SUMMARY OF ADVISORY PHILOSOPHY AND INVESTMENT TENETS

1. Caves & Associates provides comprehensive financial advice in all areas, including financial and estate planning, and specializes in institutional quality investment advisory services.

2. The practice is on a fee-only basis, the only product is advice. Neither Caves & Associates nor any affiliated entities are compensated by commissions.

3. The investment management approach is customized for each client. The preferred philosophy is conservative and long-term. Short-term trading is not practiced, and major speculation is avoided. Since few organizations or advisors can predict, consistently, and over a meaningfully long time period, the near-term movements of the financial markets or any particular investment asset (a few correct predictions over a few years does not qualify!), it is futile to attempt to “time the market” or engage extensively in so-called tactical asset allocation.

4. Investment services typically involve a comprehensive “manager of managers” approach. Client portfolios are normally implemented utilizing no-load mutual funds, or occasionally a combination of funds, separate account money managers, and non-actively managed individual fixed income securities. Caves & Associates advocates both active and passive styles and finds that mutual funds provide well for the majority of clients’ daily money management needs. Rather than making daily buy and sell decisions, our role is: a) to assist the client in establishing an investment policy comprised of long term goals and investment restrictions reflecting client risk tolerance; b) to recommend a proper strategic allocation among various investment types; c) to select and monitor the performance of specialty fund managers in each area; and d) to monitor movement of the actual asset allocation and, if necessary, reposition the portfolio, so market trends do not excessively cause the portfolio to be out of balance.

5. In a world where real risks bust be incurred to achieve returns in excess of the risk-free rate (viz., the Treasury Bill rate), the best approach is to diversify broadly so that the magnitude of any short-term negative returns is minimized. Diversification is easily accomplished with a basket of mutual funds. The various holding are selected to have low or even occasionally negative performance correlations with one another. Thus, when one holding does not perform well, there is a good chance some other holding has an offsetting strong performance. Most important, a broadly diversified portfolio stabilizes return without unduly sacrificing the magnitude of the long run return. Due to the mathematics of compounding, the reduced volatility of a stabilized return actually increases compound annual return. Accordingly, client risk-adjusted return is not compromised. Finally, the mix of assets is chosen based on computer modeling so expected portfolio compound return is consistent with the client’s goals.

6. Active money management does not necessarily involve a profitable cost/benefit trade-off. Professional managers have not shown an ability to consistently avoid down markets, pick superior securities, etc. This strongly suggests that the market is very hard to beat and that the average active money manager does not add value. Accordingly, it is imperative to either pick superior managers and/or minimize money management fees and transaction costs. This is accomplished through the use of low cost, passively managed mutual funds (also known as index funds), low cost institutional actively managed funds, and other judiciously selected funds.
 

• We diligently search for managers who produce above average returns at no increase in risk compared with peers. In the case of openend mutual funds, we recommend only no-load funds to eliminate up-front or deferred sales charges. We also occasionally use high quality closed-end and exchange-traded funds, as appropriate.

• We build at least a portion of most portfolios using indexing. Accordingly, the total portfolio includes a significant percentage of passive or index investments that have little or no management fees. Considerable indexing is particularly favored for taxable portfolios due to the superior tax efficiency of index funds compared with actively managed funds.

At times we recommend individual California general obligation and pre-refunded bonds and U.S. Treasury securities for a “laddered,” long-term buy-and-hold strategy (use of individual securities eliminates management fees). We do not recommend individual equity securities and have no practical capability to professionally select and monitor them.

7. The strategic asset allocation approach is preferred, although active tactical allocation of a small portion of a portfolio is permissible. A “permanent” strategic allocation is chosen based on the client’s objectives and risk tolerances and is adhered to diligently thereafter. Only limited variation around long-term targets is allowed after the portfolio is implemented. A corollary is that it is necessary to periodically value the total portfolio, to track compliance with the strategic asset allocation, and to rebalance the portfolio “back” reasonably close to the originally agreed asset proportions, as mentioned in Point 4 above, subject mainly to income tax considerations and existence of highly usual economic or market conditions.

8. Illiquid investments have an inherently higher risk and must have a correspondingly higher expected return to be included in a portfolio. Caves & Associates does not normally recommend limited partnerships due to illiquidity as well as high sales charges and management fees. It is preferred that clients make their own direct investments into the subject asset classes (primarily real estate) in order to increase control and also reduce costs. Caves & Associates analyzes liquid alternatives to partnerships such as mutual funds investing in publicly traded real estate investment trusts (REIT’s), energy and other commodity securities, and hedge-fund like mutual funds, as appropriate.

9. Strategic asset allocation provides effective risk management in the long-run but is only successful and applicable to client money having a similar long-term time horizon. Unfunded funds needs within five years must be met by setting aside cash reserves. They cover general and emergency needs, unusually large expenditures over the next 1-2 years, or as far into the future as foreseeable, and any on-going excess of routine expenditures over regular income streams. The various types of reserves are consistent with the underlying rationale for all cash reserves, which is to have ready cash available to avoid forced portfolio liquidations at cyclical market lows, bearing in mind that such lows are unpredictable.