ibf - updates - 2007 (q1 & q2 v1.0)

Copyright © 2007 by Institute of Business and Finance. All rights reserved. v1.0

INSTITUTE OF BUSINESS & FINANCE

QUARTERLY

UPDATES

2007 Q1 & Q2

Quarterly Updates

Table of Contents

MUTUAL FUNDS

DISTURBING RETURN FIGURES 1.1

YEAR-END WINDOW DRESSING 1.1

PICKING THE NEXT TOP PERFORMERS 1.2

A RANDOM WALK 1.2

LARGEST FUND COMPANIES 1.4

CORRELATIONS TO THE S&P 500 REVISITED 1.5

STYLE BOXES 1.6

FOCUSED FUNDS AND RISK 1.7

LIFECYCLE FUNDS 1.8

TARGET-DATE FUNDS EXPAND 1.8

MORE AGGRESSIVE LIFE CYCLE FUNDS 1.9

LONG-SHORT FUNDS 1.10

DIVERSIFICATION BENEFITS 1.10

FREQUENCY OF PORTFOLIO REBALANCING 1.12

VALUE LINE HYPE 1.12

ODDS OF BEATING AN INDEX 1.13

MIXED PERFORMANCE RANKINGS 1.15

ACTIVE VS. PASSIVE MANAGEMENT 1.16

SIDE-BY-SIDE MANAGEMENT 1.17

MANAGER-INVESTED MUTUAL FUNDS 1.19

B SHARES REVIEWED BY SEC 1.25

SHAREHOLDER PROXY VOTING 1.26

SECURITIES LENDING PRACTICES 1.27

FUND DIRECTOR PAY 1.28

DIRECTORS AND 12B-1 FEES 1.28

STOCKS AND MUTUAL FUNDS 1.29

ETFS

ETF UPDATE 2.1

THE LARGEST ETFS 2.4

ETFS WITH LOW EXPENSE RATIOS 2.5

ETF PRICE DISPARITIES 2.6

SECTOR VOLATILITY 2.7

BUYING AND SELLING ETFS 2.8

UITS AND CLOSED-END FUNDS

UIT AND NEW FUND CRITICISM 3.1

CLOSED-END FUND ASSET INCREASE 3.1

CLOSED-END COVERED CALL FUNDS 3.2

REITS

REIT UPDATE 4.1

INTERNATIONAL REITS 4.2

STOCKS

DOW MILESTONES 5.1

DOW DROPS 5.2

S&P 500 AND DJIA RETURNS 5.3

SMALL CAP STOCKS 5.4

QUALIFYING DIVIDENDS 5.4

BUFFET WARNING 5.4

DIVIDEND-PAYING BONUS 5.5

VALUE PLAY 5.5

VALUE VS. GROWTH STOCKS

ROLLING PERIODS: GROWTH VS. VALUE 6.1

REVISITING GROWTH AND VALUE 6.2

SMALL CAP VALUE 6.7

GROWTH VS. VALUE 6.8

2006 INDEX RETURNS 6.9

BONDS

CUSHION AGAINST STOCK DECLINES 7.1

STOCKS VS. BONDS 7.1

2006 HIGH-YIELD BOND FACTS 7.2

BOND MARKETS, INDEXES, AND FUNDS 7.3

GLOBAL INVESTING

WORLD’S FINANCIAL ASSETS 8.1

EMERGING MARKET DEBT 8.2

2006 GLOBAL INDEX RETURNS 8.2

REDUCED GLOBAL CORRELATION 8.3

EAFE COMPOSITION 8.4

GLOBAL SMALL CAP BENEFITS 8.6

DOMESTIC GLOBAL DIVERSIFICATION 8.7

COVERED CALL WRITING

SPDRS AND COVERED CALL WRITING 9.1

EQUITY-INDEXED ANNUITIES

EQUITY-INDEXED ANNUITIES (EIAS) 10.1

FINANCIAL PLANNING

OPTIMAL REBALANCING 11.1

PREDICTED MARKET MELTDOWN 11.4

DISTRIBUTION OF RETURNS 11.5

INVESTING IN A HOUSE 11.6

AMERICA THE BANKRUPT? 11.7

CPI SPENDING CATEGORIES 11.7

GOLD VS. HERSHEY BARS 11.9

HEDGE FUND DISASTERS 11.10

HEDGE FUND WARNING 11.11

CALCULATING A LUMP SUM 11.11

ENDING UP WITH $1,000,000 11.12

GOALS AND RISK TOLERANCE TEST 11.12

RETIREMENT PLANNING

RECONSIDERING THE ROTH 401(K) 12.1

HEALTH SAVINGS PLANS 12.2

529 PLANS 12.3

RETIREMENT PLAN INCREASES FOR 2007 12.3

RETIREMENT REALITY 12.7

BENEFITS OF PATIENCE 12.8

COSTS OF 401(K) PLANS 12.9

RETIREMENT STATISTICS 12.10

MAXIMUM SOCIAL SECURITY BENEFIT 12.10

PEOPLE WORKING LONGER 12.11

INFLATION MEASUREMENTS 12.11

LONG-TERM CARE PARTNERSHIP 12.15

DISCLOSURE PROTECTION FOR ORGAN DONORS 12.17

FULLY FUNDED PENSION PLANS 12.18

NEW MEDICAID RULES 12.18

TAXES

2007 TAX BREAKS 13.1

TAX DOCUMENTS 13.2

FREE TAX PREPARATION AND FILING 13.3

TAX FACTS 13.3

APPEAL TO CHILDREN 13.5

FEDERAL RESERVE COMIC BOOKS 13.6

YOUNG INVESTORS 13.6

QUARTERLY

UPDATES

MUTUAL FUNDS

MUTUAL FUNDS 1.1

QUARTERLY UPDATES

IBF | GRADUATE SERIES

1.DISTURBING RETURN FIGURES

According to DALBAR, the average equity mutual fund investor

experienced annualized returns of just 3.9% over the 20-year period

ending December 31st, 2005. During this same period, inflation

averaged 3% a year, while a buy-and-hold investment in the S&P

500 returned 11.9% a year.

YEAR-END WINDOW DRESSING

For roughly the last week or two of the year, many mutual and hedge

fund managers sell off poorly performing securities and replace them

with the quarter’s best performers. Over the past 16 years, the S&P

500’s top-performing stocks of the first 11 weeks or so of the fourth

quarter have outperformed the overall index by an average of 2.6%

in the final week; this strategy has worked every year.

The Thomson Financial study suggests the efficiency comes from

buying all of the top 50 performers and then selling them just before

the first trading day of the next year. Another strategy worth

considering is to buy stocks that are among the market’s worst 10%

performers. Over the past 16 years, these stocks have beaten the

S&P 500 by 1.8% in the first week of the new year (vs. 0.7% for the

top-performing stocks).

1.2 MUTUAL FUNDS

QUARTERLY UPDATES


PICKING THE NEXT TOP PERFORMERS

A study reviewed the top 30 mutual funds for sequential 5-year

periods from 1971 to 2002. In each and every 5-year period, what

had been a “top 30 fund” underperformed the S&P in subsequent

years.

A RANDOM WALK

In his 1973 book, A Random Walk Down Wall Street, author Burton

Malkeil, stated that it was time for index funds. Three years later,

Vanguard introduced the first retail index fund based on the S&P

500. Lipper data (shown in the table below) shows the difference in

returns for the S&P 500 Index and the “average equity fund” (which

consists of all Lipper large cap equity categories).

S&P 500 vs. U.S. Large-Cap Equity Funds

10 years

(ending 12/31/06)

20 years

(ending 12/31/06)

S&P 500 Index 8.4% 11.8%

Average Equity Fund 6.8% 10.4%

According to Malkeil, an S&P 500 index fund has outperformed

more than 75% of actively managed, large cap equity fund over

the past 10 and 20 years. The percentage would be even higher if it

were not for “survivorship bias” (only measuring the performance of

funds that were in existence during the 10-20 year period).

Furthermore, the index fund has been more tax efficient.

MUTUAL FUNDS 1.3

QUARTERLY UPDATES


In 1970 there were 355 equity funds, only 117 were still in

existence at the end of 2006. Of the surviving 117 funds, 57

underperformed the S&P 500, 38 had equivalent returns, and 22

outperformed the index. Looking at the funds that either closely

matched or outperformed the S&P 500, 27 outperformed the index

by 0-1%, 16 by 1%, two by 2%, one by 3%, and one by 4%.

Malkeil acknowledges that the Fundamental Index has done well

during the early 2000s, but that such performance has been due to

the fundamental index’s bias toward value and small cap. The author

further points out that there have certainly been times when “the

market makes mistakes—it goes crazy sometimes.” As an example,

at the height of the market bubble in 2000, Cisco represented 4% of

the S&P 500, yet it represented just 0.02% of the economy. In 1999,

Amazon had a market value over $30 billion, even though it had yet

to ever make a profit. In fact, its losses for 1999 were over $600

million. At its height, technology stocks represented a third of

the S&P 500 (according to TheStreet.com, telecom and technology

combined represented 45% of the S&P 500 as of March 2000).

According to Malkeil, “My argument for indexing was based on my

belief that our equity markets are remarkably efficient. When

information arises about the stock market or individual stocks, that

information gets reflected without delay—switching from stock to

stock in an attempt to provide superior performance—is unlikely to

be effective, especially when you add in trading costs and taxes.”

1.4 MUTUAL FUNDS

QUARTERLY UPDATES


LARGEST FUND COMPANIES

According to Lipper, the 30 largest mutual fund families manage

more than 75% of the industry’s assets; the top 10 companies

control 47% and the biggest 60 oversee nearly 91% of all mutual

fund assets. The table below shows the top 10 fund companies, as of

the end of the third quarter 2006 (note: “b” = billion and “t” =

trillion).

Largest Mutual Fund Companies [as of 9-30-2006]

Company

Open-

End

Closed-

End

Variable

Annuities

Total

%

Fidelity $1 t $0 $60 b $1.1 t 11%

Vanguard $1 t $0 $10 b $1.0 t 10%

American Funds $925 b $0 $85 b $1.0 t 10%

Franklin / Templeton $280 b $4.3 b $30 b $315 b 3%

BlackRock / Merrill $250 b $31 b $9 b $290 b 3%

Bank of America / Fleet $230 b $0.9 b $5.9 b $240 b 2%

Morgan Stanley $195 b $16 b $17 b $225 b 2%

Allianz / PIMCO $200 b $12 b $14 b $225 b 2%

JP Morgan / Chase $220 b $0.7 b $0.6 b $225 b 2%

Legg Mason / Citibank $200 b $8.7 b $9 b $220 b 2%

Industry Total $8.9 t $240 b $1.1 t $10.3 t 100%

MUTUAL FUNDS 1.5

QUARTERLY UPDATES


CORRELATIONS TO THE S&P 500 REVISITED

A review of the past handful of years shows that the correlation

coefficient of a number of categories with the S&P 500 has

increased. As an example, from February 2000 to February 2006,

nine of the 10 different sectors in the S&P 500 (e.g., financials,

consumer cyclicals, energy, etc.) showed a correlation of at least

75% with the overall market. By contrast, in 2000, only two

sectors moved in such close step with the S&P 500. The table below

shows five-year correlations to the S&P for four different categories.

5-Year Correlations to the S&P 500

[Feb. 2000 and Feb. 2006]

Index 2000 correlation 2006 correlation

Hedge funds 35% 96%

MSCI EAFE 32% 96%

Russell 2000 62% 94%

Goldman Commodity -14% 33%

1.6 MUTUAL FUNDS

QUARTERLY UPDATES


STYLE BOXES

Morgan Stanley, Morningstar, Russell, Standard & Poor’s, and

Wilshire have very different definitions of market capitalization.

Among just these five services, the definition of “large cap”

stocks ranges anywhere from 67% to 92% of total U.S. stock

market capitalization. These five services have different definitions

of “small cap.” The differences range from 3% of total market

capitalization (Morningstar) up to 12% (Morgan Stanley). Russell

does not recognize “mid cap” stocks per se, but does designate the

smallest 25% of their large cap index as “mid cap.”

Only half of what Morningstar classifies as “mid cap” is

categorized the same way by S&P. Morningstar and S&P disagree

about 30% of the time as to what is “mid cap.” The two companies

also disagree as to what is “growth” and “value” 20% of the time.

About 50% of Morningstar’s “mid cap” stocks are smaller than the

largest “small cap” S&P stocks.

S&P re-categorizes stocks twice a year during the second and

fourth quarters. During these quarters, an average of one in nine

stocks changes categories; 90% of these changes come as a result of

re-categorizing a growth stock as a value play, or vice versa—only

10% is size reclassification.

MUTUAL FUNDS 1.7

QUARTERLY UPDATES


Critics of the nine equity style boxes point out that diversifying

across 13 widely-recognized asset classes, such as stocks, bonds,

money market, international, etc, is seven times more effective

than diversifying across the nine different stock categories. The

critics believe that potentially 74% of portfolio volatility can be

eliminated in this way (vs. only 11% amongst the different domestic

stock categories). In short, those who question stock style boxes

believe that U.S. stocks, regardless of size or being classified as

growth, value, or blend, are a single asset class, not six or nine.

FOCUSED FUNDS AND RISK

Focused funds that have low turnover tend to also have low

volatility. For example, mutual funds that were in the quartile with

the fewest stocks and in their category’s lowest-turnover quartile had

a lower standard deviation than the category average in over 75% of

rolling one-, three-, five-, and 10-year periods combined.

For the 2000, 2001, and 2002 calendar years, as a group,

concentrated funds performed better than their non-concentrated

peers. In 2001, funds in the most-concentrated quartile had

performance in the top 39% of their category’s average; the least

concentrated quartile averaged a 54% ranking.

1.8 MUTUAL FUNDS

QUARTERLY UPDATES


LIFECYCLE FUNDS

Lifecycle fund assets increased by over 60% in 2006. Some financial

advisors are concerned that the equity exposure many of these funds

for those about to retire is too high (e.g., “2010 funds” have stock

exposures as high as 63% in the case of Charles Schwab and T.

Rowe Price). A University of Maryland finance professor

recommends using three lifecycle funds. For example, someone

retiring in 2015 could buy a 2015 fund to cover the first 10 years of

retirement, a 2025 fund to pay for the years from ages 75 to 85, and

a 2035 fund for the final years.

TARGET-DATE FUNDS EXPAND

As of early May 2007, there were 34 mutual fund companies that

offered one or more target-date funds. This $150 billion asset

category has increased in popularity partially because of the federal

pension bill, wherein target-date funds are frequently the default

option for 401(k) plan participants.

Besides growing in popularity, target-date funds have also expanded

the number of investment categories they invest in; emerging market

stocks, REITs, TIPS, private equity, commodities, leveraged loans,

and/or long-short funds are now being used by more and more of

these funds.

MUTUAL FUNDS 1.9

QUARTERLY UPDATES


MORE AGGRESSIVE LIFE CYCLE FUNDS

A number of life cycle funds have increased their stock allocation

from 80% to 90% for younger investors. One life cycle fund for

those just retiring has 55% in common stocks and 10% in REITs; the

fund shifts to 25% in stocks, 10% in REITs, and 65% in fixed

income for those age 80. The fund company’s research found that a

1% higher annual return beginning at age 25 could fund “more than

10 additional years of retirement spending.”

When determining the appropriate asset mix for your older clients,

think of their Social Security payments as a fixed-rate annuity; this

means that most retirees will end up with a larger percentage

allocated to fixed income than they think. One way to calculate this

percentage is to add up all projected Social Security payments,

discounted by a present value percentage.

Other mutual fund life cycle studies reach four additional

conclusions: (1) investors tend to pick portfolios that are more

aggressive than their ages warrant; (2) when a couple retires, it

should be expected that at least one of them will reach their 90s; (3)

the biggest risk to retirees is outliving their assets; and (4) life cycle

funds are likely to grow at an even more robust rate after the passage

of the Pension Protection Act of 2006 (which encourages companies

to automatically enroll workers into qualified retirement plans—a

life cycle fund could be the default selection if the employee does

not pick another option).

1.10 MUTUAL FUNDS

QUARTERLY UPDATES


LONG-SHORT FUNDS

Long-short funds ($14 billion in assets as of July 2006) are

sometimes confused with market neutral funds. Market neutral funds

balance their short and long positions, giving them a net market

exposure of zero; long-short funds either have a consistent long bias

or adjust their long-short mix tactically over time.

Long-short funds give smaller investors access to certain hedge

fund strategies and although they are less expensive than hedge

funds, costs can still be high. Some long-short funds have an

expense ratio as high as 4% (vs. 1.5% for the average domestic stock

fund). Over the past three years (ending 12/31/2006), long-short

funds averaged 7.5% annually.

DIVERSIFICATION BENEFITS

Many advisors have seen an “element chart” of investment

returns, asset category performance rankings over each of the

past several years. What few advisors have seen is such a chart

that includes not only growth and value plays, but REITs, mid

cap issues, and, most importantly, the ranking of a “diversified

portfolio” (defined as an equal weighting in each of the nine

asset classes ranked below).

