Finding a True Alternative to Fulfill Its Role in a Traditional Portfolio, an Alternative Investment Must Improve the Reward for Risk

The magazine of investing insights for independent-minded advisors June/July 2013 Morningstar Advisor June/July 2 0 1 3 Alternative Investing Aging Population Managed Volatility

MorningstarAdvisor.com Finding a True Alternative To fulfill its role in a traditional portfolio, an alternative investment must improve the reward for risk. TAKE A NEW LINE WITH YOUR Sector SPDR ETFs – Top Ten Holdings In Each Sector* EQUITY XLY - Consumer Discretionary XLP - Consumer Staples XLE - Energy

Company Name Symbol Weight Company Name Symbol Weight Company Name Symbol Weight 1 Walt Disney DIS 6.78% 1 Procter & Gamble PG 13.24% 1 Exxon Mobil XOM 17.15% Potential benefi ts of adding Sector SPDR ETFs to your portfolio include: 2 Home Depot HD 6.55% 2 Coca-Cola KO 10.24% 2 Chevron CVX 15.43% 3 Comcast CMCSA 6.51% 3 Philip Morris Int’l PM 9.94% 3 Schlumberger SLB 6.57% • Undiluted exposure to a specifi c sector of the S&P 500 4 McDonald’s MCD 6.12% 4 Wal-Mart Stores WMT 8.21% 4 Occidental Petroleum OXY 4.00% • The all-day tradability of stocks 5 Amazon.com AMZN 5.51% 5 CVS Caremark CVS 4.65% 5 ConocoPhillips COP 3.48% 6 News Corp NWSA 3.70% 6 PepsiCo PEP 4.60% 6 Anadarko Petroleum APC 3.15% • The diversifi cation of mutual funds 7 Time Warner TWX 3.34% 7 Altria Group MO 4.19% 7 Halliburton HAL 3.04% • Total transparency 8 Ford Motor F 3.21% 8 Colgate-Palmolive CL 3.43% 8 EOG Resources EOG 2.56% 9 NIKE Inc B NKE 2.76% 9 Mondelez International MDLZ 3.33% 9 Phillips 66 PSX 2.41% • Liquidity 10 Target TGT 2.74% 10 Costco Wholesale COST 3.11% 10 Pioneer Natural Resources PXD 2.34%

XLF - Financial XLV - Health Care XLI - Industrial

Company Name Symbol Weight Company Name Symbol Weight Company Name Symbol Weight 1 Berkshire Hathaway B BRK.b 8.48% 1 Johnson & Johnson JNJ 13.20% 1 General Electric GE 11.78% 2 JP Morgan Chase JPM 8.20% 2 Pﬁ zer PFE 11.57% 2 United Technologies UTX 5.49% 3 Wells Fargo WFC 8.14% 3 Merck MRK 7.87% 3 Union Paciﬁ c UNP 5.19% 4 Citigroup C 6.20% 4 Amgen AMGN 4.32% 4 3M MMM 4.68% 5 Bank of America BAC 5.82% 5 Gilead Sciences GILD 4.27% 5 Boeing BA 4.46% 6 American Express AXP 2.87% 6 AbbVie ABBV 4.03% 6 United Parcel Service B UPS 4.29% 7 Goldman Sachs GS 2.79% 7 Bristol-Myers Squibb BMY 3.62% 7 Honeywell Intl HON 4.17% 8 US Bancorp USB 2.71% 8 Unitedhealth Group UNH 3.43% 8 Caterpillar CAT 4.06% 9 American Intl Group AIG 2.67% 9 Lilly Eli LLY 3.06% 9 Emerson Electric EMR 2.91% 10 Simon Property Group SPG 2.44% 10 Biogen Idec BIIB 2.93% 10 Danaher DHR 2.72%

XLB - Materials XLK - Technology XLU - Utilities Time For A Company Name Symbol Weight Company Name Symbol Weight Company Name Symbol Weight Stock Alternative 1 Monsanto MON 11.81% 1 Apple AAPL 13.87% 1 Duke Energy DUK 9.44% 2 E. I. du Pont de Nemours DD 10.51% 2 Microsoft MSFT 8.32% 2 Southern SO 8.10% 3 Dow Chemical DOW 8.43% 3 Google Inc GOOG 7.35% 3 Dominion Resources D 6.87% 4 Praxair PX 6.99% 4 Intl Business Machines IBM 7.08% 4 NextEra Energy NEE 6.72% 5 Freeport McMoRan Copper & Gold FCX 5.96% 5 AT&T T 6.86% 5 Exelon EXC 6.20% 6 LyondellBasell Industries LYB 4.76% 6 Verizon Communications VZ 5.17% 6 American Electric Power AEP 4.85% 7 Ecolab ECL 4.64% 7 Oracle ORCL 4.06% 7 PG&E PCG 4.13% 8 PPG Industries PPG 4.40% 8 Cisco Systems CSCO 3.72% 8 PPL PPL 3.77% 9 Intl Paper IP 4.36% 9 QUALCOMM QCOM 3.55% 9 FirstEnergy FE 3.76% Visit www.sectorspdrs.com 10 Air Products & Chemicals APD 3.78% 10 Intel INTC 3.37% 10 Sempra Energy SRE 3.64%

or call 1-866-SECTOR-ETF * Components and weightings as of 4/30/13. Please see website for daily updates. Holdings subject to change.

An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, which brokerage commissions apply. ETFs are considered transparent because their portfolio holdings are disclosed daily. Liquidity is characterized by a high level contains this and other information, call 1-866-SECTOR-ETF or visit www.sectorspdrs.com. Read the prospectus carefully before investing. of trading activity. The S&P 500, SPDRs, and Select Sector SPDRs are trademarks of The McGraw-Hill Companies, Inc. and have been licensed for use. The stocks included Select Sector SPDRs are subject to risks similar to those of stocks, including those regarding short-selling and margin account maintenance. All ETFs are in each Select Sector Index were selected by the compilation agent. Their composition and weighting can be expected to differ to that in any similar indexes subject to risk, including possible loss of principal. Funds focusing on a single sector generally experience greater volatility. Diversifi cation does not eliminate that are published by S&P. The S&P 500 Index is an unmanaged index of 500 common stocks that is generally considered representative of the U.S. stock the risk of experiencing investment losses. market. The index is heavily weighted toward stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. Investors cannot invest directly in an index. The S&P 500 Index fi gures do not refl ect any fees, expenses or taxes. Ordinary ALPS Distributors, Inc. a registered broker-dealer, is distributor for the Select Sector SPDR Trust. TAKE A NEW LINE WITH YOUR Sector SPDR ETFs – Top Ten Holdings In Each Sector* EQUITY XLY - Consumer Discretionary XLP - Consumer Staples XLE - Energy

XLF - Financial XLV - Health Care XLI - Industrial

An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, which brokerage commissions apply. ETFs are considered transparent because their portfolio holdings are disclosed daily. Liquidity is characterized by a high level contains this and other information, call 1-866-SECTOR-ETF or visit www.sectorspdrs.com. Read the prospectus carefully before investing. of trading activity. The S&P 500, SPDRs, and Select Sector SPDRs are trademarks of The McGraw-Hill Companies, Inc. and have been licensed for use. The stocks included Select Sector SPDRs are subject to risks similar to those of stocks, including those regarding short-selling and margin account maintenance. All ETFs are in each Select Sector Index were selected by the compilation agent. Their composition and weighting can be expected to differ to that in any similar indexes subject to risk, including possible loss of principal. Funds focusing on a single sector generally experience greater volatility. Diversifi cation does not eliminate that are published by S&P. The S&P 500 Index is an unmanaged index of 500 common stocks that is generally considered representative of the U.S. stock the risk of experiencing investment losses. market. The index is heavily weighted toward stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. Investors cannot invest directly in an index. The S&P 500 Index fi gures do not refl ect any fees, expenses or taxes. Ordinary ALPS Distributors, Inc. a registered broker-dealer, is distributor for the Select Sector SPDR Trust. As one of the groundbreaking ETFs in the marketplace, PowerShares QQQ invests in 100 of the world’s most revolutionary companies. Each is listed on the Nasdaq Stock Market® and includes household names such as Oracle, Starbucks, Microsoft, Intel, Cisco Systems, and Google. With all of these revolutionary companies in one fund, innovative investing is within your reach.

PowerShares QQQ is based on the Nasdaq-100 Index ®. The Fund Shares are not individually redeemable and owners of the shares will, under most circumstances, consist of all stocks in the Index. may acquire those shares from the Funds and tender those The Index includes 100 of the largest domestic and international shares for redemption to the funds in Creation Unit aggregations nonfinancial companies listed on the Nasdaq Stock Market based on only, typically consisting of 50,000 shares. market capitalization. PowerShares® is a registered trademark of Invesco PowerShares Capital There are risks involved with investing in Exchange-Traded Funds Management LLC. ALPS Distributors, Inc. is the distributor for QQQ. (ETFs) including possible loss of money. The funds are not actively Invesco PowerShares Capital Management LLC is not affiliated with managed and are subject to risks similar to stocks, including those ALPS Distributors, Inc. related to short selling and margin maintenance. Ordinary brokerage An investor should consider the Fund’s Investment objective, commissions apply. Shares are not FDIC insured, may lose value and risks, charges and expenses carefully before investing. To obtain have no bank guarantee. a prospectus, which contains this and other information about Holding Weights as of 4/11/13: Microsoft 7.6%, Google 6.4%, Oracle the QQQ, a unit investment trust, please contact your broker, 4.8%, Cisco Systems 3.4%, Intel 3.3%, Starbucks 1.3%. Holdings are subject to change. call 800.983.0903 or visit www.invescopowershares.com. Please read the prospectus carefully before investing. powershares.com/innovation | @PowerShares June/July 2013

Features

Spotlight: Alternative Investing Morningstar Conversation Undiscovered Manager

49 The World 58 Waiting to Pull Alternative Designs Is Getting Grayer Up Anchor Investors need to understand what drives Globally, almost all Small caps have reached the populations are getting older. top of their cycle, manager returns to know which alternative investments Europe’s sovereign debt Eric Cinnamond says. create a truly diversified portfolio. crisis provides a glimpse He’s hoarding cash for when of the economic troubles this the market turns. aging will cause, economist 36 Beware the Lure of Diversification Edward Hugh says. To truly diversify a traditional portfolio, alternative investments need to be cheap and behave differently than stocks and bonds.

40 Using Alternatives in Practice Advisors and clients need to understand what they’re buying and the role a strategy has in a portfolio.

45 Managed Futures and Cash Rates Before attempting to cash in on managed-futures funds, understand how these funds use cash.

3 MorningstarAdvisor June/July 2013

Departments

6 Contributors Know-How Sector Rap Screen

7 Letter From the Editor 14 How to Put Buffett’s 30 Defense Firms Will 69 Let’s Get Back Investing Philosophy Stay Aloft to Basics Behavior Gap into Practice Industry faces short-term challenges, but discipline and By the Numbers 8 Not Your Values 10 Questions strong balance sheets will 72 Our Favorite Mutual On Topic get them through. 16 Sophisticated Funds Strategies Gray Matters 10 How Do You 76 50 Most-Popular Use Alternatives for the Masses 63 The Price of Managing Equity ETFs for Clients? Volatility 18 Investments á la Carte 78 Undervalued Stocks Do riders with volatility Advisor Profile With Wide Moats 21 Investment Briefs controls cost VA investors 12 Working to Build potential gains? Phillips Curve a Niche In Practice Carol Berger sees a need 80 Mutual Fund 24 The Percentile Trap to serve same-sex couples. Urban Myths When researching fund managers, put relative performance measures in their proper context.

4 What’s your plan to avoid market bubbles?

Consider the PowerShares FTSE RAFI US 1000 Portfolio (PRF). Based on the Fundamental Index methodology, PRF uses evaluation criteria (cash ﬂ ow, book value, sales and dividends) that are independent of market speculation. To see how our Fundamental Index ETFs stack up against traditional benchmarks, visit PowerShares.com/RAFI.

PRF Ignore market Weight by Expect more FTSE RAFI speculation fundamentals from your beta US 1000

// Beta is a measure of relative risk and the slope impacted by market volatility, than more and Invesco Distributors, Inc. are indirect, wholly of regression. diversiﬁ ed investments. owned subsidiaries of Invesco Ltd. // There are risks involved with investing in ETFs, // Shares are not FDIC insured, may lose value // An investor should consider the Funds’ including possible loss of money. Shares are and have no bank guarantee. investment objectives, risks, charges and not actively managed and are subject to risks // Shares are not individually redeemable and owners expenses carefully before investing. For including those regarding short selling and margin of the shares may acquire those shares from the Fund this and more complete information about maintenance requirements. Ordinary brokerage and tender those shares for redemption to the Fund in the Funds call 800 983 0903 or visit commissions apply. Creation Unit aggregations only, typically consisting of invescopowershares.com for a // Investing in securities of small and medium- 50,000 shares. prospectus. Please read the sized companies may involve greater risk than prospectus carefully // Invesco Distributors, Inc. is the distributor of the before investing. is customarily associated with investing in large PowerShares Exchange-Traded Fund Trust II. companies. // PowerShares® is a registered trademark of // Investments focused in a particular industry Invesco PowerShares Capital Management LLC. are subject to greater risk, and are more greatly Invesco PowerShares Capital Management LLC www.powershares.com 800 983 0903 @powershares Contributors MorningstarAdvisor

Michael Coop Editor-in-Chief Jerry Kerns Editor-at-Large Don Phillips As head of alternative investments for Ibbotson Associates Australia, Contributing Editors Dan Culloton, Haywood Kelly Michael Coop sees a lot of investors make mistakes when Contributors Basili Alukos, Michael Brennan, Greg Carlson, Matthew Coffina, Michael Coop, Rajneesh Motay, Steven Pikelny, choosing which alternatives to add to their portfolios. “Alternative Jeffrey Ptak, Carl Richards, Kate Stalter, Terry Tian, investments are still a great way to get diversification,” he says, Francisco Torralba, Dan Werner, Abby Woodham, John Zecy “but investors have struggled to distinguish between good Data Editors Mnason Chew, Alina Tarlea Proofreaders Ann Marie Gray, Courey Gruszauskas diversifiers versus funds with high fees that behave like equities or government bonds.” Coop discusses how investors can find Art Director Alexander Skoirchet true alternatives in this issue’s Spotlight section, “Beware the Lure Illustrator Lloyd Miller Photographer Stan Kaady of Diversification,” Page 36.

Publisher Leslie Marshall Director of Advertising Sales Mary Uribe Regional Sales Directors Dan Atkinson, Tony Lignelli, Kristina Niemi, Stuart Roge

Morningstar, Inc. Chairman and CEO Joe Mansueto Rajneesh Motay Managing Director, Design David Williams Director, Corporate Marketing Kristin Mateja After the market crash of 2008, the investment industry scrambled to develop products that would offer investors a smoother ride. How to Reach Morningstar Advisor Subscriber Services and Circulation One example is variable annuities with built-in volatility manage- [email protected] ment. In “The Price of Managing Volatility,” Page 63, Rajneesh Editorial and Letters to the Editor [email protected] Motay, an investment consultant with the Morningstar Investment Advertising [email protected] Rate card available at Management division, takes a close look at these riders to determine www.global.morningstar.com/mediakit2013 whether they are good deals for investors. Reprints and Licensing [email protected]

How to Reach Morningstar Customer Service +1 312 384-4000 Advisor Product Sales +1 877 586-5405 Data Questions +1 312 696-6600

Morningstar Advisor is published bimonthly by Morningstar, Inc., 22 W. Washington St., Chicago, IL 60602. An annual subscription for delivery in the U.S. is $60. All exhibit data in this magazine is provided by Morningstar and Ibbotson Associates unless otherwise noted. Lloyd Miller © 2013 Morningstar. All Rights Reserved. The information contained herein: (1) is intended solely Lloyd Miller collects the objects and tools that often appear for informational purposes; (2) is proprietary to Morningstar and/or its content providers; (3) may not be copied or distributed; (4) is not warranted to be accurate, complete, or timely; and in his illustrations. He finds that they help him convey the ideas he’s (5) does not constitute investment advice of any kind. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past trying to communicate. “I find that their efficiency and purpose, performance is no guarantee of future results. “Morningstar” and the Morningstar logo are registered marks of Morningstar, Inc. combined with their clarity of form, make them particularly Disclosure: Morningstar licenses its indexes to certain providers, including BlackRock Institutional applicable to the investing subjects in this issue,” he says. This Trust Company, N.A., First Trust, and Deutsche Bank, for use in exchange-traded funds and exchange-traded notes. These ETFs and ETNs are not sponsored, endorsed, issued, or sold by issue is the third time we’ve worked with Miller. He illustrated our Morningstar. Morningstar does not make any representation regarding the advisability of debut issue, which focused on hedge funds in spring 2007, investing in ETFs and ETNs that are based on Morningstar indexes.

and the August/September 2012 issue on municipal bonds. His work

has also appeared in The New York Times, The Wall Street Journal, 1483181 and the Harvard Business Review.

6 Morningstar Advisor June/July 2013 Letter From the Editor

Diversify Me

Many investors are buying into the alternatives I interviewed the members of one panel, which story—that in today’s market they need more will be moderated by Nadia Papagiannis, than traditional stocks and bonds in their Morningstar’s director of alternative funds portfolios to guard against downside risk—but research, to get an inside view of this are they receiving the diversification benefits burgeoning segment of the industry. Bradley they think they’re getting? Alford, Richard Raby, and Richard Bregman Jerry Kerns have many decades of experience researching Morningstar’s Michael Coop thinks investors alternative investments and managers often are not. In his Spotlight article, “Beware for clients, and they share their vast experience the Lure of Diversification,” Page 36, Coop, (“Using Alternatives in Practice,” Page 40). the head of alternative investments with Ibbotson Associates Australia, says that For our 10 Questions feature (“Sophisticated investors often overpay for alternative assets Strategies for the Masses,” Page 16), I also that behave too much like equities and interviewed Henry Davis, a member of the fixed income. Just because an investment is second alternative-investing panel, which also being marketed by the industry as alternative will be moderated by Papagiannis. Davis’

Follow Jerry on Twitter doesn’t mean it will magically diversify a firm, Arden Asset Management, runs hedge @jerrykerns stocks-and-bonds portfolio. Coop focuses on funds of funds, and his firm recently launched a two elements: the drivers of returns and mutual fund that invests in hedge fund valuation. He says that investors first need to strategies. He discusses the convergence take the time to understand the market of the mutual fund and hedge fund worlds and elements and conditions that affect the returns why he believes it will benefit investors. of stock and bonds and then find alternative investments that behave differently. After Many alternative strategies were once only all, the true test of an alternative investment is accessible to the very wealthy. For better whether adding it to a traditional portfolio or worse, these investments are being pack- improves the portfolio’s risk-adjusted returns, aged as open-end mutual funds and exchange- not hurts returns. In his article, Coop runs traded funds. They are more accessible a study to find the types of alternatives that are but not less sophisticated. As advisors, you truly the best diversifiers. But then, Coop have a huge role in guiding clients to the most says, investors need to be mindful of valuation appropriate alternative investments. You and the amount of capital competing for are the link to help clients figure out whether these opportunities. No matter what the drivers they are truly getting the diversification of returns are, large losses are more likely benefits promised by alternatives. I hope the to follow surges in asset prices, creating more articles in this issue help you with this job. If risk for the portfolio. you have any feedback, let me know via Twitter.

Two panels at this year’s Morningstar Investment Conference in June will be devoted to alternative investing and its growth in the advisor and individual-investor markets.

MorningstarAdvisor.com 7 Behavior Gap

Not Your Values

By Carl Richards

I imagine one of the big reasons you’re a financial advisor is that you want to help people make better decisions about their money. Part of that process involves understanding what’s important to clients and helping them clarify their goals.

During that process, it can be a challenge to stay focused on what’s really important to them versus what might be really important to you. The line between our values and their values is an important one to keep clear. When we cross that line, we run the risk of imposing our values on a client’s money, and that’s not our job. Let me give you an example.

I had a conversation with a financial journalist who publicly claimed that being a stay-at-home mom is bad financial planning and that the numbers prove it. I informed her that my wife, who chose to be a stay-at-home mom, had numbers that would disagree. My wife and I ever give anything to charity. Obviously, your However much we may wish otherwise, we have a line item on our mental balance sheet choice is “good,” and your client’s is “bad.” don’t have the right to impose our values on our where we put a high value on her being able to clients’ decisions. We can advise, guide, stay at home with the kids. We understand the Housing: You were raised to see owning a and share strong opinions about what we think “risk” financially, but the rewards outweigh the home as a wise investment and a fundamental is the right approach, but the second we make risk. That is not “bad” planning for us, because part of being a responsible adult. Your client a value judgment is the moment we undermine we understand the trade-offs. Now, this prefers renting and the flexibility to move our role as that all-important, objective example may be dramatic, but the mistake of every few years. You can’t believe he’s passing third party. When it comes to decisions being imposing our values on someone else’s money up the opportunity to earn equity in a home. driven by values, we can’t start describing happens in more subtle ways all the time. them as “good” or “bad.” They simply are what This is where we get into trouble. Remember, they are. You can’t afford to make the mistake Education: You worked your tail off to get there’s nothing wrong with having an opinion, of thinking your values matter more than through a public university. Your client wants to but when it comes to value decisions, we your clients’. K pay for their kids’ Ivy League educations. They need to look at them like any other decision. should have to work for it like you did, right? There will be trade-offs, and it’s your job to Carl Richards, CFP, is director of investor education at help your clients understand those trade-offs. BAM Advisor Services and author of The Behavior Gap: Simple Ways to Stop Doing Dumb Things With Money. Charitable giving: You contribute to a charity But it’s not your job to judge the trade-offs your each year, but you notice that a client doesn’t clients consider acceptable.

8 Morningstar Advisor June/July 2013 P172045_1J01_GOGGLES_MRNGSTR_336.INDD Client: Invesco Bleed: 9” x 11” Region: US Inks Used: Cyan, Magenta, Yellow, Black Campaign: Master Brand “Foresight Goggles” Trim: 8.75” x 10.75” Language: English Fonts: Helvetica Neue LT Std, Invesco Interstate, ITC Century Std Agency Job #: 610-ININVMG3001 Live: 8.25” x 10.25” Notes: Morningstar AD #/AD ID: 336 Links: Goggles_v8_CMYK_cMAG.psd (1074 ppi; CMYK) Studio Job #: 640-171578 Keyline Scale: Actual Size, 100% Date Modified: 5-1-2013 3:07 PM Output at: None CR: , 01.17.13 Page: Morningstar Advisor AD Round: 1

ECD: CD: S. Block / E. Routenberg AD: CW: P: S. Anderson / T. Kakos CSM: D. Barnes PD: Naka B:9” T:8.75” S:8.25” Invesco Distributors, Inc. Distributors, Invesco S:10.25” T:10.75” B:11”

FORESIGHT GOGGLES as compared with

INTENTIONAL INVESTING

To start, Foresight Goggles don’t exist, so strike one there. If they did, you could use them to see where the market is headed, category by category, nicely benefi ting you and your clients. On the other hand, Intentional Investing® as practiced by Invesco does exist. For example: Instead of having a single chief investment offi cer, Invesco prudently deploys multiple experts — each a specialist in their category, each giving you specialized insight on the markets, working together with over 750 investment professionals worldwide. Which also sounds like something that might nicely benefi t you and your clients.

To learn more about our multiple Intentional Investing minds, contact your Invesco representative today. invesco.com/intentional

Invesco • “Goggles” Ad • 4C • Morningstar Advisor • Ad#336 Invesco • Master Brand “Foresight Goggles” • Morningstar Advisor • Ad#336 Pubs: Morningstar On Topic

How Do You Use Alternatives for Clients?

Let us know your thoughts at [email protected]

We use alternative strategies for clients. Alternative investments are currently only We are looking for more-effective diversifica- about 10% to 15% of my clients’ allocation. Quick Poll (given May 2, 330 responses) tion in portfolios because of the increasing I primarily use alternatives correlation of asset classes in downturns. as noncorrelated alpha rather 1 In your typical client’s portfolio, how much is allocated to alternative investments? Fiscal problems in the United than a hedge or to counter equity or fixed- States are not likely to be solved income movements. 10% 51.7% by the political class until a 11% to 15% 24.9% crisis, so protecting clients against black Prakash Subramaniam 16% to 20% 11.2% swan events is critical. Regent Financial Services, part of LPL Financial 20% 12.2% Tulsa, OK

Donald Roy, CFP 2 What is the main role alternatives should play in a portfolio? New England Wealth Advisors We use alternatives in our client portfolios Merrimack, NH for one main reason: to increase Diversification 60.8% their risk-adjusted investment Risk-adjusted return 18.8% How do you define “alternatives”? Is there such performance. Whether we are Absolute return 10.4% a thing as “traditional”? I suspect the question using a long/short manager, global macro, Hedging 10.0% is meant to be simple, but in my view, absent or MLPs, we look first to the degree that these 3 Have you increased or decreased your clients’ a clear definition, the answer is akin to managers correlate with more-traditional allocations to alternative investments since answering the query, “What is art?” I know it assets for a client. We then think about how the 2008 financial crisis? when I see it. I would say that non-traded that manager might behave in the future Increased 67.0% REITs and business development and if we think their alpha-drivers will be Decreased 4.5% corporations are alternatives, and sustainable. With the low yields in high-quality No change 28.5% I use them to diversify my clients’ portfolios. fixed income today (a traditional volatility Perhaps up to 10% of wealth managed for reducer), we continue our allocation of 20% 4 More and more alternative strategies are certain clients finds its way into “alternatives.” to 25% to alternatives to help our clients becoming available in open-end mutual funds. meet their goals without over-allocating them How do you view this development? James Hallett, CFP to equity assets. Positively. My clients should have access 70.3% Hallett Advisors to sophisticated alternative strategies. Port Angeles, WA Jonathan R. Kelley, CFP Negatively. My clients do not need 9.7% Hinds Financial Group sophisticated alternative strategies. Lakewood, CO We are always looking for places to put our No opinion 20.0% clients’ money when we take money out of the stock market. Increasingly, we are nervous 5 What concerns you the most about investing allocating that money to bonds. We look for in alternative investments? low-volatility, absolute-return Complexity 23.9% strategies that are not correlated Transparency 23.3% to the stock or bond markets for a Costs 21.2% risk-off allocation. Performance 19.3% Liquidity 12.3% Anthony Pace, CFP Lindberg & Ripple Windsor, CT

10 Morningstar Advisor June/July 2013 P173829_1E02_MRNGSTR_328.INDD Client: Invesco Bleed: 9” x 11” Region: US Inks Used: Cyan, Magenta, Yellow, Black Campaign: Income Finder Trim: 8.75” x 10.75” Language: English Fonts: Helvetica Neue LT Std, Invesco Interstate, Century Ex- Agency Job #: 610-ININVMG3001 Live: 8.25” x 10.25” Notes: Income Finder AD #/AD ID: 328 panded LT Std Studio Job #: 640-171578 Keyline Scale: Actual Size, 100% Links: Barrons_Income_Selector_QR_040413.ai Date Modified: 5-1-2013 2:38 PM Output at: None OCC black_revd.eps CR: , 01.17.13 Page: Morningstar Advisor IncomeSelectorChart_CMYK_MAG.ai AD Round: 1

ECD: CD: S. Block / E. Routenberg AD: CW: P: S. Anderson / T. Kakos CSM: D. Barnes PD: Naka B:9” T:8.75” S:8.25”

INTENTIONAL INVESTING® in the

AGE OF INCOME

R TO TO D S A E Y V ’S N I M

S A ’ R Y K A

Intentional E

D SM T

O Income Finder T Get Started

T S S:10.25” O T:10.75”

E B:11” MO M R CO ROW’S OUT

We’re living in a time shaped by two powerful and opposing forces: demographics and economics. This means millions of baby boomers are retiring — and seeking income — in a low-growth, low-rate environment. We call this the Age of Income.

