Quarterly Asset Management Letter
August 22, 2007
John and Mary Smith
303 Whatever Place
Any Town, New Jersey 00000
Dear John and Mary,
A few weeks ago, you should have received the 2nd quarter 2007 performance reports for your accounts. As of June 30, 2007, John’s IRA Rollover Account was up +4.58%, net of withdrawals and management fees, and Mary’s Roth IRA Account was up +3.34%.
According to the July 2007 edition of First Affirmative Financial Network’s Market Commentary, which was included with your reports, as of June 30, 2007, the Dow was up +8.80%, the S&P 500 was up +7.00%, the Russell 2000 (Small-Cap) was up +6.50%, the EAFE (Europe, Asia, Far East) was up +10.70%, and the Lehman Aggregate Bond index was up +1.00%. Given the market conditions at this point in the year, we would expect that your accounts’ performance would be consistent, and they were.
Your accounts are invested in what is referred to as a Strategic Asset Management program. This is essentially a volatility (risk) reduction strategy. You are diversified among multiple asset classes that do not rise and fall at the same time. By design, the portfolios will probably never drop as much as the worst performing asset class in any one period. Conversely, they will likely never rise as much as the best-performing asset class in any one period.
Since June 30, 2007, the market picture has changed dramatically. The impact of sub-prime mortgages, securitized and sold by large banks and Wall Street brokerage houses, has been swift and dramatic. Most of us, even the most seasoned professionals, did not see it coming, at least not entirely. This is primarily due to the fact that as long as real estate was going up, mortgage companies could continue to put people into mortgages that they had no business being in, and no one (government, regulators, etc.) was challenging it.
While it is too soon to fully evaluate the impact of the “mortgage meltdown” and also how your accounts are doing against benchmarks (the S&P 500 for example), what I do know is that while your accounts are down a bit, they are not down nearly as much as the markets in general. This is where the combination of Strategic Asset Management and Socially Responsible Investments is proving their worth.
I am very grateful that we have your accounts in the Efficiencies program: you are getting tremendous value from it. As I stated above, Strategic Asset Management is a strategy that, by design, reduces volatility. By using multiple asset classes with a set allocation, and then periodically rebalancing back to that original allocation (as percentages) we are keeping your investments properly diversified, while at the same time always selling high and buying low, but only on the incremental changes from the original percentages.
One of a number of factors that can trigger a rebalancing is when there is a major market move, up or down, which causes a 5-10% change in one or more asset classes in the portfolio, relative to their target allocation. For example, let’s say that a portfolio calls for a 14.4% allocation to global equities and a 37.2% allocation to fixed income. Due to market conditions, global equities have risen to 20% of the portfolio and fixed income has dropped to 32%. At this point, the allocation to global equities can be pared back from 20% to 14.4% (5.6% is sold) and fixed income is raised from 32% to 37.2% (5.2% is bought). Relatively speaking, we are selling high with global equities, but only the 5.6%, and buying low with fixed income, with the 5.2%.
The net effect of periodic rebalancing is to protect a portfolio from the adverse impact of a “high flying” asset class suddenly dropping. This protects the downside, which is critically important; more so than maximizing the upside. I will use a somewhat extreme example to illustrate this point.
Let’s assume we have a $100,000 portfolio that is very aggressively invested. We go into a market slide, and the account drops by 50%. It is now down to $50,000. So: what is the return that needs to be made to get back to even? An impulsive answer would be 50%, since that is what we dropped by. However, a 50% return on $50,000 is only $25,000, which would only get us up to $75,000. The answer is a 100% return is needed: 100% of $50,000 is $50,000 which would get the account back to $100,000.
Conversely, let’s assume we have a second $100,000 account invested in a Strategic Asset Management program that limited the drop to 10%. The account is now down to $90,000. To get back to even, a ~11.12% return is needed on the $90,000. The question becomes, which do you think we will see first from the markets; an 11.12% return or a 100% return? Assuming both accounts had a steady 11.12% return per year, it would take the first one 7 years just to get back to even. Meanwhile, the second account would have grown to ~$188,275 in those same 7 years. Protecting the downside is more important than maximizing the upside in building wealth.
The second element of the Efficiencies program, Socially Responsible Investing, has also benefited you in the current market situation. Simply put, you are invested with the “good guys”. Your portfolio likely has relatively minimal exposure to the sub-prime mortgage security market. This is because sub-prime mortgages are often predatory in nature (taking advantage of the poor and ignorant) and are hence shunned by SRI fund managers. In all fairness, the effect of the sub-prime “meltdown” has painted all mortgage backed securities with the same brush, so to speak, but this effect is likely to be temporary. Having said this, I do not believe we are “out of the woods” yet in terms of mortgages impact on investment markets.
