1st Quarter 2004 Review

From the Desk of Ron Rowland

Does a year matter? Consider where we were twelve months ago. The economy was weak, unemployment was high, and the markets were uncertain. American troops were still in the process of pacifying Iraq, and we didn't know who would be opposing President Bush in the 2004 election. And now - well, at least we know John Kerry is the frontrunner to be the Democratic nominee.

One thing we are starting to get some clarity on is the future of the mutual fund industry. I've written before about the trading scandals that erupted last fall. Six months later the impact is becoming clearer. Big changes have already been made. More are coming. From where I sit - making decisions on your behalf about where to invest - these changes are more than a passing interest. I would like to highlight some of them for you.

The Mutual Fund Industry Is Not Always Your Friend. For years, mutual funds were acclaimed by the media as worthy of investors' trust. Mr. Spitzer has proven this to be far from the truth. As often seems to be the case in white-collar crime, the cover-up is more disturbing than the initial offense. The so-called "market timing" activities (see our 3Q 2003 report) probably did have an impact on fund returns, but for the average investor it only amounts to spare change. Still, after what has been revealed we have to wonder what else may be going on at some of these firms.

The good news is that regulators and the fund industry are responding quickly. Four firms have already paid settlements totaling $1.65 billion; likely more will follow. More important, investors are voting with their feet. Two fund groups prominent in the scandals, Janus and Putnam, lost $40 billion in assets in the last six months. At the same time, two comparable firms that have not been implicated, Vanguard and American Funds, raked in more than $85 billion. Hopefully the reforms now being implemented will prevent such problems in the future.

No-Load Funds Are Increasingly Difficult To Trade. The unfortunate side of this is that virtually all fund companies are tightening up their rules, making it more difficult or expensive to trade. Since active management is what we do at Capital Cities Asset Management, this presents a challenge for us. In recent weeks, we've received a steady steam of notifications from funds that they are adding redemption fees or extending their minimum holding periods. Our programs simply don't work under these restrictions, so we are left with little choice but to avoid those funds. Fortunately, this is a trend we recognized many years ago, and we have taken steps to reduce the impact on our clients.

Additionally, there are firms like Rydex whose entire purpose is to cater to active investors like ourselves. At Fidelity, we're still able to trade the Select Portfolios with relative freedom. For now I think we have enough alternatives to keep delivering the results you expect and deserve. I am, however, concerned where we may be if this trend continues the next few years. This brings me to my final point:

ETFs and Individual Stocks Are The Future. Our two programs devoted to exchange-traded funds just celebrated their three-year anniversaries, and we've been integrating ETFs into some other programs as well. We're starting to see in our performance results how the trading flexibility allowed by ETFs can make a difference. New ETFs are being introduced all the time, and we now have the ability to gain exposure this way to almost all the styles and sectors that are available in conventional funds.

Some investors object to ETFs because they involve a brokerage commission every time you buy or sell. These costs have fallen dramatically and are thus less and less of a factor. The lower expense ratios of ETFs also help. In my opinion, the potential for improved results easily overcomes the small costs. In case you are wondering, Capital Cities Asset Management does not receive any share of brokerage fees. Our incentive is the same as yours, and we negotiate the lowest rates we can while still receiving good brokerage service and execution.

The ultimate in flexibility is, of course, to buy individual stocks. As you may know, we've been experimenting in this area for a few years now, both with our own money and a few clients who asked us to work with stocks for them. I'm not yet comfortable enough with our results to make a stock program widely available. As the cost of both trading stocks and the technology to analyze them continues to fall, I am hopeful we can introduce such a program in the future.

The bottom line of this discussion is that we intend to stay flexible at CCAM. We are always seeking ways to improve your results. With the investment landscape changing so rapidly, we will continue our research and keep you informed when you need to take action.

The Quarter in Review

After a banner year in 2003, the markets were relatively calm in the first quarter. Even after a rally in the last half of March, the Dow Jones Industrial Index was almost unchanged at -0.9%. The Nasdaq Composite fell 0.5%, and the S&P 500 gained 1.7% including dividends.

A deeper look reveals segments of strength beneath the radar of broad market indexes. The small-cap value corner of the market was up 5-6% for the quarter. Among industry sectors, mining, casinos, and wireless communications all shot up 15% or more. On the other end of the scale, auto manufacturers, airlines, and railroads posted big losses. Most of the technology categories were down as well.

Bonds and bond funds made up some lost ground with solid gains. According to Morningstar, the average U.S. Treasury bond fund gained 3.3% for the quarter. As always, we look for opportunities not only in the U.S. markets but the rest of the world as well. Japanese stocks resumed their rally, as did several emerging markets.

The outlook for the rest of 2004 is even less clear than usual. Several potentially huge issues are overhanging the markets: renewed terrorist threats after the Madrid bombing, volatile energy prices, political uncertainty as the U.S. elections draw near, and questions about the economy while unemployment remains stubbornly high. We expect a volatile year.

CCAM News

I am pleased to introduce to you a new member of our staff. Patrick Watson joined us in February. He has fifteen years experience in financial services, most recently as Vice President at ProFutures Investments here in Austin, and holds an M.A. degree from Rice University. Patrick's primary role is to be Managing Editor and Publisher of All Star Fund Trader.

Final Tax Reports for 2003 - Final tax reports have been sent for the 2003 tax year. If you have taxable accounts with CCAM and have not received your final report, please call us at (800) 767-2595. If you would like copies of these reports sent directly to your accountant, send us a signed letter or fax with your accountant's name, address, and phone number along with instructions to send these reports on your behalf.