MUTUAL FUNDS 1.11

QUARTERLY UPDATES


Yearly Asset Category Rankings [1992-2006]

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

SV

29%

FS 33%

FS 8%

LG 38%

RE 36%

LG 37%

LG 42%

SG 42%

RE 26%

RE 15%

IB 10%

SG 49%

RE 30%

FS 14%

RE 34%

HY

16%

SV

24%

LG

3%

LV

37%

LG

24%

MC

32%

FS

20%

LG

28%

SV

23%

SV

14%

RE

5%

SV

46%

SV

22%

MC

13%

FS

27%

RE 12%

LV 19%

RE 1%

SG 31%

LV 22%

SV 32%

MC 19%

FS 27%

MC 18%

IB 8%

HY -1%

FS 39%

FS 21%

RE 8%

SV 23%

MC

12%

RE

19% DP

0%

MC

31%

SV

21%

LV

30%

LV

14%

MC

15%

IG

12%

HY

5%

SV

-11%

RE

38%

MC

16% DP

7%

LV

21%

LV 11%

HY 17%

LV -1%

SV 26%

MC 19%

DP

21%

DP

9%

DP

13%

LC 6%

MC -1%

DP

-12%

MC 36%

DP

16%

LV 6%

DP

17%

DP

10%

DP

17%

HY

-1% DP

26%

DP

17%

RE

19%

IB

9%

LV

13% DP

2%

DP

-1%

MC

-15% DP

33%

LV

16%

SV

5%

SG

13%

SG 8%

MC 14%

SV -2%

HY 19%

HY 11%

SG 13%

HY 2%

HY 2%

HY -6%

SG -9%

FS -16%

LV 32%

SG 14%

SG 4%

HY 12%

IG

7%

SG

13%

SG

-2%

IG

18%

SG

11%

HY

13%

SG

1%

IG

-1%

FS

-14%

LV

-12%

LV

-21%

HY

29%

HY

11%

LG

3%

LG

11%

LG

5%

IG

10%

IG

-3%

RE

18%

FS

6%

IG

10%

SV

-6%

SV

-1%

LG

-22%

LG

-13%

LG

-24%

LG

-26%

LG

6%

HY

3%

MC

10%

FS

-12%

LG

-2%

MC

-4%

FS

12%

IG

4%

FS

2%

RE

-19%

RE

-6%

SG

-22%

FS

-21%

SG

-30%

IG

4%

IG

4%

IG

2%

IG

4%

SV = Russell 2000 Value Index MC = S&P MidCap 400 Index IG = Lehman Aggregate Bond Index

SG = Russell 2000 Growth Index FS = EAFE Index RE = FTSE NAREIT REIT Index

LG = S&P 500 / Barra Growth Index HY = Lehman High-Yield Index DP = equal parts of other 9 indexes

LV = S&P 500 / Barra Value Index

Observations

Large growth ranked at the top or bottom—never in the middle.

REITs ranked number one more than any other category.

Quality bonds ranked last more than any other category.

The diversified portfolio always landed in the middle.

1.12 MUTUAL FUNDS

QUARTERLY UPDATES


FREQUENCY OF PORTFOLIO REBALANCING

According to the Financial Planning Association (FPA), the

optimal interval for rebalancing is 15-17 months, on average.

Research shows that if a portfolio is rebalanced more than about

once every 16 months, winners are sold off too quickly. An October

2006 study by the Pension Research Council at Wharton showed that

only 10% of 401(k) participants studied rebalanced their accounts on

either an active or a passive basis (e.g., using a lifecycle or target

retirement fund). The study, which looked at over one million 401(k)

participants, showed that passive rebalancing increased returns by

84 basis points annually, versus just 26 basis points for those

who rebalanced on their own.

VALUE LINE HYPE

The Value Line Web site states, “A stock portfolio with #1 Ranked

stocks for Timeliness from The Value Line Investment Survey,

beginning in 1965 and updated at the beginning of each year, would

have shown a gain of 19,715% through December 31st, 2004. This

gain would have beaten the S&P 500 by more than 15 to 1 for the

same time span.

MUTUAL FUNDS 1.13

QUARTERLY UPDATES


ODDS OF BEATING AN INDEX

For the five-year period ending December 31st, 2006, only 15% of

large value managers beat their respective index; 90% of large

growth managers beat their index. One group of managers is not any

smarter or intuitive than the other. The disparity shows that most

funds are less “style-pure” than “style specific” (e.g., large value

funds hold stocks other than those classified as “large value,”

whereas a large value index would have virtually all, if not all, of its

holdings in “large value”). For example, the typical large cap

growth fund has the following composition.

Composition of the Average U.S. Large Cap Growth Fund

49% large growth 10% mid-cap growth < 1% small blend

27% large blend 4% mid-cap blend < 1% small growth

6% large value < 1% small value

If new benchmarks are calculated using the actual weightings, 35%

of large cap growth managers outperformed their “index” over the

past five years ending December 31st, 2006; 38% in the case of large

cap value managers. For the three-year period ending 12/31/2006,

24% of small growth funds beat their weighted benchmark versus

39% of large growth funds. Such results may cast some doubt on

whether or not the common assumption that small caps are a better

arena for active management.

1.14 MUTUAL FUNDS

QUARTERLY UPDATES


Looking at just annual returns, the pattern remains consistent within

a fairly narrow range. In 1998, 44% of mutual funds in the nine style

box categories (e.g., large cap growth, large cap value, large cap

blend, mid-cap growth, etc.). In 1999, when technology stocks

soared, 50% of the funds beat their custom benchmark; the same

results occurred for 2000 and 2001 and actually increased to 57% in

2002 (probably due to the large cash holdings that year when the

market dropped). When the market rebounded in 2003, only 35% of

actively managed funds outperformed their custom benchmark. In

2004, the number rose to 42%, 47% in 2005, and then fell to 35% for

the 2006 calendar year.

Over 90% of domestic stock funds have geometric mean market

capitalizations below that of the S&P 500; thus, these funds could

outperform the S&P 500 when small and mid cap stocks are in favor,

and underperform when large blue chips do well.

Not only has independent research come up with a dramatically

lower return figure than Value Line’s claim, recent data would

appear to support the independent research. The flagship Value Line

mutual fund (VLIFX) uses the same criteria that guide The Value

Line Investment Survey (according to the fund’s prospectus). Yet,

the fund has only outperformed the S&P 500 twice over the past 10

years. The fund’s 10-year record as of May 30th, 2006 was 6%

annually, versus 9% for the S&P 500. Over the past 15 years, the

fund averaged 9.1% versus 10.9% for the S&P 500.

MUTUAL FUNDS 1.15

QUARTERLY UPDATES


MIXED PERFORMANCE RANKINGS

A 2007 study by DeiMeo Schneider shows that roughly 90% of

mutual fund managers whose performance ranking in the top quartile

for 10 years ending December 31st, 2006 also had performance that

was below its category’s median for at least three or more of those

10 years. It turns out that just over 50% of pension managers

whose 10-year record was in the top quartile experienced below

median results for at least five consecutive years during the same

10 years.

The results become even more extreme within certain categories.

Over two-thirds of the top quartile foreign equity fund managers and

just under 75% of the top quartile medium-term bond fund managers

underperformed their category’s median returns for three years or

more during the 10-year period. There was at least a five-year

continuous stretch of underperformance for 72% of mid-cap blend,

71% of REIT, and 70% for emerging market equity managers whose

performance ranked in the top quartile for the same 10 years ending

December 31st, 2006.

Overall, the study showed that, on average, 22% of top-quartile

managers were in the bottom half of their peer groups during any

given three-year period. Based on these findings, it appears that at

any given time, close to a quarter of the top-performing pension

fund managers and mutual fund managers will experience a

three-year stretch of underperformance at any given quarterly

review.

1.16 MUTUAL FUNDS

QUARTERLY UPDATES


ACTIVE VS. PASSIVE MANAGEMENT

Advocates of passive management (index funds) rarely talk about

accurate benchmark comparisons. For example, the average large

cap value fund has only about 40% of its assets in large cap value

stocks; the balance is in a variety of other stocks such as small and

mid cap growth as well as value.

Over the past five years ending March 31st, 2007, only 15% of the

large cap value stock funds outperformed their benchmark. Using

“custom” benchmarks (meaning an index that is comprised of

equities that a particular asset category’s management actually

invests in), 35-47% of the managers outperform their “actual” index.

The editor of a Vanguard newsletter uses active management for his

core portfolio. The editor suggests using actively-managed funds for

those you have “the greatest confidence in; use passive index funds

in those categories you cannot find a super-compelling active

management.”

MUTUAL FUNDS 1.17

QUARTERLY UPDATES


SIDE-BY-SIDE MANAGEMENT

A number of mutual fund managers are serving two masters: the

fund(s) they oversee and one or more hedge funds. Mutual funds

sharing managers with hedge funds include Ameriprise, Nationwide,

Pioneer, and Vanguard. There are 125 individual portfolio

managers simultaneously running mutual funds and hedge

funds. Total mutual fund assets potentially affected by this possible

conflict of interest is $450 billion.

In 2003, the U.S. House of Representatives approved a measure,

later shelved, that would have barred someone from running a hedge

fund and mutual fund at the same time. Early in 2007, an SEC

official testifying in front of Congress said such a practice “presents

significant conflicts of interest that could lead the adviser to favor

the hedge fund over other clients.” Indeed, there are a number of

ways such favoritism could occur:

1. sell shares of a security in a hedge fund before a similar sale

in the mutual fund;

2. instead of assigning a trade to a specific fund at the time of

execution, a manager could “cherry pick” trades (e.g., trade in

the morning and assign it to the hedge fund or mutual fund

later in the day depending on its performance);

3. managers who have access to a limited number of hot IPOs

might favor the hedge fund over the mutual fund (since the

hedge fund has higher management fees plus a typical 20%

performance incentive fee); and

4. shorting stocks in a hedge fund while holding a long position

in a mutual fund could cause the stock’s price to drop.

1.18 MUTUAL FUNDS

QUARTERLY UPDATES


The SEC does not dictate how managers should address these

potential conflicts of interest. Academic studies are divided on

whether or not mutual fund investors are well served or hurt by

multiple-role (side-by-side) management.

A study by William & Mary’s Mason School of Business and the

Wharton School looked at more than 450 mutual funds run by

companies who also managed hedge funds between 1994 and 2004.

The study found that in such instances, the mutual fund investors

underperformed their peer group by 1.2% a year. A Loyola

University Chicago, University of California, and University of

Illinois study reviewed 200 mutual funds run by side-by-side

managers (who also ran hedge funds) with a similar investment style

and found that the mutual funds outperformed their peers by 1.5%

annually from 1990 through 2005.

Starting in 2006, the SEC began to require funds to disclose

other types of accounts run by the manager and total assets

affected. Such information is found in the fund’s statement of

additional information (SAI). To find out what types of funds are

managed by a fund company, advisors and investors can search

www.adviser info.sec.gov.

MUTUAL FUNDS 1.19

QUARTERLY UPDATES


MANAGER-INVESTED MUTUAL FUNDS

Mutual fund managers who own shares of the funds they oversee

outperform, on average, funds that are not partially owned by

management. A 2006 study done by three business schools looked at

the total returns of 1,300 stock and bond funds. The study looked at

managers who owned shares (43% of the 1,300 funds) versus funds

with no management ownership (57%).

Manager-owned funds had a mean return of 8.7% vs. 6.2% for

funds with no management ownership; the highest percentage of

management ownership was with U.S. stock funds and lowest

with foreign bond funds.

As of the beginning of 2007, of the 500 mutual funds most highly

recommended by Morningstar, more than 150 managers had each

invested more than $1 million in their funds. The most extreme

example of management ownership was Bill D’Alonzo who

oversees Brandywine (BRWIX) and Brandywine Blue (BLUEX); he

had 100% of his liquid net worth invested in these two funds. Other

examples include: Selected American (SLASX) and Selected Special

(SLSSX), two funds whose employees and those affiliated with the

fund collectively owned over $2 billion worth of shares; Longleaf

employees and directors owned over $500 million of their funds;

Chuck Royce had $50 million of his own money invested in Royce

Total Return (RYTRX) and Royce Premier (RYPRX).

The extensive table below shows over 170 mutual funds whose

management owns over $1 million in their fund.

1.20 MUTUAL FUNDS

QUARTERLY UPDATES


Mutual Funds Whose Management Owns

$1,000,000+ in the Fund [partial list]

Fund Name Fund Name

ABN AMRO/Montag Gr. N Amer Funds WashingtonA

Aegis Value American Beacon IntEq Pln

Allianz REC Glob Tech Ins Ariel

Amer Funds Amcap A Ariel Appreciation

Amer Funds Amer Bal A Artisan International Inv

Amer Funds Amer Mut A Artisan Intl Sm Cap

Amer Funds CapWrldBd A Artisan Intl Val

Amer Funds CapWrldGl A Artisan Mid Cap Inv

Amer Funds CpIncBldr A Artisan Small Cap

Amer Funds EuroPacific A Baron Asset

Amer Funds Fundamental A Baron Fifth Avenue Growth

Amer Funds Growth Fund A Baron Growth

Amer Funds Income Fund A Baron Partners

Amer Funds Inv. Co. Am A Baron Small Cap

Amer Funds New Economy A Bogle Small Cap Gr Inv

Amer Funds New Perspective A Brandywine

Amer Funds New World A Brandywine Blue

Amer Funds Sm World A Calamos Gr & Inc A

MUTUAL FUNDS 1.21

QUARTERLY UPDATES




Fund Name Fund Name

Calamos Growth A FBR Small Cap

Causeway Intl Value Inv Fidelity Balanced

Chase Growth Fidelity Blue Chip Grth

Chesapeake Core Growth Fidelity Contrafund

Columbia Acorn Z Fidelity Dividend Growth

Davis Appr & Income A Fidelity Equity-Inc

Davis Financial A Fidelity Leverage Co Stk

Davis NY Venture A Fidelity Low-Priced Stk

Delafield Fidelity Magellan

Delphi Value Retail Fidelity Value

Dodge & Cox Balanced First Eagle Fund of Am Y

Dodge & Cox Intl Stock First Eagle Glbl A

Dodge & Cox Stock First Eagle Overseas A

Dreyfus Appreciation FPA Capital

Dreyfus Prem Bal Opp J Franklin Growth A

Eaton Vance Wld Health A Gabelli Asset AAA

Fairholme Gabelli Growth AAA

FAM Value Gabelli Sm Cp Growth AAA

1.22 MUTUAL FUNDS

QUARTERLY UPDATES




Fund Name Fund Name

Gateway Fund Legg Mason Opp Prim

Harbor Capital App Instl Legg Mason Value Prim

Harbor Intl Instl LKCM Small Cap Equity Ins

Homestead Value Longleaf Partners

Hussman Strategic Growth Longleaf Partners Intl

ICAP Equity Longleaf Partners Sm-Cap

ICAP International Loomis Sayles Bond Ret

ICAP Select Equity Lord Abbett Affiliated A

Janus Marsico Focus

Janus Contrarian Fund Marsico Growth

Janus Enterprise Masters’ Select Equity

Janus Mid Cap Val Inv Matrix Advisors Value

Janus Orion Meridian Growth

Janus Overseas Meridian Value

Janus Sm Cap Val Instl Merrill Global Alloc A

Janus Twenty Muhlenkamp

Jensen J Mutual Shares A

Kalmar Gr Val Sm Cp Nicholas

MUTUAL FUNDS 1.23

QUARTERLY UPDATES




Fund Name Fund Name

Nicholas II I Royce Value Service

Northeast Investors RS Emerging Growth

Oak Value RS MidCap Opport

Oakmark Equity & Inc I Schneider Value

Oakmark Global I Selected American S

Oakmark I Sequoia

Oakmark International I Skyline Spec Equities

Oakmark Intl Small Cap I Sound Shore

Oakmark Select I T. Rowe Price Eq Inc

Osterweis Fund T. Rowe Price Gr Stk

Pioneer A T. Rowe Price Mid Gr

Pioneer High Yield A T. Rowe Price New Horiz

PRIMECAP Odyssey Agg Gr T. Rowe Price Sm Val

PRIMECAP Odyssey Growth Third Avenue Intl Value

Royce Opportunity Inv Third Avenue RealEst Val

Royce Premier Inv Third Avenue Sm-Cap Val

Royce Special Equity Inv Third Avenue Value

Royce Total Return Inv Thompson Plumb Growth

1.24 MUTUAL FUNDS

QUARTERLY UPDATES




Fund Name Fund Name

Thornburg Intl Value A Vanguard PRIMECAP Core

Thornburg Value A Vanguard Selected Value

Torray Vanguard Wellesley Inc

Turner Small Cap Growth Vanguard Wellington

Tweedy, Browne American Vanguard Windsor II

Tweedy, Browne Glob Val Wasatch Micro Cap

Van Kampen Comstock A Wasatch Small Cap Growth

Van Kampen Eq and Inc A Wasatch Ultra Growth

Van Kampen Growth & IncA Weitz Hickory

Vanguard Cap Opp Weitz Partners Value

Vanguard Capital Value Weitz Value

Vanguard Explorer Wesport R

Vanguard Health Care WF Adv Common Stk Z

Vanguard PRIMECAP WF Adv Opportunity Inv

MUTUAL FUNDS 1.25

QUARTERLY UPDATES


B SHARES REVIEWED BY SEC

During 2006, the NASD imposed more than $40 million of fines on

brokerage firms for improperly selling B and C mutual fund shares.

