IBF - Updates - 2012 (Q1 v1.0)

QUARTERLY UPDATES Q1 2012

Copyright Š 2012 by Institute of Business & Finance. All rights reserved.

v1.0

Quarterly Updates Table of Contents STOCKS WHY WE DON’T SELL LOSING STOCK BUY VS. SELL RECOMMENDATIONS UNDERSTANDING P/ES REINVESTING DIVIDENDS DOW 1,339,411 GROWTH STOCKS MEGA CAP STOCKS NASDAQ COMPOSITE INDEX STOCK ANALYSTS STOCK MARKET BUY SIGNALS S&P 500 RETURNS EMERGING MARKETS AND INDEXING

1.1 1.1 1.2 1.2 1.3 1.3 1.4 1.4 1.5 1.6 1.6 1.7

BONDS TREASURYS: RETURNS AND INFLATION EMERGING MARKET BONDS BAD LOANS SECURITIES 2011 MUNICIPAL BOND DEFAULTS I SAVINGS BONDS BARCLAYS AGGREGATE BOND INDEX HIGH-YIELD BONDS MUNICIPAL BOND DEFAULT UPDATE GLOBAL BOND MARKETPLACE

2.1 2.2 2.2 2.3 2.3 2.4 2.5 2.5 2.6

COMMODITIES OIL MILK CONTRACTS COMMODITY UPDATE

3.1 3.2 3.2

ALTERNATIVE INVESTMENTS PRIVATE EQUITY NON-LISTED REITS VENTURE CAPITAL RENTAL PROPERTY RETURNS

4.1 4.3 4.5 4.5

MUTUAL FUNDS & ETFS MORNINGSTAR MUTUAL FUND LIAISONS STABLE-VALUE FUNDS ETFS ETF TAXATION MUTUAL FUND FEES YEAR-END WINDOW DRESSING BEATING BENCHMARK SHARE CLASS FEES ACTIVE VS. PASSIVE RISK-PARITY FUNDS PERFECT VS. TERRIBLE MARKET TIMING INDEXING VS. ACTIVE FUNDS TWO MYTHS ABOUT EQUITY FUNDS JOHN BOGLE INTERVIEW EXCERPTS ETF TAX EFFICIENCY MONEY MARKET ACCOUNTS CORRELATIONS AND FUND RETURNS

5.1 5.1 5.2 5.2 5.3 5.4 5.4 5.5 5.6 5.6 5.8 5.8 5.9 5.11 5.12 5.13 5.13 5.14

FINANCIAL PLANNING CHANGING BETA RETIREMENT UNCERTAINTY REVERSE MORTGAGES 2012 EARLY SOCIAL SECURITY DE-RISKING OR RE-RISKING HOME PRICES VS. ANNUAL INCOMES GREY DIVORCES WITHDRAWAL RATES: WILL ASSETS LAST? CLIENT LANGUAGE INFORMATION EXPLOSION

6.1 6.1 6.1 6.2 6.2 6.2 6.3 6.3 6.5 6.8

ECONOMICS U.S. EXPORTS TO EUROPE 2011 ECONOMISTS’ PREDICTIONS U.S. MANUFACTURING

7.1 7.1 7.1

QUARTERLY UPDATES STOCKS

STOCKS

1.WHY

1.1

WE DON’T SELL LOSING STOCK

Research published in 1998 by UC Berkeley showed that individual investors were 50% more likely to sell a winning stock than a loser. According to numerous academic studies, mutual fund managers who hold onto losing stocks underperform, on average, by four percentage points annually compared to those fund managers who cut their losses. A study from Northwestern University found that people are much worse at estimating whether a bad investment will produce mild or severe losses than they are at predicting whether or not a winning investment will generate small or large gains.

BUY VS. SELL RECOMMENDATIONS According to FactSet Research Systems, only 3% of all U.S. listed stocks were considered “sells” as of November 2011.

Analysts Ratings for U.S.-Listed Companies # of Recommendations

% of Total

Buy

13,339

45%

Overweight

2,606

9%

Hold

12,312

42%

Underweight

398

15%

Sell

814

3%

In theory, the ratio of buy to sell ratings should be roughly 50/50. However, this has likely never been the case. In the late 1990s, the ratio was 100+ buys for every sell.

During this time, Merrill Lynch had buy ratings on 940 stocks and sell ratings on just seven; Salomon Smith Barney: 856 buy ratings and four sells; Morgan Stanley Dean Witter: 670 buys and zero sells.

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STOCKS

1.2

UNDERSTANDING P/ES A company’s P/E ratio is its stock price divided by a year’s worth of its per-share earnings. It is one measure of how much investors are paying for the value a company creates. The S&P 500’s P/E is useful for sizing up the broad market at a glance.

As of January 2012, the S&P 500 was trading at 14.5 times trailing earnings (actual earnings over the previous four quarters). Between 1872 and 2000, U.S. stocks had an average P/E of 14.5 (source: Federal Reserve Bank of Kansas City).

Yale economist Robert Shiller advocates using 10 years of earnings, adjusted for inflation. His “cyclically adjusted P/E” is 20.8, versus an average of 16.4 since 1881.

Operating Earnings A variation of the P/E ratio is to use “operating” earnings, as defined by regulators.

According to S&P, there is no legal definition for operating earnings; it is more principle.

A good way to look at operating earnings is if a company wanted to know what it made from the sale of its products, not how much the company paid to finance production.

Based on operating earnings, the S&P has a P/E of 13.4, versus an average of 19.1 since 1988. Unfortunately, the historical data on operating earnings is not extensive enough to make this indicator reliable.

REINVESTING DIVIDENDS As of early 2012, Con Ed had single-digit sales growth and its common stock had 1/5th the volatility of the U.S. stock market. Over the past decade, Con Ed’s stock price only slightly outperformed inflation. However, with dividends reinvested, shares return 128%, vs. a total return of 33% for the S&P 500. Co Ed has increased its dividend for 37 consecutive years. Over the past decade (2002-2011), Chevron returned almost 200% with dividends reinvested; Altria Group returned more than 300%.

Over the eight decades ending September 2010, dividends contributed 44% of S&P 500 total returns. During the 1970s, when stock returns average just 5.9% a year, dividends contributed 71% of that figure. Advisors can find companies with slow, steady growth and rising dividends by reviewing S&P’s Dividends Aristocrats list. The list is comprised of S&P 500 stocks whose dividend payments have increased for at least 25 years in a row. There are 42 such companies; and 15 of them pay at least a 3% dividend (e.g., J&J, Emerson Electric, Pepsico and P&G). ETF advisors should consider PowerShares Dividend Achievers Portfolio and Vanguard High Dividend Yield.

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STOCKS

1.3

DOW 1,339,411 The Dow was launched on May 26, 1896 as a “price-only” index that does not capture (include) the dividend income of the underlying companies. According to finance professor Statman of Santa Clara University, with dividends reinvested along the way, from its May 1896 inception to March 2012, the Dow would have closed at 1,339,411 (not 13,000). This number is more than 100 times a closing price of 13,000.

The numbers become quite different when looked at from another perspective. Using a March 2012 closing price of 13,000 (meaning dividends have been excluded), if inflation is factored in, the Dow would have closed at 456 (> 96% below its value of 13,000).

From the Dow’s 1896 inception to March 2012, if you factor in inflation and dividends, the close would have been 46,986.

GROWTH STOCKS One way to determine sustainable growth for a stock is a measurement called “return on invested capital.” This measures whether companies are finding lucrative projects that can power future growth. Today, numbers in the 13-16% are considered ordinary, while those above 30% are excellent (e.g., Apple, Philip Morris International, and Priceline.com both have returns on invested capital of more than 40% as of March 2012).

Determining whether growth stocks are reasonably priced is difficult since P/E ratios alone do not show growth rates and complex financial models rely on making assumptions far into the future. A simple alternative is “relative” valuation, which involves comparing companies on a combination of metrics such as P/E ratios and longterm earnings-growth forecasts.

Advisors should keep in mind that with fast growth comes the possibility of a quick loss if that growth slows. P/E ratios in the high teens or even low 20s do not significantly increase an investor’s risk level; however, once you get above 25, one should have a “very clear understanding of the long-term potential for the business.”

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1.4

MEGA CAP STOCKS The largest stocks are sometimes classified as “megacaps,” companies with a market value of > $100 billion. The S&P 100 Stock Index is comprised of stocks whose average market capitalization is $114 billion (as of March 2012).

NASDAQ COMPOSITE INDEX As of March 2012, the NASDAQ Composite Index was close to 3,000, a level it first broke through in November 1999. The table below compares the top 10 companies of the composite in 1999 (when the trailing P/E ratio was 78) through the first part of March 2012 (trailing P/E of 23). The index peaked at 5,048.62 on March 10, 2000.

