IBF - Updates - 2007 (Q1 & Q2 v1.0)

INSTITUTE

OF

BUSINESS & FINANCE

QUARTERLY UPDATES 2007 Q1 & Q2

Copyright © 2007 by Institute of Business and Finance. All rights reserved.

v1.0

Quarterly Updates Table of Contents MUTUAL FUNDS DISTURBING RETURN FIGURES YEAR-END WINDOW DRESSING PICKING THE NEXT TOP PERFORMERS A RANDOM WALK LARGEST FUND COMPANIES CORRELATIONS TO THE S&P 500 REVISITED STYLE BOXES FOCUSED FUNDS AND RISK LIFECYCLE FUNDS TARGET-DATE FUNDS EXPAND MORE AGGRESSIVE LIFE CYCLE FUNDS LONG-SHORT FUNDS DIVERSIFICATION BENEFITS FREQUENCY OF PORTFOLIO REBALANCING VALUE LINE HYPE ODDS OF BEATING AN INDEX MIXED PERFORMANCE RANKINGS ACTIVE VS. PASSIVE MANAGEMENT SIDE-BY-SIDE MANAGEMENT MANAGER-INVESTED MUTUAL FUNDS B SHARES REVIEWED BY SEC SHAREHOLDER PROXY VOTING SECURITIES LENDING PRACTICES FUND DIRECTOR PAY DIRECTORS AND 12B-1 FEES STOCKS AND MUTUAL FUNDS

1.1 1.1 1.2 1.2 1.4 1.5 1.6 1.7 1.8 1.8 1.9 1.10 1.10 1.12 1.12 1.13 1.15 1.16 1.17 1.19 1.25 1.26 1.27 1.28 1.28 1.29

ETFS ETF UPDATE THE LARGEST ETFS ETFS WITH LOW EXPENSE RATIOS ETF PRICE DISPARITIES SECTOR VOLATILITY BUYING AND SELLING ETFS

2.1 2.4 2.5 2.6 2.7 2.8

UITS AND CLOSED-END FUNDS UIT AND NEW FUND CRITICISM CLOSED-END FUND ASSET INCREASE CLOSED-END COVERED CALL FUNDS

3.1 3.1 3.2

REITS REIT UPDATE INTERNATIONAL REITS

4.1 4.2

STOCKS DOW MILESTONES DOW DROPS S&P 500 AND DJIA RETURNS SMALL CAP STOCKS QUALIFYING DIVIDENDS BUFFET WARNING DIVIDEND-PAYING BONUS VALUE PLAY

5.1 5.2 5.3 5.4 5.4 5.4 5.5 5.5

VALUE VS. GROWTH STOCKS ROLLING PERIODS: GROWTH VS. VALUE REVISITING GROWTH AND VALUE SMALL CAP VALUE GROWTH VS. VALUE 2006 INDEX RETURNS

6.1 6.2 6.7 6.8 6.9

BONDS CUSHION AGAINST STOCK DECLINES STOCKS VS. BONDS 2006 HIGH-YIELD BOND FACTS BOND MARKETS, INDEXES, AND FUNDS

7.1 7.1 7.2 7.3

GLOBAL INVESTING WORLD’S FINANCIAL ASSETS EMERGING MARKET DEBT 2006 GLOBAL INDEX RETURNS REDUCED GLOBAL CORRELATION EAFE COMPOSITION GLOBAL SMALL CAP BENEFITS DOMESTIC GLOBAL DIVERSIFICATION

8.1 8.2 8.2 8.3 8.4 8.6 8.7

COVERED CALL WRITING SPDRS AND COVERED CALL WRITING

9.1

EQUITY-INDEXED ANNUITIES EQUITY-INDEXED ANNUITIES (EIAS)

10.1

FINANCIAL PLANNING OPTIMAL REBALANCING PREDICTED MARKET MELTDOWN DISTRIBUTION OF RETURNS INVESTING IN A HOUSE AMERICA THE BANKRUPT? CPI SPENDING CATEGORIES GOLD VS. HERSHEY BARS HEDGE FUND DISASTERS HEDGE FUND WARNING CALCULATING A LUMP SUM ENDING UP WITH $1,000,000 GOALS AND RISK TOLERANCE TEST

11.1 11.4 11.5 11.6 11.7 11.7 11.9 11.10 11.11 11.11 11.12 11.12

RETIREMENT PLANNING RECONSIDERING THE ROTH 401(K) HEALTH SAVINGS PLANS 529 PLANS RETIREMENT PLAN INCREASES FOR 2007 RETIREMENT REALITY BENEFITS OF PATIENCE COSTS OF 401(K) PLANS RETIREMENT STATISTICS MAXIMUM SOCIAL SECURITY BENEFIT PEOPLE WORKING LONGER INFLATION MEASUREMENTS LONG-TERM CARE PARTNERSHIP DISCLOSURE PROTECTION FOR ORGAN DONORS FULLY FUNDED PENSION PLANS NEW MEDICAID RULES

12.1 12.2 12.3 12.3 12.7 12.8 12.9 12.10 12.10 12.11 12.11 12.15 12.17 12.18 12.18

TAXES 2007 TAX BREAKS TAX DOCUMENTS FREE TAX PREPARATION AND FILING TAX FACTS APPEAL TO CHILDREN FEDERAL RESERVE COMIC BOOKS YOUNG INVESTORS

13.1 13.2 13.3 13.3 13.5 13.6 13.6

QUARTERLY UPDATES MUTUAL FUNDS

MUTUAL FUNDS

1.DISTURBING

1.1

RETURN FIGURES

According to DALBAR, the average equity mutual fund investor experienced annualized returns of just 3.9% over the 20-year period ending December 31st, 2005. During this same period, inflation averaged 3% a year, while a buy-and-hold investment in the S&P 500 returned 11.9% a year.

YEAR-END WINDOW DRESSING For roughly the last week or two of the year, many mutual and hedge fund managers sell off poorly performing securities and replace them with the quarter’s best performers. Over the past 16 years, the S&P 500’s top-performing stocks of the first 11 weeks or so of the fourth quarter have outperformed the overall index by an average of 2.6% in the final week; this strategy has worked every year.

The Thomson Financial study suggests the efficiency comes from buying all of the top 50 performers and then selling them just before the first trading day of the next year. Another strategy worth considering is to buy stocks that are among the market’s worst 10% performers. Over the past 16 years, these stocks have beaten the S&P 500 by 1.8% in the first week of the new year (vs. 0.7% for the top-performing stocks).

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1.2

MUTUAL FUNDS

PICKING THE NEXT TOP PERFORMERS A study reviewed the top 30 mutual funds for sequential 5-year periods from 1971 to 2002. In each and every 5-year period, what had been a “top 30 fund” underperformed the S&P in subsequent years.

A RANDOM WALK In his 1973 book, A Random Walk Down Wall Street, author Burton Malkeil, stated that it was time for index funds. Three years later, Vanguard introduced the first retail index fund based on the S&P 500. Lipper data (shown in the table below) shows the difference in returns for the S&P 500 Index and the “average equity fund” (which consists of all Lipper large cap equity categories).

S&P 500 vs. U.S. Large-Cap Equity Funds 10 years (ending 12/31/06)

20 years (ending 12/31/06)

S&P 500 Index

8.4%

11.8%

Average Equity Fund

6.8%

10.4%

According to Malkeil, an S&P 500 index fund has outperformed more than 75% of actively managed, large cap equity fund over the past 10 and 20 years. The percentage would be even higher if it were not for “survivorship bias” (only measuring the performance of funds that were in existence during the 10-20 year period).

Furthermore, the index fund has been more tax efficient.

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1.3

In 1970 there were 355 equity funds, only 117 were still in existence at the end of 2006. Of the surviving 117 funds, 57 underperformed the S&P 500, 38 had equivalent returns, and 22 outperformed the index. Looking at the funds that either closely matched or outperformed the S&P 500, 27 outperformed the index by 0-1%, 16 by 1%, two by 2%, one by 3%, and one by 4%.

Malkeil acknowledges that the Fundamental Index has done well during the early 2000s, but that such performance has been due to the fundamental index’s bias toward value and small cap. The author further points out that there have certainly been times when “the market makes mistakes—it goes crazy sometimes.” As an example, at the height of the market bubble in 2000, Cisco represented 4% of the S&P 500, yet it represented just 0.02% of the economy. In 1999, Amazon had a market value over $30 billion, even though it had yet to ever make a profit. In fact, its losses for 1999 were over $600 million. At its height, technology stocks represented a third of the S&P 500 (according to TheStreet.com, telecom and technology combined represented 45% of the S&P 500 as of March 2000).

According to Malkeil, “My argument for indexing was based on my belief that our equity markets are remarkably efficient. When information arises about the stock market or individual stocks, that information gets reflected without delay—switching from stock to stock in an attempt to provide superior performance—is unlikely to be effective, especially when you add in trading costs and taxes.”

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1.4

MUTUAL FUNDS

LARGEST FUND COMPANIES According to Lipper, the 30 largest mutual fund families manage more than 75% of the industry’s assets; the top 10 companies control 47% and the biggest 60 oversee nearly 91% of all mutual fund assets. The table below shows the top 10 fund companies, as of the end of the third quarter 2006 (note: “b” = billion and “t” = trillion).

Largest Mutual Fund Companies [as of 9-30-2006] Company

Open- Closed- Variable End End Annuities Total

%

Fidelity

$1 t

$0

$60 b

$1.1 t

11%

Vanguard

$1 t

$0

$10 b

$1.0 t

10%

American Funds

$925 b

$0

$85 b

$1.0 t

10%

Franklin / Templeton

$280 b

$4.3 b

$30 b

$315 b

3%

BlackRock / Merrill

$250 b

$31 b

$9 b

$290 b

3%

Bank of America / Fleet

$230 b

$0.9 b

$5.9 b

$240 b

2%

Morgan Stanley

$195 b

$16 b

$17 b

$225 b

2%

Allianz / PIMCO

$200 b

$12 b

$14 b

$225 b

2%

JP Morgan / Chase

$220 b

$0.7 b

$0.6 b

$225 b

2%

Legg Mason / Citibank

$200 b

$8.7 b

$9 b

$220 b

2%

Industry Total

$8.9 t

$240 b

$1.1 t

$10.3 t 100%

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1.5

CORRELATIONS TO THE S&P 500 REVISITED A review of the past handful of years shows that the correlation coefficient of a number of categories with the S&P 500 has increased. As an example, from February 2000 to February 2006, nine of the 10 different sectors in the S&P 500 (e.g., financials, consumer cyclicals, energy, etc.) showed a correlation of at least 75% with the overall market. By contrast, in 2000, only two sectors moved in such close step with the S&P 500. The table below shows five-year correlations to the S&P for four different categories.

5-Year Correlations to the S&P 500 [Feb. 2000 and Feb. 2006] Index

2000 correlation

2006 correlation

Hedge funds

35%

96%

MSCI EAFE

32%

96%

Russell 2000

62%

94%

Goldman Commodity

-14%

33%

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1.6

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STYLE BOXES Morgan Stanley, Morningstar, Russell, Standard & Poor’s, and Wilshire have very different definitions of market capitalization.

Among just these five services, the definition of “large cap” stocks ranges anywhere from 67% to 92% of total U.S. stock market capitalization. These five services have different definitions of “small cap.” The differences range from 3% of total market capitalization (Morningstar) up to 12% (Morgan Stanley). Russell does not recognize “mid cap” stocks per se, but does designate the smallest 25% of their large cap index as “mid cap.”

Only half of what Morningstar classifies as “mid cap” is categorized the same way by S&P. Morningstar and S&P disagree about 30% of the time as to what is “mid cap.” The two companies also disagree as to what is “growth” and “value” 20% of the time.

About 50% of Morningstar’s “mid cap” stocks are smaller than the largest “small cap” S&P stocks.

S&P re-categorizes stocks twice a year during the second and fourth quarters. During these quarters, an average of one in nine stocks changes categories; 90% of these changes come as a result of re-categorizing a growth stock as a value play, or vice versa—only 10% is size reclassification.

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1.7

Critics of the nine equity style boxes point out that diversifying across 13 widely-recognized asset classes, such as stocks, bonds, money market, international, etc, is seven times more effective than diversifying across the nine different stock categories. The critics believe that potentially 74% of portfolio volatility can be eliminated in this way (vs. only 11% amongst the different domestic stock categories). In short, those who question stock style boxes believe that U.S. stocks, regardless of size or being classified as growth, value, or blend, are a single asset class, not six or nine.

FOCUSED FUNDS AND RISK Focused funds that have low turnover tend to also have low volatility. For example, mutual funds that were in the quartile with the fewest stocks and in their category’s lowest-turnover quartile had a lower standard deviation than the category average in over 75% of rolling one-, three-, five-, and 10-year periods combined.

For the 2000, 2001, and 2002 calendar years, as a group, concentrated funds performed better than their non-concentrated peers. In 2001, funds in the most-concentrated quartile had performance in the top 39% of their category’s average; the least concentrated quartile averaged a 54% ranking.

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1.8

MUTUAL FUNDS

LIFECYCLE FUNDS Lifecycle fund assets increased by over 60% in 2006. Some financial advisors are concerned that the equity exposure many of these funds for those about to retire is too high (e.g., “2010 funds� have stock exposures as high as 63% in the case of Charles Schwab and T. Rowe Price). A University of Maryland finance professor recommends using three lifecycle funds. For example, someone retiring in 2015 could buy a 2015 fund to cover the first 10 years of retirement, a 2025 fund to pay for the years from ages 75 to 85, and a 2035 fund for the final years.

TARGET-DATE FUNDS EXPAND As of early May 2007, there were 34 mutual fund companies that offered one or more target-date funds. This $150 billion asset category has increased in popularity partially because of the federal pension bill, wherein target-date funds are frequently the default option for 401(k) plan participants.

Besides growing in popularity, target-date funds have also expanded the number of investment categories they invest in; emerging market stocks, REITs, TIPS, private equity, commodities, leveraged loans, and/or long-short funds are now being used by more and more of these funds.

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1.9

MORE AGGRESSIVE LIFE CYCLE FUNDS A number of life cycle funds have increased their stock allocation from 80% to 90% for younger investors. One life cycle fund for those just retiring has 55% in common stocks and 10% in REITs; the fund shifts to 25% in stocks, 10% in REITs, and 65% in fixed income for those age 80. The fund company’s research found that a 1% higher annual return beginning at age 25 could fund “more than 10 additional years of retirement spending.”

When determining the appropriate asset mix for your older clients, think of their Social Security payments as a fixed-rate annuity; this means that most retirees will end up with a larger percentage allocated to fixed income than they think. One way to calculate this percentage is to add up all projected Social Security payments, discounted by a present value percentage.

Other mutual fund life cycle studies reach four additional conclusions: (1) investors tend to pick portfolios that are more aggressive than their ages warrant; (2) when a couple retires, it should be expected that at least one of them will reach their 90s; (3) the biggest risk to retirees is outliving their assets; and (4) life cycle funds are likely to grow at an even more robust rate after the passage of the Pension Protection Act of 2006 (which encourages companies to automatically enroll workers into qualified retirement plans—a life cycle fund could be the default selection if the employee does not pick another option).

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1.10

MUTUAL FUNDS

LONG-SHORT FUNDS Long-short funds ($14 billion in assets as of July 2006) are sometimes confused with market neutral funds. Market neutral funds balance their short and long positions, giving them a net market exposure of zero; long-short funds either have a consistent long bias or adjust their long-short mix tactically over time.

Long-short funds give smaller investors access to certain hedge fund strategies and although they are less expensive than hedge funds, costs can still be high. Some long-short funds have an expense ratio as high as 4% (vs. 1.5% for the average domestic stock fund). Over the past three years (ending 12/31/2006), long-short funds averaged 7.5% annually.

DIVERSIFICATION BENEFITS Many advisors have seen an “element chart” of investment returns, asset category performance rankings over each of the past several years. What few advisors have seen is such a chart that includes not only growth and value plays, but REITs, mid cap issues, and, most importantly, the ranking of a “diversified portfolio” (defined as an equal weighting in each of the nine asset classes ranked below).