During the early part of 2007, the SEC acknowledged that one of its

key arguments no longer exists; the agency had assumed A shares

were always better than B shares. The NASD commission now

believes that cost alone is not the only decision in making

investment recommendations.

Most of the lawsuits against brokerage firms were based on one of

three things: (1) failure to tell clients that A shares can be cheaper

than B shares, (2) fraud, and/or (3) suitability. In a 2007 case

dropped by the SEC, the agency acknowledged that even at the

$250,000 breakpoint, B shares may not be more expensive for the

client than A shares.

Because of regulatory concern, brokerage firms have generally

limited B share sales to $50,000 or less. Shares of B shares had

fallen to 3% of the market in 2006, down from 10% in 2001. One

broker, now retired, spent $400,000 in legal fees and lost $1.6

million in deferred compensation in 2001 when his broker-dealer

fired him over the sale of B shares. In late 2005, a NYSE arbitration

panel ordered the firm to pay all deferred compensation plus legal

fees.

1.26 MUTUAL FUNDS

QUARTERLY UPDATES


SHAREHOLDER PROXY VOTING

During 2006, there were 1,400 filings by mutual funds asking

shareholders to vote on fund changes. The number of filings

represents about 20% of all mutual funds. During the first quarter of

2007, roughly 340 were seeking shareholder votes, according to

governance tracker the Corporate Library. The top issues voting

upon by shareholders have been issues dealing with directors and/or

trustees, investment restrictions and policies, and sub-advisor

agreements.

Fund companies want shareholders to vote as soon as possible for

such changes. If the necessary number of votes is not obtained, more

shareholder solicitation is required and this costs the fund, and

specifically its shareholders, more money. Among the most popular,

and worrisome proposals, are changes to investment limits,

loosening limits on borrowing and lending, requesting greater

flexibility in real estate and commodity investments, and taking

bigger positions in stocks or foreign holdings.

Despite investors’ concerns about proxy voting, shareholders rarely

show up at an announced meeting. For example, only 50 Dodge &

Cox investors showed up a few years ago to a meeting; only one

shareholder attended the $4.3 billion Alger Funds’ January meeting.

MUTUAL FUNDS 1.27

QUARTERLY UPDATES


SECURITIES LENDING PRACTICES

Mutual funds and ETFs lend some of the securities in their portfolios

in exchange for interest payments and collateral, which provides

additional returns for fund investors (well under 1/10th of 1%).

Although this practice is not new, the explosive growth of hedge

funds engaged in short selling has greatly increased the demand for

borrowed securities.

When a hedge fund, or any investor, enters a short sale (betting a

stock will fall), they are selling a stock they have borrowed in hopes

of buying it a lower price later, replacing the borrowed shares and

pocketing the difference. Lending occurs through an agent that finds

brokerage firms needing to borrow the securities. The agent takes a

split of the money earned from the lending—from 10-30% of the

interest charge. What remains is then added to the portfolio’s cash

reserves.

The SEC issues guidelines that funds and ETFs must follow when

setting up securities-lending agreements. The requirements are more

stringent if the fund does its lending through an agent affiliated with

the fund management company.

1.28 MUTUAL FUNDS

QUARTERLY UPDATES


FUND DIRECTOR PAY

As measured by asset size, the largest fund companies had a median

annual compensation of $172,000 for a director in 2006. For 2005,

the median annual compensation for the large fund companies was

$147,000 per director. The average cost to shareholders was 15.4¢

per $10,000 in assets. The figure was 16.1¢ in 2005.

A survey of over 330 fund families found that over 80% of fund

directors are independent; 60% of the time in the case of the fund’s

chairperson, up from 50% in 2005.

DIRECTORS AND 12B-1 FEES

An association of independent mutual fund directors has prepared

guidelines to help fund directors assess fees. The May 2007 report

follows an earlier announcement in 2007 that the SEC was

reviewing the rule that allows such fees.

MUTUAL FUNDS 1.29

QUARTERLY UPDATES


STOCKS AND MUTUAL FUNDS

Today’s S&P 500 was created in 1913 by Alfred Cowles in order to

“portray the average experience of U.S. stock market investors.” In

2005, about 41% of the revenue for the S&P 500 companies came

from operations outside the U.S. GE expects that 49% of its global

revenue for 2007 will come from countries other than the U.S. At

the end of 2006, the top 10 stocks in the S&P 500 represented

20% of the index’s total value and performance.

The number of households with more than $5,000 in stock fell from

40% to 35% from 2001 to 2004. In 2001, the top 10% of all U.S.

households owned 75% of all taxable stock; the wealthiest 1%

owned 29%. For each $1 increase in stock wealth boosts

consumption by 4.5¢, while each $1 increase in housing wealth

increases consumption by 7¢. Mutual funds represent approximately

25% of the financial assets owned by homeowners.

QUARTERLY

UPDATES

ETFS

ETFS 2.1

QUARTERLY UPDATES


2.ETF UPDATE

The first table below shows exchange-traded fund (ETF) asset

growth over each of the past several years.

ETFs: Number and Assets (in billions) [5/15/07]

Year # Assets Year # Assets

2002 109 $10.2 2005 206 $30.2

2003 116 $15.1 2006 335 $41.8

2004 152 $22.7 2007 (2nd

qtr.) 500 $50.0

The next table shows the largest ETF management companies. The

percentage figures indicate the percentage of the entire ETF

marketplace managed by each company; Barclays oversees just

under 60% of the entire ETF industry assets.

2.2 ETFS

QUARTERLY UPDATES


Market Share of ETF Companies

Management Co. % of Whole

Barclays Global Investors Fund 59.6%

State Street Global Advisors 23.4%

BNY Hamilton 6.3%

Vanguard Group 5.7%

Powershares Capital 2.3%

Rydex Funds 0.9%

WisdomTree 0.5%

Victoria Bay Asset Management 0.5%

DB Commodity Services 0.3%

Van Eck Corporation 0.2%

First Trust Advisors 0.1%

Claymore Advisors 0.1%

Fidelity Distributors 0.1%

There is expected to be roughly 800 ETFs by the end of 2007. There

are currently 32 ETFs that focus on technology, 35 investing in

natural resources, 39 devoted to health care, and 22 focused on the

financial sector.

If you have high-risk investors, consider the “double” ETF funds

listed below. These funds, with an average expense ratio of just

under 1%, are designed to double an investor’s gains (or losses),

whether the market (or sector) goes up (long) or drops (short). All of

these ETFs trade on the AMEX.

ETFS 2.3

QUARTERLY UPDATES


ETFs That Double Gains (or Losses)

Double Long ETFs Double Short ETFs

Ultra Basic Materials (UYM) UltraShort Basic Materials (SMN)

Ultra Consumer Goods (UGE) UltraShort Consumer Goods (SZK)

Ultra Consumer Services (UCC) UltraShort Consumer Services (SCC)

Ultra Financials (UYG) UltraShort Financials (SFK)

Ultra Health Care (RXL) Ultra Short Health Care (RXD)

Ultra Industrials (UXI) UltraShort Industrials (SIJ)

Ultra Oil & Gas (DIG) UltraShort Oil & Gas (DUG)

Ultra Real Estate (URE) UltraShort Real Estate (SRS)

Ultra Semiconductors (USD) UltraShort Semiconductors (SSG)

Ultra Technology (ROM) UltraShort Technology (REW)

Ultra Utilities (UPW) Ultra Short Utilities (SPD)

2.4 ETFS

QUARTERLY UPDATES


THE LARGEST ETFS

The table below shows the 15 largest ETFs, ranked largest to

smallest, based on asset size in billions of dollars, as of the

beginning of 2007.

2007 Largest ETFs

ETF Symbol Size ($b)

SPDR Trust 1 SPY $70

iShares MSCI EAFE Index EFA $40

NASDAQ 100 Trust 1 QQQQ $20

iShares S&P 500 Index IVV $19

iShares MSCI Japan Index EWJ $15

iShares MSCI Emerging Markets Index EEM $14

iShares Russell 2000 Index IWM $12

MidCap SPDR Trust 1 MDY $10

iShares Russell 1000 Value Index IWD $9

StreetTRACKS Gold Trust GLD $8

iShares Dow Jones Select Dividend Trust DVY $8

iShares Russell 1000 Growth Index IWF $7

DIAMONDS Trust 1 DIA $7

iShares Lehman 1-3 Year Treasury Bond SHY $6

iShares S&P SmallCap 600 Index IJR $5

ETFS 2.5

QUARTERLY UPDATES


ETFS WITH LOW EXPENSE RATIOS

The table below shows the 15 lowest expense ratio ETFs, as of

the beginning of 2007.

2007 Lowest Expense Ratio ETFs

ETF Symbol Expense

Vanguard Large Cap VV 0.09

iShares S&P 500 Index IVV 0.09

SPDR Trust 1 SPY 0.10

iShares Lehman 7-10 Year Treasury Bond IEF 0.15

iShares iBoxx $ Invest. Grade Corp. Bond LQD 0.15

iShares Lehman 1-3 Year Treasury Bond TIP 0.15

iShares Lehman 20+ Year Treasury Bond TLT 0.15

iShares Russell 1000 Index IWB 0.15

DIAMONDS Trust 1 DIA 0.17

iShares S&P 500 Growth Index IVW 0.18

iShares S&P 500 Value Index IVE 0.18

NASDAQ 100 Trust 1 QQQQ 0.20

iShares Lehman Aggregate Bond AGG 0.20

iShares Lehman TIPS Bond TIP 0.20

iShares NYSE 100 Index NY 0.20

2.6 ETFS

QUARTERLY UPDATES


ETF PRICE DISPARITIES

Often times, some of the most actively traded issues on the NYSE

and other U.S. markets are ETFs. Barclays estimates that on any

given day, 80% of the trading of its ETFs are traded by large

investors such as hedge funds. As of May 2007, there were about

500 ETFs in the U.S., valued at $500 billion (vs. 8,100 traditional

mutual funds valued at $10.5 trillion). Although ETFs are expected

to closely track an underlying index, this is not always the case

during extreme days in the market.

For example, on February 27th

, 2007, an ETF managed by Barclays

that tracks the Chinese stock market closed down 9.9% in the U.S.,

even though the underlying index had fallen 2.1% during Chinese

trading hours. The index fell an additional 3.1% the next day in

China (but the Barclay’s iShares rose 4.3%). However, had U.S.

investors sold the Barclays ETF just before the close of trading on

February 27th

, their loss would have been 9.9%, not the actual loss of

the index, 2.1%. On the positive side, purchasers of the Barclays

ETF would have bought at a 7.8% discount (9.9% - 2.1%), resulting

in a substantial gain for owning the ETF shares for less than a day.

Another example is the precious metals ETF offered by Powershares

Capital Management. On Februrary 27th

, the ETF ended the day

3.3% below the actual value of the fund’s holdings. The iShares

emerging markets ETF lost 8.1%, even though the index was down

just 3.1%. As a result, a seller of $10,000 of the Barclay’s iShares

would have received $500 less than if the fund had actually tracked

the index.

ETFS 2.7

QUARTERLY UPDATES


There are disparities even for ETFs that track just U.S. stocks. The

Russell 2000 Index (small company stocks) fell 3.75% on February

27th

, 2007, versus 4.70% for the actual index. In this case, a large

part of the disparity (almost 1%) was because like other ETFs, this

Russell ETF trades for 15 minutes longer than regular stocks. For all

of February 27th

, 89 of the 421 ETFs tracked by Morningstar fell

short of their portfolio value by more than 1% (+/-1/2% is considered

normal). Of those 89 ETFs, 60 fell short by more than 2%.

There are three lessons to be learned from these index and ETF

disparities. First, when there is a panic, the pricing of a number of

ETFs can be quite different than the underlying index (somewhat

similar to the premium-discount difference with most closed-end

funds). Second, advisors should think twice about selling any

investment, and in particular an ETF or CEF, during periods of high

short-term volatility. Third, it is extremely likely that any disparity,

no matter how narrow or wide, is likely to be corrected within one or

two days, thereby making moot any attempt to sensationalize such

price differences.

SECTOR VOLATILITY

The most volatile sector ETFs are, from highest to lowest risk, are:

1. Technology 6. Materials

2. Financial (includes REITs) 7. Energy

3. Healthcare 8. Consumer Staples

4. Consumer Discretionary 9. Utilities

5. Industrial

2.8 ETFS

QUARTERLY UPDATES


BUYING AND SELLING ETFS

The majority of all stock and ETF trades are:

1. Market order—You get the best price currently available;

most orders are market orders.

2. Limit order—You place a buy order, indicating that you are

willing to pay $X per share or less. If you place a sell limit

order, you are indicating that you want $Y per share or more.

If someone is not willing to sell you shares for $X or less, the

order is not filled; similarly, if someone is not willing to buy

your shares for $Y or more, you will end up not selling the

shares.

3. Stop-loss (or stop) order—The order goes into effect as soon

as the price per share of the stock (or ETF) hits a certain

price. Once this price is reached, the stop-loss order becomes

a market order. This type of order is frequently used to limit

price declines if the security’s price falls.

4. Short sale—You believe the price per share of a stock or

ETF is going to fall. Shares of a stock or ETF are borrowed

by your brokerage firm on your behalf (note: you will be

paying an ongoing interest charge for the borrowing). If the

price of the security falls after the short sale, you have a gain;

if the price of the security rises, you have a loss. At some

point in the future, the investor will decide to buy the stock or

ETF and thereby repay the original borrowed shares.

QUARTERLY

UPDATES

UITS AND

CLOSED-END FUNDS

UITS AND CLOSED-END FUNDS 3.1

QUARTERLY UPDATES


3.UIT AND NEW FUND CRITICISM

Some newly launched mutual funds as well as UITs rely on

historical data to increase sales and help market their portfolios.

Critics argue that these new offerings simply keep shifting the

composition of the funds’ proposed holdings until they find one that

happens to have worked over the necessary range of dates.

CLOSED-END FUND ASSET INCREASE

For the first quarter of 2007, more than $13 billion was raised

through closed-end fund IPOs, more than was raised for all of 2006.

At the end of 2006, the closed-end fund (CEF) industry managed

$420 billion in assets. As of the end of the first quarter of 2007, the

median discount for all CEFs was 2.3%; about 35% of all CEFs

trade at a premium over their NAV.

CEF IPOs

Year # of IPOs $ (billions)

2006 21 $11

2005 47 $21

2004 50 23

2003 48 28

2002 77 16

3.2 UITS AND CLOSED-END FUNDS

QUARTERLY UPDATES


A number of sources believe that CEF IPOs are not good for

investors since the majority of them end up trading at a discount

to NAV. These same critics believe that the IPO market for CEFs

largely rely on unsophisticated income-oriented investors. In January

2007, the IPO for Alpine Total Dynamic Dividend Fund raised over

$4 billion.

CLOSED-END COVERED CALL FUNDS

Closed-end covered-call funds have the objective of generating high

income by selling call options on stocks in their portfolios. These

types of funds first appeared in 2004 and accounted for 85% of IPO

money going into closed-end funds. Even though these are equity

funds, a number of analysts consider them to be a “fixed-income

application.”

The goal of a closed-end covered-call fund manager is to achieve the

highest premium income possible while forfeiting the least amount

of equity upside. Critics feel that these funds cap returns in bull

markets (since good-performing stocks will be called away), and in a

crash or severe correction do not generate enough option-writing

income to offset the decline. In some respects, these funds perform

best, at least comparatively speaking, when the market is flat or

rising slightly.

The Chicago Board Options Exchange (CBOE) currently licenses

four buy-write indexes. The table below lists the six largest closed-

end covered-call funds. As of the third quarter of 2006, all six of

these funds were selling at a discount that ranged from 3% to 9%.

UITS AND CLOSED-END FUNDS 3.3

QUARTERLY UPDATES


The Largest Closed-End Covered-Call Funds

NFJ Dividend, Interest &

Premium Strategy

Nuveen Equity Premium

Opportunity

Eaton Vance Tax-Managed

Global Buy-Write

Eaton Vance Tax-Managed Buy-

Write Opportunity

ING Global Equity Dividend &

Premium Opportunity

Black Rock Enhanced Dividend

Achievers

QUARTERLY

UPDATES

REITS

REITS 4.1

QUARTERLY UPDATES


4.REIT UPDATE

After stagnating in 1999, real estate funds went on to average just

under 22% per year for the next seven years (ending 12/31/2006).