That’s why Invesco created the Intentional Income Finder, a new tool designed to help you find the right income for your clients. The Intentional Income Finder will show you a list of income strategies available in a variety of vehicles — mutual funds, ETFs and unit trusts — customized for your clients’ needs.

Because your clients don’t just need income. They need the right income.

To learn how the Intentional Income Finder can help you find the right income for your clients, go to invesco.com/incomefinder.

Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about a fund, ETF or unit trust, investors should contact their advisors for a prospectus and/or summary prospectus or visit invesco.com/fundprospectus. Investments in these strategies are subject to certain risks. There is no guarantee any investment will be successful. Income levels and volatility will vary with market conditions. Investors should consider their own situation and risk tolerance before investing. Invesco Distributors, Inc.

Invesco • “Income Finder” Ad • 4C • Morningstar Advisor • Ad#328 Advisor Profile

Working to Build a Niche

By Kate Stalter Carol Berger sees a need to serve same-sex couples.

For same-sex couples, financial planning American school. She graduated from the Cambridge Southern and joined the firm as an can be more challenging than for their Georgia Institute of Technology with an analyst, gradually working her way up and heterosexual peers. Carol Berger recognizes industrial engineering degree and went to work taking on more responsibility. She passed the this problem and wants to do something for Mobil Oil at a refinery in Texas. At Mobil, CFP exam in 2006 and earned her designation about it. In early 2012, she founded she designed computer systems and served as in 2009, after logging the requisite three years Halcyon Wealth Management in Peachtree a financial analyst. During those years, she had of work experience. City, Ga., with the idea of serving gay and an inkling that she would be drawn to investing. lesbian couples. Staying With DFA “When I was working for Mobil, my first boss Many of the lessons she learned at Cambridge When she opened her firm, she had been did his own investments and followed apply to her practice today. She continues an advisor for six years and a Certified mutual funds, and he taught me a lot about it,” to use funds from Dimensional Fund Advisors. Financial Planner for three. Before founding she says. “That’s how my interest started.” Dimensional, which makes its products Halcyon, Berger was a wealth manager available exclusively to fee-only shops, with Cambridge Southern Financial Advisors, Berger eventually took a buyout to leave Mobil. requires advisors to attend training seminars now known as Cambridge Wealth Counsel, in She moved back to Georgia and opened before being approved to sell the funds. Berger Stockbridge, Ga. There, she honed her planning a Mail Boxes Etc. franchise. That experience took the training while at Cambridge. In skills and served as the firm’s head trader. gave her plenty of first-hand knowledge she keeping with Dimensional’s philosophy, Berger would later use when opening her own is a proponent of the efficient market hypoth- The client base at Cambridge was fairly advisory practice. esis, which maintains that publicly available traditional. She had a full workload, assisting information is built into a stock’s price. the firm’s owner by serving about 85 of the She owned the mailbox business for about five firm’s 130 clients. But Berger realized that if she years before tiring of the retail environment. “So, you don’t gain a whole lot of advantage wanted to expand her practice into the gay She sold the store and saw a newspaper ad for buying and selling,” she says, noting that and lesbian community, she needed to strike CFP courses at Oglethorpe University in Atlanta. she prefers the passive investment approach, out on her own. “It was a good group of “I’d always been a numbers person; I was which minimizes turnover within client clients,” she says. “I learned a lot. But I wanted good at math and science,” she says. “I did a accounts. That also serves to keep client to be able to get more of my own clients, and I little research into financial planning, because I expenses lower than they may be with actively didn’t have the time.” didn’t know much about it, and I thought it managed funds. would be a great way to work with numbers From Mobil to Mail Boxes Etc. and investments, and also help people.” Like many advisors, Berger allocates portfolio Berger took a somewhat circuitous route to the investments according to individual client advisory world. She grew up in the Canal Zone While taking the courses at Oglethorpe, objectives, adjusting the equity-to-fixed-income in Panama, the daughter of a teacher at an she learned about the opportunity with mix on a case-by-case basis. The tent pole of

12 Morningstar Advisor June/July 2013 In a nod toward cost-containment, Berger Carol Berger, CFP, ADPA, Founder and Principal, Halcyon Wealth Management works from a home office.

To boost credibility among potential gay and lesbian clients, she earned the Accredited Domestic Partnership Advisor designation from the College for Financial Planning.

Though she is committed to attracting same-sex couples to her practice, Berger acknowledges that it has not been as easy as she’d hoped. She currently works with a more traditional client base, and she empha- sizes that she does not turn away qualified prospects, regardless of their status. She has about $10 million under management.

Although Berger does financial planning as well as asset management, she won’t take planning- How she caught our eye: Launched own firm to Cambridge Southern Financial Advisors in only clients. build niche serving gay and lesbian community. Stockbridge, Ga., for six years before launching Halcyon Wealth Management in 2012. Career path: Earned bachelor’s degree with “The investments are such an ongoing, high honors in industrial and systems engineering Personal: Partner of 34 years. Has a 7-year-old important piece that I can’t put together a from Georgia Institute of Technology in 1981. African Grey parrot named Turbo. Raised in the comprehensive plan knowing that clients Worked for Mobil Oil for 14 years designing Canal Zone in Panama. are going to do it themselves or have somebody computer systems and as a financial analyst before else working on that part of it. I wouldn’t opening and operating a Mail Boxes Etc. franchise Favorite Funds: DFA US Core Equity II Fund DFQTX, know whether it’s going to be done the way for five years. Completed the Financial Planning DFA Tax-Advantaged World ex US Core Equity Program at Oglethorpe University in Atlanta. Passed Fund DFTWX. I said it should be,” she says. CFP exam in fall of 2006 and became CFP professional in 2009. Was a wealth manager with She does, however, manage the portfolios of some clients without having done a financial plan. In those cases, she charges a lower percentage of assets under management, because clients are not getting the full her approach is the DFA US Core Equity II Fund it with calm. She settled on Halcyon, a Greek wealth-management package from her firm. DFQTX, which is generally the largest portfolio word that not only suggests peace and tranquil- holding. Another significant holding is the ity, but also richness or prosperity. Though Halcyon is still young and in growth DFA Tax-Advantaged World ex US Core Equity mode, Berger sees plenty of potential Fund DFTWX, the key piece of Berger’s Because Halcyon is so new, much of Berger’s in her goal of working with same-sex couples, international allocation. Other investments effort goes toward marketing and prospecting. which she believes form an underserved niche. diversify clients into small-cap value, She is a member of the local chamber of international small caps, emerging markets, commerce, as well as the Atlanta Gay Chamber. “There have been times in my own life when and other asset classes. She is experimenting with advertising I wasn’t entirely comfortable getting advice, in a local alternative newspaper and plans to so hopefully they will feel more comfortable Building a Client Base increase her social media presence. with me than with someone else,” she says. K When she set out on her own, one of the toughest decisions was what to name her firm. She hasn’t yet relied heavily on referrals, Kate Stalter is an investment advisor with Portfolio LLC. She wanted something that reflected her desire opting to wait until she has a longer track She is also a columnist for RealMoney.com to remove stress from clients’ lives and replace record with her existing clients.

MorningstarAdvisor.com 13 Know-How

How to Put Buffett’s Philosophy into Practice

By Matthew Coffina Lessons from this year’s Berkshire Hathaway meeting.

Year after year, shareholders return to 4 Think like an owner. share. He compares this growth with the Omaha to hear Warren Buffett and returns of the S&P 500; if Berkshire’s Charlie Munger expound on topics large Thinking like an owner changes your whole book value appreciates faster than the S&P 500, and small. Here are some of the perspective on stock investing. If a company Buffett and Munger are earning their keep. has a bad quarter or two because it is If book value doesn’t keep up with the enduring lessons that came up in this making investments for the future, that’s a S&P 500, in Buffett’s words, “our management year’s Berkshire Hathaway meeting. good thing. If there’s no change in a company’s will bring no value to our investors.” fundamental outlook, a decline in the stock price can be a good thing, too; it allows you to 1 It’s OK to pay a fair price for a increase your ownership stake at a better price. 8 In general, however, book company with very strong, growing value is a terrible proxy for competitive advantages. intrinsic value. 5 Stay within your circle Buffett credits Munger with teaching him that of competence. Book value is based on historical cost and occa- “it is far better to buy a wonderful business sionally arbitrary accounting rules. Companies at a fair price than to buy a fair business For investors who have neither the time nor that make wise investments over time will end at a wonderful price.” In my opinion, investors inclination to research individual securities, up with assets worth more than their historical are far more likely to lose money by compro- Buffett and Munger recommend low-cost index cost, but the opposite could just as easily be mising on quality to buy an apparently “cheap” funds. Berkshire’s managers concentrate true of companies that make poor investments. stock than by purchasing a fairly valued on companies in the United States and have no company with a very strong competitive problem passing on stocks whose future position (what Morningstar calls a wide moat). outlook they deem too hard to understand. 9 Macroeconomic forecasts are of little use to investors.

2 Stay sane while others go crazy. 6 Management quality and culture “To ignore what you know because of predic- are essential. tions about something nobody knows is silly.” Buffett said the average investor can expect to see four or five serious market dislocations You want to find companies where outstanding in a lifetime. The challenge is to have the stewardship is part of a deeply ingrained 10 The United States’ past “mental fortitude” to take advantage of them. culture that will live on through future and future is a story of ever- management transitions. increasing prosperity.

3 Investing is about much more Buffett said that he envies a baby being born than just numbers. 7 Management should set today in the United States because, “on a a straightforward performance probability basis, that is the luckiest person Investing involves a large degree of subjective yardstick, and then stick to it. ever born.” Buffett is a perpetual optimist. K judgment. Buffett and Munger don’t buy stocks solely based on financial ratios; they need to Buffett measures performance for Berkshire Matthew Coffina, CFA, is editor of Morningstar understand how the business actually works. Hathaway by using growth in book value per StockInvestor.

14 Morningstar Advisor June/July 2013 PowerShares DB Currency ETFs

UUP US Dollar UDN US Dollar DBV G10 Currency Bullish Bearish Harverst Fund Fund Fund

To download a copy of the prospectus, visit http://pwr.sh/CUp | http://pwr.sh/DBVp The funds are not mutual funds or any other type of Investment Company within the meaning of the Investment CompanyAct of 1940 and are not subject to its regulation. DB Commodity Services LLC, a wholly owned subsidiary of Deutsche Bank AG, is the managing owner of the funds. Certain marketing services may be provided to the funds by Invesco Distributors, Inc. or its affiliate, Invesco PowerShares Capital Management LLC (together, “Invesco”). Invesco will be compensated by Deutsche Bank or its affiliates. ALPS Distributors, Inc. is the distributor of the funds. Invesco, Deutsche Bank and ALPS Distributors, Inc. are not affiliated. Commodity futures contracts generally are volatile and are not suitable for all investors. An investor may lose all or substantially all of an investment in the funds. 10 Questions

Sophisticated Strategies for the Masses

Henry P. Davis Managing Director, Arden Asset Management LLC, a manager of portfolios of hedge funds, and President/CEO of Arden Investment Series Trust. Davis will be speaking at the Morningstar Investment Conference, June 12–14, Chicago. Interviewed May 14.

1 Why invest in alternative investments? 4 What’s the biggest drawback of this trend? 8 What is the biggest investing mistake you made? Alternatives provide differentiated or Some hedge fund strategies do Probably underestimating the “alternative” return streams from traditional not fit in a daily liquidity mutual severity of the liquidity squeeze investments. Alternatives may fund structure owing to the less-liquid that negatively impacted a number of hedge enhance portfolio efficiency and nature of some of their underlying holdings. fund strategies during the global financial diversification, resulting in more crisis in 2008. Yet, in a way, this paved the way attractive portfolio characteristics (e.g., higher 5 Would you be interested in managing for alternative mutual funds, as the demand risk-adjusted returns and lower overall risk). a mutual fund? for hedge fund strategies available in a daily Yes. In fact, we have launched Arden liquidity format increased significantly and 2 What is the biggest misconception investors have Alternative Strategies I ARDNX, a multimanager remains high to this day. about alternatives? mutual fund that invests in hedge fund One significant misconception strategies, and we are launching additional 9 What did you learn from it? investors have about alterna- alternative mutual funds in the near future. In periods of extreme risk tives concerns their riskiness. Arden has 20 years of experience managing aversion, everyone seems One often hears references to hedge fund hedge fund portfolios for pension plans to follow the same playbook managers “making bets,” “gambling,” and so and other institutional investors and believe we of cutting positions/exposures and buying forth, whereas in reality many if not most can use our capabilities to create portfolios T-bills/raising cash. Liquidity is a precious thing managers follow disciplined strategies that are with attractive diversification properties in a in a time of crisis. Less-liquid hedge fund designed to reduce risks associated with daily liquidity format. strategies were vulnerable, but the more-liquid riskier assets. For example, certain hedge-fund strategies fared well. strategies such as Equity Event employ 6 What’s the most important attribute that you look process-driven methodologies with hedges for when selecting a manager? 10 What has influenced you the most as an investor? designed to mitigate risk. Integrity, discipline, and Extreme market events such judgment all tie for most important as stock market crashes 3 Sophisticated alternative strategies are becoming attributes in a manager. A close second would have influenced me the most as an investor. more available to advisors and retail investors through be “seasoning,” meaning a manager In each of the events of 1987 (crash), 1994 (rate mutual funds. Is this development a good thing? who has survived and thrived in the face of shock), 1998 (Russia/Long-Term Capital Yes, I’d say it’s a great thing. It’s all difficulties and challenging market conditions. Management), and 2008 (financial crisis/crash), about leveling the playing field by providing important lessons were learned. Learning individual investors access to strategies 7 What’s the biggest challenge to investing in how to avoid large drawdowns is the key to previously only available to institutions and the today’s climate? compounding high rates of return over very wealthy. It means more choice, more The biggest challenge for investing today is the time. One of the reasons I was attracted to options for building portfolios, thereby “financial repression” that has hedge funds in the first place is their ability to increasing the likelihood of meeting one’s been created by artificially low interest rates mitigate risk in adverse markets. investment objectives in an environment that places savers and particularly fixed-income of lower overall expected returns. I look investors at a disadvantage relative to forward to the day when my kids will be able to borrowers. Fixed-income investors face make diversified hedge fund investments in significant risks in the event interest rates rise their 401(k) plans. from current historically low levels.

16 Morningstar Advisor June/July 2013 A Directional Long/Short Mutual Fund with a 9 year track record. ★★★★ Wasatch Long/Short Fund™ (FMLSX) (Inception 8/1/2003) Among 99 Long/Short funds. Morningstar Overall Rating™ as of 03/31/13. Morningstar Ratings measure risk-adjusted returns. The Morningstar Overall Rating is the weighted average based on the fund’s 3, 5, and 10 year rating.

• Long stock positions in large & mid cap value stocks • Short stock positions in companies believed to be overvalued • Seeking lower volatility and higher risk adjusted returns • 75% upside capture ratio, 66% downside capture ratio*

Advisor Line: 800.381.1065 www.WasatchFunds.com RISKS: The Fund makes short sales of securities which involves *Source: Morningstar Direct, 5 year Upside/Downside Capture Ratio and rewarding consistent performance. The top 10% of the funds the risk that losses may exceed the original amount invested. compared to the S&P 500 as of 03/31/13. Upside/Downside in each category receive 5 stars, the next 22.5% receive 4 stars, Equity investing involves risks, including potential loss of the Capture Ratio measures a manager’s ability to generate excess the next 35% receive 3 stars, the next 22.5% receive 2 stars, and principal amount invested. Being non-diversified, the Wasatch return above the benchmark return in up markets and retain the bottom 10% receive 1 star. (Each share class is counted as a Long/Short Fund can invest a larger portion of its assets in the more of the excess return in down markets. The upside/downside fraction of one fund within this scale and rated separately, which securities of a limited number of companies than a diversified fund. capture ratio is the Fund’s up/down market return divided by the may cause slight variations in the distribution percentages.) Non-diversification increases the risk of loss to the Fund if the index’s up/down market return. The up/down market return equals Past performance is no guarantee of future results. values of these securities decline. the linked returns for all quarters in which the index return was © 2013 Morningstar, Inc. All rights reserved. The information An investor should consider investment greater/less than zero. contained herein (1) is proprietary to Morningstar and/or its The Fund’s 3 and 5 year ratings are 4 stars out of 99 funds, and content providers; (2) may not be copied or distributed; and (3) is not objectives, risks, charges and expenses carefully 4 stars out of 63 Long-Short Equity funds, respectively. For each warranted to be accurate, complete, or timely. Neither Morningstar before investing. To obtain a prospectus, which fund with at least a three-year history, Morningstar calculates nor its content providers are responsible for any damages or contains this and other information, visit www. a Morningstar Rating™ based on a Morningstar Risk-Adjusted losses arising from any use of this information. Return measure that accounts for variation in a fund’s monthly © 2013 Wasatch Funds. All rights reserved. Wasatch Funds are wasatchfunds.com or call 800.551.1700. Please performance (including the effects of sales charges, loads, and distributed by ALPS Distributors, Inc. WAS003120 7/20/13 read the prospectus carefully before investing. redemption fees), placing more emphasis on downward variations Investments à la Carte

Five Picks for the Present

Stock: Capital One Financial COF

Fair Value Estimate Morningstar Rating Uncertainty Economic Moat Forward P/E Market Cap $74 QQQQ High Narrow 8.5 $34.4 billion

2012 Stock Price Compared With Fair Value Estimate Capital One has evolved from a monoline credit divided into three segments: credit cards, $80K Daily stock price Fair value estimate card company to a diversified holding company consumer banking, and commercial banking. offering a broad spectrum of financial products It has an astounding 74 million customer (Gaps indicate when fair value estimate was under review.) and services to consumers and businesses. As accounts. While the company is well-known for 60 a result of bold acquisitions into traditional and its credit-card segment, we think Capital One’s nontraditional banking spaces, Capital One has expansion into other consumer and commercial become the seventh-largest bank by deposits in banking businesses will be the primary growth the United States. Capital One can be generally catalyst in the nearer term. Dan Werner 05/12 08/12 11/12 02/13

Mutual Fund: T. Rowe1/30/13 Price Capital Appreciation PRWCX

Category Morningstar Rating Morningstar Analyst Rating Expenses Minimum Investment Total Assets 480 Large Blend QQQQQ 0.71% $2,500 $15.2 billion 80 60 120 14 Fair Value - Daily Fair Value - Daily Fair Value - Daily Fair Value - Daily Fair Value - Daily Daily Closing Price Daily Closing Price Daily Closing Price Daily Closing Price Daily Closing Price Asset Allocation This broadly diversified fund does a lot of call options for additional income. Deft 100 12 40 Cash things right. David Giroux oversees a portfolio security selection has led the equity, bond, and 60 60 80 10 US Stock with an equity weighting of 50% to 70%, converts sleeves to each outperform 20 Non US Stock where he focuses on undervalued blue chips. their respective benchmarks during his nearly 60 8 Bond The rest of the fund is composed of a mix seven-year tenure, and returns have been 40 40 0 40 6 5/1/125/2/125/3/125/4/125/10/125/7/125/11/125/8/125/14/125/9/125/15/125/16/125/17/125/18/125/21/125/22/125/23/125/24/125/25/125/28/125/29/125/30/125/31/126/1/126/4/126/5/126/11/126/6/126/12/126/7/126/13/126/8/126/14/126/15/126/18/126/19/126/20/126/21/126/22/126/25/126/26/126/27/126/28/126/29/127/2/127/3/127/4/127/10/127/5/127/11/127/6/127/12/127/9/127/13/127/16/127/17/127/18/127/19/127/20/127/23/127/24/127/25/127/26/127/27/127/30/127/31/128/1/128/2/128/3/128/6/128/10/128/7/128/13/128/8/128/14/128/9/128/15/128/16/128/17/128/20/128/21/128/22/128/23/128/24/128/27/128/28/128/29/128/30/128/31/129/3/129/4/129/10/129/5/129/11/129/6/129/12/129/7/129/13/129/14/129/17/129/18/129/19/129/20/129/21/129/24/129/25/129/26/129/27/129/28/1210/1/1210/2/1210/3/1210/4/1210/10/1210/5/1210/11/1210/8/1210/12/1210/9/1210/15/1210/16/1210/17/1210/18/1210/19/1210/22/1210/23/1210/24/1210/25/1210/26/1210/29/1210/30/1210/31/1211/1/1211/2/1211/5/1211/6/1211/12/1211/7/1211/13/1211/8/1211/14/1211/9/1211/15/1211/16/1211/19/1211/20/1211/21/1211/22/12Other11/23/1211/26/1211/27/1211/28/1211/29/1211/30/1212/3/1212/4/1212/10/1212/5/1212/11/1212/6/1212/12/1212/7/1212/13/1212/14/1212/17/1212/18/1212/19/1212/20/1212/21/1212/24/1212/25/1212/26/1212/27/1212/28/1212/31/121/1/131/2/131/3/131/4/131/10/131/7/131/11/131/8/131/14/131/9/131/15/131/16/131/17/131/18/131/21/131/22/131/23/131/24/131/25/131/28/131/29/131/30/131/31/132/1/132/4/132/5/132/11/132/6/132/12/132/7/132/13/132/8/132/14/132/15/132/18/132/19/132/20/132/21/132/22/132/25/132/26/132/27/132/28/133/1/133/4/133/5/133/11/133/6/133/12/133/7/133/13/133/8/133/14/133/15/133/18/133/19/133/20/133/21/133/22/133/25/133/26/133/27/133/28/133/29/134/1/134/2/134/3/134/4/134/10/134/5/134/11/134/8/134/12/134/9/134/15/134/16/134/17/134/18/134/19/134/22/134/23/134/24/134/25/134/26/134/29/134/30/13 of traditional bonds, leveraged loans, convert- remarkably consistent versus the fund’s 5/1/125/2/125/3/125/4/125/10/125/7/125/11/125/8/125/14/125/9/125/15/125/16/125/17/125/18/125/21/125/22/125/23/125/24/125/25/125/28/125/29/125/30/125/31/126/1/126/4/126/5/126/11/126/6/126/12/126/7/126/13/126/8/126/14/126/15/126/18/126/19/126/20/126/21/126/22/126/25/126/26/16/27/126/28/126/29/127/2/127/3/127/4/127/10/127/5/127/11/127/6/127/12/127/9/127/13/127/16/127/17/127/18/127/19/127/20/127/23/127/24/127/25/127/26/127/27/127/30/127/31/128/1/128/2/128/3/128/6/128/10/128/7/128/13/1228/8/128/14/128/9/128/15/128/16/128/17/128/20/128/21/128/22/128/23/128/24/128/27/128/28/128/29/128/30/128/31/129/3/129/4/129/10/129/5/129/11/129/6/129/12/129/7/129/13/129/14/129/17/129/18/129/19/129/20/129/21/129/24/129/25/129/26/129/27/129/28/1210/1/1210/2/1210/3/1210/4/1210/10/1210/5/1210/11/1210/8/1210/12/1210/9/1210/15/1210/16/1210/17/1210/18/1210/19/1210/22/1210/23/1210/24/1210/25/1210/26/1210/29/1210/30/1210/31/1211/1/1211/2/1211/5/1211/6/1211/12/1211/7/1211/13/1211/8/1211/14/1211/9/1211/15/1211/16/1211/19/1211/20/1211/21/1211/22/1211/23/1211/26/1211/27/1211/28/1211/29/1211/30/1212/3/1212/4/1212/10/1212/5/1212/11/1212/6/1212/12/1212/7/1212/13/1212/14/1212/17/1212/18/1212/19/1212/20/1212/21/1212/24/1212/25/1212/26/1212/27/1212/28/1212/31/121/1/131/2/131/3/131/4/131/10/131/7/131/11/131/8/131/14/131/9/131/15/131/16/131/17/131/18/131/21/131/22/131/23/131/24/131/25/131/28/131/29/131/30/131/31/132/1/132/4/132/5/132/11/132/6/132/12/132/7/132/13/132/8/132/14/132/15/132/18/132/19/132/20/132/21/132/22/132/25/132/26/132/27/132/28/133/1/133/4/133/5/133/11/133/6/133/12/133/7/133/13/133/8/133/14/133/15/133/18/133/19/133/20/133/21/133/22/133/25/133/26/133/27/133/28/133/29/134/1/134/2/134/3/134/4/134/10/134/5/134/11/134/8/134/12/134/9/134/15/134/16/134/17/134/18/134/19/134/22/134/23/134/24/134/25/134/26/134/29/134/30/13 1/2/121/3/121/4/121/10/121/5/121/11/121/6/121/12/121/9/121/13/121/16/121/17/121/18/121/19/121/20/121/23/121/24/121/25/121/26/121/27/121/30/121/31/122/1/122/2/122/3/122/6/122/10/12/7/122/13/122/8/122/14/122/9/122/15/122/16/122/17/122/20/122/21/122/22/122/23/122/24/122/27/122/28/122/29/123/1/123/2/123/5/123/6/123/12/123/7/123/13/123/8/123/14/123/9/123/15/123/16/123/19/123/20/123/21/123/22/123/23/123/26/123/27/123/28/1223/29/123/30/124/2/124/3/124/4/124/10/124/5/124/11/124/6/124/12/124/9/124/13/124/16/124/17/124/18/124/19/124/20/124/23/124/24/124/25/124/26/124/27/124/30/125/1/125/2/125/3/125/4/125/10/125/7/125/11/125/8/125/14/125/9/125/15/125/16/125/17/125/18/125/21/125/22/125/23/125/24/125/25/125/28/125/29/125/30/125/31/126/1/126/4/126/5/126/11/126/6/126/12/126/7/126/13/126/8/126/14/126/15/126/18/126/19/126/20/126/21/126/22/126/25/126/26/126/27/126/28/126/29/127/2/127/3/127/4/127/10/127/5/127/11/127/6/127/12/127/9/127/13/127/16/127/17/127/18/127/19/127/20/127/23/127/24/127/25/127/26/127/27/127/30/127/31/128/1/128/2/128/3/128/6/128/10/128/7/128/13/128/8/128/14/128/9/128/15/128/16/128/17/128/20/128/21/128/22/128/23/128/24/128/27/128/28/128/29/128/30/128/31/129/3/129/4/129/10/129/5/129/11/129/6/129/12/129/7/129/13/129/14/129/17/129/18/129/19 2/7/13 –100 –50 0 1/30/1350 100 ible bonds, and cash; he’ll also write covered moderate allocation peers. Greg Carlson 1/24/132/25/13

