IBF - Updates - 2009 (Q4 v1.0)

QUARTERLY UPDATES Q4 2009

Copyright Š 2010 by Institute of Business & Finance. All rights reserved.

v1.0

Quarterly Updates Table of Contents FINANCIAL PLANNING HEALTH C ARE DJIA: OCTOBER 2008 TO OCTOBER 2009 M ARKET LINKED CD EXAMPLE COMMODITY LINKED CD EXAMPLE THE DOW JONES - UBS COMMODITY INDEX DOW JONES - COMMODITY INDEX QUARTERLY FIGURES WORLD EQUIT Y MARKET CAPIT ALIZATION CORRELATION COEFFICIENTS STATE D EATH TAXES 529 P LANS REASONS TO OWN FOREIGN SECURITIES REDUCING SYSTEMATIC RISK

1.1 1.1 1.2 1.5 1.5 1.6 1.7 1.7 1.7 1.9 1.9 1.10

MUTUAL FUNDS ACTIVE MANAGEMENT INDEXING VS ACTIVE M ANAGEMENT WORLD ’S L ARGEST MUTUAL F UND MEASURING AND COMPARING F UND P ERFORMANCE

2.1 2.1 2.2 2.2

RETIREMENT PLANNING ROTH IRA CONVERSIONS FIXED R ATE ANNUITY RETIREMENT RESEARCH A S ECURE RETIREMENT USING STANDARD DEVIATION ADVANT AGE OF ANNUITIZATION DURING RETIREMENT REPLACEMENT RATIO THE VALUE OF HUMAN C APITAL

3.1 3.2 3.6 3.9 3.10 3.12

BONDS WHAT H APPENS WHEN R ATES INCREASE EMERGING MARKETS DEBT TREASURIES VS. INFLATION M UNICIPAL BOND SAFETY BONDS STOCK/BOND CORRELATION AND INDEXES BOND SECTOR R ETURNS

4.1 4.1 4.2 4.3 4.4 4.7 4.8

EFTS KEEPING ETF P RICES CLOSE TO NAVS THE STRANGE STATE OF EFT E VALUATIONS & RATINGS

5.1 5.1

QUARTERLY UPDATES FINANCIAL PLANNING

FINANCIAL PLANNING

1.HEALTH

1.1

CARE

Health care costs have risen at more than twice the pace of overall inflation since 1990 , more than doubling their share of the economy during that period. Even adjusting for the size of its economy and population, the U.S. spends far more money on health care each year than any other country in the world. As of 2009, health care spending made up 15.3% of the U.S. economy compared to an average of 8.8% for developed countries.

Under current policies, government spending on health care is projected by the Congressional Budget Office to rise to more than 18% of GDP per year over the next 75 years; since WWII, the U.S. government has collected tax revenue to finance its entire budget that has equaled an average of 18% of GDP each year.

DJIA: O CTOBER 2008 TO OCTOBER 2009 The table below shows DJIA numbers from October 1 st , 2008 through September 2009.

Over this period, the Dow dropped from its peak of over 14,000 down to 10,000 (October 2008) to its March 2009 low and then back up to 10,000 for the first time (October 14, 2009) since dropping to 10,000 at the beginning of October 2008. The “Losers” figures show the percentage of DJIA stocks with a negative monthly return; “P/E” reflects the DJIA price/earnings (source: WSJ Market Data Group). The DJIA hit a closing-day low point (6,547) on March 9 th , 2009.

Dow: From 10,000 to 6,547 back to 10,000 [October 2008 through September 2009] Date

10-08

11-08

12-08

1-09

2-09

3-09

4-09

5-09

6-09

7-09

8-09

9-09

Return

-14%

-5%

-1%

-9%

-12%

+8%

+7%

+4%

-1%

+9%

+3%

+2%

Losers

~26% ~31%

~13%

~72% ~68%

~24%

~45% ~26%

~55%

~30% ~74%

~65%

P/E

N/A

18.3

19.3

25.2

33.4

12.3

14.8

15.7

18.5

23.4

42.7

15.3

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1.2

MARKET LINKED CD E XAMPLE During the last part of October 2009, Union Bank offered a market-linked certificate of deposit (MLCD) with the following features:      

4-year term (Oct. 28th , 2009 to Oct. 28th , 2013) 4% minimum cumulative return (e.g., worst case, $100k grows to $104k) 80-112%* of S&P 500 growth (dividends not included) 5-7%* quarterly cap rate on gains (but no quarterly cap on downs ide) FDIC insured up to $250,000 (includes principal and growth) note: * means actual rate was determined on Oct. 28 th , 2009

The advantage of this investment is your client is guaranteed to earn at least 1% simple interest each year. There is also the possibility of a return that ranges from 80-112% (a best-case annualized yield of 15.8% to 20.6%). The disadvantages of this type of CD are: [1] little, if any liquidity during the four-year hold; [2] any quarterly loss, no matter how great, “stays on the books” until it is fully offset by future quarterly gains; [3] return potential does not include S&P 500 dividends; [4] annual tax liability (whether gains or not)—IRS imputes (assumes) a 3.9% growth rate each year and taxpayer must pay taxes on that 3.9%—if the cumulative return works out to be less, investor is entitled to a refund; [5] any form of averaging (in this case, quarterly) is usually a negative for investors; [6] there is little likelihood of capital appreciation of 80-112% for the S&P 500 over any four-year period and [7] this is a note, any eventual gains are taxed as ordinary income. Each of these points is expanded upon below.

[1] Little Liquidity The issuer does not intend to make a secondary market and there is no assurance any kind of secondary market will be developed by anyone. This means if money is needed before the four-year maturity date, investor will either not be able to tap this source or (if a secondary market does develop) incur a moderate to severe discount of actual value.

[2] Quarterly Losses Since there is no downside to a quarterly loss, it could take the investor several quarters to offset any such loss. For example, during the extremely negative year of 2008 S&P 500 quarterly losses were (dividends excluded): Q1—2008 (-5%), Q2—2008 (-7%), Q3—2008 (-8%) and Q4—2008 (-23%). None of any quarterly losses for 2007, 2006, 2005 or 2004 even come close to the negatives of 2008; in fact, almost all quarterly results from 2004 through 2007 were positive. Still, the gains enjoyed during those years were completely offset by the losses of 2008.

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1.3

[3] Dividends Not Counted Often times, investors are shown a “mountain” chart of total returns (appreciation and dividend reinvestment) over an extended period of time, such as from 1926 to the present.

This is misleading when used in conjunction with equity-indexed annuities and marketlinked CDs since neither includes dividends. The difference can be profound. For example, from the beginning of 1926 to the end of 2008, $1 invested in the S&P 500 grew to $2,050 (total return) but only $70.80 (capital appreciation) if dividends were excluded. This extreme percentage difference should be viewed only as an interesting historical figure since loss of dividends over a 4-8 year period would not be nearly as dramatic. Still, over time, dividends have averaged about 3.5% per year over the past 80+ years and, therefore, have had a significant impact on overall returns.

[4] Annual Tax Liability The Union Bank disclosure statement points out that there is a tax schedule for this investment each year, regardless of performance. The “imputed” rate is 3.9% each year.

Thus, a $100,000 investment in a taxable account would incur a $1,000 federal income tax liability each year, assuming a 25% tax rate. The investor would also be liable for any state income taxes (based on the same imputed rate). When the note comes due in four years, there will be additional tax liability if the investment’s return exceeds its 3.9% annual imputed growth rate; if growth is below 3.9%, the investor will be entitled to a refund.

[5] Averaging There are situations wherein averaging can be beneficial. However, this is usually not the case. For example, if one compares an equity-indexed annuity (EIA) that includes averaging with one that does not, upside potential for the EIA without averaging is typically a third to a half higher than the one with averaging.

