Sector Performance Report 12/31/06

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Market Summary

2006 turned out to be a terrific year for most investors. Stocks rose more than Wall Street analysts predicted after the Fed. halted 2 years of interest rate increases while energy prices fell 22% from their high in July. The S & P 500 was up 14%, the Dow Jones Industrial Average was up 16% and the NASDAQ moved up 9% for the year. Overall, the equities market performed remarkably well in spite of pressures from higher interest rates and energy prices.

In writing this newsletter, I reviewed my predictions from last year and would like to report the results. I suggested large cap stocks with high dividends or “value stocks” would have a big year. In fact, this asset class was up 23%. I also suggested the Fed would stop raising rates after another 1/2% increase. The Fed did stop, but not until after raising short-term rates another 1%. I suggested the energy and real estate sectors were due for a correction. I was way off here. The energy sector posted a strong 21% return beating the S & P 500 by 7%.

The real estate market was mixed. Commercial real estate continued to post excellent returns while residential real estate fell considerably. As for mortgage rates, I predicted a 1/2 % increase in rates. As predicted, 30 year fixed rates mortgages did increase from 6.25% to 6.75%; however, they came back down to 6.25% ending the year where they started.

For the record, my predictions are done mainly for sport. Predicting short term economic trends is more luck than skill and my predictions should not be acted upon at home. Market timing should never be substituted for sound asset allocation and rebalancing strategies.

Expectations for 2007 That thought in mind, let’s see what may be in store for 2007. As the current economic cycle matures, I expect larger stocks to perform better. This sector has been an underperformer since the late 90’s and is due for a good year. 2007 may be the year the S&P 500 and Large Cap growth stocks out perform all other asset classes. I also expect Healthcare and Financials to be in the top US sectors. As for rates, the market is pointing to a 50 basis point drop by the Fed and mortgage rates to lower by about 1/2%

Book Review: The Alchemist

The Alchemist: A Fable About Following Your Dream by Paulo Coelho

Paulo Coelho's enchanting novel has inspired millions of delighted readers around the world. This story, dazzling in its simplicity and wisdom, is about an Andalusian shepherd boy named Santiago who ventures from his homeland in Spain to North Africa in search of a treasure buried in the Pyramids.

Along the way he meets a beautiful, young gypsy woman, a man who calls himself a king, and an alchemist, all of whom point Santiago in the direction of his quest. No one knows what the treasure is or if Santiago can surmount the obstacles along the way through the desert. But what starts out as a boyish adventure to discover exotic places and worldly wealth turns into a quest for the treasures only found within.

Lush, evocative, and deeply humane, Santiago's story is an eternal testament to following our dreams and listening to our hearts. - Taken from www.santjordi-asociados.com

This is an excellent little book about following your heart. Read it with your children and enjoy a wonderful fable. –Michael Rebibo

Retirement Planning

Does Your 401(k) Plan Have All the Elements of a Successful Retirement Plan?

Planning and saving for retirement is a major financial issue for most Americans. We spend decades worrying about whether or not we will have enough money saved for the goal of being financially independent. One of the best tools to improve our odds of successful retirement is our company retirement plan. Since most companies today offer only defined contribution plans (primarily 401(k) and Simple Plans), we will focus on the key aspects of successful defined contribution plans. This is written for the plan sponsor/trustee, usually the owner or top executive in smaller businesses or the human resources director in larger organizations.


The key elements of a successful Retirement Plan are as follows:

Compliance: A successful retirement plan is in compliance with all necessary testing and government filings, distributes all legally required information to participants first and is administered exactly as the plan document is written. The fiduciaries of the plan, the trustees, members of the plan committee and members of the board of directors, meet the fiduciary requirements mandated under ERISA, the federal law that regulates retirement plans. Fiduciaries must exercise the “care, skill, prudence, and diligence” of an experienced fiduciary in fulfilling his/her duties. Fiduciaries are responsible for what they “should know” about investments-as opposed to what they actually know. More than one court has said, “A pure heart and empty head are not enough”. All plans should have an Investment Policy Statement which will assist the fiduciaries in meeting these stringent requirements.

Participation: This is the litmus test for a successful 401(k) plan. Average participation rates vary by industry and wage levels. The overall participation rate across all industries is about 75%. A successful plan will have higher than average participation rates.