Separate Account: Bridgeway Blue Chip 35 Index

Category Investment Style Morningstar Rating Minimum Investment Number of Holdings Total Assets 4 Large Blend 4 Large Blend QQQ $5 million 37 $407 million

Asset Allocation This concentrated fund homes in on the than by market cap. The index is typically Cash market’s behemoths, but it does so in a sensible reconstituted every few years (except US Stock way. The fund tracks an in-house index when high market volatility results in big Non US Stock composed of the 35 largest U.S. companies by market-cap changes) to keep trading Bond market capitalization—except it won’t own costs down. This construction method, paired Other more than four firms from the same sector, so it with the fund’s cheap 0.15% expense ratio, –100 –50 0 50 100 must reach further down the market-cap has led to fine risk-adjusted returns. ladder for constituents. The fund further diversi- Greg Carlson fies by weighting its holdings equally rather

18 Morningstar Advisor June/July 2013 Closed-End Fund: AllianceBernstein Income ACG

Earnings Rate (Share Price) 6-Mo Avg. Discount Total Expense Ratio Effective Duration Leverage Ratio Avg. Daily Volume 4.87% –8.2% 0.64% 9.2 years 1.47 $4.8 million

$16K AllianceBernstein Income Fund Common (Index) Any investor looking to make a tactical, discount gives an extra boost to income, Barclays US Agg Bond TR USD (Index) long-duration bet should consider this fund. The making it an even better bargain. In all, 14 0.64% total expense ratio doesn’t appear investors can effectively purchase $1.60 in 12 too impressive at first glance, but shareholders enterprise value for every $1 invested. get a lot of bang for their buck. Expenses Nevertheless, the portfolio’s long duration 10 are inclusive of the financing cost for the of 9.2 years—a side effect of its high 05/08 05/09 05/10 05/11 05/12 05/13 portfolio’s 1.47 leverage ratio (total assets/net long-dated Treasury exposure—means it isn’t assets). The fund’s persistent (and sizable) for everyone. Steven Pikelny

Exchange-Traded Fund: PowerShares International Dividend Achievers Portfolio PID

16000 Morningstar Category Expense Ratio TotalBarclays Assets US Agg Bond TR USD12-Mo (Index Yield) Morningstar Rating Avg. Daily Volume Foreign Large Value 0.56% $836 million 2.43% QQQQQ 211,000 AllianceBernstein Income Fund Common (Index) 14000 PowerShares Intl Dividend Achievers (Index) The rationale for domestic dividend investing avoids investing in highly distressed stock 12000$16K MSCI EAFE NR USD (Index) also applies to the international market. and has been significantly less volatile 10000 This fund tracks the International Dividend relative to other international dividend ETFs. Achievers Index, which selects companies that While competing funds offer higher yields, 800010 MaJun-08Jul-08Ay-08Sep-08ug-08Oct-08Nov-08Dec-08Jan-09FeMarApr-09MabJun-09-09-09Jul-09Ay-09Sep-09ug-09Oct-09Nov-09Dec-09Jan-10FeMarApr-10MabJun-10-10-10Jul-10Ay-10Sep-10ug-10Oct-10Nov-10Dec-10Jan-11FeMarApr-11MabJun-11-11-11Jul-11Ay-11Sep-11ug-11Oct-11Nov-11Dec-11Jan-12FeMarApr-12MabJun-12-12-12Jul-12Ay-12Sep-12ug-12Oct-12Nov-12Dec-12Jan-13FeMarApr-13Mab-13-13y-13 have increased their annual dividend for PID’s risk-adjusted total return over the the past five years and weights constituents by past five years was the highest in its peer dividend yield. With this screen, the fund group. Abby Woodham 05/08 05/09 05/10 05/11 05/1205/13

Hindsight: April/May 2012

Charles Schwab SCHW led the way for our four ARTGX emphasis on steady growers has paid weighting in financials has held back the picks from a year ago, trouncing the S&P 500 off over the past year even in a strong market usually strong Harris & Associates Equity & Index as rising asset-management and for stocks; it’s well ahead of its MSCI All Income. Finally, Barclays S&P 500 Dynamic administrative fees made up for declining trade Country World Index benchmark. A relatively VEQTOR VQT was far too cautious over the past 16000 volumes. Meanwhile, Artisan Global Value’s heftyMSCI stake EAFE inNR energyUSD (Index firms) and a modest year. Greg Carlson PowerShares Intl Dividend Achievers (Index) 16000 16000 12000 15000 Barclays US Agg Bond TR USD (Index) MSCI EAFE GR USD (Index) S&P 500 TR (IA Extended) (Index) S&P 500 TR (IA Extended) (Index) Pick Type Cum Rtn to Back Then, We Said ... Now, We Say ... AllianceBernstein Income Fund Common (Index) WisdomTree Japan Hedged Equity (Index) Barclays S&P 500 Dynamic VEQTOR ETN (Index) Barclays S&P 500 Dynamic VEQTOR ETN (Index) Date (%) 14000 10000 10000 Charles Schwab Corp SCHW S 25.18 “Strong position in personal-investing business…” “Weakened interest-rate conditions constraining profits…” 12000 10000 10000 Artisan Global Value Investor ARTGX MF 18.50 “Moving further up the quality spectrum…” “Unexpectedly thriving in a bullish environment…” 5000 Harris & Associates Equity & Income SA 7.29 “Strong risk-adjusted returns over the long haul…” “Quirky, but impressive…” 10000 4000 BarclaysMaJun-08Jul-08Ay-08Sep-08ug-08Oct-08Nov-08Dec-08Jan-09 FeS&PMarApr-09MabJun-09-09-09Jul-09 Ay-09500Sep-09ug-09Oct-09Nov-09Dec-09 Jan-10DynamicFeMarApr-10MabJun-10-10-10Jul-10Ay-10Sep-10ug-10Oct-10Nov-10Dec-10 VEQTORJan-11FeMarApr-11MabJun-11-11-11Jul-11Ay-11Sep-11ug-11Oct-11Nov-11 Dec-11ETNJan-12FeMarApr-12Mab VQTJun-12-12-12Jul-12Ay-12Sep-12ug-12Oct-12Nov-12 Dec-12Jan-13FeETFMarApr-13Mab-13 -13y-13 1.08 “A compelling portfolio diversifier…” “A way to access volatility over longer periods…” 8000 4000 8000 0 MaJun-08Jul-08Ay-08Sep-08ug-08Oct-08Nov-08Dec-08Jan-09FeMarApr-09MabJun-09-09-09Jul-09Ay-09Sep-09ug-09Oct-09Nov-09Dec-09Jan-10FeMarApr-10MabJun-10-10-10Jul-10Ay-10Sep-10ug-10Oct-10Nov-10Dec-10Jan-11FeMarApr-11MabJun-11-11-11Jul-11Ay-11Sep-11ug-11Oct-11Nov-11Dec-11Jan-12FeMarApr-12MabJun-12-12-12Jul-12Ay-12Sep-12ug-12Oct-12Nov-12Dec-12Jan-13FeMarApr-13Mab-13-13y-13 Jan-08FeMarApr-08MabJun-08-08-08Jul-08Ay-08Sep-08ug-08Oct-08Nov-08Dec-08Jan-09FeMarApr-09MabJun-09-09-09Jul-09Ay-09Sep-09ug-09Oct-09Nov-09Dec-09Jan-10FeMarApr-10MabJun-10-10-10Jul-10Ay-10Sep-10ug-10Oct-10Nov-10Dec-10Jan-11FeMarApr-11MabJun-11-11-11Jul-11Ay-11Sep-11ug-11Oct-11Nov-11Dec-11Jan-12FeMarApr-12MabJun-12-12-12Jul-12Ay-12Sep-12ug-12Oct-12Nov-12Dec-12Jan-13 Jun-11Jul-11Aug-11Sep-11Oct-11Nov-11Dec-11Jan-12FebMar-12Apr-12-12May-12Jun-12Jul-12Aug-12Sep-12Oct-12Nov-12 Aug-10Sep-10Oct-10Nov-10Dec-10Jan-11FebMar-11Apr-11-11MaJun-11y-11Jul-11Aug-11Sep-11Oct-11Nov-11Dec-11Jan-12Feb-12 The April/May 2012 issue was mailed to subscribers in April 2012. Return data is from March 31, 2012, through March 31, 2013.

MorningstarAdvisor.com 19

16000 16000 12000 15000 MSCI EAFE NR USD (Index) MSCI EAFE GR USD (Index) S&P 500 TR (IA Extended) (Index) S&P 500 TR (IA Extended) (Index) PowerShares Intl Dividend Achievers (Index) WisdomTree Japan Hedged Equity (Index) Barclays S&P 500 Dynamic VEQTOR ETN (Index) Barclays S&P 500 Dynamic VEQTOR ETN (Index) 10000

10000 10000 10000

5000

4000 4000 8000 0 MaJun-08Jul-08Ay-08Sep-08ug-08Oct-08Nov-08Dec-08Jan-09FeMarApr-09MabJun-09-09-09Jul-09Ay-09Sep-09ug-09Oct-09Nov-09Dec-09Jan-10FeMarApr-10MabJun-10-10-10Jul-10Ay-10Sep-10ug-10Oct-10Nov-10Dec-10Jan-11FeMarApr-11MabJun-11-11-11Jul-11Ay-11Sep-11ug-11Oct-11Nov-11Dec-11Jan-12FeMarApr-12MabJun-12-12-12Jul-12Ay-12Sep-12ug-12Oct-12Nov-12Dec-12Jan-13FeMarApr-13Mab-13-13y-13 Jan-08FeMarApr-08MabJun-08-08-08Jul-08Ay-08Sep-08ug-08Oct-08Nov-08Dec-08Jan-09FeMarApr-09MabJun-09-09-09Jul-09Ay-09Sep-09ug-09Oct-09Nov-09Dec-09Jan-10FeMarApr-10MabJun-10-10-10Jul-10Ay-10Sep-10ug-10Oct-10Nov-10Dec-10Jan-11FeMarApr-11MabJun-11-11-11Jul-11Ay-11Sep-11ug-11Oct-11Nov-11Dec-11Jan-12FeMarApr-12MabJun-12-12-12Jul-12Ay-12Sep-12ug-12Oct-12Nov-12Dec-12Jan-13 Jun-11Jul-11Aug-11Sep-11Oct-11Nov-11Dec-11Jan-12FebMar-12Apr-12-12May-12Jun-12Jul-12Aug-12Sep-12Oct-12Nov-12 Aug-10Sep-10Oct-10Nov-10Dec-10Jan-11FebMar-11Apr-11-11MaJun-11y-11Jul-11Aug-11Sep-11Oct-11Nov-11Dec-11Jan-12Feb-12 Values-Based Global Equity Managers

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States’ Permanent-Fund committed it is to delivering on that promise. appropriate asset levels are retained in the We evaluate the legal source of the state’s fund throughout the year. For the programs Programs Are Strong obligation to act and how much structured included here, we found growth in total assets by Elizabeth Foos oversight is required of local participants once to be relatively stable from 2007 to present and they enter the program. Permanent-fund annual distributions from the funds to be a Nearly 30 states offer a credit-enhancement programs provide a strong security pledge to small portion of net assets each year contribut- program to aid their local municipalities in bondholders; their promise to repay is clearly ing to their continued flexibility. financing bonds for capital projects. These established by constitutional and statutory programs vary from state to state, but they all provisions. Investors can be confident that the Most assets securing debt in state-permanent- provide some security to bondholders. When state’s promise to pay won’t be broken. fund programs are recorded as cash, and municipalities cannot, or do not, make investments on balance sheets and investment payments for qualifying bonds, states use their Operating Procedures income remain major sources of annual credit programs to make the payments. Evaluating a program’s operating procedures revenue. We review what types of investments involves understanding exactly when and how are held and what policies are in place to guide One of the strongest types of credit-enhance- the commitment to repay debt will be honored. investment decisions. Each permanent-fund ment programs secures debt through a state’s Each permanent-fund program included in our program strives to include a balance of permanent fund. Many states have these analysis is designed to pay debt-service diversity within its asset allocation, with a mix dedicated funds to support a specific purpose, bondholders before an actual default by the of equities, fixed income, and cash. The Texas usually education. These funds are created by a borrowing district occurs. This is accomplished and Wyoming programs’ investments reflect state’s constitution or legislation and are by requiring the local borrower to transfer that goal, while Nevada’s program is still capitalized through the sale or licensing of debt-service payments to a third party, either a entirely invested in a conservative fixed-income state land, mineral rights, or other resources. designated paying agent or the state treasurer, allocation. But Nevada’s legislature recently Annual revenues generally consist of land sales, well in advance of the actual payment date. If voted to allow investments in equities. fees, and investment income, and a portion is that payment isn’t transferred, notification transferred to local entities to support is immediately sent to the state treasurer, who Finally, once we understand the amount operations. Several states have established is required to draw from the pledged assets to pledged and stability of those assets, programs designed to draw on money from make the debt-service payment on time. we compare that total with the total amount these permanent funds to pay bondholders in of debt covered under the program. Overall, the the event that the borrower fails to pay. Pledged Revenues debt profiles of the three programs vary When the amount of pledged assets is widely, yet they all provide sufficient coverage To better understand the benefits to bondhold- identified, a review of the fund’s financial for qualifying debt. The Texas program is ers of these state-permanent-fund programs, condition, investment portfolio, and the commonly used throughout the state with we analyzed three programs: the Nevada guaranteed debt is necessary to further nearly $53 billion in principal covered for 800 Permanent School Fund Bond Guarantee understand the program’s ability to meet its issuing school districts at the end of 2012. Program, the Texas Permanent School Fund promise. Our review uncovered that This results in a 195.4% ratio of debt as a Bond Guarantee Program, and the Wyoming each permanent-fund program in our analysis percentage of net assets. Although it’s School District Bond Guarantee Program. had substantial and stable assets to back above 100%, the ratio is still well below the Our evaluation included a review of each debt-service payments, a diversified investment statutory restriction for debt service. The program’s security pledge, program procedures, approach, and satisfactory debt levels to Wyoming program covers a modest amount of and pledged revenues. These programs provide support credit strength. principal, only $6.8 million for six participating a strong, legal security pledge, employ issuers, resulting in a low 6.8% of debt as clear operating procedures, and secure debt Because the funds qualify as permanent funds a percentage of pledged assets. This program with stable financial resources, which improve in accordance with the Governmental heavily restricts new debt issuance, which is the credit quality of bonds in the programs. Accounting Standards Board’s auditing expected to result in limited participation standards, the corpus must be preserved. This moving forward. Security Pledge provides central stability to the asset guaran- Evaluating the security pledge of a program teeing the bonds. A portion of annual revenues Elizabeth Foos is a municipal credit analyst with includes understanding what the state is diverted to support education efforts, but Morningstar. To obtain our full report on state-permanent-fund programs, send a request to MuniSupport@ has pledged through each program and how defined policies are in place to make sure that morningstar.com.

MorningstarAdvisor.com 21 Investment Briefs

Don’t Overlook Active Jennison Natural Resources PGNAX, which has a five-year track record. With those constraints, one of the category’s highest energy weight- the following 10 funds have the most Buffett- Natural Resources Funds ings at 74%, focus on smaller exploration-and- like taste in stocks: BlackRock Exchange by Kevin McDevitt production firms like Concho ResourcesCXO , as STSEX, Yacktman Focused YAFFX, Vanguard well as equipment and services outfits like Dividend Appreciation Index VDAIX, Pear Tree Investors have shown a clear preference for Cameron International CAM. Quality Ordinary USBOX, State Farm Growth equity-commodity ETFs rather than their STFGX, ASTON/Montag & Caldwell Growth actively managed open-end cousins. During the In the end, what matters most is the contribu- MCGFX, John Hancock US Equity NAV JHUMX, past 12 months through March, equity tion an individual holding makes to overall Clipper CFIMX, Yacktman YACKX, and Dreyfus natural resources ETFs have collected about portfolio utility, and these funds can fill a spe- Core Equity DLTSX. This list includes three You are a professional investor. $3 billion, while their open-end counterparts cialized niche for investors. But be forewarned, notable teams that manage four of the 10 funds. have seen nearly $2.2 billion in outflows. volatility is part of the deal and such funds will continue to struggle if commodity prices Donald Yacktman and his son Stephen However, those investors who are concerned resume their slide. On the other hand, a small Yacktman manage Yacktman Focused and that inflation may one day return should slice of one of these funds does offer the po- Yacktman. They follow a Buffett-esque strategy ® give actively managed offerings another look. tential to offset some of the inflation that many that focuses on profitable companies, usually At MFS , we’re building better insights for you. ETFs certainly offer better alternatives for forecasters have been warning about for years. with little debt, that are trading at a substantial We are investment management for investment managers.SM targeted, specific slivers of the market such discount to their estimate of the companies’ as agriculture and timber. But for those looking Kevin McDevitt, CFA, is a senior mutual fund analyst intrinsic value. The funds sometimes have had for one-stop, diversified natural-resources with Morningstar. significant weightings in small- and mid-cap options, actively managed funds are still worth stocks, but they are dominated by mega-cap considering. That’s because several of these blue chips of the type Buffett holds, and each equity funds may be purer commodity plays Funds That Buy of the funds has four stocks from Buffett’s top than their equity ETF counterparts and better 10 (Procter & Gamble, Coca-Cola, U.S. Bancorp, diversifiers from a portfolio perspective. Like Buffett and Wal-Mart) among its top 25 holdings. by David Kathman This distinction shows most clearly in where Dreyfus Core Equity is managed by a team led these funds get their energy exposure, Berkshire Hathaway’s BRK.B annual report by Fayez Sarofim and his son Christopher. which tends to claim 50% or more of most lists the top stocks in Warren Buffett’s Their strategy is similar to the Yacktmans’ in diversified portfolios. BecauseETF s such investment portfolio. This year’s report shows that it focuses on high-quality blue chips, as iShares S&P North American Natural that his top 10 stock holdings as of Dec. 31 though here there’s somewhat less emphasis Resources IGE and SPDR S&P Global Natural didn’t change much from a year ago. The top on valuation, which is why the fund lands in Resources GNR are based on market-cap- holding is longtime Buffett favorite Wells Fargo the large-blend category rather than large- weighted indexes, they tend to have significant WFC, moving up from third place last year value. The fund holds Coca-Cola, IBM, Procter exposure to the largest energy companies. to overtake another favorite, Coca-Cola KO, & Gamble, Wal-Mart, and American Express By and large, these are integrated oil-and-gas where Buffett is the largest shareholder. Next from among Buffett’s top 10. companies like Exxon Mobil XOM and Royal is IBM IBM, followed by American Express AXP, Dutch Shell RDSA. While these are excellent Wal-Mart WMT, Munich Re, Procter & Gamble Finally, there’s Clipper, managed by Chris Davis companies, they are already well represented PG, and U.S. Bancorp USB, all of which and Ken Feinberg. Under their management, in large-cap equity indexes such as the S&P were in last year’s top 10. The top-10 newcom- Clipper has often been one of the biggest 500 Index and the MSCI EAFE Index and are ers are SanofiSNY and Tesco PLC TSCDY. holders of Berkshire Hathaway stock. Berkshire common to many core mutual fund portfolios. was Clipper’s second-largest holding as Plenty of mutual fund managers are Buffett of Dec. 31, with 9.34% of assets, topped only Most open-end natural-resources funds we fans who emulate his investment approach in by Berkshire holding American Express at cover have little exposure to integrated energy one way or another. We recently calculated 12.44%. Clipper also holds Wells Fargo from companies. T. Rowe Price New Era PRNEX which funds have the biggest weighting in among Buffett’s top 10. mfs.com is the only one with more than 10% of assets in Berkshire’s latest top 10 holdings. We left out such stocks. Instead, funds such as RS Global sector funds, as well as funds with less than David Kathman, CFA, is a senior mutual fund analyst Natural Resources RSNRX and Prudential $100 million in assets and those with less than with Morningstar. Boston I Hong Kong I London I MexIco cIty I sÃo PauLo I sIngaPore I sydney I toKyo I toronto

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RELEASE DATE 05-07-13 In Practice

The Percentile Trap

By Jeffrey Ptak When researching fund managers, put relative performance measures in their proper context.

You can see it, but can you hit it? August/September 2011). Our research found not represent how a fund was categorized in considerable flux within peer groups, the past). The peer groups that we assembled It’s a baseball adage, but for manager with funds flitting between categories, raising should closely approximate the peer groups researchers like us, it’s the pivotal question— questions about the substance of rankings that actually existed at the end of each relevant we know that “good” managers are out there, themselves. We’ve also examined the fleeting five-year period. but can we find them before it is too late? nature of relative performance (“Performance The historical record isn’t terribly encouraging Chasing, Evaluated,” April/May 2012), In assembling the data, we sought to find out in this regard. Examples of remarkably which tends to be mean-reverting (owing to whether past top-quartile rankings predicted successful manager researchers—be they stylistic biases, capacity constraints, “career outperformance in successive five-year periods. investment committees, gatekeepers, or private risk,” or just plain luck). What we haven’t investors—do not exactly abound. studied, however, is the convergence of the Our Findings two and its implications on our ability to find We found that unerringly consistent perfor- What’s the hitch? Well, manager researchers successful managers in advance. mance is rare: 40% to 50% of top-quartile are human, after all. They chase returns; they funds promptly fell from the top quartile, on misattribute outperformance; they rationalize Our Study average, in the next consecutive rolling underperformance; they get complacent; We compiled rolling five-year net returns of all five-year period Exhibit( 1). That is, if a fund they dig in. That is, they act like the managers U.S. open-end mutual funds (existing and was top quartile in the five-year period they’re paid to scout and monitor, whether obsolete; oldest share-class only) that were ended March 2005, there was a roughly 50/50 they’re willing to admit it or not. members of the Morningstar large-value, chance that it would not be in the top quartile large-growth, mid-blend, small-value, or in the five-year period ended one year In our shop, we’re hardly strangers to such small-growth categories on March 31 of any later in March 2006. A year further out, we mistakes, though we try our best to minimize year from 2003 through 2013. We then ranked found that only about one third of the original them. That’s why, when we reflect on our the funds within their peer groups based group of top-quartile funds remained. By process and its blind spots, we consider not on trailing five-year returns. (Thus, we studied the fifth year, almost none of the top-quartile just the choices we make but also the context. 11 distinct five-year periods: April 1998 to funds were left. In short, top funds almost Are we using the right yardsticks? Do they March 2003; April 1999 to March 2004; April always fall from their perch. tell the full story? Do we have the proper frame 2000 to March 2005; and so forth.) of reference? Inevitably, our analysis has led us What became of these top-performing funds? to reconsider that most ubiquitous of manager- We compiled the returns using a “category true” We tracked the subsequent performance of the research tools—category peer rankings. method. We rebuilt the peer groups based 45 large-value funds whose trailing five-year on their historical Morningstar category returns placed them in the category’s top We’ve written previously about some of the classifications, rather than working backward quartile as of March 2003 (Exhibit 2). One year quirks of peer groups (“Pitfalls of Peer Groups,” from their current classifications (which might later (i.e., rolling five-year period ended March

24 Morningstar Advisor June/July 2013 2004), 22 of the original 45 tumbled out of the top quartile, moved to a different category, Exhibit 1 Percentage of Top-Quartile Funds That Repeat in Successive or had been mothballed. Of the 23 top-quartile Rolling Five-Year Periods (April 1998 to March 2013) funds still standing, only 14 would remain by March 2005. By March 2008, just two of the % Large Value Large Growth Mid-Blend Small Value Small Growth original 45 funds remained in the top quartile. 70 60 True, this is a very exacting test, and the results 50 aren’t shocking given the way relative 40 performance tends to revert to the mean. So, 30 instead of focusing just on consistency of 20 relative rankings, we also compared funds’ 10 five-year rankings at various points in time. We One Year Later Two Years Later Three Years Later Four Years Later Five Years Later took a look at where top-quartile funds in these categories ended up five years later (i.e., rankings in the five-year period ended March 2003 versus rankings in the five-year period ended March 2008, and so forth). What we see Exhibit 2 Top-Quartile Large-Value Funds in 2003 That Finished in Top isn’t just mean reversion, but also category flux Quartile in Subsequent Rolling Five-Year Periods and fund attrition on a significant scale Exhibit( 3). For example, on average, around 20% Top Quartile 2nd Quartile 3rd Quartile Bottom Category Change of top-quartile large-value funds had either 50 exited the category or had been merged or liquidated away by the end of the subsequent 40 five-year period. The churn was even more 30 pronounced in the small-value, small-growth, and mid-blend categories, where nearly 30% of 20 top-quartile funds didn’t even finish the following five-year period in the peer group. 10