[6] Likelihood of 80-112% Cumulative Gain Since 1970, the best four years in a row for the S&P 500 (appreciation only) were 1995 through 1998 when annual appreciation gains were: +34.1% (1995), +20.3% (1996), +31.0% (1997) and +26.7% (1998). Adding up just these annual returns results in a cumulative gain of 112%. Once a bad year is factored in, the results are quite different .

For example, from 1997 through 2000, annual appreciation for the S&P 500 was: +31.0% (1997), +26.7% (1998), +19.5% (1999) and -10.1% (2000), a cumulative gain of 67.1%.

Few would argue that being in the market from 1997 through 2000 would not have been a blessing. However, 67.1% is a little more than half the 112% cumulative gain of 1995 through 1998 (112%). Still, 67.1% works out to an annualized return of just under 14%.

Thus, there are circumstances wherein return potential for this investment could be q uite attractive.

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1.4

[7] Ordinary Income Taxes The investor needs to be reminded that she is really lending money to Union Bank (via an FDIC-insured CD). Gains on notes are always taxed as ordinary income, regardless of holding period or underlying equity link (such as the S&P 500).

Observations Evaluation of a MLCD is difficult because there is a tendency to forget there is no chance of a loss if the investment is held to maturity. This means a proper comparison would be with a traditional CD or other high-quality asset with a four-year maturity (e.g., shortterm bond or fixed-rate annuity).

The table below shows cumulative returns for the appreciation (no dividends) of the S&P 500 for the 20 years ending 2008. Even though such figures do not reflect any kind of quarterly averaging, they should still provide a fairly good idea of the historical return potential for a market-linked certificate of deposit (MLCD).

S&P 500 Cumulative Appreciation窶馬o dividends [1989-2008] Year

Index

Year

Index

Year

Index

1989

27.7

1996

58.1

2003

87.1

1990 1991

25.9 32.7

1997 1998

76.1 96.3

2004 2005

95.0 97.8

1992

34.1

1999

115.1

2006

111.2

1993

36.6

2000

103.5

2007

115.1

1994

36.0

2001

90.0

2008

70.8

1995

48.3

2002

69.0

Using numbers above as a rough guide, the investor would have made more than 1% a year (the minimum guarantee) if the investment started at the beginning of any year from 1989 through 1997 plus 2001 through 2003 (75% of the time).

Compared to an equity-indexed annuity (EIA) with a 3-5 year holding period and an annual cap rate of 6-7% (annual reset design), this equity-linked CD investment looks quite appealing. The EIA has zero downside risk (vs. 4% simple interest for the MLCD) and an upside potential 7% annualized (vs. 20.6% for the MLCD).

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1.5

COMMODITY L INKED CD EXAMPLE Commodity-Linked CD Example During the last part of October 2009, Union Bank offered a commodity-linked certificate of deposit (MLCD) with the following features:     

4-year term (Oct. 28th , 2009 to Oct. 28th , 2013) 5% cumulative minimum return (e.g., worst case, $100k grows to $105k) 45-60%* rate on gains FDIC insured up to $250,000 (includes principal and growth) note: * means actual rate was determined on Oct. 28 th , 2009

This MLCD is structured in a fashion similar to the preceding S&P-linked CD example with the following differences: [1] underlying index is Dow Jones UBS Commodity Index (DJ-UBSCI), [2] cap on gains is calculated differently and does not use any kind of averaging (it is a “point-to-point” design), [3] maximum cumulative gain is lower, 4560% and [4] IRS imputed interest increases from 3.9% to 4.6%. This commodity-linked CD could deliver annualized returns ranging from 7.7% up to 9.9%.

THE DOW JONES - UBS COMMODITY INDEX The index is comprised of 19 physical commodities in five groups (agriculture, energy, metals, industrial metals and livestock). No one commodity can comprise less than 2% or more than 15% of the index and no group can represent more than 33% of the index.

Index weightings for each commo dity as of early 2009 were:

DJ-UBS Commodity Index Weightings [2009] Crude Oil (14%)

Heating Oil (4%)

Natural Gas (12%)

Zinc (3%)

Gold (8%)

Sugar (3%)

Soybeans (8%)

Coffee (3%)

Copper (7%)

Soybean Oil (3%)

Aluminum (7%)

Nickel (3%)

Corn (6%)

Silver (3%)

Wheat (5%)

Lean Hogs (2%)

Live Cattle (4%)

Cotton (2%)

Gasoline (4%) Q UARTERLY UPDATE S

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1.6

DOW JONES - COMMODITY INDEX QUARTERLY FIGURES Qtr. Ending

Index Close

Qtr. Ending

Index Close

Qtr. Ending

Index Close

Mar—98 June—98

106.5 96.6

Mar—02 June—02

99.6 99.5

Mar—06 June—06

165.2 173.2

Sep—98

90.4

Sep—02

106.3

Sep—06

160.0

Dec—98 Mar—99

77.8 81.0

Dec—02 Mar—03

110.3 113.2

Dec—06 Mar—07

166.5 172.0

June—99

82.6

June—03

115.8

June—07

169.7

Sep—99 Dec—99

92.4 92.3

Sep—03 Dec—03

120.9 135.3

Sep—07 Dec—07

178.2 185.0

Mar—00

98.5

Mar—04

150.8

Mar—08

201.6

June—00

104.8

June—04

144.0

June—08

233.0

Sep—00

107.0

Sep—04

153.2

Sep—08

167.8

Dec—00

114.6

Dec—04

145.6

Dec—08

117.2

Mar—01

105.4

Mar—05

162.1

Mar—09

109.8

June—01 Sep—01

101.6 95.1

June—05 Sep—05

152.9 178.2

June—09

122.5

Dec—01

89.0

Dec—05

171.1

Since this commodity-linked CD has a five-year holding period, consider how often gains were positive, looking at every five-year rolling period (e.g., March 1998 through March 2002, June 1998 through June 2002, etc.). Out of the 30 possible five -year rolling periods, commodity gains were positive 26 out of 30 times. The best five -year period was September 2001 through September 2005 (an 83.1 point gain); this translates into an 87% cumulative gain (83.1/95.1). However, the CD-linked investor would have had a maximum cumulative return of 45%-60% (cap rate set by the issuer).

Observations Often, advisors and clients alike have difficulty in imaging commodity prices going down over any extended period, but the reality is quite different. For example, the difference between the table’s starting point (106.5) and the ending point (122.5) represents a gain of just 15%. The time period is just over 12 years; this translates into an annualized return of just over 1%. Extreme movements downward have also been experienced: from June 2008 through March 2009, this commodity index dropped 53%.

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1.7

WORLD EQUITY MARKET CAPITALIZATION Country/Region

2004 mkt. cap.

2009 mkt. cap.

U.S.

51%

42%

Europe

29%

29%

Asia/Pacific

15%

21%

Americas (w/o U.S.)

4%

7%

Africa/Middle East

1%

1%

CORRELATION COEFFICIENTS Over the long term, different asset categories tend to have predictable relationships (correlations). For example, U.S. Treasury prices usually move in the opposite direction of stocks because people buy Treasuries and sell stocks when they are worried about the economy and do the reverse as they get more optimistic. Over short periods of time, correlation coefficients can vary wildly.

For example, from the end of July 2009 to November 2009, the U.S. dollar index and S&P 500 were 60% inversely correlated (71% inverse correlation in October). However, between January 2007 and the end of July 2009, the correlation was just 2% (an almost perfect “random correlation�).

Over a recent 15-year period (1994-2008), the correlation between oil prices and the S&P 500 ranged from +20% to -20% (random correlation). At extremes, the correlation was +40% to -40%; in mid-June 2009, the correlation briefly hit +75%.

