on U.S. exchanges.

These stocks represent the smallest 2-3% of the investable stock markets. It appears that

overweighting this category (to some figure above 3% of the total equity exposure) has

diversification benefits.


QUARTERLY UPDATES


EQUITY STYLE PERFORMANCE

Several decades ago, it was dividend yield that was used by investors to differentiate

between growth and value stocks; equities paying high dividends were classified as value

and those with low dividends were considered growth. As investors became more

sophisticated, coupled with new mandatory SEC reporting requirements, researchers

were able to create and compare ratios such as P/E and earnings growth as well as a

company‘s market price divided by book value. Stocks with low price/earnings and low

price/book ratios were considered better values than stocks with high ratios.

In 1934, Benjamin Graham and David Dodd quantified these ratios in their book,

Security Analysis. Although analysis of growth and value has changed little since the

publication of this book, standardization of stock categories based on fundamental ratios

became widely accepted. Stocks whose price was high relative to its fundamentals

became classified as growth while those with a relative low stock price represented value

companies. Some analysts such as Morningstar added a third category called ―core‖ or

―style neutral‖ to classify stocks whose valuation was between growth and value. Armed

with historical data and computerization, researchers discovered that the same factors

that caused excess returns and lower risk with U.S. value stocks were consistent

with foreign value equities. For example, an August 1997 paper from Fama and French

(see below) found that the difference between the average global value stock

outperformed the average global growth stock by 7.6% per year from 1975-1995. The

two authors also found that value stocks outperformed growth stocks in 12 of the 13

major stock markets studied.

In June 1992, Eugene Fama and Ken French published an extensive paper on value

stocks, ―The Cross-Section of Expected Stock Returns,‖ in the Journal of Financial

Economics. Fama and French set forth the premise that the performance of a broadly

diversified U.S. stock portfolio was primarily based on three risks: beta, the percentage of

small cap stocks in the portfolio and the percentage of the portfolio that is invested in

value equities. The two authors concluded that the amount of risk taken (based on the

three measurements) explains 95% of a portfolio‘s return and very little can be attributed

to individual security selection. From these findings, Fama and French created a set of

indexes that measure size and style.

QUARTERLY UPDATES

PREFERREDS


QUARTERLY UPDATES


10.PREFERRED STOCK

From an investor‘s tax perspective, there are two types of preferred stock: those that are

qualified preferreds (dividend is taxed at a maximum rate of 15%) and those that are not

qualified (dividends are taxed at the investor‘s regular tax bracket). Preferred stock

makes quarterly fixed-rate or floating-rate dividend payments. Close to 80% of preferreds

are issued by financial corporations.

Franklin Templeton suggests that up to 5% of the investor‘s fixed-income portion of the

portfolio could be invested in preferreds. The correlation of preferreds to the common

stock is very low but high when compared to the corporation‘s bonds. Preferred stocks

frequently include a call provision—something that is never in your clients‘ best interest.

QUARTERLY UPDATES

REAL ESTATE


QUARTERLY UPDATES


11.S&P/CASE-SHILLER HOME-PRICE INDEX [2000-2008]

The table below shows the percentage changes in home prices in 20 major U.S. cities for

each of the past several calendar years, as well as the peak price and month.

Case-Shilling Index [January 1st, 2000 = 100.00]

Year

Phoenix

[PHXR]

Los

Angeles

[LXXR]

San

Diego

[SDXR]

San

Francisco

[SFXR]

Denver

[DNXR]

2000 105.9 110.9 117.5 131.2 114.7

2001 111.6 121.4 128.8 125.1 121.3

2002 117.1 144.3 155.4 141.9 124.8

2003 126.6 177.0 186.3 155.9 127.2

2004 155.5 219.4 233.8 189.3 132.3

2005 221.8 265.9 247.5 214.8 137.4

2006 220.2 268.7 237.2 211.8 135.9

2007 180.1 224.4 197.4 183.8 129.0

Apr. ‗08 161.3 202.5 180.6 164.6 128.5

Peak 227.4 (6/06) 273.9 (9/06) 249.6 (6/06) 218.4 (5/06) 140.3 (8/06)


Year DC

[WDXR]

Miami

[MIXR]

Tampa

[TPXR]

Atlanta

[ATXR]

Chicago

[CHXR]

2000 112.7 110.3 110.8 106.6 108.3

2001 126.0 124.5 120.3 111.2 117.0

2002 146.2 143.8 132.2 115.1 126.8

2003 167.8 164.8 147.9 118.7 137.6

2004 208.6 205.4 177.0 123.8 149.7

2005 247.7 268.2 229.0 130.6 164.0

2006 238.8 279.4 228.9 133.4 167.5

2007 213.2 225.4 194.6 127.7 156.4

Apr. ‗08 201.2 200.4 178.5 124.2 150.4

Peak 251.0 (6/06) 280.9 (12/06) 238.1 (7/06) 136.5 (7/06) 168.6 (9/06)


QUARTERLY UPDATES



Year Boston

[BOXR]

Detroit

[DEXR]

Minneapolis

[MNXR]

Charlotte

[CRXR]

Las Vegas

[LVXR]

2000 117.7 107.2 113.1 102.9 105.2

2001 129.9 111.3 126.2 104.1 113.7

2002 146.8 115.5 138.6 107.7 121.9

2003 158.5 119.6 149.7 109.7 145.9

2004 178.4 123.1 161.0 114.3 207.3

2005 178.2 126.6 169.6 120.0 230.5

2006 168.3 118.0 167.9 129.4 230.5

2007 162.6 100.2 151.1 131.7 186.0

Apr. ‗08 158.7 93.8 139.2 131.8 165.9

Peak 182.4 (9/05) 127.0 (12/05) 171.1 (9/06) 135.9 (8/07) 234.8 (9/06)