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1.11

Yearly Asset Category Rankings [1992-2006] 1992 1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

SV 29%

FS 33%

FS 8%

LG 38%

RE 36%

LG 37%

LG 42%

SG 42%

RE 26%

RE 15%

IB 10%

SG 49%

RE 30%

FS 14%

RE 34%

HY 16%

SV 24%

LG 3%

LV 37%

LG 24%

MC 32%

FS 20%

LG 28%

SV 23%

SV 14%

RE 5%

SV 46%

SV 22%

MC 13%

FS 27%

RE 12%

LV 19%

RE 1%

SG 31%

LV 22%

SV 32%

MC 19%

FS 27%

MC 18%

IB 8%

HY -1%

FS 39%

FS 21%

RE 8%

SV 23%

MC 12%

RE 19%

DP 0%

MC 31%

SV 21%

LV 30%

LV 14%

MC 15%

IG 12%

HY 5%

SV -11%

RE 38%

MC 16%

DP 7%

LV 21%

LV 11%

HY 17%

LV -1%

SV 26%

MC 19%

DP 21%

DP 9%

DP 13%

LC 6%

MC -1%

DP -12%

MC 36%

DP 16%

LV 6%

DP 17%

DP DP 10% 17%

HY -1%

DP 26%

DP 17%

RE 19%

IB 9%

LV 13%

DP 2%

DP -1%

MC -15%

DP 33%

LV 16%

SV 5%

SG 13%

SG 8%

MC 14%

SV -2%

HY 19%

HY 11%

SG 13%

HY 2%

HY 2%

HY -6%

SG -9%

FS -16%

LV 32%

SG 14%

SG 4%

HY 12%

IG 7%

SG 13%

SG -2%

IG 18%

SG 11%

HY 13%

SG 1%

IG -1%

FS -14%

LV -12%

LV -21%

HY 29%

HY 11%

LG 3%

LG 11%

LG 5%

IG 10%

IG -3%

RE 18%

FS 6%

IG 10%

SV -6%

SV -1%

LG -22%

LG -13%

LG -24%

LG -26%

LG 6%

HY 3%

MC 10%

FS LG -12% -2%

MC -4%

FS 12%

IG 4%

FS 2%

RE -19%

RE -6%

SG -22%

FS -21%

SG -30%

IG 4%

IG 4%

IG 2%

IG 4%

SV = Russell 2000 Value Index

MC = S&P MidCap 400 Index

IG = Lehman Aggregate Bond Index

SG = Russell 2000 Growth Index

FS = EAFE Index

RE = FTSE NAREIT REIT Index

LG = S&P 500 / Barra Growth Index

HY = Lehman High-Yield Index

DP = equal parts of other 9 indexes

LV = S&P 500 / Barra Value Index

Observations Large growth ranked at the top or bottom窶馬ever in the middle.

REITs ranked number one more than any other category.

Quality bonds ranked last more than any other category.

The diversified portfolio always landed in the middle.

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1.12

MUTUAL FUNDS

FREQUENCY OF PORTFOLIO REBALANCING According to the Financial Planning Association (FPA), the optimal interval for rebalancing is 15-17 months, on average.

Research shows that if a portfolio is rebalanced more than about once every 16 months, winners are sold off too quickly. An October 2006 study by the Pension Research Council at Wharton showed that only 10% of 401(k) participants studied rebalanced their accounts on either an active or a passive basis (e.g., using a lifecycle or target retirement fund). The study, which looked at over one million 401(k) participants, showed that passive rebalancing increased returns by 84 basis points annually, versus just 26 basis points for those who rebalanced on their own.

VALUE LINE HYPE The Value Line Web site states, “A stock portfolio with #1 Ranked stocks for Timeliness from The Value Line Investment Survey, beginning in 1965 and updated at the beginning of each year, would have shown a gain of 19,715% through December 31st, 2004. This gain would have beaten the S&P 500 by more than 15 to 1 for the same time span.

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1.13

ODDS OF BEATING AN INDEX For the five-year period ending December 31st, 2006, only 15% of large value managers beat their respective index; 90% of large growth managers beat their index. One group of managers is not any smarter or intuitive than the other. The disparity shows that most funds are less “style-pure” than “style specific” (e.g., large value funds hold stocks other than those classified as “large value,” whereas a large value index would have virtually all, if not all, of its holdings in “large value”). For example, the typical large cap growth fund has the following composition.

Composition of the Average U.S. Large Cap Growth Fund 49% large growth

10% mid-cap growth

< 1% small blend

27% large blend

4% mid-cap blend

< 1% small growth

6% large value

< 1% small value

If new benchmarks are calculated using the actual weightings, 35% of large cap growth managers outperformed their “index” over the past five years ending December 31st, 2006; 38% in the case of large cap value managers. For the three-year period ending 12/31/2006, 24% of small growth funds beat their weighted benchmark versus 39% of large growth funds. Such results may cast some doubt on whether or not the common assumption that small caps are a better arena for active management.

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MUTUAL FUNDS

Looking at just annual returns, the pattern remains consistent within a fairly narrow range. In 1998, 44% of mutual funds in the nine style box categories (e.g., large cap growth, large cap value, large cap blend, mid-cap growth, etc.). In 1999, when technology stocks soared, 50% of the funds beat their custom benchmark; the same results occurred for 2000 and 2001 and actually increased to 57% in 2002 (probably due to the large cash holdings that year when the market dropped). When the market rebounded in 2003, only 35% of actively managed funds outperformed their custom benchmark. In 2004, the number rose to 42%, 47% in 2005, and then fell to 35% for the 2006 calendar year.

Over 90% of domestic stock funds have geometric mean market capitalizations below that of the S&P 500; thus, these funds could outperform the S&P 500 when small and mid cap stocks are in favor, and underperform when large blue chips do well.

Not only has independent research come up with a dramatically lower return figure than Value Line’s claim, recent data would appear to support the independent research. The flagship Value Line mutual fund (VLIFX) uses the same criteria that guide The Value Line Investment Survey (according to the fund’s prospectus). Yet, the fund has only outperformed the S&P 500 twice over the past 10 years. The fund’s 10-year record as of May 30th, 2006 was 6% annually, versus 9% for the S&P 500. Over the past 15 years, the fund averaged 9.1% versus 10.9% for the S&P 500.

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1.15

MIXED PERFORMANCE RANKINGS A 2007 study by DeiMeo Schneider shows that roughly 90% of mutual fund managers whose performance ranking in the top quartile for 10 years ending December 31st, 2006 also had performance that was below its categoryâ&#x20AC;&#x2122;s median for at least three or more of those 10 years. It turns out that just over 50% of pension managers whose 10-year record was in the top quartile experienced below median results for at least five consecutive years during the same 10 years.

The results become even more extreme within certain categories.

Over two-thirds of the top quartile foreign equity fund managers and just under 75% of the top quartile medium-term bond fund managers underperformed their categoryâ&#x20AC;&#x2122;s median returns for three years or more during the 10-year period. There was at least a five-year continuous stretch of underperformance for 72% of mid-cap blend, 71% of REIT, and 70% for emerging market equity managers whose performance ranked in the top quartile for the same 10 years ending December 31st, 2006.

Overall, the study showed that, on average, 22% of top-quartile managers were in the bottom half of their peer groups during any given three-year period. Based on these findings, it appears that at any given time, close to a quarter of the top-performing pension fund managers and mutual fund managers will experience a three-year stretch of underperformance at any given quarterly review.

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1.16

MUTUAL FUNDS

ACTIVE VS. PASSIVE MANAGEMENT Advocates of passive management (index funds) rarely talk about accurate benchmark comparisons. For example, the average large cap value fund has only about 40% of its assets in large cap value stocks; the balance is in a variety of other stocks such as small and mid cap growth as well as value.

Over the past five years ending March 31st, 2007, only 15% of the large cap value stock funds outperformed their benchmark. Using “custom” benchmarks (meaning an index that is comprised of equities that a particular asset category’s management actually invests in), 35-47% of the managers outperform their “actual” index.

The editor of a Vanguard newsletter uses active management for his core portfolio. The editor suggests using actively-managed funds for those you have “the greatest confidence in; use passive index funds in those categories you cannot find a super-compelling active management.”

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SIDE-BY-SIDE MANAGEMENT A number of mutual fund managers are serving two masters: the fund(s) they oversee and one or more hedge funds. Mutual funds sharing managers with hedge funds include Ameriprise, Nationwide, Pioneer, and Vanguard. There are 125 individual portfolio managers simultaneously running mutual funds and hedge funds. Total mutual fund assets potentially affected by this possible conflict of interest is $450 billion.

In 2003, the U.S. House of Representatives approved a measure, later shelved, that would have barred someone from running a hedge fund and mutual fund at the same time. Early in 2007, an SEC official testifying in front of Congress said such a practice “presents significant conflicts of interest that could lead the adviser to favor the hedge fund over other clients.” Indeed, there are a number of ways such favoritism could occur: 1. sell shares of a security in a hedge fund before a similar sale in the mutual fund; 2. instead of assigning a trade to a specific fund at the time of execution, a manager could “cherry pick” trades (e.g., trade in the morning and assign it to the hedge fund or mutual fund later in the day depending on its performance); 3. managers who have access to a limited number of hot IPOs might favor the hedge fund over the mutual fund (since the hedge fund has higher management fees plus a typical 20% performance incentive fee); and 4. shorting stocks in a hedge fund while holding a long position in a mutual fund could cause the stock’s price to drop.

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MUTUAL FUNDS

The SEC does not dictate how managers should address these potential conflicts of interest. Academic studies are divided on whether or not mutual fund investors are well served or hurt by multiple-role (side-by-side) management.

A study by William & Maryâ&#x20AC;&#x2122;s Mason School of Business and the Wharton School looked at more than 450 mutual funds run by companies who also managed hedge funds between 1994 and 2004.

The study found that in such instances, the mutual fund investors underperformed their peer group by 1.2% a year. A Loyola University Chicago, University of California, and University of Illinois study reviewed 200 mutual funds run by side-by-side managers (who also ran hedge funds) with a similar investment style and found that the mutual funds outperformed their peers by 1.5% annually from 1990 through 2005.

Starting in 2006, the SEC began to require funds to disclose other types of accounts run by the manager and total assets affected. Such information is found in the fundâ&#x20AC;&#x2122;s statement of additional information (SAI). To find out what types of funds are managed by a fund company, advisors and investors can search www.adviser info.sec.gov.

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1.19

MANAGER-INVESTED MUTUAL FUNDS Mutual fund managers who own shares of the funds they oversee outperform, on average, funds that are not partially owned by management. A 2006 study done by three business schools looked at the total returns of 1,300 stock and bond funds. The study looked at managers who owned shares (43% of the 1,300 funds) versus funds with no management ownership (57%).

Manager-owned funds had a mean return of 8.7% vs. 6.2% for funds with no management ownership; the highest percentage of management ownership was with U.S. stock funds and lowest with foreign bond funds.

As of the beginning of 2007, of the 500 mutual funds most highly recommended by Morningstar, more than 150 managers had each invested more than $1 million in their funds. The most extreme example of management ownership was Bill Dâ&#x20AC;&#x2122;Alonzo who oversees Brandywine (BRWIX) and Brandywine Blue (BLUEX); he had 100% of his liquid net worth invested in these two funds. Other examples include: Selected American (SLASX) and Selected Special (SLSSX), two funds whose employees and those affiliated with the fund collectively owned over $2 billion worth of shares; Longleaf employees and directors owned over $500 million of their funds; Chuck Royce had $50 million of his own money invested in Royce Total Return (RYTRX) and Royce Premier (RYPRX).

The extensive table below shows over 170 mutual funds whose management owns over $1 million in their fund.

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1.20

MUTUAL FUNDS

Mutual Funds Whose Management Owns $1,000,000+ in the Fund [partial list] Fund Name

Fund Name

ABN AMRO/Montag Gr. N

Amer Funds WashingtonA

Aegis Value

American Beacon IntEq Pln

Allianz REC Glob Tech Ins

Ariel

Amer Funds Amcap A

Ariel Appreciation

Amer Funds Amer Bal A

Artisan International Inv

Amer Funds Amer Mut A

Artisan Intl Sm Cap

Amer Funds CapWrldBd A

Artisan Intl Val

Amer Funds CapWrldGl A

Artisan Mid Cap Inv

Amer Funds CpIncBldr A

Artisan Small Cap

Amer Funds EuroPacific A

Baron Asset

Amer Funds Fundamental A

Baron Fifth Avenue Growth

Amer Funds Growth Fund A

Baron Growth

Amer Funds Income Fund A

Baron Partners

Amer Funds Inv. Co. Am A

Baron Small Cap

Amer Funds New Economy A

Bogle Small Cap Gr Inv

Amer Funds New Perspective A

Brandywine

Amer Funds New World A

Brandywine Blue

Amer Funds Sm World A

Calamos Gr & Inc A

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1.21

Mutual Funds Whose Management Owns $1,000,000+ in the Fund [partial list] Fund Name

Fund Name

Calamos Growth A

FBR Small Cap

Causeway Intl Value Inv

Fidelity Balanced

Chase Growth

Fidelity Blue Chip Grth

Chesapeake Core Growth

Fidelity Contrafund

Columbia Acorn Z

Fidelity Dividend Growth

Davis Appr & Income A

Fidelity Equity-Inc

Davis Financial A

Fidelity Leverage Co Stk

Davis NY Venture A

Fidelity Low-Priced Stk

Delafield

Fidelity Magellan

Delphi Value Retail

Fidelity Value

Dodge & Cox Balanced

First Eagle Fund of Am Y

Dodge & Cox Intl Stock

First Eagle Glbl A

Dodge & Cox Stock

First Eagle Overseas A

Dreyfus Appreciation

FPA Capital

Dreyfus Prem Bal Opp J

Franklin Growth A

Eaton Vance Wld Health A

Gabelli Asset AAA

Fairholme

Gabelli Growth AAA

FAM Value

Gabelli Sm Cp Growth AAA

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1.22

MUTUAL FUNDS

Mutual Funds Whose Management Owns $1,000,000+ in the Fund [partial list] Fund Name

Fund Name

Gateway Fund

Legg Mason Opp Prim

Harbor Capital App Instl

Legg Mason Value Prim

Harbor Intl Instl

LKCM Small Cap Equity Ins

Homestead Value

Longleaf Partners

Hussman Strategic Growth

Longleaf Partners Intl

ICAP Equity

Longleaf Partners Sm-Cap

ICAP International

Loomis Sayles Bond Ret

ICAP Select Equity

Lord Abbett Affiliated A

Janus

Marsico Focus

Janus Contrarian Fund

Marsico Growth

Janus Enterprise

Mastersâ&#x20AC;&#x2122; Select Equity

Janus Mid Cap Val Inv

Matrix Advisors Value

Janus Orion

Meridian Growth

Janus Overseas

Meridian Value

Janus Sm Cap Val Instl

Merrill Global Alloc A

Janus Twenty

Muhlenkamp

Jensen J

Mutual Shares A

Kalmar Gr Val Sm Cp

Nicholas

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1.23

Mutual Funds Whose Management Owns $1,000,000+ in the Fund [partial list] Fund Name

Fund Name

Nicholas II I

Royce Value Service

Northeast Investors

RS Emerging Growth

Oak Value

RS MidCap Opport

Oakmark Equity & Inc I

Schneider Value

Oakmark Global I

Selected American S

Oakmark I

Sequoia

Oakmark International I

Skyline Spec Equities

Oakmark Intl Small Cap I

Sound Shore

Oakmark Select I

T. Rowe Price Eq Inc

Osterweis Fund

T. Rowe Price Gr Stk

Pioneer A

T. Rowe Price Mid Gr

Pioneer High Yield A

T. Rowe Price New Horiz

PRIMECAP Odyssey Agg Gr

T. Rowe Price Sm Val

PRIMECAP Odyssey Growth

Third Avenue Intl Value

Royce Opportunity Inv

Third Avenue RealEst Val

Royce Premier Inv

Third Avenue Sm-Cap Val

Royce Special Equity Inv

Third Avenue Value

Royce Total Return Inv

Thompson Plumb Growth

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MUTUAL FUNDS

Mutual Funds Whose Management Owns $1,000,000+ in the Fund [partial list] Fund Name

Fund Name

Thornburg Intl Value A

Vanguard PRIMECAP Core

Thornburg Value A

Vanguard Selected Value

Torray

Vanguard Wellesley Inc

Turner Small Cap Growth

Vanguard Wellington

Tweedy, Browne American

Vanguard Windsor II

Tweedy, Browne Glob Val

Wasatch Micro Cap

Van Kampen Comstock A

Wasatch Small Cap Growth

Van Kampen Eq and Inc A

Wasatch Ultra Growth

Van Kampen Growth & IncA

Weitz Hickory

Vanguard Cap Opp

Weitz Partners Value

Vanguard Capital Value

Weitz Value

Vanguard Explorer

Wesport R

Vanguard Health Care

WF Adv Common Stk Z

Vanguard PRIMECAP

WF Adv Opportunity Inv

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1.25

B SHARES REVIEWED BY SEC During 2006, the NASD imposed more than $40 million of fines on brokerage firms for improperly selling B and C mutual fund shares.