NASDAQ Composite Index [10 largest companies] 1999 [% of total index] Microsoft [11.4%] Cisco Systems [6.9%] Intel [5.2%]

2012 [% of total index] Apple [11.2%] Microsoft [6.0%] Google [3.5%]

Oracle [3.0] MCI Worldcom [2.8%] Dell [2.5%] Sun Microsystems [2.3%] Qualcomm [2.2%] Yahoo [2.1%] Amgen [1.2%]

Oracle [3.3%] Intel [3.0%] Cisco Systems [2.4%] Qualcomm [2.3%] Amazon [1.8%] Comcast [1.4%] Amgen [1.3%]

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STOCKS

1.5

STOCK ANALYSTS According to a Wall Street Journal article (February 2012), historical evidence shows stocks with lots of “buys” from analysts do no better than the broad market, on average.

Perhaps this is because analysts give 11 times as many “outperform” or “buy” recommendations than they do “underperform.” New research suggests there may be a way to discern which “buys” are worth heeding.

Analysts S&P 500 Recommendations Buy/Outperform

Hold

Underperform/Sell

5,800

4,480

530

To form their recommendations, analysts often begin with “discounted-cash-flow” analysis, which uses forecasts of revenues, margins and other factors to determine a fair share price for investors to pay today. Some factors are difficult to measure (i.e., riskiness) while others are impossible to know (i.e., distant growth rates); subtle changes in assumptions can product sharply different results.

The new research indicates that the best recommended changes come from concrete new information, and changes in near-term earnings forecasts are a good sign of such information. The authors of the study calculated that between 1994 and 2007, a trading strategy of buying stocks following raised ratings and earnings estimates and holding for a month, while doing the opposite (short selling) for stocks following lowered ratings and estimates, would have returned more than 45% a year. That works out to several times what an S&P 500 index found would have done.

One approach starts with a stock’s current price and then calculates the number of widgets the company must sell to justify its current share price—referred to as its required business performance (RBP). The analyst uses the company’s recent results as a guide in determining the probability it will achieve its RBP. The RBP percentages change daily. For example, during the summer of 2011, Netflix had an RBP probability of < 5%, which its stock price was > $280; once the stock’s price dropped to < $100 a share, its RBP was almost 90%.

An index that selects 100 stocks, with the highest RBP probabilities, is the Dow Jones RBP U.S. Large-Cap Core Index. This index returned 10.9% annually in back-testing (vs. an actual return of 2.1% a year for the S&P 500).

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STOCKS

1.6

STOCK MARKET BUY SIGNALS Companies that buy back their own stock reduce their outstanding share count that, in turn, helps to boost earnings per share. Some argue that buybacks are not a good predictor of the stock’s future performance (e.g., executive officers of a company may encourage a buyback because their bonus may be tied to earnings per share). It appears that the best kinds of repurchases are ones that managers opt for simply because they view shares as cheap.

Three studies from 1995 to 2000 were based on the premise that buybacks from companies with low valuations was a superior criteria for predicted a risk in a stock’s price. Each of these studies came to the same conclusion using the price-to-book ratio—if the company’s P/B ratio was modest, a stock buyback helped. The S&P 500 companies have a median P/B ratio of 2.4 (source: Thomson).

Another approach that appears to result in positive returns is to seek out companies whose managers use their own cash to buy shares back. A study covering the period 1991 to 2006 shows the relationship between share repurchases and stock performance; stocks purchased by companies beat other stocks by almost 900 basis points over four years.

Stocks that were the subject of both repurchases and insider trading beat others by 29 percentage points over the same four years.

S&P 500 RETURNS Anyone who put money into an S&P 500 index fund between late 1998 and early 2001 experienced a cumulative loss, as of January 21, 2012. Adjusted for inflation, the S&P lost 18% from August 2000 to January 2012. According to Yale economist Robert Shiller, this has never happened to the U.S. stock market, even if one were to go back to 1871. Even those who bought on the eve of the 1929 crash experienced a brief gain, in inflation-adjusted terms, in 1937. Although the S&P 500 has not done particularly well over the past 10+ years, an equal-weighted S&P 500 index returned 52% from August 2000 to January 2012. The equal-weighted approach means a much larger weighting in value stocks.

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STOCKS

1.7

EMERGING MARKETS AND INDEXING The division of foreign markets into developed and emerging segments dates back to 1981, when Antoine van Agtmael, an economist at the World Bank, referred to thirdworld countries as emerging markets. In a 2011 performance study, the Aperio Group looked at 10 years of return data (12/31/2000 to 12/31/2010) from all active emerging markets mutual funds.

On a pretax basis, jut 28% of active mutual funds outperformed their respective benchmark (almost 2/3 of the 28% beat their benchmark by ~ 1% per year). Emerging market hedge funds have done slightly better on a pretax basis, risk-adjusted basis.

However, given the reality that hedge funds are generally very tax inefficient, the everso-slight benefit likely overstates what happens on an after-tax basis.

Of the 21 countries that comprise the MSCI Emerging Markets Index, two may be promoted to developed market status (Korea and Taiwan). These two countries represent significant market cap weightings in the emerging index. As of March 2012, the top five countries were: China (17% of the index), Brazil (15%), South Korea (15%), Taiwan (11%), and South Africa (8%). The top five countries in the EAFE Index were: U.K. (22%), Japan (21%), France (9%), Australia (8%), and Germany (8%).

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QUARTERLY UPDATES BONDS

BONDS

2.TREASURYS:

2.1

RETURNS AND INFLATION

The returns on 20-year U.S. Treasurys have been amazing over the past decade (20022011) and over the past 30 years (11.03% vs. 0.05% for the S&P 500). This marks the first time that over any given 30-year period, Treasurys outperformed the S&P. For 2011, these long-term bonds had a total return of 28%; for 2008 the total return was 26%. These Treasurys have not seen a better year since 1995.

At the beginning of 2011, the yield was 3.3%; by the end of 2011 it was 1.9%. To match 2011 returns, the 10-year note’s yield would have to drop to 1.05%. Over the past 50 years, the record low for 10-year Treasurys was 1.72% (September 2011). The surprise about Treasurys is how they fare compared to inflation. For example, inflation was ~ 3.4% for 2011. If someone bought a 10-year Treasury at the beginning of 2012 and held it to maturity, adjusted for inflation, the investor would lose ~ 1.5% annually—and this does not include the impact of taxes.

Treasury yields can stay below inflation for extended periods. From 1942 through 1951, the Treasury Department “forced” the Federal Reserve to keep 10-year rates below 3% as the country sought to pay off its massive WWII debt. During this period, investors of 5year Treasurys lost 4.5% each year after adjusting for inflation (worse if income taxes are factored in). Analysts generally agree that the Fed’s massive rounds of quantitative easing are keeping rates artificially low.

Alternative Considerations As of early January 2012, 3-month Treasury bills were yielding 0.02% while a one-year bank CD was paying 0.8%. FDIC bank money market funds were yielding 0.4% while mutual fund money market accounts were offering 0.02% (source: iMoneyNet). During the middle of the 2008 financial crisis, Warren Buffet sold $5 million of T-bills maturing in four months for $5,000,090.70, meaning the buyer was willing to lose $90.70 over four months (to ensure he did not lose even more in something else).

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BONDS

2.2

I Series savings bonds are an often overlooked alternative to Treasurys. These government-backed securities yielded 3.06% at the beginning of 2012. I Series bonds offer a number of features: [1] interest payments are adjusted for inflation every six months [2] investors can hold them for up to 30 years [3] taxation of interest can be delayed until maturity or sold by the investor [4] interest payments, when paid, are not subject to state income taxes [5] redemption is possible at any time after a 12-month minimum holding period [6] if the holding period is < 5 years, investor will forfeit three months of interest [7] interest accrues daily and is compounded semi-annually [8] interest rates are determined each May 1st and November 1st

EMERGING MARKET BONDS As a group, emerging markets have debt equal to ~ 1/3 their GDP, half that of the U.S. The average emerging market has a budget deficit of ~ 2% of GDP versus more than 11% for the U.S. The investment-grade portion of the J.P. Morgan Emerging Market Bond Index has jumped from 2% in 1993 to 58% by November 2011; > 70% of the issuers in the J.P. Morgan Corporate Emerging Markets Bond Index are investment grade.

As of November 2011, the J.P. Morgan Emerging Bond Index was yielding 6.5%, triple the yield of 10-year U.S. Treasuries.

BAD LOANS SECURITIES Resolution Trust securitization set the stage for modern-day CMBS. Roughly $30 billion of distressed commercial real estate debt was sold in 2011 and a similar amount is expected for 2012. In 2007, the CMBS delinquency rate was less than 1%; during October 2011 it reached 9.8% (source: Trepp LLC).

