Investment Fund of the Diocese of Long Island
Report to the Shareholders for the year ended December 31, 2004

Introduction

The Investment Fund of the Diocese of Long Island seeks to maximize total return while at the same time assuring sufficient liquidity and guarding against excessive investment risk. The Trustees of the Estate Belonging to the Diocese of Long Island, Inc. are responsible for the Fund, and have established an Investment Committee to assist in managing the portfolio. The members of the Investment Committee, which includes four Trustees, all possess strong business backgrounds. Several are investment professionals. The rules and regulations governing prudent fund management are always uppermost in the minds of the Trustees and the Investment Committee.

Summary

The Fund performed well in 2004. Total return of 10.95% exceeded our benchmark, a blend of the Standard & Poor’s 500 stock index and the Lehman Brothers Aggregate bond index, by 2.25%. Our 2004 return also slightly exceeded the 10.88% return of the S&P 500 stock index. The value of a share in the Fund rose from $532.85 at year-end 2003 to $558.18 at year-end 2004. Total investments of the Fund stood at $95,220,837 at year-end. (The summary of Valuations and Dividends, together with unaudited financial statements as of December 31, 2004, are attached.)

Discussion of results

The 2004 performance came about in large part because JP Morgan, manager of our largest equity portfolio and all of our fixed income investments, had a superior year. Both of their portfolios were in the top quartile of the peer universe and substantially exceeded our benchmarks.

The Investment Committee made significant changes in the management of the portfolio. In late 2003 the Investment Committee, with the approval of the Trustees, engaged a consulting firm to aid in determining the best allocation of the Fund’s assets, and in selecting investment firms to manage those assets. Over the last 18 months the Investment Committee, working with our consultants, Evaluation Associates, Inc. (EAI), and with the advice of counsel, has sought to instill a disciplined process for allocating monies in the Fund. The goal of this process is a portfolio that provides the maximum return consistent with prudent trust management. In pursuit of that goal the Committee has developed a series of allocation ranges for different classes of investments. These allocations are designed to reduce our exposure to equities, broaden the international scope of the portfolio and dampen volatility, while at all times keeping in mind acceptable interest, credit and market risk levels, and the need to produce consistent returns.

In addition to the extensive research provided by EAI, members of the Committee have contacted professionals in other organizations, such as The Domestic and Foreign Missionary Society of the Protestant Episcopal Church in the USA and the Church Pension Fund. As we are taking steps that are bold by comparison with our peers and our past, we wanted corroboration of our judgment and a check that we were not too far ahead of the pack. After checking we are satisfied that our new portfolio allocations are in line with the progressive strategies of the organizations we consulted.¹

Managers were chosen based on demonstrated ability in their respective areas. EAI provided the Committee with preliminary lists of manager candidates drawn from their database. The members of the Committee then conducted a series of interviews to make the final selections. Some of these managers – JP Morgan, Sanford Bernstein, Montag & Caldwell, American Funds and Ironbridge Capital – are already participants. New to the list are Rexiter, Gartmore, AEW, Crestline and Offit Hall.

Implementation of our new policies and manager appointments began in the fourth quarter of last year and were completed by June 30th of this year.

The Spending Rate

An additional aspect of the Committee’s work over the past year was an analysis of the method for determining the Spending Rate. The Spending Rate is not the earnings of the Fund; it is the rate at which earnings are distributed to the shareholders. The earnings of the Fund – the total return – include interest, dividends, realized capital gains and the change in the market value of the shares.

All shareholders in the Fund should be aware that, with the exception of those trust funds managed by the Trustees, withdrawals from the Fund are not necessarily limited to the Spending Rate. For example, there are parishes that draw a fixed amount from the Fund each month. How much a shareholder withdraws is determined by their budget requirements or by any agreements, such as a trust agreement, that may control use of the funds.

Prudent fund management, especially for an entity such as the Investment Fund of the Diocese, requires that the purchasing power of the assets be maintained. This concept is incorporated in the regulations governing the conduct of such funds. To meet this requirement, a portion of the total return – the allowance for inflation – is retained in the Fund. The Trustees determine the Spending Rate by estimating the expected return, subtracting the inflation rate and administration expense rate, resulting in the Spending Rate.

In the current environment, the specific numbers are 8% (expected return) – 3% (anticipated inflation) – 0.5% (administration expense) = 4.5% (the Spending Rate).² There may be deviations from these expected rates in the short term, but these numbers represent the most reasonable forecasts over the long term.

As in the past, the base to which the rate is applied is a three-year rolling average of the net assets of the Fund. The significant difference from the practice of previous years is that the rate now directly accounts for the impact of inflation. The calculation is revisited and adjusted as conditions warrant. Using a rolling three-year average avoids sharp fluctuations in the amount paid to shareholders. The charts in the attached supplement illustrate the impact of this approach. Chart I shows the difference between average and point-in-time net assets. Chart II shows that, despite the volatility of the market, the payment method provides a steady yield. Chart III shows that the dividend yield remains very steady, despite changes in the Spending Rate, as the yield is also a function of the net asset values.

1. Endowments with assets between $50 million and $250 million.

2. The numbers for expected return and inflation were obtained from Evaluation Associates and reflect their five-year planning cycle. The number for administration expense is based on the Fund’s historical experience.