During the early part of 2007, the SEC acknowledged that one of its key arguments no longer exists; the agency had assumed A shares were always better than B shares. The NASD commission now believes that cost alone is not the only decision in making investment recommendations.

Most of the lawsuits against brokerage firms were based on one of three things: (1) failure to tell clients that A shares can be cheaper than B shares, (2) fraud, and/or (3) suitability. In a 2007 case dropped by the SEC, the agency acknowledged that even at the $250,000 breakpoint, B shares may not be more expensive for the client than A shares.

Because of regulatory concern, brokerage firms have generally limited B share sales to $50,000 or less. Shares of B shares had fallen to 3% of the market in 2006, down from 10% in 2001. One broker, now retired, spent $400,000 in legal fees and lost $1.6 million in deferred compensation in 2001 when his broker-dealer fired him over the sale of B shares. In late 2005, a NYSE arbitration panel ordered the firm to pay all deferred compensation plus legal fees.

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1.26

MUTUAL FUNDS

SHAREHOLDER PROXY VOTING During 2006, there were 1,400 filings by mutual funds asking shareholders to vote on fund changes. The number of filings represents about 20% of all mutual funds. During the first quarter of 2007, roughly 340 were seeking shareholder votes, according to governance tracker the Corporate Library. The top issues voting upon by shareholders have been issues dealing with directors and/or trustees, investment restrictions and policies, and sub-advisor agreements.

Fund companies want shareholders to vote as soon as possible for such changes. If the necessary number of votes is not obtained, more shareholder solicitation is required and this costs the fund, and specifically its shareholders, more money. Among the most popular, and worrisome proposals, are changes to investment limits, loosening limits on borrowing and lending, requesting greater flexibility in real estate and commodity investments, and taking bigger positions in stocks or foreign holdings.

Despite investorsâ&#x20AC;&#x2122; concerns about proxy voting, shareholders rarely show up at an announced meeting. For example, only 50 Dodge & Cox investors showed up a few years ago to a meeting; only one shareholder attended the $4.3 billion Alger Fundsâ&#x20AC;&#x2122; January meeting.

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MUTUAL FUNDS

1.27

SECURITIES LENDING PRACTICES Mutual funds and ETFs lend some of the securities in their portfolios in exchange for interest payments and collateral, which provides additional returns for fund investors (well under 1/10th of 1%).

Although this practice is not new, the explosive growth of hedge funds engaged in short selling has greatly increased the demand for borrowed securities.

When a hedge fund, or any investor, enters a short sale (betting a stock will fall), they are selling a stock they have borrowed in hopes of buying it a lower price later, replacing the borrowed shares and pocketing the difference. Lending occurs through an agent that finds brokerage firms needing to borrow the securities. The agent takes a split of the money earned from the lendingâ&#x20AC;&#x201D;from 10-30% of the interest charge. What remains is then added to the portfolioâ&#x20AC;&#x2122;s cash reserves.

The SEC issues guidelines that funds and ETFs must follow when setting up securities-lending agreements. The requirements are more stringent if the fund does its lending through an agent affiliated with the fund management company.

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1.28

MUTUAL FUNDS

FUND DIRECTOR PAY As measured by asset size, the largest fund companies had a median annual compensation of $172,000 for a director in 2006. For 2005, the median annual compensation for the large fund companies was $147,000 per director. The average cost to shareholders was 15.4¢ per $10,000 in assets. The figure was 16.1¢ in 2005.

A survey of over 330 fund families found that over 80% of fund directors are independent; 60% of the time in the case of the fund’s chairperson, up from 50% in 2005.

DIRECTORS AND 12B-1 FEES An association of independent mutual fund directors has prepared guidelines to help fund directors assess fees. The May 2007 report follows an earlier announcement in 2007 that the SEC was reviewing the rule that allows such fees.

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MUTUAL FUNDS

1.29

STOCKS AND MUTUAL FUNDS Today’s S&P 500 was created in 1913 by Alfred Cowles in order to “portray the average experience of U.S. stock market investors.” In 2005, about 41% of the revenue for the S&P 500 companies came from operations outside the U.S. GE expects that 49% of its global revenue for 2007 will come from countries other than the U.S. At the end of 2006, the top 10 stocks in the S&P 500 represented 20% of the index’s total value and performance.

The number of households with more than $5,000 in stock fell from 40% to 35% from 2001 to 2004. In 2001, the top 10% of all U.S. households owned 75% of all taxable stock; the wealthiest 1% owned 29%. For each $1 increase in stock wealth boosts consumption by 4.5¢, while each $1 increase in housing wealth increases consumption by 7¢. Mutual funds represent approximately 25% of the financial assets owned by homeowners.

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ETFS

2.1

2.ETF

UPDATE

The first table below shows exchange-traded fund (ETF) asset growth over each of the past several years.

ETFs: Number and Assets (in billions) [5/15/07] Year

#

Assets

Year

#

Assets

2002

109

$10.2

2005

206

$30.2

2003

116

$15.1

2006

335

$41.8

2004

152

$22.7

2007 (2nd qtr.)

500

$50.0

The next table shows the largest ETF management companies. The percentage figures indicate the percentage of the entire ETF marketplace managed by each company; Barclays oversees just under 60% of the entire ETF industry assets.

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2.2

ETFS

Market Share of ETF Companies Management Co.

% of Whole

Barclays Global Investors Fund

59.6%

State Street Global Advisors

23.4%

BNY Hamilton

6.3%

Vanguard Group

5.7%

Powershares Capital

2.3%

Rydex Funds

0.9%

WisdomTree

0.5%

Victoria Bay Asset Management

0.5%

DB Commodity Services

0.3%

Van Eck Corporation

0.2%

First Trust Advisors

0.1%

Claymore Advisors

0.1%

Fidelity Distributors

0.1%

There is expected to be roughly 800 ETFs by the end of 2007. There are currently 32 ETFs that focus on technology, 35 investing in natural resources, 39 devoted to health care, and 22 focused on the financial sector.

If you have high-risk investors, consider the “double” ETF funds listed below. These funds, with an average expense ratio of just under 1%, are designed to double an investor’s gains (or losses), whether the market (or sector) goes up (long) or drops (short). All of these ETFs trade on the AMEX.

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ETFS

2.3

ETFs That Double Gains (or Losses) Double Long ETFs

Double Short ETFs

Ultra Basic Materials (UYM)

UltraShort Basic Materials (SMN)

Ultra Consumer Goods (UGE)

UltraShort Consumer Goods (SZK)

Ultra Consumer Services (UCC)

UltraShort Consumer Services (SCC)

Ultra Financials (UYG)

UltraShort Financials (SFK)

Ultra Health Care (RXL)

Ultra Short Health Care (RXD)

Ultra Industrials (UXI)

UltraShort Industrials (SIJ)

Ultra Oil & Gas (DIG)

UltraShort Oil & Gas (DUG)

Ultra Real Estate (URE)

UltraShort Real Estate (SRS)

Ultra Semiconductors (USD)

UltraShort Semiconductors (SSG)

Ultra Technology (ROM)

UltraShort Technology (REW)

Ultra Utilities (UPW)

Ultra Short Utilities (SPD)

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2.4

ETFS

THE LARGEST ETFS The table below shows the 15 largest ETFs, ranked largest to smallest, based on asset size in billions of dollars, as of the beginning of 2007.

2007 Largest ETFs ETF

Symbol

Size ($b)

SPDR Trust 1

SPY

$70

iShares MSCI EAFE Index

EFA

$40

NASDAQ 100 Trust 1

QQQQ

$20

iShares S&P 500 Index

IVV

$19

iShares MSCI Japan Index

EWJ

$15

iShares MSCI Emerging Markets Index

EEM

$14

iShares Russell 2000 Index

IWM

$12

MidCap SPDR Trust 1

MDY

$10

iShares Russell 1000 Value Index

IWD

$9

StreetTRACKS Gold Trust

GLD

$8

iShares Dow Jones Select Dividend Trust

DVY

$8

iShares Russell 1000 Growth Index

IWF

$7

DIAMONDS Trust 1

DIA

$7

iShares Lehman 1-3 Year Treasury Bond

SHY

$6

iShares S&P SmallCap 600 Index

IJR

$5

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ETFS

2.5

ETFS WITH LOW EXPENSE RATIOS The table below shows the 15 lowest expense ratio ETFs, as of the beginning of 2007.

2007 Lowest Expense Ratio ETFs ETF

Symbol

Expense

Vanguard Large Cap

VV

0.09

iShares S&P 500 Index

IVV

0.09

SPDR Trust 1

SPY

0.10

iShares Lehman 7-10 Year Treasury Bond

IEF

0.15

iShares iBoxx $ Invest. Grade Corp. Bond

LQD

0.15

iShares Lehman 1-3 Year Treasury Bond

TIP

0.15

iShares Lehman 20+ Year Treasury Bond

TLT

0.15

iShares Russell 1000 Index

IWB

0.15

DIAMONDS Trust 1

DIA

0.17

iShares S&P 500 Growth Index

IVW

0.18

iShares S&P 500 Value Index

IVE

0.18

NASDAQ 100 Trust 1

QQQQ

0.20

iShares Lehman Aggregate Bond

AGG

0.20

iShares Lehman TIPS Bond

TIP

0.20

iShares NYSE 100 Index

NY

0.20

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2.6

ETFS

ETF PRICE DISPARITIES Often times, some of the most actively traded issues on the NYSE and other U.S. markets are ETFs. Barclays estimates that on any given day, 80% of the trading of its ETFs are traded by large investors such as hedge funds. As of May 2007, there were about 500 ETFs in the U.S., valued at $500 billion (vs. 8,100 traditional mutual funds valued at $10.5 trillion). Although ETFs are expected to closely track an underlying index, this is not always the case during extreme days in the market.

For example, on February 27th, 2007, an ETF managed by Barclays that tracks the Chinese stock market closed down 9.9% in the U.S., even though the underlying index had fallen 2.1% during Chinese trading hours. The index fell an additional 3.1% the next day in China (but the Barclay’s iShares rose 4.3%). However, had U.S. investors sold the Barclays ETF just before the close of trading on February 27th, their loss would have been 9.9%, not the actual loss of the index, 2.1%. On the positive side, purchasers of the Barclays ETF would have bought at a 7.8% discount (9.9% - 2.1%), resulting in a substantial gain for owning the ETF shares for less than a day.

Another example is the precious metals ETF offered by Powershares Capital Management. On Februrary 27th, the ETF ended the day 3.3% below the actual value of the fund’s holdings. The iShares emerging markets ETF lost 8.1%, even though the index was down just 3.1%. As a result, a seller of $10,000 of the Barclay’s iShares would have received $500 less than if the fund had actually tracked the index.

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ETFS

2.7

There are disparities even for ETFs that track just U.S. stocks. The Russell 2000 Index (small company stocks) fell 3.75% on February 27th, 2007, versus 4.70% for the actual index. In this case, a large part of the disparity (almost 1%) was because like other ETFs, this Russell ETF trades for 15 minutes longer than regular stocks. For all of February 27th, 89 of the 421 ETFs tracked by Morningstar fell short of their portfolio value by more than 1% (+/-1/2% is considered normal). Of those 89 ETFs, 60 fell short by more than 2%.

There are three lessons to be learned from these index and ETF disparities. First, when there is a panic, the pricing of a number of ETFs can be quite different than the underlying index (somewhat similar to the premium-discount difference with most closed-end funds). Second, advisors should think twice about selling any investment, and in particular an ETF or CEF, during periods of high short-term volatility. Third, it is extremely likely that any disparity, no matter how narrow or wide, is likely to be corrected within one or two days, thereby making moot any attempt to sensationalize such price differences.

SECTOR VOLATILITY The most volatile sector ETFs are, from highest to lowest risk, are: 1.

2.

3.

4.

5.

Technology Financial (includes REITs) Healthcare Consumer Discretionary Industrial

6. Materials 7. Energy 8. Consumer Staples 9. Utilities

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2.8

ETFS

BUYING AND SELLING ETFS The majority of all stock and ETF trades are: 1. Market order—You get the best price currently available; most orders are market orders.

2. Limit order—You place a buy order, indicating that you are willing to pay $X per share or less. If you place a sell limit order, you are indicating that you want $Y per share or more.

If someone is not willing to sell you shares for $X or less, the order is not filled; similarly, if someone is not willing to buy your shares for $Y or more, you will end up not selling the shares.

3. Stop-loss (or stop) order—The order goes into effect as soon as the price per share of the stock (or ETF) hits a certain price. Once this price is reached, the stop-loss order becomes a market order. This type of order is frequently used to limit price declines if the security’s price falls.

4. Short sale—You believe the price per share of a stock or ETF is going to fall. Shares of a stock or ETF are borrowed by your brokerage firm on your behalf (note: you will be paying an ongoing interest charge for the borrowing). If the price of the security falls after the short sale, you have a gain; if the price of the security rises, you have a loss. At some point in the future, the investor will decide to buy the stock or ETF and thereby repay the original borrowed shares.

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QUARTERLY UPDATES UITS AND CLOSED-END FUNDS

UITS AND CLOSED-END FUNDS

3.UIT

AND

3.1

NEW FUND CRITICISM

Some newly launched mutual funds as well as UITs rely on historical data to increase sales and help market their portfolios.

Critics argue that these new offerings simply keep shifting the composition of the fundsâ&#x20AC;&#x2122; proposed holdings until they find one that happens to have worked over the necessary range of dates.

CLOSED-END FUND ASSET INCREASE For the first quarter of 2007, more than $13 billion was raised through closed-end fund IPOs, more than was raised for all of 2006.

At the end of 2006, the closed-end fund (CEF) industry managed $420 billion in assets. As of the end of the first quarter of 2007, the median discount for all CEFs was 2.3%; about 35% of all CEFs trade at a premium over their NAV.

CEF IPOs Year

# of IPOs

$ (billions)

2006

21

$11

2005

47

$21

2004

50

23

2003

48

28

2002

77

16

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3.2

UITS AND CLOSED-END FUNDS

A number of sources believe that CEF IPOs are not good for investors since the majority of them end up trading at a discount to NAV. These same critics believe that the IPO market for CEFs largely rely on unsophisticated income-oriented investors. In January 2007, the IPO for Alpine Total Dynamic Dividend Fund raised over $4 billion.

CLOSED-END COVERED CALL FUNDS Closed-end covered-call funds have the objective of generating high income by selling call options on stocks in their portfolios. These types of funds first appeared in 2004 and accounted for 85% of IPO money going into closed-end funds. Even though these are equity funds, a number of analysts consider them to be a â&#x20AC;&#x153;fixed-income application.â&#x20AC;?

The goal of a closed-end covered-call fund manager is to achieve the highest premium income possible while forfeiting the least amount of equity upside. Critics feel that these funds cap returns in bull markets (since good-performing stocks will be called away), and in a crash or severe correction do not generate enough option-writing income to offset the decline. In some respects, these funds perform best, at least comparatively speaking, when the market is flat or rising slightly.

The Chicago Board Options Exchange (CBOE) currently licenses four buy-write indexes. The table below lists the six largest closedend covered-call funds. As of the third quarter of 2006, all six of these funds were selling at a discount that ranged from 3% to 9%.

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UITS AND CLOSED-END FUNDS

3.3

The Largest Closed-End Covered-Call Funds NFJ Dividend, Interest & Premium Strategy

Nuveen Equity Premium Opportunity

Eaton Vance Tax-Managed Global Buy-Write

Eaton Vance Tax-Managed BuyWrite Opportunity

ING Global Equity Dividend & Premium Opportunity

Black Rock Enhanced Dividend Achievers

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QUARTERLY UPDATES REITS

REITS

4.REIT

4.1

UPDATE

After stagnating in 1999, real estate funds went on to average just under 22% per year for the next seven years (ending 12/31/2006).

This sector category can also provide diversification, when the S&P 500 dropped 9% in 2000, real estate funds gained 27%. The table below shows return figures for REIT sectors, as of March 1st, 2007.

REIT Sector Returns [ending 3-1-2007] REIT category

1-year

3-year

5-year

10-year

Apartments

24.1%

29.6%

21.7%

15.9%

Regional Malls

30.8%

28.4%

33.9%

21.4%

Shopping Centers

34.7%

26.7%

29.1%

18.5%

Office Buildings

41.7%

27.3%

22.3%

15.4%

Industrial

24.8%

25.8%

26.0%

17.2%

Health Care

41.1%

18.3%

23.1%

14.9%

Self Storage

29.7%

30.8%

25.6%

18.0%

Lodging / Resorts

24.5%

24.4%

17.1%

5.3%

Manufactured Homes

8.7%

3.4%

8.2%

9.1%

Mortgage REIT Index

7.2%

-4.6%

15.1%

6.6%

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4.2

REITS

INTERNATIONAL REITS From 2003 to 2007, Asia REITs returned an average of 35.4% per year; 43.5% annually in the case of European REITs (67% in 2006).

