IBF - Updates - 2010 (Q3 v1.0)

QUARTERLY UPDATES Q3 2010

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

v1.0

Quarterly Updates Table of Contents STOCKS INFLATION AND P/E RATIOS MAJOR MARKET DROPS SINCE 1987 S&P 500 SECTORS MARKET VOLATILITY OVERSEAS PROFITS

1.1 1.1 1.2 1.3 1.6

BONDS MUNICIPAL VS. CORPORATE BOND DEFAULT RATES A BOND STRATEGY BOND YIELDS VS. DIVIDENDS HIGH-YIELD BONDS 100-YEAR CORPORATE BONDS

2.1 2.2 2.2 2.3 2.3

MUTUAL FUNDS FRONTIER FUNDS BOND FUND CATEGORY RETURNS LOW FEES OUTSHINE FUND STAR SYSTEM MONEY MARKET FUNDS: BREAKING THE BUCK PIMCO MANAGED FUTURES FUNDS FLOATING-RATE VS. HIGH-YIELD BOND FUNDS TARGET-DATE RETIREMENT FUNDS 130/30 FUNDS QUANT FUNDS REITS CLOSED-END FUNDS

3.1 3.1 3.1 3.2 3.2 3.3 3.3 3.4 3.4 3.5 3.5 3.5

FUTURES GOLD AS A COMMODITY CURRENCY TRADING

4.1 4.1

FINANCIAL PLANNING PAYING BACK SOCIAL SECURITY BENEFITS CORRELATION COEFFICIENTS BLACK SWANS AND FAT TAILS GLOBAL DEMOGRAPHICS INVESTMENT SUCCESS AND LUCK DECREASED DEMAND BY BABY BOOMERS MASTER LIMITED PARTNERSHIPS STAYING WITH THE SAME EMPLOYER LIFE INSURANCE HOW WE SPEND TIME NUCLEAR POWER RATES OF RETURN

5.1 5.2 5.3 5.4 5.4 5.5 5.6 5.6 5.6 5.7 5.7 5.7

QUARTERLY UPDATES STOCKS

Stocks

1.1

1.INFLATION

AND

P/E RATIOS

From the middle of 2007 to the third quarter of 2010, inflation expectations, as measured by the yield on 5-year TIPS have ranged from 1% (2007) up to 4.2% during the middle of 2008, down to just under ½% by August 2010 (source: FactSet and Federal Reserve). Inflation and deflation impact the valuation of corporate America. A dollar of earnings is worth more when inflation is low. However, when inflation gets too low or turns negative (deflation), valuations can also suffer, as shown in the table below (source: Department of Labor and FactSet, June 2010).

Inflation vs. S&P 500 P/E Ratios Inflation < 0%

Average P/E 12.6

Peak P/E 17.1

Trough P/E 9.3

0 – 1%

14.5

22.5

9.2

1 – 2%

19.8

32.6

9.2

2 – 3%

20.5

35.1

9.7

3 – 4%

18.7

34.4

9.7

4 – 5%

16.8

22.4

9.6

5 – 6%

15.9

19.8

7.4

6 – 7%

12.2

18.1

7.7

> 7%

11.9

19.1

7.9

MAJOR MARKET DROPS SINCE 1987 Major Market Drops Since 1987 Event

S&P 500 Loss

1987 Stock Market Crash [10/16/1987 - 12/4/1987]

-21%

Iraqi Invasion of Kuwait [8/2/1990 - 2/28/1991]

-16%

Implosion of Long-Term Capital [7/17/1998 - 8/31/1998]

-19%

Collapse of Lehman Brothers [9/12/2008 – 3/9/2009]

-46%

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Stocks

1.2

S&P 500 SECTORS S&P Sector Weightings [August 2010] Sector Consumer Discretionary

S&P 500 10%

Wilshire 5000 12%

Consumer Staples

11%

10%

Energy

11%

9%

Financials Health Care

16% 11%

18% 11%

Industrials

11%

11%

Information Technology

19%

19%

Materials

4%

4%

Telecom

3%

3%

Utilities

4%

3%

The table below shows the number of years of negative performance for 12 sectors from 1992-2009, along with the sectorsâ&#x20AC;&#x2122; average negative returns during the period.

Years of Negative Returns [1992-2009] Sector Business Services

Negative Years 4 out of 18

Average Negative Return -20%

Consumer Goods Consumer Services

4 out of 18 5 out of 18

-9% -15%

Energy

4 out of 18

-17%

Financial Services

5 out of 18

-18%

Hardware Health Care

5 out of 18 6 out of 18

-31% -14%

Industrial Materials

4 out of 18

-19%

Media

7 out of 18

-21%

Software

5 out of 18

-27%

Telecommunication

6 out of 18

-22%

Utilities

5 out of 18

-20%

U.S. Stock Market

4 out of 18

-20%

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Stocks

1.3

MARKET VOLATILITY One way to reframe your mindset is to look beyond short-term volatility trends such as daily index moves and toward longer, multi-year views. Measuring the percentage of days the market was up or down by a certain percentage (say, 1% or more) over a longer time period also allows the separate measurement of upside and downside volatility. Few investors likely complain when market volatility is on the upside. It’s the down days that cause consternation. So, what can we learn from stock market history? Do the past few years of heightened volatility herald a new and lasting trend of extreme gyrations in the stock market?