Year NY City

[NYXR]

Cleveland

[CEXR]

Portland

[POXR]

Dallas

[DAXR]

Seattle

[SEXR]

2000 112.7 103.9 103.9 106.5 106.7

2001 125.2 106.2 108.1 111.8 111.8

2002 146.5 110.1 113.7 113.9 115.8

2003 163.3 115.6 122.1 114.0 124.4

2004 187.2 120.1 135.5 116.4 140.2

2005 213.5 122.1 165.3 121.9 165.5

2006 212.8 118.6 179.0 122.6 183.9

2007 200.9 108.5 178.8 118.6 181.6

Apr. ‗08 193.9 109.5 174.9 120.4 179.6

Peak 215.8 (6/06) 123.5 (7/06) 186.5 (7/07) 126.5 (7/07) 192.3 (7/07)


QUARTERLY UPDATES



Year Composite 10

[CSXR]

Composite 20

[SPCS20R]

2000 114.6 112.4

2001 123.9 120.6

2002 142.9 135.6

2003 162.9 151.7

2004 193.3 176.4

2005 222.5 202.4

2006 221.3 202.3

2007 196.2 180.8

Apr. ‗08 183.1 169.8

Peak 226.3 (6/06) 206.4 (6/06)

HARVARD REAL ESTATE STUDY

Each year, Harvard‘s Joint Center for Housing Studies releases a housing report. The

2008 edition states that local housing markets are facing ―corrections that are rivaling the

deepest slowdowns since WWII.‖ Furthermore, th fall in home prices and the rise in

mortgage defaults are the worst on record since the 1960s and 1970s. The study‘s authors

points out that housing markets usually recover after an economic recession and a mix of

falling mortgage rates and dropping home prices. The author concludes by stating that he

believes the housing downturn will take longer to rebound because of the high volume of

foreclosures and credit market constraints.

REAL ESTATE INVESTMENTS

According to a study by the Brandes Investment Institute and Prudential Financial, the

long-term annualized return on U.S. commercial real estate has been similar to the returns

for U.S. stocks, as measured by total stock market capitalization. For the period 1934

through 2004, the total return (rents plus appreciation) for commercial real estate

averaged 9.3% versus 9.7% for U.S. stocks and 2.8% for inflation. The study also points

out that the income return from rents has been very consistent over the past several

decades (see table below). Almost all commercial leases include an annual CPI

adjustment that helps insulate the owner from the effects of inflation.


QUARTERLY UPDATES


U.S. Commercial Real Estate Returns [1930-2004]

Decade Annual

Return

Annual Income Capital Return

1930s 8.1% 8.4% -0.3%

1940s 13.7% 6.3% 7.0%

1950s 6.2% 6.1% 0.2%

1960s 6.5% 6.2% 0.3%

1970s 10.1% 6.3% 3.6%

1980s 11.1% 6.5% 4.3%

1990s 5.5% 6.6% -1.1%

2000-2004 10.5% 7.5% 3.0%

From the end of 1972 to the end of 2004, the NAREIT Equity Index (price appreciation

only) generally tracked to rate of inflation but overall failed to match cumulative price

increases over the period. As a point of fairness, such a comparison is largely unfair since

a large component of the real estate‘s total return was annual dividends (rental income).

According to NAREIT, after adjusting for corporate holdings, there is about $4 trillion in

investable U.S. commercial real estate, less than 7% of which is part of publicly-traded

REITs. In fact, equity REIT capitalization represents just 2-3% of the capitalization of the

U.S. stock market.

The rolling 36-month correlation between the NAREIT Equity Index and the CRSP Total

U.S. Stock Index has overall declined since late 1974. For the period 1975 to the end of

2004, the correlation was as high as about 0.9 to roughly -0.1. Thus, there have been

periods of time when the addition of an equity REIT has been an excellent portfolio risk-

reduction tool.

Looking at the efficient frontier of the CRSP Total Stock Market Index and the

Wilshire REIT Equity Index from 1978 to the end of 2004 shows the best risk-adjusted

returns came from a portfolio that had a 50/50 for each of these two asset categories

(about 14.5% annualized return and a standard deviation of 13%). Over the same period,

a 100% U.S. stock market portfolio averaged about 13.5% with a standard deviation of

16% vs. a 100% Equity REIT portfolio that averaged about 14.5% with a standard

deviation of just under 17%. Over the same period of time, a 20% REIT and 80% total

U.S. stock market portfolio resulted in lower risk and higher returns at every point of the

frontier as the bond mix went from zero to 90% (with the equity portion always having a

weighting of 80% stocks and 20% REITs).


QUARTERLY UPDATES


MORTGAGE SAVINGS

The table below shows the interest savings that can be obtained on a $200,000 loan with

a fixed-rate of 6%. The savings are based solely on how much interest is saved if loan

payments are made for 25, 20 or 15 years compared to the traditional 30 years. Thus, if

someone were willing to pay off a $200,000, 6% loan in 15 years instead of 30 years, he

or she would save a total of $127,888 along the way.

Interest Savings—6% Fixed Rate Loan for $200,000

Loan Term Monthly

Payment

Total Interest Savings

30 years $1,119.10 $231,676

25 years $1,288.60 $186,580 $45,096

20 years $1,432.86 $143,886 $87,790

15 years $1,687.71 $103,788 $127,888

MORTGAGE IMPACT REDUCTION

By adding an additional $300 per month to the payment on a 6.25%, 30-year, $300,000

loan, the borrower will end up saving 10 years of payments and $83,000 of after-tax

money. Adding just a $100 a month (instead of $300) results in a savings of $57,000 of

interest payments and shave four years off a 30-year mortgage. Change the $100 to $500

per month saves $170,000 and reduces the length of the mortgage from 30 to 17 years.