In the U.S. there are about 180 REITs registered with the SEC. Japan now has more than 40. Over 20 countries have passed or considered laws allowing the formation of REITs. The U.K. and Germany adopted REIT laws in early 2007.

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STOCKS

5.DOW

5.1

MILESTONES

The Dow Jones Industrial Average (DJIA) began with just 12 stocks in 1896 when the average had a starting value of 40.94. Since 1928, there have been 30 stocks in the Dow. The table below shows Dow milestones.

It took 127 days for the DJIA to move from 12,000 to 13,000. In 1999, it took 24 days to move from 10,1000 to 11,000. But it took 7.5 years to move from 11000 to 12,000. The Great Depression caused the DJIA to lose 90% of its value. The high it reached on September 3rd, 1929, was not surpassed until 1954.

The Dow Hitting 1,000 Point Increments Dow

Date

Dow

Date

12000

Oct. 19, 2006

5000

Nov 21, 1995

11000

May 3, 1999

4000

Feb 23, 1995

10000

March 29, 1999

3000

Apr. 17, 1991

9000

April 6, 1998

2000

Jan. 8, 1987

8000

July 16, 1997

1000

Nov. 14, 1972

7000

Feb. 13, 1997

start

May 26, 1896

6000

Oct 14, 1996

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5.2

STOCKS

DOW DROPS The table below shows the biggest percentage drops in the Dow Jones Industrial Average (DJIA) from the beginning of 2003 to March 17th, 2007. Since 1980, the return on the DJIA has averaged 13.9% per year, versus 13.1% for the S&P 500. There are 10 sectors in the S&P 500:

DJIA Biggest 1-Day Drops [1-1-2003 through 3-17-2007] Date

% Change

Date

% Change

3-24-03

3.6%

5-19-03

2.1%

2-27-07

3.3%

1-30-03

2.0%

1-24-03

2.9%

3-13-07

2.0%

3-10-03

2.2%

S&P 500 Sectors consumer discretionary

industrials

consumer staples

materials

energy

technology

financials

telecom

health care

utlities

If the technology sector were excluded from the S&P 500, the S&P 500 would be 16% above its 2000 peak. Looking at the entire S&P 500 (including technology stocks), more than 2/3 of the stocks are above their peak prices reached in 2000.

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STOCKS

5.3

S&P 500 AND DJIA RETURNS As of May 3rd, 2007, the S&P 500 was within 2% of its record close of 1527.5 in March 2000. On the same day, the Dow Jones Industrial Average (DJIA) hit another all-time record for 2007, closing at 13,241.4. The NASDAQ, which closed at 2,565.5, is still roughly 50% below its 2000 all-time high of over 5,000.

50TH ANNIVERSARY OF THE S&P 500 From its March 1st, 1957 inception through the end of 2006, the average annual return of the S&P 500 has been 10.83%. The S&P 500 comprises 83% of the value of all U.S. stocks. Almost 1,000 new companies have been added and deleted from the index since its inception.

The materials and energy sectors made up half the value of the original index, compared to 12% in 2007. By a wide margin, the best performing stock has been Altria (formally Phillip Morris); from March 1957 through the end of 2006, investors averaged 19.9% annually. A $10,000 investment grew to $8.4 million (vs. $168,000 if the $10,000 had been invested in the entire index). Of the original 111 surviving companies, 20 outperformed the index by an average of almost 5% per year.

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5.4

STOCKS

SMALL CAP STOCKS U.S. small company stocks with market capitalizations of less than $3.5 billion have averaged 16.5% a year versus 12.2% for the S&P 500 over the past 30 years (ending 6/30/2006). As of the beginning of 2007, small cap companies represented 78% of all listed stocks in the U.S. (84% in Japan, 79% in Hong Kong, 74% in the U.K. and 65% in France).

QUALIFYING DIVIDENDS Legislation passed in 2004 cut the tax rate on “qualifying” dividends to a maximum of 15%. For investors, “qualified” means that the stock (paying the dividend) has to be owned by both the investor and the mutual fund or ETF for at least 61 of the 121 days surrounding the ex-dividend date. Income paid out by REITs and some overseas companies do not qualify for this lower rate.

BUFFET WARNING During the May 2007 Berkshire Hathaway annual meeting, Warren Buffet repeated his warning about derivatives and leverage. Buffet believes that derivatives are the “financial weapons of mass destruction.” He expects that derivatives and the use of leverage by traders, investors, and corporations will eventually end in huge losses. According to Buffet, “The introduction of derivatives has totally made any regulation of margin requirements a joke.”

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STOCKS

5.5

DIVIDEND-PAYING BONUS According to a Morgan Stanley report, from 1970 through 2005, stocks that paid dividends averaged annual returns of 10.2%, almost six percentage points ahead of non-payers. According to S&P, 383 companies in the S&P 500 paid dividends in 2006, compared with 351 in 2001. A decade ago, 427 out of 500 paid dividends. The average payout ratio is just below 32%. Morgan Stanley estimates that 40% of the S&P 500’s annual total returns were from dividends for the period 1926 through 2004. Standard & Poor’s reports that approximately one out of every nine stocks (59 total) in the S&P 500 has increased its annual dividend for at least 25 consecutive years as of the end of 2006.

VALUE PLAY Suppose you wanted to buy a quart of milk. Last week you bought a quart for $1.20. This week it is selling for $13.00 a quart. How likely is it that you would buy a $13 quart of milk?

Yet, when it comes to buying stock, no one asks what the “quart” (stock) used to sell for.

From the beginning of 2000 to the end of 2006, the average large cap value fund had a cumulative return of just under 60%, versus just 18% for the typical large cap growth fund. The Russell 1000 Value Index was up 22% in 2006, but only 6% of active large cap value managers beat the index. Even though financial stocks currently comprise 36% of the Russell 1000 Value Index, few active money managers will devote that much to financials or any other single sector.

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QUARTERLY UPDATES VALUE VS. GROWTH STOCKS

VALUE VS. GROWTH STOCKS

6.ROLLING

6.1

PERIODS: GROWTH VS. VALUE

The table below shows the number of positive rolling three-year periods, for different growth and value categories over the past 30 years, ending December 31st, 2006. Over a 30-year period, there are 28, three-year rolling periods.

Positive 3-Year Rolling Periods, Growth vs. Value Stocks [1977-2006] Category

+ Returns

%+

Large Growth

25 / 28 yrs.

89%

Large Value

26 / 28 yrs.

93%

Mid Growth

27 / 28 yrs.

96%

Mid Value

28 / 28 yrs.

100%

Small Growth

27 / 28 yrs.

96%

Small Value

28 / 28 yrs.

83%

ALL GROWTH

25 / 28 yrs.

89%

ALL VALUE

26 / 28 yrs.

93%

The table below shows the number of positive rolling five-year periods, for different growth and value categories over the past 30 years, ending December 31st, 2006. Over a 30-year period, there are 26, five-year rolling periods.

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6.2

VALUE VS. GROWTH STOCKS

Positive 5-Year Rolling Periods, Growth vs. Value Stocks [1977-2006] Category

+ Returns

%+

Large Growth

22 / 26 yrs.

85%

Large Value

25 / 26 yrs.

96%

Mid Growth

24 / 26 yrs.

92%

Mid Value

26 / 26 yrs.

100%

Small Growth

24 / 26 yrs.

92%

Small Value

26 / 26 yrs.

100%

ALL GROWTH

22 / 26 yrs.

85%

ALL VALUE

25 / 26 yrs.

96%

In summary, looking at both tables in this section, almost all of the negative annual returns took place during the 2000-2002 stock market meltdown. In the case of three- and five-year rolling periods, all negative periods were the result of the same meltdown.

REVISITING GROWTH AND VALUE From the beginning of 1969 to the end of 2006, large cap growth stocks experienced eight negative years versus 10 negative years for large cap value stocks (see table below). Excluding 1970, every year large cap growth stocks experienced a negative return, so did large cap value issues.

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VALUE VS. GROWTH STOCKS

6.3

1969-2006 Losing Years for Large Cap Stocks Large Cap Growth

Large Cap Value

-5.1% (1970)

-16.9% (1969)

-18.7% (1973)

-10.1% (1973)

-32.4% (1974)

-22.0% (1974)

-12.1% (1977)

-4.7% (1977)

-8.8% (1981)

-3.3% (1981)

-22.0% (2000)

-8.3% (1990)

-20.1% (2001)

-1.0% (1994)

-23.9% (2002)

-3.0% (2000) -8.8% (2001) -20.1% (2002)

-143.1% = total

-98.2% = total

-17.9% = average loss

-9.8% = average loss

Using a simple average (adding up all of the negative numbers and dividing by the number of negative years), the average loss for growth stocks was -17.9% versus -9.8% for large cap value stocks, a 45% difference. The biggest loss was -32.4% for large cap growth stocks (1974) versus -22.0% for large cap value stocks (1974), a 32% difference; the smallest loss was -5.1% for growth versus -1.0% for value, an 80% difference. From the beginning of 1969 to the end of 2006, mid cap growth stocks experienced 11 negative years versus seven negative years for mid cap value stocks (see table below). Excluding 1977, every year mid cap value stocks experienced a negative return, so do mid cap growth issues.

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6.4

VALUE VS. GROWTH STOCKS

1969-2006 Losing Years for Mid Cap Stocks Mid Cap Growth

Mid Cap Value

-13.6% (1969)

-18.6% (1969)

-6.4% (1970)

-15.7% (1973)

-32.5% (1973)

-20.9% (1974)

-33.1% (1974)

-1.0% (1987)

-3.1% (1981)

-15.6% (1990)

-6.1% (1984)

-1.7% (1994)

-5.1% (1990)

-12.8% (2002)

-2.3% (1994) -18.5% (2000) -7.2% (2001) -21.5% (2002) -149.2% = total

-86.3% = total

-13.6% = average loss

-12.3% = average loss

Using a simple average (adding up all of the negative numbers and dividing by the number of negative years), the average loss for growth stocks was -13.6% versus -12.3% for value stocks, a 10% difference. The biggest loss was -33.1% for mid cap growth stocks (1974) versus -20.9% for mid cap value stocks (1974), a 63% difference; the smallest loss was -2.3% for growth versus -1.7% for value, a 26% difference.

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VALUE VS. GROWTH STOCKS

6.5

From the beginning of 1969 to the end of 2006, small cap growth stocks experienced 11 negative years versus eight negative years for small cap value stocks (see table below). Excluding 1998, every year small cap value stocks experienced a negative return, so do small cap growth issues.

1969-2006 Losing Years for Small Cap Stocks Small Cap Growth

Small Cap Value

-19.6% (1969)

-19.1% (1969)

-13.7% (1970)

-24.4% (1973)

-40.6% (1973)

-20.4% (1974)

-28.9% (1974)

-4.7% (1987)

-4.9% (1981)

-18.7% (1990)

-7.4% (1984)

-0.1% (1994)

-7.9% (1987)

-4.1% (1998)

-16.3% (1990)

-13.3% (2002)

-1.9% (1994) -22.6% (2000) -27.8% (2002) -191.6% = total

-104.8% = total

-17.4% = average loss

-13.1% = average loss

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6.6

VALUE VS. GROWTH STOCKS

Using a simple average (adding up all of the negative numbers and dividing by the number of negative years), the average loss for growth stocks was -17.4% versus -13.1% for value stocks, a 25% difference. The biggest loss was -40.6% for small cap growth stocks (1973) versus -24.4% for small cap value stocks (1973), a 40% difference; the smallest loss was -1.9% for growth versus 0.1% for value, a 95% difference.

Conclusions Whether the comparison is between large, mid, or small cap issues, value has suffered less than growth from 1969 through 2006; the average loss has been smaller. The largest losses were always in growth and the smallest losses were always in value stocks. In the case of mid and small cap stocks, the frequency of losses has been greater for growth.

Adding up the cumulative returns of growth versus value from 1969 to the end of 2006, value has dramatically outperformed growth (as shown in the table below); large value outperformed large growth by almost 2-1, over 3-1 in the case of mid cap value versus mid cap growth, and over 7-1 in the case of small cap value versus small cap growth. As a side note, the standard deviation for large, mid, and small cap value stocks has been lower than their growth counterparts in the 1970s, 1980s, 1990s, 2000s, and from 1997 through 2006.

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VALUE VS. GROWTH STOCKS

6.7

Growth of $10,000 from 1969 to the end of 2006 LC Growth

LC Value

MC Growth

MC Value

SC Growth

SC Value

$276,070

$539,470

$342,940

$1,429,090

$276,970

$2,338,810

From the beginning of 1928 through the end of 2006, $10,000 invested in small cap value stocks grew to $549,670,000 versus $13,710,000 for small cap growth stocks (a margin of 39 to 1).

The same dollar invested in large cap value stocks grew to $76,620,000 versus $9,740,000 for large cap growth stocks (a margin of 6.7 to 1). Surprisingly, from 1928 through 2006, the standard deviation for small cap value stocks was only slightly lower than it was for small cap value stocks; the large cap growth stocks has less risk (standard deviation of 20) than large cap value stocks (standard deviation of 27) during the same period

SMALL CAP VALUE Dartmouth finance professor Kenneth French and University of Chicago economics professor Eugene Fama, who founded Dimensional Fund Advisors (DFA) in 1981, developed the “Three Factor Model” that questioned the validity of William Sharpe’s capital asset pricing model (CAPM). DFA believes that tilting a portfolio towards value and small cap stocks leads to better performance over time. According to their historical studies, value has outperformed growth by 5.1% annually since 1927.

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6.8

VALUE VS. GROWTH STOCKS

GROWTH VS. VALUE The table below shows the number of positive annual returns for different growth and value categories over the past 30 years, ending December 31st, 2006.

Positive Annual Returns Growth vs. Value Stocks [1977-2006] Category

+ Returns

%+

Large Growth

25 / 30 yrs.

83%

Large Value

23 / 30 yrs.

77%

Mid Growth

23 / 30 yrs.

77%

Mid Value

26 / 30 yrs.

87%

Small Growth

22 / 30 yrs.

73%

Small Value

25 / 30 yrs.

83%

ALL GROWTH

24 / 30 yrs.

80%

ALL VALUE

25 / 30 yrs.

83%

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VALUE VS. GROWTH STOCKS

6.9

2006 INDEX RETURNS The tables below show returns for nine major indexes and the 10 Dow Jones industry groups for the 2006 calendar year.

2006 Index Returns Index

Return

Index

Return

DJIA

16.3%

AMEX

16.9%

DJ World (excl. U.S.)

23.0%

S&P 500

13.6%

DJ Wilshire 5000

13.9%

Value Line

11.0%

NYSE Composite

17.9%

NASDAQ

9.5%

Russell 2000

17.0%

2006 Dow Jones Industry Group Returns Industry Group

Return

Industry Group

Return

Basic Materials

16.1%

Industrials

12.7%

Consumer Goods

12.5%

Oil & Gas

20.3%

Consumer Services

13.5%

Technology

9.5%

Financials

16.5%

Telecommunications

32.2%

Health Care

5.7%

Technology

9.5%

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QUARTERLY UPDATES BONDS

BONDS

7.CUSHION

7.1

AGAINST STOCK DECLINES

The table below shows the benefit of owning tax-free bonds during stock market declines. From1986-2006, there have been four instances when the S&P 500 has declined by 15% or more.

S&P 500 Decline (high to low)

S&P 500 (with dividends)

Lehman Brothers Municipal Bond Index

8-25-87 to 12-4-87

- 32.8%

- 0.8%

7-16-90 to 10-11-90

- 19.2%

- 1.4%

7-17-98 to 8-31-98

- 19.1%

1.8%

3-24-00 to 10-9-02

- 47.4%

25.1%

STOCKS VS. BONDS Even though the 2000-2002 bear market represents the worst cumulative drop in the S&P 500 over the past 50 years (-49%), stocks still did better than bonds for the 10-year period ending December 31st, 2006 (124% for the S&P 500 vs. 83% for the Lehman Brothers Aggregate bond index).

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7.2

BONDS

2006 HIGH-YIELD BOND FACTS In 1980, slightly less than a third of U.S. industrial corporations tracked by Standard & Poorâ&#x20AC;&#x2122;s were rated junk. By the late 1980s, more than half were; the number increased to 71% by early 2007.

The S&P 500 includes 70 companies whose bonds are rated below investment grade.

During the past 20 years, 4.5% of junk bonds have gone into default; in 1991 and 2002, defaults were more than 10% of outstanding highyield bonds. The default rate was just 1.3% for 2006 (only 0.8% according to Fitch). The table below shows that the number of companies with high-risk credit ratings (BB or lower) has jumped since 1980 (note: the table does not include utilities or financial institutions).