This sector category can also provide diversification, when the S&P

500 dropped 9% in 2000, real estate funds gained 27%. The table

below shows return figures for REIT sectors, as of March 1st, 2007.

REIT Sector Returns [ending 3-1-2007]

REIT category 1-year 3-year 5-year 10-year

Apartments 24.1% 29.6% 21.7% 15.9%

Regional Malls 30.8% 28.4% 33.9% 21.4%

Shopping Centers 34.7% 26.7% 29.1% 18.5%

Office Buildings 41.7% 27.3% 22.3% 15.4%

Industrial 24.8% 25.8% 26.0% 17.2%

Health Care 41.1% 18.3% 23.1% 14.9%

Self Storage 29.7% 30.8% 25.6% 18.0%

Lodging / Resorts 24.5% 24.4% 17.1% 5.3%

Manufactured Homes 8.7% 3.4% 8.2% 9.1%

Mortgage REIT Index 7.2% -4.6% 15.1% 6.6%

4.2 REITS

QUARTERLY UPDATES


INTERNATIONAL REITS

From 2003 to 2007, Asia REITs returned an average of 35.4% per

year; 43.5% annually in the case of European REITs (67% in 2006).

In the U.S. there are about 180 REITs registered with the SEC. Japan now has more than 40. Over 20 countries have passed or

considered laws allowing the formation of REITs. The U.K. and

Germany adopted REIT laws in early 2007.

QUARTERLY

UPDATES

STOCKS

STOCKS 5.1

QUARTERLY UPDATES


5.DOW MILESTONES

The Dow Jones Industrial Average (DJIA) began with just 12 stocks

in 1896 when the average had a starting value of 40.94. Since 1928,

there have been 30 stocks in the Dow. The table below shows Dow

milestones.

It took 127 days for the DJIA to move from 12,000 to 13,000. In

1999, it took 24 days to move from 10,1000 to 11,000. But it took

7.5 years to move from 11000 to 12,000. The Great Depression

caused the DJIA to lose 90% of its value. The high it reached on

September 3rd

, 1929, was not surpassed until 1954.

The Dow Hitting 1,000 Point Increments

Dow Date Dow Date

12000 Oct. 19, 2006 5000 Nov 21, 1995

11000 May 3, 1999 4000 Feb 23, 1995

10000 March 29, 1999 3000 Apr. 17, 1991

9000 April 6, 1998 2000 Jan. 8, 1987

8000 July 16, 1997 1000 Nov. 14, 1972

7000 Feb. 13, 1997 start May 26, 1896

6000 Oct 14, 1996

5.2 STOCKS

QUARTERLY UPDATES


DOW DROPS

The table below shows the biggest percentage drops in the Dow

Jones Industrial Average (DJIA) from the beginning of 2003 to

March 17th, 2007. Since 1980, the return on the DJIA has averaged

13.9% per year, versus 13.1% for the S&P 500. There are 10 sectors

in the S&P 500:

DJIA Biggest 1-Day Drops [1-1-2003 through 3-17-2007]

Date % Change Date % Change

3-24-03 3.6% 5-19-03 2.1%

2-27-07 3.3% 1-30-03 2.0%

1-24-03 2.9% 3-13-07 2.0%

3-10-03 2.2%

S&P 500 Sectors

consumer discretionary industrials

consumer staples materials

energy technology

financials telecom

health care utlities

If the technology sector were excluded from the S&P 500, the S&P

500 would be 16% above its 2000 peak. Looking at the entire S&P

500 (including technology stocks), more than 2/3 of the stocks are

above their peak prices reached in 2000.

STOCKS 5.3

QUARTERLY UPDATES


S&P 500 AND DJIA RETURNS

As of May 3rd

, 2007, the S&P 500 was within 2% of its record close

of 1527.5 in March 2000. On the same day, the Dow Jones Industrial

Average (DJIA) hit another all-time record for 2007, closing at

13,241.4. The NASDAQ, which closed at 2,565.5, is still roughly

50% below its 2000 all-time high of over 5,000.

50TH

ANNIVERSARY OF THE S&P 500

From its March 1st, 1957 inception through the end of 2006, the

average annual return of the S&P 500 has been 10.83%. The S&P

500 comprises 83% of the value of all U.S. stocks. Almost 1,000

new companies have been added and deleted from the index since its

inception.

The materials and energy sectors made up half the value of the

original index, compared to 12% in 2007. By a wide margin, the best

performing stock has been Altria (formally Phillip Morris); from

March 1957 through the end of 2006, investors averaged 19.9%

annually. A $10,000 investment grew to $8.4 million (vs. $168,000

if the $10,000 had been invested in the entire index). Of the original

111 surviving companies, 20 outperformed the index by an average

of almost 5% per year.

5.4 STOCKS

QUARTERLY UPDATES


SMALL CAP STOCKS

U.S. small company stocks with market capitalizations of less than

$3.5 billion have averaged 16.5% a year versus 12.2% for the S&P

500 over the past 30 years (ending 6/30/2006). As of the beginning

of 2007, small cap companies represented 78% of all listed

stocks in the U.S. (84% in Japan, 79% in Hong Kong, 74% in the

U.K. and 65% in France).

QUALIFYING DIVIDENDS

Legislation passed in 2004 cut the tax rate on “qualifying” dividends

to a maximum of 15%. For investors, “qualified” means that the

stock (paying the dividend) has to be owned by both the investor and

the mutual fund or ETF for at least 61 of the 121 days surrounding

the ex-dividend date. Income paid out by REITs and some overseas

companies do not qualify for this lower rate.

BUFFET WARNING

During the May 2007 Berkshire Hathaway annual meeting, Warren

Buffet repeated his warning about derivatives and leverage. Buffet

believes that derivatives are the “financial weapons of mass

destruction.” He expects that derivatives and the use of leverage by

traders, investors, and corporations will eventually end in huge

losses. According to Buffet, “The introduction of derivatives has

totally made any regulation of margin requirements a joke.”

STOCKS 5.5

QUARTERLY UPDATES


DIVIDEND-PAYING BONUS

According to a Morgan Stanley report, from 1970 through 2005,

stocks that paid dividends averaged annual returns of 10.2%,

almost six percentage points ahead of non-payers. According to

S&P, 383 companies in the S&P 500 paid dividends in 2006,

compared with 351 in 2001. A decade ago, 427 out of 500 paid

dividends. The average payout ratio is just below 32%. Morgan

Stanley estimates that 40% of the S&P 500’s annual total returns

were from dividends for the period 1926 through 2004. Standard &

Poor’s reports that approximately one out of every nine stocks (59

total) in the S&P 500 has increased its annual dividend for at least 25

consecutive years as of the end of 2006.

VALUE PLAY

Suppose you wanted to buy a quart of milk. Last week you

bought a quart for $1.20. This week it is selling for $13.00 a

quart. How likely is it that you would buy a $13 quart of milk?

Yet, when it comes to buying stock, no one asks what the

“quart” (stock) used to sell for.

From the beginning of 2000 to the end of 2006, the average large

cap value fund had a cumulative return of just under 60%, versus

just 18% for the typical large cap growth fund. The Russell 1000

Value Index was up 22% in 2006, but only 6% of active large cap

value managers beat the index. Even though financial stocks

currently comprise 36% of the Russell 1000 Value Index, few active

money managers will devote that much to financials or any other

single sector.

QUARTERLY

UPDATES

VALUE VS.

GROWTH STOCKS

VALUE VS. GROWTH STOCKS 6.1

QUARTERLY UPDATES


6.ROLLING PERIODS: GROWTH VS. VALUE

The table below shows the number of positive rolling three-year

periods, for different growth and value categories over the past 30

years, ending December 31st, 2006. Over a 30-year period, there are

28, three-year rolling periods.

Positive 3-Year Rolling Periods,

Growth vs. Value Stocks [1977-2006]

Category + Returns % +

Large Growth 25 / 28 yrs. 89%

Large Value 26 / 28 yrs. 93%

Mid Growth 27 / 28 yrs. 96%

Mid Value 28 / 28 yrs. 100%

Small Growth 27 / 28 yrs. 96%

Small Value 28 / 28 yrs. 83%

ALL GROWTH 25 / 28 yrs. 89%

ALL VALUE 26 / 28 yrs. 93%

The table below shows the number of positive rolling five-year

periods, for different growth and value categories over the past 30

years, ending December 31st, 2006. Over a 30-year period, there are

26, five-year rolling periods.

6.2 VALUE VS. GROWTH STOCKS

QUARTERLY UPDATES


Positive 5-Year Rolling Periods,











In summary, looking at both tables in this section, almost all of the

negative annual returns took place during the 2000-2002 stock

market meltdown. In the case of three- and five-year rolling periods,

all negative periods were the result of the same meltdown.

REVISITING GROWTH AND VALUE

From the beginning of 1969 to the end of 2006, large cap growth

stocks experienced eight negative years versus 10 negative years for

large cap value stocks (see table below). Excluding 1970, every

year large cap growth stocks experienced a negative return, so

did large cap value issues.


QUARTERLY UPDATES


1969-2006 Losing Years for Large Cap Stocks

Large Cap Growth Large Cap Value

-5.1% (1970) -16.9% (1969)

-18.7% (1973) -10.1% (1973)

-32.4% (1974) -22.0% (1974)

-12.1% (1977) -4.7% (1977)

-8.8% (1981) -3.3% (1981)

-22.0% (2000) -8.3% (1990)

-20.1% (2001) -1.0% (1994)

-23.9% (2002) -3.0% (2000)

-8.8% (2001)

-20.1% (2002)

-143.1% = total -98.2% = total

-17.9% = average loss -9.8% = average loss

Using a simple average (adding up all of the negative numbers and

dividing by the number of negative years), the average loss for

growth stocks was -17.9% versus -9.8% for large cap value stocks, a

45% difference. The biggest loss was -32.4% for large cap growth

stocks (1974) versus -22.0% for large cap value stocks (1974), a

32% difference; the smallest loss was -5.1% for growth versus -1.0%

for value, an 80% difference. From the beginning of 1969 to the end

of 2006, mid cap growth stocks experienced 11 negative years

versus seven negative years for mid cap value stocks (see table

below). Excluding 1977, every year mid cap value stocks

experienced a negative return, so do mid cap growth issues.


QUARTERLY UPDATES


1969-2006 Losing Years for Mid Cap Stocks

Mid Cap Growth Mid Cap Value

-13.6% (1969) -18.6% (1969)

-6.4% (1970) -15.7% (1973)

-32.5% (1973) -20.9% (1974)

-33.1% (1974) -1.0% (1987)

-3.1% (1981) -15.6% (1990)

-6.1% (1984) -1.7% (1994)

-5.1% (1990) -12.8% (2002)

-2.3% (1994)

-18.5% (2000)

-7.2% (2001)

-21.5% (2002)

-149.2% = total -86.3% = total




growth stocks was -13.6% versus -12.3% for value stocks, a 10%

difference. The biggest loss was -33.1% for mid cap growth stocks

(1974) versus -20.9% for mid cap value stocks (1974), a 63%

difference; the smallest loss was -2.3% for growth versus -1.7% for

value, a 26% difference.


QUARTERLY UPDATES


From the beginning of 1969 to the end of 2006, small cap growth

stocks experienced 11 negative years versus eight negative years

for small cap value stocks (see table below). Excluding 1998, every

year small cap value stocks experienced a negative return, so do

small cap growth issues.

1969-2006 Losing Years for Small Cap Stocks

Small Cap Growth Small Cap Value

-19.6% (1969) -19.1% (1969)

-13.7% (1970) -24.4% (1973)

-40.6% (1973) -20.4% (1974)

-28.9% (1974) -4.7% (1987)

-4.9% (1981) -18.7% (1990)

-7.4% (1984) -0.1% (1994)

-7.9% (1987) -4.1% (1998)

-16.3% (1990) -13.3% (2002)

-1.9% (1994)

-22.6% (2000)

-27.8% (2002)

-191.6% = total -104.8% = total



QUARTERLY UPDATES




growth stocks was -17.4% versus -13.1% for value stocks, a 25%

difference. The biggest loss was -40.6% for small cap growth

stocks (1973) versus -24.4% for small cap value stocks (1973), a

40% difference; the smallest loss was -1.9% for growth versus -

0.1% for value, a 95% difference.

Conclusions Whether the comparison is between large, mid, or small cap

issues, value has suffered less than growth from 1969 through

2006; the average loss has been smaller. The largest losses were

always in growth and the smallest losses were always in value

stocks. In the case of mid and small cap stocks, the frequency of

losses has been greater for growth.

Adding up the cumulative returns of growth versus value from

1969 to the end of 2006, value has dramatically outperformed

growth (as shown in the table below); large value outperformed

large growth by almost 2-1, over 3-1 in the case of mid cap value

versus mid cap growth, and over 7-1 in the case of small cap

value versus small cap growth. As a side note, the standard

deviation for large, mid, and small cap value stocks has been

lower than their growth counterparts in the 1970s, 1980s, 1990s,

2000s, and from 1997 through 2006.


QUARTERLY UPDATES


Growth of $10,000 from 1969 to the end of 2006

LC

Growth

LC

Value

MC

Growth

MC

Value

SC

Growth

SC

Value

$276,070 $539,470 $342,940 $1,429,090 $276,970 $2,338,810

From the beginning of 1928 through the end of 2006, $10,000

invested in small cap value stocks grew to $549,670,000 versus

$13,710,000 for small cap growth stocks (a margin of 39 to 1).

The same dollar invested in large cap value stocks grew to

$76,620,000 versus $9,740,000 for large cap growth stocks (a

margin of 6.7 to 1). Surprisingly, from 1928 through 2006, the

standard deviation for small cap value stocks was only slightly lower

than it was for small cap value stocks; the large cap growth stocks

has less risk (standard deviation of 20) than large cap value stocks

(standard deviation of 27) during the same period

SMALL CAP VALUE

Dartmouth finance professor Kenneth French and University of

Chicago economics professor Eugene Fama, who founded

Dimensional Fund Advisors (DFA) in 1981, developed the “Three

Factor Model” that questioned the validity of William Sharpe’s

capital asset pricing model (CAPM). DFA believes that tilting a

portfolio towards value and small cap stocks leads to better

performance over time. According to their historical studies, value

has outperformed growth by 5.1% annually since 1927.


QUARTERLY UPDATES


GROWTH VS. VALUE

The table below shows the number of positive annual returns for

different growth and value categories over the past 30 years, ending

December 31st, 2006.

Positive Annual Returns












QUARTERLY UPDATES


2006 INDEX RETURNS

The tables below show returns for nine major indexes and the 10

Dow Jones industry groups for the 2006 calendar year.

2006 Index Returns

Index Return Index Return

DJIA 16.3% AMEX 16.9%

DJ World (excl. U.S.) 23.0% S&P 500 13.6%

DJ Wilshire 5000 13.9% Value Line 11.0%

NYSE Composite 17.9% NASDAQ 9.5%

Russell 2000 17.0%

2006 Dow Jones Industry Group Returns

Industry Group Return Industry Group Return

Basic Materials 16.1% Industrials 12.7%

Consumer Goods 12.5% Oil & Gas 20.3%

Consumer Services 13.5% Technology 9.5%

Financials 16.5% Telecommunications 32.2%

Health Care 5.7% Technology 9.5%

QUARTERLY

UPDATES

BONDS

BONDS 7.1

QUARTERLY UPDATES


7.CUSHION AGAINST STOCK DECLINES

The table below shows the benefit of owning tax-free bonds during

stock market declines. From1986-2006, there have been four

instances when the S&P 500 has declined by 15% or more.

S&P 500 Decline

(high to low)

S&P 500

(with dividends)

Lehman Brothers

Municipal Bond Index

8-25-87 to 12-4-87 - 32.8% - 0.8%

7-16-90 to 10-11-90 - 19.2% - 1.4%

7-17-98 to 8-31-98 - 19.1% 1.8%

3-24-00 to 10-9-02 - 47.4% 25.1%

STOCKS VS. BONDS

Even though the 2000-2002 bear market represents the worst

cumulative drop in the S&P 500 over the past 50 years (-49%),

stocks still did better than bonds for the 10-year period ending

December 31st, 2006 (124% for the S&P 500 vs. 83% for the

Lehman Brothers Aggregate bond index).

7.2 BONDS

QUARTERLY UPDATES


2006 HIGH-YIELD BOND FACTS

In 1980, slightly less than a third of U.S. industrial corporations

tracked by Standard & Poor’s were rated junk. By the late 1980s,

more than half were; the number increased to 71% by early 2007.

The S&P 500 includes 70 companies whose bonds are rated below

investment grade.

During the past 20 years, 4.5% of junk bonds have gone into default;

in 1991 and 2002, defaults were more than 10% of outstanding high-

yield bonds. The default rate was just 1.3% for 2006 (only 0.8%

according to Fitch). The table below shows that the number of

companies with high-risk credit ratings (BB or lower) has jumped

since 1980 (note: the table does not include utilities or financial

institutions).