Real estate has weakened considerably and foreclosures are up dramatically. According to an article in today’s New York Times, RealtyTrak, a publisher of databases on foreclosures stated that “the number of foreclosure filings jumped 9% in July, to 179,599, and was 93% higher than in July 2006”. In addition, the full effect of Adjustable Rate resets has not hit us yet. We should see a lot of adjustable rate mortgages go up later this year and early next, and barring action from the government, this would likely result in even more foreclosures. By way of example, families that could barely afford a mortgage with a 5% “teaser” rate for three years since they took the mortgage out in 2005 will be hard pressed to afford 7.5% when it resets. Payments on a 5%, 30 year, $100,000 mortgage would jump from $536.82 to $699.21 with an interest rate increase to 7.5%. This is a payment increase of $162.39 or 30.25%!
It is my opinion that the combined effects of the war in Iraq, our ballooning national debt, the greedy nature of predatory sub-prime mortgage lenders, global warming, the challenges to our oil-based economy, the loss of our stature in the world, the continued detached perspective and at times downright incompetence we are getting from the Bush administration, plus numerous other concerns, will continue to bring challenges to our financial future. However, this does not mean doom and gloom.
There is a growing demand to end the war in Iraq and reduce the deficit. I believe the sub-prime mortgage problem will be corrected just as the Savings and Loan situation was a few years ago. We have a steadily rising awareness of the problem of global warming and its ties to our thirst for oil. For example, automobile companies are starting to “get it” about what kinds of cars people want and are responding: large SUV sales have been plummeting while hybrids are increasingly in demand. We have suffered a loss of our standing in the world, and then recovered it, in the past and we can do so again. We now have a democratic congress that was elected by popular demand. I believe this congress will continue to offer viable alternatives to what we have experienced so far and will neutralize or at least dampen the negative affects of the Bush Administration from now until January 2009. Lastly and most importantly, George Bush cannot run again.
While the road can be bumpy at times, such as now, in order to reach your financial objectives, staying invested is imperative. Going to cash is not the answer. First of all, selling now would make a temporary paper loss a real loss. Secondly, cash account returns (CDs, Money Markets, Bank Savings Accounts, etc.) are meager at best, and completely insufficient to allow you to reach your goals (this does not mean you should not have some money in the bank: you should). Third, numerous studies conclude that by the time it “looks safe” to get back into the markets, the opportunity has already passed. Staying invested, especially with the program you are in, will likely continue to protect your accounts during negative market conditions, and allow you to reap the benefits when they turn positive.
Since there is nothing we can do about the markets, and the program you are in is doing its job, the question becomes what can you and I do to help make things right in the world? The first thing is to continually call, write, and e-mail our senators, representatives, governors, and the Bush Administration on issues we are concerned about, and demand they take action to make things right.
The second thing that can be done is to continue investing in a Socially Responsible manner. Not only does SRI earn competitive returns, but it has a positive impact on the planet. The most powerful institution in the world is not government; it is business. Ultimately, especially in the industrialized nations, governments listen to business, not the other way around. By investing in SRI, you are consciously steering capital towards the changes we all want to see, and away from those companies who are part of the problem. The third thing you can do is tell others about Socially Responsible Investing.
While SRI is growing very rapidly, it is still unknown to many people. I suspect that if more people knew they had a choice to invest according to their values (while earning competitive returns) than to accept investments that were opposed to their values, they would choose the former, or at the very least, want to find out more about it. This would benefit all of us: quite simply, the more money that is invested in SRI, the more clout it has to move things in the direction responsible investors would like them to go.
I am sure that you know others who have been concerned with the issues we are all facing. They would probably love to find a way to make a difference, but are at a loss as to how to do so. Speaking to them about SRI may be just what they are looking for.
This group may also include people who are looking for guidance. They may be just starting to think about their financial future, or are retiring or changing jobs, and/or may need assistance with their retirement plans and/or other financial matters, or are going through a difficult transition, such as the loss of a spouse. Sadly, many people never get the help they need to reach their financial goals and their life’s dreams, let alone have the experience that their investments are making a difference in the world. This would be a very good time to inform them of the benefits you have gained from our work together, and invite them to speak with me. With their permission, I would be happy to contact them and provide details. Anyone you refer will receive prompt and courteous attention.
In conclusion, let me again say how much I appreciate the trust that you have given me during these challenging times. Thank you for being my valued client.
Sincerely Yours,
Scott M. Buttfield, CFP®, AIF®