S&P 500 One-Day Price Volatility [1930-2010] Period 1930s

> +/- 1% 52%

> +/- 2% 25%

> +/- 3% 13%

> +/- 4% 6%

> +/- 5% 3%

1940s

21%

4%

2%

1%

½%

1950s

13%

2%

½%

0%

0%

1960s

9%

1%

0%

0%

0%

1970s

20%

3%

½%

0%

0%

1980s

24%

5%

1%

½%

½%

1990s

20%

4%

½%

0%

0%

2000s

33%

11%

4%

2%

1%

2010 (7 months)

36%

11%

6%

1%

0%

Totals 2000-2003

24% 41%

7% 13%

3% 4%

1% 1%

1% ½%

2004-2006

13%

½%

0%

0%

0%

2007-2009

42%

19%

9%

5%

3%

(source: Bloomberg, 8/2010)

The 2000s were the most volatile decade since the 1930s, as measured by the percentage of trading days with moves of +/-1% or more in the S&P 500 Index. From 2000 to 2003, 41% of the total trading days had a daily change of +/-1%. Of these 414 days, a little more than half (217 days) were down days with loses of 1% or higher. There were 66 days with loses of 2% or more and 16 days with losses of at least 3%.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Stocks

1.4

Over the next three years, from 2004 to 2006, volatility plummeted below long-term averages. During this three-year period, only 13% of the trading days had moves of +/-1%.

Remarkably, there were no trading days with losses of 2% or higher. However, this relative calm in the S&P 500 did not last. From 2007 to 2009, 42% of the trading days had moves of at least 1%, and 19% had moves of at least 3%. In 2008 alone, there were 23 days with losses of at least 3%—well above the annual average of four trading days per year (for 1928-2009), and the highest annual level since 1933.

For the first seven months in 2010, market volatility was elevated; 36% of the trading days experienced moves of +/-1% (down from 46% in 2009 and 53% in 2008). Intraday activity also has had large swings. In 2008, a gut-wrenching 90% of trading days—up from the long-term average of 54% since 1982—had intraday moves of more than 1%; 13% of the days had moves of 5% or more. This followed a five-year stretch from 2003 to 2007 when there were no days with intraday moves of more than 5% and only two days in this period that saw intraday moves of 4% or higher.

The extraordinary market volatility over the past few years has rekindled interest in asset classes beyond the traditional categories of stocks and bonds. Since their introduction in 1997, TIPS have also had a positive correlation to changes in inflation. In other words, more so than other asset types—such as equities, longer-term corporate bonds and real estate securities—returns for T-bills, TIPS, and commodities have tended to move in the same direction and around the same time (measured in months) as inflation.

Asset Category Correlation To Inflation [1/1927-6/2010] LC

CPI

CPI 1.0

SC

HY

LT

IG

Bills

COM

FS

LC

0.0

1.0

SC

0.1

0.8

1.0

HY

0.1

0.7

1.0

LT

0.0

0.3

0.7 0.2

0.6

1.0

IG

0.1

0.0

0.0

0.0

0.0

-0.1

0.8 0.2

1.0

Bills

0.3 0.0

0.5

1.0

COM

0.3

0.0

-0.1

-0.1

-0.2

-0.3

0.0

1.0

FS

-0.1

0.7

0.5

0.5

0.3

0.0

0.0

0.1

1.0

RES

0.1

0.3

0.0

0.1

0.0

0.4

0.8 -0.0

0.5

TIPS

0.6 -0.1

0.3

0.5

0.4

0.0

0.5

0.5 0.0

RES

TIPS

1.0 0.2

1.0

(source: Ibbotson Associates, 8/2010; 12-month correlations)

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Stocks

1.5

TIPS are designed to track changes in the monthly Consumer Price Index (CPI), as reported by the Bureau of Labor Statistics. If the CPI rises, the securities’ principal, or face value, increases. The coupon rate for TIPS is constant, but generates higher interest when the inflation-adjusted principal rises. When the securities mature, investors get back the CPI-adjusted principal.

TIPS can decrease in value prior to maturity because of changes in investors’ expectations for future inflation—and investors selling TIPS before maturity can still suffer losses. Dating back to December 1972 and through May 28, 2010, the rolling 12-month return for T-bills has never been negative. Since their introduction in 1997, TIPS have had a negative 12-month rolling return 7% of the 12-month rolling periods.