Corporate Bond Ratings in 2006 vs. 1980

S&P Rating 1980 2006

AAA/AA 17% 2%

A 33% 9%

BBB 18% 18%

BB 22% 25%

B 7% 42%

CCC/D 3% 4%

BONDS 7.3

QUARTERLY UPDATES


According to the Financial Times, 1.6% of global junk bond debt

defaulted in 2006; this is the lowest default rate experienced by

global junk bonds since 1981. The historical default rate for junk

bonds is 4.9% annually.

BOND MARKETS, INDEXES, AND FUNDS

The U.S. bond market more than doubled from $10.7 trillion in 1996

to $22.7 trillion by the middle of 2006. The Lehman Brothers

Aggregate Bond Index is comprised of more than 7,000 different

bonds, many of which are illiquid that fund managers cannot buy,

even if they wanted to. However, by copying some of the index’s

broad characteristics, such as sector exposure, interest rate

sensitivity and maturity, bond fund managers can end up with

portfolios that are very similar to the Lehman index.

Indices and averages are cost-free in the sense that their structure

and performance do not include any initial or ongoing costs such as

commissions, management fees, or bid-ask spreads. Since a mutual

fund incurs all of these costs, it can only beat an index by being

different. In the case of bond funds, increased credit risk, yield-curve

positioning, or emphasizing sectors or issues different from the

index are the only ways to outperform.

7.4 BONDS

QUARTERLY UPDATES


R-squared reflects the percentage change of a fund’s fluctuation

that can be explained by the change in its benchmark index. A

fund that highly corresponds to its respective index has an R-squared

in the high 80s or 90s. For the 10-year period ending September

2006, only two of 15 funds with 10-year R-squareds of 98 or higher

outperformed the Lehman Brothers Aggregate Bond Index. Fund

expenses prevented the other 13 possible candidates from

outperforming the index. However, over the past three and five

years, the following funds have been able to outperform the Lehman

index even after taking into account trading costs and expenses:

Metro West Total Return, Dodge & Cox Income, Western Asset

Credit Bond Institutional, Fidelity Mortgage Security, TCW Total

Return Bond I, Harbor Bond Institutional, Fidelity Total Bond,

Managers Fremont Bond, PIMCO Total Return D, T. Rowe Price

New Income, USAA Income, and Fidelity Investment Grade Bond.

All of these funds had an R-squared of 94 or higher, with the

exception of Dodge & Cox Income (R-squared of 91) and Metro

West Total Return (R-squared of 69).

Obviously, funds that try to match a bond index’s performance are

going to fail if their expense ratios are too high. The advisor who is

seeking index-type returns will have to either choose low expense

funds or portfolio’s that have securities different than their

respective index—specifically, high-yield issues.

BONDS 7.5

QUARTERLY UPDATES


Defaults on U.S. junk bonds for the 2006 calendar year were 1.3%,

well below the historical average of 4.5%, as computed by Standard

& Poor’s. Another respected rating service, Fitch, shows the 2006

default rate at just 0.8%, down from 3.1% in 2005 and well below

the long-term average of 5.0%. Over the past 10 years, the yield

spread between high-yield corporate debt and U.S. Treasuries has

been as low as 2.6% (early 2007) and higher than 10.0% (fall of

2002). Thus, in the current environment, your clients may be able to

outperform an index bond fund by focusing on low-cost funds that

have the flexibility to increase their exposure to high-yield.

Before discounting the importance of bonds, consider the following:

From January 1st, 2000 to December 31

st, 2002, a $100,000

investment in the S&P 500 fell to $62,406 while a $100,000

investment in the Lehman Brothers Aggregate Bond Index grew to

$133,466.

QUARTERLY

UPDATES

GLOBAL INVESTING

GLOBAL INVESTING 8.1

QUARTERLY UPDATES


8.WORLD’S FINANCIAL ASSETS

As of the beginning of 2006, the value of the world’s financial

assets was over $140 trillion. This figure is three times as large as

the total output of goods and services produced around the globe.

Flows of investment across borders hit $6 trillion in 2005.

Of all the savings that people are willing to invest outside their

country, the U.S. gets 85%. Worldwide, about one in five stocks

is owned by someone who lives outside the country where the

stock was issued. The table below shows financial assets for

countries and regions at the beginning of 2005, in trillions of U.S.

dollars.

World Assets as of 1-1-2006 [in trillions of U.S. dollars]

Area $ (t) Area $ (t)

U.S. $48 Australia, New Zealand, & Canada $5

Euro Area $27 Other Western Europe $4

Japan $17 Latin America $3

Emerging Asia $10 Hong Kong & Singapore $2

U.K. $7 Eastern Europe $2

8.2 GLOBAL INVESTING

QUARTERLY UPDATES


EMERGING MARKET DEBT

In 1997, emerging market government debt was $786 billion; by the

end of 2006, the figure was $3.15 trillion. Corporations in those

countries had $416 billion of home-currency debt in 1997, versus

$1.4 trillion by the end of 2006.

2006 GLOBAL INDEX RETURNS

The tables below show returns for Dow Jones global indexes in 2006

in U.S. dollars and in local currency.

2006 Dow Jones Global Index Returns

Country U.S. $ Local Country U.S. $ Local

Venezuela 63% 111% Mexico 39% 42%

Indonesia 62% 48% Singapore 39% 28%

Philippines 49% 38% Austria 38% 24%

Spain 47% 31% Hong Kong 38% 39%

Sweden 43% 23% Germany 35% 21%

Norway 43% 32% Greece 35% 21%

Ireland 42% 27% Denmark 34% 20%

Portugal 42% 27% France 34% 20%

Brazil 42% 30% Malaysia 33% 24%


QUARTERLY UPDATES


2006 Dow Jones Global Index Returns

Country U.S. $ Local Country U.S. $ Local

Belgium 32% 18% South Africa 18% 31%

Italy 31% 17% Canada 16% 16%

Chile 30% 36% South Korea 15% 6%

Netherlands 30% 16% U.S. 14% 14%

Finland 28% 15% New Zealand 13% 9%

Australia 28% 19% Thailand 6% -6%

U.K. 28% 12% Japan 2% 3%

Switzerland 27% 18% World 19%

Taiwan 21% 20%

Greater China has two major exchanges, the Shanghai and the

Shenzhen. For 2006, China’s Shanghai A Shares increased 131% in

local currency (96% in the case of Shenzhen A shares).

REDUCED GLOBAL CORRELATION

For the two-year period ending February 2007, correlation between

U.S. and other developed markets was 0.63, according to ING Asset

Management. From 2003 to 2005, the correlation was an incredibly

high 0.93 (S&P 500 vs. EAFE). Bear Sterns believes that these very

high correlations were due to the bursting of the tech bubble.


QUARTERLY UPDATES


EAFE COMPOSITION

Five countries, France, Germany, Japan, Switzerland, and the

U.K., comprise 70% of the EAFE index; Japan alone represents

22% of the index. Over the past 10 years (ending 12/31/2006),

Japanese stocks have averaged 2.3% in U.S. dollar terms.

The S&P 500 and EAFE index have either both risen or fallen in

the same calendar year for each of the last 14 consecutive years

(1993-2006); however, during the same period, the spread between

the two indexes averaged 13% per year.

As of the beginning of March 2007, the EAFE Index was divided as

follows: Japan (23%), the U.K. (23%), France (10%), Germany

(7.5%), Switzerland (7%), and Asia ex-Japan (8.5%). The market

capitalization of the typical stock in the EAFE is $33 billion; 57%

of the index is comprised of “giant” stocks, 33% large stocks, 11%

medium, and 0.1% small stocks.

The market capitalization of the roughly 1,400 stocks in the

EAFE is $10.2 trillion. The largest stock in the index is British

Petroleum, which has a market capitalization of over $220 billion.

The only Japanese stock in the top 10 is Toyota, ranked number

three (1.5% of the index). Of the top seven companies, five are from

the U.K. Over half the stocks in the portfolio are classified as either

financials, consumer discretionary, or industrial issues. The table

below shows the composition of the MSCI EAFE Index as of the

beginning of 2006.


QUARTERLY UPDATES


EAFE Index

Country Securities Weight Country Securities Weight

Japan 369 23% Finland 21 1%

U.K. 155 23% Belgium 20 1%

France 62 10% Singapore 41 1%

Germany 50 7% Denmark 19 1%

Switzerland 38 7% Ireland 17 1%

Australia 83 5% Norway 18 < 0.8%

Italy 39 4% Greece 21 < 0.7%

Spain 33 4% Austria 13 < 0.5%

Netherlands 26 3% Portugal 11 < 0.4%

Sweden 47 2% New Zealand 13 < 0.2%

Hong Kong 41 2% EAFE Total 1,137 100%


QUARTERLY UPDATES


GLOBAL SMALL CAP BENEFITS

Over the past five years ending December 31st, 2006, small and

mid-cap foreign stocks of developed countries averaged 25%

annually. Returns on small cap foreign stocks have a lower

correlation than either emerging market or large cap foreign

stocks have to the S&P 500. This positive trait is likely due to the

fact that small cap stocks are influenced more by domestic or

regional factors than by global influences such as oil prices or U.S.

interest rate changes.

A study by ING shows that foreign small cap stocks were less

volatile than emerging market stocks for the past 12 years. Volatility

for foreign small cap stocks was roughly the same as it was for large

cap foreign stocks and U.S. stocks.

Even though the average market capitalization for a foreign

small stock is almost twice that of a U.S. small stock, greater

opportunity exists since there is less analyst coverage of

international small stocks.


QUARTERLY UPDATES


DOMESTIC GLOBAL DIVERSIFICATION

Since roughly 40% of the profits from S&P 500 companies come

from overseas operations, a fairly strong argument can be made that

a broadly diversified U.S. portfolio has “global” diversification.

Such overseas sales reflect the economies of a number of foreign

countries as well as the value of their currencies. The table below

shows the percentage of sales and operations of a select group of

corporations outside of their home country.

Multinational Companies

Corporation

(domicile)

Outside

Sales

Corporation

(domicile)

Outside

Sales

Roche Group (Switzerland) 92% Nokia (Finland) 71%

Philips (Netherlands) 86% ExxonMobil (US) 66%

BP (UK) 82% Unilever (UK) 64%

Nestle (Switzerland) 74% Proctor & Gamble (US) 58%

Honda (Japan) 72% Toyota (Japan) 47%

QUARTERLY

UPDATES

COVERED CALL

WRITING

COVERED CALL WRITING 9.1

QUARTERLY UPDATES


9.SPDRS AND COVERED CALL WRITING

The table below shows the monthly returns for the S&P 500 over

each of the past 20 years. The table shows the number of times the

market had a negative return for each of the 12 months over the last

20 years (1987-2006). It also shows the number of months the

market was positive: up less than 1%, 1-2%, 2-3%, 4-5%, 5-6%, 6-

7%, and over 7%.

Monthly Returns for the S&P 500 [1987-2006]

J F M A M J J A S O N D return

6 7 7 7 5 7 10 8 11 7 6 2 negative

1 3 2 1 3 3 1 3 1 1 1 3 < 1%

2 4 1 6 3 2 1 2 2 4 1 7 1-2%

2 1 6 2 2 2 0 3 1 4 2 2 2-3%

3 1 1 1 2 0 3 2 0 1 2 1 3-4%

3 2 1 0 2 5 3 1 2 0 3 0 4-5%

0 0 1 2 1 1 0 0 2 1 1 3 5-6%

1 0 0 0 1 0 0 1 1 1 2 0 6-7%

2 2 1 1 1 0 2 0 0 1 2 2 > 7%

9.2 COVERED CALL WRITING

QUARTERLY UPDATES


From 1987 to the end of 2006, the S&P 500 had a total of four

negative years (1990, 2000, 2001, and 2002). For three of those

four years, January as also negative months. Over the past 20 years,

December had fewer negative months than any other month of the

year (2 vs. 5 for May). September had more negative months than

any other (11 vs. 10 for July).

A second reason for looking at monthly returns has to do with a

defensive strategy of buying the market (the S&P 500 in this case)

and then writing calls against the portfolio (what is referred to as

“covered call writing”). This is a defensive strategy because the

investor, who owns the S&P 500, is receiving option money every

time he or she writes calls.

This strategy can be done on a monthly basis. It provides income

immediately to the investor (the person writing the covered calls).

The investor is giving up some of the upside potential in return for

current income.

Covered call writing could be compared to Las Vegas. The covered

call writer is the “house” (casino); gains are limited to the option

money received (plus any spread—see below). The option buyer is

the gambler; there is no limit to the possible gains (e.g., a one dollar

slot machine bet could result in a jackpot of thousands of dollars),

but losses are more than likely. The analogy is appropriate because

roughly 70% of all options are never exercised (which favors the

option writer and not the option buyer).


QUARTERLY UPDATES


Months When The S&P 500 Returned Less than 2%

[When Covered Call Writing May Be A Good Idea]

Month - <1% 1-2% Total January 6 1 2 9

February 7 3 4 14

March 7 2 1 10

April 7 1 6 14

May 5 3 3 11

June 7 3 2 12

July 10 1 1 12

August 8 3 2 13

September 11 1 2 14

October 7 1 4 12

November 6 1 1 8

December 2 3 7 12

The table shows that February, April, and September were the best

months during the past 20 years to write S&P 500 covered calls.

These were the “best” months because returns were modest (or

negative); covered call writers do not mind having their portfolio

(the S&P 500 in this example) “called away” when it is not doing

particularly well.

At the other extreme are those months where the market is up 4-7%

or more. During such positive months, the covered call writer misses

out on the difference between the option money collected plus the

spread (e.g., buy the S&P 500 at 150 and give someone the right to

call it away at 151 during the next month—the “spread” is one point)

versus the 4, 5, 6, 7% or more gain that would have been

experienced had the portfolio not been called away.


QUARTERLY UPDATES


For example, if a covered call writer receives one point for writing

the calls, the writer is making about two points (the option money

plus the spread). If the portfolio is called away and ends up

advancing five points for the month, the covered call writer loses out

on three points (5-2 = 3).

Advisors considering a monthly covered call program using an S&P

500 exchange-traded fund (SPY) should be familiar with the months

where such a strategy has made sense (all negative months, all

months where the return was less than 1%, and all months where the

S&P 500 return was 1-2%). Counting up all three of these periods

(months of negative returns, positive returns of less than 1%, and

returns of between 1-2%), the results are as follows:

Based on the past 20 years, it appears that November and December

have been the months when selling calls was a bad idea (since there

was a fair chance that returns for one of those two months was +4%

or more). Moreover, December has only been a negative month

twice over the past 20 years.

The stock market, as measured by the S&P 500 has experienced

negative returns on a monthly basis well under 50% of the time; the

range has been from two months out of 20 (December) up to 11

months out of 20 (September). At the other extreme are those

months where the market is up 4-7% or more. During such positive

months, the covered call writer misses out on the difference between

the option money collected plus the spread (e.g., buy the S&P 500 at

150 and give someone the right to call it away at 151—the “spread”

is one point) versus the 4, 5, 6, 7%+ gain that would have been

experienced had the portfolio not been called away.


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For example, if a covered call writer receives one point for writing

the calls, the writer is making about two points (the option money

plus the spread). If the portfolio is called away and ends up

advancing five points for the month, the covered call writer loses out

on three points (5 - 2 = 3).

Conclusions There may be no meaningful conclusions that can be from the

historical monthly analysis of the S&P 500 over the past 20 years. In

the past, stock market returns have been negative 83 out of 240

months (20 years), or 36% of the time. If you include the 23 months

that the market experienced returns of less than 1%, the total number

of months it would have made sense to write covered calls increases

from 83 to 106 out of 240 months, or 44% of the time.

Based on historical data only, the best candidates for S&P 500

covered call writing are clients who:

1. believe the market will experience flat returns

2. feel market returns will be minor to modest (1-6% annually)

3. need market exposure but still expect stocks to decline

4. are willing to forego some upside potential for income

Looking at the forest (annual returns) instead of the trees (monthly

returns), a strong case can be made for covered call writing. After

all, the strategy works two out of three of the times—during a flat or

negative market. It also works (at least some of the time) during the

third possible outcome—when the market is going up (since minor

positive returns may not equal the covered call money received).


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Think of the strategy this way: (1) If the market stays flat, your

client receives roughly 9-12% a year in covered call writing (plus a

2% dividend since the stocks are never called away in a perfectly flat

market); (2) In a down market, the client’s losses are reduced by

whatever option money was collected for those months when the

market was at the same level of purchase or higher (i.e., originally

buy at 150 and only sell options for 150 or higher); and (3) in a very

strong up market, the client still receives 9-12% in option money

plus the “spread” of 1/2-3/4% each time the S&P is called away

(which translates into a total return of 15-20% a year if the stocks

were called away every months—extremely unlikely).

When covered call writing is explained in this manner, it makes

much more sense intuitively than a review of the monthly figures.

And, as mentioned before, you may have clients who are willing to

give up X in returns in order to reduce risk by something less than X.

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UPDATES

EQUITY-INDEXED

ANNUITIES

EQUITY-INDEXED ANNUITIES 10.1

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10.EQUITY-INDEXED ANNUITIES (EIAS)

The sales of EIA contracts in recent years have been explosive.

