Download ARK_letter10-07 - ARK Financial Services

October 2007
Dear Client:
During the quarter just ended, US and other equity markets experienced a period of increased volatility. From mid-July to mid-August, the S&P 500 fell about 10%. Subsequently, the Federal Reserve
responded by lowering the federal funds rate by 0.50% which helped stabilize markets and resulted
in many markets finishing the quarter close to where they began.
The main culprit for this volatility (as we all know by now) was the melt down in the subprime
mortgage market. But what exactly happened here?
The subprime mortgage market consists of borrowers with poor credit histories and the brokers
who made risky loans to those borrowers. It is a part of the mortgage industry not visited by consumers with excellent credit who can easily qualify for high-quality loans. Many of the borrowers
that make up the subprime market took a gamble that interest rates would not go up on their adjustable-rate mortgages or they could refinance before rates increased. Many did not understand the
gamble they were making. When rates increased or the initial “teaser” interest rates expired, many
homeowners could no longer make their monthly payments.
If it were only a matter of borrowers not being able to repay their loans, how did the problem extend to the overall stock market? Mortgage brokers that made subprime loans sold them to market
participants. In a September 12 Wall Street Journal (WSJ) article, Harvard professor Martin Feldstein
explained the sequence of events: “The mortgage brokers who originated those risky loans sold
them quickly to sophisticated buyers who bundled [the loans] into large pools and then sold participation in those pools to other investors.” It is not surprising that the subprime market, with a
structure resembling a house of cards, finally collapsed.
A liquidity crisis developed and changed the mood of the entire market: “Investors and lenders became increasingly suspicious of each other and unwilling to lend, driving up interest rates for all
sorts of borrowers,” according to a WSJ article’s account of August’s events.
How should you respond to these events? Stay disciplined and adhere to your carefully designed investment strategy. Stocks are volatile, so no one can consistently predict when the risks of equity
investing will appear. It would be a mistake to try to time the market by reacting to events such as
the subprime collapse. Occasional short-term volatility is to be expected and has been factored into
your plan. Remember, if risk never showed up, there would be no basis for higher expected returns.
While no one can be certain whether the current credit crisis is near resolution or will be with us for
some period of time, one should expect that market volatility will remain. We know that, at some
point in the future, we are likely to experience more prolonged down markets. Long-term success depends on the discipline to weather these periods with confidence that markets recover.
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In volatile times such as these, it is important to remember that successful investing requires a welldeveloped plan as well as the discipline to stick with that plan in the face of adversity. Many plans
fail because investors take an inappropriate amount of risk. When risks materialize, investors may
abandon their plan, either out of necessity or because panic sets in.
During these inevitable market corrections, we remind you that you need only to ensure that your
Investment Policy Statement (IPS) truly reflects your unique ability, willingness and need to take
risk. If your IPS accurately reflects your risk tolerance, we recommend continued, non-panicked
adherence to your planned strategy. After all, incidents that occur - a tightening credit market (as in
the present case), terrorism, recession - have been risks all along; they simply have not been experienced for some time so many investors have forgotten they exist.
Following is a representative sample, as of September 30, 2007, of DFA funds currently recommended for use in our client portfolios. This is not a complete list of all DFA funds, and your
portfolio may or may not contain all of these funds.
Fund Name/Ticker
US Core Equity 2 Portfolio (DFQTX)
US Large Co Institutional Index (DFUSX)
Tax-Mgd US Equity (DTMEX)
US Large Cap Value III (DFUVX)
Tax-Mgd US Mktwide Value II (DFMVX)
US Micro Cap (DFSCX)
Tax-Mgd US Small Cap (DFTSX)
US Small Cap Value (DFSVX)
Tax-Mgd US Small Cap Value (DTMVX)
International Core Equity Portfolio (DFIEX)
International Value III (DFVIX)
Tax-Mgd International Value (DTMIX)
International Small Company (DFISX)
International Small Cap Value (DISVX)
Emerging Markets Core Equity Portfolio (DFCEX)
Emerging Markets (DFEMX)
Emerging Markets Value (DFEVX)
Real Estate Securities (DFREX)
Two-Year Global Fixed (DFGFX)
3rd Qtr
–1.39
1.99
1.39
–5.62
–3.55
–4.03
–3.75
–8.59
–7.36
0.54
1.16
1.31
–1.70
–2.35
9.39
9.44
10.49
1.52
1.31
YTD
6.41
9.11
8.87
2.90
4.84
1.82
4.53
–2.12
–0.75
12.52
14.61
14.60
11.88
11.28
34.60
31.73
41.79
–4.88
3.81
One-Year
14.82
16.39
16.07
11.16
13.72
11.55
14.14
7.80
8.28
24.81
28.53
28.48
26.01
26.33
59.37
54.43
68.42
3.64
4.98
Three-Year
N/A
13.11
13.24
15.31
16.54
13.20
14.35
13.85
13.61
N/A
27.71
27.76
25.45
27.63
N/A
37.98
45.99
18.91
3.40
Five-Year
N/A
15.37
15.48
18.27
19.50
20.40
19.99
22.21
20.85
N/A
29.65
28.84
29.30
32.27
N/A
37.64
46.98
21.25
2.76
Ten-Year
N/A
N/A
N/A
9.31
N/A
10.57
N/A
12.05
N/A
N/A
12.51
N/A
12.74
14.95
N/A
13.10
N/A
12.73
4.27
Notes: Returns for more than one year are annualized. “N/A” appears where returns data did not exist for the entire period. We
hope you will find the above information of interest, and that you will use it in the spirit it is provided. While not meant to serve as a
basis for your portfolio assessment, results from one year or less are useful as a tool to better understand how frequently such
short-term market fluctuations occur, and yet how unpredictable they are. Likewise, three- and five-year returns demonstrate that
different asset classes can be in or out of favor for longer periods, but again without a reliable basis for prediction. This in turn
provides further evidence that clients should build entire portfolios and focus on their portfolio’s total return rather than on individual asset classes.
Best wishes,
Andrew Kline, CPA, CFP