Asset Class Returns During Different Inflation Rates [1973-2010] Inflation Rate

-2.1 to +2.4%

+2.4 to +3.1%

+3.1 to +4.1%

+4.1 to +6.6%

Average

- Periods

Average

- Periods

Average

- Periods

Average

- Periods

2%

9%

3%

0%

4%

0%

5%

0%

Large Stocks

13%

29%

15%

9%

13%

20%

10%

27%

Small Stocks

10%

36%

18%

14%

14%

22%

7%

39%

H/Y Bonds

11%

19%

14%

8%

13%

13%

8%

20%

LT Bonds

12%

12%

10%

17%

13%

9%

10%

9%

MT Bonds

8%

0%

6%

11%

10%

2%

9%

3%

T-Bills

4%

0%

4%

0%

6%

0%

7%

0%

Commodities

-3%

49%

12%

17%

14%

17%

20%

16%

Foreign Stocks

15%

33%

13%

19%

15%

24%

7%

34%

R.E. Securities

10%

30%

16%

20%

17%

20%

6%

39%

CPI

(source: Ibbotson Associates, 8/2010; 12-month rolling returns, annualized)

Because commodities are the raw input for many consumer expenditures, such as food, fuel, cars and housing, they may offer some protection from the corrosive impact significant inflation can have on the purchasing power of a portfolio. While exposure to commodities may offer long-term protection against rising prices, commodity prices can be extremely volatile. Therefore, perhaps more so than other asset types, it is important to understand how commodities have performed in periods of both high and low inflation.

As shown in the table above, during past periods of low inflation, commodities had an average annual loss of 3.2% and a negative return 49% of the rolling 12-month periods.

During periods of the highest inflation, commodities had an average annual return of 20%, but still had negative returns 28% of the 12-month periods.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Stocks

1.6

Asset Category Returns By Decade 1930s

1940s

1950s

1960s

1970s

1980s

1990s

2000s

Inflation

-2%

5%

2%

3%

7%

5%

3%

3%

Large Stocks

0%

9%

8%

6%

18%

1%

21%

15%

11%

14%

18% 13%

-1%

Small Stocks

19% 17%

H/Y Bonds

1%

10%

5%

3%

5%

14%

11%

7%

LT Bonds

3%

1%

2%

6%

13%

9%

7%

MT Bonds

7% 5%

2%

1%

3%

7%

12%

7%

5%

T-Bills

½%

½%

2%

4%

6%

9%

5%

3%

Commodities

n/a

n/a

n/a

n/a

21%

11%

6%

7%

Foreign Stocks

n/a

n/a

n/a

n/a

9%

22%

7%

1%

R.E. Securities

n/a

n/a

n/a

n/a

n/a

16%

4%

10%

TIPS

n/a

n/a

n/a

n/a

n/a

n/a

n/a

7%

3%

OVERSEAS PROFITS The table below shows Dow companies whose overseas operations represent the highest and lowest percentage of their overall revenues.

Dow Stocks and Share of Revenues From Overseas Operations [2009] Highest Percentage

Lowest Percentage

Intel 85%

Verizon 0%

Coca-Cola 74%

AT&T 0%

Exxon Mobil 70%

Travelers 6%

McDonald’s 65%

Home Depot 11%

Hewlett-Packard 64%

Bank of America 18%

QUARTERLY UPDATES

IBF | GRADUATE SERIES

QUARTERLY UPDATES BONDS

Bonds

2.1

2.MUNICIPAL

VS.

CORPORATE BOND DEFAULT RATES

Among the more than18,000 municipal bonds rated by Moody's from 1970 to 2009 (a period that included five recessions), only 54 issuers defaulted, mostly in the housing and healthcare sectors. The average 10-year cumulative default rate was just a fraction of 1%, compared with a cumulative default rate of about 11% for corporate bonds.

Cumulative Default Rates Moody’s Rating

S&P

Municipal

Corporate

Municipal

Corporate

Aaa / AAA

0.00

0.52

0.00

0.60

Aa / AA

0.06

0.52

0.00

1.50

A/A

0.03

1.29

0.23

2.91

Baa / BBB

0.13

4.64

0.32

10.29

Ba / BB

2.65

19.12

1.74

29.93

B/B

11.86

43.34

8.48

53.72

Caa to C / CCC to C

16.58

69.18

44.81

69.19

Investment grade

0.07

2.09

0.20

4.14

Non-investment grade

4.29

31.37

7.37

42.35

All

0.10

9.70

0.29

12.98

Averages

(source: U.S. Municipal Bond Fairness Act, 2008)

A number of interesting observations can be made from this table, incorporated in the U.S. Congressional Municipal Bond Fairness Act: [1] The period covered is 1970 to 2006 (source: Moody’s).

[2] All percentages shown in the table above are cumulative numbers.

[3] Chances of a GO bond defaulting is almost zero (always been rated A or higher).

[4] Default rates at any rating are much higher for corporates than municipal counterparts.

[5] Default rate for all munis, including ―junk,‖ was 1/10th of 1% for entire 36-year period.

[6] Default rates increase substantially from investment grade to non-investment grade.

[7] Over this 36-year period, corporates rated ―barely junk‖ (Ba) had an average annual default rate of ~ ½% a year (19.12/36 years).

[8] There > 55,000 issuers of muni bonds alone; 74% are for issues of $1 million or less.

[9] A 2007 study by Moody’s shows just one of its investment-grade GO municipal bonds defaulted b/w 1970 and 2006.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Bonds

2.2

There's no legal provision for states to declare bankruptcy. And practically speaking, municipal-debt issuers want to avoid default, much less bankruptcy. Along with tax revenue, money raised from selling bonds is the lifeblood of government entities—and the loss of investor confidence from default would block access to the bond market.

States have historically favored bond payments over other types of obligations. For example, California's constitution gives its general obligation (GO) bonds priority over other payments except those funding education. In any case, debt payments are usually a relatively small portion of state budgets.