Advocates of equity-indexed annuities feel that this investment

vehicle offers the upside potential of the stock market and none

of its downside risk—in fact the contract owner (investor) is

guaranteed at least a 2.7% annualized return if the contract

is held to maturity (typically 5-12 years). Critics of EIAs

point out that the actual returns are not nearly as high as most

investors would anticipate, contracts are often not correctly

represented, and that there would be far fewer sales if the

commission paid to the agent was lower.

There are four examples that follow. Each example is based

on a popular EIA contract offered during the first half of 2007.

As you will see, returns are perhaps lower than expected, but

returns can still be respectable. Thus, perhaps the truth lies

somewhere in-between.

EIA Calculations Using Point-to-Point The S&P 500 is the most commonly used index by EIA

contracts. When considering an EIA, it is helpful to see what

the annual returns of the S&P 500 have been excluding

dividends (since no EIA contract includes any type of

crediting for dividends). The table below shows the annual

returns of the S&P 500 for each of the past 20 years, excluding

dividends.

10.2 EQUITY-INDEXED ANNUITIES

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S&P 500 Annual Returns Without Dividends [1987-2006]

Year S&P Year S&P Year S&P Year S&P

1987 2.0% 1992 4.5% 1997 31.0% 2002 -23.4%

1988 12.4% 1993 7.1% 1998 26.7% 2003 26.4%

1989 27.3% 1994 -1.5% 1999 19.5% 2004 9.0%

1990 -6.6% 1995 34.1% 2000 -10.1% 2005 3.0%

1991 26.3% 1996 20.3% 2001 -13.0% 2006 13.6%

Point-to-Point Annual Reset Example #1 One popular EIA contract has the following features: (1) seven-year

contract (100% withdrawal at the end of seven years without

penalty); (2) 100% participation in the S&P 500, (3) annual reset, (4)

no spread (no fees), and (5) a 6.5% cap rate (however great the gains

are for a year, the contract owner will not be credited more than

6.5%).

Looking at the past seven years, the popular contract mentioned in

the paragraph above would have the following annual returns: 0%

(2000), 0% (2001), 0% (2002), 6.5% (2003), 6.5% (2004), 3%

(2005), and 6.5% (2006). Returns for 2000-2002 are zero because

during negative years the investor is credited zero; returns for 2003

are not 26.4% because the contract has a 6.5% annual cap. Similarly,

for 2004 and 2006, despite the returns of the S&P 500, there is still a

cap of 6.5% for each of those two years. For the 2005 calendar year,

the return matches that of the S&P 500 since the contract has a 100%

participation clause and includes no spread (no fees).


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Continuing with this same example (or contract), the investor’s

return calculation would be: 0 X 0 X 0 X 6.5% X 6.5% X 3% X

6.5% = 1.244 (or a cumulative gain of 24.4% over seven years). A

cumulative gain of 24.4% over seven years translates into an

annualized return of 3.15%. Over these same seven years, the S&P

500 had an annualized return of 1.1% (a figure that includes

dividends plus all of the negative years in the early 2000s) while

U.S. T-bills had an annualized return of 3.00%.

Point-to-Point Annual Reset Example #2 Let us go through another example and see if we can come up with

better returns (using the same seven-year EIA contract). For

example, seven of the best continuous years historically have been

the seven years ending 12/31/1999. Using those numbers (see table

above), here are the returns the contract would have experienced:

6.5% (1993), 0% (1994), 6.5% (1995), 6.5% (1996), 6.5% (1997),

6.5% (1998), and 6.5% (1999). Remember, despite the market’s

actual returns during some of these years (e.g., +31% in 1997,

without dividends), the contract owner can earn no more than 6.5%

in any given year.

Continuing with this same example (1993-1999), the investor’s

return calculation would be: 6.5% X 0 X 6.5% X 6.5% X 6.5% X

6.5% X 6.5% = 1.459 (or a cumulative gain of 45.9% over seven

years). A cumulative gain of 45.9% over seven years translates into

an annualized return of 6.0%. For this type of contract, this is

probably as good as it is going to get (maximum returns for every

year but one).

10.4 EQUITY-INDEXED ANNUITIES

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Point-to-Point Annual Reset Example #3 Another popular EIA contract has the following features: (1) eight-

year contract (100% withdrawal at the end of eight years without

penalty); (2) 50% participation in the S&P 500, (3) annual reset, (4)

no spread (no fees), and (5) no cap rate.

Looking at the past eight years, the contract mentioned in the

paragraph above would have the following annual returns: 9.75%

(1999), 0% (2000), 0% (2001), 0% (2002), 13.2% (2003), 4.5%

(2004), 1.5% (2005), and 6.8% (2006). Remember that during the

negative years (2000-2002) returns are zero and that for any positive

year the investor receives exactly half the gain (50% participation

rate).

Continuing with this same example (or contract), the investor’s

return calculation would be: 9.75% X 0 X 0 X 0 X 13.2% X 4.5% X

1.5% X 6.8% = 1.407 (or a cumulative gain of 40.7% over eight

years). A cumulative gain of 40.7% over seven years translates into

an annualized return of 5%.

Point-to-Point Annual Reset Example #4 Let us go through another example and see if we can come up with

better returns (using the same eight-year EIA contract). For example,

eight of the best continuous years historically have been the eight

years ending 12/31/1998. Using those numbers (see table above),

here are the returns the contract would have experienced: 13.15%

(1991), 2.25% (1992), 3.55 (1993), 0% (1994), 17.05% (1995),

10.15% (1996), 15.5% (1997), and 13.35% (1998). Remember,

despite the market’s actual returns during some of these years (e.g.,

+26.7% in 1998, without dividends), the contract owner is only

credited with half the actual gain.


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Continuing with this same example (1991-1998), the investor’s

return calculation would be: 13.15% X 2.25% X 3.55% X 0% X

17.05% X 10.15% X 15.5% X 13.35% = 2.022 (or a cumulative gain

of 102.2% over eight years). A cumulative gain of 102.2% over

eight years translates into an annualized return of 9.2%. This turns

out to be a very attractive return since the investor had no downside

risk and was guaranteed to earn 3% on 90% of the initial investment

(or 2.7% annual compounding on the entire investment) if stock

market returns had been poor. However, keep in mind that this

example covers eight of the very best continuous years for the S&P

500. Over the past eight years (1999-2006), the S&P had an

annualized return of 6.0%, while T-bills averaged 3.2% a year.

Conclusion There are literally dozens of different ways to compute (credit) gains

in an EIA contract. The examples you have seen are some of the

better choices from an investor’s perspective. As a broad generality,

the best way to summarize a well-structured equity-indexed annuity

is that the investor should be expected to earn just a little more than

CD rates on an annualized basis—assuming things turn out pretty

good. The worst case is probably an annualized return of under 3%;

the best case, although very unlikely, is annualized returns in the 7-

9% range.

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UPDATES

FINANCIAL PLANNING

FINANCIAL PLANNING 11.1

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11.OPTIMAL REBALANCING

In order to maintain an investor’s risk level and return expectations,

the equity and fixed-income portions of a portfolio need to be

periodically rebalanced. The frequency of such rebalancing is what

practitioners are uncertain. Research by Leibowitz and Hammond in

2004 indicates that professionals tend to rebalance more frequently

than individual investors.

An extensive study by David Smith and William Desormeau looked

at 19 model portfolios between 1926 and 2006, with rebalancing

frequencies ranging from 1-60 months, as well as thresholds ranging

from 0.5% to 10%. The researchers then revisited the question of

rebalancing frequency over the same period by including two

different Federal Reserve policies, a tight money versus expanding

monetary policy. The results show that investors and advisors

need to rebalance less frequently than previously thought and

that the Fed’s monetary policy should be taken into account in

the rebalancing decision.

The Study Using 2003 Ibbotson data, the study’s authors constructed 19

portfolios, ranging from 5-95% in the S&P 500 and the balance in

U.S. long-term government bonds, at 5% intervals (all dividends and

interest payments were reinvested). For each of the 19 portfolios

(e.g., 5% bonds + 95% stocks, 10% bonds + 90% stocks, etc.) over

the 78-year period, 1-60 month rebalancing policies were reviewed.

11.2 FINANCIAL PLANNING

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The second part of the researchers analysis looked at the same 19

portfolios but the rebalancing was solely based on one of the two

asset class weightings changing by 5% or more. The thresholds

reviewed ranged from 0.5% through 10.0%, at 0.5% intervals.

The third, and final, analysis looked at the effects of Federal

Reserve monetary policy on optimal rebalancing. Smith and

Desormeau identified 32 instances from 1926 to 2003 when the Fed

switched the direction of change in the discount rate. It was then

assumed that the portfolio could be rebalancing at the end of the

month when the change of direction occurred.

The returns for all three of the rebalancing methods were based on

risk-adjusted returns (return divided by standard deviation)—similar

to the Sharpe ratio. The authors of the study refer to this

measurement as “scaled returns;” in short, the best performers

“maximized scaled returns.”

Results Regardless of the stock/bond weighting, maximum risk-adjusted

returns were achieved when the portfolio was rebalanced once

every 44 months; the lowest returns took place when there was

monthly rebalancing. From 1926 to 2003, the five best rebalancing

intervals were found when rebalancing took place in the 39-44

month range; the lowest returns were when the portfolios were

rebalanced once every 1-6 months.


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Whether the stock weighting is 5%, 95%, or somewhere in-

between, rebalancing once every 44 fours produced the best

returns on a risk-adjusted basis. The second best risk-adjusted

returns were obtained when the portfolios were rebalanced once

every 45 months (42 months in the case of portfolios with a stock

weighting of 20% or less); the third best results occurred when

rebalancing took place every 42-43 months. At the other extreme,

the smallest risk-adjusted returns occurred with one month

rebalancing; the second smallest risk-adjusted returns resulted from

rebalancing every two months.

Using threshold instead of time as a criteria for rebalancing also

greatly favored patient investors. When the stock or bond weighting

deviated by 8.5% to 10.0% of its weighting before rebalancing

occurred (the very upper range in the study), maximum risk-adjusted

returns were usually produced (note: only 0.5% if the stock

weighting was 95%, but 10% if the stock weighting was 90%). The

second best threshold was most often in the 9.5% to 10.0% range.

The lowest risk-adjusted returns were experienced when rebalancing

was very sensitive—a 0.5% weighting change; the second lowest

results most occurred when the threshold percentage was in the 1.0%

to 1.5% range. The “threshold” results are consistent with what

took place when rebalancing occurred based on set time intervals

(see above)—infrequently (once every 42-45 months).

When the Federal Reserve was trying to cool down the economy by

raising interest rates (a restrictive monetary policy), all 19

portfolios benefited the most when threshold rebalancing was high;

the lowest threshold level (0.5% change) almost always generated

the lowest risk-adjusted returns.


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During periods when the Fed was trying to stimulate the economy by

lowering rates (an expansionary policy), the better risk-adjusted

returns occurred for 15 of the 19 portfolios for the less frequently

rebalanced portfolios. However, for stock-heavy portfolios (85%+),

the evidence does not strongly favor low or high thresholds.

The studies do show what is not effective when rates are dropping:

rebalancing every 10 months or less in the case of lower stock

weightings and every 20 months or less in the case of higher stock

weighted portfolios. Similarly, when the Fed is raising rates,

rebalancing every 10-20 months also produces suboptimal risk-

adjusted returns.

Results and conclusions from the Smith and Desormeau study

(1926-2003) are similar to those of the study by Patrick Dennis and

Steven Perfect, Karl Snow, and Kenneth Wiles (Financial Analysts

Journal, May/June 1995) as well as the research done by Jeffrey

Horvitz (Journal of Wealth Management, Fall 2002).

PREDICTED MARKET MELTDOWN

A number of sources have reported that baby boomers will cause a

sharp decline in the stock and bond markets as they sell off assets

when they retire. After reviewing a number of academic studies and

using its own numbers, the Government Accountability Office

(GAO) believes that such fears are unfounded for the following

reasons:


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1. Most baby boomers have few or no securities to sell; the

top 5% hold over 50% of the baby boomer wealth and the top

25% hold over 85%. Thus, few assets will have to be sold by

the top 25% in order to generate income during retirement.

2. Retirees spend down assets slowly; baby boomers with a

higher life expectancy will spin off such assets even more

slowly.

3. Studies show that more and more people are working long

past the traditional retirement age of 65.

THE 1% DIFFERENCE

Over a 20-year period, $100,000 grows to $732,800, assuming a

10% return. If the 10% return is reduced to 9%, the same $100,000

grows to $600,900, a difference of almost $132,000. According to

the Financial Planning Association, the average long-term gain for

a diversified equity mutual fund portfolio is about 10%; 8% for

a portfolio that has a stock/bond mix of 60%/40%.

DISTRIBUTION OF RETURNS

Annualized returns usually mask the actual ups and downs

experienced by investors on a year-by-year basis. For example, over

the past 20 years (1987-2006), large stocks (S&P 500) had an

annualized return of 11.8%, while small stocks had an

annualized return of 13.2%.


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During this same 20-year period, large stocks only experienced

annual returns between 8-16% three times (10.0% in 1993,

10.9% in 2004, and 15.8% in 2006). Over the same period, small

stocks experienced annual returns between 6-19% four times (10.2% in 1989, 17.6% in 1996, 18.4% in 2004, and 16.2% in 2006).

What is surprising is the distribution of returns for 20-year U.S.

Government bonds. From 1987-2006, these bonds had an annualized

return of 8.6%. Yet, during these 20 years, annual returns between

6.6-10.6% occurred just four times (9.7% in 1988, 8.0% in 1992,

8.5% in 2004, and 7.8% in 2005).

INVESTING IN A HOUSE

There are two key points to keep in mind when analyzing the

benefits of home ownership. First, national price appreciation of

residential real estate has historically not been as high as most

people perceive. Over the past 30 years (ending 12/31/2006), U.S.

house prices increased 6.2% annually vs. 4.3% for inflation,

according to Freddie Mac.

Second, home ownership is expensive. It is comparable to owning a

mutual fund or variable annuity that charges 3% annually

(homeowner’s insurance, property taxes, and maintenance costs) and

also has a back-end sales charge of 6-7% (the real estate selling

commission plus closing costs of about 1%). Annual expenses are

higher than 3% if home improvements or monthly mortgage costs

are included.


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AMERICA THE BANKRUPT?

While the U.S. national debt has climbed from $800 billion in 1981

to $5 trillion in 2006, the nation’s assets have climbed from $11

trillion to $76 trillion. If all private assets and liabilities are added

up, net national wealth has increased by $40 trillion over this same

period. In the past four years (ending 12/31/2006) alone, U.S. assets

have increased by $13 trillion—much of which will be inherited by

future generations.

Paying benefits to 75 million baby boomers in 2030 will be much

easier if we have a $25 trillion GDP and net worth of $100 trillion.

Social Security actuaries calculate that the addition of one million

immigrants reduces the long-term unfunded liability of Social

Security by at least $5 trillion.

CPI SPENDING CATEGORIES

The table below shows the weighting of the different spending

categories that comprise the CPI, as of July 2006 (source: Bureau of

Labor Statistics).


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How Inflation is Calculated

Category Weighting

Housing (all costs of home ownership or

renting—including utilities, appliances, and

furniture

42.4%

Transportation (cost of vehicles, gas, and

public transportation)

17.4%

(gas = 4.1%)

Food and beverages 15.1%

Apparel 3.8%

Medical care (doctor and hospital fees, health

insurance, and prescription drugs)

6.2%

Education and communication (ranges from

day care to college tuition; communication

includes phone and computer-related expenses)

6.1%

Recreation (sports, video and audio equipment,

club fees, pet-related costs, books, and

subscriptions)

5.6%

Other goods and services (includes things such

as legal services, haircuts, cosmetics, and funeral

costs)

3.5%


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GOLD VS. HERSHEY BARS

The table below shows the price of gold between 1920 and 2006, the

average price of a basic Hershey chocolate bar (WWW.FOOD

TIMELINE.ORG), and how many bars of chocolate could be bought

with an ounce of gold. As an example, in 1980, an ounce of gold

bought 2,460 Hershey bars; 20 years later, it bought just 558 bars (a

very poor hedge against “chocolate” inflation). Based on 2006 prices

($680 an ounce), one could purchase 906 Hershey bars (at 75 cents

each) with an ounce of gold).

Year Hershey Bar Ozs. Of Gold Bars Per Oz.

1920 $0.03 $21 700

1965 $0.05 $35 700

1980 $0.25 $615 2,460

2000 $0.50 $279 558

2006 $0.75 $679 906

Based on 1920 or 1965 chocolate prices, gold has been a pretty good

hedge against inflation; based on the price of gold per ounce since

1980, gold has been a terrible hedge against inflation.

http://www.foodtimeline.org/

http://www.foodtimeline.org/


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HEDGE FUND DISASTERS

On September 14th

, 2006, the hedge fund Amaranth said its assets

under management dropped 50% in one month due to losses from a

32-year-old natural gas trader. Several days later, the loss was

reported to be $6 billion (a 65% loss) instead of $5 billion.

