December Table of Contents

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1 December 2007 Mutual Fund Selection Timothy Bock, founder of Summit Portfolio Management, spoke on the topic of mutual fund selection on Nov. 3 at the Santa Monica branch library, 2101 Ocean Park Blvd. Summit Portfolio Management, founded in 1984 by Bock, has six offices and is a feeonly financial consulting firm that offers comprehensive personal financial services. Portfolio structure determines returns, is Bock s thesis. Only four percent of returns are attributable to stock picking and market timing, factors that can actually reduce return. Bock reviewed active versus passive investing, coming down on the side of passive investing, due to the efficient market hypothesis. Investors should use index funds, because capital markets are efficient. Concentrated portfolios have higher risks and costs. Superior returns are attributable to asset structure. Picking a manager or funds based on track record does not help. Less than 10 percent of the managers of mutual funds actually add value. Between 1926 and 2006: stocks produced a 6.8 percent higher return than Treasury bills; value stocks produced a 3.1 percent higher return than growth stocks; and small company stocks produced a 4.7 percent higher return than large company stocks. To get a superior return one s portfolio should be more heavily weighted with small cap and value stocks. 1 Dimensional Fund Advisors (DFA) created one of the first index funds in DFA created passively managed mutual funds designed to capture the added returns from small and value stocks. DFA funds aim to keep expense ratios and transactions costs low. The funds are sold only through investment advisors. The active management approach takes the position that stock prices are often incorrect and can be exploited via market timing or stock picking. In contrast, the passive management Table of Contents Timothy Bock Mutual Fund Selection.p.1 Erick Glicksman Structured Products...p. 2 Sharat Shroff.Investment in India p.3 approach takes the position that market mechanisms price securities correctly, guided by the efficient market hypothesis. Evidence on these strategies comes from examining the results of the average stock fund investor. During the same period that the Standard and Poors 500 returned an average of 13.2 percent a year, the average stock fund investor earned 3.7 percent a year. Bad timing based on emotional reactions was largely responsibly for the poor results. Star fund manager performance may be suspect. For example, Bill Miller of Legg Mason outperformed the S&P 500 for fifteen consecutive years. But he is a value manager, so should have been evaluated against a value index. Against that index he was average. Most of Miller s success was due to an early pick of AOL.

2 Relying on fund ratings is another way to lose money. A study of five rating services showed a fund receiving wildly different ratings by different services. No consistency has been found in fund manager performance. Regarding Morningstars ratings, it has been found that 80 percent of money goes into five star funds. But, that is a formula for losing money, as three star funds were found to outperform five star funds by a four percent compounded rate. Bock had a number of conclusions: invest. Don t speculate. Passive investing is better, due to lower costs, less risk and above average returns. Control risks through diversification of securities, and countries. Control your emotional influences a huge source of underperformance and loss. Measure results against appropriate benchmarks. Get expert guidance if you are not an expert. Bock distributed an information packet, containing eight articles on financial topics, such as how emotions influence investing outcomes, equilibrium-based investing, active versus passive management, and strategies to reduce taxes. These articles and many more are available at Bock s website, at: Improving Portfolio Efficiency Using Structured Product Investments Erick Glicksman spoke on structured financial products at the Skirball meeting of the AAII Los Angeles Chapter on Saturday, November 17. Glicksman is Managing Director and head of product development for structured products at UBS. Structured products are defined as an emerging investment class; they are a means to get access to liquid asset classes. Currently structured products are more common in Europe. Traditional investments include stocks, bonds and cash. Nontraditional investments include: hedge funds, commodities, foreign exchange and such financial instruments as: options, swaps and forwards. Structured products meet the objectives of enhanced return, risk management, market access, tax and regulatory efficiency, and cost and time efficiency. The promise of enhanced return with structured products makes them attractive as you doe not have to time the market and they reduce risk. Structured products bridge the gap between the individual and the institutional investor. With structured products you can defer taxes and convert short-term capital gains into long-term capital gains. Los Angeles County Meeting Schedule Westside Computer Group Don Gimpel, 310/ dgimpel@prodigy.net Sat. Dec. 1, at 10:30 a.m.. Veterans of Foreign Wars Memorial Bldg. Culver Blvd. & Overland Avenue, Culver City, Topic The Retirement Withdrawal Issue (featuring six spread sheets). Pasadena Group Pasadena Library 285 E. Walnut Street, Topic and date TBA Mutual Fund Group Gunter Hagen 310/ , ghagen1@yahoo.com. 10:30 a.m. Sat, March 1, Topic: Smart Investing Strategies and Global Investing Trends. In the community room of the Fairview Branch of the Santa Monica Public Library, 2101 Ocean Park Blvd., Santa Monica. The meeting is free to the public Stock Selection Group Norm Langhout, 310/ , normlang@comcast.net. Fourth Wednesday of the month at 7 p.m. Fairview Branch of Santa Monica Library, 2101 Ocean Park Blvd., Santa Monica. Topic TBA San Fernando Valley Group Mid Valley Library Community Room, Nordhoff St. North Hills, Topic, TBA IBD Meet-Up/AAII CANSLIM Group Santa Monica Library, Fairview Branch, 2101 Ocean Park Blvd., Santa Monica Los Angeles Chapter Mtg. No meeting in Dec Up-coming meeting dates through July for 2008: Jan. 12, Feb. 23, March 22, April 19, May 17,, June 28, and July 19. Growth of structured products started in Europe in the early 1980s, but has lagged in development in the U.S.A. Structured product growth in the U.S.A. hit $1.8 B(illion) in 1998, grew to$9.6 B in 2003; rose to $40.4 B in 2007, 2