2003 2004 2005 2006 2007 2008 All told, only 10% to 20% of top-quartile funds remained in the top quartile over the subsequent five-year period (versus 20% to 30% that fell to the bottom quartile), on average. About 30% to 40% finished in the top half Exhibit 3 Where Top-Quartile Funds Are Five Years Later (April 1998 (versus 40% to 50% in the bottom half, though to March 2013) that swells to 60% to 70% when we include funds that switched categories or died). In % Large Value Large Growth Mid-Blend Small Value Small Growth other words, you had far better odds of picking 30 a future loser, category émigré, or casualty 25 among top-quartile funds than you did a winner. 20

So, if top-quartile funds tend not to repeat in 15 subsequent periods (or even survive them), where exactly do they come from? To answer 10 that question, we examined the percentile 5 rankings of all top-quartile funds in the Top 2nd 3rd Bottom Leave Category Obsolete five-year periodimmediately preceding the five-year period in which they landed in the top

MorningstarAdvisor.com 25 In Practice

quartile. For example, if a small-value fund Asset Allocation, Diversi ed. ranked in the top quartile in the five-year period Exhibit 4 Where Top-Quartile Funds Come From: Percent Breakdown ended March 31, 2010, we took a look at its of Quartile Rank Five Years Earlier (April 1998 to March 2013) While common asset allocation strategies simply focus on diversi cation among major ranking for the five-year period ended March 31, asset classes, we believe your clients need more. At Ivy Funds, we offer a variety of funds 2005, and so forth for other categories and % Large Value Large Growth Mid-Blend Small Value Small Growth re ecting multiple approaches to asset allocation. From predictable allocation strategies periods. We summarize our findings inExhibit 4. 30 that seek a consistent balance of equities and xed income to exible portfolios that select 25 from an array of asset classes worldwide, our funds offer comprehensive asset allocation A few aspects of the chart stand out. For one, 20% to 25% of top-quartile funds began 20 solutions for a crowded, complex marketplace. the five-year period in a different category. In 15 addition, new funds—those that lacked a 10 five-year track record at the beginning of the five-year period concerned—accounted for 15% 5 to 25% of eventual top-quartile funds, on Top 2nd 3rd Bottom Joined Category New Inception average. Try as one might to predict which fund would beat its category peers in the future, the reality is that many of those outperformers are nowhere to be found—they reside outside managers own, in aggregate, within that identifiable, investing style. This presents its of the category in question or lack a sufficiently defined area or style, no matter if it’s the same own challenges, such as finding a suitable long track record to be considered. group of managers over time. This should make benchmark for an eclectic manager. But as a for cleaner, more-telling comparisons. practical matter, it avoids some of the problems And then there’s the other striking aspect. You associated with peer grouping, including head were likelier to find a top-quartile fund in a Avoid Granularity fakes caused by swings in relative performance. At Ivy Funds, we use a collaborative process — born of rigorous debate, IVY BALANCED FUND (IBNAX) category’s bottom half than its top half. In fact, Funds migrate between categories with some It also can mitigate issues associated with 2, 3, 5, 6 only about 10% of eventual top-quartile funds regularity. If the manager you’ve chosen isn’t career risk, whereby a manager creates a hands-on research and a proven cross-disciplinary approach — to fully IVY GLOBAL INCOME ALLOCATION FUND (IVBAX) began the period in that category’s top flitting about, chances are that at least some of portfolio in his or her peer group’s image, rather assess the opportunities we pursue for our investors every day. To learn 2, 3, 4, 5 quartile, which is roughly the same proportion his or her peers are. This makes comparisons than investing with high conviction wherever more about Ivy Funds’ asset allocation strategies, visit ivyfunds.com IVY ASSET STRATEGY that hailed from the category’s bottom quartile. challenging, especially over longer periods. The the best ideas reside. or call 800-532-2780. FUND (WASAX) 1, 2, 3, 4, 5 more granular our classifications, the worse No Silver Bullet this flux is likely to be and the less meaningful Incorporate Returns-Based Analysis The key takeaway isn’t that category rankings our comparisons would be. So, to the extent Holdings-based analysis is useful, and we use are unreliable and should be avoided at all possible, it makes sense to avoid getting too it in our manager-research process. However, costs. Rather, it’s that, like virtually anything in granular when classifying managers. to remove some of the noise of peer-group Learn more. investing, they’re not a silver bullet. The rankings, it can be worthwhile to create custom IVYFUNDS.COM vagaries of mean reversion and the changing Make Choices benchmarks for managers based on the SM FACEBOOK.COM/IVYFUNDS nature of peer groups see to that, making If manager research is hard, it stands to reason sensitivity of the portfolio’s returns to various it important that manager researchers place that we compound the difficulty when we style-based indexes over time. relative performance in the proper context. Put weigh down a portfolio with numerous funds. another way, a fund’s percentile ranking Why? As mentioned, classifications that Be Contrarian Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. shouldn’t govern investment decisions, which are too granular have less meaning. And while Our research strongly suggests that relative For a prospectus containing this and other information for the Ivy Funds, call your financial advisor or visit us online at is a trap that many of us have fallen into. there’s theoretically a case to be made for performance is mean-reverting. Leaders www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing. diversifying into funds with uncorrelated alphas, become laggards and vice versa (if they don’t What are the implications for manager the fact is that we as manager researchers switch categories or get merged away As with any mutual fund, the value of a fund’s shares will change, and you could lose money on your investment. Diversi cation researchers? We can think of a few: have to make judgments about when to buy first). This should strike fear into the heart of does not ensure a pro t or protect against loss in a declining market. 1 – The Fund may allocate from 0-100% of its assets between and sell, something we don’t excel at. any trend-follower, which is what manager stocks, bonds and short-term instruments, across domestic and foreign securities. 2 – International investing involves additional risks, including currency uctuations, political or economic conditions affecting the foreign country, and differences in accounting Emphasize Benchmarks research too often devolves to. K standards and foreign regulations. These risks are magni ed in emerging markets. 3 – Fixed-income securities are subject to Unlike managers who might move to and Embrace Flexibility interest-rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. 4 – The Fund may focus its investments fro for a variety of reasons, a well-constructed Consider managers who don’t pigeonhole Jeffrey Ptak, CFA, is president and chief investment officer of Morningstar Investment Services. in certain regions or industries, thereby increasing its potential vulnerability to market volatility. 5 – Dividend-paying investment index shouldn’t stray. It’ll simply reflect what themselves, but rather focus on a flexible, but may not experience the same price appreciation as non-dividend paying instruments. Dividend-paying companies may not pay a dividend or it may be less than expected. 6 – Loan participations may be unsecured or not fully collateralized and may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. These and other risks are more fully discussed in 26 Morningstar Advisor June/July 2013 each Fund’s prospectus. IVY FUNDS DISTRIBUTOR, INC. (06/13) Asset Allocation, Diversi ed.

While common asset allocation strategies simply focus on diversi cation among major asset classes, we believe your clients need more. At Ivy Funds, we offer a variety of funds re ecting multiple approaches to asset allocation. From predictable allocation strategies that seek a consistent balance of equities and xed income to exible portfolios that select from an array of asset classes worldwide, our funds offer comprehensive asset allocation solutions for a crowded, complex marketplace.

At Ivy Funds, we use a collaborative process — born of rigorous debate, IVY BALANCED FUND (IBNAX) 2, 3, 5, 6

hands-on research and a proven cross-disciplinary approach — to fully IVY GLOBAL INCOME

assess the opportunities we pursue for our investors every day. To learn ALLOCATION FUND (IVBAX) 2, 3, 4, 5

more about Ivy Funds’ asset allocation strategies, visit ivyfunds.com IVY ASSET STRATEGY

or call 800-532-2780. FUND (WASAX) 1, 2, 3, 4, 5

Learn more.

IVYFUNDS.COM SM FACEBOOK.COM/IVYFUNDS

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus containing this and other information for the Ivy Funds, call your financial advisor or visit us online at www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing. As with any mutual fund, the value of a fund’s shares will change, and you could lose money on your investment. Diversi cation does not ensure a pro t or protect against loss in a declining market. 1 – The Fund may allocate from 0-100% of its assets between stocks, bonds and short-term instruments, across domestic and foreign securities. 2 – International investing involves additional risks, including currency uctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magni ed in emerging markets. 3 – Fixed-income securities are subject to interest-rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. 4 – The Fund may focus its investments in certain regions or industries, thereby increasing its potential vulnerability to market volatility. 5 – Dividend-paying investment may not experience the same price appreciation as non-dividend paying instruments. Dividend-paying companies may not pay a dividend or it may be less than expected. 6 – Loan participations may be unsecured or not fully collateralized and may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. These and other risks are more fully discussed in each Fund’s prospectus. IVY FUNDS DISTRIBUTOR, INC. (06/13) B:17.75 in T:17.5 in S:17 in

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Consider a fund’s investment objectives, risks, charges, and expenses carefully before investing. The prospectus and the summary interest rate risk, and their value will decline as interest rates rise (PCIZX, PZTRX, PGVZX, PHYZX, PHIZX, DNMZX, PIFZX, PDBZX). prospectus contain this and other information about the fund. Contact your financial professional for a prospectus and the summary The risks associated with each fund are explained more fully in each fund’s respective prospectus. There is no guarantee a fund’s prospectus. Read them carefully before investing. objectives will be achieved. Only eligible investors, including various institutional investors and investors in certain mutual fund wrap or asset allocation Some Morningstar Ratings may not be customarily based on adjusted historical returns. If so, an investment’s independent Morningstar Rating metric is compared against the retail mutual fund universe breakpoints to determine its hypothetical rating for certain time periods. For each fund with a 3-year history, Morningstar programs, may purchase Class Z shares. See the prospectus for eligibility requirements. calculates a Morningstar Rating based on a Morningstar risk-adjusted return measure that accounts for variation in a fund’s monthly performance, including the Mutual fund investing involves risks. Some funds are riskier than others. The risks associated with investing in these funds effects of sales charges, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Funds were rated S:10.25 in include but are not limited to: derivative securities, which may carry market, credit, and liquidity risks (All funds); T:10.75 in short sales, which involve costs and the risk of potentially unlimited losses (PFSZX, PZTRX, PHYZX, JDEZX, PJFZX, PHSZX, PTWZX, against U.S.-domiciled funds. Other share classes may have different performance characteristics. Past performance does not guarantee future results. B:11 in SPFZX, PIFZX, PDBZX, SPVZX, PSCZX, PEGZX); leveraging, which may magnify losses (PZTRX, PGVZX, PHYZX, DNMZX, PIFZX, © 2013 Morningstar, Inc. All rights reserved. The information contained herein (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied PDBZX); high yield (“junk”) bonds, which are subject to greater market risks (PCIZX, PZTRX, PHYZX, PHIZX, DNMZX, PIFZX, 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 PDBZX); small/mid-cap stocks, which may be subject to more erratic market movements than large-cap stocks (SPVZX, PSCZX, arising from any use of this information. PEGZX); foreign securities, which are subject to currency fluctuation and political uncertainty (PFSZX, PURZX, PZTRX, JDEZX, Mutual funds are distributed by Prudential Investment Management Services LLC, a Prudential Financial company, member SIPC. Prudential Investments, Prudential, PJFZX, PHSZX, PTWZX, SPFZX, PDBZX, SPVZX, PSCZX, PEGZX); real estate, which poses certain risks related to overall and specific Jennison Associates, Jennison, the Prudential logo, the Rock symbol and Bring Your Challenges are service marks of Prudential Financial, Inc., and its related entities, economic conditions as well as risks related to individual property, credit, and interest-rate fluctuations (PURZX); and mortgage- registered in many jurisdictions worldwide. backed securities, which are subject to prepayment and extension risks (PZTRX, PGVZX, PIFZX, PDBZX). Sector funds and specialty *65.6% of our Morningstar-rated funds as of 3/31/2013. funds may not be suitable for all investors. Such funds are non-diversified, so a loss resulting from a particular security will have **The Prudential Jennison Health Sciences Fund closed all share classes to new investors on June 29, 2012. greater impact on the fund’s return (PFSZX, PURZX, PZTRX, PHSZX, PTWZX, SPFZX). Fixed income investments are subject to ***The Prudential Jennison Mid-Cap Growth Fund closed all share classes to certain new investors on April 8, 2013. 0215935-00009-00 B:17.75 in T:17.5 in S:17 in

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Defense Firms Will Stay Aloft

By Basili Alukos Industry faces short-term challenges, but discipline and strong balance sheets will get companies through.

Budget cuts and the winding down of wars Basili Alukos: The president released his This year, we think it’s going to be closer in Iraq and Afghanistan have many investors budget this month, and there’s been to $90 billion, or less. We’ve withdrawn from wary of the defense industry. To find out a lot of talk about the size of the defense Iraq, and Afghanistan is supposed to be whether defense companies can handle these budget. Neal, before we dive in to the sector, done by the end of 2014. We maxed out the near-term challenges and whether they how big is the defense budget? overall defense budget at almost $700 billion in will have long-term consequences for the 2010 when we had the surge in Iraq. industry, I sat down with Neal Dihora, a Neal Dihora: The base defense budget is Morningstar equity analyst who covers industri- around $530 billion. We’ve seen that number Alukos: What about the effects of sequestra- als, and Rick Tauber, who is Morningstar’s stagnate for about the past three to four tion and the implications of longer-term director of corporate-bond research. Our years. That does not include war funding, defense spending in light of our government discussion took place April 10. which they designate as “overseas contingency looking to cut costs? operations.” That’s been running all over the map. We’ve seen it as high as $187 billion.

30 Morningstar Advisor June/July 2013 Dihora: There’s this misperception in the disciplined financially and have built up cash on About a quarter of GD’s business comes from marketplace that defense is going to get cut by their balance sheets, so most of them have the U.S. Army in their combat division. $1.2 trillion over 10 years. If you look at modest net-debt positions. They still have With the pullback from both Iraq and Afghani- the raw numbers and assume that the fiscal strong free cash flows, which gives them the stan, that division has struggled and will 2013 baseline defense budget was $530 billion, flexibility to manage their balance sheets. continue to struggle. But the fascinating thing even after sequestration, we’ll have $480 is that when we model these struggles, we still billion of spending to do. It’s a real cut of 9% in One thing I’ve focused on is how disciplined get a pretty attractive value. the interim, and then we get back to $500 will they be to not make big acquisitions, billion by 2016. We’re not really cutting or not do massive share-repurchase programs The positive side of GD is half of its business is $1.2 trillion out of anything. We’re $1.2 trillion to re-lever up the companies and feed solidly covered by a large sustainable from a trend baseline that was created before. shareholders that excess cash. As the stocks competitive advantage. The sequester brings us to a new baseline. hold up, the credits will also hold up, because So, we’re going to start from that $530 billion, they won’t need to do anything extreme. Gulfstream Aerospace business jets are 25% we’re going to cut what we think needs to be of GD’s business, and that has nothing to cut in one or two years, and then we start The other trend that I’ve noticed in some of do with the Department of Defense. Corporate growing again. these companies is rather than acquiring, private jet usage in the United States will they’re splitting off divisions. L-3 Communica- hit a new all-time high in the first quarter of A new baseline is not the worst thing for tions LLL split off Engility. Engility is now 2013. The number of millionaires in the world defense contractors, as long as they’re able to a junk credit, but L-3 has maintained its also has hit a brand-new high. These trends manage their costs to it. They’re not in the investment-grade ratings. SAIC SAI has got will be good for General Dynamics. Their same situation that they were in the 1990s, plans to split into two companies, one business jet serves the high end of the market. which is when the last big defense cuts of which will remain an investment-grade happened, what the industry calls the “Last company and the other a junk-rated company. The other solidly profitable segment ofGD is its Supper,” when 15 industry CEOs were told by The split-offs tend to be the companies marine division, which primarily sells to the the Department of Defense that the budget with the worst business positions; they think U.S. Navy. They’re one of two companies was being substantially cut post-Gulf War I. they can put a little bit of leverage on and within the United States that offers these continue to generate good cash flows. services. The other one is Huntington Ingalls. Companies started consolidating, took on a lot President Obama’s and the Department of of debt, and before 9/11 happened, they were You also saw Northrop split out Huntington Defense’s shift to the Asia theater away from struggling. We circle to today, and there Ingalls HII, its shipbuilding unit. We’ve the Middle East is good for the Navy. We don’t are only five prime defense contractors: Boeing seen portfolio paring, a focus on profitability, have countries that we can just naturally go to. BA, Lockheed Martin LMT, General Dynamics rather than doing some of the more potentially Japan has been back and forth on whether GD, Raytheon RTN, and Northrop Grumman extreme and risky measures in the sector. they’re going to allow us to have a base there. NOC. None of these players has a whole lot of That speaks to the health of the sector and the We have bases in Korea and Australia, but if debt. They’re in a position of pretty strong management teams that are in place right now. we really want to target the trading channels in financial strength. If they can manage their cost the Asian theater, we need a strong navy. base to the revenue opportunity, I think the Alukos: Let’s talk about individual stocks. Full stocks are going to be pretty interesting. disclosure: I own General Dynamics. It’s a So, I think over time the Navy will get better name that I think is interesting, at least from a funding, and there are only two players Alukos: Rick, how do defense companies look valuation perspective. that can provide these goods: General from a credit perspective? Dynamics and Huntington Ingalls. These are Dihora: GD is a favorite of ours, too. People massively long-cycle programs. It takes two Rick Tauber: They’re all A/high BBB, which is aren’t expecting much out of the company. One years to build a sub. The funding of these solidly positioned in investment-grade. of the reasons is that in the last couple of programs is generally long-dated. It’s almost The recent trends ahead of the sequester have quarters, it has run into execution issues. Some embedded in Congress’ numbers, and they made it very impressive to maintain that credit of it is its own doing. Some of it’s not. But really don’t change all that much. quality. I view their credits as stable, with they’ve done a lot of acquisitions over the past potential margins coming down and revenues 10 years, and some of them have not been The final division thatGD has is information under pressure. But these guys are being very integrated well. technology. The entire defense industry has

MorningstarAdvisor.com 31 Sector Rap

struggled with IT. We think it’s more of Dihora: People think of Boeing as more of a pension deficit. We treat the pension just as a federal government spending issue than it is commercial airline company than a defense straight debt, or as a proxy for debt. If you told company-specific. ButGD , to its detriment, company. A couple of years ago, the split was me that the discount rate that Boeing was has done a lot of acquisitions over the 50-50; it actually used to get slightly more going to use was going to go up by 100 or 200 past 10 years in this division, and it has not suc- operating dollars from defense than it did from basis points, our fair value would go up cessfully integrated them. We think the firm’s commercial aerospace. But that was mainly significantly. For right or wrong, that’s the way incoming CEO, Phebe Novakovic, is going to due to the delays with the 787. It was delayed that we look at the company. Unfortunately, take significant action.GD’s shares are more than three years. One was finally Boeing uses a 3.8% discount rate, as of attractively priced because people are waiting delivered in September 2011, and then it was December, for its pension obligation valuation. for the execution to show up. They see a grounded on Jan. 16 due to battery fires. I think it raised the amount that it owes in the new manager coming in. They see issues that future by about $3 billion, which is a huge have been happening for the past couple of The 787, at its current point, is a detriment to number. quarters. They see an admittance of a process operating profit margins. We think it will be that’s broken in terms of acquisitions and three to four years until Boeing starts making We just said that $6.3 billion was how much integrations. So, why pay for it here? This is money on an actual cost and revenue basis. operating profit Boeing generated in 2012. where the opportunity lies. Because here you Boeing will make a low single-digit number like This discount rate change made them owe have a company that generates a ton of money, 2% operating margin on the 1,100 aircraft it will more than $3 billion in just their pension over that’s got half its business in solid growth produce in the next 10 years. That’s about the next however many years. So, discount mode, and you’re getting paid to take the risk $4 billion to $5 billion in total. Last year, the rates have a material impact on our fair value on the other two sides. company posted operating profit dollars estimates going forward. of $6.3 billion. The initial 1,100 deliveries of the Alukos: What else is out there besides GD? 787 are not going to be all that meaningful. Alukos: Okay. We’ve discussed a lot. Can you give us a quick sum-up of the sector? Dihora: Most of our defense stocks are rated 3 But this is not atypical of new programs. In stars, meaning they are fairly valued based three to four years, the 787 is going to be a Dihora: Worries about defense cuts and the on our estimates. But investors looking for yield huge generator of revenue. The balance sheet sequestration are relevant, but they’re should look at Lockheed Martin. It has will get better, because right now they’re overplayed in the media, because what a 5% yield. holding a lot of this stuff on inventory. When it sequestration really does is just to reset the bar, starts delivering the planes, the balance sheet and then we can move forward to growth. Lockheed Martin is a company that is the will finally start shrinking, and it will actually That’s the important takeaway for me. Yes, largest defense contractor in the world. Most generate some cash flows. we’re going to have an issue in 2013 and of the headline risk comes from the next- maybe part of 2014. But we’re talking about an generation military aircraft, the F-35, where we Tauber: In the meantime, Boeing is cranking out issue that lasts for two to four quarters at best. have a back-and-forth in Congress about 737s and 777s. I don’t see a problem in the funding and not funding it. But Lockheed has balance sheet. I don’t think anybody questions If we can get the flexibility from the defense broad exposure to different areas. It has the viability of the 787 and the differentiation it contractor’s point of view, if companies can cut Navy businesses, it has Air Force businesses. It has as a product. It’s just taking a long time to costs to meet the new revenue bar, then has some Army business, although it’s not get there. they’re going to be fine. Their balance sheets much. It has a strong international component. are pretty solid, and they’ve been shareholder- The company isn’t really going to lose a whole Dihora: Yes, but if you think the aerospace or friendly, so I really don’t see a huge downside lot in terms of sequestration, but it will be aircraft business will turn down in any way, risk in these names. K affected by it, just like all the other players. But defense is not going to come to the rescue, per with its size and cash flows, I wouldn’t expect se. We forecast the defense side to be flat Basili Alukos, CPA, CFA, is an equity analyst its yield to go down. to down 2% to 3%. I don’t see a resurgence with Morningstar. really helping them all that much. It’s mostly a Alukos: What about Boeing? The company has commercial-focused company. been in the news a lot with the 787. How much of its success is tied to the 787? Our fair value estimate of Boeing is $80. It is negatively impacted by Boeing’s massive

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1 Additional fees apply; see prospectus for details. 2 According to Morningstar, the average VA has 45 underlying funds. (12/12) Variable annuities are subject to market fl uctuation and risk. Principal value and investment returns will fl uctuate and you may have a gain or loss when money is withdrawn. Variable annuities are long-term investments to help you meet retirement and other long-range goals. Withdrawals of tax-deferred accumulations are subject to ordinary income tax. Withdrawals made prior to age 59 1⁄2 may incur a 10% IRS tax penalty. Monument Advisor is issued by Jefferson National Life Insurance Company (Dallas, TX) and distributed by Jeff erson National Securities Corporation, FINRA member. Policy series JNL-2300-1, JNL-2300-2, JNL-2300-3.

JNL201304-A024 FOR FINANCIAL PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE. Sector Snapshot: Aerospace and Defense

The data on this page represents aerospace and defense companies covered by Morningstar analysts.

Industry Structure Key Stats Industry Map

Moat Breakdown* Aggregates 1 2 Market % Breakdown S&P 500 Number of Companies 16 Cap Wide Moat 18.8% 19.6% Total Market Cap $356,733 million 4 3 Large Narrow Moat 68.8% 53.0% Total Fair Value $315,212 million 5 786 No Moat 12.5% 19.8% Total Revenue $396,137 million 9 10 11 Medium 6479.800293 12 5234.600220 Stock Type Breakdown Valuation 3989.400146 2744.200073 131415 % Breakdown S&P 500 1499.000000 Sector S&P 500 Small High Yield 6.3% 5.0% Price/Fair Value 1.13 1.02 Distressed 0.0% 1.0% P/E 13.18 18.73 Hard Asset 0.0% 0.0% Price/Book 2.86 2.61 Undervalued Overvalued Cyclical 56.3% 44.6% Price/Sales 0.83 1.80 020.5 1 1.5 Slow Growth 0.0% 12.8% Price/CF 9.42 11.27 Price/Fair Value Classic Growth 0.0% 1.0% Dividend Yield % 2.35 2.05 Aggressive Growth 0.0% 16.8% Aerospace and defense companies are plotted Here you go (from Direct) (Market Cap): Speculative Growth 0.0% 4.0% Profitability and Financial Health based on their market cap and price/fair value ratio. Not Classified 37.5% 14.8% Sector S&P 500 Companies with a price/fair value ratio of less ROE % 21.40 14.70 than 1 are undervalued. Companies with a ratio Region Giant Large Medium Small *Based on Morningstar analyst coverage. ROA % 5.71 5.66 of more than 1 are overvalued. Numbered plots show United States 37916.090 7725.170 1498.401 420.612 companies listed in the table below. Net Margin % 6.04 9.18 Debt/Capital % 36.60 35.40 So the dividing line between giant and large is 37916.090, etc.