Before the huge decline, a number of investors expressed concern to

the fund’s principal and founder, Nick Maounis, about its trading

practices. Mr. Maounis assured the investors that the fund was

making “appropriately cautious and diversified bets.” Two weeks

before the losses were reported, Maounis told The Wall Street

Journal that the trader’s reputation for taking big and reckless bets

was “greatly exaggerated.”

Additionally, after suffering a $1 billion loss in May, the hedge fund

assured investors that it was reducing its risk exposure by cutting

back on its use of borrowed money and other leverage. When talking

to money management companies in August 2006, the hedge fund

said it might spend “1% of its capital to energy for the right to buy or

sell natural gas. If the bet didn’t pan out, only a tiny fraction of the

fund’s assets would be at risk.”

Of the 400 hedge funds launched in 2005, FrontPoint Partners (a

hedge fund with $6 billion under management) estimates that

roughly 20% will not survive a year. According to FrontPoint, “Most

hedge fund organizations today are, quite literally, three guys with a

Bloomberg terminal in a garage.” The average life span of a

medium-sized hedge fund is 3.5 years.


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According to a report by Dresdner Kleinwort, hedge funds need to

generate returns of 18-19% in order to deliver a 10% return to

investors, once fees, incentives, and trading costs are factored in.

Hedge funds can improve returns through leverage. It is estimated

that the $1.3 trillion invested (as of early 2007) in hedge funds

borrows from $1.2 to $5.5 trillion at any given time.

HEDGE FUND WARNING

Despite a 2006 increase in assets of 26%, the Federal Reserve Bank

of New York issued a March 2007 statement, warning that the “$1.4

trillion hedge fund industry could be caught in a web of crisis”

because trading strategies concentrate ”way too much risk in way

too few markets.”

As of April 2007, the 100 largest hedge funds controlled about 70%

of the money in the business, up from less than 50% at the end of

2003. Hedge funds with $1 billion or more in assets controlled about

85% of all hedge fund money.

CALCULATING A LUMP SUM

A popular question with clients is, “How much money (lump sum)

will I need before I can retire?” The answer is simple: About 20

times their annual expenses, assuming no erosion of principal. For

example, if one of your clients needs $30,000 a year to live on, he or

she will need a nest egg of $600,000 plus Social Security retirement

benefits.


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ENDING UP WITH $1,000,000

The table below shows the deposits required to reach $1 million,

assuming an annual return of 8%.

Deposits Needed to Reach $1,000,000 [8% return]

Years 40 30 20 15 10 5 1

Monthly

deposit

$298 $681 $1,686 $2,842 $5,623 $13,153 $77,161

Annual

deposit

$3,574 $8,172 $20,234 $34,101 $63,916 $157,830 $925,926

Total

deposit

$142,969 $245,206 $404,671 $511,521 $639,162 $789,150 $925,926

GOALS AND RISK TOLERANCE TEST

The 7-question test below can be taken by your clients in order to

help evaluate their situation. The test is divided into three parts:

time horizon, long-term goals and expectations, and short-term

attitudes toward risk.


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Time Horizon [1] My current age is:

Less than 45 years 5

45-55 years 4

56-65 years 3

66-75 years 2

Over 75 years 1 Score _____

[2] I expect to start drawing income from this investment:

Not for at least 20 years 5

In 10-20 years 4

In 5-10 years 3

Not now, but within 5 years 2

Immediately 1 Score _____

Long-Term Goals and Expectations [3] For this investment, my goal is:

To grow aggressively 5

To grow with caution 3

To avoid losing money 1 Score _____


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[4] Assuming a normal stock market, what would you expect

from this investment over time?

To generally keep pace with the stock market 5

To trail the market, but still make a decent profit 3

A high degree of stability, with modest profits 1 Score _____

[5] Suppose stocks perform unusually poorly over the next 10

years; what would you expect from this investment?

I will be OK if I lose money 5

To make a small gain 3

To be little affected by the stock market 1 Score _____

Short-Term Risk Attitudes [6] Which statement below describes your attitude about the

next three years’ performance of this investment?

I will be OK if I lose money 5

I want to at least break even 3

I need at least a small profit 1 Score _____


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[7] Which statement below describes your attitude about the

next three months’ performance of this investment?

No concern; One quarter means nothing 5

If I suffered a loss of > 10%, I’d get concerned 3

I can tolerate only small short-term losses 1 Score _____

If the client has at least one 1-point answer and at least one 5-point

answer, consider stopping and evaluating the investor’s responses;

they may be unrealistic.

Score Total Time Horizon (Questions 1 and 2)

Points Dynamic Asset Allocation Portfolio

2 Preservation

3-4 Conservative

5-7 Balanced

8-9 Capital Growth

10 Aggressive

Long-Term Goals and Expectations (Questions 3, 4, and 5)


3 Preservation

5 Conservative

7-9 Balanced

11-13 Capital Growth

15 Aggressive


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Short-Term Risk Attitudes (Questions 6 and 7)


2 Preservation

4 Conservative

6 Balanced

8 Capital Growth

10 Aggressive

Total (Questions 1 through 7)

Total Points Dynamic Asset Allocation Portfolio

7-10 Preservation

11-17 Conservative

18-24 Balanced

25-31 Capital Growth

32-35 Aggressive

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RETIREMENT

PLANNING

RETIREMENT PLANNING 12.1

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12.RECONSIDERING THE ROTH 401(K)

Unlike a Roth IRA, the Roth 401(k) has no participant income

limits but does require that certain sums be distributed at age 70

1/2. However, Roth 401(k) plan participants can avoid this

requirement by rolling their account into a Roth IRA.

A traditional 401(k) may be a better choice than a Roth 401(k).

Workers will have to come up with $20,666 before taxes to fully

fund the $15,500 limit for a Roth 401(k) in 2007—more than

$20,666 if the worker’s tax bracket is higher than 25%. Tax savings

from a deductible contribution to a qualified plan could be used for

other investments. The table below covers Roth 401(k) basics.

Benefits of Using a Roth 401(k)

Type of Worker Consideration

Young Decades of tax-free compounding. Paying taxes on

contributions at current rates is better than paying

taxes later on profits and contributions.

Older with high assets Retirement account asset withdrawal could later

put you in a higher bracket.

Large balances in

sheltered accounts Tax-free access to part of portfolio during retirement.

Strong donative intent Pass assets to heirs tax-free.

Saving for a child’s

college education Tax-free access if the account is at least 5 years old and

participant is 59 1/2 when the child enrolls; retirement

accounts are usually not part of federal financial aid

calculations.

12.2 RETIREMENT PLANNING

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HEALTH SAVINGS PLANS

Health savings accounts (HSAs) provide high-deductible (at least

$1,100 for an individual and $2,200 for a family) health insurance

plans using pretax dollars. Besides receiving a deduction for

contributions, these accounts grow tax-free, as long as the money is

used for qualified medical expenses. Once the account owner turns

65, the HSA can be used for any purpose without penalty, but

withdrawals are taxable. HSAs are of particular benefit for people

who have not yet qualified for Medicare. Plan assets can also be

used to pay long-term care expenses.

For 2007, individuals can contribute up to $2,850; families are

allowed to invest up to $5,650 into an HSA; those who are at least

55 years old can contribute an additional $800 (the dollar amounts

are adjusted upward each year). Additionally, a one-time trustee-to-

trustee transfer from an IRA into a new or existing HSA is allowed;

the amount that can be moved is limited to the person’s maximum

HSA allowed for the year.

There is no requirement that HSA assets must be used by a certain

date; money can grow and compound either tax-free or tax-deferred

(depending upon how assets are eventually used) while Medicare or

other insurer pays the bills. Once someone has enrolled in Medicare,

a new HSA cannot be set up and no further contributions are allowed

to an existing HSA. Those who work past 65, remain enrolled in a

high-deductible health plan, and do not apply for Medicare, can still

contribute to an HSA.


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529 PLANS

In the late 1990s, Congress established 529 plans (named after the

IRC that created them). Contributions are made with after-tax

dollars, but distributions of growth and/or principal are not, provided

account assets are used to pay for higher education. The plans are

overseen by the states.

A number of states allow a state tax deduction or credit for

contributions. Some states also offer “prepaid” 529 plans that lock in

current tuition rates. Investor interest in 529 plans has also increased

due to the lowering of fees from several mutual fund companies.

Investors can set up 529 plan accounts directly with the states or

through a third-party source such as a mutual fund.

RETIREMENT PLAN INCREASES FOR 2007

Proprietors with an owner-only 401(k) can contribute up to $45,000

for their 2007 contribution, up $1,000 from 2006. Employees under

age 50 in a 401(k) can contribute up to $15,500 for 2007; for

those age 50 and older, the maximum for 2007 is $20,500 ($15,500

+ a catch-up contribution of up to $5,000).

For Roth IRA contributors, the amount of money you can make

and still fully contribute to a Roth IRA is $156,000 for a married

couple filing jointly in 2007 ($99,000 for singles). The traditional

IRA contribution remains at $4,000 ($5,000 if age 50 or older). As a

side note, the Social Security wage base rises to $97,500 in 2007.


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MYTHS AND REALITY ABOUT RETIREMENT

Surveys show that roughly 65-75% of baby boomers expect to work

for pay after retiring. However, a study published by McKinsey &

Co. found that 40% of retirees had to stop working earlier than

planned, usually because of either layoffs or poor health. The

Employee Benefit Research Institute found that just 27% of

surveyed retirees had ever worked for pay while retired; a similar

study by the Pew Research Center found that just 12% of current

retirees are collecting a salary.

Almost two-thirds of affluent baby boomers (investable assets of

at least $500,000) intend to finance their retirement by selling

their home. The median value of a primary residence in the U.S.

among those age 55 to 64 was $200,000 in 2004 (vs. $139,000 in

2001). The problem is that it may be that when the time comes,

people will not actually want to pack up and move to something

smaller or to a less expensive area.

Another belief is that one will be able to live on 70-80% of pre-

retirement income. This is very likely if that individual or couple

were saving 20-30% of their working income for retirement. Yet,

according to the Employee Benefit Research Institute, 55% of

surveyed retirees were living on 95% or more of their pre-retirement

income.

Some believe that their tax bracket will be lower in retirement. This

may or may not be the case, depending upon where the retirement

income is coming from. Income from qualified accounts, bank CDs,

traditional IRAs, and annuities are taxed as ordinary income.

Additionally, up to 85% of one’s Social Security benefits could be

subject to ordinary income taxes.


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About 45% of people in their 60s were still carrying a mortgage

in 2000, up from 34% in 1980 for the same age group; 20% in 2000

were carrying a second mortgage, up from 7% in 1980. It is

estimated that a couple retiring today could easily incur annual

health care costs of $7,000; this figure includes $2,800 for Medicare

Part B premiums, $800 for Medicare Part D, $2,800 for a

supplemental Medicare policy, and about $1,000 for out-of-pocket

prescriptions and doctors visits. If long-term care insurance

premiums are included, the total annual cost could easily be $10,000.

A number of people believe that they are going to get an inheritance.

It is true that as much as $41 trillion could be passed down during

the next 50 years, but two- thirds of whatever the amount ends up

being will be concentrated among the wealthiest 7% of estates.

Factor in taxes, settlement costs, and charity, the figure drops down

to $7.5 trillion. The actual figure could be substantially lower than

this once lifetime annuities, health costs, and long-term are expenses

are included; remember, people are living longer. An AARP study

found that just 15% of boomer households expect to receive an

inheritance; among those that have received an inheritance by 2004,

the median value was less than $50,000.

Over 60% of those surveyed by the Employee Benefit Research

Institute expect to receive a pension. Yet, only 40% of working

couples are covered by such plans. The numbers become even less

likely when one factors the freezing or cutting of benefits that has

already taken place at such huge companies such as GM, IBM, and

Verizon.


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Among all of the myths or expectations, the one that is probably

realistic is that most people will not need long-term care. A

Georgetown University study projects that 65% of all people age 65

will need some type of long-term care in the future. The good news

is that family members will provide much of this assistance (since

most or all of it will take place in the retiree’s home).

Just 35% of those 65 will eventually spend time in a nursing

home; only 5% will stay in such a place for more than five years. For those who will end up paying for such care, about 45% of the

expenses will be paid out of pocket; government programs and

private insurance will pick up the balance. The average person will

need to set aside $21,000 at age 65 to pay those future bills; 6%

of the patients will need to invest $100,000 at age 65 to pay for

future care.

Based on historical returns, a portfolio with about 60% in domestic

large cap stocks (the S&P 500) and 40% in intermediate-term bonds

should be able to sustain a 4.15% annual withdrawal rate indefinitely

(based on looking at all 30-year periods since 1926). Using a 6.00%

annual withdrawal real rate (meaning inflation is factored in), close

to half of all 60/40 portfolios failed to last the entire 30 years.

One way to increase the withdrawal rate from 4.15% to 4.40%

would be to add small cap stocks. If the investor were willing to

accept a 94% probability that the portfolio would last 30 years, the

withdrawal rate could be increased to 5% without having to add

small cap stocks. Rebalancing annually would be another way to

increase the annual withdrawal rate to just over 5%.


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RETIREMENT REALITY

The table below shows what are believed to be the most popular and

major sources of retirement income. As you can see, your job as an

advisor is to help clients understand the difference between

perception and reality.

Retirement Income: Perception vs. Reality

Perception Reality

At 65 years of age,

remaining life expectancy

is modest.

50% chance one spouse will live to age 92;

25% chance one will live to age 97.

Pensions are funded

and guaranteed.

Fewer than 1-in-5 Americans have one;

some will default or are underfunded.

Social Security will not

change.

In 2007, there were 3.3 workers for each

beneficiary vs. 16 workers in 1950; in 2017,

Social Security is projected to pay out more

than it takes in.

401(k) and other plans will

rescue many.

Only 42% of workers participate; median

401(k) balance in 2004 was $58,600 for

those in the 55-64 age range.

76% of pre-retirees say they

plan to work full- or part-

time during retirement.

32% of retirees actually work; 44% of

workers are forced to stop working earlier

than they had planned.

Trillions of dollars will be

inherited by the next

generation.

Median inheritance received by Baby

Boomers to date: $49,000.


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BENEFITS OF PATIENCE

Behavioral finance researchers from Harvard and MIT conducted a

study that shows investors often overreact to short-term performance

even with their long-term investments. The study shows that the

more frequently investors viewed the performance of their

investments (monthly vs. annually) the more likely they were to see

negative performance. Seeing negative return figures increased the

likelihood of investors decreasing their weighting in stocks.

Specifically, investors who reviewed monthly portfolio

performance figures found that returns were negative almost

40% of the time and ended up with a final stock allocation of

41%. Investors who reviewed performance just once a year saw

negative returns less than 15% of the time and had a final stock

allocation of 70%. Both test groups started out with a 50/50 split

between stocks and bonds. Each time a group saw performance

figures (monthly for one group, annually for the other group), each

individual in the group was allowed to make “one final decision” for

his or her long-term allocation.


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COSTS OF 401(K) PLANS

According to Matthew Hutcheson, an independent pension fiduciary,

the typical “low-cost, growth oriented mutual fund,” incurs the

following expenses:

2007 Annual 401(k) Plan Costs

Fee Cost

Management 1.13%

Fund trading costs 0.86%

Participant education 0.75%

Administration 0.15%

Custodial 0.05%

Audit and legal 0.05%

Total charges 2.99%

As of the first quarter of 2007, more than 47 million employees

participated in 401(k) plans; the cumulative total of these plans was

$2.5 trillion. Just one percentage point in costs amounts to a “wealth

transfer” of $25 billion a year from workers to investment

companies and other financial services firms.

A November 2006 report by the Government Accountability Office

found that 401(k) fee disclosures are often supplied in “a piecemeal

fashion that make it difficult for employees to compare investment

options or even have a clear idea of the costs they are incurring.”


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RETIREMENT STATISTICS

According to a 2005 study by the Urban Institute in Washington,

people age 75 and older typically spend 10% less per person than

those age 65 to 74. It appears that this drop in spending may not be

“voluntary.”

The U.S. Census Bureau reports that seniors have an average

household net worth of $100,000, versus $120,000 for those age

70 to 74 and $114,000 for those 65 to 69 (note: all of these figures

include home equity). If you strip out home equity, households

headed by someone age 75 and older have a typical net worth of

just $19,000. As a side note, annual inflation for seniors over the

past 20 years has been 3.2% versus 3.0% for the general public.

MAXIMUM SOCIAL SECURITY BENEFIT

According to the Social Security Administration, an individual

retiring in 2007 who is eligible for the maximum Social Security

retirement benefit will receive $2,116 per month, or $25,392 for the

first year. According to Kiplinger, 58% of Americans believe they

will need to accumulate at least $2 million in savings in order to

enjoy a comfortable retirement.


