ibf - updates - 2009 (q4 v1.0)

Copyright © 2010 by Institute of Business & Finance. All rights reserved. v1.0

QUARTERLY UPDATES

Q4 2009

Quarterly Updates

Table of Contents

FINANCIAL PLANNING

HEALTH CARE 1.1

DJIA: OCTOBER 2008 TO OCTOBER 2009 1.1

MARKET LINKED CD EXAMPLE 1.2

COMMODITY LINKED CD EXAMPLE 1.5

THE DOW JONES - UBS COMMODITY INDEX 1.5

DOW JONES - COMMODITY INDEX QUARTERLY FIGURES 1.6

WORLD EQUITY MARKET CAPITALIZATION 1.7

CORRELATION COEFFICIENTS 1.7

STATE DEATH TAXES 1.7

529 PLANS 1.9

REASONS TO OWN FOREIGN SECURITIES 1.9

REDUCING SYSTEMATIC RISK 1.10

MUTUAL FUNDS

ACTIVE MANAGEMENT 2.1

INDEXING VS ACTIVE MANAGEMENT 2.1

WORLD’S LARGEST MUTUAL FUND 2.2

MEASURING AND COMPARING FUND PERFORMANCE 2.2

RETIREMENT PLANNING

ROTH IRA CONVERSIONS 3.1

FIXED RATE ANNUITY RETIREMENT RESEARCH 3.2

A SECURE RETIREMENT USING STANDARD DEVIATION 3.6

ADVANTAGE OF ANNUITIZATION DURING RETIREMENT 3.9

REPLACEMENT RATIO 3.10

THE VALUE OF HUMAN CAPITAL 3.12

BONDS

WHAT HAPPENS WHEN RATES INCREASE 4.1

EMERGING MARKETS DEBT 4.1

TREASURIES VS. INFLATION 4.2

MUNICIPAL BOND SAFETY 4.3

BONDS 4.4

STOCK/BOND CORRELATION AND INDEXES 4.7

BOND SECTOR RETURNS 4.8

EFTS

KEEPING ETF PRICES CLOSE TO NAVS 5.1

THE STRANGE STATE OF EFT EVALUATIONS & RATINGS 5.1

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FINANCIAL PLANNING

FINANCIAL PLANNING 1.1

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IBF | GRADUATE SERIES

1.HEALTH CARE

Health care costs have risen at more than twice the pace of overall inflation since 1990 ,

more than doubling their share of the economy during that period. Even adjusting for the

size of its economy and population, the U.S. spends far more money on health care each

year than any other country in the world. As of 2009, health care spending made up

15.3% of the U.S. economy compared to an average of 8.8% for developed countries.

Under current policies, government spending on health care is projected by the

Congressional Budget Office to rise to more than 18% of GDP per year over the next 75

years; since WWII, the U.S. government has collected tax revenue to finance its entire

budget that has equaled an average of 18% of GDP each year .

DJIA: OCTOBER 2008 TO OCTOBER 2009

The table below shows DJIA numbers from October 1st, 2008 through September 2009.

Over this period, the Dow dropped from its peak of over 14,000 down to 10,000 (October

2008) to its March 2009 low and then back up to 10,000 for the first time (October 14,

2009) since dropping to 10,000 at the beginning of October 2008. The “Losers” figures

show the percentage of DJIA stocks with a negative monthly return; “P/E” reflects the

DJIA price/earnings (source: WSJ Market Data Group). The DJIA hit a closing-day low

point (6,547) on March 9th

, 2009.

Dow: From 10,000 to 6,547 back to 10,000

[October 2008 through September 2009]

Date 10-08 11-08 12-08 1-09 2-09 3-09 4-09 5-09 6-09 7-09 8-09 9-09

Return -14% -5% -1% -9% -12% +8% +7% +4% -1% +9% +3% +2%

Losers ~26% ~31% ~13% ~72% ~68% ~24% ~45% ~26% ~55% ~30% ~74% ~65%

P/E N/A 18.5 18.3 19.3 23.4 25.2 33.4 42.7 12.3 14.8 15.3 15.7


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MARKET LINKED CD EXAMPLE

During the last part of October 2009, Union Bank offered a market-linked certificate of

deposit (MLCD) with the following features:

4-year term (Oct. 28th, 2009 to Oct. 28th, 2013)

4% minimum cumulative return (e.g., worst case, $100k grows to $104k)

80-112%* of S&P 500 growth (dividends not included)

5-7%* quarterly cap rate on gains (but no quarterly cap on downside)

FDIC insured up to $250,000 (includes principal and growth)

note: * means actual rate was determined on Oct. 28th, 2009

The advantage of this investment is your client is guaranteed to earn at least 1% simple

interest each year. There is also the possibility of a return that ranges from 80-112% (a

best-case annualized yield of 15.8% to 20.6%). The disadvantages of this type of CD are:

[1] little, if any liquidity during the four-year hold; [2] any quarterly loss, no matter how great, “stays on the books” until it is fully offset by future quarterly gains; [3] return

potential does not include S&P 500 dividends; [4] annual tax liability (whether gains or

not)—IRS imputes (assumes) a 3.9% growth rate each year and taxpayer must pay taxes

on that 3.9%—if the cumulative return works out to be less, investor is entitled to a

refund; [5] any form of averaging (in this case, quarterly) is usually a negative for

investors; [6] there is little likelihood of capital appreciation of 80-112% for the S&P 500

over any four-year period and [7] this is a note, any eventual gains are taxed as ordinary

income. Each of these points is expanded upon below.

[1] Little Liquidity

The issuer does not intend to make a secondary market and there is no assurance any kind

of secondary market will be developed by anyone. This means if money is needed before

the four-year maturity date, investor will either not be able to tap this source or (if a

secondary market does develop) incur a moderate to severe discount of actual value.

[2] Quarterly Losses

Since there is no downside to a quarterly loss, it could take the investor several quarters

to offset any such loss. For example, during the extremely negative year of 2008 S&P

500 quarterly losses were (dividends excluded): Q1—2008 (-5%), Q2—2008 (-7%),

Q3—2008 (-8%) and Q4—2008 (-23%). None of any quarterly losses for 2007, 2006,

2005 or 2004 even come close to the negatives of 2008; in fact, almost all quarterly

results from 2004 through 2007 were positive . Still, the gains enjoyed during those years

were completely offset by the losses of 2008.


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[3] Dividends Not Counted

Often times, investors are shown a “mountain” chart of total returns (appreciation and

dividend reinvestment) over an extended period of time, such as from 1926 to the present.

This is misleading when used in conjunction with equity-indexed annuities and market-

linked CDs since neither includes dividends. The difference can be profound. For

example, from the beginning of 1926 to the end of 2008, $1 invested in the S&P 500

grew to $2,050 (total return) but only $70.80 (capital appreciation) if dividends were

excluded. This extreme percentage difference should be viewed only as an interesting historical figure since loss of dividends over a 4-8 year period would not be nearly as

dramatic. Still, over time, dividends have averaged about 3.5% per year over the past 80+

years and, therefore, have had a significant impact on overall returns.

[4] Annual Tax Liability

The Union Bank disclosure statement points out that there is a tax schedule for this

investment each year, regardless of performance. The “imputed” rate is 3.9% each year.

Thus, a $100,000 investment in a taxable account would incur a $1,000 federal income

tax liability each year, assuming a 25% tax rate. The investor would also be liable for any

state income taxes (based on the same imputed rate). When the note comes due in four

years, there will be additional tax liability if the investment’s return exceeds its 3.9%

annual imputed growth rate; if growth is below 3.9%, the investor will be entitled to a

refund.