Aerospace and Defense

Name/Ticker Market Revenue Price/ Economic Morningstar Uncertainty Growth Profit- Financial Price/Fair Dividend Price/ Cap ($mil) TTM ($mil) Sales Moat Rating Rating Grade ability Health Value Yield % Earnings Grade Grade 1 United Technologies UTX 86,294.76 59,691.00 1.39 Wide QQQ Medium C C X 0.98 2.22 16.86 2 Boeing BA 71,915.39 81,208.00 0.86 Narrow QQ High C C X 1.18 1.90 17.09

3 European Aeronautic Defence and Space NV 33,481.72 56,480.00 0.58 Narrow QQ High C0.00C .5 C 1.011.25 .5 1.10 2.0 26.74 4 Lockheed Martin LMT 32,963.30 46,959.00 0.69 Wide QQ Medium C Z Z 1.16 4.18 11.44 5 General Dynamics GD 26,559.64 31,338.00 0.83 Wide QQQ Medium C V X 0.92 2.78 —

6 Rolls-Royce Holdings 21,453.38 12,161.00 1.74 Narrow QQ Medium C X — 1.18 1.05 9.29 7 Raytheon RTN 20,600.00 24,355.00 0.84 Narrow QQ Medium C C Z 1.11 3.23 10.55 8 Northrop Grumman NOC 18,157.39 25,124.00 0.75 Narrow QQ Medium C X X 1.15 2.85 9.62 9 BAE Systems 12,163.03 16,927.00 0.73 Narrow QQQ Medium C C — 1.04 5.20 10.15 10 Rockwell Collins COL 8,866.07 4,664.00 1.91 Narrow QQ Medium C C Z 1.15 1.84 14.60

0.94 2.29 12.63 11 Bombardier 7,458.59 16,768.00 0.41 Narrow QQQQ High C Z X 0.77 2.35 12.30 12 Embraer S.A. ADR ERJ 6,519.79 6,111.70 1.03 Narrow QQ High C V C 1.17 0.24 18.28 13 Spirit AeroSystems Holdings SPR 2,991.29 5,574.10 0.53 None QQQ Medium C V C 1.10 — 83.33 14 Cobham 2,770.86 1,749.40 1.54 Narrow QQ Medium — — — 1.12 3.43 15.58 15 Alliant Techsystems ATK 2,406.81 4,519.51 0.54 Narrow QQQ High C C X 1.15 1.25 9.34

Data as of April 30, 2013

MorningstarAdvisor.com 33

Spotlight: Alternative Investing

Alternative Designs Investors need to understand what drives returns to know which alternative investments create a truly diversified portfolio.

In this section:

36 Beware the Lure of Diversification Michael Coop

40 Using Alternatives in Practice Jerry Kerns

45 Managed Futures and Cash Rates Terry Tian

MorningstarAdvisor.com 35 Spotlight

Beware the Lure of Diversification

By Michael Coop To truly diversify a traditional portfolio, alternative investments need to be cheap and behave differently than stocks and bonds.

Much like the Greek sailors who were lured investments as diversifiers. Adding them total portfolio outcomes if it suffers a large fall to shipwreck by the enchanting music to a traditional portfolio is supposed to improve in value, as tends to happen after surges in and voices of the Sirens, investors have been outcomes in ways that would not be possible popularity and prices. seduced by the call of diversification into simply by varying the mix of stocks and buying overvalued, cyclical strategies marketed bonds. The aim is to improve risk-adjusted Is It Really Alternative? as alternative investments and paying high returns, so that for a given amount of risk, The first condition for getting diversification fees to obtain them. returns should be higher, or for a given return, is very important; many funds are promoted risk should be lower. as alternative investments but there The superior performance of commodities, is no widely accepted definition of “alternative.” infrastructure assets, and hedge funds over Two Conditions of Diversification Investors need to understand what drives equities during the 2000–2002 bear market The risk investors should be most concerned the prices of equities and bonds before they attracted a lot of capital to these areas with is the permanent loss of capital can determine if the alternative investment in ensuing years. But all performed far worse rather than volatility. For diversification is giving them more of the same, or during the global financial crisis of 2008 to work, an alternative investment must meet something different. When equities and bonds than they did in the earlier downturn; losses for two conditions: suffer large losses, will the alternative commodities and infrastructure were on par investment behave the same way or will with those of equities (Exhibit 1). 1. It needs to behave differently from equities it provide the needed diversification at that and bonds over a full market cycle. time? Let’s look at some drivers of equity and Adding these assets to a traditional stock/bond Whatever drives alternatives’ underlying cash bond returns. portfolio barely improved the portfolio’s flows and changes in valuation cannot be performance. From 2000 to 2012, diversifying the same drivers of the behaviors of equities Equity Returns into alternatives would have increased returns and bonds. Dividends and corporate earnings per share by a meager 0.2% annualized and not have been the key drivers of real equity returns reduced risk (based on a 10% allocation equally 2. It should be priced low enough to generate a over the long term.1 Income comes from split between hedge funds, infrastructure, return high enough to improve the portfolio’s dividends; capital return comes from changes and commodities, funded pro rata for a 50% performance, taking into account valuation and in share prices, reflecting 1) inflation, equity/50% bond portfolio). fees. An alternative investment’s returns 2) growth in corporate earnings that accrues do not need to be higher than those of equities to shareholders, and 3) changes in valuation This outcome is a far cry from what most or bonds, providing the investment does (for example, how much investors pay for investors expect when they use alternative behave differently. But adding it won’t improve future cashflows).

1 Ibbotson, Roger G. and Peng Chen, “Long Run Stock Returns: Participating in the Real Economy,” 2003

36 Morningstar Advisor June/July 2013 Over the very long term, valuation changes have been small relative to corporate Exhibit 1 Performance of Equities, Commodities, Hedge Funds, and earnings growth, though they have been the Infrastructure, 2000–2012 dominant driver of returns over short periods. Corporate earnings rise and fall with Peak to trough change in price % Commodities Hedge Funds Intrastructure Equities economic growth, making shares a cyclical 0 investment. As economic growth slows, sales volumes fall, causing a decline in –10 revenues but not a decline in fixed costs. The result is a fall in profit margins, often made worse by price discounting as companies –20 compete more aggressively. Eventually, this leads to cost cutting. Profit margins then –30 rise, and sales volumes rise when economic growth recovers. –40

Swings in valuation levels are also cyclical. –50 Investors pay more in times of prosperity and less during recessions. Large losses from equities have coincided with economic –60 recessions; extreme losses occur when 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 investors also fall out of love with shares, causing valuation levels to fall from Note: Commodity returns are proxied by the Dow Jones-UBS Commodity Index Total Return USD. Hedge-fund returns are proxied by the HFRI highs to lows (as they did in 1929–1933, Fund of Fund Composite Index. Infrastructure returns are proxied by the UBS Global Infrastructure and Utilities Index 50/50 USD total return net dividends. Equity returns are proxied by the S&P 500 Index total return. 2000–2002, and 2007–2009) This means that alternative assets and strategies that are cyclical are unlikely to be good diversifiers. 12/31/991/31/002/29/003/31/004/30/005/31/006/30/007/31/008/31/009/30/0010/31/0011/30/0012/31/001/31/012/28/013/31/014/30/015/31/016/30/017/31/018/31/019/30/0110/31/0111/30/0112/31/011/31/022/28/023/31/024/30/025/31/026/30/027/31/028/31/029/30/0210/31/0211/30/0212/31/021/31/032/28/033/31/034/30/035/31/036/30/037/31/038/31/039/30/0310/31/0311/30/0312/31/031/31/042/29/043/31/044/30/045/31/046/30/047/31/048/31/049/30/0410/31/0411/30/0412/31/041/31/052/28/053/31/054/30/055/31/056/30/057/31/058/31/059/30/0510/31/0511/30/0512/31/051/31/062/28/063/31/064/30/065/31/066/30/067/31/068/31/069/30/0610/31/0611/30/0612/31/061/31/072/28/073/31/074/30/075/31/076/30/077/31/078/31/079/30/0710/31/0711/30/0712/31/071/31/082/29/083/31/084/30/085/31/086/30/087/31/088/31/089/30/0810/31/0811/30/0812/31/081/31/092/28/093/31/094/30/095/31/096/30/097/31/098/31/099/30/0910/31/0911/30/0912/31/091/31/102/28/103/31/104/30/105/31/106/30/107/31/108/31/109/30/1010/31/1011/30/1012/31/101/31/112/28/113/31/114/30/115/31/116/30/117/31/118/31/119/30/1110/31/1111/30/1112/31/111/31/122/29/123/31/124/30/125/31/126/30/127/31/128/31/129/30/1210/31/1211/30/1212/31/12 relationship to inflation are unlikely to be and communication. This covers a wide range Government Bonds good diversifiers. of assets from those that face competition and The key driver of the returns of government are more sensitive to economic activity bonds is changes in inflation. Bonds perform Cyclicality (such as airports) to those that are monopolies well when there is downward pressure on Investors need to be pragmatic in working with more stable demand (such as regulated inflation, either during recessions or as a result out how much equity-like cyclicality and utilities). Defensive infrastructure has proved of longer-term structural changes. They perform bond-like inflation sensitivity they can tolerate, a good diversifier. Its returns relative to poorly when there is upward pressure on because almost all investments, to some more-cyclical infrastructure investments held inflation, either during booms or as a result of extent, are affected by economic growth and up better during the recession and equity bear inflationary structural changes, such as the rise inflation. It is possible to improve the markets from 2000 to 2012. in oil prices in the 1970s. diversifying quality of investments by careful selection of asset classes, subsectors, and Exhibit 2 plots the relative return of more- What makes bonds different from other specific strategies to reduce the exposure to cyclical versus less-cyclical infrastructure. investments is the fixed nature of their coupon cyclicality. This applies to most types of When the line is rising, the value of payments. Their purchasing power goes investments regarded as alternative invest- cyclical assets is increasing relative to up when inflation rates fall and down when ments, including infrastructure, commodities, less-cyclical. When the line is falling, the value inflation rates rise. Investors pay more to and hedge funds. of cyclical asset returns is decreasing receive coupons when their purchasing power relative to less-cyclical. More-cyclical is rising, causing bond prices to rise and Infrastructure infrastructure companies underperformed by bond yields to fall. The biggest rise in bond Infrastructure as an asset class refers to assets 30% in the 2000–2002 and 2007–2009 bear yields and resulting losses have coincided with used to provide essential services to the markets. Tilting to less-cyclical infrastructure rising inflation. Investments with a similar community, including power, water, transport, investments clearly would have improved

MorningstarAdvisor.com 37 Spotlight

diversification benefits at the most important along with hedge-fund strategies that exhibit the prices of assets were generally bid up. time: when equity losses were large. low equity beta, would have markedly Then came 2008, and the withdrawal of capital improved performance of portfolios during the by investors and debt providers had a big Commodities recent large equity downturns. A 10% impact on returns. The forced unwinding Commodities are also a broad asset class, allocation equally split between less-cyclical of positions (long and short) across most hedge covering precious metals, agricultural infrastructure and commodities and low- funds coincided with losses in most strategies goods, energy, and industrial metals. Commodi- equity-beta hedge funds (the same portfolio during the fourth quarter of 2008. The ties that are not directly used to produce weights as our earlier example and funded pro impact was made worse by government goods and services, such as gold and rata for a 50% equity/50% bond portfolio) intervention that banned short selling and agricultural goods, have been more effective would have added 0.6% annualized to returns led to a chain reaction of portfolio liquidation diversifiers than commodities with cyclically- while reducing volatility by 0.7% annualized. for arbitrage and hedged strategies. driven demand, such as industrial metals. This result fulfills the aim of diversification: More-cyclical commodities underperformed improving the reward for risk, in this case by Infrastructure assets enjoyed a similar bout less-cyclical commodities by 40% in increasing return and reducing risk. of popularity in the mid-2000s. Utility the 2000–2002 bear market and by 30% in the companies traded at the high end of their 2007–2009 bear market (Exhibit 2). As with Mind the Valuations historic price/earnings ratios (Exhibit 4). New infrastructure, the gains from reducing Reducing cyclicality and equity beta helps listed and unlisted infrastructure funds were cyclicality were largest when equity losses meet the first condition for diversification: set up, using increasing amount of debt were largest. adding investments that behave differently financing. Transportation and communications from equities and bonds. Achieving the assets became a larger part of infrastructure Hedge Funds second condition of diversification—avoiding portfolios. From 2007 to 2008, valuation Hedge-fund strategies differ widely both in large negative returns—requires a fundamen- levels reverted to historic norms and then fell terms of the size of their exposure to tal analysis of valuation and the amount of to the low end of historic valuation ranges. This equities and assets derived from corporate competition for different strategies. de-rating and the inclusion of more-leveraged earnings. Some hedge funds maintain a large and -cyclical assets resulted in larger losses net-long exposure to equities and corporate Unfortunately, this is not a simple process, during the period than in 2000–2002. debt. Ibbotson, Chen, and Zhu estimated given the lack of publically available informa- historic equity betas of equity long-short and tion, short track records, and important Commodities, though harder to value, experi- event-driven offerings to be 0.49 and 0.31, changes to composition, ownership, and market enced similar patterns of popularity followed respectively, in their analysis of hedge fund structure. But the effort is worthwhile. by extreme losses. After the 2000–2002 returns from 1995 to 2009.2 Other hedge Parabolic rises in asset prices and a flood equity bear market, commodity prices rose to funds have a more variable market exposure to of money into an asset class or strategy new highs supported by growing demand from any asset class and can be long or short. have been leading indicators of subsequent China. Commodity indexes proliferated; For example, according to Ibbotson, Chen, and large losses. high-profile pension funds added commodities Zhu, global-macro funds have a historic to their strategic asset allocation; and equity beta of 0.16. We applied the same The worst year on record for hedge-fund commodity retail funds and exchange-traded analysis to hedge funds and found similar returns was 2008, after a spectacular rise of products became available. The underlying cost though less-pronounced results. While inflows in 2006 and 2007 Exhibit( 3). Investment of supply did rise for many commodities high-beta strategies actually performed better banks were investing more of their own (especially oil, when low-cost supplies were than lower-beta strategies in the 2000–2002 capital in hedge-fund-like strategies run by depleted, leaving much-higher-cost oil sources bear market, they underperformed by 25% in internal teams. The amount of leverage that as the only way to meet growing demand). the 2007–2009 market. was available went up markedly as equity The long history of commodities shows that market volatility fell to very low levels in the large price rises trigger changes in demand As the above examples illustrate, the simple mid-2000s. As the total amount of money and supply that force prices back to the approach of holding less-cyclical versions competing for opportunities increased, the size long-run cost of supply. When oil peaked at of infrastructure and commodities investments, of spreads in arbitrage strategies shrank, and $150 per barrel in 2008 (Exhibit 4), industry

2 Ibbotson, Roger G., Peng Chen, and Kevin X. Zhu, “The ABCs of Hedge Funds: Alphas, Betas, and Costs, Financial Analysts Journal, January/February 2011, vol. 67, no. 1.

38 Morningstar Advisor June/July 2013 sources estimated the marginal cost at around $80. Even expensive oil sources were highly Exhibit 2 Performance of Higher vs. Lower Cyclicality for profitable to extract. Oil fell to a low of $30 per Infrastructure and Commodities Against Equities barrel and remains well below that peak today. Infrastructure Higher vs Lower Cyclicality Equities Commodities Higher vs Lower Cyclicality Recession The Takeaways 140 1.0 0.9 We started this article by warning about 120 the lure of diversification and how it can lead 0.8 100 0.7 to paying high fees for investments billed 80 0.6 as alternative that add little benefit to a 0.5 standard portfolio of equities and government 60 0.4 bonds. Here are some simple ways to avoid 40 0.3 0.2 the pitfalls of alternative investing and tilt the 20 0.1 odds in your favor. 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 First, limit your alternative investment portfolio Note: For infrastructure, higher cyclicality is proxied by UBS World Toll Roads Index total return USD, lower cyclicality by UBS Transmission and to assets and strategies that behave Distribution Index total return USD. For commodities, higher cyclicality is proxied by an average of returns from the S&P GSCI Industrial Metals Index total return and S&P GSCI Energy Index total return; lower cyclicality by an average of returns from the S&P GSCI Agriculture and Livestock differently from equities and bonds over a full Index total return and the S&P GSCI Precious Metals Index Total Return. Recession periods as estimated by the NBER market cycle. When possible, customize your alternative investments to reduce exposure to the economic cycle, as this is a key 12/31/991/31/002/29/003/31/004/30/005/31/006/30/007/31/00Exhibit8/31/0010/31/009/30/0011/30/0012/31/001/31/012/28/013/31/014/30/015/31/016/30/017/31/018/31/0110/31/019/30/0111/30/0112/31/01 31/31/022/28/02 3/31/02 Net4/30/025/31/026/30/027/31/028/31/0210/31/029/30/0211/30/0212/31/02 1/31/03Flows2/28/033/31/034/30/035/31/036/30/037/31/038/31/0310/31/039/30/0311/30/0312/31/031/31/042/29/04 3/31/04into4/30/045/31/046/30/047/31/048/31/0410/31/049/30/0411/30/0412/31/04 1/31/05Hedge2/28/053/31/054/30/055/31/056/30/057/31/058/31/0510/31/059/30/0511/30/0512/31/051/31/062/28/063/31/064/30/06 5/31/06Funds6/30/067/31/068/31/0610/31/069/30/0611/30/0612/31/061/31/072/28/073/31/074/30/075/31/076/30/07 7/31/078/31/0710/31/079/30/0711/30/0712/31/071/31/082/29/083/31/084/30/085/31/086/30/087/31/088/31/0810/31/089/30/0811/30/0812/31/081/31/092/28/093/31/094/30/095/31/096/30/097/31/098/31/0910/31/099/30/0911/30/0912/31/091/31/102/28/103/31/104/30/105/31/106/30/107/31/108/31/1010/31/109/30/1011/30/1012/31/101/31/112/28/113/31/114/30/115/31/116/30/117/31/118/31/1110/31/119/30/1111/30/1112/31/111/31/122/29/123/31/124/30/125/31/126/30/127/31/128/31/1210/31/129/30/1211/30/1212/31/12 driver of long-run equity returns. Hedge Fund Industry Net Flows ($U.S. billion) Second, be mindful of valuation and the 200 amount of capital competing for opportunities. 150 Large losses are more likely to follow when both reach extreme highs. Investors with 100 long-term fixed allocations need to review their Peak to trough change in price % Commodities Hedge Funds Intrastructure Equities asset weights at least once a year and 50 0 reduce target weights if these extreme 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 conditions apply. Those with the capacity to –10 dynamically adjust weights should be prepared Source: Hedge Fund Research, Inc. to exit entire allocations. Admittedly, this –20 requires a difficult, fundamental, valuation- Exhibit 4 Utility Sector Price/Earnings Ratio (Normalized) based analysis that may not suit all investors, but the rewards are worth the effort. K and–30 Crude Oil Price

Michael Coop is head of alternative investments and Oil Price U.S. Utilities PER Normalized –40 capital markets with Ibbotson Associates Australia. 160 3.0 140 2.5 2.0 120 –50 1.5 1.0 100 80 –60 0.5 0.0 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 60 –0.5 40 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 –1.0 20 –1.5 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Note: Oil price is proxied by West Texas Intermediate price, normalized. Utilities price/earnings ratio is based on the FactSet U.S. equity index price/earnings ratio.

MorningstarAdvisor.com 39

Infrastructure Higher vs Lower Cyclicality Equities Commodities Higher vs Lower Cyclicality Recession 140 1.0 120 0.8 100 80 0.6

60 0.4 40 0.2 20 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 12/31/ 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Spotlight

Using Alternatives in Practice

By Jerry Kerns Advisors and clients need to understand what they’re buying and the role a strategy has in a portfolio.

The number of liquid alternatives offerings has Jerry Kerns: What is your definition of an there are three categories of investments: skyrocketed since the 2008 financial crisis. Not alternative investment? equity (ownership), debt (lending), and satisfied with the performance of their insurance (short sales and derivatives). traditional stock and bond portfolios, many Bradley Alford: The term alternative invest- So-called long positions in equity and debt are advisors and investors have sought out the ment is used to describe both asset typically referred to as traditional investments; sophisticated strategies that hedge funds and classes and investment strategies. Alternative alternatives incorporate that third category— institutional investors have been using for asset classes are those other than the three insurance as a hedge against security, decades. Mutual fund and exchange-traded- traditional asset classes, which are stocks, industry, and systemic risks. Alternatives by fund firms quickly answered the call. The fund bonds, and cash. Examples of alternative asset themselves are not an asset class. For example, industry has launched hundreds of alternative classes are private equity, real assets, from this perspective, a long-only commodities offerings of varying strategies and asset and commodities. Alternative strategies are fund is a traditional equity portfolio in that classes over the past five years. To get a those that use management techniques other you own a basket of stocks, metals, or practical view of this burgeoning segment of than long-only, such as leverage and short contracts. Long-only REIT funds are traditional the industry, we interviewed three profession- selling. The term hedge fund is generally used equity funds because you own positions in als who have many years of experience to describe the vast array of alternative REITs. An emerging-markets bond fund is a investing in alternatives for clients. investment strategies. It’s worth highlighting traditional fixed-income portfolio because you that alternative investment strategies are are lending to emerging country governments Bradley Alford founded Alpha Capital implemented using traditional asset classes, as or corporations. By contrast, a long/short Management in 2006, a registered investment well as alternative asset classes. commodities fund, or a long/short REIT fund, or advisor based in Atlanta. He is the portfolio a long/short emerging-markets bond fund manager of Alpha Opportunistic Growth ACOPX Richard Raby: An alternative investment is any is an alternative strategy, as the funds contain and Alpha Defensive Growth ACDEX. Richard investment outside the standard, long-only traditional positions in stocks and bonds Raby is a portfolio manager for Creative investments in equities and fixed income. This but also contain short positions as insurance. Financial Group, also based in Atlanta. The firm would include precious metals, futures, short Adding that third category—insurance— provides financial planning and investment positions, options, and asset-allocation typically will reduce correlations with advisory services for high-net-worth clients. strategies that can use those same vehicles. traditional strategies and reduce volatility Richard Bregman is the founder and CEO of relative to traditional strategies. MJB Asset Management, a RIA firm based in Richard Bregman: Alternatives are not New York City. investments per se, but rather are strategies Kerns: What role should alternative invest- that incorporate some element of hedging, ments play in a portfolio? The three will appear together June 13 whether through individual short sales at the 2013 Morningstar Investment Conference or by use of derivatives, such as options, Alford: Alternative investments are intended in Chicago. futures, swaps, etc. From this perspective, to generate returns that are far less dependent

40 Morningstar Advisor June/July 2013 Bradley Alford One thing each alternative asset class has in common is the ability to provide investors with insurance against declines in a 60/40 portfolio.

Richard Raby The idea of buying and hoping the market will go up while witnessing 2000–2002 and 2008 is a little hard for many to handle.

on stock- and bond-market exposure. It is Alford: I have been investing in alternatives Bregman: The biggest change I have seen is getting more and more difficult for investors to for more than 20 years, so I have witnessed an the incredible migration of alternative meet their objectives with a traditional incredible amount of change, but especially strategies into the open-end ’40 act mutual 60/40 stock/bond portfolio—equities keep in the past 10 years. There has been a fund format. rising but that can’t last forever, and bonds are mainstreaming of alternatives, particularly due a poor investment as the 30-plus-year bull to the availability of liquid alternative mutual Kerns: What is the biggest challenge to invest- market in interest rates comes to a close. funds. Ten years ago, alternatives were ing in alternatives? I view alternatives as the necessary third confined to the biggest institutions, but they component to a diversified portfolio. Alterna- have now become an accessible component of Alford: Due diligence is crucial, but many tives can play many different roles in a a diversified portfolio for all investor types. advisors don’t have experience with alterna- portfolio, from return enhancer, to fixed-income tives. With traditional alternatives such substitute, to diversifier; one thing Raby: People have opened up to the use of as hedge funds, managers do not offer much each alternative asset class has in common alternative, hedged, and flexible strategies a transparency into portfolio positions or is the ability to provide investors with great deal more. The idea of buying and hoping investment process, making these investments insurance against declines in a 60/40 portfolio. the market will go up while witnessing difficult to evaluate. With liquid alternatives, Combining non-correlated investments 2000–2002 and 2008 is a little hard for many to although transparency is high due to the ’40 can create a portfolio with better risk- handle. The Jeremy Siegel “Stocks for Act fund structure, most products have short adjusted returns. the Long Run” concept does not apply to many track records, making it difficult to judge how investors as they are not patient enough to these managers will perform over a full market Raby: They are a means to mitigate downside hold out for 30 years while the market is down cycle. The dispersion in returns between the risk, maximize risk-adjusted returns, and 38% or more. Most retirees, or those approach- best and worst U.S. large-cap equity manager minimize correlation to the market. ing retirement, are open to a strategy that does might only be a few percentage points in any not resemble a roller coaster. In turn, the given year; in hedge funds, it can be more than Bregman: Risk mitigation in the form of limiting marketplace has started to provide some viable 15 percentage points per year. The stakes are overall portfolio volatility, for starters. and dynamic solutions via ‘40 Act funds, which high for picking the wrong managers. Curtailing volatility can provide an investor we like very much. These solutions are in with the opportunity to limit downward contrast to the lack of transparency, low Raby: Educating clients on the nuances movements and position the portfolio for gains liquidity, and high expenses in the hedge fund of alternative funds. in the future. world. Our most important job is the management of risk, not management of returns, Bregman: The biggest challenge is fully Kerns: How has the environment changed over to paraphrase Ben Graham. In our opinion, the understanding the risk-and-return the past 10 years for alternative investing? unregulated world of hedge funds does not fit opportunities of particular strategies in that profile. particular market environments.

MorningstarAdvisor.com 41 Spotlight

Richard Bregman It is important to roll up your sleeves and do the homework on a strategy to find out what the consequences might be under various circumstances.