Corporate Bond Ratings in 2006 vs. 1980 S&P Rating

1980

2006

AAA/AA

17%

2%

A

33%

9%

BBB

18%

18%

BB

22%

25%

B

7%

42%

CCC/D

3%

4%

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BONDS

7.3

According to the Financial Times, 1.6% of global junk bond debt defaulted in 2006; this is the lowest default rate experienced by global junk bonds since 1981. The historical default rate for junk bonds is 4.9% annually.

BOND MARKETS, INDEXES, AND FUNDS The U.S. bond market more than doubled from $10.7 trillion in 1996 to $22.7 trillion by the middle of 2006. The Lehman Brothers Aggregate Bond Index is comprised of more than 7,000 different bonds, many of which are illiquid that fund managers cannot buy, even if they wanted to. However, by copying some of the indexâ&#x20AC;&#x2122;s broad characteristics, such as sector exposure, interest rate sensitivity and maturity, bond fund managers can end up with portfolios that are very similar to the Lehman index.

Indices and averages are cost-free in the sense that their structure and performance do not include any initial or ongoing costs such as commissions, management fees, or bid-ask spreads. Since a mutual fund incurs all of these costs, it can only beat an index by being different. In the case of bond funds, increased credit risk, yield-curve positioning, or emphasizing sectors or issues different from the index are the only ways to outperform.

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7.4

BONDS

R-squared reflects the percentage change of a fund’s fluctuation that can be explained by the change in its benchmark index. A fund that highly corresponds to its respective index has an R-squared in the high 80s or 90s. For the 10-year period ending September 2006, only two of 15 funds with 10-year R-squareds of 98 or higher outperformed the Lehman Brothers Aggregate Bond Index. Fund expenses prevented the other 13 possible candidates from outperforming the index. However, over the past three and five years, the following funds have been able to outperform the Lehman index even after taking into account trading costs and expenses: Metro West Total Return, Dodge & Cox Income, Western Asset Credit Bond Institutional, Fidelity Mortgage Security, TCW Total Return Bond I, Harbor Bond Institutional, Fidelity Total Bond, Managers Fremont Bond, PIMCO Total Return D, T. Rowe Price New Income, USAA Income, and Fidelity Investment Grade Bond.

All of these funds had an R-squared of 94 or higher, with the exception of Dodge & Cox Income (R-squared of 91) and Metro West Total Return (R-squared of 69).

Obviously, funds that try to match a bond index’s performance are going to fail if their expense ratios are too high. The advisor who is seeking index-type returns will have to either choose low expense funds or portfolio’s that have securities different than their respective index—specifically, high-yield issues.

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BONDS

7.5

Defaults on U.S. junk bonds for the 2006 calendar year were 1.3%, well below the historical average of 4.5%, as computed by Standard & Poorâ&#x20AC;&#x2122;s. Another respected rating service, Fitch, shows the 2006 default rate at just 0.8%, down from 3.1% in 2005 and well below the long-term average of 5.0%. Over the past 10 years, the yield spread between high-yield corporate debt and U.S. Treasuries has been as low as 2.6% (early 2007) and higher than 10.0% (fall of 2002). Thus, in the current environment, your clients may be able to outperform an index bond fund by focusing on low-cost funds that have the flexibility to increase their exposure to high-yield.

Before discounting the importance of bonds, consider the following: From January 1st, 2000 to December 31st, 2002, a $100,000 investment in the S&P 500 fell to $62,406 while a $100,000 investment in the Lehman Brothers Aggregate Bond Index grew to $133,466.

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QUARTERLY UPDATES GLOBAL INVESTING

GLOBAL INVESTING

8.WORLDâ&#x20AC;&#x2122;S

8.1

FINANCIAL ASSETS

As of the beginning of 2006, the value of the worldâ&#x20AC;&#x2122;s financial assets was over $140 trillion. This figure is three times as large as the total output of goods and services produced around the globe.

Flows of investment across borders hit $6 trillion in 2005.

Of all the savings that people are willing to invest outside their country, the U.S. gets 85%. Worldwide, about one in five stocks is owned by someone who lives outside the country where the stock was issued. The table below shows financial assets for countries and regions at the beginning of 2005, in trillions of U.S. dollars.

World Assets as of 1-1-2006 [in trillions of U.S. dollars] Area

$ (t) Area

$ (t)

U.S.

$48

Australia, New Zealand, & Canada $5

Euro Area

$27

Other Western Europe

$4

Japan

$17

Latin America

$3

Emerging Asia

$10

Hong Kong & Singapore

$2

U.K.

$7

Eastern Europe

$2

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8.2

GLOBAL INVESTING

EMERGING MARKET DEBT In 1997, emerging market government debt was $786 billion; by the end of 2006, the figure was $3.15 trillion. Corporations in those countries had $416 billion of home-currency debt in 1997, versus $1.4 trillion by the end of 2006.

2006 GLOBAL INDEX RETURNS The tables below show returns for Dow Jones global indexes in 2006 in U.S. dollars and in local currency.

2006 Dow Jones Global Index Returns Country

U.S. $

Local

Country

U.S. $ Local

Venezuela

63%

111%

Mexico

39%

42%

Indonesia

62%

48%

Singapore

39%

28%

Philippines

49%

38%

Austria

38%

24%

Spain

47%

31%

Hong Kong

38%

39%

Sweden

43%

23%

Germany

35%

21%

Norway

43%

32%

Greece

35%

21%

Ireland

42%

27%

Denmark

34%

20%

Portugal

42%

27%

France

34%

20%

Brazil

42%

30%

Malaysia

33%

24%

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GLOBAL INVESTING

8.3

2006 Dow Jones Global Index Returns Country Belgium

U.S. $ 32%

Local 18%

Country South Africa

U.S. $ Local 18% 31%

Italy

31%

17%

Canada

16%

16%

Chile

30%

36%

South Korea

15%

6%

Netherlands

30%

16%

U.S.

14%

14%

Finland

28%

15%

New Zealand

13%

9%

Australia

28%

19%

Thailand

6%

-6%

U.K.

28%

12%

Japan

2%

3%

Switzerland

27%

18%

World

19%

Taiwan

21%

20%

Greater China has two major exchanges, the Shanghai and the Shenzhen. For 2006, Chinaâ&#x20AC;&#x2122;s Shanghai A Shares increased 131% in local currency (96% in the case of Shenzhen A shares).

REDUCED GLOBAL CORRELATION For the two-year period ending February 2007, correlation between U.S. and other developed markets was 0.63, according to ING Asset Management. From 2003 to 2005, the correlation was an incredibly high 0.93 (S&P 500 vs. EAFE). Bear Sterns believes that these very high correlations were due to the bursting of the tech bubble.

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8.4

GLOBAL INVESTING

EAFE COMPOSITION Five countries, France, Germany, Japan, Switzerland, and the U.K., comprise 70% of the EAFE index; Japan alone represents 22% of the index. Over the past 10 years (ending 12/31/2006), Japanese stocks have averaged 2.3% in U.S. dollar terms.

The S&P 500 and EAFE index have either both risen or fallen in the same calendar year for each of the last 14 consecutive years (1993-2006); however, during the same period, the spread between the two indexes averaged 13% per year.

As of the beginning of March 2007, the EAFE Index was divided as follows: Japan (23%), the U.K. (23%), France (10%), Germany (7.5%), Switzerland (7%), and Asia ex-Japan (8.5%). The market capitalization of the typical stock in the EAFE is $33 billion; 57% of the index is comprised of â&#x20AC;&#x153;giantâ&#x20AC;? stocks, 33% large stocks, 11% medium, and 0.1% small stocks.

The market capitalization of the roughly 1,400 stocks in the EAFE is $10.2 trillion. The largest stock in the index is British Petroleum, which has a market capitalization of over $220 billion.

The only Japanese stock in the top 10 is Toyota, ranked number three (1.5% of the index). Of the top seven companies, five are from the U.K. Over half the stocks in the portfolio are classified as either financials, consumer discretionary, or industrial issues. The table below shows the composition of the MSCI EAFE Index as of the beginning of 2006.

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GLOBAL INVESTING

8.5

EAFE Index Country

Securities Weight Country

Securities Weight

Japan

369

23%

Finland

21

1%

U.K.

155

23%

Belgium

20

1%

France

62

10%

Singapore

41

1%

Germany

50

7%

Denmark

19

1%

Switzerland

38

7%

Ireland

17

1%

Australia

83

5%

Norway

18

< 0.8%

Italy

39

4%

Greece

21

< 0.7%

Spain

33

4%

Austria

13

< 0.5%

Netherlands

26

3%

Portugal

11

< 0.4%

Sweden

47

2%

New Zealand

13

< 0.2%

Hong Kong

41

2%

EAFE Total

1,137

100%

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8.6

GLOBAL INVESTING

GLOBAL SMALL CAP BENEFITS Over the past five years ending December 31st, 2006, small and mid-cap foreign stocks of developed countries averaged 25% annually. Returns on small cap foreign stocks have a lower correlation than either emerging market or large cap foreign stocks have to the S&P 500. This positive trait is likely due to the fact that small cap stocks are influenced more by domestic or regional factors than by global influences such as oil prices or U.S. interest rate changes.

A study by ING shows that foreign small cap stocks were less volatile than emerging market stocks for the past 12 years. Volatility for foreign small cap stocks was roughly the same as it was for large cap foreign stocks and U.S. stocks.

Even though the average market capitalization for a foreign small stock is almost twice that of a U.S. small stock, greater opportunity exists since there is less analyst coverage of international small stocks.

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GLOBAL INVESTING

8.7

DOMESTIC GLOBAL DIVERSIFICATION Since roughly 40% of the profits from S&P 500 companies come from overseas operations, a fairly strong argument can be made that a broadly diversified U.S. portfolio has “global” diversification.

Such overseas sales reflect the economies of a number of foreign countries as well as the value of their currencies. The table below shows the percentage of sales and operations of a select group of corporations outside of their home country.

Multinational Companies Corporation (domicile)

Outside Corporation Sales (domicile)

Outside Sales

Roche Group (Switzerland)

92%

Nokia (Finland)

71%

Philips (Netherlands)

86%

ExxonMobil (US)

66%

BP (UK)

82%

Unilever (UK)

64%

Nestle (Switzerland)

74%

Proctor & Gamble (US)

58%

Honda (Japan)

72%

Toyota (Japan)

47%

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QUARTERLY UPDATES COVERED CALL WRITING

COVERED CALL WRITING

9.SPDRS

AND

9.1

COVERED CALL WRITING

The table below shows the monthly returns for the S&P 500 over each of the past 20 years. The table shows the number of times the market had a negative return for each of the 12 months over the last 20 years (1987-2006). It also shows the number of months the market was positive: up less than 1%, 1-2%, 2-3%, 4-5%, 5-6%, 67%, and over 7%.

Monthly Returns for the S&P 500 [1987-2006] J F M A M

J J

A S

O N D

6

7

7

7

5

7

10

8

11

7

6

2

negative

1

3

2

1

3

3

1

3

1

1

1

3

< 1%

2

4

1

6

3

2

1

2

2

4

1

7

1-2%

2

1

6

2

2

2

0

3

1

4

2

2

2-3%

3

1

1

1

2

0

3

2

0

1

2

1

3-4%

3

2

1

0

2

5

3

1

2

0

3

0

4-5%

0

0

1

2

1

1

0

0

2

1

1

3

5-6%

1

0

0

0

1

0

0

1

1

1

2

0

6-7%

2

2

1

1

1

0

2

0

0

1

2

2

> 7%

return

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9.2

COVERED CALL WRITING

From 1987 to the end of 2006, the S&P 500 had a total of four negative years (1990, 2000, 2001, and 2002). For three of those four years, January as also negative months. Over the past 20 years, December had fewer negative months than any other month of the year (2 vs. 5 for May). September had more negative months than any other (11 vs. 10 for July).

A second reason for looking at monthly returns has to do with a defensive strategy of buying the market (the S&P 500 in this case) and then writing calls against the portfolio (what is referred to as “covered call writing”). This is a defensive strategy because the investor, who owns the S&P 500, is receiving option money every time he or she writes calls.

This strategy can be done on a monthly basis. It provides income immediately to the investor (the person writing the covered calls).

The investor is giving up some of the upside potential in return for current income.

Covered call writing could be compared to Las Vegas. The covered call writer is the “house” (casino); gains are limited to the option money received (plus any spread—see below). The option buyer is the gambler; there is no limit to the possible gains (e.g., a one dollar slot machine bet could result in a jackpot of thousands of dollars), but losses are more than likely. The analogy is appropriate because roughly 70% of all options are never exercised (which favors the option writer and not the option buyer).

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COVERED CALL WRITING

9.3

Months When The S&P 500 Returned Less than 2% [When Covered Call Writing May Be A Good Idea] Month January February March April May June July August September October November December

-

<1%

1-2%

Total

6 7 7 7 5 7 10 8 11 7 6 2

1 3 2 1 3 3 1 3 1 1 1 3

2 4 1 6 3 2 1 2 2 4 1 7

9 14 10 14 11 12 12 13 14 12 8 12

The table shows that February, April, and September were the best months during the past 20 years to write S&P 500 covered calls.

These were the “best” months because returns were modest (or negative); covered call writers do not mind having their portfolio (the S&P 500 in this example) “called away” when it is not doing particularly well.

At the other extreme are those months where the market is up 4-7% or more. During such positive months, the covered call writer misses out on the difference between the option money collected plus the spread (e.g., buy the S&P 500 at 150 and give someone the right to call it away at 151 during the next month—the “spread” is one point) versus the 4, 5, 6, 7% or more gain that would have been experienced had the portfolio not been called away.

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9.4

COVERED CALL WRITING

For example, if a covered call writer receives one point for writing the calls, the writer is making about two points (the option money plus the spread). If the portfolio is called away and ends up advancing five points for the month, the covered call writer loses out on three points (5-2 = 3).

Advisors considering a monthly covered call program using an S&P 500 exchange-traded fund (SPY) should be familiar with the months where such a strategy has made sense (all negative months, all months where the return was less than 1%, and all months where the S&P 500 return was 1-2%). Counting up all three of these periods (months of negative returns, positive returns of less than 1%, and returns of between 1-2%), the results are as follows: Based on the past 20 years, it appears that November and December have been the months when selling calls was a bad idea (since there was a fair chance that returns for one of those two months was +4% or more). Moreover, December has only been a negative month twice over the past 20 years.

The stock market, as measured by the S&P 500 has experienced negative returns on a monthly basis well under 50% of the time; the range has been from two months out of 20 (December) up to 11 months out of 20 (September). At the other extreme are those months where the market is up 4-7% or more. During such positive months, the covered call writer misses out on the difference between the option money collected plus the spread (e.g., buy the S&P 500 at 150 and give someone the right to call it away at 151—the “spread” is one point) versus the 4, 5, 6, 7%+ gain that would have been experienced had the portfolio not been called away.

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COVERED CALL WRITING

9.5

For example, if a covered call writer receives one point for writing the calls, the writer is making about two points (the option money plus the spread). If the portfolio is called away and ends up advancing five points for the month, the covered call writer loses out on three points (5 - 2 = 3).

Conclusions There may be no meaningful conclusions that can be from the historical monthly analysis of the S&P 500 over the past 20 years. In the past, stock market returns have been negative 83 out of 240 months (20 years), or 36% of the time. If you include the 23 months that the market experienced returns of less than 1%, the total number of months it would have made sense to write covered calls increases from 83 to 106 out of 240 months, or 44% of the time.

Based on historical data only, the best candidates for S&P 500 covered call writing are clients who: 1.

2.

3.

4.

believe the market will experience flat returns feel market returns will be minor to modest (1-6% annually) need market exposure but still expect stocks to decline are willing to forego some upside potential for income

Looking at the forest (annual returns) instead of the trees (monthly returns), a strong case can be made for covered call writing. After all, the strategy works two out of three of the timesâ&#x20AC;&#x201D;during a flat or negative market. It also works (at least some of the time) during the third possible outcomeâ&#x20AC;&#x201D;when the market is going up (since minor positive returns may not equal the covered call money received).

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9.6

COVERED CALL WRITING

Think of the strategy this way: (1) If the market stays flat, your client receives roughly 9-12% a year in covered call writing (plus a 2% dividend since the stocks are never called away in a perfectly flat market); (2) In a down market, the client’s losses are reduced by whatever option money was collected for those months when the market was at the same level of purchase or higher (i.e., originally buy at 150 and only sell options for 150 or higher); and (3) in a very strong up market, the client still receives 9-12% in option money plus the “spread” of 1/2-3/4% each time the S&P is called away (which translates into a total return of 15-20% a year if the stocks were called away every months—extremely unlikely).