STATE DEATH TAXES For 2009, individuals avoided estate taxes if their taxable estate was valued at $3,500,000 or less. At this level, it is estimated just 5,500 estates a year were subject to federal estate taxation. At the previous $2,000,000 limit, 17,500 estates annually were subject to the tax (source: Urban-Brookings Tax Policy Center). The figures for state estate and inheritance taxes vary widely.

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1.8

State Estate and Inheritance Taxes State Connecticut

Tax Type E

Exemption $2,000,000

Max Rate % 16

State New Jersey

Tax Type E/I

Exemption $675,000/$0

Max Rate % 16/16

Delaware

E

$3,500,000

16

New York

E

$1,000,000

16

Illinois

E

$2,000,000

16

N. Carolina

E

$3,500,000

16

Indiana

I

$100

20

Ohio

E

$338,333

7

Iowa Kansas

I E

$0 $1,000,000

15 3

Oklahoma Oregon

E E

$2,000,000 $1,000,000

10 16

Kentucky

I

$500

16

Pennsylvania

I

$0

15

Maine

E

$1,000,000

16

Rhode Island

E

$675,000

16

Maryland

E/I

$1,000,000/$150

16/10

Tennessee

I

$1,000,000

9.5

Massachusetts

E

$1,000,000

16

Vermont

E

$2,000,000

16

Minnesota

E

$1,000,000

16

Wash., D.C.

E

$1,000,000

16

Nebraska

I

$10,000

18

Washington

E

$2,000,000

19

Keeping track of constantly changing state death taxes can be difficult. Delaware added an estate tax in 2009, while Kansas and Illinois were expected to eliminate such a tax in 2009. Eight states have inheritance taxes that are levied on heirs, not estates. In many states, rates are tied to how closely the heir is related to the now deceased donor. For example, Pennsylvania taxes children and grandchildren at an almost-flat rate of 4.5% while more distant relatives pay up to 15%.

Taxpayers who live in states without estate taxes, such as California and Florida, may face estate taxation if they own property in a state that has an estate or inheritance tax.

Such possible taxation is based on “domicile,” a much broader definition than “residency.” It is possible for someone to have multiple domiciles since domicile may be determined by where the person votes, has a church or club membership, registers a car or owns a burial plot. For example, when Campbell Soup magnate John Dorrance died in 1930, both New Jersey and Pennsylvania each collected about $15 million in death taxes.

Advisors may wish to consider a bypass trust for married couples living in a state that imposes any kind of death tax that has an exemption lower than the federal level. With a bypass trust, when the first spouse dies, assets go into a trust the surviving spouse can draw. When the second spouse dies, any remaining assets in the bypass trust pass tax-free to heirs, thereby preserving the value of both individual exemptions.

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1.9

529 PLANS About 32% of parents’ savings for children’s college expenses put money into 529 plans during 2009, up from 30% for 2008. Every state except Wyoming offe rs at least one plan; many states offer more than one plan. Investors are not required to invest in their home state’s plan. However, by sticking to a plan offered by one’s state of residency, the investor may be entitled to an upfront state tax deduction.

The most common investments for 529 plans are those tailored to a child’s expected date of matriculation or the family’s appetite for risk. Under IRS rules, 59 plan investors could only make one change per year; in December of 2008, the IRS stated plan holders could now make two changes per year. As of November 2009, four plans (Arkansas, Indiana, Iowa and Missouri) offered ETFs. Besides generally having lower expense ratios, ETFs inside a 529 plan are not subject to commissions every time there is a buy or sell.

REASONS

TO

OWN FOREIGN SECURITIES

The U.S. share of exchange-based global market capitalization has been falling, from 52% at the end of 2001 to 35.2% as of September 2007. As of January 2009, roughly 40,000 stocks traded in foreign exchanges—compared with about 6,000 on the NYSE and NASDAQ. At one time, sticking to the domestic market ensured the world's greatest quality of management, accounting standards, and transparency. But much of the world has caught up: Today more than 1,500 of the world's largest 2,000 companies are domiciled outside America's borders, including industry leaders such as Nestlé, Toyota, HSBC, Royal Dutch Shell, and Samsung.

Investing directly on a foreign exchange is not the only way to gain exposure to international shares, of course. Take American depositary receipts (ADRs), which are certificates corresponding to a certain number of shares of a foreign company. ADRs trade on U.S. exchanges providing investors with timely dividend payments and widespread information, but sticking to ADRs limits your universe to the large, multinational firms that tend to issue the securities (about 3,200 foreign firms currently list in the U.S.). ADRs are priced in U.S. dollars, so they mute the effects of exchange rate fluctuations—one of the arguments for investing in international stocks.

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1.10

While foreign markets have some unique investing risks—some regions are more volatile and can have the potential for faster gains or losses—they have also been home to some of the largest returns over specific periods of time.

International markets historically have been much more likely to produce outsized returns than U.S. stocks—or other assets, for that matter. Fidelity tracked the performance of 17 asset classes—including cash, high-yield bonds, real estate, gold, and stocks of different sizes and styles—during the 27 calendar years since 1983 (including the first half of 2009). Foreign stocks of one kind or another were the top-performing asset 15 times, while domestic stock categories generated the best returns only five times. Foreign stocks were also the worst-performing asset class eight times during that time period.

Of the 50 top-performing stocks in the MSCI All Country World Index through March 31, 2009, 40 were foreign. Foreign countries have a much more favorable macroeconomic outlook than the U.S.—which could provide the backdrop for greater stock returns. U.S. GDP is expected to grow 1.5% during 2010, compared with 3.1% for the overall world economy.

REDUCING SYSTEMATIC RISK According to The Handbook of Financial Investments (2002) by Frank J. Fabozzi: “For common stocks, several studies suggest that a portfolio size of about 20 randomly selected companies will completely eliminate unsystematic risk leaving only systematic risk (note: the first empirical study of this type was by Wayne Wagner and Sheila Lau, “The Effect of Diversification on Risks,” Financial Analysts Journal, NovemberDecember 1971). In the case of corporate bonds, generally less than 40 corporate issues are needed to eliminate unsystematic risk.”

A chart in Fabozzi’s book shows roughly 60% of total risk is 95% eliminated through the (near 100%) elimination of unsystematic risk. This means that an advisor can eliminate close to 60% of a client’s stock market risk by avoiding unsystematic risk.

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2.ACTIVE

2.1

MANAGEMENT

A 2009 study by Morningstar concludes: “while about half of actively managed funds outperformed their respective Morningstar indexes, only 37% did on a risk-, size- and style-adjusted basis. The numbers are similar for five and 10-year returns.” Funds that performed in the top 25% over the past three years had much lower risk and volatility than their peers.

INDEXING

VS

ACTIVE M ANAGEMENT

According to financial advisor William Thatcher, indexing tends to beat active management in top-performing asst classes and loses to active management in the worstperforming asset classes. Thatcher believes “in the best-performing asset classes, index funds are rewarded for purity and active managers are punished for their impurity (many do not stay true to a particular investment style).” Results of Thatcher’s study (1998 2007) show that the benefit of indexing was not consistent over one-year periods. The results of the Thatcher study were consistent with research done in 1999 by advisors Steve Dunn and William Bernstein.

Active vs. Index Investing [1998-2007] Asset

Annualized

Active Managers

S&P MidCap 400

11.2%

78% underperformed

S&P MidCap 400 Growth S&P MidCap 400 Value

11.1% 11.1%

72% underperformed 70% underperformed

S&P MidCap 600 Value

9.0%

53% underperformed

S&P SmallCap 600 S&P SmallCap 600 Growth

9.0% 8.2%

61% underperformed 50% underperformed

S&P 500/Citigroup Value

6.6%

46% underperformed

S&P 500

5.9%

60% underperformed

S&P 500/Citigroup Growth

4.8%

35% underperformed

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2.2

WORLD’S LARGEST MUTUAL FUND As of November 2009, PIMCO’s $186 billion Total Return fund is easily the biggest mutual fund in the world; it would be the seventh largest fund group (family) in the U.S. The second largest U.S. bond fund is Vanguard’s Total Bond Market Index at $64 billion.