Kerns: What do investors and clients fear most long/short equity funds always have a short portfolio, I thought all great money managers about investing in alternatives? How do you component and will never keep up with had to be hedge funds in a 2-and-20 limited deal with this perception? the S&P 500 in an overheated equity market partnership structure. I have opened my eyes to like we have today. Many investors will sell all the alternative managers in mutual funds. Alford: In many ways, 2008 represented their alternative funds and just buy long- investors’ biggest fears. Some categories of only equity managers right as the market peaks. Raby: Ryan Caldwell and the Waddell & Reed alternatives were hit even harder than They will suffer the greatest in a correction. team are my favorites. Caldwell and Ivy pushed stocks and bonds, and previously uncorrelated Alternative managers need to be held for three me to jump into asset-allocation strategies asset classes showed significantly higher to five years, even during raging bull markets. because they performed so well in both up and correlations to each other than expected. Performance chasing is a great way to down markets and they were not a huge leap of Additionally, the illiquidity of many alternatives underperform the markets. faith for our clients to make into the scary meant that cash-strapped investors had to sell world of alternatives. As a firm, Research liquid assets at the worst time possible since Raby: Advisors make the mistake Affiliates and Rob Arnott have been the most the money in hedge funds or private equity was of not educating their clients on how influential to us. locked up, in some cases for multiple years. alternatives work. With liquid alternatives, investors have the Bregman: Benoit Mandelbrot, who developed flexibility and liquidity to quickly change their Bregman: I believe the biggest challenge fractal geometry, has had a huge influence portfolio across market cycles. for an advisor is not fully understanding the on my views of markets and volatility. complete risk/return trade-off for various Raby: They fear the unknown, mostly. Being strategies. It is important to roll up your Kerns: What is your best piece of advice for unlike an index in performance and structure, sleeves and do the homework on a strategy to advisors who are considering alternative an alternative investment does not fit into find out what the consequences might be under investments for their clients’ portfolios? a nice, easy paradigm, so we have to educate various circumstances. them. The best way to educate them is to run Alford: Education, education, education. I like through the performance stories during times Kerns: Who is your favorite alternatives to joke that alternatives compose 20% of a like 2000 to 2002 and 2008 to 2009. investor? Who has influenced you the most? portfolio but will consume 80% of an advisor’s time. Both the advisors and the clients need to Bregman: A few clients have feared the word Alford: My favorite alternative fund is Robeco take the time to understand the risks and derivative and a few have feared anything Long/Short Equity BPLSX managed by Bob benefits of alternatives in a diversified portfolio. sounding quantitative. If a client has a fear, we Jones. Not only is his performance excellent see no point in exacerbating it. There are over all time periods, but he closed the fund Raby: Review the performance in both up and a sufficient number of alternative strategies years ago to focus on returns instead of down markets and do not let expense ratios that we can find several with which a client gathering assets for more management fees. I scare you away from an important asset class. can be comfortable. just love it when a manager closes to new investors as it shows his interest is clearly Bregman: Do your research and make sure you What is the biggest mistake advisors and aligned with his investors. Warren Buffett has have a clear purpose for using alternative investors make when investing in alternatives. influenced me the most. He taught me that you strategies. K don’t have to pay a manager 2-and-20 for them Alford: The biggest mistake is not holding to be great. At the Duke Endowment, where I Jerry Kerns is editor-in-chief of Morningstar Advisor. alternatives for a full market cycle. For example, used to manage the alternative investment

42 Morningstar Advisor June/July 2013 The municipal bond market is a whole new ballgame. Lord Abbett has a hard-hitting lineup.

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This is exclusively for financial advisors only (registered representatives of broker/dealers or associated persons of registered investment advisers). All of the funds are subject to certain risks. Because municipal bonds are sensitive to interest rate movements, the fund’s yield and share price will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in the fund adjust to a rise in interest rates, the fund’s share price may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. Income from national tax-free income funds may be subject to state and local taxes and may be subject to the alternative minimum tax. These and other risks are described in each fund’s prospectus. ETFs for Real-World Goals

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Before investing visit www.flexshares.com/prospectus to obtain a prospectus that includes the investment objectives, risks, fees, expenses and other information you should read carefully and consider carefully. Foreside Fund Services, LLC, distributor. Investment in FlexShares Morningstar US Market Factor Tilt Index Fund (TILT), FlexShares Morningstar Developed Markets ex-US Factor Tilt Index Fund (TLTD) or FlexShares Morningstar Emerging Markets Factor Tilt Index Fund (TLTE) is subject to numerous risks, including possible loss of principal. Highlighted risks: concentration (may invest 25% or more of assets in a single industry/sector); currency (foreign currencies may fluctuate in value relative to the US dollar, adversely affecting the Fund’s investments); emerging markets (countries potentially less liquid and subject to greater volatility); foreign securities (TLTD and TLTE typically invest at least 80% of assets in ADRs and GDRs); small cap stock (smaller-company stock may be subject to more abrupt/erratic market movement than larger companies); value investing (possibility that an investment in companies whose securities are believed to be undervalued may not appreciate in value as anticipated). See prospectus for full description of risks. nt1221_MAM_8.25x10.25.indd 1 4/10/13 7:46 AM Managed Futures and Cash Rates

By Terry Tian Before attempting to cash in on managed-futures funds, understand how these funds use cash.

Managed-futures mutual funds introduced had 128 constituents as of January 2013) Excess Returns of Managed Futures the concept of momentum-based futures and the relationship between interest rates and Many studies touting the benefits of managed- trading strategies to many investors. Before the managed-futures returns. futures returns often fail to mention that first such mutual fund launched in late 2009, these returns come from both futures trading managed-futures strategies were only Cash Efficiency as well as from interest earned on the accessible to those who had the wherewithal Unlike traditional investments, such as stocks cash collateral. For example, Schneeweis, to open a futures trading account and several and bonds, futures contracts are traded on Spurgin, and Szado (2012) studied the return hundred thousand dollars to invest. Now, margin. This means that an investor needs only drivers of three indexes—Barclay CTA Index, 50 different managed-futures mutual funds are a small percentage of the total (notional) value CISDM CTA Asset Weighted Index, and available to all types of investors, with of the contract up front (about 5% for the CSFB/Tremont Managed Futures Index, each of minimum investments as low as $500. These E-mini S&P 500 contract, for example). Margin which had returned more than 6% annualized funds often lure investors with statistics requirements are higher for more-volatile between 1994 and 2009—but do not delve such as the near-zero long-term correlations to assets, such as some commodity contracts. into the effects of interest rates on the funds’ stocks and bonds, as well as the amazing Often, managed-futures trading programs only returns.2 In today’s near-zero interest-rate historical returns of various managed-futures use 15% of their assets for margin (this is environment, the returns on cash seem industry indexes. What the fund marketing called the margin/equity ratio).1 The rest of the negligible, but over the period studied, materials, and even academic literature, assets sit in cash-like instruments, typically short-term interest rates were much higher. fail to explain, however, is how many of these short-term U.S. Treasuries. historical returns were attributable to high Looking at our own data, the Morningstar interest rates. After all, since short-term This special structure enables managers to MSCI Systematic Trading Index returned interest rates dropped to near-zero levels at the easily adjust a managed-futures fund’s an annualized 8.6% between January 1994 and end of 2008, managed-futures strategies leverage to match their clients’ risk appetites December 2012, while three-month U.S. have languished. (a two times leveraged program, for example, Treasuries returned an annualized 3.1%. If we would use 30% of the total account assets for assume that the index constituents invested In this article, we estimate the proportion of margin purposes, instead of 15%), and it also 85% of their assets in three-month Treasuries cash returns of managed-futures trading frees up the capital to earn additional and 15% in futures contracts (which results in a programs (both private pools and separate short-term interest-rate returns aside from the notional exposure of more than 100% of account composites) in the Morningstar MSCI futures strategy returns. assets), the cash portion would have contrib- Systematic Trading Hedge Fund Index (which uted 2.6% of the returns over the time period

1 Based upon commodity-trading-advisors programs that disclose this information in Morningstar’s hedge fund database. 2 “Managed Futures: A Composite CTA Performance Review,” by Thomas Schneeweis, Richard Spurgin, and Edward Szado.

MorningstarAdvisor.com 45 Spotlight

(30% of the total return). If we assume the interest rate had been zero throughout Exhibit 1 Managed Futures Risk and Return Statistics, 1994–2012 the time, the Morningstar MSCI Systematic Trading Index would have returned 5.82% Correlation to Correlation to Barclays Return Standard the S&P 500 U.S. Agg Bond Deviation annually from January 1994 to December 2012.3 Morningstar MSCI Systematic Trading –0.09 0.19 8.59 13.59

That is still a decent return, although it trails 40/40/20 Managed Futures Portfolio N/A N/A 7.97 9.42 equities over the same time period. One Traditional 60/40 Portfolio N/A N/A 7.79 13.69 must remember, however, that the purpose of investing in managed futures is not just for the absolute return, but also for the low correlation to stocks and bonds (negative 0.09 Exhibit 2 Managed-Futures Returns in Rising/Falling Interest- and 0.19 to the S&P 500 and the Barclays U.S. Rate Environments Aggregate Bond Index, respectively, between

1994 and 2012). When added to a 60% 3-Month Treasury Constant Maturity Rate Morningstar MSCI Systematic Trading Rising Interest Rates Falling Interest Rates stock/40% bond portfolio (as represented by Rolling 12-Month Return (%) 3-Month U.S. Treasuries (%) the S&P 500 and Barclays U.S. Aggregate Bond 50 7

Indexes, respectively), a 20% investment 40 6 in the Morningstar MSCI Systematic Trading 30 5 Index (out of equities) would have improved both the return (from 7.79% to 7.97%) 20 4 and the standard deviation (13.69% to 9.42%) 10 3 (Exhibit 1). 0 2

Interest-Rate Environments –10 1 If interest-rate returns consist of such a large 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ portion of managed-futures index returns, 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 does the movement of interest rates explain the returns of managed-futures strategies? We examined the performances of managed- futures strategies’ in rising and falling (0.01), however, are relatively weak as the interest-rate risk into the cash sleeve of the interest-rate environments. We identified the variation in managed-futures returns is largely portfolio. But active cash management peaks and valleys of the three-month explained by factors (momentum) other than only slightly improved this fund’s return over its U.S. Treasury bill rate over the studied period interest-rate movements. more traditional managed-futures strategy, and define the periods in between those Altegris Managed Futures Strategy MFTAX, in dates as rising and falling interest-rate The Implications 2012 (negative 3.2% versus negative 3.9%). environments. In Exhibit 2, rising and falling Investors should be mindful when being interest-rate environments are shaded in green presented with historical managed-futures When interest rates do eventually rise, these and orange, respectively. returns, as these strategies are no longer risky strategies will likely buckle, and receiving a boost from interest rates, which more pure managed-futures strategies will It’s apparent from the chart that managed- have largely benefited them in the past. probably outperform. K futures returns tend to move with interest-rate levels, and the peak and valley points Some funds, such as the Altegris Futures Terry Tian is a former alternatives analyst of the two tend to coincide with one another. Evolution Strategy EVOAX, have tried to solve with Morningstar. The actual correlation (0.12) and R-squared this problem by introducing credit and

3 The difference between 5.82% and 6% results from the rounding and compounding effect of 228 monthly return data.

46 Morningstar Advisor June/July 2013 9.0 in. 8.75 in. 8.25 in. 11.0 in. 10.75 in. 10.25 in.

THINK OUTSIDE THE INDEX.

Th e PIMCO StocksPLUS Funds Innovative equity strategies backed by PIMCO’s time-tested investment process. LIPPER LARGE COMPANY Bill Gross pioneered the StocksPLUS® approach in 1986, combining passive equity EQUITY MANAGER indexing with active bond management. Lipper recognized these strategies and OF THE YEAR PIMCO’s equity platform by naming PIMCO Large Company Equity Manager of 2010, 2011, 2012 & 2013 the Year for four consecutive years. To fi nd out more about the PIMCO StocksPLUS strategies, harness our thinking at PIMCO.com/StocksPLUS.

Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your PIMCO representative. Please read them carefully before you invest or send money. A word about risk: Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit, and infl ation risk; investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. 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 Lipper Large Company Equity Manager of the Year Award recognizes fund groups that have delivered consistently strong risk-adjusted performance, relative to peers. On 22 March 2013, the fund’s name and objective changed from “Total Return” or “TR” to “Absolute Return” or “AR.” In managing the strategy’s investments in fi xed income instruments, PIMCO utilizes an absolute return approach; the absolute return approach does not apply to the equity index replicating component of the strategy. Investors should consult their fi nancial advisor prior to making an investment decision. PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO.

13PIM0045_D

Title: Stocks plus Bill to: 13PIZ0037 Executive CD: J. DiPiazza Market: Magazine REQ 125248 Creative Director: Run/Disk Date: 05/09/13 04:52 Art Director: M. McCallum Color/Space: 4C CE: 1/0 Writer: J. Perreca Live: 8.25 10.25 Production Artist: Renee Account Executive: S. Welborn Trim: 8.75 10.75 Task: resize Production Supervisor: S. Osterrout Bleed: 9 11 Spell checked Coordinator: Notes: FUNDSad189-TCWmorningstarAd_2013_TCW - Morningstar Ad 5/2/13 9:43 AM Page 1

Some stars have always stood out from the rest. Our Universe of Stars Our 4 and 5 star rated funds shine across several categories. H H H H H H TCW Emerging Markets Income H H TCW Select Equities Out of 105 funds in the Emerging Markets Bond category Out of 1,482 funds in the H H MetWest Total Return Bond H Large Growth category H H Out of 1,004 funds in the H H H Intermediate-Term Bond category H H H TCW Total Return Bond H H H Out of 1,004 funds in the H TCW Core Fixed Income H H Intermediate-Term Bond category H Out of 1,004 funds in the Intermediate-Term Bond category H MetWest Intermediate Bond H H Out of 1,004 funds in the Intermediate-Term Bond category H H H H H MetWest High Yield Bond H H H Out of 518 funds in the High Yield Bond category TCW Conservative Allocation H H H Out of 582 funds in the Conservative Allocation category MetWest Strategic Income H H Out of 91 funds in the Non-Traditional Bond category H H H H H H H MetWest Low Duration MetWest Ultrashort Bond TCW Short Term Bond H Out of 355 funds in the Short-Term Bond category H Out of 87 funds in the Ultrashort Bond category H Out of 87 funds in the Ultrashort Bond category H H H

Don’t miss Tad Rivelle, TCW Chief Investment Officer – Fixed Income, at the General Session: “Managing Bonds in a Brave New World” on June 13 at 4:30 p.m.

For the TCW Total Return Bond Fund (I & N Share), TCW Core Fixed Income Fund (I & N Share), MetWest Total Return Bond Fund (I & M Share), and the MetWest Intermediate Bond Fund (I & M Share), the total number of Intermediate- Term Bond funds for the 3-, 5-, and 10-year time periods were 1,004, 877, and 605, respectively. For the TCW Emerging Markets Income Fund (I & N Share) the total number of Emerging Markets Bond funds for the 3-, 5-, and 10-year time periods were 105, 86, and 42, respectively. For the TCW Select Equities Fund (I & N Share) the total number of Large Growth funds for the 3-, 5-, and 10-year time periods were 1,482, 1,278, and 856, respectively. For the MetWest High Yield Bond Fund (I & M Share) the total number of High Yield Bond funds for the 3-, 5-, and 10-year time periods were 518, 462, and 324, respectively. For the MetWest Low Duration Fund (I & M Share) the total number of Short- Term Bond funds for the 3-, 5-, and 10-year time periods were 355, 319, and 204, respectively. For the TCW Short Term Bond Fund (I & N Share) and the MetWest Ultrashort Bond Fund (I & M Share) the total number of Ultrashort Bond funds for the 3-, 5-, and 10-year (TCW Short Term Bond Fund only) time periods were 87, 80, and 63, respectively. For the MetWest Strategic Income Fund (I & M Share) the total number of Non-Traditional funds for the 3- and 5-year time periods were, 91 and 37 respectively. For the TCW Conservative Allocation Fund ((I & N Share), the total number of Conservative Allocation funds for the 3- and 5-year time periods were, 593 and 509, respectively. ©2013 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. You should consider the investment objectives, risks, charges and expenses of a Fund carefully before investing. The Fund’s Pro spectus and Summary Prospectus contain this and other information about the Fund. To receive a Prospectus, please call 1-800-386-3829 or you may download the Prospectus from the Fund websites at www.tcw.com or www.mwamllc.com. Read it carefully before you invest. Investment return and principal value of an investment will ﬂuctuate so that investor’s shares, when redeemed, may be worth more or less than their original cost.

Visit us www.TCW.com Proud to support at Booth 343 The Morningstar Investor Conference since 1999

The TCW Funds are distributed by TCW Funds Distributors, a subsidiary of The TCW Group, Inc. and the MetWest Funds are distributed by Foreside Fund Distributors LLC, which is not affiliated with TCW. The TCW Funds are advised by TCW Investment Management Company. The MetWest Funds are advised by Metropolitan West Asset Management, LLC, which is a wholly-owned subsidiary of The TCW Group. FUNDSad189-TCWmorningstarAd_2013_TCW - Morningstar Ad 5/2/13 9:43 AM Page 1

Some stars have always stood out from the rest. Morningstar Conversation Our Universe of Stars Our 4 and 5 star rated funds shine across several categories. H H H H H H TCW Emerging Markets Income H H TCW Select Equities Out of 105 funds in the Emerging Markets Bond category Out of 1,482 funds in the H H MetWest Total Return Bond H Large Growth category H H Out of 1,004 funds in the H H H Intermediate-Term Bond category H H H TCW Total Return Bond H H H Out of 1,004 funds in the H TCW Core Fixed Income H H Intermediate-Term Bond category H Out of 1,004 funds in the Intermediate-Term Bond category H MetWest Intermediate Bond H H Out of 1,004 funds in the Intermediate-Term Bond category H H H H H MetWest High Yield Bond H H H Out of 518 funds in the High Yield Bond category TCW Conservative Allocation H H H Out of 582 funds in the Conservative Allocation category MetWest Strategic Income H H Out of 91 funds in the Non-Traditional Bond category H H H H H H H MetWest Low Duration MetWest Ultrashort Bond TCW Short Term Bond H Out of 355 funds in the Short-Term Bond category H Out of 87 funds in the Ultrashort Bond category H Out of 87 funds in the Ultrashort Bond category H H H The World Is Getting Grayer

By Francisco Torralba Don’t miss Tad Rivelle, TCW Chief Investment Officer – Fixed Income, at the General Session: “Managing Bonds in a Brave New World” on June 13 at 4:30 p.m. Globally, almost all populations are getting older. Europe’s sovereign debt crisis provides a glimpse of the economic troubles For the TCW Total Return Bond Fund (I & N Share), TCW Core Fixed Income Fund (I & N Share), MetWest Total Return Bond Fund (I & M Share), and the MetWest Intermediate Bond Fund (I & M Share), the total number of Intermediate- Term Bond funds for the 3-, 5-, and 10-year time periods were 1,004, 877, and 605, respectively. For the TCW Emerging Markets Income Fund (I & N Share) the total number of Emerging Markets Bond funds for the 3-, 5-, and 10-year this aging will cause, economist Edward Hugh says. time periods were 105, 86, and 42, respectively. For the TCW Select Equities Fund (I & N Share) the total number of Large Growth funds for the 3-, 5-, and 10-year time periods were 1,482, 1,278, and 856, respectively. For the MetWest High Yield Bond Fund (I & M Share) the total number of High Yield Bond funds for the 3-, 5-, and 10-year time periods were 518, 462, and 324, respectively. For the MetWest Low Duration Fund (I & M Share) the total number of Short- Term Bond funds for the 3-, 5-, and 10-year time periods were 355, 319, and 204, respectively. For the TCW Short Term Bond Fund (I & N Share) and the MetWest Ultrashort Bond Fund (I & M Share) the total number of Ultrashort Bond funds for the 3-, 5-, and 10-year (TCW Short Term Bond Fund only) time periods were 87, 80, and 63, respectively. For the MetWest Strategic Income Fund (I & M Share) the total number of Non-Traditional funds for the 3- and 5-year time periods were, 91 and 37 respectively. For the TCW Conservative Allocation Fund ((I & N Share), the total number of Conservative Allocation funds for the 3- and 5-year time periods were, 593 and 509, respectively. ©2013 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. Edward Hugh is a Catalan economist of British number of economics blogs, including but ended up visiting topics as diverse as how You should consider the investment objectives, risks, charges and expenses of a Fund carefully before investing. The Fund’s Pro spectus and extraction who lives near Barcelona. As a “A Fistful of Euros,” “Global Economy Matters,” the United States’ national identity has Summary Prospectus contain this and other information about the Fund. To receive a Prospectus, please call 1-800-386-3829 or you may download macroeconomist, he specializes on demograph- and “Demography Matters.” helped it through the financial crisis and how the Prospectus from the Fund websites at www.tcw.com or www.mwamllc.com. Read it carefully before you invest. Investment return and principal value of an investment will ﬂuctuate so that investor’s shares, when redeemed, may be worth more or less than their original cost. ic processes, migration flows, and growth Italy might be the greatest threat to the and productivity theory. Although recently he I spoke with Hugh on March 14 at the eurozone’s stability. Our conversation has been has done a lot of work on the economic Morningstar Investment Conference in Vienna, edited for clarity and length. troubles of the eurozone (for obvious reasons), where he delivered a presentation titled www.TCW.com his curiosity has taken him far away from “What Do Aging Populations Have to Do With Francisco Torralba: You argue that the Visit us his home continent, and he has written about the Sovereign Debt Crisis?” We started demographic situation in Western Europe, Proud to support at Booth 343 The Morningstar the economies of India, Eastern Europe, our conversation with a discussion of the Japan, and the UK implies that sovereign Investor Conference and Japan. Hugh is a regular contributor to a demographic problem of the developed world, finances are going to be in a very sticky since 1999

We’re making an inversion from having too many children in proportion to the rest of the population to having too many old people.

Edward Hugh

situation within 10 to 20 years. The popula- then, population doesn’t matter.” But Kuznets’ the current crisis are out of date in light of that tions of these countries are aging rapidly and research was very specific: thesize of a paradigm shift, I would argue. will need help funding their retirements. But population didn’t matter. Iceland is no different fewer younger people are working and paying from China in this sense. Torralba: You argue that there’s a ratio called into the system. What will be the ramifications the dependency ratio: the number of older, of these trends for sovereign finances? Later, as we got into the 21st century, with the retired people relative to working-age growth of emerging markets, people started people…. Edward Hugh: What this means for sovereign discovering again that population structure finances in Europe is that there is increasing does matter. It’s not the size; it’s the population Hugh: If I can interrupt, actually, there are pressure on the level of sovereign debt and structure, stupid. two dependency ratios. There’s a child increasing pressure from markets on sovereign dependency ratio and an elderly dependency bonds simply because of political risk. So from the end of the 20th century, there ratio. The problem with the super-underdevel- It’s going to be very difficult, as years go by, for was increasing interest among development oped economies is that they have a massive the politicians to keep convincing voters economists in the way in which the drop in child dependency ratio, which means that the necessary sacrifices have to be made fertility rates in the emerging economies could they have very little in the way of saving, to help an aging population. So, we’re in a help those economies get up to speed, if because they have large numbers of children. complex situation. they made the necessary institutional reforms My father was one of a family of 14 and started to accompany these changes. work at 12 in the Liverpool of the United But if I can broaden this a bit, it’s not simply Kingdom, which was the richest country on the a question of the demographic change The first warning signal came from countries planet at that time. As my father told me, in Europe, the United States, or Japan. What like the Asian Tigers—Singapore, South Korea, having lots of children means poverty. Having a we’re facing at the moment is a paradigm Taiwan, and Hong Kong. Then, Goldman lot of old people, if we’re not very careful, shift in the way markets, investors, economists, Sachs got the idea of BRICs, as China started to could also mean poverty, too. and everybody are thinking about economic come online, and suddenly, we were talking processes, debts, and sovereign risk. about countries like Brazil, India, Indonesia, We’re making an inversion from having too Somebody told me about a recent pensions and the Philippines. many children in proportion to the rest of the meeting where a presenter said, “It’s the population to having too many old people. population, stupid.” There’s been a definite before and after For developing economies, the news that to the global crisis, with the emerging markets fertility is dropping is good. In developed This idea is very simple, and it’s just surprising assuming a far greater importance. The societies where the key ratio to watch is the that it went out of people’s heads for so valuation of the outlook for both growth and elderly dependency ratio, then a continuing fall long. In fact, traditionally, economists were sovereign risk in the developed economies has can become a major issue. Having let the always interested in population dynamics and shifted into another gear, as has the perception developed world population pyramid get to demographic processes. But there were of growth possibilities, and therefore, the stage it’s now in, trying to address the some famous studies in the 1970s and 1980s by sovereign risk in the emerging markets. problem is going to be difficult. Giving more the Nobel Economist Simon Kuznets, who facilities to working mothers who want found that size of population was not a factor That’s why I call this a paradigm shift. Some of to have children, for example, or some kind of in economic growth. That was the necessary these debates which we have between family support system, or paying to subsidize catalyst that caused people to think, “Well, Schumpeter and Keynes about how to handle school textbooks so that having a child is not