Depending on state law, municipalities may be able to file for bankruptcy protection, but that has rarely happened over the last 75 years. Bankruptcy protection can be costly and cumbersome and can create an unwelcome stigma. Often a state will step in to bring fiscal discipline to the local entity, help it to restructure its debt or both.

A BOND STRATEGY By 2007, the difference between a junk bond and 10-year Treasury was 2.8 percentage points, the smallest gap since 1987; the historical average has been six percentage points.

One strategy is to invest ½ the bond portfolio in 15-year zero-coupon Treasurys (duration similar to 30-year Treasurys) and the other ½ in short-term junk bonds. The strategy provides a current yield of 5.5%, more than twice the yield of 10-year Treasurys (September 2010). If rates decline, the zeros will experience appreciation; if rates increase, the highyield bonds mature in 1-2 years and can then be invested in higher yielding securities.

BOND YIELDS VS. DIVIDENDS During the very early 2000s, some technology stocks were selling for 100 times earnings. The aftermath was predictable: many tech stocks declined by 80-100%. By August 2010, TIPS have yields of less than 1%. Thus, like a technology stock, these bonds were selling for more than 100 times their projected payout. At the same time, four year T-bonds had yields of 1%. In both bond instances, investors received negative real returns on an after-tax basis. An alternative worth considering is mutual funds, ETFs and individual dividend-paying stocks.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Bonds

2.3

As of September 2010, the 10 largest dividend payers in the U.S. were: AT&T, Exxon Mobil, Chevron, Procter & Gamble, Johnson & Johnson, Verizon Communications, Phillip Morris, Pfizer, GE and Merck. Collectively, these stocks had an average dividend yield of 4%, three percentage points above the then-current yield on 10-year TIPS and one percentage point more than the yield on a traditional 10-year T-bond. The 10 biggest S&P 500 dividends ranged from Frontier Communications (10%) down to AT&T (6%).

Historically, the average dividend yield from S&P 500 companies has increased at a rate higher than inflation. Since its 1957 inception, the S&P 500 dividend rate has increased 5% per year, one percentage point higher than what inflation averaged.

As of the beginning of 2010, the U.S. fixed-income market was valued at $34.7 trillion; the U.S. stock marketâ&#x20AC;&#x2122;s value was $11.6 trillion.

HIGH-YIELD BONDS From 1980 to 2010, there were eight years when U.S. GDP grew by 2.5% or less. In six of those eight years, high-yield bonds beat the S&P 500, with a mean return of 4% versus -1% for stocks. From 1990 to 2010, the average median yield for high-yield corporate bonds was 4.7 percentage points above 10-year Treasurys (source: Moodyâ&#x20AC;&#x2122;s).

100-YEAR CORPORATE BONDS Most 100-year bonds were brought to the marketplace in 1993, 1996 and 1997. Until 2010, these bonds were considered quite rare. Issuers included Anadarko Petroleum, Burlington Northern Santa Fe, Motorola, Disney, Coca-Cola, Federal Express, Ford Motor Company and IBM. The coupons on most of these bonds were 7-8%. One company, Norfolk Southern, has issued 100-year bonds three times, 1997, 2005 and 2010.

By the time these bonds mature, their original buyers will all be dead. Life insurance companies and pension plans have been the natural buyers of these bonds (since both have long-term commitments). During 2010, bankers were polled and asked what kind of yield newly issued 100-year bonds would have to pay to attract buyers today. The response was just 75 basis points more than what 30-year bonds are currently yielding. In 1996, the yield difference between newly issued 100-year and 30-year bonds was only 0.15 percentage point.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

QUARTERLY UPDATES MUTUAL FUNDS

Mutual Funds

3.1

3.FRONTIER

FUNDS

From the beginning of 2005 to the end of 2009, the 12-month rolling correlation of U.S. stocks to frontier market stocks and international stocks has increased. From an initial low of -0.5 during the early part of 2005 to a high of 0.9 during the later part of 2009, the correlation of returns between the S&P 500 and the MSCI Frontier Markets Index has increased significantly. During the same period, the correlation of the S&P 500 and returns from the MSCI EAFE Index increased from 0.6 to just under 1.0.

BOND FUND CATEGORY RETURNS Range of returns for bond fund categories (1985-2009) Bond Fund Category

Range of Returns

High-Yield

-27.1% to 45.7%

Long-Term Government

-15.1% to 28.0%

Long-Term Corporate

-5.8% to 22.2%

Med-Term Corporate

-5.1% to 22.1%

Med-Term Government

-3.8% to 18.5%

Short-Term Corporate

-4.6% to 17.5%

Short-Term Government

-1.0 to 15.8%

(source: Morningstar Advisor, July 2010)

Generally, when interest rates have gone up, shorter maturity bonds have dropped an average of 1.3%; when rates have fallen, the average gain has been 1.4%. Longer maturity bonds have declined an average of 8.3% when rates have gone up and increased an average of 9.7% when rates have dropped.

