April 12, 2007

Dear Client:

The major asset classes had positive returns in the first quarter of 2007. Markets were volatile, with several large one-day changes. Chinese equity markets dropped 9% in one day (February 27, 2007). The S&P 500 index declined 3.8% the same day, probably in response. Chinese equities recovered and then some, gaining 13.6% from February 28th through March 31st*. The S&P 500 also recovered, ending the quarter with just under a 1% gain.

Equities that are denominated in non-US currencies benefited from the continued decline in the value of the U.S. dollar. The EAFE index** gained 3.3% in local currencies, but gained 4.1% in U.S. dollar terms.

Although it seemed that markets were volatile this quarter, in fact we have become accustomed to lower than normal volatility. Only seven days of the quarter resulted in positive or negative returns greater than 1% (see the seven blue dots between Jan-07 and Mar-07 in the chart below). Over the past three years, daily returns have been fairly consistent, varying by more than 1% per day only about 12% of the time (93 out of 755 trading days).

Looking back at the last twenty five years, daily volatility has been much higher, varying by more than 1% roughly one out of every four days.

Efficient Markets and their Relationship to Volatility

The investor who expects to "beat the market" is one who believes that markets are inefficient, i.e., that security prices do not accurately incorporate current data. Such an investor believes that s/he has information that others are not privy to, which will enable her/him to make investments that will yield higher than market returns. That information is then used to select stocks, asset classes, or periods of time in which to invest or not invest money.

On the other side of the spectrum are "efficient market" believers. Efficient market theory holds that information is so widely distributed and analyzed that security prices respond immediately to changes in fundamental data, and accurately represent the present value of future cash flows. This future cash flow determines the value of a security.

Grubman Financial is a "passive" (index) manager. We believe that markets are mostly efficient, and that the main determinant of a portfolio's risk and return is the asset classes that make up the portfolio. It is our belief that markets have become more efficient in recent years.

Taking the efficient market theory a step further, we think it is possible that the internet has significantly increased the efficiency of security pricing, thus reducing the opportunity for investors to outperform market indices. And if volatility results even partially from imperfect information, then it seems reasonable that the improvement in information flow created by the internet would decrease volatility.

Whether this explains reduced volatility or not, the last three years have been a blissful time for investors: high returns with low volatility. If volatility remains low, then investment returns should decrease over time, since risk (volatility) and return have a direct relationship.

The best protection against irrational pricing is diversification and rebalancing. It is imperative that investors use a disciplined approach to rebalancing, continuing to take money out of the highest performing asset classes and reinvesting in the underperforming asset classes. At this time, this means taking money out of investment real estate (REITs), foreign equities and small-cap equities, and reinvesting in U.S. large-cap growth equities and bonds (primarily mortgage and inflation-indexed bonds).

If you have any questions please don't hesitate to call us.

Regards,

Audrey Grubman, CFP^®

* MSCI China Equity Index
** Europe, Australia/Asia and the Far East Index