50 Morningstar Advisor June/July 2013 such a direct economic burden on a family— So, at the moment, the corporate sector is taking demand from the future in terms of all these are going to be very, very difficult in a reorienting and reinventing itself. This is being credit. In this sense, rather than a credit cycle, situation where resources are so strained, reflected in the U.S. equity markets; companies what we see is a structural shift in the role of because of the demands on the pension and are reorienting production toward these credit. Where we do get strong consumer health systems due to the large proportions of new, growing areas. But it’s going to be quite demand growth in countries like Spain or elderly people. difficult for the populations in the developed Ireland or the United Kingdom during the first countries to come to terms with the fact that decade of the century, the driving force was a Torralba: The problem is that we used to have their status in the world is changing. very large increase in private domestic credit. a demographic dividend, where we always Once that comes to an end, you seem to notice had an adequate ratio of retired people that consumer demand doesn’t have anything to working people. It’s what we call a What Can We Learn From Japan? like the same dynamic, because a higher pay-as-you-go system. Each year’s taxes are proportion of the population is just buying out used to pay the pensions for that year. That Torralba: Japan is a little bit further along of current earnings and current income. model will be inadequate for the next two or in the demographic transition than Western three decades. How are we going to transition Europe. Is there anything we can learn There is a certain age profile associated with to a new form of financing retirement? from Japan’s situation that is applicable to patterns of spending and borrowing. Western Europe? Nobel economist Franco Modigliani noticed Hugh: Well, the transition will be turbulent. this in formulating his lifecyle model. It was That’s the only clear thing we can say. Hugh: The thing that’s distinguished Japan indeed a pattern that had already been Our societies just aren’t prepared for this the most has been its ongoing deflation. identified by the British social philanthropist transition. People in many countries— Up to now, no other countries have had this Joseph Rowntree at the start of the 20th century. and it’s not just Southern Europe, because I kind of deflation. So, at the moment, this There are different stages in life. And these think the United Kingdom could soon be in the is a unique Japanese feature. We need more stages are successively either ones of same situation—don’t understand that you time to see whether it’s going to typify other increasing borrowing or ones of increasing need to make systematic cuts—in health countries or not. saving for the future. systems, for example. One of the reasons why the proportions of elderly dependents are rising What we can say, though, is that Germany, When we extend these stages to a whole is simply because of advances in medical which has a similar aging profile as Japan’s, population, we can see that the domestic technology. It’s getting easier to extend has had a very strong disinflationary tendency demand dynamic isn’t what it was as countries people’s lives, but we achieve this end by using over the past few years. The Germans have get older. So, that’s one of the points that we more and more expensive medication and patted themselves on the back about this and can get from Japan. technology for increasingly lower additions to said how good they’ve been in comparison with quality of life. It’s a very expensive process, but their European peers. But to some extent, this The other point is this increasing dependency it’s going to be very hard to explain to people could simply be a product of the internal on exports and external saving. One way that that’s the case. demand dynamic. Because I think the lesson of making the situation easier was always the that we can get from Japan is that with idea that during the good years, when you are What do I see in the future? In the first place, populations aging beyond certain thresholds, having higher levels of economic growth, I see a lot of turbulence in the political systems. the structure of production changes. Invest- savings could be diverted out of the country Second place, I see a process of realignment in ment oriented toward domestic consumption, into overseas investments—and to some the global markets. Every company needs and domestic consumption itself, tends to extent, the population can live off of these growth. Companies need markets to grow for become more and more lackluster, while the overseas investments. their products to justify the next generations of country comes to depend increasingly on investment. For corporations, the expansion having a super-efficient tradable sector and Indeed, this is what we’re seeing in Japan at in emerging markets is a godsend. Even though ramping up the level of export production. the moment, because Japan’s got a 50% the majority of the population can’t buy Italian of GDP net national investment position, which luxury products or expensive German cars, the We do see a rather similar pattern in Germany. helps the current account, but the country volume of the population is so large that even Why is it the case that domestic demand starts can’t live forever off this. Little by little, we can with only a small percentage of that population to weaken? Because most of the actual see the surplus weaken as people draw down being rather rich, you’ve got quite a big market. economic growth that we get comes from on their savings. So, there’s then a big

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Take Because if it isn’t, then what you are left with only Southern Europe but also Eastern the example of Spain; even when the economy is what the old East Germany would be like, if Europe—these are all countries that are about was growing at 4% a year and 750,000 it wasn’t part of the Federal Republic, a country to enter this important aging period, and migrants were entering the country every year, with a very large number of old people, quite a they’ve got strong negative external investment there was double-digit unemployment in the high unemployment rate, and insufficient positions. This is a great concern. How are they southern parts of Spain. There was no growth to support the basic welfare system. going to manage the aging process? They movement from these areas towards richer haven’t got the external savings to draw down, regions like Madrid, Valencia, or Barcelona, Torralba: From a political point of view, it’s and they have external debts to pay. where the economies were booming, and there going to be extremely complicated. It creates was plenty of opportunity for work. tensions between regions, and it creates Torralba: Exactly. Not only do they have resentment. In Spain, people in Catalonia current account deficits, but on top of that, Spain is quite a nice microcosm of the think they’re paying too much to Madrid. How they owe money to the external sector. problems that the euro area has as a whole. If is that going to work in Europe when Germany this mobility wasn’t evident, or wasn’t is told that they’re going to have to send Hugh: Every month, just to cover the current evident in Italy from the south to the north in checks every month to pay for the Spanish outflows on the equities and on the debt the first decade of this century, how much less retirees? I don’t see that going down very well. obligations these countries have, they have to wasn’t it there in the euro area as a whole. I do an extra dose of exporting to be able mean, there was a migration from Eastern Hugh: No, and I don’t think that’s going to to earn the money to pay it down. That Europe into the euro area, but not from one happen, either. Japan has these problems, not exporting doesn’t help compensate for deficient eurozone country to another, except at the most at the regional level, but the problem simply of internal demand. So, it’s going to become an highly qualified level. sustaining the health and pension system, increasing headache. given the lackluster nature of the economy and What we are seeing now is something new, now the declining workforce and problems of and something that in principle is very productivity that they’re having, associated Labor Mobility welcome—people are moving from countries with its aging. How Japan is handling this is which are stuck in deep recession to areas just by boosting debt. Japan’s gross sovereign Torralba: I’d like to discuss the relationship where there is economic growth, where there debt last year was around 235% of GDP, between migration and fiscal policy. is demand for labor. and they were running a fiscal deficit of around In an economic area like the eurozone, where 10%. The prime minister, Shinzo Abe, is talking in theory you have a free labor market— But, as you’re suggesting, this basically good about doing even more of the same this year, people are free to work and live wherever news also presents us with a problem, as it so we can imagine they could go up through they choose—you have the possibility that highlights yet another institutional deficiency in the 250% of GDP and onwards to upwards to people will move from the least-productive, the design of the euro area. Basically, those more than 300% over the next few years. lowest-wage parts of the eurozone to the who are moving have been brought up, most-productive, highest-wage areas. That educated, and prepared for life by one society These are unheard of proportions in any modern leaves behind retirees, or people with very but they then go and work in another one. society. We don’t know where this leads. But I low earnings, who make small fiscal Instead of paying contributions through the would suggest that the most likely tendency contributions to the state. What does the free pay-go system of their own country, they that we can see in Europe at the moment is a labor market in the eurozone imply for fiscal contribute to the pay-go system of another one, tendency for some kind of mechanism to be solidarity in the eurozone? and there’s no evident mechanism whereby any devised, yet to be specified, which allows of this money gets recycled back to meet the these countries to continue spending without Hugh: This is a very important point. The euro old-age needs of the parents who raised them. all the weight of this falling on Germany. was set up with major institutional deficiencies. Some of these had to do with the fiscal The issue then is, is the euro area going to set Torralba: We’ve been talking about the coordination and product market integration, up some kind of equivalent arrangement to implications of demographics for fiscal services integration, or whatever. One of the the one that’s been set up in the Federal Repub- solidarity. Another implication that we read deficiencies was the absence of widespread lic of Germany, or the autonomous communities about is that having a single financial labor mobility. For some reason or another, of Spain, and make some kind of allowance for system eventually leads to some sort of

MorningstarAdvisor.com 53 Morningstar Conversation

The whole idea of a working European Union, and especially the euro, depends on everybody feeling part of the same entity. They obviously don’t. Therefore, it’s dysfunctional.

Edward Hugh

burden-shedding in the end, because It’s going to be very difficult to convince it’s difficult within the short time horizons to eventually, the state is the guarantor of the German voters to accept that, so some other have responsible fiscal policies, so we’re financial system’s liabilities. way has to be found. What’s concentrated going to resort to monetary policy to finance everybody’s mind recently is the outcome of the deficits. In the United States, you don’t have You wrote recently that what Ireland did may Italian election, because it’s clear in Italy that fiscal constraint. Why has theU .S. be a peek into the future of the eurozone. that people are not voting at the moment and embarked on this monetary expansion policy First, the Irish Central Bank bought promissory are unlikely to vote in the foreseeable future for that seems to be turning into “QE infinity”? notes that were meant to recapitalize the a government that is strongly committed financial system, and then those promissory to the kind of reforms that will be needed in Hugh: I think there are two questions here. One notes were actually later swapped for Irish order to apply to Mario Draghi to implement an is, why has the United States gone for government debt. In the end, what this means Outright Monetary Transactions bond-buying quantitative easing? And the other one is, why basically is that the Irish Central Bank is program. Yet, the whole market current is it possible for the United States to do certain financing the deficit, even though it complete- position is based on the idea that ultimately things where they don’t mind who’s paying— ly goes against the European Union Treaty— these countries, Italy and Spain in particular, whether it’s somebody in Alabama who’s that the central banks are not supposed to will, if need be, apply to Mario Draghi. paying or in California? finance deficits. TheEuropean Central Bank is against it, the Bundesbank is against it, and So, everyone is skating on thin ice at the Most people I talk to from the United States nonetheless, it seems to be happening in moment. What happened in Italy could easily say that the United States can have this federal Ireland. Is this where we’re headed in Europe? happen in Greece in the next elections. You system—where people maybe moan a little bit, could get another party which is not favorable but nobody really seriously takes issue with Hugh: Something is going to have to happen, to continuing with the Troika programs, with a who’s paying for what. They had a Civil War, isn’t it? The market’s assuming as well that majority, because Greece has this first-past- and the Civil War settled this question. something is going to happen, because the-post party system, winner takes nearly otherwise, you can’t make sense of the pricing all. So, if it was Syriza instead of New Now, that’s not an argument for having a civil of European sovereign bonds at the moment, Democracy that came first by a short head in war in Europe, but we’ve never settled the unless you think that’s the case. the next elections, this would cause all question, despite all these wars we’ve had. It’s kinds of problems. Portugal is going to have quite interesting that the whole idea of the The premise would be what you said in the elections one day or another and has a similar European Union, the traditional argument for it, earlier question, and that is that it’s going to be situation pending. You don’t have to be a is that because we were always at war. very, very difficult for the Europeans collectively genius to see that there’s a limited lifespan to But in fact, war didn’t settle this issue, because to agree to have the kind of fiscal arrangement the unpopular austerity measures, necessary as we are still a continent of bigger and they have in the United States, where there many of them may be. smaller nations, where the national identity is are automatic stabilizers from one state to something that’s important to us. another, which operate immediately. If there is some kind of economic slowdown in one Strength of the U.S. Federal System Yet, the whole idea of a working European part, that doesn’t affect another. People can go Union, and especially the euro, depends on and live in Florida and have pensions paid, just Torralba: This reminds us that monetary policy everybody feeling part of the same entity. They the same as if they were living at home. and fiscal policy are not independent. They’re obviously don’t. Therefore, it’s dysfunctional. kind of two sides of the same coin. In Europe, That’s why the United States can do something

54 Morningstar Advisor June/July 2013

Morningstar Conversation

that Europe can’t, and I don’t see any But we are locked into these kinds of situations But the interesting thing is that these countries short-term or easy solution to this question. because nobody’s come up with a better with large net-negative external investment idea. The alternative to this is not to raise positions and high levels of sovereign debt Why do they keep doing QE even when there’s interest rates. So, what do we do? normally would experience a big run on their no evidence it works? Again, we can go currency. What the euro does is stop the big back to Japan. It’s curious that people say that Torralba: Speaking about inflation, a predic- run on the currency, because they’re in a the Bank of Japan hasn’t ramped up its balance tion that you hear about sometime is common currency—although it isn’t a national sheet as much as anybody else. In fact, that the monetization of government debt in level currency. it did ramp up its balance sheet quite a lot the long run will imply much higher rates of before the crisis started, so the baseline is a bit inflation. In fact, this is one way how But what Willem Buiter, the chief Citigroup different there. governments are going to deal with their economist, has spoken about over the past fiscal problems: just wipe away the real value months, and it’s becoming increasingly relevant, But it was quite obvious that in fact QE didn’t of their debt by letting inflation run higher. is the possible ruble-ization of the euro, making work the first time it was tried in Japan. There a comparison with the old USSR, when the was this critical moment in 2005 when the G20 Do you think this eventually is an outcome ruble was retained as a common currency for a had decided that everybody was going to go that we should be worried about? number of increasingly independent states. In back home and try to start raising interest rates, fact, 5 euros in Germany may already because the environment was perceived as Hugh: Well, it’s not a concern that I have at the effectively have a different value, even though being excessivley risky with people extending moment, because there seems to be a we’re talking about the same banknote, to 5 too much credit, etc. People were anticipating, structural deficiency in domestic demand in euros in Greece. a little bit, the crisis. many of the economies where they’re applying this technique. So, it’s hard to see how you can Torralba: Just to make sure I understand Japan got as far as putting the rate up a quarter get domestically driven inflation. How you what you’re saying. Right now, the value of the percentage point and then stopped the could get troubling inflation is if you provoke a euro is in a sense anchored by Germany. whole tightening cycle, because it couldn’t go collapse in the currency. This is a risk Japan is Germany is seen as a responsible country any further without imploding the economy. running, as George Soros is pointing out. with a current account surplus.

So, on the one hand, it wasn’t working, but on So, in the long run, you could have hyperinfla- Hugh: Yes, and as a result of that perception the other hand, Japan wasn’t able to apply a tion, let’s say, in Japan, if the yen really Germans get all kinds of financial perks, more hawkish monetary policy without really collapsed—not if it went from JPY80 to JPY100 like cheaper interest rates when they want putting the economy itself at risk. to JPY120, but went from JPY120 to JPY300. credit. But it’s interesting, the Germans If there was a dramatic collapse in the yen, and the French are increasingly arguing now This is the whole point. It’s working in that it’s because there was a dramatic flight of funds about this point that you’ve drawn attention boosting the equity markets and boosting out of Japan at some moment, because to. It was interesting to hear Jens Weidmann, carry trades across the planet, but this way people anticipating continuing falls in the yen the president of the German central bank, may be indirectly creating a little bit of inflation. started really panicking, then, this could recently raising doubts about the French will to But it’s not meeting its primary objectives of precipitate a very strong inflationary dynamic. implement major structural reforms and restarting credit flows and generating a slightly to bring the fiscal deficits under control. If the higher inflation rate to aid deleveraging. Fine, This creates a peculiar position, then, for the tensions grow on the German/French axis, but what would? countries in Southern Europe, because we’re going to be in even more trouble. the only way you can avoid breakup risk coming But, yes, Germany is seen at the moment So, if you haven’t got an answer to “what back again is to let some economies spend as the heart. K would?” then you stay where you are. more money. The advantage of doing it through I think that’s why we are where we are. There the national central banks is that it doesn’t all Francisco Torralba, Ph.D., is an economist with the are people in the United States who would fall back onto Target2 balances and generate Morningstar Investment Management division. argue that QE is doing certain things, achieving additional liabilities for the Germans. If this is some of its objectives. That’s a huge debate that shown to be the case, then maybe the Germans I don’t really want to go into because it isn’t will become more relaxed about the situation. really within the bounds of my expertise.

56 Morningstar Advisor June/July 2013 Research breeds results.

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Waiting to Pull Up Anchor

By Michael Brennan Small caps have reached the top of their cycle, manager Eric Cinnamond says. He’s hoarding cash for when the market turns.

By at least one standard, it might be difficult assets Cinnamond’s strategies manage (the He reached his $1 billion limit mostly by way to be Eric Cinnamond right now. The brains remaining $260 million are in separate of inflows rather than from performance; behind River Road Asset Management’s accounts), has not done much. It’s up 3% on the Independent Value and his separate accounts small-cap strategy, which fuels ASTON/River year and appears unlikely for a performance netted $660 million worth of inflows in 2011 Road Independent Value ARIVX, spent the boost in the short term. Cinnamond has and $224 million in 2012. It suggests that winter watching mostly from the sidelines as fled from the party by unloading many of his Cinnamond’s 15-year track record has earned the Russell 2000 Value Index posted scorching holdings and letting cash build up to a him a good deal of trust among investors. returns. After it shot up 15.5% in 2012, the whopping 58% of his portfolio as of March 31. small-cap index swelled by more than 8% this Cinnamond says that his investment universe— year through April 22. Given the recent disparity between Cinna- the 300 small caps on his watchlist—has mond’s performance and that of the Russell enjoyed a runup and is approaching what he Meanwhile, Independent Value, which 2000 Value, how is it that he’s activated a soft believes is the peak of its performance accounts for $740 million of the $1 billion in close and is turning away would-be investors? cycle. A downturn, he believes, is approaching.

58 Morningstar Advisor June/July 2013 I think I was the only manager to lose money in 1999. In hindsight, I’m almost proud of that year. It was smart to not play along with the tech bubble. We picked up a lot of small caps that paid off by 2002.

Eric Cinnamond

His performance over the course of the can be extremely uncomfortable because you It’s equally true that his strategy has missed previous two market cycles gives his investors have to buy out of favor. When you do that, out on the top end of performance spikes confidence in his long-term vision, even you can perform out of favor, and we do. There in the small-cap universe as he begins to gather if it means he’s not trying to squeeze every last are periods when we’ll underperform by cash before the bottom falls out. But he’s cent out of the ongoing small-cap boom. hundreds of basis points. You have to be bested Russell 2000 Value by more than three willing to look out of touch and lose assets.” percentage points since he started managing “We focus on adequate returns for the risk money, and he’s done it with less volatility. we’re assuming,” he says. “So, we don’t play So, losses are going to happen. The key, he along; we just pull back and wait. Sometimes, says, is avoiding the big loss. He learned that “We’ve proven that we won’t let maintaining you have to underperform to have a lot from the York Group (later bought by Matthews assets drive our investment strategy,” Cinna- of success later.” International) and from Gibson Greetings mond says. “That happens in our industry too (bought by American Greetings). Cinnamond often. I’ve been fighting that my entire career. A A Proven Commodity was rocked by both in 1999, early in his lot of it is driven by the goal of being hired by Cinnamond is pleased with his win rate, which, time managing assets. He sold York at a 55% consultants. I’m very passionate about it. It’s so according to River Road’s documentation, sits loss and was hit with a 64% loss by Gibson. much easier to just look like a benchmark. at a handsome 84% from Nov. 1, 1998, through You’d be rich, but what about the client?” Sept. 30, 2012. The presentation materials for “To this day, I think I was the only manager to potential investors and financial journalists lose money in 1999,” Cinnamond says. “I was It’s an approach, Cinnamond says, that has list every stock Cinnamond has purchased since down 8% that year. In hindsight, I’m almost its detractors. he established his strategy at Intrepid Capital proud of that year. It was smart to not play Management 15 years ago, through Indepen- along with the tech bubble. We picked up a lot “When things get expensive, I’m not thinking of dent Value’s January 2011 inception, to the of small caps that paid off by 2002.” how to make 20% this year,” he says. “I’m not present. Three columns of green print list all thinking about some benchmark. I’m thinking, ‘I the buys that turned into profitable sells. The lesson: Avoid the big losses by knowing want to be in things that aren’t crowded,’ A short list, in red, sits off to the right. Those when to back away from a melt-up, and because when the cycle turns, everybody else are the ones that didn’t work out so well. remember that savvy use of cash can go a long is going to be in the same thing.” way toward normalizing performance. His It makes for an effective visual, putting those worst year was the negative 8% showing in Performance Perspective 137 victories side by side with the 26 whiffs. 1999, when the Russell 2000 Value lost 1.49%. Bradley Alford is chief investment officer of Cinnamond could probably do pretty well for Other than that, though, when the index Alpha Capital Management, which runs Alpha himself by simply passing that slide around and was throttled, Cinnamond held up compara- Defensive Growth ACDEX and Alpha Opportu- letting it do the talking for him. Except he tively well. In 2002, the index dropped nistic Growth ACOPX, a pair of alternative wants to talk about the York Group. And about 11.4%; Cinnamond was up 10%. In 2007 and funds of funds that have invested in Cinna- Gibson Greetings. They’re in the red list. 2008, the index plunged 9.8% and 28.9%, mond’s strategy since he plied it at Intrepid respectively. Cinnamond was up 9.2% in 2007 Small Cap Fund. When Cinnamond left Intrepid “We’ll go through periods of significant and limited his losses to negative 6.1% in 2008. in 2010, Alpha sold its investments in that fund underperformance,” he says. “Value investing and waited for him to set up shop elsewhere.

MorningstarAdvisor.com 59 Undiscovered Managers

The approach is fairly simple in terms of how what he’s doing. He’s been right for so long, so Eric Cinnamond it’s organized. Cinnamond monitors 300 we’re confident eventually he’ll be right again.” established companies, the average age of which, he says, is about 50 years old. Cinnamond says the small caps are, collectively, They all have strong balance sheets, sustain- near their earnings peaks, and that investors able cash flows, and attractive valuations. continuing to dump money into them are He’ll look past either operating risk or financial making dangerous projections that those stocks ASTON/River Road Independent risk, but never both simultaneously. will continue to exceed their historical norms. Value ARIVX 14000 $14K Independent Value is concentrated—it holds “It’s called extrapolation risk, and we try to fewer than 30 names—but even the biggest avoid it,” Cinnamond says. “It’s one of the 40 investment, natural-gas firmWPX Energy WPX, deadliest investing sins. It’s taking current 11000 11 accounts for just 4% of the fund’s assets. trends and operating results and interest S&P 500 TR (IA Extended) (Index) Precious-metal miner Pan American Silver rates—the environment—and extrapolating 20 PAAS, business-services provider Sykes them too far into the future, based on the 8000 Enterprises SYKE, rent-to-own retailer Aaron’s premise that current conditions won’t change. 01/ 01/ 01/ 05/ 11 12 13 AAN, and gold11 producer AuRico Gold AUQ each People are paying for peak profits and for peak account for more than 2.5%, as well. multiples. In 2007, a lot of stock prices Category Expense Ratio (%) Jan-11Feb-11MarAprMay-11-11-11Jun-11Jul-11Aug-11Sep-11Oct-11Nov-11Dec-11Jan-12Feb-12MarAprMay-12-12-12Jun-12Jul-12Aug-12Sep-12Oct-12Nov-12Dec-12Jan-13Feb-13MarAprMay-13-13-13 50 Funds rated Small Value 1.42 appeared reasonable based on profit levels, but Jan-13 Cinnamond closes the strategy at $1 billion in they were at peak profits. Profits don’t stay at Morningstar Rating 1-Yr Annl Total Rtn (%) — 7.17 order to stay nimble enough to traffic success- the same level.” fully in small caps. River Road, which operates Minimum Investment 5-Yr Total Rtn % Rank Cat 4 or 5 stars the mutual fund, has followed Cinnamond’s Too Short-Term Focused $2,500 99 recommendation and closed the fund to new Cinnamond says the investment community’s investors. According to Aston Asset Manage- increasingly short-term focus and insistence on Morningstar Analyst Rating ment CEO Stuart Bilton, however, it is possible benchmarking its asset managers have by Morningstar. Morningstar Pillars to invest in Independent Value through advisors driven ingenuity from the industry. He believes Process TPositive with clients who have assets in the fund. other talented active managers are stymied Performance TPositive by investors—both institutional and private— People TPositive Parent TPositive Alford said the $1 billion limit is shareholder- being vastly more sensitive to short-term Price YNegative friendly. “He could raise billions, and he won’t fluctuations than they were when he was Our commitment to advisors and investors is backed by the focused expertise do it,” Alford says. “You look at these $3 billion establishing himself. He says that the days of our independent affiliates and more than a century of industry leadership. Data as of April 30, 2013 and $4 billion small-cap funds, you get into when an asset manager had years to establish these companies you can’t get out of. He won’t a comfort level with investors—mirroring the Find out more about our array of funds at nuveen.com or by calling 800.752.8700. raise more money just to give himself the pace of an investment cycle—are over. manager fees.” “It’s so short-sighted,” he says. “They want you “We believe wholeheartedly that those track Alford was with Cinnamond’s strategies in two to outperform, but they don’t want you to look Past performance is no guarantee of future results. Mutual fund investing involves risk; principal loss is possible. records are generated by the portfolio manager previous market cycles (from the late-1990s to different when you do it.” Ratings are for the period ended 3/31/13 and include all share classes, some of which are load-waived and may not be available to all investors. Out of 82 mutual funds rated by Morningstar, 28 received a 5-star overall rating and 22 received a 4-star overall rating. The Overall Morningstar Rating™ is based on the weighted average of the number of stars assigned to the fund’s applicable time periods. and not the firm,” Alford says, pointing 2002 and again from 2003 to 2008) and Morningstar ratings may vary among share classes and are based on historical risk-adjusted total returns, which are not indicative of future results. Some funds may have experienced negative returns over out how quickly Cinnamond’s strategy reached observed how shrewd the manager is at adding He says he views it as an asset manager’s the time periods rated. its billion-dollar cap. “He raised $700 million future high performers when the time is right. fiduciary responsibility to look beyond the For funds with at least a three-year history, a Morningstar Rating™ is based on a risk-adjusted return measure (including the effects of sales charges, loads, and redemption fees) with emphasis on overnight. That’s the fastest I’ve ever seen usual indexes. downward variations and consistent performance. The Overall Morningstar Rating™ for a fund is derived from a weighted average of the fund’s three-, five-, and 10-year (if applicable) risk-adjusted return that happen.” “It’s a love-hate relationship; we love (Cinna- measures and Morningstar ratings metrics. The top 10% of funds in each category receive 5 stars, the next 22.5% 4 stars, the next 35% 3 stars, the next 22.5% 2 stars, and the bottom 10% 1 star. Each share class is counted as a fraction of one fund within this scale and rated separately. mond’s approach) on big correction days,” “We want to make money,” he says. “Isn’t that Although Alpha has slightly pared back its Alford says. “He’s a very difficult manager for our fiduciary duty? Isn’t that what people pay ©2013 Morningstar, Inc. All Rights Reserved. The Morningstar information contained herein: (1) is proprietary to Morningstar; (2) may not be copied; 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. investments in Independent Value, Alford said me to hold right now. From our point of us to do?” K his firm remains a strong believer in Cinna- view, we want a manager to be fully invested Investors should consider the investment objectives and policies, risk considerations, charges and expenses of a fund carefully before investing. For a prospectus which contains this and other information relevant to an investment in a fund, please contact your financial advisor or Nuveen Investments directly at 800.257.8787. mond’s strategy and supports his conviction. and not be tactical. But he’s proven he knows Michael Brennan is a freelance financial journalist. Investors should read the prospectus carefully before they invest. Nuveen Asset Management, LLC; Symphony Asset Management LLC; NWQ Investment Management Company, LLC; Santa Barbara Asset Management, LLC; Tradewinds Global Investors, LLC; Winslow Capital Management, LLC and Gresham Investment Management LLC are registered investment advisors and subsidiaries of Nuveen Investments, Inc. Funds distributed by Nuveen Securities, LLC. 60 Morningstar Advisor June/July 2013 ©2013 Nuveen Investments, Inc.

05-2013 Morningstar Advisor 50 Funds 8-75x10-75.indd 1 5/1/2013 11:02:19 AM 50 Funds rated 4 or 5 stars by Morningstar.