FOREIGN REAL ESTATE FUNDS

During the first half of 2007, investors poured $6 billion into foreign real estate funds.

Some of the companies offering a foreign real estate fund are: Alpine, Charles Schwab,

Cohen & Steers, Fidelity, State Street Global Advisors, and WisdomTree Investments.

Companies that offer global real estate funds include: AIM, Franklin, ING, Kensington,

and Northern Trust. A few of these funds hedge against the U.S. dollar‘s fluctuation.

QUARTERLY UPDATES

RETIREMENT

RETIREMENT 12.1

QUARTERLY UPDATES


12.STANDARD OF LIVING PERSPECTIVE

During 2008, voters were bombarded with presidential candidates advocating that things

were terrible; polls showed that 81% polled felling the nation was on the ―wrong track‖

(the highest number ever tracked). Another poll stated that 78% of those questioned

believed that the U.S. is worse off today than five year ago (again, the highest reading

ever). Indeed, television viewers and readers of the financial press read on an almost

weekly basis about the collapse of housing. Through all of this, investors and

homeowners lost perspective.

As of the middle of June 2008, unemployment was 5.5% (low by historical standards).

True, housing prices are down—but only from their peak. The typical house was still

worth a third more than in 2000 and 94% of Americans do not have threatening

mortgages. Inflation was up in 2007, but the comparison is not quite fair since the

previous 16 years had inflation averaging at an extremely low rate. The standards of

living are the highest they have ever been—including measurements used for the middle

class. Since 1992, the percentage of Americans who tell Pew Research Center pollsters

they ―can afford what they want‖ has risen steadily, from 39% in 1992 to 52% in 2008.

We can blame part of standard of living psychology on the media. With its 24/7 telecast,

it is easy to think that the world is coming apart. If a factory closes, it is news. If a factory

opens, it is not. We all know about the factories closed by GM and Ford, but how about

the factories that are being opened in the U.S. by Honda, Toyota and BMW? There is no

denying, or minimizing, the effects of a costly war in Iraq and Afghanistan as well as

coping with gasoline at $4-$5 per gallon.

But do we really want to go back to the past? A time of systemic prejudice (1950s), when

inflation-adjusted income was far lower than today and the fear of a nuclear holocaust

(1960s), the energy shocks and high inflation rates of the 1970s and leadership that left

the country paralyzed (Nixon and Carter), or the early 1980s when the Dow Jones

Industrial average was trying to get to 2,000, a number that it had never even come within

several hundred points of reaching (and a prime interest rate that peaked at 21.5%).

RETIREMENT 12.2

QUARTERLY UPDATES


RETIREMENT PAYOUT FUNDS

Last year, 52% of workers with annual incomes of $50,000 to $100,000 said they planned

to rely primarily on 401(k) and IRA accounts to pay for living expenses once they stop

working (up from 46% the year before). The percentage counting on Social Security also

grew to 19% from 13%, while those counting on company pension plans dropped from

18% to 11%.

There are two main approaches to retirement payout funds are: [1] grow the account but

eventually exhaust it (via payouts) by a designated date and [2] expand, or at least keep

he principal intact, while also paying out income

RETIREMENT INCOME STRATEGIES

Academics and practitioners alike now realize that the timing of retirement will

frequently have a large impact as to how the nest egg will fare in the future. Those

fortunate enough to retire at the beginning of a bull market are likely to see their savings

last for three or more decades. Retirees who begin withdrawals during the start of a bear

market could struggle for years to come.

Consideration #1

You have a client with $1 million who needs $40,000 a year in addition to Social

Security. One possible strategy would be to place $200,000 into a money market account

so that the income stream would be guaranteed for at least five years (200,000/40,000 =

5). The remaining $800,000 would then be invested into a well-diversified portfolio (that

would not have to include cash equivalents).

Under this approach, the retiree would not have to be overly concerned with market

volatility since none of the diversified portfolio would liquidated for at least five years.

Any dividends or interest generated from the portfolio would be deposited into the money

market account.

There are two possible problems with this approach. First, although unlikely, there is

always the chance that unacceptable volatility (or lack of any meaningful gain) would

continue for more than five years (e.g., from 2001 through most of 2008, the cumulative

return of the S&P 500 was basically zero). Second, and more likely, setting aside

$200,000 in a low-interest-bearing account could have too much of an impact on the

overall portfolio.

RETIREMENT 12.3

QUARTERLY UPDATES


Consideration #2

A second strategy worth considering is a three-prong approach: a modest amount in a

money market fund with check-writing privileges, a ―reserve cash flow‖ fund wherein ½

is in a money market fund and the other ½ is in a high-quality short-term (a duration of 1-

2 years) bond fund, and the balance (which would be most of the portfolio) a long-term

investment account that has about a 70/30 equity/fixed-income split.

With this approach, the retiree with $1 million who needs $40,000 a year would have

$100,000 in a money market fund, about $100,000 in a quality bond fund with a duration

of 1-2 years, $170,000 in intermediate-term bonds and the remaining $630,000 would be

invested in equities such as stocks and REITs. The investor would be able to easily ride

out a rough market for at least five years.

Consideration #3

A more sophisticated approach relies much more on equities but includes downside

protection. Thus, the third consideration includes a variable annuity with a living benefit

rider along, longevity insurance and a managed payout mutual fund (a new type of

mutual fund that was first introduced in 2008). This ―downside protection‖ approach

works best if implemented 5-10 years before retirement.

