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Our Recent 2007 Client Newsletter ....

TO:                  CLIENTS AND FRIENDS

FROM:            VERN C. HAYDEN, CFP & STAFF

I suggested to the producer at CNBC that I discuss our Ten Rules for Managing Mutual Fund Portfolios in 2007.  Of course, these same rules apply to any time period but on television you have to make it sound more dramatic and timely.  This interview actually ended up being one of their new streaming videos on CNBC.com. My host was Joe Kernan.  As we were wired up and sitting in comfortable living room type chairs I found Joe to be an extremely intelligent yet relaxed interviewer.  To see the interview go to www.CNBC.com  - type my name in the blank search space which should allow the interview to pop up - dated December 22, 2006.  Here are our ten rules:

RULE 1.  DO NOT INDEX

Simply putting money in a passive, unmanaged index is like not heeding the warnings for tornado or tsunami.  The seeds for destruction of a portfolio are planted when you accept some of the academic research that says you can’t beat the market so you should join it.  In other words, use an index fund that represents the market.  The underlying assumption that the investment objective is to beat the market is a premise that defies legitimacy.  It’s imperative for us to distance ourselves from the indexing theory in order to create portfolios for clients that will not result in sending them into catastrophic poverty.  In our Investment Policy Statements we state:  “The first rule

 in managing money is not to lose money.”  Of course, that is not a guarantee a portfolio won’t lose money but we try hard to prevent and control losses during market downturns.

Here is my point:  Indexing may work in up markets, but it’s a disaster in down markets.  The 1990’s gave vigorous life to indexing because of the general uptrend in the market.  Cocktail parties were ringing with the noise of the big payoff in low cost indexing.  Then, starting March 10, 2000, the market said, “Follow me, oh faithful ones, and I will lead you into a financial abyss!”  The two most popular indexes were the S&P 500 and the NASDAQ.  Here’s what they did from 2000 through the end of last year using $100,000 as a hypothetical investment:

During the merry-go-round of the 2006 holiday parties did you hear anybody bragging like, “Indexing was fabulous, since the beginning of 2000 my $100,000 turned into a little over $98,000 - or $59,000.  It took me seven years, but I’m almost back to even in the S&P!”?  About that time, the guys in the tight white jackets starting saying, “Come with me!”

In the meantime, one of our core funds had the following record:

The paradox is that nobody wanted this value oriented fund in 1998 (-0.26) and in 1999 (+19.56) because of the hot growth market.  I must also add a required disclosure that says past performance does not connote future performance.

Two of the most highly respected investment gurus are Burton Malkiel (Random Walk Down Wall Street) and Charles Ellis (Winning the Losers Game).  They are both believers and apologists for indexing.  In 2004, Ellis wrote a book entitled “Capital”.  The subject was the Capital Research Group that manages the American Funds Group.  It was a very positive endorsement of the active management ability of the Capital Group.  Malkiel wrote the forward and stated as follows, “The table shows that investors would, in fact, have been better off by investing in six of those mutual funds managed by Capital.  Capital has indeed produced above-average and even well-above-average market returns for investors.”

In June of 2004, I wrote an article published in the Journal of Financial Planning entitled “The Death of Indexing”, in which I listed several funds that were far superior to an index fund.  If anyone would like a copy please call Joan and she will send you one.

RULE 2.  THE OBJECTIVE IS NOT TO BEAT THE S&P 500 EVERY YEAR.

The S&P is composed 100% of stocks.  There is no diversification as a result of allocation to different asset classes.  The asset classes in general are: stocks, bonds, cash, real estate and commodities.  While not an asset class, the foreign markets are an important part of allocation.  The reason for diversification is to try and control risk, since we can not control the market.  It is simply too risky to invest in only one asset class such as stocks.  An example of a manager that effectively allocated his fund for 25 years (1979 -2005) is Jean Marie Eveillard, of the First Eagle Global Fund.  The fund underperformed the S&P 500 10 out of 25 years.  BUT, it only had a loss in two calendar years (1990 & 1998).  The cumulative loss was only -1.56%.  During the same period the S&P 500 had 5 negative years (1981, 1990, 2000, 2001, 2002) equaling a 51% loss.  An investment of $10,000 for the 25 year period in the S&P 500 grew to $296,824 and in the First Eagle Global Fund $490,887.

