Third Quarter 2002

From the Desk of Ron Rowland

With the bear market in U.S. equities now well into its third year, it is not unreasonable that many investors are interested in learning more about "absolute return" investment strategies. Absolute return strategies attempt to deliver a consistent (positive) return every year independent of market activity. This differs from the more common "relative return" investment strategies that attempt to deliver a return that is variable and is benchmarked to a given index. The most common of these relative return benchmarks is the S&P 500 index. The job of most equity money managers is to deliver investment returns that are relative to the S&P 500 index. If the S&P 500 is up 25%, then the manager is expected to deliver a return of 25% or better. If the S&P 500 is down 25%, then the manager is doing a good job if losses are kept to less than 25%. The S&P 500 is not the only relative return benchmark, but it is the most popular. The Russell 2000 index is a widely followed benchmark for money managers that focus on small cap stocks. The MSCI EAFE index is a benchmark used for many international equity investments. Although they may have different benchmarks, all relative return money managers have the same goal: to deliver returns that are in excess of their benchmark. Their job is one of "relative" performance. This is true for the vast majority of mutual fund managers, pension fund managers, and private money managers.

In the world of fixed income investments we find the same phenomena. Fixed income managers are paid to deliver a return that is relative to a benchmark. However, since many fixed income investments deliver a positive return nearly every year, they are often mistaken for absolute return investment strategies. A manager of a diversified bond portfolio is expected to produce returns relative to the Lehman Brothers Aggregate Bond Index. Money market fund managers are expected to produce 2% annual returns when short-term interest rates are at 2% and are then expected to produce a 9% annual return when short-term interest rates are at 9%. Those expectations imply that money market funds are a relative return strategy.

Absolute return strategies are different. The goal of an absolute return strategy is to deliver a consistent positive return independent of market conditions. For example, an absolute return strategy with a goal of producing a 10% annual return would have the same expectations of return in 2002 as in 1999 even though the S&P 500 gained 21% in 1999 and is down 28% for the first three quarters of 2002. However, you should not expect an absolute return strategy to deliver identical returns every year. A 10% absolute return strategy could very well return 5% one year and 15% in another year.

As with all investments, there are no guarantees that come with an absolute return strategy. Just like a relative return strategy might deliver only a 7% return in a year when its benchmark returns 27%, an absolute return strategy can easily under-perform its target return or have a losing year.

Many investors have associated the concept of absolute return strategies with investment vehicles known as hedge funds. Although many hedge funds do offer absolute return strategies, one should not confuse an investment strategy with an investment vehicle. It is possible to offer absolute return strategies in the form of hedge funds, mutual funds, privately managed accounts, or other vehicles. By the same token, hedge funds may offer relative return, absolute return, or other types of investment strategies. There is not a direct relationship between absolute return investment strategies and hedge funds. However, in today's investment marketplace, most absolute return strategies are offered in the form of a hedge fund, or more commonly a fund of funds, which is a fund that invests in a portfolio of hedge funds. Most successful absolute return strategies are built on a combination of multiple strategies such as long/short equities, currency trading, merger arbitrage, convertible bond arbitrage, commodity futures, and others.

Currently, all of the investment programs that are managed directly by CCAM are relative return strategies. The objective for each of our programs is to outperform their respective benchmarks with less risk. For our various equity portfolios, the benchmarks are the S&P 500, the Nasdaq Composite, or the MSCI EAFE indexes. Our Flexible Income portfolio is benchmarked to the Vanguard Total Bond Index. These are relative return strategies in that their expected return is not an "absolute" number, but is "relative" to their benchmark. A quick glance of our current performance report indicates that we have been successful at outperforming our equity benchmarks for the past quarter, as well as the past one-year, three-year, and five-year periods.