For example, someone 65-70 could receive a guaranteed 5-7% a year from a variable

annuity living benefit rider indefinitely. If the account performs better than the 5-7%

withdrawal rate (doubtful once you tack on the 2-3% hidden annual fees), the benefit can

be reset to a higher dollar amount (meaning the 5-7% withdrawals would be based on a

larger principal amount). Other insurers guarantee that if the investor waits 10 years, the

account value will at least be double (for income purposes only) and the 5-7% annual

withdrawals would result in twice as much money each year (since the principal has at

least doubled).

Longevity insurance, which has been around for a few years (e.g., MetLife and NY Life)

promises a guaranteed lifetime income once the owner reaches a later age, such as 80 or

85 (note: the premium is nonrefundable). For example, a 65-year old male who deposited

$100,000 into MetLife‘s Longevity Income Guarantee annuity would receive $83,800 a

year starting at age 85. Additional protection becomes expensive: someone who wants an

inflation rider or return-of-premium benefits may need to initially invest up to 50% more.

The third part of this third possible strategy is a ―payout‖ mutual fund that attempts to

make monthly payments for a set period of time. These funds have dramatically lower

fees than annuity-based products, but provide no guarantees against a losing stock market

or reduced monthly benefits.

RETIREMENT 12.4

QUARTERLY UPDATES


Consideration #4

For retirees looking for the simplest and most straightforward approach, it is hard to beat

an immediate fixed-rate annuity (www.immediateannuities.com). Payments are

guaranteed for one or more lives. The disadvantage of most of these kinds of annuities is

that nothing is left over for the heirs. The other disadvantage is that there is usually no

inflation hedge in the payout—it stays flat until payments stop altogether. Thus, a single

person in their late 70s or early 80s could expect an annual return in the 8-11% range.

Consideration #5

Another approach is to start with a withdrawal rate of 5, 6 or 8% and see what the

diversified portfolio looks like after four years. Viewing stock and bond performance

data back to 1990 shows that if the portfolio is higher after the fourth year of retirement

(returns minus withdrawals during those four years), there is about a 100% guarantee that

the retiree will not run out of money for 20+ years if annual withdrawals from that point

forward are 5%; if 6% is taken out, the chances of the money lasting 20+ more years is

still 98%, 94% likelihood if withdrawals after the first four years are 8% a year.

If, after four years of retirement the original nest egg has shrunk, there is a 62% chance

that a 6% annual withdrawal rate will last 20+ years (only 28% chance if the subsequent

withdrawal rate is 8% but a 93% chance if it is just 5%).

The table below, based on Monte Carlo simulation with data going back to 1900 and with

a 90% probability of survival, shows different time periods, asset mixes and different

withdrawal rates. For example, it is likely that a 5% annual withdrawal rate will not last

for 30 years. At the other extreme, there is a 90% chance that a 15/85 stock/bond mix

would last for at least 10 years if annual withdrawals were 9.3%.

90% Probability of Not 100% Depletion

Time

S&P 500 /

Bond Mix

Annual

Withdrawals

10 years 15/85 9.3%

15 years 30/70 6.4%

20 years 30/70 5.1%

25 years 40/60 4.4%

30 years 40/60 3.8%

35 years 40/60 3.5%

RETIREMENT 12.5

QUARTERLY UPDATES


Whatever withdrawal rate is used, if the advisor finds out that that losses are becoming

too severe, either due to market performance or a withdrawal rate that is too high, the best

alternative probably then becomes an immediate annuity for the remaining balance. For

example, taking out $50,000 a year from a $500,000 portfolio for 13-20 years or more is

an almost guaranteed losing strategy. In fact, a withdrawal rate of more than 10% a year

has never ―in history‖ lasted more than 19 years. By investing $500,000 into a fixed-rate

immediate annuity, a 65-year-old retiree would expect $37,000-$42,000 a year for life.

PROJECTED PROBABILITY OF SUCCESS

The table below shows the likelihood of not running out of money (100% depletion of

principal) for a 30-year retirement, based on the portfolio‘s performance during the first

five years of retirement. As you can see, if return figures are weak during the first five

years and the investor does not reduce the withdrawal amount, the chances of survival

begin to fall significantly. For example, if annualized returns for the first five years are

between 4% and 5%, there is a 74% chance that retirement savings will last another 25

years. If annualized returns during the first five years are 0% to 1%, the chances of

survival for another 25 years are about 50-50.

The table below assumes that 55% of the portfolio is in stocks and 45% in bonds. The

table also assumes a first-year withdrawal of 4% and then withdrawals are increased by

3% each year to offset inflation (e.g., $40,000 the first year, $41,200 the second year,

etc.).

Probability of Success

Returns in 1st

5 years

Chances

of Success

4% to < 5% 75%

3% to < 4% 68%

2% to < 3% 62%

1% to < 2% 58%

0% to < 1% 50%

Less than 0% 42%

RETIREMENT 12.6

QUARTERLY UPDATES


RETIREMENT SURVEY RESULTS

Close to 75% of retirees say that their retirement is better than their parents‘; 80% of

those still working expect that their retirement will be better.

Less than half of all workers and/or their spouses have tried to determine how much

money they will need for a comfortable retirement

Close to 45% of those surveyed said that when it came to using a method to calculate

their retirement needs, they simply guessed; only 19% asked a financial advisor and

another 19% did their own estimate.

25% of surveyed workers said they would need less than $250,000 for retirement; 23%

cited a goal of between $500,000 and $1 million.

50% of buyers of long-term care insurance (individual policies) were age 55 to 65.

There are 7,100 doctors in the U.S. that are certified in geriatric medicine.

Only about a third of those surveyed knew that Medicare eligibility begins at age 65.

The most popular sports activity for those age 55 to 64 is exercise walking; the second

most popular activity is exercising with equipment.

The median value of a baby boomer‘s inheritance so far is $48,000; only 2% of baby

boomers have received a $100,000+ inheritance.

