Q4 2013: Clients and Friends Letter

January, 2014
Dear Clients and Friends:

We want to express our heartfelt thanks to everyone participating in our program this past year, along with hearty congratulations on earning the kind of returns that our low-cost, globally diversified program is capable of delivering when the investment stars are in alignment.

cartoonAgainst a backdrop of uncertainty including the Fed’s printing press obsession, the prospect of tapering, the impact of Obamacare, gridlock in Washington, etc., the markets finished the year on a remarkably ebullient note. Uncharted territory, indeed! As for whether this bull run can continue, it is anyone’s guess. Some worry that the markets, especially the S&P 500 with its increase of 32% last year, moved too far and too fast. Others state that longer term, the S&P is merely reverting to its long-term performance average after a decade of underperformance. Some argue that the market rally will fade due to the slow start in the first week of 2014 with the reinforcing argument that a growing number of options traders are betting on higher volatility in the months ahead. Greater volatility usually implies lower stock prices. Others maintain that the equity markets will benefit from redeployment of cash that continues to be on the sidelines, the expectation of continued low interest rates and inflation, and a general strengthening of economies here and abroad. Still others express concerns about rising violence in the Middle East and fears that escalating tensions will explode, causing problems in all markets.

The point here is that no one can consistently predict where the markets are headed, particularly over the shorter term. Longer term, there is strong evidence that markets, indeed, revert to an historical average rate of return. (Note that we define shorter term as any time period less than three years while longer term is anything greater than three years.) This is why we believe so strongly in our buy-hold-rebalance methodology as our core solution for investors who have a longer-term focus and who elect not to succumb to the speculative purveyors of shorter-term, market-timed investing. Stated another way, we believe the downside risks of not investing in one of our risk-calibrated core model portfolios—missing out on market gains, having cash holdings erode due to whatever number you believe inflation is today—far outweigh the risks of being in the market over the longer term.

cartoon2One of the greatest traits among the investors we admire is their ability to be completely unfazed by doom-and-gloom headlines. Some might view their attitude to be as unthinking as the “what, me worry?” outlook of MAD Magazine’s character Alfred E. Newman. generalBut in point of fact their adherence to discipline in the face of potential downside is as unflinching as General Eisenhower planning the Battle of Normandy. As investment advisors with fiduciary responsibilities over client assets, we must pursue our mission of helping our clients systematically build and preserve long-term financial security with this same unflinching discipline.


Core Strategic Portfolios

As reflected below, our core strategic model portfolios performed in their customary way with the lower-risk models following the higher-risk, higher equity-driven returns both for the final quarter and full year performance. Note that the fourth quarter was only the third best quarter of the year, slightly trailing the “on-fire” third quarter and the very robust first quarter results. Perhaps the most remarkable part of the quarterly performance is the similarity of the pattern of absolute returns for our models for each of these three quarters, with the performance differences between each model equalling about 70 basis points for each quarter.

For our two target models, Cedarstar and Cedarstar +, unlike the results for the third quarter, the results lagged compared to our core models owing to their higher concentration in the poorly performing emerging markets asset classes. The lone exception to our solid equity performance was the small loss reflected in our Capital Preservation model, the first loss in 20 years. Because this model consists of four fixed income funds and since interest rates began to increase during the year due to concerns about the Fed’s tapering activities, all fixed income funds have been adversely affected. If there is any good news here, because we keep maturities short we believe our exposure to interest rate increases is minimal compared to the average bond fund.

Tactical Allocation Model

Our tactical model portfolio has not done as well as we had hoped for the quarter and for the full year. Recall that this model operates according to a rules-based strategy using exchange traded funds (ETFs) in which specific ETF positions are selected based upon a proprietary ranking system we have developed using DFA funds as the primary determinant of asset class composition. In analyzing performance of this model, it is clear that there was a strong “whipsaw” effect during the year, meaning that the price movements of the funds we use were very inconsistent in terms of how they performed month-to-month. Our tactical model tends to perform well when the underlying asset classes move in clusters or groupings over shorter time periods, so the performance rankings are consistent, thereby reducing the rotational effect of heavy turnover in the portfolio.


