Third Quarter 2003

From the Desk of Ron Rowland

The mutual fund landscape is constantly changing. Sometimes the change is quick, while other times it can be extremely slow. We now find ourselves in an era of rapid change. Many of the changes that lay before us have been in the works for some time. The mutual fund world has been on a path of segregation, delineating funds that are available for active trading from those where a buy & hold approach is essentially mandated. The recent allegations by Eliot Spitzer will hasten those changes.

Fidelity was a pioneer in the area of using funds as trading vehicles. Their Select Funds have been available for more than 20 years. Unlike traditional mutual funds that are priced only once a day at 4:00, the Fidelity Select Funds are priced seven times a day, each hour starting at 10:00 and continuing until the market closes at 4:00. All buy and sell orders are consolidated every hour, receiving the next hour's price. Any orders that come in after the 4:00 close receive the next day's 10:00 price. During the early years, they had to adjust the trading rules a few times to control abuse, but by the late 1980s they had found a solution that still works today. To keep fund inflows and outflows to a manageable level, Fidelity imposes a 0.75% short-term trading fee on any shares held less than 30 days. Fidelity also reserves the right to require that extremely large redemptions take place in stages over multiple hours of trading. 

Rydex is another pioneer in this area. Rydex was the first fund family to clearly state by prospectus that unlimited trading was allowed. Furthermore, because their products were indexed, and subject to tracking error scrutiny by those who used the funds, Rydex put in place the technology to roll-up and consolidate all orders prior to the market's close. That way, their fund managers could immediately place any trades necessary for the fund to remain 100% invested in the index it was tracking. ProFunds and Potomac are two other fund companies that have followed in Rydex's footsteps, allowing unlimited trading by prospectus.

I believe that the ultimate concept in fund trading has been the introduction of the Exchange Traded Funds (ETFs). One of the first ETF products was the Standard & Poor's Depository Receipts, commonly known as SPDRs and traded under the ticker symbol SPY. SPDRs trade all day long, just like individual stocks. When you purchase a SPDR, you are buying all 500 stocks in the S&P 500 in the exact proportions that are defined by that index. The major difference is that instead of incurring 500 commissions on the trade, you only incur one. Today there are more than 130 ETFs representing more than 50 sectors, 35 styles and broad indexes, 35 international and single country indexes, and five fixed income products.

At the other end of the spectrum from funds allowing active trading are fund companies like DFA, which strictly limit transaction activity and the types of investors who can buy their funds. DFA funds are not generally available directly to retail investors and are targeted as passive asset allocation funds. Initial investments must be pre-approved, transactions are limited to "pre-defined" rebalancing, and instructions regarding rebalancing must be received days in advance.

Vanguard is another fund company that has also taken steps to discourage anyone except buy & hold investors from many of their funds. In many cases, Vanguard requires that transaction instructions must be in writing and must be received at least one day in advance.

However, the various fund companies mentioned here are in the minority. The vast majority of fund companies lie somewhere in the middle, reluctant to take a firm stance regarding transactions in their funds. The mutual fund industry, and many of its participants, will have to do some serious soul-searching to determine which path they will take to rectify these shortcomings. Those that embark on a course to severely restrict trading will find themselves at odds with the original regulations that were built on the promise of daily liquidity. However, in the new light of activism on behalf of shareholders, many of those regulations may be deemed to be out of date.

As stated earlier, the segregation of funds into tradable and non-tradable categories has already begun but is now about to enter a period of rapid acceleration. CCAM has been preparing for this change for many years. We added ETFs to our investment options more than two years ago, and have sought to work with companies like Rydex, ProFunds, and Fidelity who clearly define the parameters under which they operate in addition to understanding and welcoming our business. 

The Quarter in Review

The stock market got off to a good start this quarter, but by mid-July, stocks had mostly settled into a sideways holding pattern. In early August, the markets really began to take off again with a nice rally that carried into the first three weeks of September. If all this seemed unusual for this time of year, we weren't about to argue with it. We kept most of our equity programs in the market through the rally. But a correction (at this writing we do believe it was just a correction) got underway the week of September 22, which ultimately led to a somewhat disappointing month for stocks. The major indexes posted a negative month and began to eat into August's gains as September came to a close. Seasonally, it is not unusual to have a sour period in the stock market in September, but that makes it no less disappointing given the rally's promise. Nevertheless, the S&P 500 managed to post a 2.6% gain for the quarter. We have high hopes that seasonal tendencies will pan out for the coming quarter, as stock market rallies often kick off in October. 

The U.S. stock market has not been our only focus. We have been bullish on Japan for a few months now, and we have been moving a portion of some of our multi-fund programs into that part of the world. In fact, Japanese stocks had a much stronger quarter than their U.S. counterparts. For example, the Tokyo Nikkei Index rose more than 12% for the quarter, whereas the S&P 500 tacked on less than 3%. 