When covered call writing is explained in this manner, it makes much more sense intuitively than a review of the monthly figures.

And, as mentioned before, you may have clients who are willing to give up X in returns in order to reduce risk by something less than X.

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EQUITY-INDEXED ANNUITIES

10.EQUITY-INDEXED

10.1

ANNUITIES (EIAS)

The sales of EIA contracts in recent years have been explosive.

Advocates of equity-indexed annuities feel that this investment vehicle offers the upside potential of the stock market and none of its downside riskâ&#x20AC;&#x201D;in fact the contract owner (investor) is guaranteed at least a 2.7% annualized return if the contract is held to maturity (typically 5-12 years). Critics of EIAs point out that the actual returns are not nearly as high as most investors would anticipate, contracts are often not correctly represented, and that there would be far fewer sales if the commission paid to the agent was lower.

There are four examples that follow. Each example is based on a popular EIA contract offered during the first half of 2007.

As you will see, returns are perhaps lower than expected, but returns can still be respectable. Thus, perhaps the truth lies somewhere in-between.

EIA Calculations Using Point-to-Point The S&P 500 is the most commonly used index by EIA contracts. When considering an EIA, it is helpful to see what the annual returns of the S&P 500 have been excluding dividends (since no EIA contract includes any type of crediting for dividends). The table below shows the annual returns of the S&P 500 for each of the past 20 years, excluding dividends.

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10.2

EQUITY-INDEXED ANNUITIES

S&P 500 Annual Returns Without Dividends [1987-2006] Year

S&P

Year

S&P

Year

S&P

Year

S&P

1987

2.0%

1992

4.5%

1997

31.0%

2002

-23.4%

1988

12.4%

1993

7.1%

1998

26.7%

2003

26.4%

1989

27.3%

1994

-1.5%

1999

19.5%

2004

9.0%

1990

-6.6%

1995

34.1%

2000

-10.1%

2005

3.0%

1991

26.3%

1996

20.3%

2001

-13.0%

2006

13.6%

Point-to-Point Annual Reset Example #1 One popular EIA contract has the following features: (1) seven-year contract (100% withdrawal at the end of seven years without penalty); (2) 100% participation in the S&P 500, (3) annual reset, (4) no spread (no fees), and (5) a 6.5% cap rate (however great the gains are for a year, the contract owner will not be credited more than 6.5%).

Looking at the past seven years, the popular contract mentioned in the paragraph above would have the following annual returns: 0% (2000), 0% (2001), 0% (2002), 6.5% (2003), 6.5% (2004), 3% (2005), and 6.5% (2006). Returns for 2000-2002 are zero because during negative years the investor is credited zero; returns for 2003 are not 26.4% because the contract has a 6.5% annual cap. Similarly, for 2004 and 2006, despite the returns of the S&P 500, there is still a cap of 6.5% for each of those two years. For the 2005 calendar year, the return matches that of the S&P 500 since the contract has a 100% participation clause and includes no spread (no fees).

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EQUITY-INDEXED ANNUITIES

10.3

Continuing with this same example (or contract), the investor’s return calculation would be: 0 X 0 X 0 X 6.5% X 6.5% X 3% X 6.5% = 1.244 (or a cumulative gain of 24.4% over seven years). A cumulative gain of 24.4% over seven years translates into an annualized return of 3.15%. Over these same seven years, the S&P 500 had an annualized return of 1.1% (a figure that includes dividends plus all of the negative years in the early 2000s) while U.S. T-bills had an annualized return of 3.00%.

Point-to-Point Annual Reset Example #2 Let us go through another example and see if we can come up with better returns (using the same seven-year EIA contract). For example, seven of the best continuous years historically have been the seven years ending 12/31/1999. Using those numbers (see table above), here are the returns the contract would have experienced: 6.5% (1993), 0% (1994), 6.5% (1995), 6.5% (1996), 6.5% (1997), 6.5% (1998), and 6.5% (1999). Remember, despite the market’s actual returns during some of these years (e.g., +31% in 1997, without dividends), the contract owner can earn no more than 6.5% in any given year.

Continuing with this same example (1993-1999), the investor’s return calculation would be: 6.5% X 0 X 6.5% X 6.5% X 6.5% X 6.5% X 6.5% = 1.459 (or a cumulative gain of 45.9% over seven years). A cumulative gain of 45.9% over seven years translates into an annualized return of 6.0%. For this type of contract, this is probably as good as it is going to get (maximum returns for every year but one).

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10.4

EQUITY-INDEXED ANNUITIES

Point-to-Point Annual Reset Example #3 Another popular EIA contract has the following features: (1) eightyear contract (100% withdrawal at the end of eight years without penalty); (2) 50% participation in the S&P 500, (3) annual reset, (4) no spread (no fees), and (5) no cap rate.

Looking at the past eight years, the contract mentioned in the paragraph above would have the following annual returns: 9.75% (1999), 0% (2000), 0% (2001), 0% (2002), 13.2% (2003), 4.5% (2004), 1.5% (2005), and 6.8% (2006). Remember that during the negative years (2000-2002) returns are zero and that for any positive year the investor receives exactly half the gain (50% participation rate).

Continuing with this same example (or contract), the investorâ&#x20AC;&#x2122;s return calculation would be: 9.75% X 0 X 0 X 0 X 13.2% X 4.5% X 1.5% X 6.8% = 1.407 (or a cumulative gain of 40.7% over eight years). A cumulative gain of 40.7% over seven years translates into an annualized return of 5%.

Point-to-Point Annual Reset Example #4 Let us go through another example and see if we can come up with better returns (using the same eight-year EIA contract). For example, eight of the best continuous years historically have been the eight years ending 12/31/1998. Using those numbers (see table above), here are the returns the contract would have experienced: 13.15% (1991), 2.25% (1992), 3.55 (1993), 0% (1994), 17.05% (1995), 10.15% (1996), 15.5% (1997), and 13.35% (1998). Remember, despite the marketâ&#x20AC;&#x2122;s actual returns during some of these years (e.g., +26.7% in 1998, without dividends), the contract owner is only credited with half the actual gain.

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EQUITY-INDEXED ANNUITIES

10.5

Continuing with this same example (1991-1998), the investor’s return calculation would be: 13.15% X 2.25% X 3.55% X 0% X 17.05% X 10.15% X 15.5% X 13.35% = 2.022 (or a cumulative gain of 102.2% over eight years). A cumulative gain of 102.2% over eight years translates into an annualized return of 9.2%. This turns out to be a very attractive return since the investor had no downside risk and was guaranteed to earn 3% on 90% of the initial investment (or 2.7% annual compounding on the entire investment) if stock market returns had been poor. However, keep in mind that this example covers eight of the very best continuous years for the S&P 500. Over the past eight years (1999-2006), the S&P had an annualized return of 6.0%, while T-bills averaged 3.2% a year.

Conclusion There are literally dozens of different ways to compute (credit) gains in an EIA contract. The examples you have seen are some of the better choices from an investor’s perspective. As a broad generality, the best way to summarize a well-structured equity-indexed annuity is that the investor should be expected to earn just a little more than CD rates on an annualized basis—assuming things turn out pretty good. The worst case is probably an annualized return of under 3%; the best case, although very unlikely, is annualized returns in the 79% range.

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QUARTERLY UPDATES FINANCIAL PLANNING

FINANCIAL PLANNING

11.OPTIMAL

11.1

REBALANCING

In order to maintain an investor’s risk level and return expectations, the equity and fixed-income portions of a portfolio need to be periodically rebalanced. The frequency of such rebalancing is what practitioners are uncertain. Research by Leibowitz and Hammond in 2004 indicates that professionals tend to rebalance more frequently than individual investors.

An extensive study by David Smith and William Desormeau looked at 19 model portfolios between 1926 and 2006, with rebalancing frequencies ranging from 1-60 months, as well as thresholds ranging from 0.5% to 10%. The researchers then revisited the question of rebalancing frequency over the same period by including two different Federal Reserve policies, a tight money versus expanding monetary policy. The results show that investors and advisors need to rebalance less frequently than previously thought and that the Fed’s monetary policy should be taken into account in the rebalancing decision.

The Study Using 2003 Ibbotson data, the study’s authors constructed 19 portfolios, ranging from 5-95% in the S&P 500 and the balance in U.S. long-term government bonds, at 5% intervals (all dividends and interest payments were reinvested). For each of the 19 portfolios (e.g., 5% bonds + 95% stocks, 10% bonds + 90% stocks, etc.) over the 78-year period, 1-60 month rebalancing policies were reviewed.

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11.2

FINANCIAL PLANNING

The second part of the researchers analysis looked at the same 19 portfolios but the rebalancing was solely based on one of the two asset class weightings changing by 5% or more. The thresholds reviewed ranged from 0.5% through 10.0%, at 0.5% intervals.

The third, and final, analysis looked at the effects of Federal Reserve monetary policy on optimal rebalancing. Smith and Desormeau identified 32 instances from 1926 to 2003 when the Fed switched the direction of change in the discount rate. It was then assumed that the portfolio could be rebalancing at the end of the month when the change of direction occurred.

The returns for all three of the rebalancing methods were based on risk-adjusted returns (return divided by standard deviation)—similar to the Sharpe ratio. The authors of the study refer to this measurement as “scaled returns;” in short, the best performers “maximized scaled returns.”

Results Regardless of the stock/bond weighting, maximum risk-adjusted returns were achieved when the portfolio was rebalanced once every 44 months; the lowest returns took place when there was monthly rebalancing. From 1926 to 2003, the five best rebalancing intervals were found when rebalancing took place in the 39-44 month range; the lowest returns were when the portfolios were rebalanced once every 1-6 months.

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FINANCIAL PLANNING

11.3

Whether the stock weighting is 5%, 95%, or somewhere inbetween, rebalancing once every 44 fours produced the best returns on a risk-adjusted basis. The second best risk-adjusted returns were obtained when the portfolios were rebalanced once every 45 months (42 months in the case of portfolios with a stock weighting of 20% or less); the third best results occurred when rebalancing took place every 42-43 months. At the other extreme, the smallest risk-adjusted returns occurred with one month rebalancing; the second smallest risk-adjusted returns resulted from rebalancing every two months.

Using threshold instead of time as a criteria for rebalancing also greatly favored patient investors. When the stock or bond weighting deviated by 8.5% to 10.0% of its weighting before rebalancing occurred (the very upper range in the study), maximum risk-adjusted returns were usually produced (note: only 0.5% if the stock weighting was 95%, but 10% if the stock weighting was 90%). The second best threshold was most often in the 9.5% to 10.0% range.

The lowest risk-adjusted returns were experienced when rebalancing was very sensitive—a 0.5% weighting change; the second lowest results most occurred when the threshold percentage was in the 1.0% to 1.5% range. The “threshold” results are consistent with what took place when rebalancing occurred based on set time intervals (see above)—infrequently (once every 42-45 months).

When the Federal Reserve was trying to cool down the economy by raising interest rates (a restrictive monetary policy), all 19 portfolios benefited the most when threshold rebalancing was high; the lowest threshold level (0.5% change) almost always generated the lowest risk-adjusted returns.

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11.4

FINANCIAL PLANNING

During periods when the Fed was trying to stimulate the economy by lowering rates (an expansionary policy), the better risk-adjusted returns occurred for 15 of the 19 portfolios for the less frequently rebalanced portfolios. However, for stock-heavy portfolios (85%+), the evidence does not strongly favor low or high thresholds.

The studies do show what is not effective when rates are dropping: rebalancing every 10 months or less in the case of lower stock weightings and every 20 months or less in the case of higher stock weighted portfolios. Similarly, when the Fed is raising rates, rebalancing every 10-20 months also produces suboptimal riskadjusted returns.

Results and conclusions from the Smith and Desormeau study (1926-2003) are similar to those of the study by Patrick Dennis and Steven Perfect, Karl Snow, and Kenneth Wiles (Financial Analysts Journal, May/June 1995) as well as the research done by Jeffrey Horvitz (Journal of Wealth Management, Fall 2002).

PREDICTED MARKET MELTDOWN A number of sources have reported that baby boomers will cause a sharp decline in the stock and bond markets as they sell off assets when they retire. After reviewing a number of academic studies and using its own numbers, the Government Accountability Office (GAO) believes that such fears are unfounded for the following reasons:

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FINANCIAL PLANNING

11.5

1.

Most baby boomers have few or no securities to sell; the top 5% hold over 50% of the baby boomer wealth and the top 25% hold over 85%. Thus, few assets will have to be sold by the top 25% in order to generate income during retirement.

2.

Retirees spend down assets slowly; baby boomers with a higher life expectancy will spin off such assets even more slowly.

3.

Studies show that more and more people are working long past the traditional retirement age of 65.

THE 1% DIFFERENCE Over a 20-year period, $100,000 grows to $732,800, assuming a 10% return. If the 10% return is reduced to 9%, the same $100,000 grows to $600,900, a difference of almost $132,000. According to the Financial Planning Association, the average long-term gain for a diversified equity mutual fund portfolio is about 10%; 8% for a portfolio that has a stock/bond mix of 60%/40%.

DISTRIBUTION OF RETURNS Annualized returns usually mask the actual ups and downs experienced by investors on a year-by-year basis. For example, over the past 20 years (1987-2006), large stocks (S&P 500) had an annualized return of 11.8%, while small stocks had an annualized return of 13.2%.

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11.6

FINANCIAL PLANNING

During this same 20-year period, large stocks only experienced annual returns between 8-16% three times (10.0% in 1993, 10.9% in 2004, and 15.8% in 2006). Over the same period, small stocks experienced annual returns between 6-19% four times (10.2% in 1989, 17.6% in 1996, 18.4% in 2004, and 16.2% in 2006).

What is surprising is the distribution of returns for 20-year U.S. Government bonds. From 1987-2006, these bonds had an annualized return of 8.6%. Yet, during these 20 years, annual returns between 6.6-10.6% occurred just four times (9.7% in 1988, 8.0% in 1992, 8.5% in 2004, and 7.8% in 2005).

INVESTING IN A HOUSE There are two key points to keep in mind when analyzing the benefits of home ownership. First, national price appreciation of residential real estate has historically not been as high as most people perceive. Over the past 30 years (ending 12/31/2006), U.S. house prices increased 6.2% annually vs. 4.3% for inflation, according to Freddie Mac. Second, home ownership is expensive. It is comparable to owning a mutual fund or variable annuity that charges 3% annually (homeownerâ&#x20AC;&#x2122;s insurance, property taxes, and maintenance costs) and also has a back-end sales charge of 6-7% (the real estate selling commission plus closing costs of about 1%). Annual expenses are higher than 3% if home improvements or monthly mortgage costs are included.

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FINANCIAL PLANNING

11.7

AMERICA THE BANKRUPT? While the U.S. national debt has climbed from $800 billion in 1981 to $5 trillion in 2006, the nationâ&#x20AC;&#x2122;s assets have climbed from $11 trillion to $76 trillion. If all private assets and liabilities are added up, net national wealth has increased by $40 trillion over this same period. In the past four years (ending 12/31/2006) alone, U.S. assets have increased by $13 trillionâ&#x20AC;&#x201D;much of which will be inherited by future generations.

Paying benefits to 75 million baby boomers in 2030 will be much easier if we have a $25 trillion GDP and net worth of $100 trillion.

Social Security actuaries calculate that the addition of one million immigrants reduces the long-term unfunded liability of Social Security by at least $5 trillion.

CPI SPENDING CATEGORIES The table below shows the weighting of the different spending categories that comprise the CPI, as of July 2006 (source: Bureau of Labor Statistics).

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11.8

FINANCIAL PLANNING

How Inflation is Calculated Category

Weighting

Housing (all costs of home ownership or rentingâ&#x20AC;&#x201D;including utilities, appliances, and furniture

42.4%

Transportation (cost of vehicles, gas, and public transportation)

17.4% (gas = 4.1%)

Food and beverages

15.1%

Apparel

3.8%

Medical care (doctor and hospital fees, health insurance, and prescription drugs)

6.2%

Education and communication (ranges from day care to college tuition; communication includes phone and computer-related expenses)

6.1%

Recreation (sports, video and audio equipment, club fees, pet-related costs, books, and subscriptions)

5.6%

Other goods and services (includes things such as legal services, haircuts, cosmetics, and funeral costs)

3.5%

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11.9

GOLD VS. HERSHEY BARS The table below shows the price of gold between 1920 and 2006, the average price of a basic Hershey chocolate bar (WWW.FOOD TIMELINE.ORG), and how many bars of chocolate could be bought with an ounce of gold. As an example, in 1980, an ounce of gold bought 2,460 Hershey bars; 20 years later, it bought just 558 bars (a very poor hedge against “chocolate” inflation). Based on 2006 prices ($680 an ounce), one could purchase 906 Hershey bars (at 75 cents each) with an ounce of gold).

