January 2012

Dear Fellow Shareholder,

Stock markets around the world struggled in 2011 as investors worried about debt levels in Europe, the U.S. and Japan, and also the possibility of a sharp slowing of China's growth in the face of declining property prices. The U.S. stock market was one of the world's best performing markets for the year. That this was true with price levels that were literally flat for the S&P 500 (the year's 2% return came all from dividends) says much about how tough a year it was for global stock investors. Outside the U.S. stock prices were sharply lower. The MSCI EAFE Index (developed countries) lost 12.1% in 2011 while the MSCI Emerging Market Index delivered even worse performance, losing 18%, trailing even the European stock index. During 2011, three Litman Gregory Masters equity funds generated positive returns and beat their benchmarks, while two trailed their benchmarks. Four of the five have out-returned their benchmarks by sizable margins over the past three years. (The fifth fund trailed its primary benchmark but outperformed two secondary benchmarks.) At the beginning of the fourth quarter Litman Gregory Masters launched its first non-equity fund, Litman Gregory Masters Alternative Strategies Fund. The fund returned 3.4% during its first quarter of operation and attracted significant investor interest, ending that period with over $150 million in assets.

Performance quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the funds may be lower or higher than the performance quoted. To obtain the performance of the funds as of the most recently completed calendar month, please click www.mastersfunds.com. The funds impose a 2.00% redemption fee on shares held less than 180 days. Performance does not reflect the redemption fee. If reflected, performance would be lower.

Clearly 2011 was a difficult year for equity investors to make money as they continued to worry about macro level risks. This worry was reflected in returns and also in other ways including:

• During 2011, volatility was extremely high—the third highest since the 1930s according to Ned Davis Research, Inc. There were 12 market corrections of at least 5% during the year.
• Another development that was likely related to the same macro concerns was the very high level of correlations among asset classes and among individual stocks within the stock market. At the asset class level, “risk assets” (stocks and “risky” fixed income like high-yield bonds and emerging-markets bonds) tended to share the same pattern during 2011 of selling off and rebounding based on investors’ shifting pessimism and optimism. And within the stock market, correlations reached the highest level in 35 years (as far back as our data goes), suggesting there was a similar dynamic going on.
• A third indicator of perceived risk during 2011 was sector performance. Even though correlations were high between S&P 500 stocks and the overall stock market, there was still wide dispersion of performance between the various stock market sectors. The sector story was that defensive sectors performed quite well with utilities, consumer staples and health care all delivering double digit returns. No other sector returned more than 4.4%. The financial sector (which comprises 16% of the S&P 500 index), lost 18% of its value.

Uncertain Outlook

High perceived risk is generally not good for equity market returns until investors get to a level of maximum pessimism. At that point investors have done their selling so that there is little selling pressure left and lots of potential buyers. Whether investor pessimism could get worse in the near term will likely depend on how macro issues play out including the European sovereign debt and banking crisis. Another challenge relates to the high correlations mentioned earlier, which make it more difficult for stock pickers to add value. 2010 was a particularly difficult year for stock pickers to beat their benchmarks. For example, based on Morningstar data, among large-cap blend funds, the Vanguard Index 500 had its highest performance ranking in 13 years, beating 81% of the actively managed funds. (The fund tracks the S&P 500 Index.) This compares to 2009 when the fund ranked in the bottom half of the category. These two issues, risk avoidance and high correlations, may be related as rising macro risk perceptions can impact the perceived riskiness of almost all stocks—making macroeconomics a potentially bigger temporary driver of stock prices than company-level fundamentals. This all leaves us very uncertain over the near-term outlook and underscores the need for stock market investors to have a truly long-term time horizon. In our view there are multiple scenarios, with varying probabilities, that could play out.

In the worst case, we believe stocks could experience an extended period of poor average returns. This could occur in a range bound market where some good years are offset by poor years resulting in little progress or even backsliding over a longer time period such as five years. Or it could be driven by a sizable bear market followed by very strong returns. In the best case scenario we believe that annualized double digit returns could be captured by stock investors over five years. (There are many other possible, and in our view, more likely, scenarios in between the extremes.)