[5] Averaging

There are situations wherein averaging can be beneficial. However, this is usually not the

case. For example, if one compares an equity-indexed annuity (EIA) that includes

averaging with one that does not, upside potential for the EIA without averaging is

typically a third to a half higher than the one with averaging.

[6] Likelihood of 80-112% Cumulative Gain

Since 1970, the best four years in a row for the S&P 500 (appreciation only) were 1995

through 1998 when annual appreciation gains were: +34.1% (1995), +20.3% (1996),

+31.0% (1997) and +26.7% (1998). Adding up just these annual returns results in a

cumulative gain of 112%. Once a bad year is factored in, the results are quite different .

For example, from 1997 through 2000, annual appreciation for the S&P 500 was: +31.0%

(1997), +26.7% (1998), +19.5% (1999) and -10.1% (2000), a cumulative gain of 67.1%.

Few would argue that being in the market from 1997 through 2000 would not have been a blessing. However, 67.1% is a little more than half the 112% cumulative gain of 1995

through 1998 (112%). Still, 67.1% works out to an annualized return of just under 14%.

Thus, there are circumstances wherein return potential for this investment could be quite

attractive.


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[7] Ordinary Income Taxes

The investor needs to be reminded that she is really lending money to Union Bank (via an

FDIC-insured CD). Gains on notes are always taxed as ordinary income, regardless of

holding period or underlying equity link (such as the S&P 500).

Observations

Evaluation of a MLCD is difficult because there is a tendency to forget there is no chance

of a loss if the investment is held to maturity. This means a proper comparison would be with a traditional CD or other high-quality asset with a four-year maturity (e.g., short-

term bond or fixed-rate annuity).

The table below shows cumulative returns for the appreciation (no dividends) of the S&P

500 for the 20 years ending 2008. Even though such figures do not reflect any kind of

quarterly averaging, they should still provide a fairly good idea of the historical return

potential for a market-linked certificate of deposit (MLCD).

S&P 500 Cumulative Appreciation—no dividends [1989-2008]

Year Index Year Index Year Index

1989 27.7 1996 58.1 2003 87.1

1990 25.9 1997 76.1 2004 95.0

1991 32.7 1998 96.3 2005 97.8

1992 34.1 1999 115.1 2006 111.2

1993 36.6 2000 103.5 2007 115.1

1994 36.0 2001 90.0 2008 70.8

1995 48.3 2002 69.0

Using numbers above as a rough guide, the investor would have made more than 1% a

year (the minimum guarantee) if the investment started at the beginning of any year from

1989 through 1997 plus 2001 through 2003 (75% of the time).

Compared to an equity-indexed annuity (EIA) with a 3-5 year holding period and

an annual cap rate of 6-7% (annual reset design), this equity-linked CD investment

looks quite appealing. The EIA has zero downside risk (vs. 4% simple interest for

the MLCD) and an upside potential 7% annualized (vs. 20.6% for the MLCD).


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COMMODITY LINKED CD EXAMPLE

Commodity-Linked CD Example

During the last part of October 2009, Union Bank offered a commodity-linked certificate of deposit (MLCD) with the following features:

4-year term (Oct. 28th, 2009 to Oct. 28th, 2013)

5% cumulative minimum return (e.g., worst case, $100k grows to $105k)

45-60%* rate on gains

FDIC insured up to $250,000 (includes principal and growth)

note: * means actual rate was determined on Oct. 28th, 2009

This MLCD is structured in a fashion similar to the preceding S&P-linked CD example

with the following differences: [1] underlying index is Dow Jones UBS Commodity

Index (DJ-UBSCI), [2] cap on gains is calculated differently and does not use any kind of

averaging (it is a “point-to-point” design), [3] maximum cumulative gain is lower, 45-

60% and [4] IRS imputed interest increases from 3.9% to 4.6%. This commodity-linked

CD could deliver annualized returns ranging from 7.7% up to 9.9%.

THE DOW JONES - UBS COMMODITY INDEX

The index is comprised of 19 physical commodities in five groups (agriculture, energy,

metals, industrial metals and livestock). No one commodity can comprise less than 2% or

more than 15% of the index and no group can represent more than 33% of the index.

Index weightings for each commodity as of early 2009 were:

DJ-UBS Commodity Index Weightings [2009]

Crude Oil (14%) Heating Oil (4%)

Natural Gas (12%) Zinc (3%)

Gold (8%) Sugar (3%)

Soybeans (8%) Coffee (3%)

Copper (7%) Soybean Oil (3%)

Aluminum (7%) Nickel (3%)

Corn (6%) Silver (3%)

Wheat (5%) Lean Hogs (2%)

Live Cattle (4%) Cotton (2%)

Gasoline (4%)


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DOW JONES - COMMODITY INDEX QUARTERLY FIGURES

Qtr. Ending Index Close Qtr. Ending Index Close Qtr. Ending Index Close

Mar—98 106.5 Mar—02 99.6 Mar—06 165.2

June—98 96.6 June—02 99.5 June—06 173.2

Sep—98 90.4 Sep—02 106.3 Sep—06 160.0

Dec—98 77.8 Dec—02 110.3 Dec—06 166.5

Mar—99 81.0 Mar—03 113.2 Mar—07 172.0

June—99 82.6 June—03 115.8 June—07 169.7

Sep—99 92.4 Sep—03 120.9 Sep—07 178.2

Dec—99 92.3 Dec—03 135.3 Dec—07 185.0

Mar—00 98.5 Mar—04 150.8 Mar—08 201.6

June—00 104.8 June—04 144.0 June—08 233.0

Sep—00 107.0 Sep—04 153.2 Sep—08 167.8

Dec—00 114.6 Dec—04 145.6 Dec—08 117.2

Mar—01 105.4 Mar—05 162.1 Mar—09 109.8

June—01 101.6 June—05 152.9 June—09 122.5

Sep—01 95.1 Sep—05 178.2

Dec—01 89.0 Dec—05 171.1

Since this commodity-linked CD has a five-year holding period, consider how often gains

were positive, looking at every five-year rolling period (e.g., March 1998 through March

2002, June 1998 through June 2002, etc.). Out of the 30 possible five-year rolling

periods, commodity gains were positive 26 out of 30 times. The best five-year period was

September 2001 through September 2005 (an 83.1 point gain); this translates into an 87%

cumulative gain (83.1/95.1). However, the CD-linked investor would have had a

maximum cumulative return of 45%-60% (cap rate set by the issuer).

Observations

Often, advisors and clients alike have difficulty in imaging commodity prices going

down over any extended period, but the reality is quite different. For example, the

difference between the table’s starting point (106.5) and the ending point (122.5)

represents a gain of just 15%. The time period is just over 12 years; this translates into an

annualized return of just over 1%. Extreme movements downward have also been

experienced: from June 2008 through March 2009, this commodity index dropped 53%.


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WORLD EQUITY MARKET CAPITALIZATION

Country/Region 2004 mkt. cap. 2009 mkt. cap.

U.S. 51% 42%

Europe 29% 29%

Asia/Pacific 15% 21%

Americas (w/o U.S.) 4% 7%

Africa/Middle East 1% 1%

CORRELATION COEFFICIENTS

Over the long term, different asset categories tend to have predictable relationships

(correlations). For example, U.S. Treasury prices usually move in the opposite direction

of stocks because people buy Treasuries and sell stocks when they are worried about the

economy and do the reverse as they get more optimistic. Over short periods of time,

correlation coefficients can vary wildly.

For example, from the end of July 2009 to November 2009, the U.S. dollar index and

S&P 500 were 60% inversely correlated (71% inverse correlation in October). However,

between January 2007 and the end of July 2009, the correlation was just 2% (an almost perfect “random correlation”).

Over a recent 15-year period (1994-2008), the correlation between oil prices and the S&P

500 ranged from +20% to -20% (random correlation). At extremes, the correlation was

+40% to -40%; in mid-June 2009, the correlation briefly hit +75%.