Only 7% of those workers surveyed are saving the maximum allowable amount in

their 401(k) plan.

Women age 65 and older have a median income that is just 58% of men‘s.

92% of baby boomers with more than $100,000 of investable assets have provided

financial support to their adult children; 52% have provided financial support to their

parents.

Just 39% of baby boomers with more than $100,000 of investable assets talk to their

families about money and finances on a regular basis; only 36% of their parents have

done the same thing.

Close to 85% of 401(k) plan participants had no knowledge of the fees and expenses

associated with their plans.

RETIREMENT 12.7

QUARTERLY UPDATES


17% of Florida‘s population is age 65 or older, followed by West Virginia (16%).

22% of surveyed grandparents have ever opened an investment account on behalf of a

grandchild.

The typical grandparent spends $600 a year on their grandchildren.

For men, the average monthly Social Security retirement benefit is $1,200; $900 for

women. Fewer than a third of current Social Security beneficiaries pay taxes on their

benefits.

43% of surveyed workers believe Social Security is ―in serious trouble;‖ 26% said the

system is ―in crisis‖ and another 24% said Social Security is in ―some trouble.‖

SOCIAL SECURITY SPOUSAL BENEFITS

When you begin receiving Social Security retirement benefits, your spouse may also

qualify to receive a check based on your earnings. You cannot receive spousal benefits

until your spouse has claimed Social Security. However, once you reach age 62, you can

always apply for benefits based on your own earnings.

When a spouse files for a reduced benefit based on his or her earnings, Social Security

checks to see if the applicant is also eligible for a spousal benefit. If so, that spouse is

deemed to have filed for both her benefit (as a worker) and the spousal benefit. In such a

situation, the filing spouse will usually receive the higher of the two amounts. As a side

note, you cannot claim spousal benefits at age 62 based on the other spouse‘s earnings

and then claim benefits at full retirement age based on the applicant‘s earnings (assuming

the other spouse is already collecting benefits).

If a 62-year-old working spouse claims reduced benefits based on his or her earnings, he

or she can ―step up‖ to a spousal benefit when that spouse retires (this assumes that the

other spouse, not yet retired, has higher earnings than the 62-year-old spouse). However,

often it is best to wait until ―full retirement age‖ (age 65-67, depending upon your year of

birth). For example, suppose Mr. Smith is expected to receive $1,800 a month from

Social Security at his full retirement age. Based on her earnings, Mrs. Smith is scheduled

to receive $800 a month at her full retirement age. If Mrs. Smith does wait until this time,

and assuming that Mr. Smith has also waited and is receiving benefits, she will then

receive $900 a month (the higher of her full benefit or ½ the benefit of Mr. Smith).

RETIREMENT 12.8

QUARTERLY UPDATES


GIFTS AND QUALIFYING FOR MEDICAID

Individuals generally become eligible for Medicaid after using up all but about $2,000.

Some people try to get around the intent of the law by making cash gifts to their children.

However, Medicaid has a five-year look-back period, potentially penalizing an applicant

or Medicaid recipient for any gifts made up to five years ago (note: the previous look-

back period was three years).

Besides increasing the look-back period, Medicaid has also changed the penalty period.

In the past, the penalty period was calculated based on when the gift was made; the clock

now starts when someone applies for Medicare. For example, support that under the old

rules, a New York City resident gave away $27,000 a year before applying for Medicaid

(note: $27,000 represents the cost of three months of long-term in NYC). In such an

instance, there would be no negative consequences for the applicant because an

application was not made for 12 months (nine months longer than the potential three

month penalty period). Under the new rules, there would definitely be consequences—

there would be no Medicaid payments for the first three months of the nursing home stay.

Your clients can find out the probability of needing nursing home care based on their age

and gender as well as the average length of stay by contacting the New England Journal

of Medicine which periodically collects such data from the National Nursing Home

Survey (NNHS).

HOME OWNERSHIP AS AN INVESTMENT

Advisors know that not even a stock market trader would put 60% or 70% of their

portfolio in just one stock. Yet, tens of millions of people have that much or more of their

total net worth in just one house. Over the past 30 years (1977 to 2007), home prices, on

average, increased 481%; San Francisco home owners enjoyed an 1,125% increase, while

residents of Houston experienced just 200% appreciation (source: Office of Federal

Housing Enterprise Oversight).

If you bought a house in Los Angeles in 1990, just as that real estate marketplace turned

downward, you would have had to wait 10 years before the home‘s value returned to

what you paid for it. If you bought in Rochester, N.Y. in 1980, your annual appreciation

rate for the next 25 years was 4% (between 0-1% if you adjust for inflation). If you

bought in Dallas in 1986, as the oil boom went bust, your home would not have

appreciated at all before 1998.

RETIREMENT 12.9

QUARTERLY UPDATES


To put things in perspective, if you bought a $50,000 home in San Francisco in 1977, it

was worth $613,000 by the beginning of 2007 (1,125% appreciation); after ownership

expenses (e.g., mortgage interest, taxes, insurance, maintenance and major repairs), the

true profit would have been $219,000. The comparable house in Los Angeles would have

been worth $593,000 in Los Angeles (1,085%), $549,000 in New York (998%) and

$432,000 in Washington (763%)—all of these figures are before ownership costs are

subtracted.

In some large cities, homeowners did not fare as well during the 1977 to 2007 period. In

Chicago, a $50,000 home grew to $282,000 (463%), $176,000 in Dallas (252%) and just

$147,000 in Houston (193%). After deducting ownership expenses in these three cites,

homeowners would have actually lost money over this 30-year period (not to mention the

effects of inflation along with the tax ramifications upon sale).

