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What We'll Be Buying in 2005

In our inaugural Investment Committee meeting for 2005, FCM undertook the firm's equivalent of making New Year's resolutions. Unlike the committee members who had let good personal habits erode over 2004 and who now need to resolve to lose weight, start working out, etc., FCM resolved to keep doing what we have been doing. FCM's core principles and investment philosophy have evolved and been refined over our nearly 18 years, but continue fundamentally unchanged from our founding. We will continue to provide stable value funds that meet the expectations of our ultimate consumers - plan participants. We will provide safety for their investments while at the same time providing attractive returns significantly above money market returns. Of course, we will also make sure that book value withdrawals are always available for all participant directed needs.

With the protracted period of low interest rates and the tightening of spreads, there have been lots of ads and articles about how managers are going to make changes to find that extra alpha. FCM is not going to change its style or techniques since we've had success in our portfolio management because we adhere consistently to our processes. From our proprietary credit assessment process to liquidity management to our proprietary duration management, FCM applies a team approach in all aspects of analysis to execution. A team of dedicated professionals collaborates on all of our investment decisions leading to better results and the consistently superior performance reported on elsewhere in this newsletter.

So, in the course of our endeavors, what do we expect to be buying in 2005 ? Each of our decisions is governed by a portfolio's investment guidelines so our investment choices are governed by our Plan Sponsors' marching orders. We have a number of accounts that are GIC only portfolios, the rest authorize investment in GICs, wrapped bonds and wrapped managed bond portfolios. In all cases, our clients share our belief in the value of structuring a portfolio with a core well-diversified portfolio ladder. So in 2005 most of our investments will be in GICs and bonds that continue to build a ladder of relatively level, diversified maturity stacks.

Where we have been granted the authority to buy the spectrum of securities, we expect to continue to heavily weight towards GICs. The insurance industry continues to be very healthy. Capital positions have continued to improve over the last two years, as balance sheets have benefited from solid earnings and capital raising activities. The quality of investment portfolios has improved as bond defaults are trending below historical levels. Insurers have learned from recent challenges and have taken steps to further improve risk management techniques. For example, there are new hedging programs to address market risk exposure resulting from product guarantees.

A factor that we continue to watch is the consolidation of the GIC/BIC issuer universe from over 50 when FCM was founded in 1987 to about 18 currently. So far the slow consolidation of the GIC issuer universe has caused few problems in our ability to broadly diversify our credit decisions and still secure attractive yields. However, this is a situation that we continue to watch closely. Offsetting the decline in the number of traditional GIC issuers is the continuing expansion of the GIC Backed Note universe of Rule 144A public bonds that are backed by funding agreements of high quality insurance companies. AIG and Allstate are good examples of companies that are presently out of the traditional GIC business but have GIC Backed Notes readily available in the marketplace. The spreads are seldom as attractive as traditional GICs, but they do offer additional opportunities for diversification and the Notes are more liquid than GICs. We expect to purchase some of these Notes in 2005 to include in the wrapped bond allocation of portfolios.

In those portfolios where we are permitted to diversify beyond the insurance industry, we selectively purchase (and wrap) bonds with maturities that add to the portfolio maturity ladder. We are not a large purchaser of individual bonds since the spreads of comparable quality bonds with similar risk characteristics rarely rival those of GICs, but we expect to purchase some in 2005 for diversification. Moody's has noted that corporate credit quality continued to improve in 2004 with the number and dollar volume of bond defaults declining sharply for the second straight year. They do expect the number to rise modestly in 2005. If we buy corporate bonds in 2005, they would be of very high quality and likely from the financial sectors. More likely, we would purchase very high quality mortgage related securities with collateral that increases the likelihood of stable cashflows. As with all of our purchases, we expect to buy & hold securities with limited trading in support of liquidity management.

The largest proportion of our portfolios' bond allocations is invested in high quality diversified bond portfolios actively managed by sub-advisors selected by FCM to add both performance and sector and style diversification. We hire sub advisors rather than actively manage the bonds in-house so that we will have the freedom to fire a Subadvisor who fails to fulfill our expectations. Our proprietary methodology for deciding the opportune time to establish or add to a managed Lehman Aggregate position indicates that rates still need to rise further before we will do so. Our methodology seeks to reach a position where the relative current level of rates compared to the historic benchmark minimizes the effects of potential capital losses resulting from further rises in rates.

Where on the yield curve will we be buying individual GICs and bonds? Our duration management tool compares current rate levels with historical levels to lead us to a portfolio duration target. While current levels remain relatively low, the tool indicates that current investments should remain relatively short on the curve. This positions our portfolios to better track future rises in interest rates. Our target has remained relatively short for the last three years but we are going to remain disciplined. Even when the curve has steepened, we did not stretch durations to capture additional yield since we did not want to lock in historically low yields for even longer periods. We do not attempt to predict the direction of rates or the timing of rate movements, but our portfolios are positioned to track future rate changes. In the interim, our portfolios benefit from the additional "liquidity spread" realized by overweighting in traditional GICs. Finally, after a prolonged period of low inflation, we believe that a small hedge against a reversion to inflation may benefit certain portfolios.

In conclusion, for 2005 we will continue to implement our disciplined philosophy of purchasing GICs, GIC Backed notes and bonds where appropriate. FCM will also continue to watch current rate levels relative to historic norms and adjust our duration target accordingly. We anticipate that 2005 will be another banner year for stable value and for FCM's clients.