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BONDS

2.3

2011 MUNICIPAL BOND DEFAULTS In a September 30 piece on “60 Minutes,” Meredith Whitney, a well-respected banking analyst, forecasted “hundreds of billions of dollars’ worth of municipal bond defaults would occur within the next 12 months. In the months that followed, investors pulled out money from municipal bond funds for 29 consecutive weeks (note: municipal bonds returned > 10% for 2011).

For the 2011 calendar year, ~ $6 billion; almost half of this amount was from bonds related to American Airlines (what are called “corporate-backed municipal bonds” or “private placement”). These types of private placement bonds make up a small portion of the $3.7 trillion municipal bond market. Only 1% of the $6 billion in municipal bond defaults came from what are considered the safest portion of such debt: GO and essential service bonds (e.g., water, sewer and utilities). According to Merrill Lynch, there were 10 muni bankruptcies in 2011 (vs. six in 2010).

I SAVINGS BONDS I Savings Bonds are issued by the U.S. Treasury and pay an interest rate composed of a fixed rate that lasts for the duration of the bond plus a variable inflation rate that is determined twice a year. At the end of 2011, the fixed rate was 0% and the annual inflation rate was 3.06%. Since I Bonds debuted in 1998, the composite rate for newly issued bonds has ranged from 7.5% (May 2000) down to 0% (May 2009).

Individuals can buy only $5,000 in I Savings Bonds each year. Despite the limitation, advisors should seriously consider this asset for a portion of clients’ conservative money.

Since 1999, I Bond rates have been substantially higher than money market fund yields every year. For example, money market funds had a total return of ~ 0.1% while I Bonds returned almost 5%. Moreover, these often-ignored government securities have a number of advantages over TIPS: [1] Interest payments are tax deferred for up to 30 years [2] Interest is exempt from state income taxes if used for educational purposes [3] In some instances, interest is exempt from federal and state income taxes [4] Unlike TIPS, I Bond interest rates cannot fall below 0%

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BONDS

2.4

I Bond investors can cash in their bonds after five years without a penalty. After holding these bonds for one year or longer, the penalty is equal to three months’ interest. The $5,000 annual limit applies to each member of a family; a family of five could buy $25,000 of I Bond each year. Starting in 2012, taxpayers can opt to have their refund paid in the form of I Bonds. This means each investor could effectively buy $10,000 worth of I Bonds each year (a $5,000 direct purchase plus a $5,000 tax refund). Because of this loophole, some investors are intentionally overpaying their taxes up to $5,000.

BARCLAYS AGGREGATE BOND INDEX Charles Dow created the Dow Jones Transportation Average in 1896, but total return bond indexes were not developed until 1973. Art Lipson created what is believed to be the first total return bond index. Salomon Brothers followed with a similar index two weeks later. By the time Lehman Brothers purchased Lipson’s brokerage firm at the end of 1977, Art’s original index had already become the bond benchmark.

As of the beginning of 2012, the Barclays Capital U.S. Aggregate Bond Index was comprised of ~ $15 trillion worth of domestic investment-grade bonds. Relative to equities, there is a disproportionate tilt toward passive investing in fixed income; the Barclays index is widely considered the best benchmark for efficient asset allocation. The iShares Barclays Aggregate Bond ETF (symbol AGG) is the world’s largest bond index, with assets of ~ $14 billion. Investors building at traditional 60/40 portfolio may own 10 different funds to cover their equity exposure, but often use the Barclays index as the sole component of the fixed-income portion.

Since 1977, the Barclays Aggregate Index has posted just two negative years (-2.9% for 1994 and -0.8% for 1999). From the beginning of 1990 through the end of 2010, the index’s weighting for U.S. Treasurys has dropped from 45% down to 34%; “governmentrelated” securities has gone from 10% to 12%, corporate bonds were 15% and rose to 19% by the end of 2010 and “securitized” bonds went from 29% to a 35% index weighting.

It has been said that more money has been lost reaching for higher yields than investing in the stock market. The Barclays index is heavily weighted toward government securities ever since Fannie Mae and Freddie Mac were put into conservatorship in September 2008—effectively making turning their debt into government debt. Interest rate risk accounts for 98% of the total return behavior of government bonds.

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BONDS

2.5

Two other reasons to include other bond indexes for the fixed-income portion of a portfolio: [1] Even in 2008 and 2009, only a handful of investment-grade corporate bond issuers defaulted or entered bankruptcy; and [2] the Barclays index does not include TIPS. The table below shows the correlation coefficients between several Barclays bond indexes for the period April 2004 to March 2011.

Barclays Indexes: Correlation Coefficients [2004-2011] Aggregate

Gov’t

Mortgage

TIPS

Aggregate

1.0

Gov’t

0.9

1.0

Mortgage

0.9

0.9

1.0

TIPS

0.5

0.3

0.5

1.0

H/Y

0.0

-0.5

-0.2

0.4

H/Y

1.0

HIGH-YIELD BONDS From 2008 to 2012, investment-grade and high-yield corporate bond funds doubled in size, to $1.2 trillion and ~ $250 billion, respectively. The U.S. junk bond market is estimated to have an overall value of $1 trillion. Over the past 15 years, the “spread” between high-yield corporates and Treasurys was six percentage points. As of February 2012, the high-yield bond index was yielding 7.3%, far below its 15-year average of 10%.

MUNICIPAL BOND DEFAULT UPDATE The default rate for GO bonds, which represents 40% of the municipal bond marketplace, is just 0.01%. According to Municipal Market Advisors, municipal bond segments with the highest default rates are: [1] community development districts (17% of issues), [2] assisted living (5% of issues), [3] independent living (4% of issues), [4] nursing home (3% of issues), and [5] telecom (3% of issues).

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BONDS

2.6

GLOBAL BOND MARKETPLACE The table below shows the total amount of debt for the top AAA-rated government issuers at the beginning of 2011 (source: The Wall Street Journal).

Total Amount of Outstanding Government Debt [in trillions of dollars] U.S. ($12.8)

Netherlands ($0.5)

Germany ($2.8)

Australia ($0.3)

France ($2.3)

Austria ($0.3)

U.K. ($2.0)

Sweden ($0.2)

Canada ($1.2)

Denmark ($0.1)

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COMMODITIES

3.1

3.OIL

The year 2011 marked the fifth time in recent history that has seen widespread fear that the world was running out of oil. The first time was in the 1880s, when oil production was concentrated in Pennsylvania and it was said that no oil would be found west of the Mississippi. Oil was then found in Texas and Oklahoma. Similar fears emerged after WWI and WWII. The reality is something quite different.

For example, since 1978, world oil output has increased by 30%. During the years 2007 to 2009, for every barrel of oil produced in the world, 1.6 barrels of new reserves were added. Since the start of the oil industry (during 1859 in Titusville, Pennsylvania), 1 trillion barrels have been produced. The estimated number of barrels currently considered technically and economically accessible is 1.4 trillion (note: it is believed that there are 5 trillion barrels of petroleum resources in the ground).

The U.S. currently produces about 5.5 million barrels per day. Recent discoveries in North Dakota could add another 2.0 million to U.S. production by 2020. During the latter part of 2012, North Dakota’s Bakken shale is expected to begin producing more oil than Alaska’s mammoth Pudhoe Bay field. Net imports of oil reached a high of 60% in 2005; today it is 47%, due to better energy efficiency, increased production and use of ethanol.

In the typical oil field, just 35-40% of the oil in place is produced using traditional methods. Some experts believe that a “digital oil field” (using sensors throughout the field) could increase worldwide by another 125 billion barrels, almost the identical amount that Iraq is believed to have. The world currently consumes roughly 92 million barrels per day, a figure that is expected to be 110 million by 2030.

Frack Attack: Oil Shale In the past, oil companies would drill for oil and, if they were good, would find oil four out of 10 times. Today, once shale deposits are found, the companies know there is oil.

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3.2

MILK CONTRACTS During January 2012, the number of milk contracts averaged 110,200 a day, a 32% increase from a year ago. Virtually all of the major restaurants, food companies, and dairy processors are using these milk futures contracts. Futures for Class III milk (used to make other products such as cheese), which does not meet the same standards as milk used for drinking, increased 30% for 2011, outperforming all of the commodities on the S&P GSCI Index. A large part of the reason for the increase is the demand for milk by the expanding middle class of China, India, and other developing countries. Still, the number of futures contracts is tiny compared to crude oil futures (1.5 million contracts per day) and corn futures (1.3 million contracts per day). The size of the U.S. dairy market is estimated to be worth $100 billion (source: CME Group).

COMMODITY UPDATE Despite its 17% increase in 2010 and 19% gain in 2009, the Dow Jones-UBS Commodity Index, which tracks 19 commodities, still ended 2011 11% below its level at the end of 2007. Gold ended 2011 up 30%; the metal has been up every year for the past 10 years.