STATE DEATH TAXES

For 2009, individuals avoided estate taxes if their taxable estate was valued at $3,500,000

or less. At this level, it is estimated just 5,500 estates a year were subject to federal estate

taxation. At the previous $2,000,000 limit, 17,500 estates annually were subject to the tax

(source: Urban-Brookings Tax Policy Center). The figures for state estate and inheritance

taxes vary widely.


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State Estate and Inheritance Taxes

State

Tax

Type Exemption

Max

Rate % State

Tax

Type Exemption

Max

Rate %

Connecticut E $2,000,000 16 New Jersey E/I $675,000/$0 16/16

Delaware E $3,500,000 16 New York E $1,000,000 16

Illinois E $2,000,000 16 N. Carolina E $3,500,000 16

Indiana I $100 20 Ohio E $338,333 7

Iowa I $0 15 Oklahoma E $2,000,000 10

Kansas E $1,000,000 3 Oregon E $1,000,000 16

Kentucky I $500 16 Pennsylvania I $0 15

Maine E $1,000,000 16 Rhode Island E $675,000 16

Maryland E/I $1,000,000/$150 16/10 Tennessee I $1,000,000 9.5

Massachusetts E $1,000,000 16 Vermont E $2,000,000 16

Minnesota E $1,000,000 16 Wash., D.C. E $1,000,000 16

Nebraska I $10,000 18 Washington E $2,000,000 19

Keeping track of constantly changing state death taxes can be difficult. Delaware added

an estate tax in 2009, while Kansas and Illinois were expected to eliminate such a tax in

2009. Eight states have inheritance taxes that are levied on heirs, not estates. In many

states, rates are tied to how closely the heir is related to the now deceased donor. For

example, Pennsylvania taxes children and grandchildren at an almost-flat rate of 4.5%

while more distant relatives pay up to 15%.

Taxpayers who live in states without estate taxes, such as California and Florida, may

face estate taxation if they own property in a state that has an estate or inheritance tax. Such possible taxation is based on “domicile,” a much broader definition than

“residency.” It is possible for someone to have multiple domiciles since domicile may be

determined by where the person votes, has a church or club membership, registers a car

or owns a burial plot. For example, when Campbell Soup magnate John Dorrance died in

1930, both New Jersey and Pennsylvania each collected about $15 million in death taxes.

Advisors may wish to consider a bypass trust for married couples living in a state that

imposes any kind of death tax that has an exemption lower than the federal level. With a

bypass trust, when the first spouse dies, assets go into a trust the surviving spouse can

draw. When the second spouse dies, any remaining assets in the bypass trust pass tax-free

to heirs, thereby preserving the value of both individual exemptions.


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529 PLANS

About 32% of parents’ savings for children’s college expenses put money into 529 plans

during 2009, up from 30% for 2008. Every state except Wyoming offers at least one plan; many states offer more than one plan. Investors are not required to invest in their home

state’s plan. However, by sticking to a plan offered by one’s state of residency, the

investor may be entitled to an upfront state tax deduction.

The most common investments for 529 plans are those tailored to a child’s expected date

of matriculation or the family’s appetite for risk. Under IRS rules, 59 plan investors could

only make one change per year; in December of 2008, the IRS stated plan holders could

now make two changes per year. As of November 2009, four plans (Arkansas, Indiana,

Iowa and Missouri) offered ETFs. Besides generally having lower expense ratios, ETFs

inside a 529 plan are not subject to commissions every time there is a buy or sell.

REASONS TO OWN FOREIGN SECURITIES

The U.S. share of exchange-based global market capitalization has been falling, from

52% at the end of 2001 to 35.2% as of September 2007. As of January 2009, roughly

40,000 stocks traded in foreign exchanges—compared with about 6,000 on the NYSE

and NASDAQ.

At one time, sticking to the domestic market ensured the world's greatest quality of

management, accounting standards, and transparency. But much of the world has caught

up: Today more than 1,500 of the world's largest 2,000 companies are domiciled outside

America's borders, including industry leaders such as Nestlé, Toyota, HSBC, Royal

Dutch Shell, and Samsung.

Investing directly on a foreign exchange is not the only way to gain exposure to international shares, of course. Take American depositary receipts (ADRs), which are

certificates corresponding to a certain number of shares of a foreign company. ADRs

trade on U.S. exchanges providing investors with timely dividend payments and

widespread information, but sticking to ADRs limits your universe to the large,

multinational firms that tend to issue the securities (about 3,200 foreign firms currently

list in the U.S.). ADRs are priced in U.S. dollars, so they mute the effects of exchange-

rate fluctuations—one of the arguments for investing in international stocks.


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While foreign markets have some unique investing risks—some regions are more volatile

and can have the potential for faster gains or losses—they have also been home to some

of the largest returns over specific periods of time.

International markets historically have been much more likely to produce outsized returns

than U.S. stocks—or other assets, for that matter. Fidelity tracked the performance of 17

asset classes—including cash, high-yield bonds, real estate, gold, and stocks of different

sizes and styles—during the 27 calendar years since 1983 (including the first half of 2009). Foreign stocks of one kind or another were the top-performing asset 15 times,

while domestic stock categories generated the best returns only five times. Foreign stocks

were also the worst-performing asset class eight times during that time period.

Of the 50 top-performing stocks in the MSCI All Country World Index through March

31, 2009, 40 were foreign. Foreign countries have a much more favorable

macroeconomic outlook than the U.S.—which could provide the backdrop for greater

stock returns. U.S. GDP is expected to grow 1.5% during 2010, compared with 3.1% for

the overall world economy.

REDUCING SYSTEMATIC RISK

According to The Handbook of Financial Investments (2002) by Frank J. Fabozzi: “For

common stocks, several studies suggest that a portfolio size of about 20 randomly

selected companies will completely eliminate unsystematic risk leaving only systematic

risk (note: the first empirical study of this type was by Wayne Wagner and Sheila Lau,

“The Effect of Diversification on Risks,” Financial Analysts Journal, November-

December 1971). In the case of corporate bonds, generally less than 40 corporate issues

are needed to eliminate unsystematic risk.”

A chart in Fabozzi’s book shows roughly 60% of total risk is 95% eliminated through

the (near 100%) elimination of unsystematic risk. This means that an advisor can

eliminate close to 60% of a client’s stock market risk by avoiding unsystematic risk.

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MUTUAL FUNDS

MUTUAL FUNDS 2.1

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2.ACTIVE MANAGEMENT

A 2009 study by Morningstar concludes: “while about half of actively managed funds

outperformed their respective Morningstar indexes, only 37% did on a risk-, size- and

style-adjusted basis. The numbers are similar for five and 10-year returns.” Funds that

performed in the top 25% over the past three years had much lower risk and volatility

than their peers.

INDEXING VS ACTIVE MANAGEMENT

According to financial advisor William Thatcher, indexing tends to beat active

management in top-performing asst classes and loses to active management in the worst-

performing asset classes. Thatcher believes “in the best-performing asset classes, index

funds are rewarded for purity and active managers are punished for their impurity (many

do not stay true to a particular investment style).” Results of Thatcher’s study (1998 -

2007) show that the benefit of indexing was not consistent over one-year periods. The

results of the Thatcher study were consistent with research done in 1999 by advisors

Steve Dunn and William Bernstein.