Given that powerful macro forces that are in play, and the potential impact of government policies that may or may not happen, no investor should be confident that they can accurately predict how the next few years will play out. For this reason we believe owners of stocks are wise to think long term. We are much more confident in our belief that investors who can allocate a portion of their portfolio to stocks for a period closer to 10 years or longer will be adequately rewarded. We believe this because over that time period, based on our analysis, there is a good chance that we will have made enough progress in reducing debt in the global economy to remove that headwind and related risks to economic growth. Secondly, we believe there are plenty of individual companies that are attractively priced, often because of temporary factors or general macro pessimism, that will be able to thrive in coming years and over an extended time period. If that is the case we believe they are likely to deliver satisfying returns given an investment time horizon that is long enough to allow their fundamentals to drive their stocks’ return. As a general example of the opportunity in individual stocks, Southeastern Asset Management’s Mason Hawkins, a sub-advisor on the Equity and Value funds, points out that the stocks he owns for Masters are priced at an average discount of more than 40% of Southeastern’s estimate of their value. And, on average, the portfolio’s yield on free cash flow is over 10%. Understanding the thinking behind many of the individual stock holdings also helps support the view that there is opportunity at a stock-picking level. A number of stock stories will be included in our annual report. In addition, here are three:

One example of this is Segro PLC, purchased by Amit Wadhwaney of Third Avenue Management LLC for the International fund. Segro is a real estate investment trust which owns industrial properties primarily in the U.K. This opportunity is an example of how economic uncertainty can create opportunities to buy quality companies at a discounted price. In this case, Wadhwaney purchased Segro’s stock at a discount in excess of 30% to his estimate of its net asset value (“NAV”). The company’s U.K. properties are mostly located in the highly desirable and space-constrained Southeastern part of the country. In 2009, Segro acquired Brixton PLC near the bottom of the market cycle when the vacancy rate on Brixton’s portfolio of properties was around 25%. Since then the company has created a market-leading position in many of the key industrial areas in and around London and they’ve made significant progress in bringing vacancy rates down to low double-digit percent levels. Despite these positive developments, the company’s stock price declined sharply in recent months as investors worried about how a slowing economy would impact Segro’s tenants. Wadhwaney saw this as an opportune time to buy a company with attractive assets and an able management team that can realize the value of those assets by maximizing cash flow and/or selling a portion of its portfolio to a strategic or a financial buyer. Moreover, the company is pursuing development in areas with attractive growth prospects. Segro also meets Wadhwaney’s “safe” criteria: it has a strong financial position with about a 50% loan to value, a 2.2 times fixed-charge coverage ratio and a very long-dated maturity schedule on its property loans with an average of about 10 years remaining. Finally, the stock has a 6.5% dividend yield so he is getting paid to wait for the stock price to move closer to his assessment of the NAV.

Another notable example is QR National, an Australian Freight Company also purchased for the International fund by Jim Gendelman of Marsico Capital Management. Given high macro risks, Gendelman has a portion of his portfolio invested in companies that he views as offering stable growth at reasonable prices that are also undergoing positive fundamental change. He believes companies with these traits may experience relatively less downside if volatility continues or worsens. QR National is geographically well positioned to benefit from China's growth. It was previously owned by the Queensland government and went public in 2010. Its management has embarked on a restructuring plan that Gendelman believes will result in lower operating costs, improved service and the ability to raise prices over three to five years. According to Gendelman, the combined effect of lower operating costs and faster price increases should allow QR to grow earnings at an annual rate of 30% over the next several years. (Gendelman has seen a similar restructuring story unfold successfully with Canadian National Railway.) However, many investors, especially those based in the Pacific basin, do not recognize the impact such a restructuring can have on the earnings of a normally slow-growing railroad company. As a result, Gendelman is paying only 10x his estimate of 2014 calendar earnings. In addition to the stock trading at attractive valuations, Gendelman believes management will return about 10% of the company's market capitalization through dividend payouts and/or share buybacks in the next few years. Finally, QR's railroad-related hard assets provide some downside protection in adverse market conditions. Gendelman says he would own this stock in any environment and that it is especially attractive given his current cautious view on the markets. One key risk to Gendelman's thesis on QR is that China or Asian demand for commodities declines materially.