Silver gained 84% for 2011. At the end of 2011, the silver market was valued at $19 billion versus $170 billion for gold. Oil was up 15% for the year while natural gas dropped 21% for 2011.

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Alternative Investments

4.PRIVATE

4.1

EQUITY

The perception about private equity firms ranges from vultures, barbarians and flippers to job-creators and increasing a company’s net worth. Private equity firms typically invest in U.S. companies that are underperforming their industry peers. Investors in private equity only make money if they improve the performance of the companies invested in; private equity companies are last in line to be paid in case of insolvency. Private equity companies tend to use more incentive-based pay than other firms.

Private equity firms specialize in leverage buyouts or deals funded by debt that is loaded onto the target company’s balance sheet. The acquired companies are often restructured to reduce costs, improve efficiency and repay the debt, before being sold or listed on the public markets.

The preferred “exit strategy” of a private equity firm is to take the company it has acquired public, thereby raising even more money that may help the company become even stronger. By law, a company cannot pay a dividend unless it is solvent. It is illegal for a director to authorize a dividend that would render the company insolvent. Board members can be personally liable for agreeing to a dividend of an insolvent corporation.

Private Equity Firms The Good

The Bad

6.6% annualized returns over 5 years vs. -0.9% annual returns for stocks held by pension plans (Sept. 2011)

2% annual fees + 20% of any profits

Industry employs 8.1 million worldwide

Borrowed money = 49% of buyout value

In 2010, Apollo Global invested $1.5 billion in LyondellBassell; Apollo was worth $6.6 billion in early 2012

Annualized rates have fallen to single digits

At the height of the 2008 financial crisis, the GAO’s private equity report wrote “academic research suggests that recent equity LBOs have had a positive impact on the financial performance of the acquired companies.” The same reported noted that in the 2004-2008 period it studied, none of the 500 complaints received by the SEC’s Division of Investment Management involved private equity fund investors.

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Alternative Investments

4.2

The 2008 GAO report shows that companies that the private equity firms invested in had low growth relative to their peers and that employment growth grew after they were acquired by a private equity firm. In 2009, Ford sold Hertz to a private equity firm for $14 billion. A year later, the private equity firm took Hertz public at a $17 billion valuation.

Bain Capital In a January 2012 article, The Wall Street Journal reported about their assessment of 77 businesses Bain invested in while Mitt Romney led the firm from its 1984 start until early 1999. Among the findings: [a] 22% filed for bankruptcy reorganization or went out of business by the end of eight years after Bain first invested. Another 8% resulted in Bain losing its entire investment money was lost (note: the figure drops down to 12% if the period is five years). [b] A different study, covering the 1985-1999 period found bankruptcy rates among target companies globally was 5-8%. [c] The stellar returns for its investors was largely concentrated in a small number of deals; 10 deals produced more than 70% of the dollar gains. Of these 10 companies, four later landed in bankruptcy. [d] Many of the Bain acquisitions that went into bankruptcy emerged far healthier after the reorganization (similar to GM a few years ago). [e] Bain generally invested in smaller companies that carried greater risk. [f] A 1995 Bain investment of $6.4 million in eye-wear company Wesley Jessen VisionCare resulted in a gain of more than $300 million, a 46-fold return. [g] Research shows that buyout companies, on average, add value to their targets.

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Bain Capital: 10 Deals That Resulted in its Largest Profits [1984-1998] Investment Date and Amont Bain Invested [in millions]

Estimated Bain Gain

What Happened

Chap. 11 B/K

Steel Dynamics [1994] $18m

$85m

Public in 1996

no

American Paper & Pad [1992] $5m

$102m

Public in 1996

2003

DDi Corp. [1996] $41m

$117m

Public in 2000

2003

Experian Corp. [1996] $88m

$164m

Sold in 1996

no

Physio Control [1994] $10m

$168m

Public in 1995

2000

Stage Stores [1988] $10m

$175m

Public in 1996

no

Waters [1994] $27m

$178m

Public in 1995

no

Dade [1994] $30m

$186m

Dividend

2002

Wesley Jessen [1995] $6m

$302m

Public in 1997

no

Italian Yellow Pages [1997] $17m

$373m

Sold in 2000

no

Unlike other investments that trade in debt and derivatives, private equity firms make money by investing in businesses making things and providing services.

NON-LISTED REITS As of October 2011, the REIT marketplace was valued at $1.2 trillion: $738 billion in listed equity REITs, $291 billion in listed mortgage REITs, $158 billion in nonlisted equity, and 1% in nonlisted mortgage REITs. Nonlisted REIT growth from 2000 to 2011 was explosive, as shown in the table below.

Nonlisted REIT Growth 2011

2000

Equity Mkt. Cap.

$92 billion

$18 billion

Assets Held

$67 billion

< $2 billion

# of REITs

73

5

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Even though nonlisted REITs are SEC-registered and classified as “public” entities, they do not trade on major exchanges. Nonlisted REITs are sold as “blind pool” investments, meaning that capital is raised but specific properties for purchase are not identified during the offering period (unlike publicly-traded REITs). Costs and fees in nonlisted REITs average 15-18% of the initial investment (meaning 82-85 cents of each dollar raised is invested); this compares to 97-99 cents for listed REITs bought in the secondary marketplace. Listed below are nine other possible drawbacks of nonlisted REITs: [1] Diversification—focus tends to be narrow—but this allows management to capitalize on their sector or geographical expertise.

[2] Blind Pool—Raising money may take several years; evaluation is difficult during this period (since properties have not been identified).

[3] Possible Dividend Risk—For the first few years, cash flow may not be sufficient to sustain shareholders’ dividends; cash reserves and investor capital may be needed. This is in contrast to listed REITs that have an FFO dividend payout ratio of 70%, which means there is an ample difference between cash flow and dividend payouts (source: NAREIT).

[4] Pressure to Buy Quickly—There can be significant pressure (e.g., the dividend) on the REIT advisor to buy properties for the blind pool as soon as possible, regardless of market conditions. From 2005-2008, nonlisted REITs raised $33 billion (45% of the total amount rose since year-end 1999); this period was the peak in commercial real estate valuations.

[5] Potential Conflicts of Interest—While most listed REITs are internally advised; most nonlisted REITs, at least initially, use an “outside” advisor that is affiliated with the REIT sponsor. These advisors are owned, controlled, and managed by the REIT’s principals and board members—which could result in substantial conflicts of interest.

[6] Lack of Transparency—Nonlisted REITs report less useful and less relevant data than their listed counterparts.

[7] Volatility—Although promoted as a positive, reduced share price volatility (compared to listed REITs) can be very misleading since nonlisted REITs are not subject to marked-to-market valuations. An economic downturn can result in a nonlisted REIT reducing its dividend or price per share without any advance notice.

[8] Limited Capital and Liquidity—Money is mostly raised during specific offering periods, meaning additional capital may not be available in the future when needed; assets may have to be sold at inopportune times. Investors have limited options if they need capital.

[9] Marketing Machines—Nonlisted REITs spend quite a bit of time and money on promotion and possible acquisitions. Critics point out that more time should be spent on property development and ongoing management.

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VENTURE CAPITAL During 2011, venture capital commitments reached $33 billion (vs. $22 billion in 2009).

For 2011, venture capital companies raised $10 billion through IPOs. Tech-focused vehicles accounted for 35% of the venture capital raised for 2011. There are approximately 140 venture capital funds.

For funds raised in 2000, the median performer’s annualized return was -3.3% while the top quartile returned 3.3% a year (source: Cambridge Associates). For funds raised in 2007, the median fund has returned 5.1%, versus 19.6% for the top quartile. Key to those high returns were investments like Facebook and LinkedIn. However, access to top funds is difficult. Overall, U.S. venture capital funds raised $16.2 billion over 135 funds in 2011, up 5% from 2010.

RENTAL PROPERTY RETURNS Due to the cumulative losses of residential real estate from 2007 to the present, some investors are receiving 1-2% of their purchase price from renters each month. Generally, one should expect about half that range (or $500 to $600 per month for a $100,000 home). In a 2012 article, The Wall Street Journal listed six traps that investors in rental properties often fall victim to: [1] Confusing a cheap price for a good deal—The investor lives in a high-priced area such as San Francisco and think similar returns are possible in a lower-cost area such as Sacramento. The prospective buyer should verify rents in the area by canvassing local apartments. It could turn out that renters in some areas are given incentives, such as several months of free rent.

[2] Overlooking key costs—The purchase of a property often means paying closing costs and commissions in the 6-7% as well as fix-up expenses, leasing agent fees, property management fees, property taxes, and insurance.