RULE 3.  CREATE YOUR OWN PERSONAL BENCHMARK

To create your own benchmark you need to know what you want your portfolio to do for you.  Just saying, “I want it to grow!” isn’t enough.  Do you want it to grow to buy a house, pay for kids’ educations, start a business or provide for retirement?  Does that mean a target rate of 8% will meet your goal?  A target rate will always relate to the amount of risk you want to take.  Also, how much time do you have to reach a particular goal?  It is these three issues that create your personal benchmark:  your objectives, the amount of risk you can take and the amount of time you have.

RULE 4.  HAVE AN OVERRIDING INVESTMENT PHILOSOPHY

You need to decide which route you’re going to take to achieve your personal benchmark.  For instance, our overriding philosophy is grounded in the value teachings of Professor Benjamin Graham and most exemplified by Warren Buffett.  We’ve articulated this in some detail in previous newsletters.

RULE 5.  MANAGING A MUTUAL FUND PORTFOLIO REQUIRES A DIFFERENT APPROACH THAN A STOCK & BOND PORTFOLIO.

A mutual fund portfolio is all about the manager(s).  You must know the philosophy and strength of a manager.  What are their criteria for buying and selling?  What do they invest in?  How did they do in down markets as well as up markets?  How much risk do they take and what are their disciplines?  Once we get to know a manager we decide if they qualify to be on our team.  We always want strong offense and defense and some with specialties such as health care and energy.

RULE 6.  INDENTIFY MANAGERS FROM FUND FAMILIES WITH GREAT CHARACTER AS WELL AS PERFORMANCE.

Elliot Spitzer, now Governor of New York, caught several companies, such as Putnam and Janus cheating their investors.  We need to avoid them.

RULE 7.  ALLOCATE THE PORTFOLIO BY MANAGER(S) NOT JUST ASSET CLASS OR STYLE BOX.

It is desirable to use independent thinkers and go anywhere managers.  For instance, we typically have about 40% of a portfolio in hybrid funds.  These are managers that can allocate money to any asset class as well as foreign investments.  This creates an element of safety since this kind of manager can change the allocation in an effort to protect the investor.  We make every effort to find the best manager in every kind of investment and use them when appropriate.

RULE 8.  DON’T BUILD A PORTFOLIO BASED ON “EXPERT” PROJECTIONS ON WHAT WILL HAPPEN NEXT YEAR.

Why not?  Because they don’t know.  If any turn out to be right, it’s probably because they are lucky vs. smart.  In past letters, we enclosed projections made by the 22 experts from Wall Street Week.  It was published in Barron’s in 2003 – none of them were even close to the actual results.  The right question to ask is “If we don’t know what is going to happen next year, what is the best way to manage a portfolio?”  There are three significant categories of risk that preclude accurate predicting:

·   Geopolitical – globally

·   Economics – globally

·   The Unexpected Event – globally

We all have opinions, even beliefs about the future but our intellectual and emotional ideas and feelings are far from “bullet proof” when it comes to managing a portfolio.  The best approach is a diversified long term portfolio in the more secure funds.

RULE 9.  DON’T PICK FUNDS FROM THE TOP 10 LISTS

The leading funds in the short term will almost always represent the latest, hottest trend.  A very risky choice.  Doing so often ensures you buy at the highs.  Generally, the best managers start showing up on the 10 year lists.

RULE 10.    CLIENT DRIVEN CERTIFIED FINANCIAL PLANNER

Have an advisor that is a CFP (Certified Financial Planner) and client driven, not product driven – avoid the planner that’ll use financial plans to sell products.

Those are 10 rules we use in working with you.  It makes for a lengthy letter, but we hope you attribute similar importance to the subject as we do.

We hope you had a great holiday.  As the Times Square ball hit the bottom lighting up “2007” we wondered what events the year would reveal.  Whatever it is, we will do our best to protect your portfolio, meet your financial planning needs and give you the service you deserve.  As always, thanks for being the lifeblood of our business.  We wish you and your families the best for 2007.