Savings Percentage: The more money people put aside in their 401(k), the greater their chance for a secure retirement. Also, the higher the rate, the easier it is to pass discrimination testing. The overall average employee deferral percentage is between 6% and 8%.

Asset Allocation/Investment Selection: A 401(k) is fundamentally a long term savings and retirement plan. The difference between 6%, 8% and 10% rate of return over 20-, 30- and 40- years can be enormous. Asset allocation, or the relative percentage a participant puts into cash, bonds, and stock, is the fundamental investment decision and can have a huge impact on the funds available for retirement. Each plan must have the appropriate investment classes available to meet the Prudent Investor standards.

Investment Performance: In addition to having the appropriate investment options, the absolute and relative performance of the investments must be monitored at least annually against the appropriate benchmarks. In addition, high cost plans drain away returns from participants’ accounts.

Costs and Administrative Efficiency: It is the plan sponsor’s fiduciary duty to insure that the fees of the plan are “reasonable”. Many plans have fees buried inside the underlining mutual fund investments that increase overall fund costs. In order to know whether or not a plan's costs are reasonable, the plan sponsor must know what the actual costs are. This requires some due diligence on the part of the sponsor. An annual review of plan expenses will assist in determining reasonability.

Ask yourself the following questions:

1. Was your retirement plan provided to you by an objective party other than an insurance company, investment brokerage house or other commission oriented firm?

2. Are you happy with the performance of the funds in your plan? Are you or your investment advisor able to select from the best funds available in the market today? Are you or your advisor reviewing the performance of your funds and comparing them to their corresponding bench marks on an annual basis?

3. Have you reviewed the total costs of your retirement plan, both disclosed and undisclosed?

4. Does your retirement plan provider acknowledge the fiduciary responsibility under ERISA sections 3(38) and 405(d)(1)?

5. Is your overall participation rate in excess of 75%?

6. Is your overall savings rate in excess of 6%?

7. Does your plan have an Investment Policy Statement? Is this reviewed annually?

If you answered no to any of the above questions, consider having 1st Portfolio provide you or your company with a qualified plan review. We help plan sponsors make their plans more successful by increasing participation and savings rates and helping participants allocate their assets in an age and risk-appropriate manner. We also assist plan sponsors in meeting their fiduciary obligations by assisting them with the investment selection and monitoring process as well as in controlling and lowering the total cost of the plan. We provide our business services in a transparent manner openly discussing our fees and avoiding any real or perceived conflicts of interest. We act as fiduciaries to the plan, always keeping the interests of the participants and their beneficiaries as our top priority.

Children & Money: Instill the Value of a Dollar at an Early Age

Most children today do not actually know where money comes from. Think about how different the world is from our childhood. While technology has greatly simplified our monetary transactions, it has created a significant disconnect for our children. Items are seldom purchased with cash; rather we use a magical plastic card to fulfill their material wants. Paychecks are deposited automatically into banking accounts, while money appears to be earned simply by typing a secret code into an Automated Teller Machine. Bills are paid electronically or automatically. To top it all off, there is very little taught in school on the subject of money. How are our children to learn?

When my son was five, we ordered him a scooter off the internet. As soon as I completed the transaction, he sprinted down to the mailbox to look inside. He came back disappointed to learn that the scooter had not magically appeared in the mailbox. I had to explain not only how the financial transaction occurred, but also how the order was fulfilled and then eventually mailed to our home. The instant gratification world our children and most of us live in does not prepare us for the long-term focus required to manage our money and create wealth and prosperity.

What can we do? Here are a few ideas to get you started:

1. Break the spending habit.

2. Explain how money flows through the economy. For example, “Our money is earned by creating some sort of value in our community. The greater the value created, the greater the money earned. This money is generally deposited directly into our account via electronic credits. Some of the money earned is immediately saved in a different investment account for our future. Some of the money is given to our favorite charities and/or our religious organizations. What is left is ours to spend on our way of living. We use credit cards to buy things but pay them off each month with the money we earn. If we spend too much, we have to pay the credit card company interest. This makes it harder for us to pay our expenses the next month”.