Active vs. Index Investing [1998-2007]

Asset Annualized Active Managers

S&P MidCap 400 11.2% 78% underperformed

S&P MidCap 400 Growth 11.1% 72% underperformed

S&P MidCap 400 Value 11.1% 70% underperformed

S&P MidCap 600 Value 9.0% 53% underperformed

S&P SmallCap 600 9.0% 61% underperformed

S&P SmallCap 600 Growth 8.2% 50% underperformed

S&P 500/Citigroup Value 6.6% 46% underperformed

S&P 500 5.9% 60% underperformed

S&P 500/Citigroup Growth 4.8% 35% underperformed

MUTUAL FUNDS 2.2

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WORLD’S LARGEST MUTUAL FUND

As of November 2009, PIMCO’s $186 billion Total Return fund is easily the biggest

mutual fund in the world; it would be the seventh largest fund group (family) in the U.S.

The second largest U.S. bond fund is Vanguard’s Total Bond Market Index at $64 billion.

For a fund that focuses on U.S. Treasuries, a market that exceeds $7 trillion, size is not an

issue for either fund. According to Barclays, the total size of the investment-grade

corporate bond market is about $5 trillion. The Barclays Capital U.S. Aggregate Bond

Index, the fund’s benchmark, has a market value of about $13 trillion (note: PIMCO Total Return’s size represents roughly 1.5% of the benchmark’s market value). The total

amount of global debt is roughly $53 trillion.

MEASURING AND COMPARING FUND PERFORMANCE

Fund advisory services know that past performance is not necessarily indicative of future

returns. The regulatory structure that requires this acknowledgment of future performance

uncertainty is appropriate because: [1] most fund ratings are based primarily on past

performance and [2] the evidence of predictive value in fund ratings is uneven.

Amenc and Le Sourd (2007) found little merit in the fund rating methodologies of

Lipper, Morningstar and Standard & Poor’s. Yet, there is somewhat conflicting evidence.

For example, Morey and Gottesman (2006), arguably the most laudatory evaluation of a fund rating service published in recent years, concluded that the Morningstar rating system, as revised in 2002, predicted relative mutual fund performance within nine

domestic equity fund categories pretty well over the following three years . The

principal change in the Morningstar rating system in 2002 was to switch from a single

domestic equity category to nine categories analogous to the Morningstar style boxes.

A number of studies have found that funds that have performed well in the past tend to

continue to perform relatively well, with some reservations. Past performance may be

useful in selecting the better performers among, say, large-cap growth funds. Of course,

the ratings primarily reflect the recent relative performance of the funds, so it is difficult

to see any need to transform recent fund performance into a rating system. The

transformation may create a salable proprietary product, but it does not necessarily

improve the usefulness of the information delivered to investors. The Morey and

Gottesman results suggest that investors would be as well served with simple past

performance comparisons as with formal ratings.

MUTUAL FUNDS 2.3

QUARTERLY UPDATES


The fact that most fund ratings emphasize performance relative to a peer group of funds

is the most significant weakness of most fund evaluation models. Every investor would

not necessarily have (or want) access to the peer group funds that a fund evaluation

service selects for its comparisons. Furthermore, it is usually possible to invest in an asset

class or category without using any of the funds in a mutual fund peer group. ETFs and

structured notes are alternative vehicles, for example. Even if comprehensive fund peer

group ratings are sometimes useful to investors, the appropriate way to evaluate a fund

varies as costs, fund holdings, fund structures and investors’ objectives change.

To illustrate how an adviser might develop and use detailed fund information effectively,

consider how to enhance an investor’s or an adviser’s understanding of the elements of

fund performance. Even if a fund-rating calculation considers a fund’s ability to do better

than its peers during the most recent bear market, the performance measurement that

dominates most ratings is a single performance number for each fund for each year or

quarter. A breakdown of how and why the performance of the fund was achieved in that

period is a better guide to what the future might hold for that fund than a simple historic

return calculation or a longer-term comparison of returns among a group of funds.

For example, good performance achieved by consistent implementation of a stock

valuation strategy with patient trading is likely to be more sustainable than performance

achieved by a single major allocation shift or by moving from equities to cash and back

again in an attempt to predict market direction. It is essential to look beyond ratings and rankings and into the manager’s actions for better ways to identify funds with superior

investment processes and prospects and to develop comprehensive information that will

improve fund choices. A number of academic studies have shown the following:

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

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

and out of mutual funds.

Portfolio transaction costs for funds exceed the fund’s expense ratio on average, but

funds add value with some of their discretionary transactions. Transactions made to accommodate investor flow into and out of a fund and transactions larger than the

average trade size in comparable competitive funds will hurt performance.

Managers with superior stock selection skills can be identified and their skills persist over

time. Past performance may not be a reliable indicator of future results, but it is not meaningless.

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RETIREMENT PLANNING

RETIREMENT PLANNING 3.1

QUARTERLY UPDATES


3.ROTH IRA CONVERSIONS

Starting January 1st, 2010, an income limit that previously prevented many Americans

from converting their traditional IRAs into Roth IRAs disappeared. If your client’s

household income is more than $100,000 (the previous limit), converting to a Roth will

be an option for the first time. Married couples filing separate tax returns also will now

be able to convert. Listed below are strategies for the advisor’s consideration.

Pay taxes on converted amount

You have to pay income taxes when you convert. For example, a client in the 28% tax

bracket will owe $28,000 (plus state income taxes) on a $100,000 conversion.

Converting may benefit the client in the long run—if a higher tax rate is expected during

retirement. If, like most people, the client is not sure about his future tax rate, consider

converting just part of his traditional IRA to a Roth. Doing so gives "tax diversification"

because some money would be in a Roth and some still in a traditional IRA.

Consider source used for taxes

Stick with the traditional IRA if the client does not have money available outside of the

IRA to pay conversion taxes. Pulling money out of an IRA to cover taxes can defeat the

purpose of making the switch in the first place. By reducing retirement savings, clients

reduce the ability to generate future tax-free earnings on money invested in the Roth. If

under age 59½, amounts pulled out of a traditional IRA to cover taxes may be subject to a 10% IRS penalty.

Two conversion strategies

If the client does not have enough money to pay taxes on all converted assets, or if doing

so would push her into a higher tax bracket, consider converting just part of the

traditional IRA assets. A special option applies only to 2010 conversions; the taxpayer

can elect to evenly divide the tax liability over 2011 and 2012. If tax rates go up in 2011,

this split-year strategy may not be a good idea.

Longer time horizons are better

A conversion may not be wise for clients who expect to withdraw money wit hin five

years. Generally speaking, the client will only be able to withdraw earnings from the

account without taxes and penalties if age 59½ or older and a Roth IRA has been held for

at least five years. Withdrawals of the original conversion amount are always tax-free;

however a 10% early penalty may still apply. The client must be either at least age 59½ or wait at five years after the conversion to make the withdrawal in order to avoid the

10% penalty.


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Heirs can benefit

During lifetime, the Roth IRA client is not subject to RMDs, meaning the entire amount

can be left to someone else. A beneficiary who inherits a Roth IRA may be subject to

RMDs, but withdraw the original conversion tax-free. Earnings are also tax-free,

provided the Roth IRA meets the five-year holding requirement.

FIXED RATE ANNUITY RETIREMENT RESEARCH

Following are summaries of major research studies that demonstrates the important role

of fixed annuities in securing retirement income.

Wharton Financial Institutions

Investing your Lump Sum at Retirement, August 2007

by David F. Babbel

Summary: This essay describes the conclusions from an earlier study as well as findings

by other prominent economists. It concludes that income annuities can provide secure

income for one's entire lifetime for 25-40% less money than it would otherwise cost

an individual, thanks to an insurer's ability to spread risk across large numbers of

people.

The authors note that "...economists have come to agreement from Germany to New

Zealand, and from Israel to Canada, that annuitization of a substantial portion of

retirement wealth is the best way to go. The list of economists who have discovered this

includes some of the most prominent in the world, including Nobel Prize winners.