NURSING HOME RATING SYSTEM

By the end of 2008, it is expected that there will be a star rating system that will compare

the 16,000 nursing homes in the U.S. The system is expected to be available on

Medicare‘s web site. About 1.5 million Americans live in nursing homes each year; more

than three million end up in nursing homes at least temporarily. Roughly 22% of 5.3

million people 85 years old and older had a nursing home stay in 2006.

The rating system will give each nursing home from one to five stars based on

government inspection results, staffing data and quality measures. In 2007, Medicare

alone spent $21 billion on nursing homes.

HSA ACCOUNTS

Health Savings Accounts (HSAs), first introduced in 2004, are a high-deductible health

care plan for individuals. For 2008, the individual‘s health care deductible must be at

least $1,100 and have an out-of-pocket cap of $5,600. For a couple or family, the

deductible must be at least $2,200 and have a cap of at least $11,200. HSA non-

participants miss out on triple tax savings: [1] pre-tax contributions, [2] tax-free

growth and [3] qualified tax-free withdrawals.

RETIREMENT 12.10

QUARTERLY UPDATES


HSA accounts are somewhat similar to 401(k) retirement accounts: qualified workers can

contribute pre-tax dollars each year. Contributions and account earnings must be used to

pay for qualified health-care costs. The money grows tax free and workers can keep their

accounts if they switch jobs. Two thirds of employers who have high deductible health

care plans also make contributions to their workers‘ HSAs; the average employer

contribution in 2007 was $626 per employee. The total contributions cannot exceed an

annual limit, which is adjusted every year. For 2008, the maximum contribution is $2,900

(or $5,800 for a family or married couple).

Just like an IRA account, your clients have up until April 15th

(or when they file their tax

return, whichever is earlier) to make a contribution for the previous year as long as two

conditions have been fulfilled: [1] the client was enrolled in an eligible high-deductible

insurance plan by December 1st of the previous year and [2] the client remains in that

plan until at least December 31st of the current year (e.g., if the account was opened by

Dec. 1st, 2007, the client needs to stay with the plan until Dec. 31

st, 2008 in order to make

a 2007 contribution).

Your HSA clients should not file their tax return until they have received a copy of IRS

Form 5498. This form shows the custodian‘s tally of contributions made, which is

reported to the IRS. Several states tax the contributions and earnings of HSAs.

RETIREMENT STATISTICS

According to a 2005 study by the Urban Institute in Washington, people age 75 and older

typically spend 10% less per person than those age 65 to 74. It appears that this drop in

spending may not be ―voluntary.‖

The U.S. Census Bureau reports that seniors age 75 and older have an average

household net worth of $100,000, versus $120,000 for those age 70 to 74 and $114,000

for those 65 to 69 (note: all of these figures include home equity). If you strip out home

equity, households headed by someone age 75 and older have a typical net worth of

just $19,000. As a side note, annual inflation for seniors over the past 20 years has

been 3.2% versus 3.0% for the general public.

QUARTERLY UPDATES

STOCKS

STOCKS 13.1

QUARTERLY UPDATES


13.HOW TO LOVE A BEAR MARKETS

As of the middle of July 2008, the S&P 500 was up just 75 points from exactly 10 years

earlier, translating into a 10-year return of 0.63% per year. This means it would take an

investor 111 years to double their money. In order to have averaged 10% a year, an

investor would have had to bought into the market 19 years ago and held onto their

stocks.

From 1969 to 1982, the S&P 500 returned just 5.6% annually; factoring in inflation, the

5.6% gain turned into an annualized lose of 2% per year. Over the following 18 years

(1983 through 2000), stocks averaged 18.5% a year, meaning that a $10,000 investment

grew to more than $200,000.

According to Ben Graham, the author of the classic book, The Intelligent Investor, the

investor‘s ―chief problem–and even his worst enemy—is likely to be himself.‖ Warren

Buffet points out that investing is much like dieting; it is simple, but not easy. Perhaps the

real secret of being, or becoming, a great investor is bolstering your self-control.

During the 2008 annual meeting of Berkshire Hathaway, Mr. Buffet told the attendees

what it means to be an intelligent investor, ―If a stock goes down 50%, I look forward to

it so I can buy more shares before the bounce back.‖ An advantage Buffet has over most

investors is that he is usually sitting on a huge pile of cash; most investors are mostly, or

fully invested, and do not have the cash to take advantage of market downturns.

However, Buffet‘s belief brings up the idea of how one could structure a client‘s equity

portfolio: invest half now and use the ―equity‖ balance to buy quality bonds or cash

equivalents that can be used to buy more stocks when the market drops significantly.

Unfortunately, as appealing as such a strategy may sound, it smacks of a type of market

timing—something that has been shown not to work.

STOCKS 13.2

QUARTERLY UPDATES


S&P SECTOR WEIGHTINGS

Beginning in February 2002, the financial sector became the largest of the 10 sectors that

comprise the S&P 500. As of May 2008, the financial sector dropped down to 16% of the

S&P 500 (note: financial stocks make up a significant portion of the typical domestic

value stock fund), falling behind technology‘s 16.4% share. From October 2007 to May

2008, financial stocks lost $814 billion in market value. During the same period,

technology lost ―just‖ $263 billion. Tech stocks peaked in March 2000 at 34.9% of the

S&P 500; by October 2002 the sector represented just 13%. In the early 1980s, the

energy sector peaked at about 30% of the S&P; three years later, its share had been cut in

half.