For a fund that focuses on U.S. Treasuries, a market that exceeds $7 trillion, size is not an issue for either fund. According to Barclays, the total size of the investment-grade corporate bond market is about $5 trillion. The Barclays Capital U.S. Aggregate Bond Index, the fund’s benchmark, has a market value of about $13 trillion (note: PIMCO Total Return’s size represents roughly 1.5% of the benchmark’s market value). The total amount of global debt is roughly $53 trillion.

MEASURING

AND

COMPARING FUND PERFORMANCE

Fund advisory services know that past performance is not necessarily indicative of future returns. The regulatory structure that requires this acknowledgment of future performance uncertainty is appropriate because: [1] most fund ratings are based primarily on past performance and [2] the evidence of predictive value in fund ratings is uneven.

Amenc and Le Sourd (2007) found little merit in the fund rating methodologies of Lipper, Morningstar and Standard & Poor’s. Yet, there is somewhat conflicting evidence.

For example, Morey and Gottesman (2006), arguably the most laudatory evaluation of a fund rating service published in recent years, concluded that the Morningstar rating system, as revised in 2002, predicted relative mutual fund performance within nine domestic equity fund categories pretty well over the following three years. The principal change in the Morningstar rating system in 2002 was to switch from a single domestic equity category to nine categories analogous to the Morningstar style boxes.

A number of studies have found that funds that have performed well in the past tend to continue to perform relatively well, with some reservations. Past performance may be useful in selecting the better performers among, say, large-cap growth funds. Of course, the ratings primarily reflect the recent relative performance of the funds, so it is difficult to see any need to transform recent fund performance into a rating system. The transformation may create a salable proprietary product, but it does not necessarily improve the usefulness of the information delivered to investors. The Morey and Gottesman results suggest that investors would be as well served with simple past performance comparisons as with formal ratings.

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2.3

The fact that most fund ratings emphasize performance relative to a peer group of funds is the most significant weakness of most fund evaluation models. Eve ry investor would not necessarily have (or want) access to the peer group funds that a fund evaluation service selects for its comparisons. Furthermore, it is usually possible to invest in an asset class or category without using any of the funds in a mutual fund peer group. ETFs and structured notes are alternative vehicles, for example. Even if comprehensive fund peer group ratings are sometimes useful to investors, the appropriate way to evaluate a fund varies as costs, fund holdings, fund structures and investors’ objectives change.

To illustrate how an adviser might develop and use detailed fund information effectively, consider how to enhance an investor’s or an adviser’s understanding of the elements of fund performance. Even if a fund-rating calculation considers a fund’s ability to do better than its peers during the most recent bear market, the performance measurement that dominates most ratings is a single performance number for each fund for each year or quarter. A breakdown of how and why the performance of the fund was achieved in that period is a better guide to what the future might hold for that fund than a simple historic return calculation or a longer-term comparison of returns among a group of funds.

For example, good performance achieved by consistent implementation of a stock valuation strategy with patient trading is likely to be more sustainable than performance achieved by a single major allocation shift or by moving from equities to cash and back again in an attempt to predict market direction. It is essential to look beyond ratings and rankings and into the manager’s actions for better ways to identify funds with superior investment processes and prospects and to develop comprehensive information that will improve fund choices. A number of academic studies have shown the following: 

Active fund manager “value-add” is obscured by combining good results for true active managers with poor results from closet indexers who are charging active management fees to their investors but not delivering value.



The ability of fund managers to value securities and make performance-enhancing portfolio transactions can be obscured and overwhelmed by flows of investor funds into and out of mutual funds.



Portfolio transaction costs for funds exceed the fund’s expense ratio on average, but funds add value with some of their discretionary transactions. Transactions made to accommodate investor flow into and out of a fund and transactions larger than the average trade size in comparable competitive funds will hurt performance.



Managers with superior stock selection skills can be identified and their skills persist over time. Past performance may not be a reliable indicator of future results, but it is not meaningless.

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RETIREM ENT PLANNING

3.ROTH

3.1

IRA CONVERSIONS

Starting January 1 st , 2010, an income limit that previously prevented many Americans from converting their traditional IRAs into Roth IRAs disappeared. If your client’s household income is more than $100,000 (the previous limit), converting to a Roth will be an option for the first time. Married couples filing separate tax returns also will now be able to convert. Listed below are strategies for the advisor’s consideration.

Pay taxes on converted amount You have to pay income taxes when you convert. For example, a client in the 28% tax bracket will owe $28,000 (plus state income taxes) on a $100,000 conversion.

Converting may benefit the client in the long run—if a higher tax rate is expected during retirement. If, like most people, the client is not sure about his future tax rate, consider converting just part of his traditional IRA to a Roth. Doing so gives "tax diversification" because some money would be in a Roth and some still in a traditional IRA. Consider source used for taxes Stick with the traditional IRA if the client does not have money available outside of the IRA to pay conversion taxes. Pulling money out of an IRA to cover taxes can defeat the purpose of making the switch in the first place. By reducing retirement savings, clients reduce the ability to generate future tax-free earnings on money invested in the Roth. If under age 59½, amounts pulled out of a traditional IRA to cover taxes may be subject to a 10% IRS penalty.

Two conversion strategi es If the client does not have enough money to pay taxes on all converted assets, or if doing so would push her into a higher tax bracket, consider converting just part of the traditional IRA assets. A special option applies only to 2010 conversions; the taxpayer can elect to evenly divide the tax liability over 2011 and 2012. If tax rates go up in 2011, this split-year strategy may not be a good idea.

Longer time horizons are better A conversion may not be wise for clients who expect to withdraw money wit hin five years. Generally speaking, the client will only be able to withdraw earnings from the account without taxes and penalties if age 59½ or older and a Roth IRA has been held for at least five years. Withdrawals of the original conversion amount are always tax-free; however a 10% early penalty may still apply. The client must be either at least age 59½ or wait at five years after the conversion to make the withdrawal in order to avoid the 10% penalty.

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3.2

Heirs can benefit During lifetime, the Roth IRA client is not subject to RMDs, meaning the entire amount can be left to someone else. A beneficiary who inherits a Roth IRA may be subject to RMDs, but withdraw the original conversion tax-free. Earnings are also tax-free, provided the Roth IRA meets the fi ve-year holding requirement.

FIXED RATE ANNUITY RETIREMENT RESEARCH Following are summaries of major research studies that demonstrates the important role of fixed annuities in securing retirement income.

Wharton Financial Institutions Investing your Lump Sum at Retirement, August 2007

by David F. Babbel Summary: This essay describes the conclusions from an earlier study as well as findings by other prominent economists. It concludes that income annuities can provide secure income for one's entire lifetime for 25-40% less money than it would otherwise cost an individual, thanks to an insurer's ability to spread risk across large numbers of people.

The authors note that "...economists have come to agreement from Germany to New Zealand, and from Israel to Canada, that annuitization of a substantial portion of retirement wealth is the best way to go. The list of economists who have discovered this includes some of the most prominent in the world, including Nobel Prize winners.

Studies supporting this conclusion have been conducted at such universities and business schools as MIT, The Wharton School, Berkeley, Chicago, Yale, Harvard, London Business School, Illinois, Hebrew University, and Carnegie Mellon. The value of annuities in retirement seems to be a rare area of consensus among economists."

In the press release accompanying the essay release, Prof. Babbel said: "Our research shows that only lifetime income annuities can protect individuals in an efficient way from the risk of outliving their assets and that this simply cannot be duplicated by mutual funds, certificates of deposit, or any number of homegrown solutions. We believe we have shown that income annuities clearly should be more widely used, given that highly rated insurance companies are reliable and inexpensive sources of guaranteed income streams in retirement."