3 and is projected to hit $100 B in the U.S.A. and $200 B in Europe by the end of the year The majority of money invested in structured products comes from individual investors. Structured products can access: indexes, individual equities, hedge funds, commodities, interest rates, foreign exchange rates, baskets of credits and baskets of equities. The components of structured products fall into four risk categories, as follows: 1) Protection: in which 100 percent of the investment is guaranteed at the end of investment term. Example: an absolute return barrier note with a term of 18 months, and 100 percent principal protection, with the underlying index being the S & P ) Optimization: in which the return on the investment is range bound at the end of the investment term. Example: a yield optimization 10 percent per annum note with contingent protection with a range bound return and a oneyear term, issued by UBS. 3) Performance: uses a tactical strategy for flat or bullish markets, with the S &P financial index as the underlying index. Example: an autocallable optimization security, with contingent protection, with a one-year term, callable quarterly, issued by Lehman Brothers. 4).Leverage: the most risky as the investment would be in call or put options. Example: performance securities with contingent protection, with S&P 500 being the underlying index, and the issuer being HSBC USA Inc., with a term of five years. It trades daily, giving a higher risk-adjusted return. Glicksman envisions structured products as a component of your portfolio, along with equities, bonds, real estate and alternative asset classes. In the question and answer session, Glicksman pointed out that UBS is developing financial products with a longer holding time to avoid tax hits. The three percent fee, an opportunity cost, is being squeezed down to the most competitive level. Structured products is a very robust area that is growing like crazy. Growing in a Slowing World, Investment Opportunities in India India s equity market and business climate offer challenges to overseas investors, but progress is being made, and the country has an enticing growth rate. Sharat Shroff, CFA, portfolio manager for Matthews International Capital Management, LLC, spoke on investing in India and the country context at a November 17 talk to the Los Angeles Chapter of AAII at the Skirball Center. Among the challenges to foreign investors are ownership restrictions (a premium is charged to foreign investors for such stocks as telecom, banks and defense), tax laws are ambiguous, the rupee is not fully convertible, and shorting of stocks is prohibited to institutional investors. The difficulty in direct overseas investment in India led to the rise of a parallel market, where participatory notes (offshore derivative instruments) were sold. They rose in value from about $7 billion in 2004 to about $90 billion by late 2007, accounting for 8 percent of India s total market capitalization. In mid-october, the Securities and Exchange Board of India announced measures to substantially curtail the issuance of participatory notes, in hopes creating a more equitable market between domestic investors and participatory note investors. India s growth rate has picked up significantly. Between 1950 and 1980 it was3-4 percent; between 1980 and 2000, it was 5-6 percent; and between 2000 and 2005 it was 6-8 percent. Growth has been stable within a band of 4 to 8 percent for the last 10 years. The government s micromanagement of the economy and a stifling bureaucracy have been sources of complaint, but the situation is improving. Entrepreneurial activity is increasing despite existing constraints: 11 3