Studies supporting this conclusion have been conducted at such universities and business

schools as MIT, The Wharton School, Berkeley, Chicago, Yale, Harvard, London

Business School, Illinois, Hebrew University, and Carnegie Mellon. The value of

annuities in retirement seems to be a rare area of consensus among economists."

In the press release accompanying the essay release, Prof. Babbel said: "Our research

shows that only lifetime income annuities can protect individuals in an efficient way

from the risk of outliving their assets and that this simply cannot be duplicated by

mutual funds, certificates of deposit, or any number of homegrown solutions. We

believe we have shown that income annuities clearly should be more widely used, given

that highly rated insurance companies are reliable and inexpensive sources of guaranteed

income streams in retirement."


QUARTERLY UPDATES


Employee Benefit Research Institute (EBRI)

Measuring Retirement Income Adequacy, September 2006

by Jack Van Derhei

Summary: The author notes that for decades "replacement rates" have been the primary

rule of thumb measure used to estimate an adequate level of income during retirement.

Replacement rate is annual retirement income divided by annual income just before

retirement. For example, someone who retires from a job with $100,000 in salary and has $75,000 in retirement income has a replacement rate of 75% (which many financial

planners consider adequate).

A weakness of replacement rate models is that some important retirement risks are not

taken into account, including investment risk, longevity and the risk of potentially

catastrophic health care costs. Taking these risks and inflation into account and using a

Monte Carlo model, the study demonstrates that for most retiree groups, converting

some retirement assets to an income annuity at retirement can lower the

replacement rate needed to achieve a 90% probability of income adequacy. For

example, the study illustrates one example where a 124% replacement ratio, half of

which is provided by an annuity, can have a probability of adequacy, equal to replacement ratios of 148% to 180%, with no annuity purchase and various earnings

assumptions.

Journal of Financial Planning

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

by John Rekenthaler, CFA

Summary: The author educates the financial planning community about pitfalls of

developing retirement income plans based on "average" investment returns. He uses

historical charts to show that, for the retiree making withdrawals from assets, the sequence of the annual returns on those assets can be of greater importance than the

average of those annual returns.

The author makes the case that traditional asset allocation models, used to optimize

accumulations while saving for retirement, do not work for allocating assets during

retirement. In retirement, the asset allocation mix should recognize that a long time

horizon, which is a friend of the young investor, is an enemy of the retiree who needs

income from the portfolio for every year of retirement. Asset allocation models also

need to consider that volatility in portfolio returns, which may average out for

investors accumulating assets, will damage the level of withdrawals that a

retirement portfolio can sustain.


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The author (correctly) predicts that new asset allocation models will be developed for the

asset "draw down" phase to account for the risks that are not present during the asset

accumulation phase.


Making Retirement Income Last a Lifetime, December 2001

by John Ameriks, Ph.D., Robert Veres and Mark Warshawsky, Ph.D.

Summary: The authors explore the sustainability of alternative asset withdrawal plans

using different asset allocation mixes during retirement. The probability of failure of

various plans is examined for various model portfolios ranging from asset allocations

labeled from conservative to aggressive.

An historical chart illustrates that, regardless of the asset allocation strategy, the

withdrawal rates that were sustainable for a full 30 years were between 3 .50% and 5.00%

per year adjusted for inflation. The aggressive portfolio sustained the higher withdrawal

rates for the 30-year period. Looking specifically at a 4.50% inflation-adjusted

withdrawal rate, historical analysis shows that, relative to the conservative portfolios, the

more aggressive portfolios had a higher likelihood of sustaining income for a long

withdrawal period. But even the aggressive portfolio showed a tendency to fail too

frequently to be considered a stable withdrawal plan for a long retirement.

Finally the authors examine whether the purchase of an immediate fixed annuity helps or

hurts the sustainability of the withdrawal plans considered. Using both an historical

analysis and a Monte Carlo analysis, their charts illustrate that for all time periods

and for all investment portfolios in the study, the addition of the fixed annuity leads

to better results. Also provided is a "discussion" of the pros and cons of an immediate

annuity purchase and the factors that should be considered.


Determining Withdrawal Rates Using Historical Data, March 2004

by William P. Bengen, CFP

Summary: The author shows how to use historical performance data to determine "safe"

withdrawal rates and asset allocations during retirement so that retirees do not outlive

their savings. This paper is a reprint of the author's 1994 landmark research on this

subject.


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From the historical data, Bengen concludes the maximum "safe" withdrawal rate is about

4% for the typical retiree of age 60-65 relying on a conventional portfolio of stocks and

bonds. The 4% withdrawal rate is used to calculate the actual withdrawal dollar amount

in the first year of retirement. This withdrawal amount (in dollars, not percentages) is

then increased in each future year for actual inflation. Looking at the historical

evidence, he characterizes 5% withdrawal rates (adjusted for actual inflation) as

"risky" and 6% rates as "gambling."


Merging Asset Allocation and Longevity Insurance, June 2003

by Peng Chen, Ph.D. and Moshe A. Milevsky, PhD.

Summary: MPT is widely accepted in the academic and finance industries as the

primary tool for developing asset allocations. Its effectiveness is questionable,

however, when dealing with asset allocations for individual investors in retire-ment,

because it does not consider longevity risk and the portfolio's random time horizon.

This article reviews the need for longevity insurance (i.e., income annuities) during

retirement and establishes a framework to study the total asset and product allocation

decision in retirement, which includes both conventional asset classes and immediate

payout annuity products. Retirees must make their own decisions on what products

should be used to generate income in retirement. However, there are two important risks

that must be considered when making these decisions:

[1] Financial market risk — the volatility in the capital markets that causes portfolio

values to fluctuate. If the market drops or negative corrections occur early during retirement, the portfolio may not be able to cushion the added stress of systematic

withdrawals. This may make the portfolio unable to provide the necessary income for the

desired lifestyle or it may simply run out of money too soon.

[2] Longevity risk — the odds of outliving one’s portfolio. Life expectancies have been

increasing and retirees should be aware of the substantial chances for a long retirement

and plan accordingly. This risk is further magnified for individuals taking advantage of

early retirement offers or who have a family history of longevity.

The authors claim an optimal asset/product allocation mix in a well-balanced retirement

portfolio is derived from a two-step process. First, a conventional asset allocation process

is used to derive an optimal asset mix (without regard to longevity risk). The product

(i.e., income annuity) purchase decision is then developed after considering the retiree's

bequest motives and health assessments.


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A SECURE RETIREMENT USING STANDARD DEVIATION

Using a 70-90% equity weighting, studies over the past few years recommend an

inflation-adjusted (real) retirement withdrawal rate of 4-6% per year. Pension actuarial

tables show that a 65-year-old client has a 94% chance of living for an additional five

years, 56% chance of making it to age 85 and a 16% chance of living to age 95. All this

translates into a median remaining life expectancy (for someone age 65 and in good

health) of 23 years. The next four tables show the probability of “retirement ruin”

(running out of money before death) based on two remaining life expectancies (23

and 35 years) and two different annual withdrawal (spending) rates (4% and 8%).

All of the four tables below share the following characteristics: [1] a mortality rate is

assumed (note: by using real world mortality rates, the probability of outliving one’s

income decreases), [2] a median life expectancy (withdrawal period) is assumed, [3] rates

of return adjusted for inflation are listed (1-10%), [4] failure rates (probability of

outliving one’s nest egg) are defined as having a zero account balance before death and

[5] standard deviation ranges (5-25%) are provided so the advisor can select higher

equity exposure and/or greater weighting to small cap and emerging markets (in return

for accepting more volatility).