LOW FEES OUTSHINE FUND STAR SYSTEM A July 2010 by Morningstar shows using low fees as a guide for mutual fund selection would have given investors better results than using Morningstarâ&#x20AC;&#x2122;s own starrating system. The study covered the period from the very beginning of 2005 through March 2010.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Mutual Funds

3.2

―Among domestic equity funds, returns of lower-cost funds outpaced returns of highercost funds by about 1.3 percentage points a year. Over a 50-year period, a return at the 8.1% historical average for stocks would produce nearly 50% more capital than a return of 6.8%.‖ The Morningstar conclusion actually understates the benefit of using low-cost funds since its study is based on survivorship basis. According to Morningstar, only 57% of the highest-cost quintile equity funds survived the previous five years; 81% of the lowest-cost quintile survived the same period.

In 1990, fund expenses consumed 20% of equity fund dividend income, a figure similar to what funds experienced in 1960. Since 1990, as dividends decreased, expenses ate up 51% of dividends and then dropped down to 40% in 2010.

MONEY MARKET FUNDS: BREAKING THE BUCK At least 36 of the 100 largest U.S. traditional money market funds had to be propped up in order to survive during the 2007-2009 financial crisis. Without help, these 36 funds would have ―broken the buck.‖ The chaos reached a peak in September 2008 when Reserve Primary fund’s NAV dropped to 97 cents a share because of its Lehman Brothers debt holdings (source: Moody’s).

The typical money market fund has 12% of its portfolio in foreign bank obligations, largely Eurodollar CDs, Yankee dollar CDs and European bankers’ acceptances. A study

by Capital Advisors Group shows 44% of the average taxable money market fund is invested in non-U.S. financial debt; the figure is as high as 69% for larger money market funds.

PIMCO Some advisors worry PIMCO Total Return Fund, with over $240 billion in assets, has become so big, it cannot function effectively as it once did. Alternative funds include: [1] Harbor Bond Fund [managed by Bill Gross, but a lower expense ratio (0.6%) and excellent track record as an intermediate-term bond fund], [2] Dodge & Cox Income Fund (0.4% expense ratio), [3] Fidelity Total Bond Fund (0.4% expense ratio), [4] Metropolitan West Total Return Bond Fund (0.7% expense ratio), [5] Vanguard Total Bond Market Index Fund (0.2% expense ratio) and [6] iShares Barclays Aggregate Bond Fund (0.2% expense ratio).

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Mutual Funds

3.3

MANAGED FUTURES FUNDS The fee structure of a futures mutual fund can be quite a bit higher than disclosed by the expense ratio. The annual expense ratio alone is typically 2.0%, but a review of the fund’s prospectus may be warranted.

The fund’s prospectus might point out that a moderate or high percentage of fund assets can be invested in a subsidiary, which, in turn invests in private investment vehicles or commodity pools. These ―ancillary‖ investments have their own set of fees (not reflected in the fund’s expense ratio): 2-3% management fees and performance incentives ranging from 15-30% of new-high net trading profits (figures much higher than the typical hedge fund).

Disclosure of fund holdings may also be murky. The mutual fund’s semiannual report might show assets have been divided amongst a number of commodity trading advisors (CTAs) without showing the investments of each advisor. In order to achieve better tax treatment, some subsidiaries invest in offshore operations. According to the National Futures Association, ―the subsidiaries daily operations, including derivatives positions…and fees charged are not entirely transparent.‖ The CFTC commissioner has stated mutual funds dealing in futures trading are able to ―operate by evading CFTC oversight and its substantial disclosure obligations now poses increased risks to the markets and to retail investors.‖ A finance professor at the MIT Sloan School of Management states, ―There’s all sorts of opportunities and potential for abuse.‖

FLOATING-RATE VS. HIGH-YIELD BOND FUNDS Floating–rate (bank-loan) funds have credit ratings of BB and below. In 2008, these funds lost an average 27% versus a loss of 26% for high-yield bond funds. In 2009, floating-rate funds were up 41%, high-yield funds were up 47%. There are differences of opinion as to what asset category is riskier. One fund manager points out that bank loans are a senior and secured loan in an industry that historically has had recoveries twice as high as high-yield bonds. Another fund manager believes high-yield bonds are a safer bet. The interest rate on bank loans are reset every 30-90 days, depending on the securities owned. The reset is usually based on the London interbank offered rate (Libor).

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Mutual Funds

3.4

TARGET-DATE RETIREMENT FUNDS Due to their generally disastrous returns in 2008, some target-date retirement funds have introduced hedge fund alternatives (tactical asset allocation) that can increase the fund’s cost but provide a cushion against some of the downside risk.

Strategies to Improve Target-Date Fund Returns Alternatives

Protection

Tactical Asset

Strategy

Add investments that do not move in sync with stocks or bonds (e.g., commodities and hedgefund-like mutual funds).

Some firms use ―put‖ derivatives; others might reduce stock exposure during market declines.

Search for best opportunities based on a tactical asset allocation approach.

Pros

May partially offset declines

Potential for avoiding large losses.

Potential for higher returns

Cons

May be complex and expensive

Less liquidity and Expensive and unreturns may be bepredictable; holdlow market averages ings may change wildly

130/30 FUNDS The goal of a 130/30 fund, sometimes referred to as ―active extension,‖ ―short extension‖ and other names, purchase stocks expected to go up in price while shorting other stocks projected to decline. The basic format is to invest $100 in long positions and then borrow $30 of stocks (believed to be overvalued) from brokerage firms. The borrowed shares are then sold so that the fund ends up with $130 in long positions and $30 in short positions.

