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February 4, 2010 1. Do Not Try to Time the Market Flows to Equity Funds Related to Global Stock Price Performance Source: Investment Company Institute The Danger of Trying to Time the Market 15 Year Average Annual Returns (1994-2008) 15 Year Average Annual Return 6.5% 1.9% -3.7 %

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February 4, 2010

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February 4, 2010


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1. Do Not Try to Time the Market

Flows to Equity Funds Related to Global Stock Price Performance

Source: Investment Company Institute


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The Danger of Trying to Time the Market

15 Year Average Annual Returns (1994-2008)

15 Year Average Annual Return

6.5%

1.9%

-3.7%

-10.0%

-14.6%

Stayed the course Missed Best 10 Days Missed Best 30 Days Missed Best 60 Days Missed Best 90 Days

Investor Profile

Source: Standard and Poor’s, Davis Advisors, and Vanguard Investment Strategy Group. The market is represented by the S&P 500Index.

Past performance is not a guarantee of future results.


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There is Also a Selection Penalty

Quarterly Flow into Growth and Value Funds, and the Nasdaq’s Close

Nasdaq

Net Flow (bil)

Total Flow

Growth: $363b

Value: $96b

Source: Strategic Insight


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Average Stock Fund Return vs.

Average Stock Fund Investor Return

(1988-2007)

11.6%

Average Annual Return

The “Investor Behavior”

Penalty

4.5%

Source: Quantitative Analysis of Investor Behavior by Dalbar, Inc. (July 2008) computed the “average stock fund investor” returns by using industry cash flow reports from the Investment Company Institute. The “average stock fund return” figures represent the average return for all funds listed in Lipper’s U.S. Diversified Equity fund classification model.


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2. Use Dollar Cost Averaging


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The Advice of Warren Buffett

A short quiz: If you plan to eat hamburgers throughout your life and are not

a cattle producer, should you wish for higher or lower prices on beef?

Likewise, if you are going to buy a car from time to time but are not an auto

Manufacturer, should you prefer higher or lower car prices? These

questions, of course, answer themselves.

But not for the final exam: If you expect to be a net saver during the next

five years, should you hope for a higher or lower stock market during that

period? Many investors get this one wrong. Even though they are going to

be net buyers of stocks for many years to come, they are elated when stock

prices rise and depressed when they fall. In effect, they rejoice because

prices have risen for the “hamburgers” they will soon be buying. This

reaction makes no sense. Only those who will be sellers of equities in the

near future should be happy at seeing stocks rise. Prospective purchasers

should much prefer sinking prices.


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3. Rebalance Yearly

During this period, an annually rebalanced portfolio provided lower volatility and higher return


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4. Diversify, Diversify. Diversify

  • Few Places to Hide During World Wide Recession

  • But Safe Bonds (e.g. U.S. Treasury Bonds) and Gold Helped

  • While Correlations Have Risen There Have Been Large Differences in the Returns of Different AssetClasses


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Time Varying Stock-Bond Correlation

Moving three-year stock-bondreturn correlations

Long-term average

Data: 10Y Treasury return is calculated from 10Y Treasury yields. Yields are originated from FRB website. Domestic stocks: 1926-1970 S&P 500 Index (monthly reinv); 1971 – 4/22/2005 Dow Jones Wilshire 5000 Index; 4/22/2005 – present MSCI US Broad Market Index


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Diversification Into Emerging Markets Helped During the Lost Decade

+250%

+200

+150

+100

+50

-50

Emerging markets

Annual growth rate

for the decade: 10.1%

Developed markets

Growth rate: 0.2%

‘00 ’01 ’02 ‘03 ‘04 ‘05 ’06 ’07 ’08 ‘09

Sources: MSCI and Bloomberg


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A Lost Decade?

Value of $100,000 invested on January 1, 2000

50% bond,

25% U.S. stock,

25% international stock

With $1,000 monthly contributions

And annual rebalancing

Advantages of Diversification, Rebalancing and Dollar-Cost Averaging

$300,000

250,000

200,000

150,000

100,000

50,000

0

S&P 500 index

’00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ’08 ‘09

Source: Vanguard Adjusted for inflation.