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3.3

Employee Benefit Research Institute (EBRI) Measuring Retirement Income Adequacy, September 2006

by Jack Van Derhei Summary: The author notes that for decades "replacement rates" have been the primary rule of thumb measure used to estimate an adequate level of income during retirement.

Replacement rate is annual retirement income divided by annual income just before retirement. For example, someone who retires from a job with $100,000 in salary and has $75,000 in retirement income has a replacement rate of 75% (which many financial planners consider adequate).

A weakness of replacement rate models is that some important retirement risks are not taken into account, including investment risk, longevity and the risk of potentially catastrophic health care costs. Taking these risks and inflation into account and using a Monte Carlo model, the study demonstrates that for most retiree groups, converting some retirement assets to an income annuity at retirement can lower the replacement rate needed to achieve a 90% probability of income adequacy. For example, the study illustrates one example where a 124% replacement ratio, half of which is provided by an annuity, can have a probability of adequacy, equal to replacement ratios of 148% to 180%, with no annuity purchase and various earnings assumptions.

Journal of Financial Planning Meeting the Needs of Retirees: A Different Twist on Allocation, January 2000

by John Rekenthaler, CFA Summary: The author educates the financial planning community about pitfalls of developing retirement income plans based on "average" investment returns. He uses historical charts to show that, for the retiree making withdrawals from assets, the sequence of the annual returns on those assets can be of greater importance than the average of those annual returns.

The author makes the case that traditional asset allocation models, used to optimize accumulations while saving for retirement, do not work for allocating assets during retirement. In retirement, the asset allocation mix should recognize that a long time horizon, which is a friend of the young investor, is an enemy of the retiree who needs income from the portfolio for every year of retirement. Asset allocation models also need to consider that volatility in portfolio returns, which may average out for investors accumulating assets, will damage the level of withdrawals that a retirement portfolio can sustain.

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3.4

The author (correctly) predicts that new asset allocation models will be developed for the asset "draw down" phase to account for the risks that are not present during the asset accumulation phase.

Journal of Financial Planning Making Retirement Income Last a Lifetime, December 2001

by John Ameriks, Ph.D., Robert Veres and Mark Warshawsky, Ph.D. Summary: The authors explore the sustainability of alternative asset withdrawal plans using different asset allocation mixes during retirement. The probability of failure of various plans is examined for various model portfolios ranging from asset allocations labeled from conservative to aggressive.

An historical chart illustrates that, regardless of the asset allocation strategy, the withdrawal rates that were sustainable for a full 30 years were between 3 .50% and 5.00% per year adjusted for inflation. The aggressive portfolio sustained the higher withdrawal rates for the 30-year period. Looking specifically at a 4.50% inflation-adjusted withdrawal rate, historical analysis shows that, relative to the conse rvative portfolios, the more aggressive portfolios had a higher likelihood of sustaining income for a long withdrawal period. But even the aggressive portfolio showed a tendency to fail too frequently to be considered a stable withdrawal plan for a long retirement.

Finally the authors examine whether the purchase of an immediate fixed annuity helps or hurts the sustainability of the withdrawal plans considered. Using both an historical analysis and a Monte Carlo analysis, their charts illustrate that for all time periods and for all investment portfolios in the study, the addition of the fixed annuity leads to better results. Also provided is a "discussion" of the pros and cons of an immediate annuity purchase and the factors that should be considered.

Journal of Financial Planning Determining Withdrawal Rates Using Historical Data, March 2004

by William P. Bengen, CFP Summary: The author shows how to use historical performance data to determine "safe" withdrawal rates and asset allocations during retirement so that retirees do not outlive their savings. This paper is a reprint of the author's 1994 landmark research on this subject.

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3.5

From the historical data, Bengen concludes the maximum "safe" withdrawal rate is about 4% for the typical retiree of age 60-65 relying on a conventional portfolio of stocks and bonds. The 4% withdrawal rate is used to calculate the actual withdrawal dollar amount in the first year of retirement. This withdrawal amount (in dollars, not percentages) is then increased in each future year for actual inflation. Looking at the historical evidence, he characterizes 5% withdrawal rates (adjusted for actual inflation) as "risky" and 6% rates as "gambling."

Journal of Financial Planning Merging Asset Allocation and Longevity Insurance, June 2003

by Peng Chen, Ph.D. and Moshe A. Milevsky, PhD. Summary: MPT is widely accepted in the academic and finance industries as the primary tool for developing asset allocations. Its effectiveness is questionable, however, when dealing with asset allocations for individual investors in retire-ment, because it does not consider longevity risk and the portfolio's random time horizon.

This article reviews the need for longevity insurance (i.e., income annuities) during retirement and establishes a frame work to study the total asset and product allocation decision in retirement, which includes both conventional asset classes and immediate payout annuity products. Retirees must make their own decisions on what products should be used to generate income in retirement. However, there are two important risks that must be considered when making these decisions: [1] Financial market risk — the volatility in the capital markets that causes portfolio values to fluctuate. If the market drops or negative corrections occur early during retirement, the portfolio may not be able to cushion the added stress of systematic withdrawals. This may make the portfolio unable to provide the necessary income for the desired lifestyle or it may simply run out of money too soon.

[2] Longevity risk — the odds of outliving one’s portfolio. Life expectancies have been increasing and retirees should be aware of the substantial chances for a long retirement and plan accordingly. This risk is further magnified for individuals taking advantage of early retirement offers or who have a family history of longevity.

The authors claim an optimal asset/product allocation mix in a well-balanced retirement portfolio is derived from a two-step process. First, a conventional asset allocation process is used to derive an optimal asset mix (without regard to longevity risk). The product (i.e., income annuity) purchase decision is then developed after considering the retiree's bequest motives and health assessments.

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3.6

A SECURE RETIREMENT USING STANDARD DEVIATION Using a 70-90% equity weighting, studies over the past few years recommend an inflation-adjusted (real) retirement withdrawal rate of 4-6% per year. Pension actuarial tables show that a 65-year-old client has a 94% chance of living for an additional five years, 56% chance of making it to age 85 and a 16% chance of living to age 95. All this translates into a median remaining life expectancy (for someone age 65 and in good health) of 23 years. The next four tables show the probability of “retirement ruin” (running out of money before death) based on two remaining life expectancies (23 and 35 years) and two different annual withdrawal (spending) rates (4% and 8%).

All of the four tables below share the following characteristics: [1] a mortality rate is assumed (note: by using real world mortality rates, the probability of outliving one’s income decreases), [2] a median life expectancy (withdrawal period) is assumed, [3] rates of return adjusted for inflation are listed (1-10%), [4] failure rates (probability of outliving one’s nest egg) are defined as having a zero account balance before death and [5] standard deviation ranges (5-25%) are provided so the advisor can select higher equity exposure and/or greater weighting to small cap and emerging markets (in return for accepting more volatility).

The first table makes the following assumptions: 8% withdrawal rate, 23-year life expectancy and 3% annual mortality rate. Assuming a balanced portfolio of stocks and bonds that returns 5% annually (inflation-adjusted), there is a 46% chance that the client will completely delete their nest egg, assuming a portfolio standard deviation of 10%; if the volatility changes from 10% to 20%, the chance of running out of money increases to 63%. Thus, all other inputs being equal, the greater the standard deviation, the more likely the investor will use up 100% of principal. On a somewhat similar note, the higher the portfolio’s expected return, the lower the failure rate (since 8% is being withdrawn each year).

