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Dear Investors, Colleagues & Friends

2014 is well underway. Emerging markets, Fed policy and geo-political turmoil remain at the forefront of investors’ minds. Interestingly, for the first time since the great wealth crumble of 2008, we are starting to see traditional correlations creep back into the market.

As of today’s close of business, US stocks are slightly up (S&P 500 +0.27%), emerging markets are hurting (EEM -8.64%), bonds are up as measured by the Barclays Aggregate Bond Index (AGG +1.84%) and gold has had a very strong year so far (GLD +13.86%).

For those that don’t remember, in 2008 everything went down. The only way your portfolio was protected was if you had a sizable allocation to US Treasuries and gold. No matter how diversified your portfolio was, you were hit. Many people couldn’t bear it and, sadly, sold everything at or near the bottom and were hesitant to buy back in…until now when the stock market is trading at multi-year highs.

What lessons have we learned? You can get as many different answers as there are talking heads. Here are a few, to which we at Vitreous Partners subscribe:

1) Risk management and diversification should be your main focus.

Diversification is very important, but it is one of many tools that you should use to lower risk. By selecting asset classes and investments that act and move in non-correlated ways, you increase your chances of making money over the long haul and provide protection in many downside scenarios. This is something that has been ingrained into anyone who has even the slightest of investment education. However in practice, we find that many do not follow this philosophy.

We have a few clients who, before coming to us, fell prey to brokers and advisors at other firms who put their entire portfolio into municipal bonds. The clients were told that a portfolio of bonds is safer than a diversified portfolio with exposure to different asset classes and sectors (limited truth). The clients were seeking a yield that gives them something higher than a meager couple percent return a year, so they purchased longer dated bonds (15 to 20 years to maturity) that carried a slightly higher yield. It was very shocking to these clients when interest rates rose for a month and their portfolios dropped 10%. “What happened?! I thought munis were some of the safest stuff around?!”

Although it is true that many municipal bonds have low default risks (there is a very good chance that the clients will get their money back with the interest promised at maturity), there are other risk factors to consider. By buying long dated municipal bonds, they are taking on interest rate risk – meaning that if interest rates go up, the value of their bonds goes down. They may have a very volatile portfolio for 20 years until those bonds mature! In addition, they are taking on inflationary risk. When the cost of everything in the economy increases, they will be stuck earning a lackluster amount of interest. Finally, if interest rates go up, they are missing out on investing in higher yielding instruments and are stuck in the low yielding, long-term bonds. With this simple analysis we can see that the downside outweighs the upside.

We also don’t believe that diversification is the only key to risk management (as proven by what happened in 2008). You also have to be strategic and be able to move to safety when there is a high probability that a market meltdown is starting to unravel.

2) Have a plan and stick to it but be nimble and make changes to your allocation when it makes sense.

When coming up with an investment plan/policy/allocation, you should cover a wide array of circumstances (earnings, a major upcoming expense, age, tax bracket). There should be a framework in which your risk tolerance matches your return expectations. This is your home base – a general outline of where you want to be.

As the portfolio is managed, you don’t want to make changes to your plan unless you and your advisor truly believe that there are compelling reasons to do so. In other words, stick to your plan but don’t be afraid to take a few punches and step out of the ring for a bit if it means that you’ll miss the knockout punch (taking a 5% loss is better than losing 20%). Raising cash in some situations is smart management.

Hope, on the other hand, is not an investment strategy. Chasing a market down and holding on for dear life does not mean that it will be OK.

Most institutions don’t get their portfolios to safe harbors and de-risk when the hurricane is upon them. This is not because of strength of belief in a buy and hold strategy but because they simply don’t have the mechanism, technology or discretion over the assets and thousands of accounts to do so. I’m happy to report that at Vitreous Partners, we do have such capabilities.

Nevertheless, don’t be afraid to leg back into a market. No one can perfectly time the market (no matter what anyone says). So you have to be mindful when putting cash to work. It’s not always a good time to be buying every asset class, so your whole portfolio shouldn’t be bought or sold at once. Like anything, investing is a process.

3) If you are comfortable with some illiquidity and a more sophisticated investment strategy in exchange for the potential of higher and non-correlated returns, investments in private equity, hedge funds and real estate might be a good choice for you.

Although there are a variety of risks associated with such investments, in my opinion, alternative investments provide some of the best opportunities for investors for long-term growth. There is a reason that many institutions and endowments have over a 40% allocation to alternatives.

Some of these alternative managers can find value and structure investments in ways that a retail investor cannot. Real estate has and continues to make some of the wealthiest investors in the world. Long/short managers can have “hedged” positions, meaning that you may have added protection on the downside and may be able to make money in falling market scenarios.

Alternative investments are not for everyone, but they can add diversification and out-performance to a portfolio when utilized correctly.

Conclusion

There is no doubt that the world’s markets have come back from the brink of disaster. The tremendous run up in the stock market since 2009 is an example of how things have gotten better. However, we are incapable of ignoring the current risks in the market place – Fed policy, the Chinese shadow banking system and disappointing job and GDP growth (to name a few).

In this context, we continue to manage our portfolios utilizing diversification, best in class managers and investments strategically to capture as much upside as possible without significantly exposing the downside. We have been happy with the results and we hope you have been too.

We appreciate your continued confidence. If you have any questions or we can assist you in any way, please don’t hesitate to contact us.

Sincerely,

Rob Santos CEO, Vitreous Partners

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