2007 DOW JONES INVESTMENT SCOREBOARD

2006 2007

Stocks

Dow Jones Industrial Average 19.05% 8.88%

S&P 500 15.79% 5.49%

Russell 2000 18.37% -1.57%

Dow Jones Wilshire 5000 15.88% 5.62%

Bonds (Leman Brothers Indexes)

Long-Term Treasury Index 1.85% 9.81%

U.S. Credit Index AA-rated segment 4.32% 5.39%

Municipal Bond Index 4.84% 3.36%

Intermediate-Term Treasury Index 3.51% 8.83%

Mortgage-Backed Securities Index 5.22% 6.90%

Mutual Funds (Lipper Indexes)

Growth Fund Index 10.28% 8.45%

Growth and Income Fund Index 15.57% 4.68%

Balanced Fund Index 11.60% 6.76%

International Fund Index 25.89% 14.57%

Multi-Cap Value Index 17.07% -0.54%

Money Market (taxable) 4.28% 4.48%

STOCKS 13.3

QUARTERLY UPDATES


Bank Instruments (Bankrate.com)

1-Year CD 3.70% 3.72%

30-Month CD 3.83% 3.71%

Money Market Deposit Account 0.80% 0.86%

Precious Metals (futures contracts)

Platinum 17.09% 34.15%

Gold 22.95% 31.35%

Silver 45.50% 15.35%

Residential Real Estate (repeat-sale index)

Office of Federal Housing Enterprise

Oversight

4.2% 0.8%

2007 DOW JONES GLOBAL INDEXES

For the 2007 calendar year, India‘s stock market, as measured by the Bombay Sensex

Index, was up 39.3% in local currency. China‘s Shenzhen A Shares were up 167.0% and

their Shanghai A Shares were up 96.1%, both in local currency terms.

Country

U.S.

Dollars

Local

Currency

Country

U.S.

Dollars

Local

Currency

Brazil 71.1% 42.6% Greece 29.8% 17.1%

Malaysia 44.6% 35.5% Singapore 27.6% 19.7%

Hong Kong 44.5% 44.9% Canada 27.1% 7.8%

Thailand 39.0% 29.5% Norway 26.8% 10.6%

Indonesia 39% 45.1% Australia 25.3% 12.4%

Finland 39.0% 25.3% Portugal 24.5% 12.3%

Philippines 36.7% 15.1% Chile 23.0% 15.1%

South Korea 33.6% 34.5% Spain 17.8% 6.2%

Germany 30.5% 17.7% Denmark 17.6% 6.1%

STOCKS 13.4

QUARTERLY UPDATES


Country

U.S.

Dollars

Local

Currency

Country

U.S.

Dollars

Local

Currency

Iceland 13.1% -0.2% U.S. 3.8% 3.8%

South Africa 12.6% 9.1% New Zealand 2.2% -6.4%

Netherlands 12.0% 1.0% Italy 1.7% -8.3%

France 11.3% 0.4% Austria 1.6% -8.4%

Mexico 10.8% 11.7% Sweden -3.1% -8.5%

Taiwan 6.5% 6.0% Japan -6.0% -11.9%

Belgium 5.6% -4.7% Ireland -19.2% -27.1%

Switzerland 5.6% -2.0% World 8.4%

U.K. 3.8% 2.1% World, ex. U.S. 11.8%

U.S. STOCK MARKET VOLATILITY

Average daily price swings for the Dow Jones U.S. Total Market Index were more than

50% greater in 2007 than in 2006, as measured by standard deviation. Surprisingly,

volatility in 2007 was still well below the 10-year average from 1998-2007; six of the

past 10 years were more volatile than 2007. From the beginning of 1998 to the end of

2007, standard deviation for the index ranged from a low of roughly 10% (2004, 2005

and 2006) to a high of over 25% (2002).

Advisors who are looking for equities that have low correlation, as measured by R-

squared) to the overall U.S. stock market should consider the following sectors (listed

from low to high):

Sectors with Low Correlation to U.S. Stock Market: 2003-2007

(R-squared)

Travel & Tourism (2%) Automobiles & Parts (19%)

Pharmaceuticals (5%) Specialized Consumer Services

(20%)

Insurance Brokers (6%) Retailers (broadline) (26%)

Home Construction (6%) Personal Products (27%)

Forestry & Paper (8%) Semiconductors (31%)

STOCKS 13.5

QUARTERLY UPDATES


The reasons for the low correlations are straightforward. For example, pharmaceutical

profits are not tied as much to the overall economy as the prospects for a specific drug.

Similarly, cyclicals and capital-intensive sectors such as autos, forestry, paper and

semiconductors can deviate substantially from overall domestic market returns. These

―maverick‖ sectors can be quite useful when diversifying a stock portfolio since they tend

not to move with the market as a whole.

For advisors who have clients that do not like ―tracking error‖ (doing something the

market is not), consider the following sectors, all of which have an R-squared of between

95% and 99%:

Sectors with Very High Correlation to U.S. Stock Market: 2003-2007

(R-squared of 95-99%)

Commercial Vehicles Restaurants & Bars

Waste & Disposal

Services

Electric Utilities

Medical Supplies Clothing & Accessories

Electronic Equipment Life Insurance

Aerospace & Defense Industrial Services

STOCKS 13.6

QUARTERLY UPDATES


THE 20 LARGEST U.S. COMPANIES

The table below shows the 20 largest U.S. companies, as measured by stock market

capitalization as of the end of 2007 (source: Dow Jones). The market capitalization of

each is shown in parentheses (in billions).

2007 Largest U.S. Companies

Exxon Mobil ($504b) Cisco Systems ($165b)

GE ($375b) Google Class A ($163b)

Microsoft ($334b) Altria Group ($159b)

AT&T ($253b) Pfizer ($155b)

Proctor & Gamble ($228b) Intel ($155b)

Chevron ($195b) AIG ($149b)

Johnson & Johnson ($191b) J.P. Morgan Chase ($148b)

Wal-Mart Stores ($189b) IBM ($148b)

Bank of America ($186b) Citigroup ($146b)

Apple ($173b) Coca-Cola ($142b)

DOW JONES INDUSTRIAL AVERAGE

On February 19th

, 2008 the Dow Jones Industrial Average (DJIA) replaced two stocks

and added two new companies. Gone are Altria Group with a market cap of $153 billion

and Honeywell International with a market cap of $40 billion. Atria had been part of the

Dow since 1985, Honeywell since 1925. The new companies are Bank of America ($190

billion) and Chevron ($169 billion). By stock market value, Bank of America was the

largest U.S. bank and Chevron the second largest U.S. oil company after Exxon Mobil.