The first table makes the following assumptions: 8% withdrawal rate, 23-year life

expectancy and 3% annual mortality rate. Assuming a balanced portfolio of stocks and

bonds that returns 5% annually (inflation-adjusted), there is a 46% chance that the client will completely delete their nest egg, assuming a portfolio standard deviation of 10%; if

the volatility changes from 10% to 20%, the chance of running out of money increases to

63%. Thus, all other inputs being equal, the greater the standard deviation, the more

likely the investor will use up 100% of principal. On a somewhat similar note, the higher

the portfolio’s expected return, the lower the failure rate (since 8% is being withdrawn

each year).


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

Mortality: 3% a year Median Life Expectancy: 23 years

Annual Withdrawal Rate: 8%

---------------------- Portfolio’s Standard Deviation ----------------------

5% 10% 15% 20% 25%

Return

1% 83% 84% 87% 90% 93%

3% 63% 67% 72% 78% 84%

5% 41% 46% 54% 63% 71%

7% 23% 29% 37% 47% 57%

10% 7% 11% 18% 27% 38%

The next table is based on the same assumptions as above, except life expectancy is

increased from 23 to 35 years (and annual mortality drops from 3% to 2% per year). As

you can see, the failure rate increases, regardless of standard deviation, due to the

lengthened period of time (and lesser chance of death). If the portfolio returns 7% a year

(adjusted for inflation) and has a standard deviation of 15%, the probability of outliving

one’s nest egg is 49% if a balanced portfolio is used.





5% 10% 15% 20% 25%

Return

1% 96% 95% 96% 97% 99%

3% 82% 83% 85% 88% 92%

5% 57% 62% 68% 75% 81%

7% 32% 39% 49% 58% 68%

10% 8% 14% 23% 35% 46%


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The next table also assumes a 35-year withdrawal period, but a withdrawal rate that has

been cut in half—from 8% to 4% per year (inflation adjusted). As you can see, the

probability that the portfolio will run out of money over these 35 years is lessened.





5% 10% 15% 20% 25%

Return

1% 60% 67% 76% 85% 94%

3% 25% 35% 48% 62% 76%

5% 7% 13% 24% 39% 55%

7% 1% 4% 10% 21% 36%

10% 0% 0% 2% 7% 16%

The final table has the same assumptions as above, but life expectancy has been reduced

from 35 to 23 years. Again, because of the shorter expected period, the chance of failure

(outliving one’s nest egg) drops (source: Moshe A. Milevsky, 2007). Keep in mind that

the withdrawal rates used in all four of these tables are adjusted for inflation. Thus, if the

projected return is 7% and inflation is expected to be 3%, the assumption is the gross

return is 10% (but the 7% “Return”) row is being used (since “Return” numbers in all

four tables have already been adjusted for a 3% inflation rate).


QUARTERLY UPDATES






5% 10% 15% 20% 25%

Return

1% 37% 45% 66% 68% 80%

3% 15% 22% 32% 46% 60%

5% 5% 9% 16% 27% 42%

7% 1% 3% 7% 15% 27%

10% 0% 1% 2% 5% 12%

ADVANTAGE OF ANNUITIZATION DURING RETIREMENT

If a 65-year-old investor annuitizes 100% of a portfolio, the chances of outliving the nest

egg drop from 41% down to 21%, a reduction of just under 50%. The reason

annuitization helps is that it takes part of one’s portfolio and creates a “mortality

subsidy,” thereby increasing investment return (source: Milevsky, The Implied Longevity

Yield, 2005). The mortality subsidy works as follows: A large group of retirees, all the

same age and each subject to the same risk of death, pool their nest egg into one large

portfolio. Each member of the pool takes out exactly the same amount each year. As

members in the pool die off, survivors receive a higher payout (fewer members making withdrawal). The amount distributed to each living member is the sum of expected

investment return plus the mortality rate.

There is also the option of using a fixed-rate annuity that includes a cost-of-living provision. However, there are few insurers that a competitively priced annuity that

includes an annual inflation adjustment. For example, one company offered $685 a

month for a man age 65 with a single premium payment of $100,000. The same company

lowered the amount from $685 down to $502 with a CPI adjustment ($183 a month

difference). If inflation were to average 3%, it would take more than 10 years for the

$502 payment to get to $685 per month. Moreover, this calculation does not take into

account what the monthly difference could grow to (note: an annually declining

difference due to increased payments from the CPI-adjusted annuity).


QUARTERLY UPDATES


Another way to protect downside risk is to purchase put options on all or part of the

equity portion of the portfolio. Still another method is to use a variable annuity with a

living benefit feature.

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

Age at Retirement

Median Age at Death

Annual Mortality Rate

Ruin Probability with

Life Annuity

Ruin Probability w/o Life Annuity

50 78 2.5% 34% 53%

55 83 2.5% 34% 53%

60 83 3.0% 28% 48%

65 84 3.7% 21% 41%

70 85 4.7% 13% 33%

75 86 6.5% 6% 24%

80 87 9.4% 2% 14%

REPLACEMENT RATIO

One way advisors view a client’s retirement income needs is to use the expense-method

approach (projected expenditures during first year of retirement). What is not often considered is the fact that expenses generally decline as the client ages. The table below

is based on data from the Consumer Expenditure Survey. As you can see from the table,

expenses in all categories except health care decline once the client reaches age 75 and

older.


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

Expense Age 65-74 Age 75+ Change

Food $5,779 $3,970 -$1,809

Housing $12,027 $9,678 -$2,349

Apparel $2,160 $1,256 -$904

Transportation $8,185 $5,428 -$2,757

Health Care $2,385 $3,189 $804

Entertainment $2,108 $1,027 -$1,081

Insurance/Pensions $4,540 $2,678 -1,862

Total $43,967 $36,825 -$7,142

A shortcoming of several retirement income models is that they do not factor in

long-term care insurance. This type of coverage can greatly reduce the cost of nursing

home care (thereby bringing down projected expenditures for health care).

The financial planning community estimates a retiree’s expenses will drop by about 20%

upon retirement; the client who used to spend $80,000 annually will spend approximately

$64,000 during the initial years of retirement. Because one’s expenses generally decline by about 20% (from age 65 to 75+), the replacement ratio can also be adjusted

downward.

For example, with an initial replacement ratio of 80%, the rate used by the advisor

should be 70%, assuming the client has a remaining life expectancy of 25 years. The

reduction is due to a “blending”—the initial rate combined with the lower rate as one

ages. If the advisor assumes a replacement rate of 75%, then the blended rate for

remaining life expectancy (of 15 years) can be reduced to 70%; if the client has a

remaining life expectancy at age 65 of 30 years, the blended rate drops to 65%. By using

a blended replacement ratio (vs. traditional replacement ratio), a smaller nest is needed

for the 65-year-old retiree.


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Blended Replacement Ratios

Life

Expectancy

80%

Rate

75%

Rate

70%

Rate

65%

Rate

10 years 80% 75% 70% 65%

15 years 75% 70% 65% 61%

20 years 72% 68% 63% 59%

25 years 70% 66% 62% 57%

30 years 69% 65% 61% 57%

THE VALUE OF HUMAN CAPITAL

What is almost always left out of portfolio diversification discussions is the value of

human capital. As an investor begins his working career, there is a present value

that can be assigned to lifetime paychecks. That present value figure increases as the

client becomes more valuable in the workplace, receiving raises along the way.

Several years before retirement, the present value figure can begin to decline (e.g., forced

retirement, health problems, layoffs, etc.).

Including “human capital” as part of an investment portfolio means two things: [1] diversification has relatively little importance during the early years and [2] savings from

human capital can make up for portfolio losses in the early years. The table below is an

example of how human capital might be incorporated into the portfolio.