A third interesting opportunity, Newfield Exploration, was recently added to the Value fund by Bill Nygren of Harris Associates LP. Newfield is an oil and natural gas exploration and production company. Nygren believes management can grow the value of the business by about 10% per year, given his expectations of the company’s free cash flow and its capital investment opportunities. He has been particularly impressed with management’s capital allocation skill, which is driven by a disciplined return focus on each individual project they consider. In addition, analyst John Raitt tells us that while most investors tend to focus only on the company’s free cash flow or earnings, Nygren and Raitt also ascribe value to the company’s non-producing acreage. Importantly, Nygren notes that they are particularly conservative in their long-term estimate of oil prices, so if long-term oil prices remain higher than $60, their estimate of business value will  increase dramatically. The addition of Newfield to the portfolio, which was purchased at an average price that reflected a greater than 40% discount to Nygren’s assessment of its value, allowed him to lower the average price-to-value of his sleeve of the Value fund portfolio, while diversifying into a sector where there was previously little exposure. The purchase is also an example of the potential “time-value arbitrage” that long-term investors can sometimes benefit from. The stock price dropped from over $70 in the summer to under $40 by the end of the year largely because Newfield failed to meet its production targets, and also because of falling gas prices. But Nygren believes the impact will be a short-term issue since it is primarily driven by a shift in production focus to lower cost/ higher return fields (including a gradual heavier focus on oil). Because the issue is temporary he does not believe it will impact the long-term value of the business. The sell off triggered by more short-term oriented investors made Newfield the cheapest company on the Harris buy list and offered what appears to be a great opportunity for patient investors willing to wait for short-term concerns to pass.

Risk Management in a Risky World

Because there is always short-term risk in the stock market, few investors allocate their entire portfolio to stocks. Based on Federal Reserve Board data, households’ recent allocation to stocks of 31% was near its 60-year average. Where is the rest invested? Bonds and cash made up over 40% of the rest. However, while investor capital continues to flow into the bond market, many investors are increasingly nervous and/or unhappy with traditional defensive assets because of very low yields. Cash yields almost nothing, and very high quality bonds also offer low yields. U.S. Treasuries, typically viewed as a very low-risk asset are paying nearly record low yields. As of the end of 2011, the 10-year Treasury yielded 1.87%. At this yield this asset hardly seems low risk to us. The risk over 10 years is that investors do not keep up with inflation. If they sell earlier, the risk is that the price of the security is less than what they paid as a result of rising interest rates. For the investment-grade market in general, based on the widely followed Barclays Aggregate Index, the yield, as of 12/31/2011, is only slightly higher at 2.2%.

Because of currently low bond yields, which, based on simple math, should produce low single-digit returns for bond investors over longer time periods (say five years), many investors are searching for investments that have the potential to deliver better returns with substantially lower short-term risk than the stock market. Our launch of the Litman Gregory Masters Alternative Strategies Fund on September 30, 2011 was partly driven by this dynamic. The fund is sub-advised by four well-known and respected managers who have run public and private funds. Each is heavily focused on risk management using an opportunistic approach within their investment universe. Each strategy is different so that the overall fund is diversified. The fund’s first quarter was successful with a return of 3.4%, low volatility and strong demand which took assets over $150 million, a critical mass that will allow us to efficiently manage the fund’s operating expenses.

Meeting Challenges

The 2000s have been difficult for investors. The Litman Gregory Masters funds have had their ups and downs during this period. The clearest success has been Litman Gregory Masters International, which ranks in the top decile of its Morningstar Foreign Large Blend peer group over the last 10 years. (As of December 31 2011, Morningstar, Inc. ranked the fund in the top 82nd, 19th, 18th, and 10th percentiles among 817, 737, 563, and 317 Foreign Large Blend Funds over the trailing one-, three-, five, and ten-year periods, respectively, based on total return. ) Our domestic equity funds struggled for several years just preceding and during the time of the financial crisis but have rebounded on a relative and absolute performance basis over the last three years as the sub-advisor changes we made around that time have added value and the funds have materially outperformed their benchmarks. We expect continued challenges for stock market investors but believe that there is opportunity for patient investors at the individual stock level. That opportunity may or may not result in strong returns over short time periods, including one-year periods, but over sufficiently long time periods we believe that our management group can deliver. And we are excited to be building a record for our Alternative Strategies fund in a more conservative fund category where we believe there is a strong investor need for skillfully and prudently managed funds.

As always, we and the independent trustees continue to express our belief in the Litman Gregory Masters funds through sizable personal and 401k investments. As of the end of 2011, Litman Gregory partners, employees and the fund group's trustees own $15.8 million in Litman Gregory Masters fund shares.

