July 11, 2008

Dear Client:

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Q2 2008 Market Update

The U.S. stock market lost 2.7% in the second quarter of 2008. In June alone, U.S. large-cap stocks declined 8.4% and foreign stocks lost 8.2%.

The 12-month period ending June 30, 2008 resulted in the worst decline for a diversified equity portfolio in over five years. The U.S. stock market declined 13%. A diversified portfolio consisting of 45% U.S. equity, 30% foreign equity and 25% bonds would have declined 8% during this period, before fees.

In the chart below we compare returns for the recent period ending June 30, 2008 to the period ending March 31, 2004. We use this period for comparison because it had the best 12-month return in the past five years.

The X-axis shows increasingly conservative portfolios, starting from a 100% equity and 0% bond portfolio, decreasing the equity portion and increasing the bond portion, down to a 0% equity and 100% bond portfolio.

The Y-axis is the investment return for the different portfolios for different periods.

The red lines show portfolio returns for the period ending June 30, 2008: one quarter, six months and twelve months. Green lines are portfolio returns for the period ending March 31, 2004: one quarter, six months, and twelve months.

A few trends stand out when we compare the period that just ended on June 30, 2008 to the period ending March 31, 2004.

The 100% EQUITY / 0% BOND portfolio is the most volatile in both up and down markets. The investment return differs by 63 percentage points from best to worst return: from +50% for the twelve months ending 3/31/04 to -13% for the twelve months ending 6/30/08. As the bond allocation increases (moving to the right across the chart), the range of returns decreases to 8 percentage points: from +7% in the twelve months ended 6/30/08 to -1% in the twelve months ending 3/31/04.

Also, the upside volatility is a much higher absolute number than downside, i.e., the benefit of the gains is larger than the detriment of the losses. Gains for the aggressive portfolio (100% EQUITY) portfolio range from +4% to +50%, while losses range from -2% to -15%.

This view of just two discrete investment periods sums up much of what we need to know about investments:

• Equities experience more volatility than bonds
• Equities provide greater positive returns than bonds
• The magnitude of gains in equities is much higher than the magnitude of losses

Although we have illustrated just two recent periods, the data are typical of what we see in extremely up and down markets. As such, it provides a good illustration that equities are still the place to invest if your financial objectives require portfolio growth.

Risk should be minimized not by getting out of the market when it declines, but by providing the optimal diversification among asset classes.

The previous market decline of over 20% ended in 2002. On average, the U.S. stock market has experienced a decline of 20% every six years. In each case the problems appear insurmountable, and yet each time the markets recover from losses, and then some.

Following are some of the questions I've received from clients lately, which may be of interest to you.

Q: Should we sell to avoid additional losses, and jump back in when the market recovers?
A: It sounds good in theory but it rarely works. Sometimes an investment manager is able to make a market timing call, but such a person would need to be able to predict both downturns and upturns consistently to profit. The few that can (think, Warren Buffett) aren't managing mutual funds or individual portfolios. Here's a look at the real benefit of staying invested 100% of the time:

Performance of the S&P 500 Index
January 1970-December 2006

Q: Since we’re in a recession, shouldn’t we sell now and avoid more pain?
A: Recessions are a trailing indicator; i.e., we don't know we've had one until we're well into it, or often until after it's nearly over. The stock market is a leading indicator, i.e., the downturn of the stock market often predicts a recession. Stock market gains during recessionary times are significantly higher than normal.

Q: Why do you talk so much about benchmark returns, instead of your firm's performance?
A: There are several reasons. First, we are a financial manager, not just an investment manager. We consider risk management to be a primary objective in helping our clients achieve long-term goals. As such, publishing performance data would put unwarranted focus on investment returns alone.

Second, we are a "passive shop", meaning that we use asset allocation to drive returns. It is generally accepted that investment return is almost completely attributable to asset allocation. A major study of large pension funds over a ten-year period* found that asset allocation determines 94% of a portfolio's return, with stock selection and market timing combined generating only 6% of the return.

We believe that there is little a manager can do to enhance returns, and instead focus on implementing your asset allocation in the most efficient method (i.e., lowest overall cost) using an optimal mix of index funds, index-enhanced funds and exchange traded funds. Passive funds are therefore as close to a pure asset allocation as you can achieve. A blended benchmark, weighted according to your asset allocation, will provide a very good proxy of your portfolio's performance, before fees.

Our clients' individual asset allocations range from 100% bonds to 100% equities. Averages or composite data of such different portfolios would be meaningless.

Last, but not least, we are regulated by the SEC, under the same rules that apply to mutual fund companies and brokerage firms. Publication of composite returns for all portfolios requires a host of policies and procedures that would increase the cost of compliance. We feel that the publication of composite returns would increase our operating costs without any benefit to existing clients.

Q: Since we know the dollar will continue to devalue, shouldn't we overweight non-US investments, or avoid them completely?
A: Diversification is the important principal here, and that applies both to asset class and currencies. Diversification demands that we reap our gains and plow them back in to lower-performing investments, so we should be taking profits from non-U.S. dollar investments and putting them into the U.S. stock market.

The portfolios we manage have had a relatively high weighting in non-U.S. dollar securities, which has benefitted portfolios over the last five years. We need to maintain the discipline of diversification, and avoid throwing more money at the recent high performers.

Q: What do you think of currency funds?
Currency funds are 100% speculative; an investor benefits only from changes in relative valuation of currencies. There are no underlying assets to temper returns. Refer also to the question above, in terms of reaping profits and investing in underperforming asset classes.

Q: What do you think is going to happen to the stock market?
A: I think this type of crystal-ball gazing is harmful and misleading to investors. As an example, I know of no credible energy professional (including the CEOs of major oil producing or refining companies) who predicted crude oil prices would surpass $140 per barrel even six months ago. The forces and reactions of the equity markets are much more complex than even the oil markets. If no one could make an accurate six-month prediction of crude oil prices, how can anyone profess to predict the equity markets?

I would appreciate an opportunity to talk with you in more detail about your portfolio at your convenience. Please do not hesitate to contact me so we can arrange a telephone or face-to-face meeting.

Regards,

Audrey Grubman
Portfolio Manager and President
GRUBMAN FINANCIAL