Although CCAM does not directly manage any absolute return strategies at this time, we can provide access to them through various third-party relationships. These types of investments are normally offered only through limited partnerships and private placements, often referred to as hedge funds, and are available only to accredited investors. The current definition of an accredited investor includes an individual with a net worth of more than $1 million or an annual income of more than $200,000 the past two years. If you are an accredited investor, and believe that your portfolio may benefit from an allocation to an absolute return strategy, then contact your account representative to learn more about how CCAM can help you.

The Quarter in Review

All major U.S. stock market indexes continued to trend lower throughout the quarter. The August rally was not enough to break the bear trends that have been in place for several months to two years or more, depending on which index you look at. Of the major indexes, the Dow Jones Industrial Average was the slowest to succumb to bear market pressures. The Dow was stuck in a range between about 10,000 and 11,000 throughout 2000 and the first half of 2001. The S&P 500, in contrast, had begun a convincing bear trend by the end of 2000 that has persisted until the present time. The third quarter of this year was the worst quarter for the S&P 500 since 1987. That index fell over 17% in the third quarter, as did the Dow. 

The strong bear trend in the S&P 500 can be blamed on the fact that a great many technology stocks had been added to the index in the late 90's, due to the explosive growth in that sector. When the bubble burst in early 2000, technology-related companies were the first to fall, and frankly they are still falling. The Philadelphia Semiconductor Index (SOX) has fallen over 80% since March 2000, and it fell over 38% in the third quarter of this year alone. Technology stocks have led the market lower, and the Dow has only recently joined the party, if you can call it that. The Nasdaq fell almost 20% in the third quarter and is at levels not seen for six years. In short, the stock market has been ugly, but it will turn around at some point. We are watching and waiting patiently for that time. 

On the Home Front

Money Market funds just don’t pay what they used to. With interest rates at all time lows, money market funds at Fidelity are paying unimpressive returns of about 1.52%. However, this is much better than the 1.23% national average money market return as reported by iMoneyNet. With this in mind, you may see your account in short-term bond funds like SSgA Yield Plus and Pimco Short-term Bond. These funds invest in very short-term bonds, whose maturities are slightly longer than those of bonds allowed to be held in money market funds. Short-term bond funds also have the ability to invest in non-government securities. These two characteristics have helped short-term bond funds produce historically higher returns than money market funds. Keep in mind, your accounts may fluctuate a bit more than if they were invested in money market. 

International News

The fact that the U.S. may enter into a war with Iraq has certain implications for the stock market. Historically, wars have given the market some trouble, at least until it becomes apparent that the U.S. is winning the war. For the first couple of months that the U.S. was engaged in World War II, the market went down. But about the time that the tide of the war turned in our favor, so did the stock market. The market began going up in mid-1942 and did not stop going up until well after the war was over. 

The Korean conflict seems to have had little negative impact on the stock market at all, but Vietnam was a different story. By the mid-60's, when the U.S. involvement in Vietnam had escalated beyond its original intent, it began to become apparent that the U.S. had become immersed in a quagmire that was likely to drag on for years and might not be winnable. At the same time, the stock market seemed to enter its own quagmire stage, moving sideways for several years until the war was over. 

The Gulf War in 1991 was quick and extremely efficient from the standpoint of U.S. involvement and did not get in the way of stock market advances. In fact, the war probably helped spur the market higher due to increased confidence in American superiority demonstrated by our military performance. The market only had trouble prior to that war, when there was much uncertainty about what was about to happen. This seems to be roughly the same point at which we find ourselves now.

The impending war is giving the market a lot of uncertainty right now, and the market hates uncertainty. Questions about whether we are going to war, whether we should go to war, and whether we will be successful if we do go to war have mired the markets in bearish activity, for the most part. There just aren't many buyers for stocks right now. If the war gets started and goes well, it will probably be very good for the stock market. For now, the uncertainties involved are just adding to the domestic concerns about corporate earnings and corporate scandals to provide an overall bearish tone to the market.

CCAM News

Ron recently spoke at the Houston MoneyWatch Expo conducting a "Bonds 101" class. If you would like a copy of the presentation emailed or mailed to you, please just give us a call.