Year

Hershey Bar

Ozs. Of Gold Bars Per Oz.

1920

$0.03

$21

700

1965

$0.05

$35

700

1980

$0.25

$615

2,460

2000

$0.50

$279

558

2006

$0.75

$679

906

Based on 1920 or 1965 chocolate prices, gold has been a pretty good hedge against inflation; based on the price of gold per ounce since 1980, gold has been a terrible hedge against inflation.

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11.10

FINANCIAL PLANNING

HEDGE FUND DISASTERS On September 14th, 2006, the hedge fund Amaranth said its assets under management dropped 50% in one month due to losses from a 32-year-old natural gas trader. Several days later, the loss was reported to be $6 billion (a 65% loss) instead of $5 billion.

Before the huge decline, a number of investors expressed concern to the fund’s principal and founder, Nick Maounis, about its trading practices. Mr. Maounis assured the investors that the fund was making “appropriately cautious and diversified bets.” Two weeks before the losses were reported, Maounis told The Wall Street Journal that the trader’s reputation for taking big and reckless bets was “greatly exaggerated.”

Additionally, after suffering a $1 billion loss in May, the hedge fund assured investors that it was reducing its risk exposure by cutting back on its use of borrowed money and other leverage. When talking to money management companies in August 2006, the hedge fund said it might spend “1% of its capital to energy for the right to buy or sell natural gas. If the bet didn’t pan out, only a tiny fraction of the fund’s assets would be at risk.”

Of the 400 hedge funds launched in 2005, FrontPoint Partners (a hedge fund with $6 billion under management) estimates that roughly 20% will not survive a year. According to FrontPoint, “Most hedge fund organizations today are, quite literally, three guys with a Bloomberg terminal in a garage.” The average life span of a medium-sized hedge fund is 3.5 years.

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FINANCIAL PLANNING

11.11

According to a report by Dresdner Kleinwort, hedge funds need to generate returns of 18-19% in order to deliver a 10% return to investors, once fees, incentives, and trading costs are factored in.

Hedge funds can improve returns through leverage. It is estimated that the $1.3 trillion invested (as of early 2007) in hedge funds borrows from $1.2 to $5.5 trillion at any given time.

HEDGE FUND WARNING Despite a 2006 increase in assets of 26%, the Federal Reserve Bank of New York issued a March 2007 statement, warning that the “$1.4 trillion hedge fund industry could be caught in a web of crisis” because trading strategies concentrate ”way too much risk in way too few markets.”

As of April 2007, the 100 largest hedge funds controlled about 70% of the money in the business, up from less than 50% at the end of 2003. Hedge funds with $1 billion or more in assets controlled about 85% of all hedge fund money.

CALCULATING A LUMP SUM A popular question with clients is, “How much money (lump sum) will I need before I can retire?” The answer is simple: About 20 times their annual expenses, assuming no erosion of principal. For example, if one of your clients needs $30,000 a year to live on, he or she will need a nest egg of $600,000 plus Social Security retirement benefits.

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11.12

FINANCIAL PLANNING

ENDING UP WITH $1,000,000 The table below shows the deposits required to reach $1 million, assuming an annual return of 8%.

Deposits Needed to Reach $1,000,000 [8% return] Years

40

30

20

15

10

5

1

Monthly deposit

$298

$681

$1,686

$2,842

$5,623

$13,153

$77,161

Annual deposit

$3,574

$8,172

$20,234

$34,101

$63,916

$157,830 $925,926

Total deposit

$142,969 $245,206 $404,671 $511,521 $639,162 $789,150 $925,926

GOALS AND RISK TOLERANCE TEST The 7-question test below can be taken by your clients in order to help evaluate their situation. The test is divided into three parts: time horizon, long-term goals and expectations, and short-term attitudes toward risk.

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Time Horizon [1] My current age is: Less than 45 years

5

45-55 years

4

56-65 years

3

66-75 years

2

Over 75 years

1

Score _____

[2] I expect to start drawing income from this investment: Not for at least 20 years

5

In 10-20 years

4

In 5-10 years

3

Not now, but within 5 years

2

Immediately

1

Score _____

Long-Term Goals and Expectations [3] For this investment, my goal is: To grow aggressively

5

To grow with caution

3

To avoid losing money

1

Score _____

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[4] Assuming a normal stock market, what would you expect from this investment over time?

To generally keep pace with the stock market

5

To trail the market, but still make a decent profit 3 A high degree of stability, with modest profits

1

Score _____

[5] Suppose stocks perform unusually poorly over the next 10 years; what would you expect from this investment?

I will be OK if I lose money

5

To make a small gain

3

To be little affected by the stock market

1

Score _____

Short-Term Risk Attitudes [6] Which statement below describes your attitude about the next three yearsâ&#x20AC;&#x2122; performance of this investment?

I will be OK if I lose money

5

I want to at least break even

3

I need at least a small profit

1

Score _____

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[7] Which statement below describes your attitude about the next three months’ performance of this investment?

No concern; One quarter means nothing

5

If I suffered a loss of > 10%, I’d get concerned

3

I can tolerate only small short-term losses

1

Score _____

If the client has at least one 1-point answer and at least one 5-point answer, consider stopping and evaluating the investor’s responses; they may be unrealistic.

Score Total Time Horizon (Questions 1 and 2) Points

Dynamic Asset Allocation Portfolio

2

Preservation

3-4

Conservative

5-7

Balanced

8-9

Capital Growth

10

Aggressive

Long-Term Goals and Expectations (Questions 3, 4, and 5) Points

Dynamic Asset Allocation Portfolio

3

Preservation

5

Conservative

7-9 11-13 15

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Short-Term Risk Attitudes (Questions 6 and 7) Points

Dynamic Asset Allocation Portfolio

2

Preservation

4

Conservative

6

Balanced

8

Capital Growth

10

Aggressive

Total (Questions 1 through 7) Total Points

Dynamic Asset Allocation Portfolio

7-10

Preservation

11-17

Conservative

18-24

Balanced

25-31

Capital Growth

32-35

Aggressive

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12.1

12.RECONSIDERING

THE

ROTH 401(K)

Unlike a Roth IRA, the Roth 401(k) has no participant income limits but does require that certain sums be distributed at age 70 1/2. However, Roth 401(k) plan participants can avoid this requirement by rolling their account into a Roth IRA. A traditional 401(k) may be a better choice than a Roth 401(k).

Workers will have to come up with $20,666 before taxes to fully fund the $15,500 limit for a Roth 401(k) in 2007—more than $20,666 if the worker’s tax bracket is higher than 25%. Tax savings from a deductible contribution to a qualified plan could be used for other investments. The table below covers Roth 401(k) basics.

Benefits of Using a Roth 401(k) Type of Worker

Consideration

Young

Decades of tax-free compounding. Paying taxes on contributions at current rates is better than paying taxes later on profits and contributions.

Older with high assets Retirement account asset withdrawal could later put you in a higher bracket.

Large balances in sheltered accounts

Tax-free access to part of portfolio during retirement.

Strong donative intent Pass assets to heirs tax-free.

Saving for a child’s college education

Tax-free access if the account is at least 5 years old and participant is 59 1/2 when the child enrolls; retirement accounts are usually not part of federal financial aid calculations.

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HEALTH SAVINGS PLANS Health savings accounts (HSAs) provide high-deductible (at least $1,100 for an individual and $2,200 for a family) health insurance plans using pretax dollars. Besides receiving a deduction for contributions, these accounts grow tax-free, as long as the money is used for qualified medical expenses. Once the account owner turns 65, the HSA can be used for any purpose without penalty, but withdrawals are taxable. HSAs are of particular benefit for people who have not yet qualified for Medicare. Plan assets can also be used to pay long-term care expenses.

For 2007, individuals can contribute up to $2,850; families are allowed to invest up to $5,650 into an HSA; those who are at least 55 years old can contribute an additional $800 (the dollar amounts are adjusted upward each year). Additionally, a one-time trustee-totrustee transfer from an IRA into a new or existing HSA is allowed; the amount that can be moved is limited to the personâ&#x20AC;&#x2122;s maximum HSA allowed for the year.

There is no requirement that HSA assets must be used by a certain date; money can grow and compound either tax-free or tax-deferred (depending upon how assets are eventually used) while Medicare or other insurer pays the bills. Once someone has enrolled in Medicare, a new HSA cannot be set up and no further contributions are allowed to an existing HSA. Those who work past 65, remain enrolled in a high-deductible health plan, and do not apply for Medicare, can still contribute to an HSA.

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529 PLANS In the late 1990s, Congress established 529 plans (named after the IRC that created them). Contributions are made with after-tax dollars, but distributions of growth and/or principal are not, provided account assets are used to pay for higher education. The plans are overseen by the states.

A number of states allow a state tax deduction or credit for contributions. Some states also offer â&#x20AC;&#x153;prepaidâ&#x20AC;? 529 plans that lock in current tuition rates. Investor interest in 529 plans has also increased due to the lowering of fees from several mutual fund companies.

Investors can set up 529 plan accounts directly with the states or through a third-party source such as a mutual fund.

RETIREMENT PLAN INCREASES FOR 2007 Proprietors with an owner-only 401(k) can contribute up to $45,000 for their 2007 contribution, up $1,000 from 2006. Employees under age 50 in a 401(k) can contribute up to $15,500 for 2007; for those age 50 and older, the maximum for 2007 is $20,500 ($15,500 + a catch-up contribution of up to $5,000).

For Roth IRA contributors, the amount of money you can make and still fully contribute to a Roth IRA is $156,000 for a married couple filing jointly in 2007 ($99,000 for singles). The traditional IRA contribution remains at $4,000 ($5,000 if age 50 or older). As a side note, the Social Security wage base rises to $97,500 in 2007.

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RETIREMENT PLANNING

MYTHS AND REALITY ABOUT RETIREMENT Surveys show that roughly 65-75% of baby boomers expect to work for pay after retiring. However, a study published by McKinsey & Co. found that 40% of retirees had to stop working earlier than planned, usually because of either layoffs or poor health. The Employee Benefit Research Institute found that just 27% of surveyed retirees had ever worked for pay while retired; a similar study by the Pew Research Center found that just 12% of current retirees are collecting a salary.

Almost two-thirds of affluent baby boomers (investable assets of at least $500,000) intend to finance their retirement by selling their home. The median value of a primary residence in the U.S. among those age 55 to 64 was $200,000 in 2004 (vs. $139,000 in 2001). The problem is that it may be that when the time comes, people will not actually want to pack up and move to something smaller or to a less expensive area.

Another belief is that one will be able to live on 70-80% of preretirement income. This is very likely if that individual or couple were saving 20-30% of their working income for retirement. Yet, according to the Employee Benefit Research Institute, 55% of surveyed retirees were living on 95% or more of their pre-retirement income.

Some believe that their tax bracket will be lower in retirement. This may or may not be the case, depending upon where the retirement income is coming from. Income from qualified accounts, bank CDs, traditional IRAs, and annuities are taxed as ordinary income.

Additionally, up to 85% of oneâ&#x20AC;&#x2122;s Social Security benefits could be subject to ordinary income taxes.

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About 45% of people in their 60s were still carrying a mortgage in 2000, up from 34% in 1980 for the same age group; 20% in 2000 were carrying a second mortgage, up from 7% in 1980. It is estimated that a couple retiring today could easily incur annual health care costs of $7,000; this figure includes $2,800 for Medicare Part B premiums, $800 for Medicare Part D, $2,800 for a supplemental Medicare policy, and about $1,000 for out-of-pocket prescriptions and doctors visits. If long-term care insurance premiums are included, the total annual cost could easily be $10,000.

A number of people believe that they are going to get an inheritance.

It is true that as much as $41 trillion could be passed down during the next 50 years, but two- thirds of whatever the amount ends up being will be concentrated among the wealthiest 7% of estates.

Factor in taxes, settlement costs, and charity, the figure drops down to $7.5 trillion. The actual figure could be substantially lower than this once lifetime annuities, health costs, and long-term are expenses are included; remember, people are living longer. An AARP study found that just 15% of boomer households expect to receive an inheritance; among those that have received an inheritance by 2004, the median value was less than $50,000.

Over 60% of those surveyed by the Employee Benefit Research Institute expect to receive a pension. Yet, only 40% of working couples are covered by such plans. The numbers become even less likely when one factors the freezing or cutting of benefits that has already taken place at such huge companies such as GM, IBM, and Verizon.

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RETIREMENT PLANNING

Among all of the myths or expectations, the one that is probably realistic is that most people will not need long-term care. A Georgetown University study projects that 65% of all people age 65 will need some type of long-term care in the future. The good news is that family members will provide much of this assistance (since most or all of it will take place in the retireeâ&#x20AC;&#x2122;s home).

Just 35% of those 65 will eventually spend time in a nursing home; only 5% will stay in such a place for more than five years.

For those who will end up paying for such care, about 45% of the expenses will be paid out of pocket; government programs and private insurance will pick up the balance. The average person will need to set aside $21,000 at age 65 to pay those future bills; 6% of the patients will need to invest $100,000 at age 65 to pay for future care.

Based on historical returns, a portfolio with about 60% in domestic large cap stocks (the S&P 500) and 40% in intermediate-term bonds should be able to sustain a 4.15% annual withdrawal rate indefinitely (based on looking at all 30-year periods since 1926). Using a 6.00% annual withdrawal real rate (meaning inflation is factored in), close to half of all 60/40 portfolios failed to last the entire 30 years.

One way to increase the withdrawal rate from 4.15% to 4.40% would be to add small cap stocks. If the investor were willing to accept a 94% probability that the portfolio would last 30 years, the withdrawal rate could be increased to 5% without having to add small cap stocks. Rebalancing annually would be another way to increase the annual withdrawal rate to just over 5%.

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RETIREMENT REALITY The table below shows what are believed to be the most popular and major sources of retirement income. As you can see, your job as an advisor is to help clients understand the difference between perception and reality.

Retirement Income: Perception vs. Reality Perception

Reality

At 65 years of age, remaining life expectancy is modest.

50% chance one spouse will live to age 92; 25% chance one will live to age 97.

Pensions are funded and guaranteed.

Fewer than 1-in-5 Americans have one; some will default or are underfunded.

Social Security will not change.

In 2007, there were 3.3 workers for each beneficiary vs. 16 workers in 1950; in 2017, Social Security is projected to pay out more than it takes in.

401(k) and other plans will rescue many.

Only 42% of workers participate; median 401(k) balance in 2004 was $58,600 for those in the 55-64 age range.

76% of pre-retirees say they 32% of retirees actually work; 44% of plan to work full- or partworkers are forced to stop working earlier time during retirement. than they had planned.

Trillions of dollars will be inherited by the next generation.

Median inheritance received by Baby Boomers to date: $49,000.

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RETIREMENT PLANNING

BENEFITS OF PATIENCE Behavioral finance researchers from Harvard and MIT conducted a study that shows investors often overreact to short-term performance even with their long-term investments. The study shows that the more frequently investors viewed the performance of their investments (monthly vs. annually) the more likely they were to see negative performance. Seeing negative return figures increased the likelihood of investors decreasing their weighting in stocks.

Specifically, investors who reviewed monthly portfolio performance figures found that returns were negative almost 40% of the time and ended up with a final stock allocation of 41%. Investors who reviewed performance just once a year saw negative returns less than 15% of the time and had a final stock allocation of 70%. Both test groups started out with a 50/50 split between stocks and bonds. Each time a group saw performance figures (monthly for one group, annually for the other group), each individual in the group was allowed to make â&#x20AC;&#x153;one final decisionâ&#x20AC;? for his or her long-term allocation.

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12.9

COSTS OF 401(K) PLANS According to Matthew Hutcheson, an independent pension fiduciary, the typical “low-cost, growth oriented mutual fund,” incurs the following expenses:

2007 Annual 401(k) Plan Costs Fee

Cost

Management

1.13%

Fund trading costs

0.86%

Participant education

0.75%

Administration

0.15%

Custodial

0.05%

Audit and legal

0.05%

Total charges

2.99%

As of the first quarter of 2007, more than 47 million employees participated in 401(k) plans; the cumulative total of these plans was $2.5 trillion. Just one percentage point in costs amounts to a “wealth transfer” of $25 billion a year from workers to investment companies and other financial services firms.

A November 2006 report by the Government Accountability Office found that 401(k) fee disclosures are often supplied in “a piecemeal fashion that make it difficult for employees to compare investment options or even have a clear idea of the costs they are incurring.”

