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Third Quarter 2010 Quarterly Newsletter

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The View From The Bottom Of The Pond

Perceptions often differ depending on your vantage point. When we watch a duck in water, it typically appears to be gently gliding along, barely making a ripple on the surface. But that calm, serene assessment would change greatly if you were lying on your back on the bottom of the pond. In that case, you would see the rapid, almost frantic pace of webbed feet churning beneath the reflective water's surface. Simply put, there's a lot going on under there that most of us don't see from our perspective.

Asset class investing isn't much different. Some view this type of investing as akin to watching paint dry. No excitement. No trading. Occasional rebalancing. Where is the dramatic, frenetic pace that many expect, especially after watching talking heads advising buys, sells, holds, run for your lives, etc.? Actually, there is indeed a lot going on, even when you own a seemingly inert asset class mutual fund. As an example, let's take an asset class that all DHWA clients own in some capacity — Emerging Markets. On the surface, they may seem like Snoozeville, but that's because you probably are not aware of the changes that are continuously occurring.

As most investors know, Emerging Markets is a volatile asset class. It tripled, then lost over 60 percent, and now has more than doubled since the March '09 bottom of the last bear market. Just what is happening inside this fund and what does it take to be included in its portfolio? Can a country be too "emerging," or can it become too "industrialized" to be deemed emerging? Dimensional Fund Advisors (DFA Funds) has developed meaningful academic brainwork in the study of Emerging Markets for nearly two decades, and their asset class funds reflect this deep thinking. In order to be included in a DFA Emerging Markets Fund, several prerequisites must be met, including:

• Is there proper legal enforcement of contracts and fair treatment of foreign investors?
• No restrictions of repatriation of capital; i.e., can we get our money out of the country?
• Do local exchanges have sufficient infrastructure and trading volume?
• Does the company offer Depositary Receipts that trade on major global exchanges?
• Does the company have a market value of at least $250 million?

These are just a few of the safety measures that DFA uses when deciding which country's stocks should be purchased in their funds. There are plenty of third world countries that do not qualify for inclusion in DFA's Emerging Market Funds. In 2004, India was added. It wasn't until 2007 that China passed DFA's various screens, and it was just last year that Russia was allowed to join the party. This summer, three more countries were approved for inclusion into DFA funds. Can you guess which ones? Our clients now own securities from Columbia, Egypt and Peru. True, these three countries' stocks make up less than 1% of the funds' holdings, but it's a start.

Countries can also climb out of the Emerging Markets ranks. Last year, Israel moved from DFA's Emerging Markets to Developed Markets status. DFA's funds also limit the weightings of securities from any one country. There is currently a 15% limit on any country's securities. Can you guess the five countries with the highest weightings? If you guessed Libya, Haiti, Lichtenstein, Vegas and New Jersey, you are wrong. If you guessed China, Brazil, South Korea, Taiwan and India, you're a winner.

Hopefully, this bottom up view of the ongoing activities from just one of your asset class funds will dispel the notion that nothing is happening in an asset class-based portfolio. The beauty of this process is that even though the "webbed feet" of the funds are "madly churning" , there are very few taxable distributions resulting from all this "underwater" activity. So the next time you are feeding the ducks, or reviewing your portfolio, just be aware that there really is a lot of activity taking place beneath the surface.

I'm Good Enough, I'm Smart Enough, And Doggone It, People Like Me

This expression of confidence comes directly from an often used quote by Stuart Smalley, a.k.a. Al Franken, during his pre-political years on Saturday Night Live. But it might as well have been used by the majority of large corporations' chief financial officers in the US. You may remember the topic of over-confidence was cited in this investment report several quarters ago. At that time, we discussed how individual investors were often overly confident in many of their investment decisions. But it seems like the CFOs of major American corporations appear to be no better at forecasting the financial future.

In a recent New York Times article*, it was reported that in a major joint study by financial economists from Ohio State University and Duke University, top corporate CFOs' expectations regarding S&P 500 Index returns for the next year showed some major overconfidence...in a bad way. It seems that the CFOs were relatively poor at guessing potential returns. In fact, they were very good contrary indicators; their predictions were negatively correlated to the actual returns. For example, in mid-2007, just months from the start of the worst bear market in over 70 years, the CFOs felt that the worst return scenario for the next year was a small positive return. And in late February 2009, less than one month from the bear market's bottom, the CFOs had their most pessimistic predictions, expecting a worst case scenario of losing an additional 10% over the next year. In reality, the S&P 500 Index had a heady 46% return during that time period.
* NYT 8/21/10 "The Overconfidence Problem in Forecasting" by Richard Thaler

What can we learn from all this? If some of the most astute and highest paid financial minds working for some of the largest companies in the world do such a poor job predicting the direction and extent of market moves, then do we really think anyone else can? That is why active management has proven inferior, and why Modern Portfolio Theory is still the most advantageous method for investors concerned with generating the best long term return consistent with risk taken. If you don't believe that, then simply look into a mirror and repeat after me, "I'm good enough, I'm smart enough and ..."

Third Quarter 2010 Asset Class Performance

After the meaningful correction that took place in the second quarter, the third quarter came roaring back, much to the surprise of those bears waiting for the double dip recession. All equity asset classes had double digit returns, while income classes did well also, mainly due to unexpected decreases in interest rates during the quarter. Interestingly, domestic equity classes had similar returns, regardless of the size or style of the class. Similar results occurred internationally. When we review the year to date performance, we see some interesting results. Small is clearly outperforming Large in the US. In the Emerging Markets class, Small has beaten Large by over 10%. Institutional Real Estate, unlike the single family housing market, is the big domestic winner, at close to a 20% return for the first nine months of the year. European stocks have only broken even through the first three quarters, thanks to the weakening of the Euro for most of the year

The quarter to quarter Jekyll-Hyde performance of the markets seems to mirror the week to week market movements. This two-steps-forward, one-step-back pattern has made for an unsatisfying feeling by most investors, even though year-to-date performance has been very good. Unfortunately, we can probably expect similar market patterns for the short to intermediate term. After the 2008-09 bear market and the resulting economic stresses, it will take some time to get all aspects of the economy moving in the same direction at the same time. Fortunately, it does appear as though the recession is over, at least in the statistics followed by most economists. One famous investment axiom states that bull markets climb a wall of worry, and that clearly is what we are seeing throughout this year. The best course of action is simply to stay invested in the risk-reward parameters that have been set up in your portfolio. Especially during times like the present, trying to market-time the gyrations and white noise of daily financial news is a sure formula for being at the wrong place at the wrong time.

A More Principled 401(k)TM

Many of our clients are enrolled in their company's 401(k) plan. Consequently, our advisors have literally reviewed hundreds of these plans over the years, and it has become very clear that in many cases, the plans are lacking in a number of areas, including:

• Objectivity and independence
• Fee transparency and reasonable cost
• Investment choices and performance
• Level of service

Consequently, Dixon Hughes Wealth Advisors has decided to build a superior 401(k) platform, which will literally bring a high net worth alternative to all participants of any company's retirement plan. If you would like to see how our new A More Principled 401(k) TM compares to yours, please contact your advisor for more information. You will be glad that you did!


Frederick F. Kramer IV, JD
Chief Investment Officer