Quarterly Newsletter: June 2006

Click here to view the Index Returns for 2nd Quarter 2006
 (PDF, 188kb)

Inflation Fears Drive Volatility
Second quarter returns for nearly all asset classes were negative. Investor concerns about inflation and additional rate hikes by the Federal Reserve pushed both stocks and bonds lower during the period. However, thanks to a bold first quarter and a late June surge, all equity classes except US Large Cap have strong year-to-date returns.

It is difficult to predict whether this quarter's downturn is the pause that refreshes or the beginning of a sustained period of weakness for equities. But it is important to remember that the volatility in equity markets in the first half of this year is more normal than the relatively docile conditions that have prevailed over the last few years. This expected volatility underscores the importance of broad diversification in client portfolios.

Fundamental Indexing
At Arbor, we use passive investments as an important part of our strategy for clients. Index funds – particularly in the form of exchange-traded-funds (ETFs) – give us the ability to expose portfolios to specific segments of the capital markets. Key benefits of index ETFs are their low cost and high tax-efficiency for our clients.

Traditionally, index funds are capitalization weighted. This simply means that the fund will weight each security according to its market capitalization. So, the larger the market value of a given stock, the greater its weighting in the index.

Based on their extensive research, Robert Arnott and his colleagues at Research Affiliates, LLC have proposed fundamental indexing as an alternative approach. The weights of the stocks in these new indexes are based on fundamental factors such as total sales, free cash flow, gross dividends and book equity value. Arnott's contention is that market capitalization weighting will overweight stocks which are overvalued and underweight stocks which are undervalued. As such, he posits that over the long term, indexes based on fundamental factors will outperform the cap weighted indexes.

We are watching these developments closely and are meeting with one of Arnott's colleagues this month to debate the merits of the fundamental approach. We will share our findings in next quarter's newsletter.

Market Leadership Change?
Three year annualized returns through June 30, 2006 for the major equity classes have been:

Russell 1000 Growth Index    8.4%
Russell 1000 Value Index    15.7%
Russell 2000 Index    18.7%
MSCI EAFE Index    24.4%
MSCI Emerging Markets Free Index    34.8%
NAREIT Equity REIT Index    26.0%

Large Cap Growth stocks have languished since the nineties when they rode the technology wave in one of the strongest bull markets in US history. Those who study the capital markets know there is a strong tendency towards regression to the mean. Said another way, specific asset classes outperform for periods of time but tend to share the spotlight over the long haul.

Investors who have owned the alternative equities of Small Cap, International, Emerging Markets and REITs have enjoyed very good returns for the past three years relative to a straight US Large Cap Equity portfolio.

Will this change? Or more accurately, when will this change? As you know, we don't recommend that clients make large and abrupt shifts in their asset allocations in an attempt to time the market. However, it is a good reminder to broadly diversify portfolios and to include those asset classes that are currently out of favor-including Large Cap Growth. It is also important that we maintain the discipline of rebalancing to our targets.

Business Notes
We are extremely excited to welcome two new members to our team.

Scott D. Jones has joined as a principal of the firm. He will be working in business development, client servicing and firm management. Scott comes to us from the Wealth Management arm of Wachovia Bank in Philadelphia.

Kathleen G. Fagg is our newest associate in the operations area. She will be working with Paige Birchfield and April Beason to support Arbor Investment Advisors.

April and David Beason are the proud parents of their first child. On July 4th, April delivered a healthy baby boy, Tyler David Beason. We are so happy for April and David!

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Arbor Investment Advisors, LLC. Please remember to contact Arbor Investment Advisors, LLC if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. Please also advise us if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. A copy of our current written disclosure statement discussing our advisory services and fees remains available for your review upon request.

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