[3] Forgetting that time is money—Money is lost whenever the property sits empty, either due to a vacancy or having the unit painted or renovated.

[4] Assuming money will flow in effortlessly—When the investor becomes an owner, he then becomes a rent collector. Evictions can take several weeks, fixtures might be stolen, and maintenance may be an ongoing nightmare.

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[5] Underestimating repair costs—Carpet in a rental must typically be replaced at least once every 4-5 years; repainting may be needed after each tenant moves out. One agency recommends the investor set aside six months’ worth of rent to fund a major repair.

[6] Believing that owning a rental is similar to owning a home—Homeowners end up accepting flaws renters will not. Many states and communities have very strict (and complex) laws landlords must adhere to, even if they only own one property. A property manager can handle most problems, but expect to pay up to a month of rent for finding and screening tenants—and up to 10% for the property manager.

Nationwide, renter-occupied housing represents 34% of all households. In cities such as Los Angeles, San Francisco, Boston, and New York, the number ranges from 62-68%.

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Mutual Funds & ETFs

5.1

5.MORNINGSTAR

Morningstar will now add a “forward-looking ranking system to supplement the company’s 1-5 star ratings.” The new system will classify a fund as a gold, silver, bronze, neutral or negative ranking, based on Morningstar’s prediction as to whether or not the fund will outperform its peers in the future.

The new ratings are based partially on past performance, expense ratio, assessment of fund management, the fund’s strategy and the fund’s parent company. As a side note, more than 122% of mutual fund inflows over the past five years have gone into funds rated four or five stars (the number is > 100% due to net outflows of funds rated 1-3 stars).

A 2008 study by the University of Oregon found that mutual funds that moved from a 4star to 5-star rating saw a 25% increase in inflows during the six months after the rating increase.

MUTUAL FUND LIAISONS Over the past 5 years, some mutual fund companies have been hiring liaisons who have money management experience and people skills to provide advisors more detailed information as to the workings of the fund.

According to Boston-based Financial Research, by the end of 2011, mutual fund sales by advisors will account for 60% of mutual fund inflows. Gross sales by advisors are expected to grow to $2.3 trillion by 2006, from $1.4 trillion in 2009.

At some firms, such as Franklin-Templeton, the liaison is called an “institutional portfolio manager;” at T. Rowe Price the person is called a “portfolio specialist.” These liaisons do not take the place of wholesalers. In most cases, the liaison shares space with fund money managers, not the sales team. At Franklin, a typical day for the liaison might be hosting an on-site visit at Franklin for financial advisors, a couple of conference calls and 1-2 meetings with research teams at a securities firm.

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STABLE-VALUE FUNDS Stable-value funds are comprised of bundles of bonds coupled with an insurance policy and are found in some 401(k) plans. These funds have been around since the 1970s and oversee more than $600 billion. Investors in 401(k) plans have more money in stablevalue than in bond funds. During 2008, these funds were up 2% for the year. DuPont has ~ 60% of its retirement plan assets in stable-value funds.

Whenever the market value falls below book value (typically $1 a share), the insurance enables anyone making a withdrawal to receive full book value plus interest. It is important for the advisor to remember that the insurance often includes covenants that can protect the insurer. For example, the guarantee can go away if the company offering the retirement plan initiates massive layoffs or an external manager violates investment guidelines.

ETFS ETF Marketplace [2012] iShares (BlackRock) [$470 b]

Charles Schwab [$5 b]

SPDRs State Street Global Advisors [$260 b]

Fidelity [0.2]

Vanguard [$180 b]

More than 80% of ETF money is invested in funds sponsored by BlackRock, State Street and Vanguard.

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10 Largest ETFs [2012] ETF (symbol) assets in billions

Daily Share Volume

SPDR S&P 500 (SPY) $96

210 million

SPDR Gold Trust (GLD) $66

13 million

Emerging Markets ETF (VWO) $45

22 million

MSCI Emerging Mkts. Index (EEM) $34

61 million

QQQ (QQQ) $28

56 million

S&P 500 Index Fund (IVV) $28

4 million

Barclays TIPS Bond Fund (TIP) $23

< 1 million

Total Stock Market ETF (VTI) $20

2 million

iBoxx $ Investment Grade Corp. Bond (LQD) $17

1.5 million

Total Bond Market ETF (BND) $15

1.5 million

Note: for 2011 Barclays TIPS was up 8.5% About 53% of all U.S. ETFs manage less than $50 million. Almost 50 ETFs closed in 2010; roughly 30 closed for all of 2011. Of the more than 1,400 ETFs, only 41 are actively managed (source: Morningstar).

ETF TAXATION The vast majority of ETFs are regulated as traditional mutual funds under the Investment Company Act of 1940. ETFs and index mutual funds, rarely make portfolio changes. A main difference between the two is how ETFs operate.

With ETFs, ordinary investors buy and sell ETF shares from other investors (unlike a traditional open-end mutual fund). Actual ETF shares are created and redeemed through institutional investors through in-kind transactions. With this design, selling shares by one investor never forces the underlying ETF to sell underlying securities to come up with the cash to pay off the investor. The cost of trading securities is borne by the investor, not the ETF.

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5.4

The inner workings of an ETF allow its manager to make tax-wise decisions about which securities to distribute and whether to sell securities or distribute them in in-kind (to the institutional “intermediary”). ETFs can internalize losses and externalize gains. Thus, when an index change requires an ETF to get rid of stock that has dropped in price since the ETF purchased it, the ETF can make the sale on the open market, collect the cash and take the capital loss on its books. If the ETF is going to sell a stock for a gain, it can pass that stock on to an institution, removing any possible capital gains.

Not All Are Tax Efficient While most equity ETFs are tax efficient, ETFs that trade in commodities and futures contracts are regulated as commodity pools and taxed differently—any distributions of gains are subjected to a 60% long-term capital gains and 40% short-term rate. Gains on ETFs that hold gold, silver or other precious metals are taxed at the collectibles rate of a straight 28% on all gains. Some of these non-stock ETFs send investors a Schedule K-1 rather than the more common 1099 form.

MUTUAL FUND FEES According to The Wall Street Journal (December 2011), Over 10 years, an investor with $200,000 already invested in mutual funds and adding another $20,000 a year, could end up with an extra $48,000 if he could save one percentage point in yearly fees. A study done by IndexUniverse for the WSJ looked at returns of five well-known U.S. stock funds (Dodge & Cox Stock, Windsor, ICA, Fundamental Investors and GFA)) showed that their active management was explained entirely by three factors—beta, size and style (traits that can easily be duplicated by an ETF). For example, the Dodge & Cox Stock mutual fund can be mimicked by an investment in the iShares Russell 3000 Value Index ETF (reducing the expense ratio down from 0.50% to 0.25%).

YEAR-END WINDOW DRESSING Many stocks that have done well for the first 50 weeks of the year frequently trade even higher during the final 1-2 weeks of the year (e.g., Video Display +38% and another 4% during the 51st week of the year). Conversely, bad losers for year-to-date can take a final beating as the calendar year comes to a close (e.g., Salesforce.com -19% for the first 50 weeks and another 8% during the 51st week).

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5.5

Performance bonuses means there is a strong incentive for hedge fund managers to load up on these winners and dump the losers. Mutual funds and hedge funds disclose their holdings as of December 31. Whatever the manager sells before 4 p.m. on the year’s final trading day will be omitting from the report. Funds that report holding big winning stocks attract positive attention and new cash from investors.

In some instances, fund managers may be “portfolio pumping” (entering very high bids for a few shares of stock they already own during the final few minutes of the trading day), which can result in existing fund holdings of thinly-traded stocks, artificially amplifying the value of the stock. As a result of this “signal jamming,” the funds can attract much more money than their peers. Of course, any stock pumped up this way is likely to deflate on the first trading day of the next year.

According to research done by a Wharton School researcher, stocks widely held by hedge funds pop 0.4% higher than the overall market on the final trading day of the year—and then underperform the average by 0.2% on the first day of January.

In the case of mutual funds, these types of practices have pretty much disappeared completely ever since state regulators and the SEC cracked down on the practice in 2001 and 2008.

BEATING BENCHMARK According to Bianco Research, only 17% of more than 4,000 funds that invest in large U.S. stocks beat their benchmark for the 2011 calendar year. In most years, fewer than half do. According to Bianco’s research, the return correlation of U.S. stocks has quadrupled since the mid-1990s.

As recently as 1997, it took 20 stocks to eliminate most of the likelihood of enduring more risk than the market as a whole; today, according to Bianco, it takes 40.

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5.6

SHARE CLASS FEES According to The Wall Street Journal, as recently as 1989, the total number of share classes matched the 2,262 mutual funds in the U.S. (excluding money market funds).