Human Capital and the Financial Portfolio

Age Human Capital Financial Assets Total

22 $705,000 $0 $705,000

32 $871,000 $62,000 $933,000

42 $1,003,000 $206,000 $1,209,000

52 $988,000 $518,000 $1,506,000

62 $551,000 $1,171,000 $1,722,000

67 $0 $1,722,000 $1,722,000

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BONDS

BONDS 4.1

QUARTERLY UPDATES


4.WHAT HAPPENS WHEN RATES INCREASE

For every one point rise in interest rates, the price of a 10-year Treasury decreases by

8.5%; a rise of two percentage points would chop a 10-year Treasury bond’s current

value by 17% (source: Barclays Capital). In the case of a high quality taxable bond fund

with a 22-year average maturity, a two-percentage point increase would decrease the

fund’s NAV by 22%; just 3.9% if the fund’s average maturity was 2.6 years (source:

Morningstar).

According to a study by David Babbel of Wharton, stable-value funds averaged 6.3%

annual returns over the 20 years through 2008, versus 4.1% for money market funds and

5.7% for the Barclay’s index for intermediate-term corporate and government bonds.

EMERGING MARKETS DEBT

According to Morningstar, there were 31 mutual funds and ETFs emerging market bond

funds. In contrast, there were 141 funds and ETFs within the emerging market stock

category, as of October 2009.

Emerging market bond mutual funds are generally less volatile than emerging market

stock funds because interest payments help smooth out overall returns. Over the past 15

years ending March 31st, 2009, diversified emerging market bond funds suffered double-

digit losses in 12 rolling three-month periods (12 out of 58 such periods). This compares favorably to emerging market stock funds, which suffered double-digit declines in 33

rolling-three month periods (33/58). In some cases, there were distinct differences in

decline severity. For example, emerging market bonds dropped 11% in 2008 while

emerging market stocks tumbled 53%. For the 10-year period ending September

2009, emerging market bonds had average annual returns of a little more than 11%,

compared with 3% for emerging market stocks.

Another notable difference between emerging market bond and stock funds is regional

exposure. While both types of funds typically provide significant exposure to Brazil,

Mexico and Russia, emerging market bond funds generally provide less exposure to

Asian countries such as China, South Korea and India. Conversely, emerging market

bond funds may provide exposure to "frontier" countries (e.g., Venezuela), places where

emerging equity funds may not invest.

BONDS 4.2

QUARTERLY UPDATES


The table below shows bond and stock returns for 2008 and the first three quarters of

2009, ranked from lowest (U.S. investment-grade bonds) to highest volatility (foreign

stocks). In the case of fixed income, emerging markets bond funds are second only to

domestic high-yield bonds when it comes to volatility.

Total Return Figures for 2008 and first three quarters of 2009

Security

2009 YTD

(9/30/09) 2008

Short-Term Bonds 0.2% 2.2%

U.S. Investment-Grade Bonds

Intermediate Government 0.1% 10.4%

Municipal 14.0% -2.5%

Corporate 14.9% -3.1%

Foreign Bonds

Developed Markets 9.5% 1.7%

Emerging Markets 26.3% -10.9%

U.S. High-Yield Bonds 49.1% -26.1%

S&P 500 19.3% -37.0%

MSCI EAFE Index 29.1% -43.3%

TREASURIES VS. INFLATION

The table below shows the cumulative effects of inflation on 30-day Treasury Bills

(“cash equivalents”) and 20-year Treasury Bonds over the 20-year period ending

December 31st, 2008. The base year is 1989; yields for each subsequent year (for the T-

bill and T-bond columns) reflect the actual annual yield and what the yield would have

been, adjusted for inflation.

For example, in 1989, T-bills had an average yield of 8.4% for the year; for 1990, a CPI-

adjusted yield would have resulted in a yield of (8.4% x 1.061). For 1991, the CPI adjustment would have resulted in an annual yield of (8.4% x 1.061 x 1.031), reflecting

the cumulative effects of inflation since 1989. This process is repeated for each

subsequent year, up through the end of 2008. The table considers only yield, not total

return (note: total return and yield would be the same each year for T-bills). As you can

see, in order to maintain 1989 purchasing power for 2008, a T-bill would have had

to be yielding 14.0% by the end of 2008 (vs. its actual yield of 1.6%).

BONDS 4.3

QUARTERLY UPDATES


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

Year Inflation

(CPI)

T-bill yield

(CPI adjusted) T-bond yield

(CPI adjusted)

1989 4.7 8.4 (base yr.) 8.2 (base yr.)

1990 6.1 7.8 (8.9) 8.4 (8.7)

1991 3.1 5.6 (9.2) 7.3 (9.0)

1992 2.9 3.5 (9.5) 7.3 (9.2)

1993 2.8 2.9 (9.7) 6.5 (9.5)

1994 2.7 3.9 (10.0) 8.0 (9.7)

1995 2.5 5.6 (10.2) 6.0 (10.0)

1996 3.3 5.2 (10.6) 6.7 (10.3)

1997 1.7 5.3 (10.7) 6.0 (10.5)

1998 1.6 4.9 (10.9) 5.4 (10.7)

1999 2.7 4.7 (11.2) 6.8 (10.9)

2000 3.4 5.9 (11.6) 5.6 (11.3)

2001 1.6 3.8 (11.6) 5.7 (11.5)

2002 2.4 1.6 (12.1) 4.8 (11.8)

2003 1.9 1.0 (12.3) 5.1 (12.0)

2004 3.3 1.2 (12.7) 4.8 (12.4)

2005 3.4 3.8 (13.1) 4.6 (12.8)

2006 2.5 4.8 (13.5) 4.9 (13.1)

2007 4.1 4.7 (14.0) 4.5 (13.7)

2008 0.1 1.6 (14.0) 3.0 (13.7)

MUNICIPAL BOND SAFETY

Despite severe economic troubles, there have been no investment-grade defaults during

the past year (2008), and there were none in the previous 30 years. Defaults can occur,

but they almost never do, for investment-grade bonds (i.e., rated BBB/Baa or above).

BONDS 4.4

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BONDS

Advisors and clients expect stocks to outperform bonds over any reasonably long period

of time. Sometimes this is not the case, particularly if very specific dates are selected. For

example, from the beginning of 1968 to the beginning of March 2009, $1 invested in the

S&P 500 grew almost 26-fold, versus an over 29-fold increase for 20-year U.S.

Government bonds (dividends and interest payments reinvested). In addition to this 41 -

year span, bonds also did better than stocks for the 20-year span from 1929 through 1949

and for the 68-year period from 1803 through 1981. When the periods are not “cherry picked,” total return figures are much different.

From 1802 to February 2009, stocks returned about four million times one’s initial

investment, versus 27,000 times one’s initial investment for the long -term

government bond investor. This difference works out to a difference of 150 to one;

surprisingly, this 150-fold relative wealth translates into just a 2.5% per year advantage

for the stock investor. Even though 2.5% compounded over well over 200 years results is

quite a difference, the performance line has been quite jagged:

From 1803 through 1856, stock investors ended up with 1/3rd the wealth of a bond-holder (it

was not until 1871 that the stock investor caught up);

From 1857 until 1929 (72 years) stock investors beat out bond investors;

The 1929 to 1932 crash resulted in stock investors trailing bond investors on a cumulative basis until the early 1950s (20 years);

From 1932 until 2000, stocks outperformed bonds by quite a large margin and

From the peak in 2000 to the end of 2008, the equity investor lost nearly 3/4th of his wealth, relative the to bond investor.

It can take tremendous patience to be invested in stocks: from 1926 through February 2009, stocks spent 173 out of 207 years (84% of the time) either dropping from old highs or recovering past losses—and that only includes periods of 15+ years for stocks to reach a new

high and

When looking at real returns (adjusted for inflation but not income taxes), the 1965 peak for the S&P 500 was not surpassed until 1993 (28 years).

