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January 10, 2014

Dear Clients and Friends:

The stock market rally last year generated healthy returns for investors with a meaningful allocation to stocks. The S&P 500 (Large U.S. stocks) outperformed all broad developed country indexes in U.S. dollar terms. The S&P 500 returned 32% versus the MSCI ACWI, a global stock Index (including U.S.), which returned 22%. Bonds, as measured by the Barclays U.S. Aggregate Bond Index, returned -2.02%. Diversification into other markets and other strategies resulted in lower performance. This is especially true for investors with exposure to Emerging Market stocks or bonds, which underperformed U.S. broad indexes by more than 35% for stocks and almost 10% for bonds.

Willingness To Be Different

In the investment business, it is commonly understood that the greatest business or career risk exists when you underperform unconventionally. As a result, many portfolio managers in the industry measure themselves against a relative, rather than absolute performance metric, knowing that returns at or around some magical benchmark, will enhance job security. To us, this approach essentially lessens the ability to add real value. We favor managers that have the conviction and patience to be different; the true value-add investment professionals.

Jean-Marie Eveillard, the founder of the First Eagle Global and Overseas Funds, said the following regarding a period of relative underperformance: "I would rather lose half of our shareholders than half of our shareholders’ money." All of our global equity managers have the same basic belief: investing should be based on fundamentals, and when equity market valuation deviates from those fundamentals, they will move to cash, bonds, gold, etc. Adhering to fundamentals is a willing decision to be different from indexes and the herd mentality that closely mimics them. The decision to invest with these managers is only wise if an investor is willing to be patient and ignore benchmarking disparities that could exist for multiple years.

The table below shows 19 years (1995-2013) of annual returns of the S&P 500 and First Eagle Global fund. Which investment would you prefer to own?

 


You might reasonably conclude, with 7 out of the top 8 positive returns, that the S&P 500 has provided better performance over the 19 year period. Unfortunately, that conclusion would have been wrong. In fact, the First Eagle fund had an annualized return of 12% compared to the S&P 500 return of 9%. Cherry picking shorter time periods for performance comparisons leads to different results. The next 3 graphs illustrate the point:
 

 
Exhibit A - Note the magnitude of underperformance of the First Eagle Global fund from 3/31/1995 – 2/29/2000 (4 years and 11 months) versus the Vanguard 500 Index – Bull market 
 
 
Exhibit B – Note the reversal in overall performance over the time period 3/31/1995 – 12/31/2013 (almost 19 years), which includes the time period above – Bull and Bear markets 
 
 
Exhibit C – Note the outperformance of the market, as represented by the Vanguard 500 Index, since the 2009 market bottom - Bull market 
 

This review urges caution when using benchmarking to make investment decisions. Is there a point of using a tool if it does not lead to better decisions? We do not think so. It is only through a cycle of both up and down markets that one truly realizes the benefits of investing based on fundamentals.

We believe that better results are achieved by adhering to a fairly simple concept: control the downside by avoiding or limiting exposure when valuations disconnect from historical norms. Again, while the concept is simple, in practice it requires significant conviction and patience. Following the herd may provide psychological comfort, until the heard heads off the cliff (2008). Managers using valuation discipline can show lengthy periods of underperformance relative to a benchmark and, as a result, see significant withdrawals from their funds. Since their compensation is driven by the amount of money managed, managing with valuation conviction takes a degree of fortitude mostly lacking in the investment industry.

Interestingly, we choose to invest with global, fundamental managers not because of return, but because of the goal of better risk control. Simply put, our goals are to: 1) minimize the possibility of extreme downturns when clients withdraw funds and 2) minimize the point of entry risk so that clients are not overpaying for market exposure.


Investment Changes

Our baseline portfolio for equities is to maintain a diversified mix of global, go-anywhere managers. If, however, there are pockets of value in the global landscape, as measured by normalized price-to-earnings ratios, we will overweight these areas until prices normalize. For the last 3 years, we over-weighted large cap U.S. equities, which had compelling values versus a mix of global equities. With the exception of some ultra-large cap, high quality stocks, this no longer exists. Emerging markets, on the other hand, represent compelling values as shown on Exhibits D and E that follow.