When the short positions are subtracted from the long positions, these funds remain 100% net invested.

Leverage plays an important role in 130/30 funds since fund managers are making $160 in investment decisions for every $100 of shareholder money. The leveraging means that if things go as planned, returns are increased. However, there is also the possibility losses will be magnified. Liberal estimates place the amount of money managed by these funds to be about $30 billion.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Mutual Funds

3.5

QUANT FUNDS Roughly 70 mutual funds are classified as ―quantitative.‖ This investment approach relies heavily on computer models to select investments. A finance professor at MIT, who also manages quant funds, believes most quant managers rely on three laws to govern investor behavior, thereby driving securities prices; ―We’re lucky if 99 laws explain even 3% of investor behavior.‖ While quant models can vary greatly, they typically focus on measures such as a stock’s P/B or price-to-sales ratio. Another popular strategy looks at momentum factors such as how a stock’s price over the previous 12 months.

REITS The largest real estate fund is Vanguard REIT (VNQ), overseeing close to $6 billion in assets; the ETF has a 0.1% expense ratio. Another popular fund is iShares Dow Jones U.S. Real Estate Index Fund (IYR) and an expense ratio of 0.5%; some of its top holdings are Simon Property Group, Vornado Realty Trust, Public Storage, Equity Residential and Boston Properties.

An ETF analyst at Morningstar describes real estate as ―a leveraged play on the U.S. economy.‖ During a recession, real estate will likely fare worse than the broad stock market. If the economy experiences slow growth, real estate has a good chance of being a market leader. The advisory service favors T. Rowe Price Real Estate, J.Pl Morgan U.S. Real Estate and iShares FTSE NAREIT Residential Plus Capped Index. Recommended foreign real estate funds are SPDR Dow Jones International Real Estate, iShares FTSE EPRA/NAREIT Developed Asia Index and iShares FTSE EPRA/NAREIT Developed Europe Index.

CLOSED-END FUNDS As of May 2010, CEFs held about $230 billion in assets. A number of closed-end funds use borrowed money to boost returns. Historically, CEFs have traded at a 4% discount to their NAV (source: Herzfeld). Over 60% of closed-end funds leverage their portfolios with auction-rate preferred shares (ARPS). The most common form of leverage has been senior, short-term financing, such as a revolving credit facility from a bank or new term-preferred securities with a fixed maturity date that trade on a secondary market.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

QUARTERLY UPDATES FUTURES

Futures

4.GOLD

4.1

AS A

COMMODITY

Gold is often viewed as a hedge against inflation. Yet, according to Ibbotson, from 1978 through the first half of 2010, the correlation between inflation and gold prices was just 0.08% (less than 10%). However, the correlation between gold and the Major Currencies Dollar Index, as reported by the Federal Reserve, from 1973 through the first half of 2010 was -0.45; the correlation becomes even more negative over the 30-year period ending 2010, -0.65. Thus, when the dollar is strong, gold prices are likely to drop; when the dollar is weakening, gold prices should increase.

Since its separation from gold prices under President Nixon, the dollar has been in a long downtrend compared to other major currencies (but not against a trade-weighted basket of currencies). The Fed’s Major Currencies Dollar Index was down 27% from 1973 through the middle of 2010 and down 45% since the dollar’s peak in early 1985.

CURRENCY TRADING The total daily volume of currency trading worldwide has ballooned from $1.5 trillion to $4.0 trillion, as of September 2010 (source: Bank for International Settlements). Overall, the U.S. dollar remained the dominant currency, accounting for 85% of transactions (vs.

86% in 2007); the euro’s share rose to 39% from 37%. The share count data add up to 200%, reflecting the fact there are two currencies in each transaction.

The currency market is the world’s largest financial market. It dwarfs daily activity in U.S. stocks (~ $145 billion a day); daily trading in U.S. Treasurys has ranged from $460 to $570 billion a day in recent years. There are close to 50 currency ETFs; in 2004 there was just one. In the case of futures contracts, investors can borrow $50 for every $1 invested.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

QUARTERLY UPDATES FINANCIAL PLANNING

Financial Planning

5.PAYING

5.1

BACK SOCIAL SECURITY BENEFITS

Recipients of Social Security retirement benefits who started receiving benefits prior to age 70 can repay their benefits and start anew with higher monthly payments. For example, someone receiving checks at age 62 could wait one or more years, repay what was received and then start receiving the benefits of a 63-, 64-, 65- (etc.) year old. The repayment provision was originally designed to help retirees who had already been claiming benefits but were forced back to work for whatever reason.

Repayments to Social Security require only one form to be completed and there is no interest charge. This means the recipient had free use of the money and its earnings for the entire period prior to repayment. It also means additional taxes were likely paid along the way (see tax credit below). Each year Social Security retirement benefits are delayed from age 62 to 70 means a 7-8% annual increase.