By 2010, there were 6,928 U.S. funds available in 20,188 share classes (meaning each fund offered ~ 3 different share classes). A 1% difference in annual fees can have a significant impact over time. For example, a 25-year old who saves 9% of his pay each year in a typical balanced fund will end up with $510,000 by age 65 ($410,000 if the annual fee is 1.25% instead of 0.25%).

Finra offers a side-by-side comparison tool at Finra.org/fundanalyzer. For example, it shows that $25,000 invested in the Invesco S&P 500 Index Fund will cost $1,270 with A shares and $1,630 with C shares. A similar investment in the Fidelity Spartan 500 Index Fund costs just $115 over the same 10-year period (all examples assume a 5% annualized growth rate).

ACTIVE VS. PASSIVE At the beginning of 2001, there were over 540 index funds; of those, over 130 (25% of the index funds) outperformed their peer group 10 years later. Another 245 (45% of the index funds) underperformed and the balance (30%) were either liquidated or merged during the 10-year period.

During this same 10-year period (2001-2010), there were 15,790 actively managed funds (note: this number includes all share classes). Of those, 24% outperformed the peer group, meaning the â&#x20AC;&#x153;success rateâ&#x20AC;? was virtually identical with index funds. Another 27% of the actively managed group underperformed and the remaining 49% were either liquidated or merged.

A valid argument made by proponents of active management is that informed advisors and brokers are not likely to pick the worst performers but instead, are likely to focus on the top-performers or largest funds within any given category. Let us see what happens when the 10 most popular funds are used.

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10 largest funds If someone had invested in the 10 largest mutual funds (as of 1-1-2001), eight of the 10 placed in the top half of their categories 10 years later. During this same period, the 10 largest index funds averaged 3.2% a year; the 10 largest actively managed funds averaged 1.9% annually. As a side note, of the 10 largest active and 10 largest index funds, nine were equity and one was a bond fund (shown in boldface type in the table).

All 10 index funds finished in the second or third quartiles for the 10-year period. Four actively managed funds were in the top quartile, one was in the bottom quartile, and three lost money (but none of the index funds lost money).

By concentrating on expenses instead of active vs. passive management, the advisor is more likely to make a sound choice. Some advisors believe all index funds have a low expense ratio, but this is not true. In fact, the average index fund charges ~ 37 basis points less than the average actively managed fund. Although the lowest expense ratios are usually index funds, this is not always the case.

Mutual Funds Active vs. Passive [2001-2010] 10 Largest Index Funds Name

Annualized

10 Largest Active Funds Name

Annualized

Vanguard 500

1.3%

Fidelity Magellan

0.2%

Vanguard Total Stock

2.4%

ICA

3.2%

Fidelity Spartan 500

1.3%

Washington Mutual

3.2%

Vanguard Total Bond

5.6%

Janus D

-1.1%

Vanguard Growth

1.3%

Growth Fund of America

2.8%

Vanguard European

3.4%

PIMCO Total Return

7.3%

Vanguard Extended Mkt.

6.0%

Fidelity G & I

-2.6%

Schwab 1000

1.7%

Fidelity Contrafund

5.5%

Vanguard Small Cap

7.2%

Amer. Century Ultra

0.1%

Schwab S&P 500

1.3%

Putnam Voyager A

0.8%

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In a separate study covering the five-year period ending June 30, 2010, mutual funds in the cheapest quintile (of expense ratios) of each category had a strong advantage over costlier funds. Using different time periods produced similar conclusions.

RISK-PARITY FUNDS Risk-parity, also known as balanced-risk funds, is a new category of asset allocation funds. Advocates of risk-parity funds take the position that a typical asset allocation fund with a 60/40 (stock/bond) mix really has about 90% of its risk coming from the stock portion—meaning the overall risk level is higher than most investors would suspect. In a risk-parity fund, 50% of the portfolio is in bonds, 33% is in cash and the remaining 17% is split between stocks and alternative assets such as commodities. This lower risk composition means reduced volatility but also reduced returns. Risk-parity fund managers try to increase overall return by adding leverage with futures or other derivatives. Those who favor this approach believe that investors will experience more consistent returns than they would with a 60/40 mix.

PERFECT VS. TERRIBLE MARKET TIMING Consider four hypothetical investors who each invested $10,000 a year for 20 years.

Investor #1 has perfect timing—investing $10,000 when the market is at its lowest point each year; Investor #2 invests on the first trading day each year; Investor #3 invests at the market’s highest level each year; and Investor #4 avoids the S&P and invests $10,000 at the beginning of each year in T-bills. The table below shows the return each investor would have experiencing by averaging all 20-year period returns from 1926-2010.

$10,000 invested each year for 20 years [all 20-year periods from 1926-2010] Investor

Average Return

#1: perfect timing each year

$921,000

#2: $10,000 invested 1st day each year

$856,000

#3: worst timing each year

$746,000

#4: no stocks (S&P 500), 100% in T-bills

$332,000

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5.9

INDEXING VS. ACTIVE FUNDS Although it is difficult to predict the likelihood that actively managed mutual funds will outperform their benchmark index over any 12-36 month period, there is a high level of predictability (that the index will outperform its fund category) when looking at any given five-year period—as shown in the table below.

% of Actively Managed Funds Outperforming Their Index Category

Comparable Index

6/2006—6/2011

6/2001—6/2006

LC Growth

S&P 500 Growth

20%

46%

LC Core

S&P 500

37%

30%

LC Value

S&P 500 Value

65%

13%

MC Growth

S&P MidCap 400

12%

5%

MC Core

S&P MidCap 400

16%

18%

MC Value

S&P MidCap 400 Value

33%

21%

SC Growth

S&P SmallCap 600 Growth

25%

6%

SC Core

S&P SmallCap 600

41%

19%

SC Value

S&P SmallCap 600 Value

52%

41%

What is often not included in the discussion of active vs. passive management is what happens during market downturns. The next table shows two recent extreme bear markets, the 2008 meltdown and the 2000-2002 bear market (the only time the market has had three negative years in a row). As can be seen from the table, the numbers are not encouraging for those favoring active management (even during a bear market).

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Bear Markets: % of Active Funds Outperforming Their Index Mutual Fund Category

2008

2000-2002

LC Growth

10%

51%

LC Core

48%

47%

LC Value

78%

64%

MC Growth

11%

16%

MC Core

38%

30%

MC Value

33%

17%

SC Growth

5%

12%

SC Core

18%

29%

SC Value

27%

42%

All Large Cap Mutual Funds

46%

46%

All Mid Cap Mutual Funds

25%

23%

All Small Cap Mutual Funds

16%

28%

Using Screening Tools Another consideration that is often ignored in the debate over active vs. passive management is that seasoned advisors may be using a screening process that would limit their universe of possible (active) fund candidates that would only include top-quartile or top-half funds; those that make the cut would then be further screened by looking at things such as investment philosophy, fees, downside risk, Sharpe ratio, etc.

Unfortunately, such an extended review process is unlikely to helpâ&#x20AC;&#x201D;studies consistently show that the chances of selecting a top-quartile fund for the future by using historical data is similar or less than random (meaning a coin toss is likely to result in a better selection process).

There is consistency in (historical) performance, but in the wrong quartile. Mutual funds that have delivered bottom-quartile performance in the previous 3-5 years have a high chance of being merged or liquidated. Survivorship bias for mutual fund return figures is a big consideration. Over any three-year period, 10-20% of mutual funds disappear; over some five-year periods, the number can be over 25%.

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The Exceptions There are two areas where active generally looks better than indexing: [1] when return figures are based on asset weighting (and not when each fund in a category is given the same weight as another—which is what usually happens when indexes are compared to active funds) and [2] when foreign small cap and emerging market debt funds are compared to their benchmarks.

For example, it can be argued that it is much more likely that an investor will go into a huge, well-known, fund than a fund that is not particularly fund (and has substantially less assets under management). When using asset-weighted funds (e.g., $1 billion fund is given 10x the weight of a $100 fund in the same category), the typical small cap fund increases its average return from 4.3% to 5.0% annualized over a five-year period (ending 8/24/2011), beating the S&P SmallCap 600 Index that averaged 4.6% a year over the same period (note: the index does not include any expense ratio, trading costs, or other fees incurred by all mutual funds).

Looking at all foreign small cap and emerging market debt funds (not using asset weighting), 76% of foreign small cap funds and 67% of emerging market debt funds outperformed their benchmarks over the five-year period ending August, 24, 2011.

