Market Overview

In terms of market events, 2008 was divided in half. Problems surfaced only periodically during the first six months and included the failure of auction-rate securities (ARSs) markets in February, the arranged sale of Bear Stearns in March, and several sizeable Federal Reserve interest rate cuts. All assets tumbled in the year’s second half, following the conservatorship of Fannie Mae (FNMA) and Freddie Mac (FHLMC) and the mid-September bankruptcy of Lehman Brothers. At mid-year, most RCT and CUIT Funds were close to or exceeding benchmarks and absolute losses were in the single digits. In the year’s second half, absolute returns plummeted along with the financial markets, and relative results increasingly lagged benchmarks across all actively managed bond and stock programs. This result was particularly disappointing given our emphasis on quality holdings and our avoidance of many of the year’s blow-ups.

During the second half of 2008, turbulence from macroeconomic events overwhelmed the prudent investment processes followed by our sub-advisers. The magnitude of selling by hedge funds facing redemptions and liquidations, selling by investment banks seeking to boost capital ratios, and redemptions at mutual funds all impacted stock prices far more than did company fundamentals. When leveraged managers are forced to sell higher-quality assets to meet margin calls and liquidate hedged portfolios by feverishly covering short positions and selling top-quality holdings, stock performance becomes detached from any sense of rational longer-term earnings prospects.

Equities
Stock performance was weak regardless of investment style or industry. Growth, value, large-cap and small-cap stocks all suffered from a sharp reduction in expected earnings and from deepening concerns about access to credit, although larger financial institutions and commodity producers fared the worst. The more defensive sectors of the economy — such as consumer staples, healthcare and utilities — declined less.

International diversification provided no relief. Questionable financial practices and excessive consumption by consumers and governments were not confined to North America. European governments face the prospect of expensive bailouts of their major banks, whose troubled assets often represent a far larger proportion of national gross domestic product than do those of U.S. banks relative to the size of the U.S. economy. The financial crisis is particularly acute in Iceland and Eastern Europe, reflected in their declining currencies and widening credit spreads. Deterioration in residential housing was severe in the U.K. and Spain, and the woes of the financial industry had a terrible impact on the London commercial property market. The economic slowdown in China dragged down performance of surrounding East Asian nations, and the weakening global trade picture showed little sign of improvement as 2008 came to a close. In general, emerging markets declined even more than developed markets did. All in all, the magnitude of economic and financial problems worldwide left equity investors with little refuge from price weakness.

Cash and Bonds
In the cash and bond markets, portfolios structured to take advantage of the attractive yields offered early in 2008 were crushed by the freeze in trading following the Lehman bankruptcy and by forced liquidations at leveraged investors and financial institutions trying to raise capital. And there was no ability at all to price or trade the subprime mortgage issues at the heart of the financial crisis. Investors came to fear all forms of credit exposure.

Bond market conditions eased somewhat by the end of December, after substantial government intervention and with the prospect of further action in 2009. This produced some tightening of credit spreads, primarily in agency debt and in the corporate debt of financial institutions that received government backing through the Term Loan Guarantee Program. But despite such intervention and global interest rate cuts, the process of restoring investor confidence will likely be a slow one.