For example, suppose a single female originally filed for benefits at age 62. The woman is now 70 years old. By repaying the $110,845 of cumulative benefits from age 62 to 70, she will begin receiving a much higher checkâ&#x20AC;&#x201D;$8,568 more in after-tax benefits the first year alone. She is trading income that at age 62 was 78.3% of her full-retirement benefits for income eight years later now set to be 132.7% of full retirement benefits.

As part of the repayment process, she earns tax credits for taxes she paid through the years on her benefits. These tax credits lower her net repayment down to $87,290. The crossover point is the period of time to recover the $87,290. Using simple math, the crossover point appears to be 10.2 years ($87,290/$8,568).

The actual crossover point comes sooner for two reasons: [1] the formula does not factor in the use of the money for eight years in this example and [2] annual CPI adjustments will obviously be higher for a higher monthly benefit at age 70 than the adjustment for checks that began at age 62.

Just the use of the money for eight years reduces the net repayment cost from $87,290 down to $79,370 ($110,845/8 years = $13,856 per year); using $12,000 per year instead (to reflect the fact payments did not begin at $13,856), $12,000 invested for each of 7 years at an after-tax return of 4% equals about $7,920 of additional money. The crossover point (excluding CPI adjustments) now becomes 9.3 years ($79,370/$8,568). Factoring in the higher CPI increases may bring the crossover point down to about eight years.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Financial Planning

5.2

As another point of comparison, if $87,290 were invested in a fixed-rate annuity indexed to the CPI (since Social Security payments are also indexed to inflation), after-tax income the first year would be $5,100; a figure quite a bit below the $8,568 first-year excess benefit described in the paragraph above.

The obvious potential disadvantage to this strategy is the recipient may not live long enough to recoup the money sent back to Social Security (8-10 years in the example above). In order to greatly reduce this potential negative, the advisor should consider early recipients paying back Social Security after a couple of years instead of the 8-year period shown in the example.

CORRELATION COEFFICIENTS U.S. stocks 0.8

Foreign stocks

1.0

0.7

Growth stocks

0.9

0.7

0.8

Value stocks

0.8

0.7

0.8

0.8

Small/Mid stocks

0.1

0.1

0.1

0.2

0.1

U.S. Bonds

0.1

0.2

0.0

0.1

0.0

0.6

Global bonds

0.5

0.5

0.4

0.6

0.6

0.2

0.1

Equity REITs

0.2

0.4

0.2

0.2

0.3

0.1

0.2

0.2

Commodities

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Financial Planning

5.3

Asset Class Correlation [1988-2008] REITs

S&P

Small

Foreign

Bonds

REITs

1.0

S&P 500

0.7

1.0

Small Stocks

0.7

1.0

1.0

Foreign Stocks

0.4

0.7

0.7

1.0

U.S. Bonds

0.4

0.3

0.3

0.1

1.0

High-Yield Bonds

0.8

0.9

0.9

0.5

0.5

HY

1.0

REITs = FTSE NAREIT (U.S. equity REITs) S&P 500 = large cap U.S. stocks Small Stocks = Russell 2000 Index Foreign Stocks = EAFE Index U.S. Bonds = Barclays U.S. Bond Index High-Yield Bonds = Barclays High-Yield Index

BLACK SWANS AND FAT TAILS One strategy used by money managers is to provide protection against ―black swan‖ events, large market declines. The term comes from the discovery that, despite what was believed in the West (all swans are white), European explorers found black swans in Australia. When markets experience these major moves, statisticians call these events ―fat tails‖ because they occur on fringes, or tails, of a bell curve distribution.

The problem with the strategy, which often involves investing 90% of the portfolio in something ultra-conservative and the remaining 10% in options contracts or other speculative bets on a soaring market, is what worked last time may not work in the future. For example, from late 1990 to early 2000, there was not a single bear market. A black swan strategy would have missed out on one of the great bull markets of all time. A less extreme variation of the theme is a ―barbell‖ strategy wherein a mutual fund attempts to limit any annual loss to 15% while participating in a diversified portfolio of equities, foreign money market s, emerging markets bonds and real assets such as gold. Such a strategy costs about 1% a year for the protection.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Financial Planning

5.4

GLOBAL DEMOGRAPHICS Over the next 40 years, Japan and Europe will see their working-age population shrink by 30-37 million. Chinaâ&#x20AC;&#x2122;s working-age population is expected to keep growing for roughly 15 more years before it experiences a downturn. It is projected China will have 100 million fewer workers than it does today by 2050. Indiaâ&#x20AC;&#x2122;s working-age population is expected to grow by 300 million over the same period.

The U.S. working-age population is projected to grow by 35 million by 2050 (source: United Nations).

Today, one in five Japanese and Europeans is over age 65; in 2050, it will be one in three. For China, the challenge will be to build social structures and retirement plans for their older population. Today, 1.4% of Chinese are over age 80; in 2050, it is expected to be 7.2%. India could greatly increase its annual economic growth rate (by up to four percentage points a year, according to Goldman Sachs) if it: (a) dismantles archaic labor laws, (b) brings more women into the work force and (c) invests more in training and education.