This fall CCAM employees will provide lunch to volunteers who are building a house for a low-income family through Habitat for Humanity. We will go out to the worksite and serve all the workers one Saturday. Several Austin financial companies have come together to sponsor a house here in Austin, Texas. We are looking forward to strengthening our community.

Opportunity Knocks

We have outlined Retirement Plan Contribution Limits below as there have been many changes recently.

Defined Contribution Plans (Profit Sharing, 401(k), Money Purchase) 

The total amount that can be contributed by both the employee and the employer has changed significantly this year. Prior to 2002, that combined limit was the lesser of 25% of compensation or $35,000. The combined limit for 2002 is the lesser of 100% of compensation or $40,000. Please note that this limit includes an employee’s salary deferrals, the employer's match, and any other contribution made by the employer.

The limit for employee contributions to 401(k) & 403(b) plans rises to $11,000 for 2002. That is up an additional $500 from 2001. This limit will grow to $15,000 by 2006. 

Individual Retirement Plans (IRAs)

The annual contribution limits to traditional and Roth IRAs will also increase significantly under the new tax laws. From 2001 to 2008, the annual contribution limit will increase from $2,000 to $5,000 and will thereafter be adjusted for inflation. The following chart displays the contribution limit by year:

Year	IRA Contribution Limit
2001	$2,000
2002-2004	$3,000
2005-2007	$4,000
2008	$5,000

Catch-Up Options

The new tax laws give workers age 50 and over the ability to increase their contributions to 401(k) plans and IRAs even further. For IRAs, older workers will be able to stash an additional $500 above the new limits starting in 2002. The amount increases to $1,000 in 2006.

For 401(k) plans, workers aged 50 and older will generally be eligible to contribute $1,000 more than the regular limit in 2002.

These provisions are meant to allow older workers who may be behind on saving for their retirement a chance to make additional contributions to put themselves in a better position for retirement. 

CCAM does not provide tax advice. Please see your tax advisor for your specific circumstances.

Keogh Plans

Self-Employed Clients, mark your calendars! If you are self-employed, you have until December 31st to set up a Keogh plan. You can still make contributions until April 15, 2003. 

Solo 401(k) Plans

In the past, 401(k) plans have been cost prohibitive to self-employed individuals. Recently, Fidelity has introduced the "Solo 401(k)." The Solo 401(k) is designed for the self-employed person to be the sole participant. In some cases, a family member who works for the company, such as a spouse, is allowed in the plan as well. The Solo 401(k) currently has minimal administrative costs. The benefits include allowing a full contribution of $11,000 by the participant, plus an additional $25,000 profit sharing contribution by the company. Please ask your account representative for more information on this plan if you are interested in learning more.

New Star on the Horizon

Over the past two years, we have received many inquiries on our Flexible Income Program, otherwise known as our "Capital Preservation" program. CCAM has been managing this program for almost seven years, but only recently has this much interest been shown, because it has been the best performing program over the past few years.

It is important to know why Flexible Income is essential for your portfolio. First, if your portfolio is heavily weighted in equities, you will have periods of time where the market is down and so is your portfolio. If you portfolio is heavily weighted in bonds, it may not perform as well over the long term, and may even have negative returns when the stock market is up. Therefore, it is important to determine your investment objectives and to identify the appropriate allocation to both bonds and equities. It is equally important to stay with those objectives and alter them as your goals and needs change, not each time market conditions change.

The Flexible Income Program is primarily a bond timing program. Similar to our equity programs, it can retreat to money market when the bond markets look gloomy. Flexible Income has employed this defensive strategy in the past, gaining more than 5% in 1999 when the bond index was down. You will notice that the returns are not correlated with our equity investment programs. Flexible Income is up 7.7% so far this year, greatly outperforming the equity markets. However, it cannot keep pace with the equity markets during bull market years. This is an example of how important it is to have a diversified portfolio between equities and bonds and how CCAM outperforms our benchmarks while reducing risks in both equity and bond investing.

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