3. Consider replacing the allowance, an “entitlement concept”, with specific payments for specific services. In other words, let them earn their “allowance”. One of my clients implemented this with his children. The children asked if they were able to reduce the household utility bills by a percentage, could they keep 50% of the savings. Although the kids wanted to eat dinner in the dark and kept turning the lights out on their parents, they were able to cut the bills by $30 per month and kept $15 for themselves!

4. Open a savings account with their money. You can take them down to the local bank or better yet, open a mutual fund.

5. Teach them about interest and compounding! After completing the above step, your children will truly begin to understand this.

6. With the exception of birthdays and holidays, require your children to buy all or part of the items they really want. Teaching your children to earn money and buy the things the want will help them to develop the skills that will last them a lifetime.

7. Suggest they begin giving some of their savings to charity. If possible, let them experience your giving directly.

8. Teach them that it’s a “round world” that we live in. The more you give, the more get. Another similar concept is to “Pay it Forward”.

9. Together, learn how to sell things on eBay. This will provide them with many valuable tools that will help them in the future.

10. Teach them the importance of planning for their future. As we all know, a failure to plan is a plan to fail. Encourage them to save money for their future. If they are old enough to earn money outside the home, have them open a Roth IRA. Have them save up for the really big things they want. If you have your child save up for that new X-Box, they will develop a sense of accomplishment, take better care of their belongings and begin to appreciate the value of a dollar.

Market Summary

The legendary Dow Jones Industrial Average Index reached a record high of 11,750 in September. It reached this magical peak only for a few seconds during the day and closed below the record. In fact, if you take inflation in to account, we are still a long way from a record. The DJIA index would need to be around 13,000 if you adjusted for inflation. You need to go back to January of 2000, during the peak of the dot com era, to find the market in a similar range. Today’s record comes with an abundance of caution. Investors and consumers share concerns over the high cost of energy, the war in Iraq and a weakening real estate market that threatens to knock the footings off the economy and send us into recession.

As usual, there is very little consensus as to whether we will pierce through this long standing market top into new higher territory in the months and years to come, or will we plunge into recession as we did in 2001 after the last time we reached this record. What we do know is this: relative to company earnings, the prices of US stocks as a whole are considerably cheaper than they were in 2000. In addition, the fall out from the Enron and WorldCom corporate disasters has eliminated a significant amount of corporate waste.

The S&P 500, the index measuring the 500 largest US stocks by their market capitalization was up a 5.2% for the quarter, while the EAFE Index (a market value weighted index of the largest companies in Europe, Australia, and the Far East designed to measure overall conditions of overseas markets) was down -2.92% over the same period. Year to date, the S&P 500 and the EAFE idecies were up 8.79% and 10.06% respectively. Why the big jump? Fed Chair Ben Bernanke and his friends at the Fed finally stopped raising rates. This, coupled with a drop in energy prices created a new market euphoria. Debt payments and energy costs have a huge impact on consumer spending.

Sector Performance Report 9-30-08

The 12 month trailing returns for the energy sector fell to zero while the telecommunications, health and financial sectors rebounded strongly after being in the cellar for a few years. As so often is the case, last year’s winners are this year’s losers.

Book Review: It's Not About the Bike

It's Not About the Bike: My Journey Back to Life
by Lance Armstrong, Sally Jenkins

This is a fantastic read about Armstrong’s struggle with cancer only to recover and win the Tour de France. It’s a great motivational book that shows that if you truly believe, you can accomplish almost anything. –Michael Rebibo, CFP®

Estate Tax Summary

Here is a quick summary of the current federal estate tax laws. Be sure to consult your attorney before taking any recommendations listed below. If you have not updated your will and estate plan within the past few years, make an appointment with your attorney today!

Current tax law concerning federal estate taxes provides an applicable exclusion amount of $2,000,000 per person. This means that each person can give away during their life up to $1,000,000 or at death a combined total of $2,000,000 worth of property, without any taxes being due and payable.