Economists believe that more people translate into more ideas. And, unlike finite resources such as land or oil, an idea can be used by used by more than one person at the same time. Because of the Internet, it is extremely difficult for any one country to keep proprietary technology to itself. Today, power translates into large population numbers of developed and emerging nations. The advantage the U.S. is it generally has open trade policies, encourages immigrates to settle here and has strong productivity growth.

INVESTMENT SUCCESS AND LUCK The most important factors for financial success are: [1] how much can be saved each year and [2] returns from the financial markets over the 20-40 years an investor is putting away money. A Wall Street Journal study found there to be a huge range of returns for different 30-year periods.

For example, $100,000 grew to $1.2 million over 30 years ending in 1976 while the same initial investment grew to $2.7 million over the subsequent 30 years. A $100,000 investment in 1925 grew to $1 million in 30 years; if the beginning point had been 1927, its 30-year growth was $700,000.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Financial Planning

5.5

A $100,000 investment made at the beginning of 1964 grew to $1.5 million by 1994; a $100,000 investment in 1965 grew to $1.8 million over 30 years (note: all examples assume a 60/40, stock/bond mix). According to UCLA business professor Benartzi, ―It’s well established that people attribute bad luck to randomness, but then attribute good luck to their own skill.‖ Despite the flat performance of stocks over the first 10 years of the 2000s, the S&P 500 was almost 10 times higher than it was in 1980. Furthermore bond prices experienced strong returns and even housing prices more than tripled since 1980.

The solution is likely to be diversification and increased savings. Portfolio diversification can help weather market extremes and an ongoing savings plan provides time diversification (since money is continuously added). One way the advisor can greatly increase a working person’s chances of financial success is to encourage automatic savings plan enrollment, through work and with after-tax dollars (auto bank debit plans offered by mutual funds). The rule of thumb in the retirement industry is workers should try and save 12-15% of their gross salary. The sooner this is done, the greater the effect of compounding.

The way in which the advisor communicates with the client is also important. Stay away from 3-month comparisons (or reporting) and focus on how the portfolio has performed over the past 12 months (2-3 years would be even better). Updates less frequent than one year may not be practical, but quarterly or monthly updates are likely to be harmful.

DECREASED DEMAND BY BABY BOOMERS As of the first quarter of 2010, net household assets (homes, retirement plans and other investments minus debts) were $55 trillion, down 18% from the end of 2007. This works out to a net worth of $171,000 per person; however, much of this wealth is concentrated in the hands of the wealthiest.

As of 2008, the latest data available (as of September 2010), people aged 65 to 74 were spending 12% less (adjusted for inflation) than they did 10 years earlier. According to U.S. Census Bureau, spending by those age 65 to 74 has increased over the past 10 years in just a few sectors: drugs, gasoline, health insurance (huge increase), health care (huge increase) and pets, toys and hobbies (slight increase).

The biggest losing categories have been: new autos, home furnishings, eating out, apparel and food.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Financial Planning

5.6

MASTER LIMITED PARTNERSHIPS As of the third quarter of 2010, investors could own interests in master limited partnerships (MLPs) and receive an average yield of just under 7% per year. Generally, MLPs operate and own natural gas and oil pipelines as well as storage facilities. The income stream is considered quite steady. MLP securities are actually stocks, but the underlying companies are structured as limited partnerships. MLP distributions are usually not taxable until an investor sells shares.

MLP closed-end funds have been in existence for a number of years but normally have high fees. A MLP ETF can lower those fees from 2.4% down to 0.9% or less.

MLPs are a comparatively small investment category with less than 80 issues and a market capitalization of about $200 billion.

STAYING WITH THE SAME EMPLOYER Amount of time U.S. Adults Spend With the Same Employer Year: 1996

Length of Employment

Year: 2008

26%

1 year or less

23%

13%

1-2 years

13%

15%

3-4 years

17%

20%

5-9 years

20%

17%

10-19 years

17%

9%

20+ years

10%

LIFE INSURANCE Almost a third of U.S. households have no life insurance coverage (source: Limra). The number of households relying solely on life insurance provided by an employer is one in four. The percentage of households with coverage outside an employer-sponsored plan is 44%. In 2009, insurers issued over nine million individual life insurance policies.

QUARTERLY UPDATES

IBF | GRADUATE SERIES

Financial Planning

5.7

HOW WE SPEND TIME How Americans Spend a Day Sleeping [8:40]

Purchasing goods and services [0:46]

Work and work-related activities [3:32]

Caring for household members [0:32]

Watching TV [2:49]

Education [0:28]

Leisure and sports, excluding TV [2:26]

Civic and religious activities [0:20]

Household activities [1:48]

Other activities [0:14]

Eating and drinking [1:13]

Caring for non-household members [0:13]

Personal care [0:47]

Telephone calls, mail and e-mail [0:12]

(source: Wall Street Journal, June 2010)

NUCLEAR POWER Share of Electricity From Nuclear Power [2009] Country

Percentage

France

75%

Germany

26%

Japan

29%

U.S.

20%

U.K.

18%

Russia

18%

India

2%

China

2%

(source: World Nuclear Association)

RATES OF RETURN For the 20-year period through 2009, the S&P 500 had an annualized return of 8.2%; the average annualized return of an equity fund investor was just 3.2%.

QUARTERLY UPDATES

IBF | GRADUATE SERIES