TWO MYTHS ABOUT EQUITY FUNDS There are two myths about equity funds: [1] management may be forced to sell some fund holdings because of increased redemptions during bear markets (thereby triggering unwanted capital gains) and [2] embedded capital gains for equity funds can eventually trigger unwanted gains (particularly to newer investors who did not enjoy the previous appreciation that is now called “embedded”). The answer to both of these myths is the same—cash flows for equity funds are usually positive (e.g., during the 2000-2002 meltdown, $62 billion of new cash went into equity funds; in 2008, 31% billion went into equity funds). This positive cash flow means management can use the incoming cash to satisfy redemptions (without having to sell positions in the portfolio). Moreover, fund management is buying lots of stocks over a number of years. If stock positions need to be liquidated, a fund manager can sell off positions that result in losses that can later be used by the fund to offset gains.

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5.12

JOHN BOGLE INTERVIEW EXCERPTS The following are excerpts from a February 2012 interview between Vanguard founder John Bogle and the Journal of Indexes.

[1] I am an optimistic conservative…As I look ahead, I think reasonable expectations are for about a 7% return on stocks and about a 3.5% return on bonds.

[2] What people don’t get about gold and commodities in general is that they have no internal rate of return…Stocks have a 2% yield and earnings growing at 5% (adjusted for inflation) to deliver a 7% return….bonds have a 3.5% coupon today and that is probably 91% of their future return…When you get a commodity, there is no coupon, there is no dividend, there are no earnings.

When I buy gold, I’m buying gold because I think I can sell it to someone else at a higher price. If that isn’t the ultimate in speculation, I would not know what is.

[3] If you go through developed foreign markets your largest investment is Britain (23%).

And I think they’re in deep trouble. Everybody knows they’re putting on heavy austerity.

They’ve got terrible problems…The next one is Japan (18% of a foreign index)…They’ve got a structured society. They’ve had a lot of innovation in the past.

Will that continue? I don’t know…And then you go to France, who’s next in size…they don’t work very hard over there…Next are Switzerland, Australia, and Germany. They all look pretty good.

[4] People talk about double taxation as dividends; 73% of all stocks are owned by institutions that aren’t really taxable.

[5] During 2011, SPY (the largest ETF that tracks the S&P 500) turned over 7,700%. It’s a trading fund, mostly for institutional trading…The original paradigm for index funds is to buy the stock market and hold it forever. That is only the paradigm for all of 1% of the ETF market.

[6] The average mutual fund managers last for ~ six years. And 50% of mutual funds themselves go out of business every decade.

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5.13

[7] Assume that every S&P 500 company has half of its shares held by long-term investors who never trade, and half of the shares are held by short-term speculators who do trade. We know that those long-term investors as a group will capture the exact return of the S&P 500. Speculative trades will capture the exact same return because they own the same stocks. But by trading among one another, they will underperform the market by the amount of their trading costs.

ETF TAX EFFICIENCY Taxable investors may prefer ETFs over mutual funds due to a regulatory loophole that shields investors from capital gains distributions until final sale of the ETF. As shown in the table below, many popular foreign and global ETFs have not ever paid capital gains distributions (at least from their 2007-2008 inception to Dec. 2011).

ETF Fees and Capital Gains Distributions iShares Benchmark

Vanguard

MSCI ACWI Ex US

MSCI ACWI

FTSE AllWorld Ex US

FTSE All-World

Markets

Developed & Emerging ex.

U.S.

Developed & Emerging

Developed & Emerging ex.

U.S.

Developed & Emerging

Inception

3/26/2008

3/26/2008

3/2/2007

6/24/2008

Expense Ratio

0.35%

0.35%

0.22%

0.25%

Cap. Gains Distributions

0

0

0

0

MONEY MARKET ACCOUNTS The term â&#x20AC;&#x153;money marketâ&#x20AC;? can refer to two different products: [1] one is offered by the mutual fund industry and [2] the other is a type of bank account wherein the lender sets the interest rate. As of the beginning of 2012, ~ $2.7 trillion was invested in money market mutual funds while close to $6 trillion were in bank money market deposit accounts. The average money market yield was 0.06% while at banks it was 0.15% (Feb. 10, 2012, source: Crane Data). All bank money market accounts are guaranteed by FDIC for up to $250,000 per account.

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Mutual Funds & ETFs

5.14

There are some potential benefits that banks can have over their money market fund counterparts. While money funds pay a market rate based on securities yields, banks can pay “artificial rates based on funding needs and competitive factors.” In the past, some banks offered significantly higher yields because they were in trouble and needed to attract depositors. As of February 2012, one of the highest rated and highest yield bank money market accounts was offered by Sallie Mae Bank; the accounts received Bankrate.com’s top score of five stars for earnings, asset quality, capitalization, and liquidity.

Reserve Primary In the entire history of mutual fund money market accounts, only two have “broken the buck.” The first time occurred over 20 years ago. The second time occurred after the 2008 collapse of Lehman Brothers. A large money market fund, Reserve Primary ($62 billion), held some Lehman paper ($785 million). A judge ordered the fund to liquidate and investors got back ~ 99% of their money.

In 2010, the SEC enacted new rules intended to make money market funds invest in even safer paper with shorter maturities and provide more disclosure.

CORRELATIONS AND FUND RETURNS For the 2011 calendar year, just 23% of mutual funds outperformed their benchmark. The correlation between the S&P 500 and the stocks within the index averaged a record 86% (0.86) for the year. Some argue that a high correlation makes it harder for a mutual fund manager to pick winners. During the decade 2002-2011, the average correlation between stocks in the S&P 500 and the index itself averaged 56% (0.56). However, during most years, large cap managers have lagged their benchmarks when correlations were high and when correlations were low. For 2011, the best performer in the S&P was Cabot Oil & Gas (> 100% return) while the biggest loser was Bank of America (-58%). Less than 820 funds owned Cabot while over 2,460 funds owned B of A.

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QUARTERLY UPDATES FINANCIAL PLANNING

FINANCIAL P LANNING

6.CHANGING

6.1

BETA

During 2001, financial stocks had a beta of 0.9; as of November 2011 the figure was 1.6.

Over the past decade, the beta for utility stocks has been as low as 0.1 and as high as 0.9 (0.5 as of November 2011).

RETIREMENT UNCERTAINTY  50% of U.S. workers age 45+ do not know what they need to retire  20% of employees plan on retiring later than they had planned  25% of people now age 65 will live to age 90  62% of married couples disagree on when to retire  67% of investors with $250k in investable assets are concerned about outliving their assets

REVERSE MORTGAGES 2012 According to Reverse Mortgage Insight, the top three reverse mortgage lenders for 2011 were MetLife Bank, One Reverse Mortgage and Urban Financial Group. Origination fees with lenders can be as high as 2% of the home’s value, capped at $6,000. Closing costs are frequently an additional 2% and there are mortgage insurance fees charged by HUD. The interest rate charged on these loans is generally higher than the rate someone would pay with a traditional fixed-rate mortgage.

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6.2

EARLY SOCIAL SECURITY For someone whose normal retirement age for Social Security is age 66, taking benefits as early as 62 are 25% lower than someone waiting until age 66, as shown in the table below (source: SSA).

Age

% Received

62

75.0%

63

80.0%

64

86.7%

65

93.3%

66

100%

DE-RISKING OR RE-RISKING Since the end of 2008, a point in time when the financial crisis was near its worst, investors took out more than $105 billion in stock ETFs and mutual funds than they put in. During 2011, withdrew a net $34 billion in large cap stock funds. Yet, since the end of 2008, investors have added more than $55 billion to sector funds (including $12 billion in real estate funds). The question is, â&#x20AC;&#x153;Has derisking turned into rerisking?â&#x20AC;?

Between 2006 and 2011, college and university endowments cut their holdings in U.S. stocks from 25% down to 16% (source: Nacubo-Commonfund Study of Endowments).

These same institutions have also increased their holdings in alternative investments (e.g., hedge funds, private equity, and real estate) from 40% to 53% of their holdings.

HOME PRICES VS. ANNUAL INCOMES Home prices in the U.S. were ~ 2.9 times incomes from 1985 to 2000. This price-toincome ratio peaked at ~ 5.1 in 2005; as of August 2011, nationally, prices were ~ 3.3 times incomes (~ 14% above the historical trend).

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6.3

GREY DIVORCES Even though national divorce rates have declined since peaking in the 1980s, divorce rates for those ages 40-69 have dramatically increased. In 1990, only 1-in-10 of those who went through divorce was age 50 or older; by 2009, the number was 1-in-4. More than 600,000 age 50+ got divorced in 2009.

For those ages 40-69, it was the woman who initiated the divorce 66% of the time. The same AARP shows that 27% of the time, the reason for the divorce was infidelity.

For baby boomers, 53% of those 50+ seeking a divorce were married once before.

Having been previously married doubles the risk of divorce for those ages 50-64; for those ages 65+, the risk factor quadruples.