4 procedures to start a new business; 35 days to start a new business; 1,420 days to enforce a contract; and 10 years to close a business. Transformation of the economic landscape, particularly in big cities, reeling from population inflows, is under way. Average age in India is about 25 years. Capital markets need to be deepened and broadened. Deregulation and privatization are opening up new markets in a country that is aiming at achieving a greater balance between manufacturing and services. Unequal wealth distribution (making for political volatility), a dearth of public health resources, inadequate educational opportunities, lack of infrastructure and a populations base of hundreds of millions of peasants subsisting on less than $1 per day are all simultaneously significant economic challenges and opportunities for growth. India needs to broaden its base of growth, as the informal economy amounts to 60 percent of GDP, and employment growth has been stagnant over the last decade. Also, there has been a stall in the reform agenda with an uncomfortable alliance between Congress and center-left parties, with high decibel anticapitalist rhetoric coming from the communists. The social dilemma is how to create jobs for those hundreds of millions surviving in grinding poverty. On the bright side, the much publicized software sector generates $45 billion a year, and is growing at 30 percent a year. Yet it amounts to less than one percent of employment and five percent of GDP. India is a large regional supplier of pharmaceuticals, which amounts to 5 percent of GDP, and is growing at 25 percent a year. India is self-sufficient in agriculture, coal, cement and other commodities. But, 55 percent of oil is imported, and paying for imported oil presents a formidable problem. Bombay s stock market was the first stock exchange founded in Asia, but capital markets are still largely undeveloped. The Bombay Stock Exchange 100 Index finished the month of October at record high. This quarter, heavy industry and infrastructure companies reported strong results, while companies in consumer goods and automotives had compressed operating margins due to rising costs. The Bombay Sensitive Index (Sensex) of 30 stocks had a twelve month forward P/E of about 16 in 2007, and a growth rate of around 20 percent. The growth band has been between percent since The index cannot be purchased. Foreign capital continues to flow into India at a rapid pace, so far $17 billion this year, double the amount in all Capital inflows have led to a rapid appreciation of the rupee, although the currency was stronger in 1980 than today. Shroff distributed informational packets containing two in-house magazines from Matthews International Capital Management, and a quarterly report and prospectuses on the Matthews Asian funds. Matthews has nine Asian mutual funds, including four aggregate funds, a technology fund, and four country funds, including the India Fund. The India fund (symbol MINDX) started in Oct. 31, 2005, is an open-ended fund with $1.1 billion in assets, and operating expenses of 1.41 percent. The fund is spread across various sectors, the heaviest weighting being financials, industrials, consumer discretionary, information technology and health care. The India fund s benchmark is the Bombay Stock Exchange 100 index, which it has significantly underperformed. As of Oct. 31, the fund had a one-year return of 50 percent, compared to 69 percent for the benchmark. Since the fund s inception it returned 52 percent, compared to 71 percent for the benchmark. More information on Matthews Asian funds can be obtained on the web at: 4

5 Pro Forma Pro Forma Editor Pro Forma Editor, Emeritus William Parmenter Orvis Adams SIG GROUP CHAIRMEN Asia Pacific Group IBD Meet-up/ AAII CANSLIM Mutual Fund Group Pasadena Group Palm Springs Group San Fernando Valley Group Westside Computer Group Robert Hsu Norman Langhout Gunter Hagen Ivan Wong Patti Gammino Evan Press Don Gimpel Pro Forma is offered free of charge exclusively via from the Los Angeles Chapter web site at: The American Association of Individual Investors is an independent nonprofit corporation formed for the purpose of assisting individuals in becoming effective managers of their own assets through programs of education, information and research. Pro Forma is published for advising members of the groups' activities and for sharing information. All material compiled without verification of accuracy to a specific task or computer system. All material provided in the Newsletter is for educational and illustrative purposes only. Comments are the views of their author and no other person or organization. Investing is an inherently risky business. Investors may loose their entire investment or more. Past performance is not necessarily indicative of future returns. The American Association of Individual Investors, the Pro Forma and the Los Angeles Special Interest Groups of the AAII do not endorse the purchase or sale of any given security, service or product. All trademarks are the property of their holder. Pro Forma is Copyrighted by the Los Angles Special Interest Groups of the AAII. All Rights Reserved. No part may be reproduced without (freely granted) permission. AAII Los Angeles Chapter Web Site Note to Pro Forma Contributors: Please have your copy ed to me by the fifth of the month in which we publish. Letters and comments are welcome. If you want to a polemic about global warming, the price of oil, or some other looming economic catastrophe, you will have a chance to alarm, or amuse, our readers. Book reviews are welcome. Mail disks to: 319 Walnut Ave., Apt. 2, Long Beach, CA 90802, or use wparme1@lausd.k12.ca.us. My home phone is (562)