*Please refer to page 6 for full disclosure. All performance is net of management fees.

The destabilizing effect and subsequent less than truly stellar results caused by asset class volatility were very apparent during the year. As a quick example, the performance of our real estate asset class is instructive. In April, real estate was the best performer (returning nearly 7%) of all the asset classes we follow, meaning that we rotated into this investment for May. Unfortunately, May saw an exodus from the real estate asset class which resulted in a loss of roughly 6% for that specific investment Note that because we diversify this model across five asset classes, the overall results for May produced a loss of 2.2%, thus mitigating the whipsaw effect of our real estate investment. The same phenomenon occurred in October/November when our ranking system resulted in real estate once again being added to the portfolio mix for November based on a strong 4.2% increase in October, only to see it drop 5.3% during the following month. As before, because this whipsaw effect occurred at the individual asset class level and not at the total portfolio level, the overall loss was 0.7 for the month of November, as our other investments, particularly in the US Large and US Large Value sectors, helped to mitigate the poor real estate performance. Again, diversity is a good thing! Overall, the 12.57 return of this model still is not a bad performance, all things considered, including the significant downside protection this model provides in the event an extended downturn in equities were to occur.

Core Portfolio Benchmark Returns

The portfolio benchmark comparison on page 7 of this communication reflects the fourth quarter’s actual performance of our core models versus their weighted benchmarks along with the full year data for 2013. In general, the positive differences between the portfolio returns and their weighted benchmarks widened during the final quarter of the year. A closer look under the hood reveals that the primary reason for the positive performance was due to the value and small cap tilts we use in the equity part of our asset allocation strategy. Congratulations to DFA for another strong year! Note that the following two articles represent the value this firm provides to us and to our clients:

“Where the Smart Money Is Headed”
  “A Different Dimension”

Underlying Mutual Fund Performance Review

The table below represents the performance of the underlying asset classes represented in our core strategic and target asset allocation models for the final quarter of 2013 and the full year, alongside results for the previous two years for comparative purposes. Similar to the dynamics of the first three quarters, fourth quarter results continued to illustrate the strength of the US market, particularly in the small cap and value categories. On the other side of the performance spectrum, all of the emerging markets funds in our program were under water for the year.

A word about the performance of the emerging markets. The funds we use in our work reflect our view that foreign investments are an important diversifier to any well constructed portfolio. Last year, there was a massive summer sell-off in emerging market stocks, bonds and currencies, sparked by speculation that the Federal Reserve was looking to reduce the stimulus efforts that had been goosing the global economy for years. While the emerging markets managed to recover some of their earlier losses during the third quarter, they still suffered a loss for the full year. We have no intent of reducing our model exposure to these important asset classes. In fact, over the next several weeks we will be rebalancing those client portfolios which have experienced a significant reduction in % of holdings in this important asset sector due to the strength of the US asset class performance.


Data Source: Dimensional Fund Advisors


We live in a world of uncertainty. However, there is one irrefutable fact that we are absolutely certain about: the biggest risk to the markets generally is the unsustainably high debt and spending levels characterizing this country’s fiscal and monetary policies. Indeed, the math is so overwhelming it is hard to get your head wrapped around the fact that every single hour of every single day, the US government is spending about $200 million that it doesn’t have. Although the Fed has kept interest rates artificially low, if rates go up to 5%, it will add an estimated $40 trillion to our overall debt load over time. Our ability to print money has saved us in that the US dollar is the reserve currency of the world. However, this will change as the Chinese and other sovereign nations attempt to create a different world currency that will effectively remove the US from its position as the creator, and chief beneficiary, of the world’s reserve currency. As demand for US dollars goes down, inflation and rates will inevitably increase. Yet we cannot stop printing money because we cannot afford our existing debts. Talk about being between a rock and a hard place! Yet, until last week, the markets continued to press ahead into uncharted, record territory, just like the unprecedented debt levels supporting our economy. GO FIGURE!