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3.7

Probability of Outliving One’s Nest Egg [8% withdrawal rate & 23-year life expectancy] Mortality: 3% a year

Median Life Expectancy: 23 years Annual Withdrawal Rate: 8%

---------------------- Portfolio’s Standard Deviation ---------------------5%

10%

15%

20%

25%

1%

83%

84%

87%

90%

93%

3%

63%

67%

72%

78%

84%

5%

41%

46%

54%

63%

71%

7%

23%

29%

37%

47%

57%

10%

7%

11%

18%

27%

38%

Return

The next table is based on the same assumptions as above, except life expectancy is increased from 23 to 35 years (and annual mortality drops from 3% to 2% per year). As you can see, the failure rate increases, regardless of standard deviation, due to the lengthened period of time (and lesser chance of death). If the portfolio returns 7% a year (adjusted for inflation) and has a standard deviation of 15%, the probability of outliving one’s nest egg is 49% if a balanced portfolio is used.

Probability of Outliving One’s Nest Egg [8% withdrawal rate & 35-year life expectancy] Mortality: 2% a year

Median Life Expectancy: 35 years Annual Withdrawal Rate: 8%

---------------------- Portfolio’s Standard Deviation ---------------------5%

10%

15%

20%

25%

1%

96%

95%

96%

97%

99%

3%

82%

83%

85%

88%

92%

5%

57%

62%

68%

75%

81%

7%

32%

39%

49%

58%

68%

10%

8%

14%

23%

35%

46%

Return

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3.8

The next table also assumes a 35-year withdrawal period, but a withdrawal rate that has been cut in half—from 8% to 4% per year (inflation adjusted). As you can see, the probability that the portfolio will run out of money over these 35 years is lessened.

Probability of Outliving One’s Nest Egg [4% withdrawal rate & 35-year life expectancy] Mortality: 2% a year

Median Life Expectancy: 35 years Annual Withdrawal Rate: 4%

---------------------- Portfolio’s Standard Deviation ---------------------5%

10%

15%

20%

25%

1%

60%

67%

76%

85%

94%

3%

25%

35%

48%

62%

76%

5%

7%

13%

24%

39%

55%

7%

1%

4%

10%

21%

36%

10%

0%

0%

2%

7%

16%

Return

The final table has the same assumptions as above, but life expectancy has been reduced from 35 to 23 years. Again, because of the shorter expected period, the chance of failure (outliving one’s nest egg) drops (source: Moshe A. Milevsky, 2007). Keep in mind that the withdrawal rates used in all four of these tables are adjusted for inflation. Thus, if the projected return is 7% and inflation is expected to be 3%, the assumption is the gross return is 10% (but the 7% “Return”) row is being used (since “Return” numbers in all four tables have already been adjusted for a 3% inflation rate).

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3.9

Probability of Outliving One’s Nest Egg [4% withdrawal rate & 23-year life expectancy] Mortality: 2% a year

Median Life Expectancy: 23 years Annual Withdrawal Rate: 4%

---------------------- Portfolio’s Standard Deviation ---------------------5%

10%

15%

20%

25%

1%

37%

45%

66%

68%

80%

3%

15%

22%

32%

46%

60%

5%

5%

9%

16%

27%

42%

7%

1%

3%

7%

15%

27%

10%

0%

1%

2%

5%

12%

Return

ADVANTAGE

OF

ANNUITIZATION DURING RETIREMENT

If a 65-year-old investor annuitizes 100% of a portfolio, the chances of outliving the nest egg drop from 41% down to 21%, a reduction of just under 50%. The reason annuitization helps is that it takes part of one’s portfolio and creates a “mortality subsidy,” thereby increasing investment return (source: Milevsky, The Implied Longevity Yield, 2005). The mortality subsidy works as follows: A large group of retirees, all the same age and each subject to the same risk of death, pool their nest egg into one large portfolio. Each member of the pool takes out exactly the same amount each year. As members in the pool die off, survivors receive a higher payout (fewer members making withdrawal). The amount distributed to each living member is the sum of expected investment return plus the mortality rate.

There is also the option of using a fixed-rate annuity that includes a cost-of-living provision. However, there are few insurers that a competitively priced annuity that includes an annual inflation adjustment. For example, one company offered $685 a month for a man age 65 with a single premium payment of $100,000. The same company lowered the amount from $685 down to $502 with a CPI adjustment ($183 a month difference). If inflation were to average 3%, it would take more than 10 years for the $502 payment to get to $685 per month. Moreover, this calculation does not take into account what the monthly difference could grow to (note: an annually declining difference due to increased payments from the CPI-adjusted annuity).

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3.10

Another way to protect downside risk is to purchase put options on all or part of the equity portion of the portfolio. Still another method is to use a variable annuity with a living benefit feature.

8% Annual Withdrawal, Portfolio Grows 7% (inflation adjusted) [20% standard deviation] Age at Retirement

Median Age at Death

Annual Mortality Rate

Ruin Probability with Life Annuity

Ruin Probability w/o Life Annuity

50

78

2.5%

34%

53%

55

83

2.5%

34%

53%

60

83

3.0%

28%

48%

65

84

3.7%

21%

41%

70

85

4.7%

13%

33%

75

86

6.5%

6%

24%

80

87

9.4%

2%

14%

REPLACEMENT RATIO One way advisors view a client’s retirement income needs is to use the expense-method approach (projected expenditures during first year of retirement). What is not often considered is the fact that expenses generally decline as the client ages. The table below is based on data from the Consumer Expenditure Survey. As you can see from the table, expenses in all categories except health care decline once the client reaches age 75 and older.

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3.11

Expenditures Based on Age and $40,000 + Annual Income Expense

Age 65-74

Age 75+

Change

Food

$5,779

$3,970

-$1,809

Housing

$12,027

$9,678

-$2,349

Apparel

$2,160

$1,256

-$904

Transportation

$8,185

$5,428

-$2,757

Health Care

$2,385

$3,189

$804

Entertainment

$2,108

$1,027

-$1,081

Insurance/Pensions

$4,540

$2,678

-1,862

Total

$43,967

$36,825

-$7,142

A shortcoming of several retirement income models is that they do not factor in long-term care insurance. This type of coverage can greatly reduce the cost of nursing home care (thereby bringing down projected expenditures for health care).

The financial planning community estimates a retiree’s expenses will drop by about 20% upon retirement; the client who used to spend $80,000 annually will spend approximately $64,000 during the initial years of retirement. Because one’s expenses generally decline by about 20% (from age 65 to 75+), the replacement ratio can also be adjusted downward.

For example, with an initial replacement ratio of 80%, the rate used by the advisor should be 70%, assuming the client has a remaining life expectancy of 25 years. The reduction is due to a “blending”—the initial rate combined with the lower rate as one ages. If the advisor assumes a replacement rate of 75%, then the blended rate for remaining life expectancy (of 15 years) can be reduced to 70%; if the client has a remaining life expectancy at age 65 of 30 years, the blended rate drops to 65%. By using a blended replacement ratio (vs. traditional replacement ratio), a smaller nest is needed for the 65-year-old retiree.

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3.12

Blended Replacement Ratios Life Expectancy

80% Rate

75% Rate

70% Rate

65% Rate

10 years

80%

75%

70%

65%

15 years

75%

70%

65%

61%

20 years

72%

68%

63%

59%

25 years

70%

66%

62%

57%

30 years

69%

65%

61%

57%

THE VALUE

OF

HUMAN CAPITAL

What is almost always left out of portfolio diversification discussions is the value of human capital. As an investor begins his working career, there is a present value that can be assigned to lifetime paychecks. That present value figure increases as the client becomes more valuable in the workplace, receiving raises along the way.

Several years before retirement, the present value figure can begin to decline (e.g., forced retirement, health problems, layoffs, etc.).

Including “human capital� as part of an investment portfolio means two things: [1] diversification has relatively little importance during the early years and [2] savings from human capital can make up for portfolio losses in the early years. The table below is an example of how human capital might be incorporated into the portfolio.