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5. Costs Matter

Source: Lipper data for all General Equity funds


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Costs Matter

Actively-Managed mutual funds with low costs outperform funds with high costsDecember 31, 1994 through December 31, 2009

8.66%

Net Return to Investors

6.66%

Source: Lipper data for all General Equity funds


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6. Use Index Funds

  • Markets are reasonably efficient

  • But even if they are not efficient, indexing is an optimal strategy


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Distribution of returns

Likelihood

Better than the market

Below the market

6%

10%

8%

= Market Performance

Investment Performance is a Zero-sum Game


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Indexing works

Likelihood

Below the market

Better than the market

6%

7.0%

10%

8% = Market Performance

Impact of costs

After Costs, Active Management is a

Negative-sum Game


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Large-cap Equity Funds Versus S&P 500 Index

Percentage of large-cap equity funds outperformed by S&P 500

Periods ended December 31, 2008

Sources: Lipper, and Vanguard.Past performance is no guarantee of future results.


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The Odds of Success: Returns of Surviving Funds

Mutual Funds 1970-2009 Compared with S&P 500 Returns

  • Number of equity funds

  • 358

  • 2009 119

  • Nonsurvivors 239

29

28

Number of equity funds

21

18

14

3

2

2

2

Annualized Returns 1970-2009

Sources: Lipper and Vanguard.


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Percentage of Actively Managed Bond Funds Outperformed by the Benchmark

10 years ended December 31, 2008

Source: Morningstar, Barclays Capital and The Vanguard Group.


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It’s Down to One

Of 14 funds that beat the Standard & Poor’s 500-stock index for nine

consecutive years through 2007, only one continued that feat last year.

2008 return (prelim.)

-35

M&N Pro Blend Max S

S&P 500 (with divs. reinvested)

-37

-40

Amer Funds Fundamental A

Target Gr Alloc A

-40

-41

Lord Abbett Alpha Strat A

T. Rowe Price Spect Grth

-42

-43

JPMorgan Small Cap Gr A

Hartsford Cap App HLS 1A

-46

-47

AIM Capital Development A

Columbia Acorn Select Z

-50

-49

T. Rowe Price New Era

Fidelity Select Natural Res

-52

-53

Jennison Natural Res B

Fidelity Adv Energy T

Ivy Global Natural Res A

-54

-61

From: The Wall Street Journal, 1/5/09


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Satellite 1

Satellite 2

Index core

Satellite 3

Potential Advantages of Core-Satellite Approach

Core portfolio (indexed investments)

Low costs vs. active management

Lower risk budget versus active management

Diversification (broad indices)

Close tracking of benchmark performance

Satellite portfolio (active investments)

Take “bets” to enhance returns (add alpha)

Higher costs versus indexed management

Decorrelation

Require strong selection skills

Can use illiquid assets


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Despite Decades of Uncertainty the Long-Run Trend of the Stock Market Has Been Up

?

14000

4,000

2,000

16 Years

Billions

25 Years


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Valuations Are Moderate

Shiller PE Ratio

(S&P 500 Real Price/10-Yr Average Real Earnings

Source: Robert Shiller website


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Median Ten-Year Annual Compound Total Returns from Historic P/E Deciles 1926 to 2008

16.92%

15.99%

15.20%

14.48%

13.86%

11.55%

Return (%)

9.32%

8.01%

5.69%

3.27%

Stocks Cheap

Stocks Expensive


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Diversification Again

The Home Country Bias

U.S. ≈ 40% of World

Emerging Markets Are Growing Faster than Developed Markets

China‘s Growth Has Been Unprecedented

China Likely to Surpass Japan

Yuan is Severely Undervalued


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China’s GDP as a Percent of World Total*

Source: Historical Statistics for the World Economy – Angus Maddison, ISI.

*Adjusted for purchasing power parity


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China’s Strengths

  • Underdeveloped Center and Western Regions

  • Tremendous Human Capital

    • Educated

    • Hard Working

    • Entrepreneurial

  • Government Policy Promotes Growth

  • Strong Fiscal Balance


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Assessing China Through Low-Cost ETFs

  • FXI vs. YAO

  • HAO

  • Closed-end Funds


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