As this letter is being finalized towards the end of January, the markets have not done well over the last two weeks. For some time now we have been cautioning readers that there would most likely be increasing volatility in the markets. For us, the question has always been not if, but when. Not a particularly gutsy call but merely a reflection of the strength of our asset class performance going back to the third quarter of 2012 and, in our view, the unsustainably high run-up in asset prices since that time. Turmoil in the emerging markets, worries about the Fed dialing back its stimulus and concerns about a mixed earnings season have weighed on stocks this month. Because the S&P 500 Index is now off about 3% since the beginning of this year, the key question is, will there be more to come? And if so, when and how much?

Because our investment philosophy is one of buy-and-hold, we will not speculate and make any predictions on the answer to these questions other than, it depends. Dependency issues include, among others, the earnings growth and the relative price/earnings ratio in the markets generally along with macro considerations such as actual and expected interest and inflation rates and, of course, market sentiment – that squishy imponderable that vexes all the quants out there.

As we have stated many times in the past, our program is all about investing for the longer term and the best advice we have is to stay the course because expectations and uncertainties are already built into the market. After all, investing is about what happens next. But because we don’t know what happens next, we diversify. (Note: The strong results shown on the two performance sheets at the end of this communication help reinforce the value of remaining committed to a consistent, diversified asset allocation program.)


In last quarter’s client letter, we made four announcements which related to our product offerings. Specifically, these Involved our intent to:

migrate away from how our core strategic models are invested using 11 individual equity funds to an approach which would instead invest in five of DFA’s core funds
introduce what we were calling our “enhanced core” model portfolio strategy
integrate DFA’s new profitability factor into our fund line-up
offer a special 10% discount off of our already low management fee for new accounts opened in 2014 in recognition of the 10th anniversary of Cedarwinds

After extensive analysis, we have decided that it would not be in our clients’ best interests to use DFA’s five core funds as a replacement for the 11 individual funds that comprise the equity portion of our core model portfolios. The key reason is that we could not match the excellent performance of our original models despite extensive back testing, which led us to the conclusion that clients would be better served with the status quo.

Likewise, we will not be launching our “enhanced core” strategy for the same reason as above. Once again, after exhaustive research, we simply didn’t feel comfortable that the strategy we had developed offered enough value-added performance on a consistent basis to justify the launch. Please note, however, that we continue to examine different techniques that can be packaged to create sustainable investment benefits to clients.

With respect to the final two announcement bullet points above, we are continuing to execute them as referenced in our last client letter. In particular, we feel that our special anniversary pricing discount of 10% for new accounts established during 2014 should appeal to all investors, especially considering the fact that we have no minimums on our core strategic portfolios.

As always, please feel free to contact us if you have any questions, concerns or comments you would like to share. And stay warm!

Special regards,


Geoffrey G. “Rip” Maclay, Jr.
Managing Partner




SPECIAL NOTE: If you elected to receive your Cedarwinds statements via PDF e-mail, we urge you to carefully compare the information included in the accompanying quarterly report to the information on statements you receive directly from your account(s’) custodian. Should you have any questions, please contact us.


Cedarwinds Investment Management, LLC, a SEC registered investment adviser, was incorporated in March 2004 and established its first independent client investments in 2004.  Performance data shown represents hypothetical, time-weighted results of Cedarwinds’ model portfolios.  All model portfolios have been designed to seek certain risk-return relationships. The Strategic and Target model portfolios have been constructed using a blend of up to 16 underlying mutual funds managed by Dimensional Fund Advisors (DFA), Austin TX. The Tactical model portfolio has been constructed using a blend of underlying exchange-traded funds (ETFs) managed by BlackRock (www.blackrock.com), under the “iShares” trademark, and Vanguard (www.vanguard.com).