On May 26, 2001, Congress passed “The Economic Growth and Tax Relief Reconciliation Act of 2001,” which provides for the applicable exclusion amount to increase over time as follows:

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Additionally, current federal tax law provides for an unlimited marital deduction. This means that you may transfer an unlimited amount of property between you and your spouse without incurring federal estate taxes. Combining the applicable exclusion amount with the unlimited marital deduction means that a married couple can have a combined estate of $4,000,000, which passes tax-free at the death of the second spouse to die. The tax rate on any amount in excess of $4,000,000 starts at forty-six percent (46%). To ensure utilization of the $2,000,000 applicable exclusion amount, both of you should have property worth at least $2,000,000 held in your own names or revocable trusts and not with rights of survivorship.

A typical plan to fully utilize both $2,000,000.00 applicable exclusion amounts for a married couple is to place $2,000,000.00 in a bypass trust at the death of the first spouse. The bypass trust typically provides that all income is payable to the surviving spouse and the Trustee may invade principal for the spouse’s health, support, maintenance and education. Upon the spouse’s death, the principal is payable to the children outright or in continuing trust, free of any estate tax even on the appreciation of the assets in the credit shelter trust. The balance of the estate in excess of $2,000,000.00 is given outright to the surviving spouse and the surviving spouse, at his or her election, may place this additional inherited amount into his or her own revocable trust. Alternatively, the balance may be held in further trust. Upon the death of the surviving spouse, all of the survivor’s property is passed on to the children, either outright or in a continuing trust. The $2,000,000.00 in the bypass trust create upon the first spouse’s death, together with all appreciation therein, is not taxable again in the surviving spouse’s estate.

Federal Reserve Forum

Interest Rate Hikes, When Will They Stop?
The Federal Reserve has met twice since my last newsletter. After the May 10th meeting, Ben utters the dreaded “inflation” word causing the stock markets to sell off in lock step. Then in June, Ben says, “the moderation in the growth of aggregate demand should help to limit inflation pressures over time”. In other words, the interest rate increases are working. No kidding but when will it stop?

These most recent Fed comments revealed the first hint that we may be nearing the end of the Federal Reserve’s 17 consecutive 1/4 point interest rate increases. (In case you’re wondering, 17 quarter points is 4.25%) For the first time since it began raising rates from a low of 1%, in June of 2004, the Fed didn’t explicitly say another rate increase was under consideration. Currently, the futures market has priced in a 63% chance of a rate hike to 5.5% in August. This would give us a prime rate of 8.5%.

This is 50 basis points below the previous peak Mr. Greenspan set in 2000. In the mean time, the Fed will continue to read the economic tea leaves over the next 45 days. The Bank of Japan and the European Central Bank are set to raise rates in the next thirty days.

How might the current series of rate increases affect you? First, if you’re in the market for a new home or need to refinance, mortgage rates for fixed rate loans should reach 7% in 2007. If you have a home equity loan tied to the prime rate, your interest rate will more than double to somewhere around 8.5%. The popular interest only ARM loans will also double in rate just when the housing market has stalled. This may make it difficult to refinance when homes have not appreciated or may have even dropped. The overall impact here may be a loss of value in residential real estate between 10% and 20% from the 2005 peak. Combine this with the increases in gas and other raw materials and you may get a recession in late 2007. However, as with all recessions, we will not know until we have been in one for at least 6 months!

Is there a silver lining? Sure, six month CDS are now paying over 5.5%, nearly 4 times their low back in 2003! Also, market slowdowns generally create great buying opportunities. Remember, the economy works in cycles and we are about five years into the current economic cycle.

Asset Allocation

Buy Low, Sell High – Not As Easy As It Sounds

Small investors seem to continuously chase the market trend and use a strategy I call “recency”: What ever the most recent phenomenon of making money is, follow it. We have seen recency with dot bomb stocks, real estate, emerging markets, gold, etc. These investors are applying reverse market timing. Wait until something gets run up really high, then buy it only to watch it free fall. Then sell it! In other words, “buy high, sell low”.

Why does this happen? Most institutional investors apply an asset management strategy in their portfolios. This means that when one asset class of the portfolio grows beyond the tolerance set by the manager, they sell. It also means when an asset class falls below the tolerance level they buy. Here’s the rub: institutional investors have more money than retail investors. So when a retail investor is following a trend, and the institutional investors are selling what is high, the retail investor becomes the bug and the institutional investor becomes the windshield. So why play this game?

