Absolute Return Recommendation (A0059002.DOC;1)



TO: South Carolina State Firefighters’ Association

FROM: S. Bart Valley, Cheryl R. Holland, Charles B. Flowers

DATE: June 22, 2007

SUBJECT: Recommended Absolute Return Fund Additions

At this point we would like to recommend that you allocate 10% of your overall portfolio to the Absolute Return asset class. Absolute Return strategies seek to generate high long-term real rates of return by exploiting market inefficiencies. Over the long-run, we expect these strategies to offer equity-like returns with a risk level substantially lower than equities. Absolute return investments, unlike traditional domestic and foreign equity investments, provide returns that are somewhat independent of overall market movements, therefore serving as solid portfolio diversifiers. But unlike some other diversifying investments such as bonds or cash, absolute return strategies should generate high long-term real returns. Adding an allocation to absolute return strategies will substantially enhance the risk and return characteristics of the portfolio over the long-term. We will initially utilize three separate mutual funds that in aggregate will represent this Absolute Return allocation: the Calamos Convertible Growth & Income fund, the Gateway fund, and the Merger fund.

The Calamos Convertible Growth & Income fund invests primarily in a diversified portfolio of convertible securities, which are bonds or preferred stock that also provide the option to convert the security into a specific number of shares of the issuer’s common stock. Calamos provides a total-return oriented investment that combines the growth potential of equities with the potentially lower volatility of convertible securities. The beauty of convertibles is that the underlying equity component provides significant price appreciation in up markets such as 1998, 1999 and 2003, while the fixed income component dampens volatility in down markets such as 2000 and 2001. Over the long run, Calamos’ strategy should provide growth from equity appreciation, income derived from the convertibles’ dividend or interest payments, and less volatility of principal relative to investing in common stocks. Fund managers John and Nick Calamos have been managing the fund since 1988 and are considered the pre-eminent experts in the field of convertibles securities investing. Over the past ten years through 10/31/2006, Calamos has provided higher average annual returns than the S&P 500 (14.15% versus 8.64%) with less volatility (13.82% versus 15.53%).

The philosophy of the Gateway fund is to capture the majority of the equity premium over fixed income investments while at the same time reducing volatility and providing consistent returns over a wide range of equity market scenarios. To reduce equity volatility, Gateway employs an actively managed option hedging strategy through a three step process. The first step in Gateway’s process is the purchase of a broadly diversified index basket of stocks that mirrors the S&P 500 Index. Secondly, the fund managers then sell cash-settled index call options on this same index. Selling these call options provides the fund cash flow roughly equal to the expected value of future upside appreciation in the underlying index of stocks. This is Gateway’s primary source of return. The last step in the process is the purchase of index put options which collectively serve as a safety net to mitigate the impact of market declines on the portfolio. This protection significantly reduces volatility over time. Gateway’s three part strategy will generate steady gains in rising equity environments and lose less than the overall market during corrections. Over the past fifteen years (through 10/31/2006), the Gateway fund has returned 7.23% per year on average with less than half the volatility of the S&P 500 Index.

The Merger fund follows a strategy of purchasing firms that are headed for acquisition or merger in order to capture the share-price spread that occurs between the announcement of the merger and the deal’s close. The fund's primary objective is to achieve attractive total returns in various market conditions without excessive risk of capital loss. When a company agrees to be acquired by another company, its stock price often quickly rises to just below the stated acquisition price. If the fund managers’ research determines that the acquisition is likely to be consummated on schedule at the stated acquisition price, then the fund will purchase the selling company’s securities, realize the price appreciation resulting from the merger purchase, then sell the securities after the merger is complete. This event-driven strategy provides the possibility of significant returns relative to cash equivalents with a limited risk of excessive loss of capital. Again, similar to the Gateway fund, this fund will offer equity exposure with limited downside risk. At times when merger and acquisition activity slows, the fund manager may hold assets in cash until buying opportunities present themselves.

Each of these three funds has a similar goal of providing high long-term real returns with substantially lower volatility than equities. However, the three funds obviously take very different approaches towards this goal and thus they tend to work very nicely in aggregate to help diversify the portfolio. We are attaching a Morningstar report on each of the three funds. Over the past ten years the three funds in combination have provided equity-market type returns markets with significantly less risk than equity markets. Together these three funds will represent a portion of your allocation to the Absolute Return asset class and offer unique investment exposure that should benefit the portfolio in all types of market environments.

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