The underlying fund composition and weightings used in our Strategic Core model portfolios generally reflect the asset allocation strategy used in portfolio models developed by DFA beginning in 1993.  In 2010 and 2011, certain modifications were made to the fund weightings used in our strategic asset allocation models. The underlying fund composition and weightings used in our Target model portfolios were developed by Cedarwinds in 2004, shortly after the firm’s inception. The underlying iShares fund composition and weightings used in our Tactical portfolio were developed by Cedarwinds in 2009.  In 2010, a stop-loss strategy was instituted in the Tactical portfolio.

In all cases, model portfolios have been developed with the benefit of hindsight using back-tested performance results.  Back-tested performance is a hypothetical reconstruction based on historical market data accumulated after the end of a given time period.  With respect to the historical model portfolio performance data presented by Cedarwinds prior to the firm’s formation, performance results reflect what would have hypothetically occurred during periods had the firm been managing accounts.  This hypothetical performance record is merely a reflection of what worked in the past, a representation made with the benefit of hindsight.

Along with live data, simulated data has been used for performance reporting periods prior to the inception date of the underlying mutual funds and exchange traded funds used in the construction of the model portfolios. Simulated index data is based on the performance of indexes that are representative of the DFA mutual funds and exchange traded funds used in the Cedarwinds’ model portfolios.  Simulated performance does not represent actual performance and should not be construed as an indication of such performance. The simulated performance results do not represent the impact that material economic and market factors might have had on the fund management decision-making process compared to the fund manager actually managing client money during that period. Simulated performance also differs from actual performance because it is achieved through the retroactive application of a strategy designed with the benefit of hindsight.

Performance results for clients that invested in accordance with the model index portfolios will vary from the simulated performance data due to market conditions and other factors, including client objectives, investment cash flows, size and timing of mutual fund and exchange traded fund allocations, trading costs, frequency and precision of rebalancing and reconstitution, tax-management strategies, cash balances, varying custodian fees, and/or the timing of fee deductions.  The net compounded impact of the deduction of Cedarwinds’ fees over time will be affected by the amount of the fees, the time period and investment performance.  These and other factors may materially influence performance results and therefore actual client performance for any portfolio would only match model performance by coincidence. Actual performance for client accounts may be materially lower or higher than that of the model portfolios. Clients should consult their account statements for information about how their actual performance compares to that of the model portfolios.

Indexes and simulated data used prior to portfolio inception date do not reflect deduction of DFA, iShares or Vanguard fees, trading and other expenses. Average annual total returns of live data at the underlying fund level are net of DFA, iShares and Vanguard fees and include reinvestment of dividends and capital gains.  For the Strategic and Target model portfolios, historical performance results reflect the deduction of Cedarwinds’ standard annual investment management fee of 40 basis points. For the Tactical model portfolio, historical performance results reflect the deduction of Cedarwinds’ annual advisor fees of 100 basis points. In all cases, monthly fee deduction is a requirement of our software used for back-testing, however, actual fees are deducted quarterly, in advance.  Depending on the size of client assets under management or account type, the investment management fees may be less.  Transaction costs and account maintenance charges are not considered. When used for comparison purposes, it should be noted that the composition and variability of the S&P 500 and the MSCI All Country World Index, both unmanaged market-value weighted indices, and the composition and volatility of the models managed by Cedarwinds are materially different. Simulated and live performance data reflect annual rebalancing for the Strategic and Target model portfolios. For the Tactical model portfolio, simulated and live performance data reflect monthly reconstitution. Results have not been audited or reviewed by any third party.

As with any investment strategy, there is potential for profit as well as the possibility of loss.  Asset allocation does not ensure a profit or guarantee against a loss.  Cedarwinds does not guarantee any minimum level of investment performance or the success of any index portfolio or investment strategy. All investments involve risk and investment recommendations will not always be profitable. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Please contact Cedarwinds Investment Management info@cedarwinds.com for additional information on fund and portfolio performance results, data sources and descriptions, fund prospectus and fees

Updated:   1/14