Fasten your seatbelts, do not panic, have patience and follow a long term plan. In its simplest form, asset allocation is a strategy with fixed percentages in cash; bonds both domestic and international, US Equities both large and small, and international stocks both large and small. The portfolio is then rebalanced periodically. This rebalancing process creates the “buy low sell high” discipline! It also removes guessing which generally creates havoc on the portfolio.

A Time For Giving

You don’t need to wait until the holiday season to start thinking of others. Warren Buffet, the world’s second richest man, announced plans to give away 85% of his fortune ($30 billion) to the foundation started by the world’s richest man, Bill Gates. The Bill and Melinda Gates Foundation will then double in size to $60 billion, making it more than twice the size of the next 3 largest foundations combined (Ford Foundation $11 Billion, Lilly Endowment $8 Billion, and Andrew W. Mellon Foundation $5.5 Billion).

Foundations must give away 5% of their assets per year to keep their tax exempt status. Thus, the Gates Foundation will need to give away over $3 billion per year to the causes of their choice. The Foundation has been spending money on research, prevention and treatment for AIDS, tuberculosis, malaria, and vaccine-preventable childhood diseases. It focuses its efforts in developing countries, primarily in Africa and Asia. This leaves plenty of good causes for the rest of us to get involved with.

According to a survey produced by the Giving USA Foundation, Americans gave $200 billion to charities and other non-profits in 2005. In addition, nearly 80% of Americans give to at least one organization at least once per year and the average contribution per family is 2.2% of after tax annual income. That’s only $3,000 per year for a family earning $200,000 per year.

What’s the point of making lots of money and not giving anything back? There are many people who are less fortunate than us, who could benefit from even the smallest donation. And with all of the charities available today, it’s easy to choose one that you feel would best benefit from your help.

Life is short. Don’t be average. Give today!

Market Summary

The 2nd quarter of 2006 was tough for virtually all market segments. The US market and international markets fell in May, but rebounded slightly in June. The S&P 500, the index measuring the 500 largest US stocks by their market capitalization, fell 2.3% for the quarter and the EAFE Index (a market value weighted index of the largest companies in Europe, Australia, and the Far East) declined .26% over the same period. Year to date, the S&P 500 and the EAFE were up 1.8% and 8.94% respectively.

What caused the drop? It started with comments made by new Fed Chair Ben Bernanke following the May 10th Federal Reserve meeting on the subject of inflation. For the first time, Ben did not speak in code as his predecessor Alan Greenspan always had, and actually used the word “inflation” in his speech. This sent the S&P 500 down 5%, while international markets got pounded nearly 10%. Then in June, the markets recovered slightly following comments where Bernanke did not specifically mention rate increases. It is amazing what a few simple words uttered by the Fed can do to world markets. As former Chair Greenspan has said, “I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said”.

Sector Performance Report 6/30/06

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Book Review: Unconventional Success

Unconventional Success: A Fundamental Approach to Personal Investment
By David F. Swensen

Swensen, CIO of Yale University and the author of Pioneering Portfolio Management, reveals why the mutual fund industry as a whole does a disservice to the individual investor. Soft money, 12b-1 fees, overtrading, market timing, and other management practices lower performance and virtually guarantee that most mutual fund returns will fall short of their benchmark, such as the S&P 500.

Furthermore, for-profit mutual fund companies have a fiduciary obligation to their stockholders, not to their investors, and this relationship "inevitably resolves in favor of the bottom line." Swensen is also highly critical of the Morningstar rating system, which only causes investors to chase hot performing funds and managers.

He advises considering alternatives to the for-profit mutual fund industry, including Exchange Traded Funds and not-for-profit financial institutions such as Vanguard and TIAA-CREF. He highly recommends that as an individual, you should play a more active role in your financial future. This includes periodic portfolio evaluation and rebalancing, to ensure that your asset allocation remains diversified and suits your investment time line.

Credit: Booklist

Market Summary

The first quarter of 2006 has started out with a bang! Nearly every sector except utilities, one of last year’s hot sectors, is up. You could have invested in just about anything and made money (and hopefully you did). US stocks, both large and small; international and emerging markets, all posted excellent returns. The S&P 500 index increased 3.7% for the quarter, more than all of 2005!