Human Capital and the Financial Portfolio Age

Human Capital

Financial Assets

Total

22

$705,000

$0

$705,000

32

$871,000

$62,000

$933,000

42

$1,003,000

$206,000

$1,209,000

52

$988,000

$518,000

$1,506,000

62

$551,000

$1,171,000

$1,722,000

67

$0

$1,722,000

$1,722,000

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BONDS

4.WHAT

4.1

HAPPENS WHEN RATES INCREASE

For every one point rise in interest rates, the price of a 10-year Treasury decreases by 8.5%; a rise of two percentage points would chop a 10-year Treasury bond’s current value by 17% (source: Barclays Capital). In the case of a high quality taxable bond fund with a 22-year average maturity, a two-percentage point increase would decrease the fund’s NAV by 22%; just 3.9% if the fund’s average maturity was 2.6 years (source: Morningstar).

According to a study by David Babbel of Wharton, stable-value funds averaged 6.3% annual returns over the 20 years through 2008, versus 4.1% for money market funds and 5.7% for the Barclay’s index for intermediate-term corporate and government bonds.

EMERGING MARKETS DEBT According to Morningstar, there were 31 mutual funds and ETFs emerging market bond funds. In contrast, there were 141 funds and ETFs within the emerging market stock category, as of October 2009.

Emerging market bond mutual funds are generally less volatile than emerging market stock funds because interest payments help smooth out overall returns. Over the past 15 years ending March 31 st , 2009, diversified emerging market bond funds suffered doubledigit losses in 12 rolling three-month periods (12 out of 58 such periods). This compares favorably to emerging market stock funds, which suffered double-digit declines in 33 rolling-three month periods (33/58). In some cases, there were distinct differences in decline severity. For example, emerging market bonds dropped 11% in 2008 while emerging market stocks tumbled 53%. For the 10-year period ending September 2009, emerging market bonds had average annual returns of a little more than 11%, compared with 3% for emerging market stocks.

Another notable difference between emerging market bond and stock funds is regional exposure. While both types of funds typically provide significant exposure to Brazil, Mexico and Russia, emerging market bond funds generally provide less exposure to Asian countries such as China, South Korea and India. Conversely, emerging market bond funds may provide exposure to "frontier" countries (e.g., Venezuela), places where emerging equity funds may not invest.

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BONDS

4.2

The table below shows bond and stock returns for 2008 and the first three quarters of 2009, ranked from lowest (U.S. investment-grade bonds) to highest volatility (foreign stocks). In the case of fixed income, emerging markets bond funds are second only to domestic high-yield bonds when it comes to volatility.

Total Return Figures for 2008 and first three quarters of 2009 2009 YTD (9/30/09)

2008

0.2%

2.2%

Intermediate Government

0.1%

10.4%

Municipal

14.0%

-2.5%

Corporate

14.9%

-3.1%

Developed Markets

9.5%

1.7%

Emerging Markets

26.3%

-10.9%

U.S. High-Yield Bonds

49.1%

-26.1%

S&P 500

19.3%

-37.0%

MSCI EAFE Index

29.1%

-43.3%

Security Short-Term Bonds U.S. Investment-Grade Bonds

Foreign Bonds

TREASURIES

VS . INFLATION

The table below shows the cumulative effects of inflation on 30-day Treasury Bills (“cash equivalents�) and 20-year Treasury Bonds over the 20-year period ending December 31 st , 2008. The base year is 1989; yields for each subsequent year (for the Tbill and T-bond columns) reflect the actual annual yield and what the yield would have been, adjusted for inflation.

For example, in 1989, T-bills had an average yield of 8.4% for the year; for 1990, a CPIadjusted yield would have resulted in a yield of (8.4% x 1.061). For 1991, the CPI adjustment would have resulted in an annual yield of (8.4% x 1.061 x 1.031), reflecting the cumulative effects of inflation since 1989. This process is repeated for each subsequent year, up through the end of 2008. The table considers only yield, not total return (note: total return and yield would be the same each year for T-bills). As you can see, in order to maintain 1989 purchasing power for 2008, a T-bill would have had to be yielding 14.0% by the end of 2008 (vs. its actual yield of 1.6%).

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BONDS

4.3

Cumulative Effects of Inflation on Treasury Yields [1989-2008] Year

Inflation (CPI)

T-bill yield (CPI adjusted)

T-bond yield (CPI adjusted)

1989

4.7

8.4 (base yr.)

8.2 (base yr.)

1990 1991

6.1 3.1

7.8 (8.9) 5.6 (9.2)

8.4 (8.7) 7.3 (9.0)

1992

2.9

3.5 (9.5)

7.3 (9.2)

1993

2.8

2.9 (9.7)

6.5 (9.5)

1994

2.7

3.9 (10.0)

8.0 (9.7)

1995

2.5

5.6 (10.2)

6.0 (10.0)

1996

3.3

5.2 (10.6)

6.7 (10.3)

1997

1.7

5.3 (10.7)

6.0 (10.5)

1998 1999

1.6 2.7

4.9 (10.9) 4.7 (11.2)

5.4 (10.7) 6.8 (10.9)

2000

3.4

5.9 (11.6)

5.6 (11.3)

2001

1.6

3.8 (11.6)

5.7 (11.5)

2002

2.4

1.6 (12.1)

4.8 (11.8)

2003

1.9

1.0 (12.3)

5.1 (12.0)

2004

3.3

1.2 (12.7)

4.8 (12.4)

2005 2006

3.4 2.5

3.8 (13.1) 4.8 (13.5)

4.6 (12.8) 4.9 (13.1)

2007

4.1

4.7 (14.0)

4.5 (13.7)

2008

0.1

1.6 (14.0)

3.0 (13.7)

MUNICIPAL BOND SAFETY Despite severe economic troubles, there have been no investment-grade defaults during the past year (2008), and there were none in the previous 30 years. Defaults can occur, but they almost never do, for investment-grade bonds (i.e., rated BBB/Baa or above).

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BONDS

4.4

BONDS Advisors and clients expect stocks to outperform bonds over any reasonably long period of time. Sometimes this is not the case, particularly if very specific dates are selected. For example, from the beginning of 1968 to the beginning of March 2009, $1 invested in the S&P 500 grew almost 26-fold, versus an over 29-fold increase for 20-year U.S. Government bonds (dividends and interest payments reinvested). In addition to this 41 year span, bonds also did better than stocks for the 20-year span from 1929 through 1949 and for the 68-year period from 1803 through 1981. When the periods are not “cherry picked,” total return figures are much different.

From 1802 to February 2009, stocks returned about four million times one’s initial investment, versus 27,000 times one’s initial investment for the long -term government bond investor. This difference works out to a difference of 150 to one; surprisingly, this 150-fold relative wealth translates into just a 2.5% per year advantage for the stock investor. Even though 2.5% compounded over well over 200 years results is quite a difference, the performance line has been quite jagged:  From 1803 through 1856, stock investors ended up with 1/3 rd the wealth of a bond-holder (it was not until 1871 that the stock investor caught up);  From 1857 until 1929 (72 years) stock investors beat out bond investors;  The 1929 to 1932 crash resulted in stock investors trailing bond investors on a cumulative basis until the early 1950s (20 years);  From 1932 until 2000, stocks outperformed bonds by quite a large margin and  From the peak in 2000 to the end of 2008, the equity investor lost nearly 3/4th of his wealth, relative the to bond investor.  It can take tremendous patience to be invested in stocks: from 1926 through February 2009, stocks spent 173 out of 207 years (84% of the time) either dropping from old highs or recovering past losses—and that only includes periods of 15+ years for stocks to reach a new high and  When looking at real returns (adjusted for inflation but not income taxes), the 1965 peak for the S&P 500 was not surpassed until 1993 (28 years).