Sincerely,
Ken Gregory and Jeremy DeGroot
Litman Gregory Fund Advisors, LLC
Advisor to the Litman Gregory Masters Funds

¹ - The Vanguard 500 Index Fund is a passively managed fund that seeks to track the performance of a benchmark that measures the returns of 500 of the largest U.S. companies, which span many different industries and account for about three-fourths of the U.S. stock market's value. The fund's annual expense ratio is 0.17% Portfolio turnover during the fund's most recently ended fiscal year was 4.3%. Investors in the fund are subject to Index Sampling Risk, which is the chance that securities selected for the fund in, the aggregate, will not provide investment performance matching that of the Index. As of 12/31/2011, the fund's 1-, 3-, 5-, and 10-year average annual total returns were 1.97%, 14.01%, -0.33%, and 2.82%, respectively. The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so that investors' shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited.
² - Earnings growth is not a measure of the fund's future performance
³ - Morningstar, Inc., is an independent mutual fund research and rating service. Each Morningstar category represents a universe of funds with similar investment objectives. Morningstar Rankings represent the fund's total-return percentile rank relative to all funds that have the same Morningstar Category. The highest percentile rank is 1 and the lowest is 100. It is based on Morningstar total return, which includes both income and capital gains or losses and is not adjusted for sales charges or redemption fees.

©2012 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

Performance discussions for the Equity Fund, the International Fund, and the Alternative Strategies Fund are specifically related to the Institutional share class.

Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.

Litman Gregory Fund Advisors, LLC has ultimate responsibility for the performance of the Litman Gregory Masters Funds due to its responsibility to oversee the funds' investment managers and recommend their hiring, termination, and replacement.

Mutual fund investing involves risk; loss of principal is possible.

Each of the funds may invest in foreign securities. Investing in foreign securities exposes investors to economic, political, and market risks and fluctuations in foreign currencies. The Litman Gregory Masters International Fund will invest in emerging-market countries, which involve additional risks such as government dependence on a few industries or resources, government-imposed taxes on foreign investment, or limits on the removal of capital from a country, unstable government, and volatile markets. Each of the funds may invest in the securities of small companies. Small-company investing subjects investors to additional risks, including security price volatility and less liquidity than investing in larger companies. Litman Gregory Masters Focused Opportunities Fund and Litman Gregory Masters Value Fund are non-diversified funds, which means that they may concentrate more assets in fewer individual holdings than diversified funds. Though primarily equity funds, they may invest a portion of their assets in securities of distressed companies. Debt obligations of distressed companies typically are unrated, lower rated, in default, or close to default and may become worthless. Investments in debt securities typically decrease when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in mortgage-backed securities include additional risks that investor should be aware of including credit risk, prepayment risk, possible illiquidity, and default, as well as increased susceptibility to adverse economic developments. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management, and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The fund may make short sales of securities, which involves the risk that losses may exceed the original amount invested. Merger arbitrage investments risk loss if a proposed reorganization in which the fund invests is renegotiated or terminated.

Some of the comments are based on current management expectation and are considered "forward-looking statements". Actual future results, however, may prove to be different from our expectations. You can identify forward-looking statement by words such as "estimate", "may", "expect", "should", "could", "believe", "plan", and similar terms. We cannot promise future returns and our opinions are a reflection of our best judgment at the time this report is compiled.

Opinions expressed are subject to change, are not guaranteed, and should not be considered recommendations to buy or sell any security.

The views herein are those of Litman Gregory Fund Advisors, LLC at the time the material is written and may not be reflective of current conditions.

Fund holdings and/or sector allocations are subject to change at any time and are not recommendations to buy or sell any security.

To view the Equity Fund’s most recent holdings, please click HERE
To view the International Fund’s most recent holdings, please click HERE
To view the Value Fund’s most recent holdings, please click HERE
To view the Smaller Companies Fund’s most recent holdings, please click HERE
To view the Focused Opportunities Fund’s most recent holdings, please click HERE

Diversification does not assure a profit or protect against a loss in a declining market.

References to other mutual funds should not be interpreted as an offer of these securities.

Leverage may cause the effect of an increase or decrease in the value of the portfolio securities to be magnified and the fund to be more volatile than if leverage was not used.

Investment in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies.

Please click HERE for index definitions. For industry terms and definitions, click HERE.

The Litman Gregory Masters Funds are distributed by Quasar Distributors, LLC.