As a result, we will decrease large cap U.S. equity exposure and add emerging market equities, using Pimco EM Fundamental Index Plus AR Instl. (PEFIX). This fund has economic exposure to emerging market equities, but with an emphasis on more attractively valued companies (fundamental weighting). It should be emphasized that emerging markets are one of the most volatile asset classes, similar to small-cap stocks. Viewed in isolation, this can be a legitimate cause of concern. The beauty of diversification, however, is the reduction in volatility achieved over most time periods when a number of asset classes are owned. The inclusion of emerging market equities in our allocation is not a near-term prediction of out-performance. It is an over-weighting based on current valuations that have historically lead to strong five to ten year returns.

For fixed income, we will maintain allocations to high-quality bonds in addition to positions with credit, interest rate and currency diversification to protect against the effects of either dollar devaluation or rising interest rates. Still, the bulk of client fixed income portfolios are weighted in dollar-denominated assets. High quality non-dollar bonds have been absent from the portfolio as a decent point of entry has been difficult until now. To reduce dollar-denominated risk, we will be selling our fixed income short positions (RRPIX and TBT) and investing the proceeds into Pimco Global Bond Instl. (PIGLX).


Health Savings Accounts – A Great Tax Planning Tool

The combination of a high-deductible health insurance plan and a Health Savings Account (HSA) is becoming a more prevalent offering from employers. HSAs offer a unique financial planning opportunity. Contributions to an HSA are tax deductible and the contributions can be invested and grown tax-free, not just tax-deferred. Therefore, we recommend that clients with HSA accounts let them grow as long as possible. When out-of-pocket medical expenses arise pre-retirement, we recommend that you pay for them with regular savings, letting the HSA grow. If large medical expenses occur in retirement, the HSA funds can be withdrawn tax-free. This is a good way of building up tax-advantaged funds for possible long-term care expenses. If you have an HSA, you should maintain a file with all medical expense receipts. You are not restricted to using funds in an HSA tied to expenses incurred in the year of withdrawal. For example, out-of-pocket expenses incurred in 2013 can be withdrawn from your tax-free growing HSA any year in the future.
 

Annual Net Worth Statements

We are in the process of preparing personal Net Worth Statements as of December 31, 2013. Taking an accurate picture of assets and liabilities on an annual basis is an important financial planning tool that improves our ability to serve you. These statements allow us to answer these questions:

· Should any existing financial accounts be consolidated in the interest of simplification?

· Should there be any changes in asset ownership that will minimize income taxes?

· Should there be any changes in asset ownership that will minimize estate taxes or probate expenses?

· What is the nature of any current debt? Should any debt be paid off or refinanced? Was personal spending supplemented by an increase in debt, which could impact retirement feasibility or retirement security?

· Have there been any additions to personal property requiring insurance coordination?

· Were there any purchases, sales, or gifts of real estate interests?

· Were there any changes in asset ownership not communicated to us? Ownership changes impact insurance, taxes and estate planning.

Please respond promptly to our request for December 31, 2013 values.

 

Information for Tax Return Preparation

It is time to begin gathering the information needed to prepare 2013 tax returns. It is a good idea to keep a current year tax file and fill it with any documents you know will be needed to prepare your returns, such as charitable contribution receipts, property tax bills, and copies of estimated tax payments made. Financial institutions, including Fidelity, will be sending out 1099s with information on dividends and capital gains. You should assume that Fidelity’s 1099s are accurate, unless we notify you otherwise and provide you with a more accurate statement of the year’s gains and losses from our system. We will be sending out statements of planning fees paid in 2013 from taxable accounts. Note that fees paid from IRAs have already provided a tax break since payments are not treated as taxable withdrawals. Therefore, they are not deductible on Schedule A of your 1040.

 

Annual Delivery of Privacy Statement

We are committed to maintaining the confidentiality, integrity, and security of the personal information entrusted to us. The SEC requires delivery of the enclosed copy of our Privacy Statement on an annual basis.
 
 

Information Filing - Securities and Exchange Commission (SEC)

The Securities and Exchange Commission requires all registered investment advisors to update the information on file with the agency on Form ADV within 90 days of year end, or March 30. We intend to revise the form and post it on our website by that date. If you do not have access to our website and desire a copy of that form, please contact us.

 

2014 Annual Tax Planning Limits

A summary of key tax planning limits for the current year is attached for your reference.

We continue to work daily to earn your trust and confidence.

 

Best Regards,
 
 
Vincent A. Schiavi, CFP®, CPA/ PFS                                               Ravi P. Dattani, CFP®, CPA
President                                                                                        Vice-President

 
 __________________________________________________________________

 
 Sources:
Kiplinger Tax Letters, IRS.gov
                                                         Courtesy of Schiavi + Dattani
                                                        www.SDfinancialadvisors.com  
 
 


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