Expanded Value Equity Strategy

4Q07 Commentary

The performance in 2007 of the Expanded Value separately managed accounts reflected the market’s turn toward a growth-oriented and momentum style of investing. Companies that were more expensive on a variety of value metrics (price-to-earnings, price-to-sales and price-to-book) tended to be better stock performers in the past year. Apple and Google were notable outperformers that were not in our portfolios because they do not fit our value-oriented style of investing. In addition, markets became increasingly momentum driven as the sub-prime crisis unfolded; the leaders kept on leading. In particular, our underweighted position in Energy stocks hurt our relative performance versus the S&P 500 (even though Energy provided the largest contribution to absolute performance). Strategies that emphasize mean reversion, including those employed by the portfolio, lagged in this environment.

The Economic Outlook

As we head into 2008, economic and financial uncertainties are at the forefront of investors’ minds. An increasing number of economists are calling for a recession. Banks and other financial institutions are reeling from losses associated with their holdings of mortgage-backed securities. Meanwhile, the stock market is swinging wildly, plunging in response to the on-going write downs stemming from the credit crunch, then rallying on the hope that the Fed will ride to the rescue, only to give way again to pessimism and concern.

At this point, it is hard to see a return to market stability in the near term. To be sure, the Federal Reserve and other central banks around the world are trying to ease the financial crunch by lowering interest rates and providing massive injections of liquidity into the financial system. These actions are helping to ease some of the strain, but they have not eliminated it.

The Fed’s job is complicated by the fact that inflation, led by food and energy, is accelerating. Although the central bank has been cutting rates, it has been doing so reluctantly. The Fed is trying to use different tools for different purposes. It wants to reserve interest-rate reductions to combat excessive weakness in economic output, while using other tools to help depository institutions bolster their capital-constrained balance sheets. Thus far, it appears to be a distinction that is too nuanced for investors’ liking.

To put it simply, financial institutions are reluctant to lend to each other because they are unwilling to shoulder counterparty risk. Until confidence returns, the central banks will be pushing on a string. Despite a one percentage-point cut in the Federal funds in recent months, the London interbank offered bank rate (LIBOR) is still at a relatively high level. This is significant because most sub-prime paper and many other loans are benchmarked to the LIBOR rate.

The deterioration in residential mortgages remains the epicenter of the credit squeeze. While the Fed and other central banks have been busy pumping liquidity into the banking system, the Treasury has been busy brokering a bailout of sub-prime borrowers. Some $500 billion of adjustable-rate mortgages are scheduled to reset upward significantly from below-market teaser rates over the next 12 months. The plan is to modify mortgage contracts and prevent the resets from occurring for those borrowers who can pay the lower rate currently, but would be unable to afford the higher market-based rate. As with the actions of the central banks, this can serve to ease the pain, but will not cure it.

The underlying issue in the housing market is clear: The sharp appreciation in home prices during the 2003-2006 period far exceeded the rise in incomes. Buyers were able to acquire homes that were unaffordable in the past by virtue of a sharp decline in mortgage rates to historically low levels and extremely lax underwriting standards (high loan-to-value ratios, little or no documentation, negatively amortizing loans and qualification for loans based solely on the ability to pay the teaser rate). We believe it will take a meaningful decline in home prices and a return to an ultra-low interest rate regime to equilibrate demand and supply. Underwriting standards are tightening, however, and interest-rate spreads are widening, offsetting the monetary easing engineered by the Fed. Delinquency rates for residential real estate are at their highest level in 20 years and the foreclosure rate is at its highest since the introduction of the statistic in 1979. We believe these rates are likely to move higher well into 2008, prolonging the credit crunch.

Given the woes in the credit markets, it is surprising that the impact on business activity has been muted outside of the housing industry itself. Nonetheless, signs of a slowdown are slowly accumulating. Anecdotal reports suggest that the holiday selling season has been soft and very promotional (the trend in retail sales heading into December was relatively strong, however). Measures of consumer confidence have fallen sharply, although they are not yet at levels typically associated with recession. Payroll employment has risen 1% over the past 12 months, a significant deceleration from the pace recorded in the first half of 2007. More worrisomely, initial unemployment claims—a leading indicator of labor market trends—have started to move upward. This does not bode well for employment and consumer spending in the months ahead.

As has been the case through much of the economic expansion, corporations remain in better shape than the consumer, but even here, there are accumulating signs of stress. Although exports are helping to offset much of the slowdown in the growth of domestic demand, manufacturers are reporting a deceleration in growth to its lowest level since the early days of the expansion six years ago. Profits growth also has decelerated sharply, caused mostly—but not exclusively—by the losses posted by the financial and consumer cyclical sectors. Economy-wide, profits rose just 2% on a year-over-year basis in the third quarter. The bottom line: The economy continues to grind higher, but the risks definitely appear to be biased toward the downside.

The Expanded Value separately managed accounts are defensively positioned for this uncertain environment. Historically, our investment process has performed relatively well in turbulent markets owing to its conservative bias. We will continue to seek opportunities with established, financially strong companies, most of which pay a dividend. Such a strategy, in our view, is among the best available when times turn uncertain and markets undergo stress. We can hope for a soft landing, but it is wiser and more prudent to adjust one’s seat belt for a bumpy ride.

If you have any changes in your financial condition or investment objectives that are pertinent to the management of your account, please contact your Financial Advisor.

The opinions are those of the portfolio managers as of December 31, 2007, and are subject to change at any time due to market or economic conditions. Portfolio holdings and sectors are subject to change daily. All information provided is for informational purposes only and should not be deemed as a recommendation to buy or sell the securities in the industries shown above. Past performance is not indicative of future results.

ll investments involve risks, including the possible loss of principal.

Please refer to the portfolio’s Disclosure Document for risk and other important information about the strategy. Please ask your clients to consider the investment objectives, risks, charges and expenses of the program carefully before investing. The Sponsor’s Disclosure Document contains this and other information about the program. The Disclosure Document can be obtained by contacting you, the Financial Advisor. Encourage them to read it carefully before investing.