In fact the S&P 500 earned more last quarter than the average annual return of the index over the past 5 years. Small and medium sized stocks continued to out perform their larger brethren by a large margin. The Russell 2000 index of small stocks rose nearly 14% setting a new record high. “Value stocks” outperformed “growth stocks” nearly 2 to 1 for the quarter according to Morningstar, Inc.

During the first quarter, the Federal Reserve, under new Fed chairman Ben Bernanke, continued increasing short term rates. Two rate hikes of 1/4% were added to the previous 13, pushing the prime rate up to 7.75%. This is the index tied to most home equity loans. In my year end summary, I predicted the Fed would stop at this level. However, recent Fed comments like this, "some further policy firming may be needed.” indicate the fed will continue increase rates at least one more time.

When To Harvest Stock Options

Employees with stock options are faced with a tough dilemma. In order to convert the option into real value, they must cash it in. If they cash the option in, they realize the intrinsic value of the option, the difference between the option price and the current market value. This removes the risk of having the option become worthless. However, by exercising, they lose any remaining time value left in the option and they incur the tax liability.

There are a variety of strategies designed to deal with this dilemma.

1. The “Need Approach”: Cash in the option when you need the money. This clearly does nothing to balance investment risk and reward

2. The “Prediction Approach”: Many optionees and some advisors, try to time the harvesting of the stock based on some prediction of how the stock is going to perform. The reliability of such perditions is not possible. This approach often fails and sometime with spectacularly disastrous results.

3. “Timeline Approach”: There are basically three options with this approach:

a. Exercise as soon as possible. In this case, exercise options as soon as they vest as long as you are in the money. This approach is conservative but wasteful because you will lose all of the time value of the option

b. Exercise as late as possible. In this case, options are exercised just before they expire. This approach avoids wasting any of the options value but leaves the optionee exposed to risks of stock devaluation for a very long period of time.

c. Select a random period of time such as 1 year before expiration. The idea here is to minimize the risk and still receive some time value for the option .

4. A Balance Approach: This approach provides the greatest possible return for the least risk. It is also different for just about everyone. The approach here is to convert a high-risk investment, into a normal diversified investment, while not losing a large portion of its value. Thus, converting the stock in the value to be gained is significantly larger than the time value that is lost. Thus, options deep in the money should be cashed sooner than those with smaller gains. One also has to take into account the value of the option relative to ones overall net worth. Options representing large portions of net worth should be exercised sooner.

Tax Implications for Nonqualified Stock Options
If a stock is exercised after vesting, then the optionee reports compensation income equal to the amount by which the stock value exceeds the exercise price. This amount is now included in the tax basis of the stock, so they have a basis equal to their fair market value. Any subsequent change in value will result in capital gain or loss, which will be long-term if the sale occurs more than a year after the option was exercised.

Most optionees exercise and hold for a year to take advantage of long-term capital gains treatment. This however exposes them to “capital loss whipsaw”. Imagine you own PSI Net with a $100,000 gain at the time of exercise. The stock proceeds to go down $90,000 before the shares are sold a year later. Now you will report $100,000 of in compensation income with a capital loss of $90,000. You can only deduct $3000 of the capital loss and will end up paying ordinary income taxes on $97,000 even though her true profit is only $10,000!

The benefits of exercising and holding nonqualified stock options do not outweigh the risks associated with holding them over time.

Tax Implications for Incentive Stock Options
AMT tax has made it more difficult for those with ISOs who’s with income between $150,000 and $380,000. This is because the AMT tax increases the tax rate for those income brackets. Individuals making more than $382,000 already are paying higher taxes and are not affected by AMT (ISO impact). Options are to exercise and sell, exercise and hold for one year in hopes to reduce the tax liability, or a combination of the two.

There is a significant amount of risk in holding the stock for a year in hopes of reducing the tax on the gain. This is due to the fact that you will pay tax in the year you exercise and may lose value in the stock by holding it an additional year. To get the best of both worlds, possible capital gains treatment with lower risk, consider selling 65% of the stock immediately and holding the remainder for a year. This allows you to take some of the risk off the table and still reap the benefit of the capital gains tax. Ratios will vary depending on the amount of the gain and the tax credit. It is important that you consult your tax advisor before making any decisions as they relate to non qualified and qualified stock options.