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RETIREMENT PLANNING

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 â&#x20AC;&#x153;voluntary.â&#x20AC;?

The U.S. Census Bureau reports that seniors 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.

MAXIMUM SOCIAL SECURITY BENEFIT According to the Social Security Administration, an individual retiring in 2007 who is eligible for the maximum Social Security retirement benefit will receive $2,116 per month, or $25,392 for the first year. According to Kiplinger, 58% of Americans believe they will need to accumulate at least $2 million in savings in order to enjoy a comfortable retirement.

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12.11

PEOPLE WORKING LONGER In 2006, over 26% of California residents between the ages of 65 and 69 were still working (vs. 20% in 1995). Roughly 40% of this age group that is still working is doing so because they feel that they have not saved enough money for retirement.

The median balance in a 401(k) plan or IRA for the head of household between the ages of 55 and 64 in California is about $60,000; this translates into an inflation-indexed annuity of just $250 per month. If people were to retire at age 67 instead of 65, the percentage of retirees “at risk” (not having enough money to maintain their lifestyles during retirement) drops from 43% to 32%.

If workers could save just 3% more of their earnings each year, the “at risk” numbers would drop another 11%.

INFLATION MEASUREMENTS The U.S. consumer price index (CPI) has increased by an annualized rate of just under 3% over the last 25 years (1982-2006). Yet, a major risk during retirement is the retiree’s age-specific personal inflation rate (see second table).

The first table below shows the long-term impact of inflation at various rates, ranging from 0-4% annually. For example, if inflation were to continue to average 3% a year, $1,000 would have the purchasing power of $744 in 10 years.

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RETIREMENT PLANNING

Purchasing Power of $1,000 at Different Rates of Inflation Year

0%

1%

2%

3%

4%

1

$1,000

$990

$980

$971

$962

5

$1,000

$951

$906

$863

$822

10

$1,000

$905

$820

$744

$676

15

$1,000

$861

$743

$642

$555

20

$1,000

$820

$673

$554

$456

25

$1,000

$780

$610

$478

$375

30

$1,000

$742

$552

$412

$308

35

$1,000

$706

$500

$355

$253

The next table is something most advisors have never seen, the CPIE (the inflation rate that is unique to Americans age 62 and older), which is compiled by the U.S. Department of Labor through its Bureau of Labor Statistics (BLS).

Like the traditional CPI-W (“W” is for “wage earners”), each month the CPI-E measures price changes for hundreds of categories and items. Category weighting is based on average spending habits for the group.

The CPI-W reflects the spending habits of just under a third of the U.S. population. For example, working Americans spend four times as much on food and beverages as on apparel (0.16 vs. 0.04); they also spend eight times more on housing than they do on recreation (0.41 vs. 0.05).

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The table below shows the components that comprise the CPI-W index and CPI-E index plus their various component weightings; the “% of whole” column for each index, excluding “All items,” adds up to 1.00. The higher the component weighting, the more a price change for the category will affect the overall inflation rate. For example, notice how “Education & Communication” for the elderly represents just 50% of what it does for workers.

CPI-W (workers) and CPI-E (elderly) Inflation Rates % of whole

10-yr.

Inflation

% of whole

10-yr Inflation

All items

1.00

26.5%

1.00

29.7%

Apparel

0.04

-8.3%

0.03

-8.9%

Education & Communication

0.06

18.2%

0.03

4.5%

Food & Beverages

0.16

25.9%

0.13

25.4%

Housing

0.41

32.8%

0.48

34.0%

Medical Care

0.05

47.8%

0.11

47.8%

Recreation

0.05

9.8%

0.05

18.3%

Transportation

0.20

20.4%

0.15

21.9%

Other Goods & Services

0.04

56%

0.04

45.5%

Component

From 1982 to the end of 2006, the inflation rate for U.S. workers averaged just under 3% a year, versus 3.3% for the elderly. In fact, for each and every year over the past quarter of a century, CPI-E increases have been greater than CPI-W increases.

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The discussion as to how to personalize a client’s CPI rate becomes more interesting when gender and geography are factored in. For example, over the past 10 year, the rate of inflation has averaged 2.3% in Atlanta but 3.5% in San Diego. A report by Merrill Lynch shows that the recent inflation rate for women has been about 3.6% but just 0.2% for males—because their spending habits are different.

Client Customization A way to differentiate yourself from your peers is to sit down with your older clients and comprise a CPI for each, based on how that person (or couple) actually spends money. For example, suppose you have a client that spends all of her money on just two things, housing and medical care (for this simple example, pretend the client does not travel or eat, etc.). In such a case, her cumulative rate of inflation over the past 10 years would have been 41% [(34% + 48%) / 2] and her annualized rate would have been 3.5%.

Perhaps a more meaningful adjustment would be for you to match (or hedge) your clients’ expenditures with their equity holdings. For example, if a client spent 20% of their income on drugs and other medications, roughly 20% of their equity exposure could be in the pharmaceutical and healthcare sectors.

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LONG-TERM CARE PARTNERSHIP The idea behind Partnership for Long-Term Care, an insurance program used in five states (California, Connecticut, Idaho, Indiana, and New York) is that if you buy a long-term care policy that is approved by the state, you can apply for Medicaid to help cover any additional costs. Moreover, you can keep assets equal in value to the insurance benefits received. This means assets do not have to be â&#x20AC;&#x153;spent downâ&#x20AC;? before a patient qualifies for Medicaid.

For example, if you have a client that buys a policy whose cumulative benefit is $100,000 (e.g., $100 a day for 1,000 days), he or she can keep $100,000 in personal assets and still qualify for Medicaid. For the vast majority of your clients, three years of longterm care insurance coverage should be more than enough.

According to a 2005 actuarial survey of 1.6 million active policies, only eight in 100 claimants with a three-year benefit period exhausted their coverage.

For 2006, the average daily cost for a shared nursing home room nationwide was $183 ($66,795 a year) according to MetLife Inc. research. However, the average in New York City was $333 per day (or $121,545 a year). The national average hourly rate for a home health care aide is $19; the highest regional figure was $29 an hour in Rochester Minnesota.

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RETIREMENT PLANNING

When considering long-term care coverage, focus on the following: 1.

2.

3.

4.

5.

6.

Opt for an inflation protection rider (annual benefit compounds at 5%).

Lifetime benefits can cost up to 40% more than three years of benefits.

Find out average costs for care where the client lives.

Determine the financial strength of the carrier (www.ambest.com).

If the client is in good health, use companies that have extensive tests.

If the client is in poor health, one rejection is not universal.

At least 25 more states are expected to pass the Partnership for Long-Term Care during the next few years. The following web sites can help you figure out the cost of long-term care insurance where your clients live: 1.

www.longtermcare.gov: Under “Paying for Long-Term Care,” go to “Cost of Care.”

2.

www.metlife.com/maturemarketinstitute: Click on “Studies,” then go to “2006 MetLife Market Survey of Nursing Home and Home Care Costs.”

3.

www.longtermcare.genworth.com: go to “What is the Cost of Long-Term Care?”

4.

www.notaburden.com (MassMutual’s web site for financial professionals): Under the “For Producers” link, look under the “Cost by State Calculator.”

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12.17

DISCLOSURE FOR ORGAN DONORS Before the end of the third quarter of 2007, prospective organ donors will gain greater information. Specifically, transplant centers will be required to detail the risks of donor surgery plus they must provide independent patient advocates. The quality of transplants will be compared against Medicare and Medicaid standards. All transplant centers must be recertified every three years. Those that fare worse than would be statistically expected risk losing their Medicare funding.

There are 300 transplant centers in the U.S.; the number of living donors in 2006 doubled to nearly 7,000. The vast majority are liver donors. Under the new regulations, prospective living donors are given statistics on how recipients and donors fare nationally and at their hospital.

Potential donors must also be told about medical and psychological risks, the surgical procedure and post-operative treatment as well as alternate treatments. Additionally, the donor must be informed that his or her health insurance may not cover future health problems related to the donation and that the donor may have difficulty obtaining health, disability, or life insurance in the future.

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RETIREMENT PLANNING

FULLY FUNDED PENSION PLANS For the first time since 2000, the assets of defined benefit pension plans offered by Fortune 100 companies exceeded plan liabilities (as of the middle of 2007), according to the consulting firm Towers Perrin.

NEW MEDICAID RULES New Medicaid rules eliminate the “resource first” option. All states are now required to use the “income first” method, which takes into account the patient spouse’s income as well as the income of the patient. Some elder advocates believe these new rules will increase the likelihood of divorce being used.

The new rules also extend the “look-back period” for gifts from three to five years in most instances. The penalty period is now computed differently. The clock starts on the penalty period from the date the patient is eligible to receive Medicaid, instead of from the date of the gift transfer.

For example, if Ted (the patient) made a $20,000 gift four years ago, then went to a nursing home, spent down his life savings over two years, and then applied for Medicaid, he would still be subject to an additional four-month waiting period ($20,000 divided by the monthly cost of a nursing home, $5,000 in this example). If the gift were large enough, the alternative would be to wait for an additional year, so that a total of five years had lapsed since the time of the gift and the commencement of nursing home care.

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12.19

Under the new rules, an annuity is not counted an asset if the state is named as a “remainder beneficiary” (so the state can later be reimbursed). Annuities still remain an attractive strategy. The annuity contract could remain in deferral mode until the Medicaid application was submitted. At such time, the contract could then be irrevocably annuitized. The tricky part is that actuarial life expectancy tables are not those of the Internal Revenue Code or Social Security.

Additionally, loans and mortgages must have a repayment schedule that is actuarially sound; payments must be in equal amounts during the term of the loan. There can be no deferral of payments and no balloon payments. Upon death (of the Medicaid recipient), the loan balance cannot be cancelled.

In the past, Medicaid planning relied on the fact that a home, no matter how valuable, was considered an exempt asset. Under the new rules, states must consider an applicant’s home equity in excess of $500,000. States are permitted to raise that threshold to $750,000. The result is that reverse mortgages may become more popular if a large portion of the applicant’s net worth is in his or her personal residence.

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TAXES

13.2007

13.1

TAX BREAKS

For 2007, the maximum 401(k) contribution increases to $15,500 ($20,500 if the participant is age 50+). The maximum traditional and Roth IRA annual contributions stay at $4,000 ($5,000 if age 50+). A child or any other non-spouse who inherits a qualified retirement account can now transfer it directly into an IRA. Such a transfer allows the heir to stretch out distributions over numerous years.

Taxpayer’s age 70 1/2 or older can transfer as much as $100,000 directly from an IRA to a qualified charity. This transfer, also allowed for 2006, is set to expire at the end of 2007.

The maximum federal estate tax rate is 45% for estates of people who die in 2007. The basic federal estate tax exclusion remains at $2 million in 2007 and 2008; the exclusion is scheduled to rise to $3.5 million 2009, become unlimited in 2010, and then drop back down to $1 million for estates created in 2011.

Taxpayers who use their car for business have a choice of deducting their actual costs or using the IRS’s standard mileage rate; the 2007 rate is 48.5¢ (20¢ per mile for medical and moving purposes).

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13.2

TAXES

TAX DOCUMENTS The type of account(s) and activity determines the tax forms sent.

Mutual Fund Tax Information and Expected Mailing Date Document

Sent To

Information Contained

Fund year-end statement [early January]

All fund accounts that remain open after September 30th

All account activity: Cost basis of all shares purchased, reinvested, year-end values, & RMD notice to IRA owners who will be 70 1/2 that year

Form 1099-DIV [late January]

Most non-retirement & non-educational accounts

Ordinary & qualified dividends, capital gains distributions, federal taxes withheld, & foreign taxes paid

Form 1099-B [late January]

Most non-retirement & non-educational accounts

Date of each sale, number of shares sold, share price, dollar amount of each transaction, plus average cost basis & gain or loss information for most accounts

Form 1099-INT [late January]

Most non-retirement & non-educational accounts invested in muni bonds

Federally tax-exempt income dividends from muni bond funds & any private- activity bond interest used to compute AMT

Form 1099-R [late January]

IRAs & other retirement accounts

Distributions from Roth, traditional, SEP, & simple IRAs, plus distributions from most retirement plans

Form 1099-Q [late January]

Educational & Coverdell accounts

Distributions from educational accounts

Form 5498 [late May]

IRAs

All contributions, transfers, & rollovers to traditional & Roth IRAs plus SEP IRAs; year-end market values of IRA accounts

Form 5498-ESA [late April]

Coverdell accounts

Coverdell contributions & transfers (sent to beneficiary, not contributor)

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FREE TAX PREPARATION AND FILING In 2006, the U.S. Government Accountability Office estimated that 38% of taxpayers with securities transactions during the 2001 tax year misreported their capital gains or losses. TurboTax has a tool called BasicPro that taps into a database to help advisors and clients determine cost basis. Another service, AccuBasis, offered

by Depository Trust & Clearing and NetWorth Services, also provides similar information.

If you have clients with an AGI of $52,000 or less, they can go to irs.gov and click “2007 Free File.” From there your client will be linked to companies that will let them use their software and then file the return, all for free. Some companies, including Intuit, the makers of TurboTax, offer basic versions of their software on their own sites to anyone at any income level.

TAX FACTS The 16th Amendment created the federal income tax in 1913. In its first year, it taxed incomes of more than $3,000 at 1% and incomes of more than $20,000 ($400,000 in today’s dollars) at rates from 27%. Form 1040, the main tax-filing application, got its name because it was the 1,040th form issued by the Bureau of Internal Revenue, the predecessor to the IRS.

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The first electronic transmission of a tax return to the IRS occurred in 1986; for the 2006 calendar year, more than 73 million people filed electronic returns. The IRS estimates the overall compliance rate at 84%. In 2001, taxpayers paid, on average, a “surtax” of more than $2,000 each to subsidize noncompliance by others. In 2000, each $100 collected by the IRS cost 39¢ to collect.

In the beginning (1914), the original 1040 form was so small the New York Times printed it on their front page. There were just four instructions; now there are 4,000. By 1918, the government needed money to fight World War I and the top rate was increased to 70%.

In 1914, total income tax collections were $10 billion, in today’s dollars. The original IRS enforcement office had 4,000 employees.

Today, roughly $1 trillion is collected each year and the IRS has 100,000 tax agents. The New York Times wrote an editorial in 1909, warning against the possibility of an income tax, “When men get in the habit of helping themselves to the property of others, they cannot be easily cured of it.”

During the early years of the income tax, only about 1/2% of Americans (360,000) had to fill out a tax form. Today, 135 million do so; nearly every U.S. worker. As a side note, when the AMT was passed in 1969, it was originally designed to force just 155 wealthy individuals to pay taxes. For 2006, six million were subject to the AMT. If Congress does not intervene, 26 million will be subject to this tax in 2007.

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For 2007, there are over 66,000 pages of tax laws to contend with, along with 526 separate forms. It is estimated that 1.2 million people are employed as tax accountants, lawyers, and tax preparers.

American workers and businesses devote 6.4 billion hours a year, or roughly 45 hours per return. For example, there are now 16 different tax breaks for college education. Two-thirds of the adult population cannot figure out basic IRS regulations or tax laws concerning the sale of a home. According to the IRS, the number of federal estate tax returns (Form 706) for the 2007 calendar year is expected to be 30,400 (versus 90,000 in 1997).

APPEAL TO CHILDREN A number of mutual fund families now have programs and specialized products designed to appeal to investors age 20 and younger. American Century Investments offers â&#x20AC;&#x153;My [Whatever] Plan,â&#x20AC;? an online financial coach that goes over a savings strategy based on a specific goal, such as a wedding, buying a home, or retirement. Investors must commit $500 upfront and $100 a month thereafter.

Charles Schwab has a four-step IRA program that requires a $2,000 minimum investment; the materials show that by cutting out just two nights per month of partying, the young adult can end up with quite a bit of money. The Monetta Young Investor fund has a web site with a financial literacy area and a stock-picking game where children can win prizes; account holders earn 5% of their annual account balance in tuition credits.

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FEDERAL RESERVE COMIC BOOKS For the past half century, the New York Federal Reserve has been publishing comic books whose target audience is high school students (over 850,000 copies distributed in 2006). The Fed comic book most in demand is “Once Upon a Dime.” The storyline is about how money came to be on a mythical tropical island called Mazuma.

Advisors who have clients who are looking to educate their children and grandchildren can visit the newyorkfed.org web site and click on “publications catalog” to order the comics at no charge.

YOUNG INVESTORS The University of Minnesota has found that children as young as age five can develop spending and saving habits. The Investment Company Institute (ICI), the trade and lobbying group of mutual funds, lists child-friendly web sites (www.ici.org/funds/inv/ resourcesyoung.html.).

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