Bonds declined sharply in July, leveled off in August, and began to rally a little in September, leaving the Vanguard Total Bond Index Fund with a fractionally negative quarter. Our Flexible Income program closed the quarter having beaten its benchmark by 50 basis points. The U.S. Dollar Index rallied through July and August, only to give up all of its gains in September. By the end of September, the index was very close to the multi-year lows it had set in June of this year. Weakness in the dollar is a good news / bad news phenomenon - good for manufacturing and exports, bad for importers and travelers.

On the Home Front

What you need to know about Eliot Spitzer and "Market Timers"

In early September, New York Attorney General Eliot Spitzer brought a complaint against Canary Capital Partners, LLC and Edward Stern, the lead manager of the hedge fund at Canary. He alleged that Canary (and Stern) engaged in fraudulent schemes and benefited to the extent of tens of millions of dollars at the expense of mutual fund investors. Spitzer claimed there were two "schemes" taking place. One included "late trading" of mutual fund shares and the other involved "timing" of mutual funds. We'd like to address the significant differences between the two.

The late trading scheme is out-right fraud. No ifs, ands, or buts. Edward Stern settled for $40mm and is banned for the next 10 years from the industry. That said, the other firms involved will face massive scrutiny and one Bank of America broker has already been officially charged. Ultimately, people will be fired, and people will go to jail. We at CCAM have no tolerance for this, or any other type of fraudulent behavior. Late trading is similar to acting on "inside information." It is unethical and immoral. Spitzer was correct to say "late trading can be analogized to betting today on yesterday's horse race." The late trading scandal has thus far snared a few culprits within the web of deceit and more details (and abuses) will surely emanate in the future.

However, the so-called "timing scheme" alleged by Spitzer is another matter altogether. We totally agree with the heart of that allegation, specifically that the named funds failed to follow and/or evenly apply the terms of a given prospectus. However, he erroneously lumps these fund company failures as "market timing," citing it as a "banned technique." You can only guess as to our reaction! Most of you understand the benefits of being an active investor. We believe that it is much better to own what is in demand rather than to bottom fish and search for a turnaround that may not materialize. For example, Spitzer's market timing notion should enrage individual and institutional investors alike who "timed the market" by buying small cap or technology this year as opposed to big cap or energy services. Buying mutual fund shares to invest in the best performing parts of the market and selling shares to avoid the lagging styles and sectors is not a banned technique. Every investment strategy involves some level of market timing. Warren Buffett does not immediately buy every stock he likes. He times his purchase in an attempt to get the lowest possible price. The rebalancing of a passive asset allocation portfolio is a form of market timing that attempts to take advantage of the quarter-to-quarter variations among various asset classes. Market timing is not a banned technique. Mr. Spitzer's real complaint was that some fund companies chose to selectively ignore, or override, their stated policies and procedures regarding redemption fees and short-term trading restrictions. 

A spokesperson for an industry trade organization recently stated, "Agree or disagree as to its benefits vs. a buy and hold strategy, market timing has never been banned. To the contrary, for many years, hundreds of investment firms have successfully served the investing public utilizing market-timing strategies. There is absolutely no relationship between the strategies employed by these investment firms -- who conduct their investment management business in accordance with the rules promulgated by the SEC and state regulatory authorities -- and the example cited by Mr. Spitzer. To draw such an inference is both irresponsible and a disservice to the investing public. We regret that the Attorney General chose to refer to the practices that he found objectionable and/or illegal as 'timing.' The fact is the timing of buy and sell transactions, or actively managing positions and portfolios, is the only method widely used by investment management firms to successfully manage risk for clients."

CCAM's position has been, and is today, that active management is the key to success and an integral key to risk management. We apply actively managed strategies that are appropriate for clients and completely within the regulatory framework of our industry.

Other News

Fidelity eliminates 3% load on Select funds - The financial press certainly did not find Fidelity's announcement of the elimination of the 3% front-end load on Select funds to be of much interest. However, here at CCAM the announcement is significant indeed. It essentially eliminates the need for special procedures to prevent the movement of assets between no-load funds and funds with Fidelity 3% "load credits." 

It is now likely that at some point our no-load programs will include a Fidelity Select fund in their allocations. This may not be this week, this month, or this year depending on how the market behaves, but is will likely happen at some point. You can be confident that you will not be paying a load on that transaction when it does happen.

With the entire family of retail funds from Fidelity now having "no-load" status, there is no compelling reason for us to offer both a Fidelity version and No-load version of our various investment programs. For example, it is highly likely that our "Fidelity Blend" and our "No-load Blend" programs will begin to have identical holdings. Once that happens, we will probably combine the two programs into one.

Minimum Required Distributions (MRD)

Minimum Required Distributions (MRD) for 2003 can be taken at any time from your retirement accounts. You are required to take a distribution this year if you were born prior to July 1, 1933. We will be mailing out more information and distribution forms later in the month. If you prefer to receive your information immediately, please call your account executive. 

CCAM News

Pete Lynch - We would like to extend our congratulations to Pete Lynch and his new wife Patty. Pete and Patty celebrated their wedding in early October

If you have any questions about the latest news at CCAM, please call your account executive at (800) 767-2595.

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