The 1802 stock market peak was first surpassed in 1834, a 32-year period that included a

12-year bear market period when stocks suffered a cumulative loss of over 50%. The

peak of 1802 was not convincingly surpassed until 1877; by the 1929 peak, the 1802 peak

had been surpassed by a five-fold increase.

BONDS 4.5

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The 1929-32 market crash resulted in a cumulative drop in stock appreciation that,

adjusted for inflation, briefly fell below 1802 levels. It is hard to imagine that there was a

130-year period when U.S. stocks experienced a return of zero (note: none of these

figures include the impact of dividends). Still, stock investors were able to use their

dividends. The bear market of 1982 saw S&P 500 share prices fall below their inflation-

adjusted levels first reached in 1905—a 77-year period with no price appreciation.

There are a number of conclusions that can be reached from all of this historical stock analysis (again, the slant of the study is negative for stocks):

[1] Looking forward, a 2.5% excess annual return for stocks over bonds appears to be more appropriate than the 5.0% figure used in the past.

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

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

BONDS 4.6

QUARTERLY UPDATES


During September and October 2008, 16 different asset categories suffered losses ranging

from less than 1% to over 41% (source: Research Affiliates), as shown in the following

table:

September and October 2008 Asset Class Returns

Asset October Monthly

Rank Since 1988

2-Month

Return

MSCI Emerging Equity Index 2nd worst -41%

MSCI Equity Index worst -32%

FTSE NAREIT All REITs Index worst -30%

DJ-AIG Commodities Index worst -30%

Russell 2000 Equity Index worst -30%

S&P/TSX 60 Index worst -28%

ML Convertible Bond Index worst -27%

S&P 500 Index worst -25%

Barclays U.S. High Yield Index worst -23%

JP Morgan Emerging Market Bond Index 2nd worst -21%

Barclays Long Credit Index worst -19%

Credit Suisse Leveraged Loans Index worst -17%

JP Morgan Emerging Local Markets Index worst -12%

Barclays U.S. TIPS Index worst -12%

Barclays Aggregate Bond Index 4th worst -4%

ML 1-3 Year Government/Credit Index 29th worst -0.6%

Based on available historical data, losses from all 16 of these asset categories for the

same month never occurred—until September 2008. October 2008 was the worst single

month in 20 years for 3/4th

of the 16 asset categories shown. For most of these assets,

October 2008 was the single worst month ever recorded. The next table shows how selected market indexes fared (source: Research Affiliates).

BONDS 4.7

QUARTERLY UPDATES


For the 20-year period 1989-2008, the MSCI Emerging Markets Index had a monthly loss

of 10% or more 18 times, compared with four times for the S&P 500.

2008 Selected Market Returns

Asset 2008

20-30 Year Treasury STRIPS +56%

Barclays Capital U.S. Aggregate (bonds) +5%

1-Year Treasury Bill +3%

HFRI Composite Fund of Funds Index -21%

HFRX Global Hedge Fund Index -23%

S&P 500 -37%

MSCI EAFE -43%

S&P GSCI -47%

MSCI Asia Pacific ex Japan -50%

MSCI Emerging Markets -55%

HFRX Convertible Fixed Arbitrage Index* -58%

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

STOCK/BOND CORRELATION AND INDEXES

From 1969 to 2009, the classic 60/40 (stock/bond) balanced portfolio had a 98%

performance correlation to stocks, with 38% less risk. A 40% allocation to T-bills instead

of bonds would have also resulted in significant risk reduction (but with returns

averaging 1.4% less per year).

Bond indexes can have shortcomings, just like stock indexes. For example, there was a

time when Cisco represented 4% of the S&P 500, even though it had just 20,000

employees worldwide. During the same period, Nortel stock represented more than 30%

of the Canadian market. In the case of bond indexes, GM and Ford bonds together

comprised 12% of the U.S. High-Yield Bond Index in 2006.

BONDS 4.8

QUARTERLY UPDATES


BOND SECTOR RETURNS

The table below shows returns for different bond categories for 2008 and the first nine

months of 2009 (source: Barclays Capital).

Bond Sector Performance

Category 2008 2009

Treasury Securities 13.7% -2.3%

TIPS -2.4% 9.5%

GNMA Securities 7.9% 5%

Corporate Bonds—investment grade -3.1% 14.9%

Corporate Bonds—high yield -26.2% 49.0%

Municipal Bond -2.5% 14.0%

QUARTERLY UPDATES


QUARTERLY UPDATES

EFTS

ETFS 5.1

QUARTERLY UPDATES


5.KEEPING ETF PRICES CLOSE TO NAVS

ETFs usually trade at market prices that are close to the underlying NAVs of their

portfolios because large institutional investors [called Authorized Participants (APs)] can

use arbitrage to profit from any difference between the fund's price and its NAV.

Let's say an ETF has a NAV of $20 per share but is trading at a market price of $19.80—

a 1% discount to NAV. The AP can buy 50,000 ETF shares, deliver them to the ETF sponsor, receive shares of the underlying stocks or bonds equivalent to 50,000 ETF

shares and sell those securities on the open market. This nets a profit of 1% for the AP

and also pushes up the market price of the ETF. The AP will keep doing this until the

price equals the NAV.

If the ETF is trading at a premium to its NAV, the AP will buy shares of the underlying

stocks or bonds, give them to the ETF sponsor in exchange for new ETF shares and sell

those ETF shares on the market, pushing the price back down toward its NAV. Howe ver,

if the stocks or bonds become difficult to trade on the market because other buyers and

sellers are nervous, it may be difficult for the AP to engage in this arbitrage trading,

meaning prices and NAVs can diverge.

THE STRANGE STATE OF EFT EVALUATIONS & RATINGS

ETF comparisons tend to focus much more heavily on fund expense ratios than most mutual fund evaluations do. This is puzzling because index ETF expense ratios vary less

from fund-to-fund than mutual fund expense ratios. The emphasis on ETF expense ratios

is partly the result of the ready availability of this measure. The expense ratio is one of

the first things an investor sees when she examines the ETF’s Fact Sheet. Another reason

for focusing on the ETF expense ratio is probably that, while mutual funds often have a

number of share classes and fee structures, ETFs charge every investor the same fee.

Because ETF expense ratios tend to be lower than mutual fund expense ratios, expense

ratios have been emphasized by ETF proponents in making the case for ETFs. However,

the reality is that expense ratios are often lower than trading costs due to index

composition changes.

ETFS 5.2

QUARTERLY UPDATES


As ETF trading volume has expanded, there has been increased emphasis on comparing

EFT bid/ask spreads. The message investors receive from the focus on the bid/ask spread

is the obvious one: a narrow spread is better than a wide spread when trading. This point

is indisputable; but the numbers cited for an ETF’s average spread usually understate the

spread an investor will encounter when she checks a live quote. Furthermore, for a long-

term investor, the spread is paid only twice—once when she buys the shares and once

when she sells them. The cost to trade ETF shares is important for a number of reasons,

but trading cost will rarely be a make-or-break item for a long-term investor.

Another characteristic of ETF evaluation that differs strangely from mutual fund

evaluation is that a great deal of attention is paid to ETF tracking error—a measure of the

relative performance of the fund and its benchmark index. It gets a lot of attention

because it is relatively easy to measure, but most fund raters are not sure what to do with

it.

The approach most fund analysts take in evaluating ETFs and their managers is

qualitatively as well as quantitatively different from the approach they take to mutual

funds. Most ETFs are index funds ; index fund managers have yet to capture the

imagination of fund analysts and investors in the way that some active managers have

done. Trading transparency around index composition changes is usually a more costly

drag on fund performance than most of the features ETF analysts stress in their

comparisons. Furthermore, an index fund manager who trades away from the official index change date can improve the fund’s return.

ibf - updates - 2009 (q4 v1.0)

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