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PEOPLE WORKING LONGER

In 2006, over 26% of California residents between the ages of 65

and 69 were still working (vs. 20% in 1995). Roughly 40% of this

age group that is still working is doing so because they feel that they

have not saved enough money for retirement.

The median balance in a 401(k) plan or IRA for the head of

household between the ages of 55 and 64 in California is about

$60,000; this translates into an inflation-indexed annuity of just $250

per month. If people were to retire at age 67 instead of 65, the

percentage of retirees “at risk” (not having enough money to

maintain their lifestyles during retirement) drops from 43% to 32%.

If workers could save just 3% more of their earnings each year, the

“at risk” numbers would drop another 11%.

INFLATION MEASUREMENTS

The U.S. consumer price index (CPI) has increased by an annualized

rate of just under 3% over the last 25 years (1982-2006). Yet, a

major risk during retirement is the retiree’s age-specific personal

inflation rate (see second table).

The first table below shows the long-term impact of inflation at

various rates, ranging from 0-4% annually. For example, if inflation

were to continue to average 3% a year, $1,000 would have the

purchasing power of $744 in 10 years.


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Purchasing Power of $1,000 at Different Rates of Inflation

Year 0% 1% 2% 3% 4%

1 $1,000 $990 $980 $971 $962

5 $1,000 $951 $906 $863 $822

10 $1,000 $905 $820 $744 $676

15 $1,000 $861 $743 $642 $555

20 $1,000 $820 $673 $554 $456

25 $1,000 $780 $610 $478 $375

30 $1,000 $742 $552 $412 $308

35 $1,000 $706 $500 $355 $253

The next table is something most advisors have never seen, the CPI-

E (the inflation rate that is unique to Americans age 62 and

older), which is compiled by the U.S. Department of Labor through

its Bureau of Labor Statistics (BLS).

Like the traditional CPI-W (“W” is for “wage earners”), each month

the CPI-E measures price changes for hundreds of categories and

items. Category weighting is based on average spending habits for

the group.

The CPI-W reflects the spending habits of just under a third of

the U.S. population. For example, working Americans spend four

times as much on food and beverages as on apparel (0.16 vs. 0.04);

they also spend eight times more on housing than they do on

recreation (0.41 vs. 0.05).


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The table below shows the components that comprise the CPI-W

index and CPI-E index plus their various component weightings; the

“% of whole” column for each index, excluding “All items,” adds up

to 1.00. The higher the component weighting, the more a price

change for the category will affect the overall inflation rate. For

example, notice how “Education & Communication” for the elderly

represents just 50% of what it does for workers.

CPI-W (workers) and CPI-E (elderly) Inflation Rates

Component

% of

whole

10-yr.

Inflation

% of

whole

10-yr

Inflation

All items 1.00 26.5% 1.00 29.7%

Apparel 0.04 -8.3% 0.03 -8.9%

Education & Communication 0.06 18.2% 0.03 4.5%

Food & Beverages 0.16 25.9% 0.13 25.4%

Housing 0.41 32.8% 0.48 34.0%

Medical Care 0.05 47.8% 0.11 47.8%

Recreation 0.05 9.8% 0.05 18.3%

Transportation 0.20 20.4% 0.15 21.9%

Other Goods & Services 0.04 56% 0.04 45.5%

From 1982 to the end of 2006, the inflation rate for U.S. workers

averaged just under 3% a year, versus 3.3% for the elderly. In fact,

for each and every year over the past quarter of a century, CPI-E

increases have been greater than CPI-W increases.


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The discussion as to how to personalize a client’s CPI rate becomes

more interesting when gender and geography are factored in. For

example, over the past 10 year, the rate of inflation has averaged

2.3% in Atlanta but 3.5% in San Diego. A report by Merrill Lynch

shows that the recent inflation rate for women has been about 3.6%

but just 0.2% for males—because their spending habits are different.

Client Customization A way to differentiate yourself from your peers is to sit down with

your older clients and comprise a CPI for each, based on how that

person (or couple) actually spends money. For example, suppose

you have a client that spends all of her money on just two things,

housing and medical care (for this simple example, pretend the client

does not travel or eat, etc.). In such a case, her cumulative rate of

inflation over the past 10 years would have been 41% [(34% + 48%)

/ 2] and her annualized rate would have been 3.5%.

Perhaps a more meaningful adjustment would be for you to match

(or hedge) your clients’ expenditures with their equity holdings. For

example, if a client spent 20% of their income on drugs and other

medications, roughly 20% of their equity exposure could be in the

pharmaceutical and healthcare sectors.


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LONG-TERM CARE PARTNERSHIP

The idea behind Partnership for Long-Term Care, an insurance

program used in five states (California, Connecticut, Idaho, Indiana,

and New York) is that if you buy a long-term care policy that is

approved by the state, you can apply for Medicaid to help cover any

additional costs. Moreover, you can keep assets equal in value to the

insurance benefits received. This means assets do not have to be

“spent down” before a patient qualifies for Medicaid.

For example, if you have a client that buys a policy whose

cumulative benefit is $100,000 (e.g., $100 a day for 1,000 days), he

or she can keep $100,000 in personal assets and still qualify for

Medicaid. For the vast majority of your clients, three years of long-

term care insurance coverage should be more than enough.

According to a 2005 actuarial survey of 1.6 million active policies,

only eight in 100 claimants with a three-year benefit period

exhausted their coverage.

For 2006, the average daily cost for a shared nursing home room

nationwide was $183 ($66,795 a year) according to MetLife Inc.

research. However, the average in New York City was $333 per day

(or $121,545 a year). The national average hourly rate for a home

health care aide is $19; the highest regional figure was $29 an hour

in Rochester Minnesota.


QUARTERLY UPDATES


When considering long-term care coverage, focus on the following:

1. Opt for an inflation protection rider (annual benefit

compounds at 5%).

2. Lifetime benefits can cost up to 40% more than three years

of benefits.

3. Find out average costs for care where the client lives.

4. Determine the financial strength of the carrier

(www.ambest.com).

5. If the client is in good health, use companies that have

extensive tests.

6. If the client is in poor health, one rejection is not universal.

At least 25 more states are expected to pass the Partnership for

Long-Term Care during the next few years. The following web sites

can help you figure out the cost of long-term care insurance where

your clients live:

1. www.longtermcare.gov: Under “Paying for Long-Term

Care,” go to “Cost of Care.”

2. www.metlife.com/maturemarketinstitute: Click on “Studies,”

then go to “2006 MetLife Market Survey of Nursing Home

and Home Care Costs.”

3. www.longtermcare.genworth.com: go to “What is the Cost of

Long-Term Care?”

4. www.notaburden.com (MassMutual’s web site for financial

professionals): Under the “For Producers” link, look under

the “Cost by State Calculator.”

http://www.ambest.com/

http://www.longtermcare.gov/

http://www.metlife.com/maturemarketinstitute

http://www.notaburden.com/


QUARTERLY UPDATES


DISCLOSURE FOR ORGAN DONORS

Before the end of the third quarter of 2007, prospective organ donors

will gain greater information. Specifically, transplant centers will be

required to detail the risks of donor surgery plus they must provide

independent patient advocates. The quality of transplants will be

compared against Medicare and Medicaid standards. All transplant

centers must be recertified every three years. Those that fare worse

than would be statistically expected risk losing their Medicare

funding.

There are 300 transplant centers in the U.S.; the number of living

donors in 2006 doubled to nearly 7,000. The vast majority are liver

donors. Under the new regulations, prospective living donors are

given statistics on how recipients and donors fare nationally and at

their hospital.

Potential donors must also be told about medical and psychological

risks, the surgical procedure and post-operative treatment as well as

alternate treatments. Additionally, the donor must be informed that

his or her health insurance may not cover future health problems

related to the donation and that the donor may have difficulty

obtaining health, disability, or life insurance in the future.


QUARTERLY UPDATES


FULLY FUNDED PENSION PLANS

For the first time since 2000, the assets of defined benefit pension

plans offered by Fortune 100 companies exceeded plan liabilities (as

of the middle of 2007), according to the consulting firm Towers

Perrin.

NEW MEDICAID RULES

New Medicaid rules eliminate the “resource first” option. All

states are now required to use the “income first” method, which

takes into account the patient spouse’s income as well as the

income of the patient. Some elder advocates believe these new

rules will increase the likelihood of divorce being used.

The new rules also extend the “look-back period” for gifts from

three to five years in most instances. The penalty period is now

computed differently. The clock starts on the penalty period from

the date the patient is eligible to receive Medicaid, instead of

from the date of the gift transfer.

For example, if Ted (the patient) made a $20,000 gift four years ago,

then went to a nursing home, spent down his life savings over two

years, and then applied for Medicaid, he would still be subject to an

additional four-month waiting period ($20,000 divided by the

monthly cost of a nursing home, $5,000 in this example). If the gift

were large enough, the alternative would be to wait for an additional

year, so that a total of five years had lapsed since the time of the gift

and the commencement of nursing home care.


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Under the new rules, an annuity is not counted an asset if the state is

named as a “remainder beneficiary” (so the state can later be

reimbursed). Annuities still remain an attractive strategy. The

annuity contract could remain in deferral mode until the Medicaid

application was submitted. At such time, the contract could then be

irrevocably annuitized. The tricky part is that actuarial life

expectancy tables are not those of the Internal Revenue Code or

Social Security.

Additionally, loans and mortgages must have a repayment schedule

that is actuarially sound; payments must be in equal amounts during

the term of the loan. There can be no deferral of payments and no

balloon payments. Upon death (of the Medicaid recipient), the loan

balance cannot be cancelled.

In the past, Medicaid planning relied on the fact that a home, no

matter how valuable, was considered an exempt asset. Under the

new rules, states must consider an applicant’s home equity in

excess of $500,000. States are permitted to raise that threshold to

$750,000. The result is that reverse mortgages may become more

popular if a large portion of the applicant’s net worth is in his or her

personal residence.

QUARTERLY

UPDATES

TAXES

TAXES 13.1

QUARTERLY UPDATES


13.2007 TAX BREAKS

For 2007, the maximum 401(k) contribution increases to $15,500

($20,500 if the participant is age 50+). The maximum traditional and

Roth IRA annual contributions stay at $4,000 ($5,000 if age 50+). A

child or any other non-spouse who inherits a qualified retirement

account can now transfer it directly into an IRA. Such a transfer

allows the heir to stretch out distributions over numerous years.

Taxpayer’s age 70 1/2 or older can transfer as much as $100,000

directly from an IRA to a qualified charity. This transfer, also

allowed for 2006, is set to expire at the end of 2007.

The maximum federal estate tax rate is 45% for estates of people

who die in 2007. The basic federal estate tax exclusion remains at $2

million in 2007 and 2008; the exclusion is scheduled to rise to $3.5

million 2009, become unlimited in 2010, and then drop back down

to $1 million for estates created in 2011.

Taxpayers who use their car for business have a choice of deducting

their actual costs or using the IRS’s standard mileage rate; the 2007

rate is 48.5¢ (20¢ per mile for medical and moving purposes).

13.2 TAXES

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TAX DOCUMENTS

The type of account(s) and activity determines the tax forms sent.

Mutual Fund Tax Information and Expected Mailing Date

Document Sent To Information Contained

Fund year-end

statement

[early January]

All fund accounts that

remain open after

September 30th

All account activity:

Cost basis of all shares purchased, reinvested,

year-end values, & RMD notice to IRA owners

who will be 70 1/2 that year

Form 1099-DIV

[late January]

Most non-retirement &

non-educational accounts

Ordinary & qualified dividends, capital gains

distributions, federal taxes withheld, &

foreign taxes paid

Form 1099-B

[late January]



Date of each sale, number of shares sold,

share price, dollar amount of each transaction,

plus average cost basis & gain or loss

information for most accounts

Form 1099-INT

[late January]



invested in muni bonds

Federally tax-exempt income dividends from

muni bond funds & any private- activity bond

interest used to compute AMT

Form 1099-R

[late January]

IRAs & other retirement

accounts

Distributions from Roth, traditional, SEP,

& simple IRAs, plus distributions from

most retirement plans

Form 1099-Q

[late January]

Educational & Coverdell

accounts

Distributions from educational accounts

Form 5498

[late May]

IRAs All contributions, transfers, & rollovers to

traditional & Roth IRAs plus SEP IRAs;

year-end market values of IRA accounts

Form 5498-ESA

[late April]

Coverdell accounts Coverdell contributions & transfers

(sent to beneficiary, not contributor)

TAXES 13.3

QUARTERLY UPDATES


FREE TAX PREPARATION AND FILING

In 2006, the U.S. Government Accountability Office estimated that

38% of taxpayers with securities transactions during the 2001 tax

year misreported their capital gains or losses. TurboTax has a tool

called BasicPro that taps into a database to help advisors and

clients determine cost basis. Another service, AccuBasis, offered

by Depository Trust & Clearing and NetWorth Services, also

provides similar information.

If you have clients with an AGI of $52,000 or less, they can go to

irs.gov and click “2007 Free File.” From there your client will be

linked to companies that will let them use their software and

then file the return, all for free. Some companies, including Intuit,

the makers of TurboTax, offer basic versions of their software on

their own sites to anyone at any income level.

TAX FACTS

The 16th

Amendment created the federal income tax in 1913. In its

first year, it taxed incomes of more than $3,000 at 1% and incomes

of more than $20,000 ($400,000 in today’s dollars) at rates from 2-

7%. Form 1040, the main tax-filing application, got its name because

it was the 1,040th

form issued by the Bureau of Internal Revenue, the

predecessor to the IRS.

13.4 TAXES

QUARTERLY UPDATES


The first electronic transmission of a tax return to the IRS occurred

in 1986; for the 2006 calendar year, more than 73 million people

filed electronic returns. The IRS estimates the overall compliance

rate at 84%. In 2001, taxpayers paid, on average, a “surtax” of more

than $2,000 each to subsidize noncompliance by others. In 2000,

each $100 collected by the IRS cost 39¢ to collect.

In the beginning (1914), the original 1040 form was so small the

New York Times printed it on their front page. There were just four

instructions; now there are 4,000. By 1918, the government needed

money to fight World War I and the top rate was increased to 70%.

In 1914, total income tax collections were $10 billion, in today’s

dollars. The original IRS enforcement office had 4,000 employees.

Today, roughly $1 trillion is collected each year and the IRS has

100,000 tax agents. The New York Times wrote an editorial in 1909,

warning against the possibility of an income tax, “When men get in

the habit of helping themselves to the property of others, they cannot

be easily cured of it.”

During the early years of the income tax, only about 1/2% of

Americans (360,000) had to fill out a tax form. Today, 135 million

do so; nearly every U.S. worker. As a side note, when the AMT was

passed in 1969, it was originally designed to force just 155 wealthy

individuals to pay taxes. For 2006, six million were subject to the

AMT. If Congress does not intervene, 26 million will be subject to

this tax in 2007.

TAXES 13.5

QUARTERLY UPDATES


For 2007, there are over 66,000 pages of tax laws to contend with,

along with 526 separate forms. It is estimated that 1.2 million people

are employed as tax accountants, lawyers, and tax preparers.

American workers and businesses devote 6.4 billion hours a year, or

roughly 45 hours per return. For example, there are now 16 different

tax breaks for college education. Two-thirds of the adult population

cannot figure out basic IRS regulations or tax laws concerning the

sale of a home. According to the IRS, the number of federal estate

tax returns (Form 706) for the 2007 calendar year is expected to be

30,400 (versus 90,000 in 1997).

APPEAL TO CHILDREN

A number of mutual fund families now have programs and

specialized products designed to appeal to investors age 20 and

younger. American Century Investments offers “My [Whatever]

Plan,” an online financial coach that goes over a savings strategy

based on a specific goal, such as a wedding, buying a home, or

retirement. Investors must commit $500 upfront and $100 a month

thereafter.

Charles Schwab has a four-step IRA program that requires a $2,000

minimum investment; the materials show that by cutting out just two

nights per month of partying, the young adult can end up with quite

a bit of money. The Monetta Young Investor fund has a web site

with a financial literacy area and a stock-picking game where

children can win prizes; account holders earn 5% of their annual

account balance in tuition credits.

13.6 TAXES

QUARTERLY UPDATES


FEDERAL RESERVE COMIC BOOKS

For the past half century, the New York Federal Reserve has been

publishing comic books whose target audience is high school

students (over 850,000 copies distributed in 2006). The Fed comic

book most in demand is “Once Upon a Dime.” The storyline is about

how money came to be on a mythical tropical island called Mazuma.

Advisors who have clients who are looking to educate their children

and grandchildren can visit the newyorkfed.org web site and click on

“publications catalog” to order the comics at no charge.

YOUNG INVESTORS

The University of Minnesota has found that children as young as age

five can develop spending and saving habits. The Investment

Company Institute (ICI), the trade and lobbying group of mutual

funds, lists child-friendly web sites (www.ici.org/funds/inv/

resourcesyoung.html.).

http://www.ici.org/funds/inv/%20resourcesyoung.html



ibf - updates - 2007 (q1 & q2 v1.0)

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