The 1802 stock market peak was first surpassed in 1834, a 32-year period that included a 12-year bear market period when stocks suffered a cumulative loss of over 50%. The peak of 1802 was not convincingly surpassed until 1877; by the 1929 peak, the 1802 peak had been surpassed by a five-fold increase.

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4.5

The 1929-32 market crash resulted in a cumulative drop in stock appreciation that, adjusted for inflation, briefly fell below 1802 levels. It is hard to imagine that there was a 130-year period when U.S. stocks experienced a return of zero (note: none of these figures include the impact of dividends). Still, stock investors were able to use their dividends. The bear market of 1982 saw S&P 500 share prices fall below their inflationadjusted levels first reached in 1905—a 77-year period with no price appreciation.

There are a number of conclusions that can be reached from all of this historical stock analysis (again, the slant of the study is negative for stocks): [1] Looking forward, a 2.5% excess annual return for stocks over bonds appears to be more appropriate than the 5.0% figure used in the past.

[2] The only thing that goes up in a market crash is correlation; equity diversification has often been overrated—especially when it is needed the most.

[3] Quality debt asset categories should probably comprise more of an overall portfolio than what was used by advisors in the past.

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4.6

During September and October 2008, 16 different asset categories suffered losses ranging from less than 1% to over 41% (source: Research Affiliates), as shown in the following table:

September and October 2008 Asset Class Returns October Monthly Rank Since 1988 2nd worst

2-Month Return -41%

MSCI Equity Index

worst

-32%

FTSE NAREIT All REITs Index

worst

-30%

DJ-AIG Commodities Index Russell 2000 Equity Index

worst worst

-30% -30%

S&P/TSX 60 Index

worst

-28%

ML Convertible Bond Index S&P 500 Index

worst worst

-27% -25%

Barclays U.S. High Yield Index

worst

-23%

JP Morgan Emerging Market Bond Index

nd

2 worst

-21%

Barclays Long Credit Index

worst

-19%

Credit Suisse Leveraged Loans Index

worst

-17%

JP Morgan Emerging Local Markets Index

worst

-12%

Barclays U.S. TIPS Index Barclays Aggregate Bond Index

worst 4 worst

-12% -4%

ML 1-3 Year Government/Credit Index

29th worst

-0.6%

Asset MSCI Emerging Equity Index

th

Based on available historical data, losses from all 16 of these asset categories for the same month never occurred—until September 2008. October 2008 was the worst single month in 20 years for 3/4th of the 16 asset categories shown. For most of these assets, October 2008 was the single worst month ever recorded. The next table shows how selected market indexes fared (source: Research Affiliates).

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4.7

For the 20-year period 1989-2008, the MSCI Emerging Markets Index had a monthly loss of 10% or more 18 times, compared with four times for the S&P 500.

2008 Selected Market Returns Asset

2008

20-30 Year Treasury STRIPS

+56%

Barclays Capital U.S. Aggregate (bonds)

+5%

1-Year Treasury Bill

+3%

HFRI Composite Fund of Funds Index

-21%

HFRX Global Hedge Fund Index

-23%

S&P 500

-37%

MSCI EAFE S&P GSCI

-43% -47%

MSCI Asia Pacific ex Japan

-50%

MSCI Emerging Markets HFRX Convertible Fixed Arbitrage Index*

-55% -58%

* An “absolute return strategy� that was supposed to protect investors during market turbulence, taking short positions in stocks and long positions in bonds.

STOCK/BOND CORRELATION

AND

INDEXES

From 1969 to 2009, the classic 60/40 (stock/bond) balanced portfolio had a 98% performance correlation to stocks, with 38% less risk. A 40% allocation to T-bills instead of bonds would have also resulted in significant risk reduction (but with returns averaging 1.4% less per year).

Bond indexes can have shortcomings, just like stock indexes. For example, there was a time when Cisco represented 4% of the S&P 500, even though it had just 20,000 employees worldwide. During the same period, Nortel stock represented more than 30% of the Canadian market. In the case of bond indexes, GM and Ford bonds together comprised 12% of the U.S. High-Yield Bond Index in 2006.

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BONDS

4.8

BOND SECTOR RETURNS The table below shows returns for different bond categories for 2008 and the first nine months of 2009 (source: Barclays Capital).

Bond Sector Performance Category

2008

2009

Treasury Securities

13.7%

-2.3%

TIPS

-2.4%

9.5%

GNMA Securities

7.9%

5%

Corporate Bonds—investment grade

-3.1%

14.9%

Corporate Bonds—high yield

-26.2%

49.0%

Municipal Bond

-2.5%

14.0%

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QUARTERLY UPDATES EFTS

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5.KEEPING

5.1

ETF PRICES CLOSE

TO

NAVS

ETFs usually trade at market prices that are close to the underlying NAVs of their portfolios because large institutional investors [called Authorized Participants (APs)] can use arbitrage to profit from any difference between the fund's price and its NAV. Let's say an ETF has a NAV of $20 per share but is trading at a market price of $19.80 — a 1% discount to NAV. The AP can buy 50,000 ETF shares, deliver them to the ETF sponsor, receive shares of the underlying stocks or bonds equivalent to 50,000 ETF shares and sell those securities on the open market. This nets a profit of 1% for the AP and also pushes up the market price of the ETF. The AP will keep doing this until the price equals the NAV. If the ETF is trading at a premium to its NAV, the AP will buy shares of the underlying stocks or bonds, give them to the ETF sponsor in exchange for new ETF shares and sell those ETF shares on the market, pushing the price back down toward its NAV. Howe ver, if the stocks or bonds become difficult to trade on the market because other buyers and sellers are nervous, it may be difficult for the AP to engage in this arbitrage trading, meaning prices and NAVs can diverge.

THE STRANGE STATE

OF

EFT EVALUATIONS & RATINGS

ETF comparisons tend to focus much more heavily on fund expense ratios than most mutual fund evaluations do. This is puzzling because index ETF expense ratios vary less from fund-to-fund than mutual fund expense ratios. The emphasis on ETF expense ratios is partly the result of the ready availability of this measure. The expense ratio is one of the first things an investor sees when she examines the ETF’s Fact Sheet. Another reason for focusing on the ETF expense ratio is probably that, while mutual funds often have a number of share classes and fee structures, ETFs charge every investor the same fee.

Because ETF expense ratios tend to be lower than mutual fund expense ratios, expense ratios have been emphasized by ETF proponents in making the case for ETFs. However, the reality is that expense ratios are often lower than trading costs due to index composition changes.

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ETF S

5.2

As ETF trading volume has expanded, there has been increased emphasis on comparing EFT bid/ask spreads. The message investors receive from the focus on the bid/ask spread is the obvious one: a narrow spread is better than a wide spread when trading. This point is indisputable; but the numbers cited for an ETF’s average spread usually understate the spread an investor will encounter when she checks a live quote. Furthermore, for a longterm investor, the spread is paid only twice—once when she buys the shares and once when she sells them. The cost to trade ETF shares is important for a number of reasons, but trading cost will rarely be a make-or-break item for a long-term investor.

Another characteristic of ETF evaluation that differs strangely from mutual fund evaluation is that a great deal of attention is paid to ETF tracking error —a measure of the relative performance of the fund and its benchmark index. It gets a lot of attention because it is relatively easy to measure, but most fund raters are not sure what to do with it.

The approach most fund analysts take in evaluating ETFs and their managers is qualitatively as well as quantitatively different from the approach they take to mutual funds. Most ETFs are index funds ; index fund managers have yet to capture the imagination of fund analysts and investors in the way that some active managers have done. Trading transparency around index composition changes is usually a more costly drag on fund performance than most of the features ETF analysts stress in their comparisons. Furthermore, an index fund manager who trades away from the official index change date can improve the fund’s return.

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