Chevron has been in the DJIA twice before, the first time as Standard Oil of California

(1924-1925).

STOCKS 13.7

QUARTERLY UPDATES


The Dow was originally comprised of 12 ―smokestack‖ companies when it was first

published on May 26th

, 1896; it has been a 30-stock average since 1928. These changes to

the Dow mark the first time the 111-year old average has made a change since 2004. The

changes were made by the managing editor of The Wall Street Journal, which is owned

by News Corporation. The table below lists the 30 stocks that make up the Dow, along

with their stock symbol (shown in parentheses), the date the stock became part of the

average and market value (shown in billions of dollars), as of February 11th

, 2008.

2008 Dow Jones Industrial Average

Exxon Mobil (XOM) 1928-present

$446b IBM (IBM) 1932-39; 1979-present

$141b

General Electric (GE) 1896-98; 1899-1901; 1907-present

$342b Hewlett-Packard (HPQ) 1997-present

$108b

Microsoft (MSFT) 1999-present

$238b Verizon Commun. (VZ) 2004-present

$106b

AT&T (T) 1916-28; 1939-2004; 1999-present

$222b Merck (MRK) 1979-present

$97b

Proctor & Gamble (PG) 1932-present

$202b McDonald‘s (MCD) 1985-present

$67b

Bank of America (BAC) 2008-present

$190b United Technologies (UTX) 1933-34; 1939-present

$65b

Johnson & Johnson (JNJ) 1997-present

$177b Walt Disney (DIS) 1991-present

$57b

Chevron (CVX) 2008-present

$169b Boeing (BA) 1987-present

$55b

Pfizer (PFE) 2004-present

$152b 3M (MMM) 1976-present

$52b

J.P. Morgan Chase (JPM) 1991-present

$148b Home Depot (HD) 1999-present

$47b

Citigroup (C) 1997-present

$134b American Express (AXP) 1982-present

$47b

Coca-Cola (KO) 1932-35; 1987 present

$126b Caterpillar (CAT) 1991-present

$44b

Wal-Mart Stores (WMT) 1997-present

$122b DuPont (DD) 1924-25; 1935-present

$41b

Intel (INTC) 1999-present

$118b Alcoa (AA) 1959-present

$29b

AIG (AIG) 2004-present

$113b General Motors (GM) 1915-16; 1925-present

$13b

QUARTERLY UPDATES

TAXES

TAXES 14.1

QUARTERLY UPDATES


14.TOP PERFORMING FUNDS AND TAX EFFICIENCY

The table below shows 12 equity funds whose three-year track record (ending 3/31/2008)

is better than that of the Vanguard 500 Index fund (VFINX) on an after-tax basis. The

table also includes Morningstar commentary about each of the funds.

Tax-Efficient Midsize and Large Cap U.S. Stock Funds

[3-year period ending 3/31/2008]

Fund (symbol)

Before

Taxes

After

Taxes

Expense

Ratio

Vanguard Capital Opportunity (VHCOX)

— run by Primecap Mgmt., which boasts ―one of the best

records‖ in the fund industry

10.5% 9.7% 0.4%

Fidelity (FFIDX)

— basic large-blend fund, one of Fidelity‘s cheapest

actively managed funds

8.7% 8.2% 0.6%

Primecap Odyssey Growth (POGRX)

— same contrarian style used at Vanguard Primecap

8.3% 8.1% 0.8%

Vanguard Primecap Core (VPCCX)

— contrarian growth strategy with large sector bets

8.1% 7.7% 0.6%

Harbor Capital Appreciation Instl (HACAX)

— overseen by Jennison Assoc., well-know manager of

pension and endowment funds

7.2% 7.1% 0.7%

Selected American Shares D (SLADX)

— co-run by Chris Davis, whose family owns the firm

and invests heavily in its own funds

6.8% 6.5% 0.6%

MSF Mass. Investors Growth Stock (MGTIX)

— retooled in late 2006 and is ―doing much better now‖

6.4% 6.3% 0.6%

Vanguard Tax-Managed Capital Apprec. (VMCAX)

— ―extremely tax efficient and has never paid out a

capital gains distribution‖

6.3% 5.7% 0.2%

Schwab Core Equity (SWANX)

— ―solid track record‖ using quantitative model

6.0% 5.7% 0.8%

DFA Tax-Managed U.S. Marketwide Value (DTMMX)

— uses computerized screening to identify candidates

6.2% 5.6% 0.4%

Mutual Shares Z (MUTHX)

— ―has delivered sold long-term returns‖ with low risk

6.9% 5.5% 0.7%

T. Rowe Price Capital Opportunity (PRCOX)

— stocks selected by 30 analysts, overseen by director of

research

5.9% 5.5% 0.7%

Vanguard 500 Index (VFINX) 5.7% 5.4% 0.2%

TAXES 14.2

QUARTERLY UPDATES


What is interesting to note is that the fund cited as being perhaps the most tax efficient

(see Morningstar quote), Vanguard Tax-Managed Capital Appreciation, has the same tax

efficiency (95%) as a lot of other funds that do not claim to be tax efficient (e.g., Schwab

Core Equity was also 95% tax efficient while Harbor Capital Appreciation was 99%

efficient).

Documents

IBF - Updates - 2008 (Q2 v1.0)