Source: FPA Seminar on Stock Option Planning for Corporate Executives by Kay Thomas, Founder of the National Board of Certified Option Advisors.

Federal Reserve Forum

The Federal Reserve has now completed 15 consecutive 1/4 rate increases since June of 2004. This means that if you have a home equity line, your rate has nearly doubled from 4% to 7.75% over the past year and half. According to Tom Millon of the Capital Markets Cooperative, “The futures market placed 100% probability on a 5.00% funds rate in May, and 40% odds on 5.25% shortly thereafter in June. A week ago, the odds of a June hike were virtually nil. Rising commodity and energy prices, rising employment, rising gold, and a growing world economy create ripe conditions for the potential to add to inflationary pressures."

The Value of Asset Allocation: A Case for Indexing

Large cap stocks or mutual funds are core to any portfolio. Allocations to this asset class range from 15% to 35% depending on risk tolerance. (If you have more than this, you may want to evaluate your portfolio!) Most of us have seen the articles featured in the Wall Street Journal where a chimpanzee throwing darts at a stock page tends to outperform Wall Street’s brightest managers. Over the past 20 years there have been numerous studies on the value of selecting managed mutual funds vs. simply buying an index fund.

An index fund is mutual fund designed to mimic the returns of a given stock market index such as the S& P 500. For example, the Schwab Institutional S & P 500 Index fund simply utilizes a computer model to purchase all of the US’s largest 500 stocks in a weighting equal to their market cap.

According to a recent article in the Journal of Financial Planning by Thomas P. McGuigan, CFP, the large cap fund index (S& P 500) outperformed managed mutual funds 72% to 84% of the time over rolling 5,10, 15 and 20 year periods since 1993. The study concluded that the longer the period of time, the more likely the index beat the managed funds. The percentage of mutual funds that outpaced the index fund was only 10.59%. Thus, only 18 of 171 mutual funds outperformed the index fund over 20 years. The majority of out performers, 12 out of 18, only outperformed by 1% or less. This study did not take into account all the funds that are no longer in existence. If this figure was included, the percentage of funds that beat the index would be even lower. The study also found that the cost of selecting the wrong fund was very high.

The majority of the underperformers (113 funds), missed the mark by 1 percent or more. In my opinion, these odds are just not worth the risk.

Why is it that a chimp can outperform a manager in large cap stock selection? The answer lies in market efficiency, managed fund expenses and taxes. The US stock market and particularly the large cap stocks are nearly perfectly efficient. This means that the markets impound information into prices so well that the analysis of publicly available information will not produce excess returns. Thus manager out performance is simply luck rather than skill.

In addition to market efficiency, fund costs have a huge impact on performance. Fund costs include expense ratios, commissions, bid ask spreads and impact costs. Expense ratios are the cost of staff and overhead. Commissions and bid ask spreads are the actual costs of trading stocks. Impact costs relate to the expense associated with liquidating a large position in a particular stock. These expenses range form 1 to 2 percent per year for all funds.

On the other hand, an index fund has considerable lower expenses. For example, the Schwab Institutional S &P 500 Index fund mentioned above has a total expense ratio of just .22%. This gives the index fund a considerable advantage over its peers. Not only do managed funds have to beat the index, they must also cover their expenses. If the case above for indexing is not powerful enough, consider the impact of taxes. Managed portfolios generate nearly twice as much tax liability as index funds.

If all of the hold true for large cap stocks, what about smaller cap funds and international funds? While fund costs for these asset classes are actually higher, markets are less efficient giving some managers the edge. I generally used index funds for large cap portfolios and best in class institutional money managers for other asset classes.

Book Review: The Intelligent Asset Allocator

The Intelligent Asset Allocator
By William Bernstein

"As its title suggest, Bill Bernstein's fine book honors the sensible principles of Benjamin Graham in the Intelligent Investor Bernstein's concepts are sound, his writing crystal clear, and his exposition orderly. Any reader who takes the time and effort to understand his approach to the crucial subject of asset allocation will surely be rewarded with enhanced long-term returns."
– John C. Bogle

Founder & Former Chief Executive Officer, The Vanguard Group
President, Bogle Financial Markets Research Center
Author, Common Sense on Mutual Funds