Another AARP study shows that 80% of those ages 40-79 who are divorced, rate themselves in the top half of the country when it comes to happiness; over half see themselves in the top 20%. According to divorce author John Gottman, the behavioral precursors to late-life or empty nest divorce are no different from those for younger couples: criticism, defensiveness, contempt, and stonewalling. The top fear among older men and women who got divorced was â&#x20AC;&#x153;being alone.â&#x20AC;?

WITHDRAWAL RATES: WILL ASSETS LAST? The following three tables, based on a 20-, 25-, and 30-year period, show the chances of whether or not a stock/bond portfolio will last an investor until death. The 2009 study by BlackRock shows inflation-adjusted withdrawal rates ranging from 1-10% per year and stock/bond allocations ranging from 20-100%.

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6.4

20-Year Period [stock/bond allocations] 20/80

40/60

60/40

80/20

100/0

1%*

100%

100%

100%

100%

100%

2%*

100%

100%

100%

100%

100%

3%*

100%

100%

100%

100%

99%

4%*

99%

100%

98%

97%

94%

5%*

93%

94%

91%

88%

85%

6%*

65%

74%

74%

73%

73%

7%*

31%

43%

50%

55%

57%

8%*

10%

21%

32%

38%

42%

9%*

3%

8%

17%

26%

32%

10%*

1%

3%

8%

15%

23%

*inflation-adjusted annual withdrawal rate (% of portfolio)

25-Year Period [stock/bond allocations] 20/80

40/60

60/40

80/20

100/0

1%*

100%

100%

100%

100%

100%

2%*

100%

100%

100%

100%

99%

3%*

100%

100%

99%

98%

96%

4%*

94%

95%

94%

90%

86%

5%*

68%

75%

77%

75%

73%

6%*

33%

46%

54%

57%

59%

7%*

10%

22%

31%

40%

44%

8%*

3%

7%

16%

23%

33%

9%*

0%

3%

7%

13%

23%

10%*

0%

1%

4%

8%

16%

*inflation-adjusted annual withdrawal rate (% of portfolio)

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FINANCIAL P LANNING

6.5

30-Year Period [stock/bond allocations] 20/80

40/60

60/40

80/20

100/0

1%*

100%

100%

100%

100%

100%

2%*

100%

100%

100%

100%

99%

3%*

98%

98%

98%

95%

94%

4%*

83%

87%

87%

84%

82%

5%*

46%

58%

63%

64%

66%

6%*

15%

29%

40%

45%

51%

7%*

4%

11%

22%

29%

37%

8%*

1%

4%

10%

18%

27%

9%*

0%

1%

4%

11%

16%

10%*

0%

0%

2%

6%

11%

*inflation-adjusted annual withdrawal rate (% of portfolio)

CLIENT LANGUAGE A survey by LMSR and Invesco Van Kampen Consulting shows what words are preferred by investors when describing their current situation and advisors.

[1] Which of the following describes the best strategy to you today? The one that isâ&#x20AC;Ś Diversified [46%] Predictable [14%] Disciplined [11%] Not correlated to the market [9%] [2] Which do you most want to hear about from your financial advisor?

Investment strategies [37%] Investment advice [20%] Investment opportunities [11%] Investment solutions [8%]

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6.6

[3] Which type of strategy you would most like to hear about from your financial advisor?

Long term [26%] Comprehensive [10%] Progressive [6%] Conservative [4%]

Phrases to Lose

Phrases to Use

For ALL your investment needs

For a PORTION of your investment needs

Act NOW

Invest for the LONG-TERM

INSTITUTIONAL management

KNOWLEDGEABLE management

Out live your money

Have enough money for as long as you live

A HOLISTIC investment

A COMPREHENSIVE investment

Cautious or Optimistic

Cautious Optimism

Which Words Work Best With Investors 57% Stocks 43% Equities

27% Tax Deferred 25% Tax Exempt or Tax Free

62% Companies 38% Securities

82% Money markets 18% Cash

55% Bonds 45% Fixed income

56% Dividends 44% Income

82% Diversified 18% Asset allocation

78% Portfolios 22% Trusts

65% Diversified 35% Balanced

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FINANCIAL P LANNING

6.7

Words That Resonate With Investors When Communicating Aboutâ&#x20AC;Ś Portfolio managers 23% knowledgeable 17% accountable 16% experienced

Moderate investments 28% diversified 20% balanced 20% managed risk

Equity funds 78% securities 22% unique

Conservative investments 20% reliable 17% dependable 13% time tested

Aggressive investments 38% innovative 21% alternative 9% unique

Cash investments 38% personal reserve 27% emergency 9% rainy day

Active vs. Passive % of Mutual Fund Managers Who Outperform The S&P 500 [bull and bear markets: 1971-2011] Bull [Jan. 1971 to Dec. 1972] 42%

Bull [Nov. 1990 to June 1998] 25%

Bear [Jan. 1973 to Sept. 1974] 44%

Bear [July 1998 to Aug. 1998] 30%

Bull [Oct. 1974 to Nov. 1980] 43%

Bull [Sept. 1998 to Aug. 2000] 50%

Bear [Dec. 1980 to July 1982] 73%

Bear [Sept. 2000 to Feb. 2003] 50%

Bull [Aug. 1982 to Aug. 1987] 20%

Bull [Mar. 2003 to Oct. 2007] 48%

Bear [Sept. 1987 to Nov. 1987] 60%

Bear [Nov. 2007 to Feb. 2009] 43%

Bull [Dec. 1987 to May 1990] 35%

Bull [Mar. 2009 to Dec. 2011] 40%

Bear [June 1990 to Oct. 1990] 48%

Average [1971-2011] 43.4%

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FINANCIAL P LANNING

6.8

INFORMATION EXPLOSION According to authors Diamandis and Kotler (Abundance), if every word written from the earliest days of civilization to the year 2003 would represent five exabytes of information. A single Exabyte is one billion gigabytes (a one followed by 18 zeros).

From 2003 through 2010, the world created five exabytes of information every two days.

By the year 2013, we will produce five exabytes of digital information every 10 minutes.

The total of 912 exabytes for 2010 alone is the equivalent of 18 times the amount of information contained in all books ever written.

A rural farmer in a developing economy who has a cell phone using Google has access to more information than the U.S. President did just 15 years ago. The number of people living in absolute poverty has fallen by more than half since the 1950s; at the current rate of decline, it will reach zero by ~ 2035. In the U.S., groceries in 2012 cost 13 times less than 150 years ago in inflation-adjusted dollars. The standard of living has improved: 95% of Americans now living below the poverty line have electricity, running water, a refrigerator, television and Internet access.

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QUARTERLY UPDATES ECONOMICS

ECONOMICS

7.U.S.

7.1

EXPORTS TO EUROPE

Global exports make up ~ 13% of the $15 trillion U.S. economy. Of the $400 billion of U.S. affiliate income earned abroad (U.S. co. income earned from business operations), half comes from Europe and half comes from the rest of the world. The two largest contributors to U.S. affiliate income in Europe are the Netherlands (27% of Europe) and Ireland (16% of Europe).

The European Union (EU) is China’s biggest export market, buying $265 billion in Chinese products in the first three quarters of 2011.

2011 ECONOMISTS’ PREDICTIONS The table below shows the accuracy of 49 economists polled by The Wall Street Journal at the beginning of 2011. As the numbers in the table show, the predictive abilities of these economists as a whole were generally quite poor.

Economists’ Predictions for 2011 Actual

Lowest

Average

Highest

GDP (Q4)

1.6%

2.4%

3.4%

4.5%

Unemployment

8.5%

7.6%

8.8%

9.6%

Inflation

2.6%

0.4%

1.9%

3.9%

Core Inflation

1.7%

0.4%

1.3%

2.6%

U.S. MANUFACTURING At the end of WWII, while most of the world lay in ruin, the U.S. accounted for 25.6% of the planet’s industrial output. By 1970, America’s global manufacturing share stood at 22%—where it has remained for the past four decades. The 22% figure also means that the U.S. still represents the world’s largest manufacturer.

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ECONOMICS

7.2

During 2011, manufacturing output for the U.S. grew by over 11%; taken alone, U.S. manufacturing would represent the worldâ&#x20AC;&#x2122;s eighth largest economy (source: The Wall Street Journal). The crisis in America has been jobs, not world market share. After WWII, industry employed one in three workers; today, it is one in eightâ&#x20AC;&#x201D;a result largely due to gains in productivity.

Real manufacturing output stood at $35,000 per worker in 1947. Adjusted for inflation, that number doubled by 1980 and was $150,000 per worker by 2011. Manufacturing productivity has increased by 103% since the late 1980s, outpacing every other industry.

All this translates into good news for consumers: prices for manufactured goods declined a cumulative 3% since the 1990s, even though overall prices rose by 33%.

Quote About Education Education is not preparation for life; education is life itself.

--John Dewey, philosopher (1859-1952) QUARTERLY UPDATES

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