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Fourth Quarter 2012 Quarterly Newsletter

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A Sheep In Wolf's Clothing

January 10, 2013

The inverse of the above idiom comes from the Bible. "Beware of false prophets, which come to you in sheep's clothing, but inwardly they are ravening wolves." In every day usage, this verse has become a warning about bad guys disguising themselves as good, or at least harmless, and tricking an unsuspecting victim.

But that's not what we're talking about here. In fact, we are talking about just the opposite. More like a meek and harmless animal dressing like a big, aggressive creature to attempt to get your attention, or in this case, your money. In the investment world, there is a great example of this phenomenon, and it is being perpetrated by some of the biggest, most well known mutual funds in America.

Large actively managed mutual funds attempt to portray a potential for beating their passive index/benchmark performance. The only reason an investor would choose an active manager, and pay the much higher expense ratio, would be to gain better performance. Unfortunately, a recent article in InvestmentNews shows the fallacy of this line of thinking. *10/1/12 Stock market correlation leads to 'closet' indexing. It clearly shows that the largest actively managed funds own virtually the same securities, in the same percentages, as the S&P 500 Index. See the chart below:

Largest actively managed funds compared to S&P 500 Index

This chart clearly shows that the 10 largest active mutual funds in the U.S. average nearly a 98% correlation with the S&P 500 Index. Obviously, it will be very difficult to out perform something that is 98% the same. And more astonishingly, the article points out that the average of all large cap blend funds in the U.S. was reported to have a correlation of 99.7%. Think about the ramifications of this. If you buy a passively managed S&P 500 Index fund, you will pay an internal expense ratio of only 5 to 10 basis points (one basis point = one hundredth of one percent). Yet actively managed large cap mutual funds can charge 10 to 20 times that amount or more, not to mention other invisible costs of active investing, such as trading costs and high tax inefficiency. Yet, as we can see by the data, due to their incredible similarity of portfolio holdings, most of these actively managed funds, over the long term, will find it difficult if not impossible to equal the performance of the benchmark they are attempting to beat.

So perhaps now the initial sheep/wolf analogy may make more sense to you. These sheep-like active fund managers are doing nothing more than following the path of their benchmark index. As long as they continue to replicate the holdings of that index, they have little long term hope of rewarding their investors with superior returns. Yet they present themselves in a way that would lead unsuspecting investors to believe that superior returns are indeed possible. Obviously, our clients are protected from these "ravenous" sheep in wolf's clothing, because we use very low cost, institutional, pure no-load passive mutual funds to represent each of their equity asset classes. Unfortunately, millions of other investors are still being led astray toward hidden pastures of high cost and mediocre performance. All the "growling and howling" of the virtues of their active management style will undoubtedly lead to a baaa-d investment experience!

Because It's The Law

Each year at this time we follow federal law and include DHGWA's Privacy Statement with this letter. In addition, we offer you our Form ADV Part II – a Disclosure Document required by and filed with the Securities Exchange Commission. We update this document at least annually, and it is filled with much suspense and romance. Many have used it to combat insomnia. Please contact Kevin Broadwater at 828-236-5801 or kevin.broadwater@dhgwa.com if you would like us to send or email you a copy. You can also find our ADV on our website (www.dhgwealthadvisors.com). Lastly, we would like to remind you to keep us informed of anything happening in your life that may have ramifications to the risk/reward parameters of your portfolio. We can only be of maximum value to you if we have full knowledge of your current financial situation.

Read Our Blog

Just a reminder that our website (www.dhgwealthadvisors.com) has a blog that is updated every two weeks by one of our astute advisors, with his or her slant on an interesting and relevant topic in today's investment world. You can even sign up for the RSS feed.

Fourth Quarter 2012 Asset Class Returns

You might have renamed the 4th quarter as "The Fiscal Cliff Adventure". Even before October, clients started quizzing our advisors on the finer points of its effect on the market, interest rates, employment, their taxes and estate plans, and most definitely their investment portfolios. Their nervousness was fueled by a grouping of political, financial and water cooler talking heads seldom assembled at one time. Literally everyone was talking about it and fearing the worst. Many concerned investors were sure that, for the umpteenth time over the last couple of decades, all markets would come crashing down, the dollar's value would go to zero, and their money would end up in the same place as the Mayan calendar on or about December 21.

This was just one more example in a seemingly endless list of reasons to remain focused on the long term, and incorporate into your portfolio a risk level with which you are able to absorb the inevitable pullbacks that accompany the long term rewards of owning at least some amount of equity in your portfolios. Reacting to a potential market fear by selling or running for cover every time the "Squawk Box" starts making noise is truly the formula for lifetime underperformance. We have shown objective data supporting these facts several times in this report over the past several years.

There turned out to be no real negative stock market reaction to our legislators' spastic handling of the year end vote, and those investors who ran for cover not only missed a positive 4th quarter, but the strong market move in early January. Please tell those of your friends that have these unfortunate traits that there is indeed a better way. There are few better New Year's resolutions one can make than to tell family, friends and colleagues about the calm, experienced and knowledgeable advisors at DHGWA who help their clients make the proper decisions in both good and bad times.

As mentioned above, the fourth quarter ended with little market drama. Only one equity asset class had a negative return, and the full year returns of all asset classes were, frankly, great!

US Large Cap, which was a leader for 2011 and early 2012, continued its lag from the 3rd quarter, and ended the year as one of the weaker performing equity asset classes, even at a 15%+ return. As has been the long term trend, 2012 ended with Small Caps handily beating Large Cap, and Value beating Growth, in both the US and in most International and Emerging Markets asset classes. International Real Estate was the hands down winner for the year. Who would have imagined that overseas real estate would have performed so well, at a time when many countries, both large and small, and developed or not, were having meaningful economic slowdowns. This is just one reason you cannot read the newspaper or listen to CNBC and form investment opinions or stock selections. By the time you hear the news, it has already been discounted by the markets, and you are sure to be mostly late in your decision making.

So what now? The US appears to be continuing the long slow grind out of the '08-'09 recession, with employment and real estate growth showing very modest gains. The aftermath of the Fiscal Cliff legislation removed major economic slowdown potentials, but even the small changes made to tax receipts and government spending will put a bit of a damper on the economic growth expected in 2013. Across the seas, Europe and China seem to be hitting the bottom of their economic slowdowns, but their climb back will not happen too strongly or quickly. All in all, we can expect a slow growth scenario not unlike the last year or two. But the good news is that we are moving forward. Capitalism has proved that it doesn't need dramatic growth to prosper and increase earnings. With low interest rates and accompanying modest inflation, slow growth can be good for patient, long term investors.

The next few months should be interesting both politically, as our fearless representatives begin debate on how to handle the US debt limits, and economically, as both domestic and global market forces continue the grand deleveraging that started in 2008. We should bundle up warmly, celebrate last year's great performance, and keep our sights on the long term. Remember that the volatility that is certain to occur over time is simply part of the journey to be expected when prudently owning portfolios constructed of asset classes formulated to reflect the risk you are willing to take. Oh, and be sure to make a snow angel if you get the chance.

Happy New Year!


Frederick F. Kramer IV, JD
Chief Investment Officer
Dixon Hughes Goodman Wealth Advisors LLC