Our commitment to advisors and investors is backed by the focused expertise of our independent affiliates and more than a century of industry leadership. Find out more about our array of funds at nuveen.com or by calling 800.752.8700.

Past performance is no guarantee of future results. Mutual fund investing involves risk; principal loss is possible. Ratings are for the period ended 3/31/13 and include all share classes, some of which are load-waived and may not be available to all investors. Out of 82 mutual funds rated by Morningstar, 28 received a 5-star overall rating and 22 received a 4-star overall rating. The Overall Morningstar Rating™ is based on the weighted average of the number of stars assigned to the fund’s applicable time periods. Morningstar ratings may vary among share classes and are based on historical risk-adjusted total returns, which are not indicative of future results. Some funds may have experienced negative returns over the time periods rated. For funds with at least a three-year history, a Morningstar Rating™ is based on a risk-adjusted return measure (including the effects of sales charges, loads, and redemption fees) with emphasis on downward variations and consistent performance. The Overall Morningstar Rating™ for a fund is derived from a weighted average of the fund’s three-, five-, and 10-year (if applicable) risk-adjusted return measures and Morningstar ratings metrics. The top 10% of funds in each category receive 5 stars, the next 22.5% 4 stars, the next 35% 3 stars, the next 22.5% 2 stars, and the bottom 10% 1 star. Each share class is counted as a fraction of one fund within this scale and rated separately. ©2013 Morningstar, Inc. All Rights Reserved. The Morningstar information contained herein: (1) is proprietary to Morningstar; (2) may not be copied; 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. Investors should consider the investment objectives and policies, risk considerations, charges and expenses of a fund carefully before investing. For a prospectus which contains this and other information relevant to an investment in a fund, please contact your financial advisor or Nuveen Investments directly at 800.257.8787. Investors should read the prospectus carefully before they invest. Nuveen Asset Management, LLC; Symphony Asset Management LLC; NWQ Investment Management Company, LLC; Santa Barbara Asset Management, LLC; Tradewinds Global Investors, LLC; Winslow Capital Management, LLC and Gresham Investment Management LLC are registered investment advisors and subsidiaries of Nuveen Investments, Inc. Funds distributed by Nuveen Securities, LLC. ©2013 Nuveen Investments, Inc.

05-2013 Morningstar Advisor 50 Funds 8-75x10-75.indd 1 5/1/2013 11:02:19 AM GUGGENHEIM INvEstMENts

Guggenheim Investments may help uncover unique investment solutions by offering access to what we believe are our best investment thinking and institutional strategies through our fixed income mutual funds. All the funds access Guggenheim Investments’ fixed income advantage that combines in-depth macro research, intensive fundamental research and legal analysis, and rigorous risk management. Discover our Morningstar top quartile ranked fixed income funds for the one-year period ended March 31, 2013.

Guggenheim Macro Opportunities Fund (GIOAX) Top 2nd Percentile (1-Year A-Class ranked 4 out of 199 in Morningstar Nontraditional Bond Category)

Guggenheim Total Return Bond Fund (GIBAX) Top 3rd Percentile (1-Year A-Class ranked 30 out of 1,157 in Morningstar Intermediate-term Bond Category)

Guggenheim Floating Rate Strategies Fund (GIFAX) Top 11th Percentile (1-Year A-Class ranked 23 out of 202 in Morningstar Bank Loan Category)

Guggenheim Municipal Income Fund1 (GIJAX) Top 5th Percentile (1-Year A-Class ranked 11 out of 240 in Morningstar Muni National Long Category)

FOR MORe InFORMATIOn On The FunDS, vISIT GuGGenheIMInveSTMenTS.cOM/FIXeDIncOMe OR cAll The DISTRIBuTIOn SuppORT DeSk AT 800.345.7999.

Past performance is no guarantee of future results. 1 the Municipal Income Fund A-Class shares ranked in the 71st percentile (146 out of 206 funds) within the Morningstar Muni National Long Category for the 5-year period ended 3.31.2013. Please note, on 1.13.2012, the Municipal Income Fund A-Class shares acquired the assets, and assumed the liabilities and performance of a predecessor closed-end fund, which used different investment strategies and had different investment advisors. Source: Morningstar. rankings are based on the load-waived performance of class A shares of the fund. other share classes may have different performance characteristics. Fund performance may now be higher or lower than the performance Morningstar used to calculate the rankings. Fund performance reflects certain fee waivers, without which returns and Morningstar rankings would have been lower. Morningstar rankings are based on a fund’s average annual total return and the percentile ranking refers to the fund’s rank relative to all funds in the same Morningstar category. The highest (or most favorable) percentile rank is 1 and the lowest (or least favorable) percentile rank is 100. The top-performing fund in a category will always receive a rank of 1. The Funds may not be suitable for all investors. • The Funds’ market value will change in response to interest rate changes and market conditions among other factors. In general, bond prices rise when interest rates fall and vice versa. • You may have a gain or loss when you sell your shares. • It is important to note that the Fund is not guaranteed by the u.S. government. • certain Funds may have exposure to high yield securities, municipal securities, foreign securities, derivative instruments, real estate, commodity markets and other fixed income securities. • Exposure to high yield securities may subject a Fund to greater volatility. • Investments in municipal securities can be affected by events that affect the municipal bond market. • Investments in foreign securities carry additional risks when compared to U.S. securities, due to the impact of diplomatic, political or economic developments in the country in question (investments in emerging markets securities are generally subject to an even greater level of risks). • Investments in derivative instruments, be more volatile and less liquid, increasing the risk of loss when compared to traditional securities. Certain of the derivative instruments are also subject to the risks of counterparty default and adverse tax treatment. • Investments in real estate securities subject a Fund to the same risks as direct investments in real estate, which is particularly sensitive to economic downturns. • Please see each Fund’s prospectus for more information on these and other risks. Read the fund’s prospectus and summary prospectus (if available) carefully before investing. It contains the fund’s investment objectives, risks, charges, expenses and other information, which should be considered carefully before investing. Obtain a prospectus and summary prospectus (if available) at guggenheiminvestments. com. The referenced funds are offered in multiple share classes. Please read the prospectus for information on fees, expenses and holding periods that may apply to each class. The referenced funds are distributed by Guggenheim Distributors, LLC. Guggenheim Investments represents the investment management businesses of Guggenheim Partners, LLc (“GP”), which includes Guggenheim Partners Investment Management (“GPIM”), the investment advisor to the referenced funds. Guggenheim Distributors, LLC, is affiliated with GP and GPIM. #8619 Gray Matters

The Price of Managing Volatility

By Rajneesh Motay Do riders with volatility controls cost VA investors potential gains?

Insurers are increasingly limiting investment Targeting Risk understood in relative terms. Where this options in their variable annuities that Most asset-allocation offerings use the classification system falls short is in ignoring have riders to strategies with built-in volatility percentage of stocks to serve as a proxy for the absolute level of volatility. Exhibit 1 charts management. Volatility overlays mitigate risk. These are commonly billed as “target-risk the rolling 30-day standard deviation of a the risks for insurance companies by embed- funds.” A “conservative” target-risk fund “moderate” target-risk portfolio. It shows that ding some hedging within the investment typically holds between 20% and 50% of its the realized volatility was far from “moderate” strategy. But are investors who buy the riders assets in stocks; moderate, moderate- during the difficult markets of 2008–2009, giving up a portion of potential gains in growth, and growth options are analogously when standard deviation reached a high of return? We investigate this question by defined as portfolios with increasing amounts 40%, a level of volatility that would have been comparing two contracts with similar benefits; of equity exposure. This approach to invest- unexpected even from an aggressive portfolio. one with a volatility control overlay and one ment-risk classification is reasonable because without an overlay. a portfolio gets more volatile as the percentage That experience was an unpleasant surprise to of stocks it holds increases. But risk here is most investors, and it drove many investment

MorningstarAdvisor.com 63 Gray Matters

assets and volatility of the second asset is Exhibit 1 Rolling 30-Day Volatility of 50% Stock/50% Bond Portfolio assumed to be zero. According to this equation, to maintain constant portfolio volatility level, % the weight in equities should decrease when 45 forecasted volatility goes up and increase 40 when forecasted volatility goes down. 35 30 A variety of sophisticated techniques forecast 25 volatility, but simpler approaches rely on either 20 15 the Chicago Board of Options Exchange Market 10 Volatility Index—otherwise known as the 5 VIX, a measure of the market’s expectation of 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ stock market volatility over the next 30 days— 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 or recent realized volatility. Because insurance companies mark their exposures to market, their risk is mostly related to market-implied Exhibit 2 Implied Volatility and Equity Target volatility. As a result, many of the volatility overlay approaches in practice use market-

12-Month Implied Volatility Index Level for DB Equitiy Volatility Index—U.S. 12-Month Equity Target Equity Target % implied volatility as a signal. Although VIX 60 90 is the most well-known of all implied volatility 80 measures, it may not be the most appropriate 50 70 option for insurance companies because it 40 60 is a short-term measure. A better measure that 50 matches the duration of insurance companies’ 30 40 liabilities is the Deutsche Bank Equity Volatility 20 30 Index–US 12-Month, a proxy for stock-market 20 10 implied volatility for the coming year. 10 12/06/ 12/06/ 12/06/ 12/06/ 12/06/ 12/06/ 12/06/ 12/06/ 12/06/ 12/06/ 12/06/ 12/06/ 12/06/ 12/06/ Using the equation above and the Deutche Bank 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 volatility index as our forecast of volatility, the equity weights for a 10% target volatility portfolio commencing on Dec. 6, 1999 (the firms to explore approaches that might provide manage the portfolio to a volatility target rather volatility index’s inception date), are charted in a much smoother investor experience. than to a stock target by actively changing Exhibit 2. When volatility goes up, the equity Insurance companies had even more reason the allocation to stocks, which contribute most target goes down (and vice versa). to explore alternative approaches to managing of the volatility in a stock and bond portfolio. their underlying subaccounts: As portfolio Target Volatility and Guarantees in Practice volatility increased, so did the cost of hedging Targeting Volatility Variable annuities come with a variety of guarantees accompanying the investments. The The equity weight within a two-asset portfolio optional features that an investor can buy for insurers had effectively sold options and that meets a volatility target is the ratio of an additional annual fee. To illustrate the effect needed ways of managing the associated risk. the volatility target to the forecasted volatility of a managed volatility strategy, we focus The higher the unpredictability (or standard of the risky asset: on just the Guaranteed Minimum Withdrawal deviation) of the underlying investment, the Benefit. With aGMWB , the seller of the higher the risk of an option sold on it. oT benefit may guarantee that the benefit base WE  oE grows by at least a minimum percentage One approach would be to forecast future every year, irrespective of the performance of volatility and position the portfolio in where WE is the weighto in equities, o T is the the underlying subaccount. For example, T  WE  WE such a way that its effective volatility stays target volatility, and o E is the forecastedoE on each anniversary of the contract, the benefit within a tolerable range. In other words, equity volatility. Correlation between the two base would increase by the greater of the

64 Morningstar Advisor June/July 2013 annual return on the subaccount, or 5%. portfolio managed to a 10% volatility target. we had a contract for every day since the In addition, the riders may allow for a periodic The equity allocation here changes based index’s inception through the end of 2011. step-up in the benefit base. For example, on our equation by moving assets in and We tracked the last contract entered on the an annual step-up might reset the benefit base out of cash. last business day of 2011 until the end to the account value if the account value of 2012, which meant we were using daily were greater than the benefit base on the A forward-looking Monte Carlo analysis of market data between the years 2000 and 2012. anniversary date. This benefit base could then these products usually involves generating For each start date, we then compared the be used to calculate the withdrawal thousands of market paths using future growth of each portfolio while accounting for amounts at the time the investor decides to expected returns and covariance of the asset the annual credits and step-ups. We assumed annuitize. Therefore, the higher the benefit classes that are the building blocks of that there were no withdrawals before the end base, the better it is for the investor. the underlying portfolios. However, we wanted of the analysis period (December 2012). to capture the relationship between implied For our analysis, we compared two portfolios volatility and subsequent market returns, Exhibit 3 repeats our rolling 30-day volatility with different GMWB riders: so we relied on historical daily data for this chart, but this time with the rolling standard analysis. We used the S&P 500 Index as a deviation of the portfolio including the volatility 1 5% annual credit with a fee of 150 basis proxy for stocks and the three-month Treasury overlay. As we expected, the volatility of the points and annual step-up with the underlying bill as a proxy for cash. portfolio with the overlay is much more muted. portfolio invested in a static mix of 50% stocks and 50% cash. Our approach was to track the benefit bases For the period since inception of the volatility and values for accounts that start on each index through December 2011, or 3,019 2 5% annual credit with a fee of 150 basis business day since the inception of the business days—with each business points and annual step-up with the underlying Deutsche Bank volatility index. In other words, day representing an investor that entered the

MorningstarAdvisor.com 65 Gray Matters

just when the cost of hedging is high (which is Exhibit 3 Rolling 30-Day Volatility of 50% Stock/50% Bond Portfolio directly related to market volatility), they With Volatility Overlay have to engage in less hedging because of the relatively small allocation to risky assets. % No Volatility Overlay With Volatility Overlay 45 As a further illustration, imagine you are short 40 a put option and you experience profits and 35 losses on a daily basis based on the changes in 30 price of the put option. As the volatility 25 of the underlying security increases, the price 20 of the put option increases. Because you 15 are short the option, you have to register a loss, 10 5 and as volatility fluctuates, the volatility 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ 01/20/ of your profits and losses also goes up. 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 However, if the volatility of the underlying holding is kept constant by changing your position size, you experience less volatility in contract on that day—the following table For contracts entered before 2009, the volatility your profits and losses. compares the success rate of the managed overlay trails only 14% of the time. For volatility overlay versus no overlay. contracts entered in and after 2009, it trails Market volatility is only one of the parameters 81% of the time. Not surprisingly, the GMWB that goes into the valuation of guarantees. with the volatility overlay is most effective As insurers try to reduce uncertainties around when the investor goes through a market crash their profits and losses, we expect more Volatility Overlay vs. No Overlay For the period since December 1999 like that of 2008. It is not that effective in changes to their offerings. Some of the Better deal 1,062 days (35%) a rising equity market like the period between changes that are already in practice include 2009 and 2011. using passive products. This eliminates Worse deal 934 days (31%) the guesswork of understanding the composi- Same 1,023 days (34%) We must emphasize that these results are tion of the underlying subaccount when it uses specific to the assumptions, models, and actively management funds. Another practice is These results show that, using historical indexes we used. It is possible to improve upon using additional overlays like option-based volatilities and returns, the volatility overlay the volatility forecasting approach, which strategies that reduce gap risk—the risk that a results in a better deal for 35% of GMWB would make a more compelling case for the quick drop in equities leaves the insurance firm contracts, an equally good deal for 34% of the volatility overlay. with a huge mismatch between the underlying investors, and a bad deal for 31% of the subaccount and liabilities. investors. The reason 34% of the cases end up Product Innovation being the same is because the annual credits It might seem that making managed volatility We hope that the industry’s cost reductions dominate the actual returns on the portfolio. In an investment approach is an overreaction make these volatility overlays even better deals other words, the annual credit of 5% was by the makers of variable-annuity products. for investors who want a smoother ride better than the annual returns of both the In practice, however, the pricing on the during the next market crash. Improved portfolios. However, if we split the entire time guarantees with traditional asset-allocation investment and hedging approaches would seal period into two periods—pre-2009 and 2009 portfolios did not account for severe market the deal for investors. K and later—an interesting pattern emerges. conditions such as those in 2008. Insurers realized that providing compelling guarantees Rajneesh Motay, CFA, is a senior investment in this low-interest-rate environment consultant with the Morningstar Investment Management division. Volatility Overlay vs. No Overlay Pre-2009 2009 and later while charging similar fees requires them to change the way underlying investments Better deal 1,062 days (47%) 0 days (0%) are managed, as well as to enhance their Worse deal 327 (14%) 607 days (81%) hedging programs. Managed volatility is one Same 877 (39%) 146 days (19%) way insurers can control their costs, because

66 Morningstar Advisor June/July 2013 MOAT MOAT seeks to track the Morningstar® Wide Moat Focus IndexSM

Wide Moat ETF

Wide Moat Companies: Sustainable Competitive Advantages, Attractive Valuations

What are moats? marketvectorsetfs.com/moat Why do they matter? Scan to find out. 888.MKT.VCTR

The value of the securities held by the Fund may fluctuate due to market and economic conditions or factors relating to specific issuers. Small- and medium- capitalization companies may be more volatile than large-capitalization companies. The Fund is subject to index tracking risk and may not be able to invest in certain securities in the exact proportions in which they are represented in the Index. The Fund’s assets may be concentrated in a particular sector and may be subject to more risk than investments in a diverse group of sectors. The Morningstar Wide Moat Focus Index was created and is maintained by Morningstar, Inc. Morningstar, Inc. does not sponsor, endorse, issue, sell or promote the Market Vectors Wide Moat ETF and bears no liability with respect to that ETF or any security. Morningstar® is a registered trademark of Morningstar, Inc. Morningstar® Wide Moat Focus IndexSM is a service mark of Morningstar, Inc. Fund shares are not individually redeemable and will be issued and redeemed at their NAV only through certain authorized broker-dealers in large, specified blocks of shares called “creation units” and otherwise can be bought and sold only through exchange trading. Creation units are issued and redeemed principally in kind. Shares may trade at a premium or discount to their NAV in the secondary market. Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of the Fund carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 888.MKT.VCTR or visit marketvectorsetfs.com. Please read the prospectus and summary prospectus carefully before investing.

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* As of 3/31/13. TIAA-CREF personnel, through its investment management area, provide investment advice and portfolio management services through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, TIAA-CREF Alternatives Assets, LLC and Teachers Insurance and Annuity Association (TIAA). TIAA-CREF Individual & Institutional Services, LLC and Teachers Personal Investors Services, Inc., members FINRA, distribute securities products. ©2013 Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY 10017. C7384 Screens

Let’s Get Back to Basics

By John Zecy Basic materials companies are among the cheapest stocks in our coverage universe.

In recent analysis of the price/fair value ratios earned through intangible assets, cost While a firm may carry sustainable competitive of Morningstar’s stock coverage universe, advantages, switching costs, network effects, advantages, we want to ensure that we observed that basic materials companies and efficient scale. In the case of basic we are paying a reasonable valuation. offer some of the steepest discounts materials companies, a sustainable low-cost Consequently, we set the cutoff at companies to our fair value estimates. As such, we ran a advantage is the main potential source trading at less than 12 times their current detailed stock screen to find attractively of an economic moat as firms produce price/cash flow. priced basic materials names with durable undifferentiated commodities that are in many competitive advantages that could boost an cases widely fungible. Specifically within And Morningstar Rating > 4 investor’s portfolio returns. resource extraction, favorable geological characteristics are the most important determinants of costs. When considering To expand on our valuation screen, we used Sector  Basic Materials a company’s future cost position, we incorpo- the Morningstar Rating for stocks and And ( Economic Moat  Narrow rate all relevant outlays including: lease searched for companies with at least a 4-star Or Economic Moat  Wide ) and permit costs, all payments to service and rating. A number of components drive this equipment providers, development expendi- score, including our assessment of the firm’s Our analysts assign a Morningstar Economic tures, production expenses, and royalties. economic moat, our estimate of the stock’s Moat to firms that have been able to generate intrinsic value based on a discounted cash-flow returns in excess of their cost of capital for a model, the margin of safety bands we And PCF  12 decade or more thanks to their sustainable apply to our fair value estimate, and the current competitive advantages. Moats are typically stock price relative to our fair value estimate.

MorningstarAdvisor.com 69 importance of proximity between the refinery Steel Dynamics STLD And Stewardship > Standard and the raw material source. We believe Steel Dynamics operates with a narrow economic moat. The company Cloud Peak Energy CLD is a relative newcomer to the steel industry and, Finally, we ran a screen for a Morningstar Cloud Peak is the lowest-cost player in the therefore, has some of the newest and Stewardship Grade for stocks of either lowest-cost coal mining region in the most efficient mills in the business. It has a Standard or Exemplary grade to ensure that the world: the Powder River Basin. We think that very low operating cost structure and higher resulting companies are run by a quality coal prices in the basin will increase productivity than its peers because it produces management team. This rating represents our significantly from current levels of $10 per ton steel in electric arc furnaces, which are assessment of management’s stewardship over the next few years because $10-per-ton less capital-intensive, consume less energy, of shareholder capital, with particular coal is a much more cost-effective option and provide greater operational flexibility emphasis on capital-allocation decisions. than natural gas for most domestic power than traditional blast furnaces. Steel Dynamics Analysts consider companies’ investment plants to burn. Also, the basin’s coal prices lie has also established an important strategic strategies and valuations, financial leverage, well below the operating costs of marginal foothold in raw materials, investing in dividend and share-buyback policies, execution, operators. We believe above-average coal both iron- and scrap-producing assets, which compensation, related party transactions, and inventories at power plants are keeping the lid not only gives the company more control accounting practices. on coal prices, but also believe inventories over its input supply and costs, but enables it will be slowly worked down. We think to exploit the changes in steel and raw-materi- We ran this screen in April using Morningstar Cloud Peak shares could enjoy significant al prices, adjusting its internal raw-material Principia. Here are some of the results. upside, especially as Powder River Basin coal consumption to maximize profitability. The prices recover to a more normalized level. company’s average return on invested capital Alcoa AA However, we project the firm’s earnings to from 2004 to 2012 was 14.7%. We believe Alcoa operates with a narrow decline over the next several quarters before economic moat. While its products are largely hitting their trough in early 2014 (due to John Zecy is an associate equity analyst undifferentiated commodities sold into contract pricing), meaning investors may have with Morningstar. cyclical end markets with little pricing power, to be patient. the company operates with considerable scale as the largest producer of alumina and Intrepid Potash IPI has one of the largest global aluminum With mines close to its U.S. customers, Intrepid operations. Alcoa’s size enables the Potash benefits from lower freight costs company to lower its costs by optimizing and higher realized sales prices compared with its energy usage and improving the efficiency of companies operating Canadian mines. procurement, distribution, and overhead. Intrepid is a small player in the potash market, Alcoa’s upstream operations traditionally but that does not preclude it from benefiting generate double-digit operating margins. from positive industry dynamics, including barriers to entry and oligopolistic pricing behav- Alcoa also has significant cost advantages ior. We think the price of potash will drive from its vertical integration (mining 85% of its Intrepid’s future results. We think long-term bauxite needs and producing 100% of potash prices will remain above marginal its alumina needs), as not only does it source costs of production, supported by the a significant share of its raw material needs at concentrated nature of the industry. However, cost, but also the mining and refining we’re predicting industry supply will rise businesses are attractive assets themselves, faster than demand over the coming years, generating the highest operating margins leading to pressure on prices. Intrepid’s potash and the highest return on assets among Alcoa’s costs per ton should start to decline in 2014 segments. Large barriers to entry in the with the ramp-up of production at the upstream operations stem from high initial company’s new solar solution facility. investment and fixed costs, the somewhat low value/weight ratio of aluminum, and the

70 Morningstar Advisor June/July 2013 Do you see what we see?

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Our Favorite Mutual Funds The five-tiered Morningstar Analyst Rating Morningstar reserves the top three tiers over a full market cycle of at least five scale has three positive levels—Gold, Silver, for funds its analyst team thinks have sus- years. As displayed in this table, there are and Bronze—in addition to Neutral and tainable advantages that position them 185 funds with Gold Analyst Ratings Negative ratings. well versus peers on a risk-adjusted basis as of Apr. 30, 2013.

Name Cat Style Stwd- Morningstar Annualized Total Return % Yield Std Worst Exp # of Turn- Total Incep Box ship Rating % Dev 3-Mo Ratio Hold- over Assets Date Grade YTD 1Yr 3Yr 5Yr 10Yr 3 Yr % Ret % ings % ($Mil) American Funds American Mutual A AMRMX LV Ç Z ÙÙÙÙ 13.5 18.1 12.5 6.5 8.2 2.1 11.8 -24.9 0.63 211 22 27,486 02/50 American Funds Washington Mutual A AWSHX LV È Z ÙÙÙÙ 13.0 17.3 13.5 5.2 7.7 2.1 13.0 -26.0 0.62 157 22 61,440 07/52 Lg Value Dodge & Cox Stock DODGX LV È Z ÙÙÙ 13.9 24.2 11.9 3.8 8.6 1.5 17.6 -35.7 0.52 76 11 45,651 01/65 T. Rowe Price Equity Income PRFDX LV Ç Z ÙÙÙ 13.0 20.1 11.2 5.1 8.3 1.9 15.3 -28.3 0.68 122 16 27,133 10/85 American Funds Fundamental Invs A ANCFX LB É Z ÙÙÙ 11.4 17.4 11.6 4.0 10.0 1.4 15.7 -33.8 0.65 243 28 57,997 08/78 Davis NY Venture A NYVTX LB É — ÙÙÙ 13.5 15.6 9.2 2.4 7.7 1.2 15.3 -31.5 0.90 78 11 20,673 02/69 Lg Blend Fidelity Spartan 500 Index Inv FUSEX LB È C ÙÙÙÙ 12.7 16.8 12.7 5.2 7.8 2.0 15.0 -29.7 0.10 506 4 56,718 02/88 FMI Large Cap FMIHX LB È — ÙÙÙÙÙ 13.9 18.1 11.3 7.5 10.7 1.0 14.2 -24.2 0.96 33 21 7,832 12/01 Longleaf Partners LLPFX LB È — Ù 10.3 15.8 9.6 3.2 6.6 0.8 18.4 -47.4 0.91 22 26 8,343 04/87 Manning & Napier Equity EXEYX LB É — ÙÙÙ 11.6 15.6 8.0 4.7 9.0 0.2 17.2 -32.0 1.05 70 63 1,199 05/98 Oakmark I OAKMX LB È — ÙÙÙÙ 11.6 18.3 12.1 9.0 8.7 0.7 15.8 -31.8 1.03 55 27 9,492 08/91 Oakmark Select I OAKLX LB È — ÙÙÙ 9.6 14.9 11.4 8.8 7.5 0.1 17.0 -34.7 1.05 22 32 3,770 11/96 PRIMECAP Odyssey Stock POSKX LB È Z ÙÙÙÙÙ 15.0 20.9 11.9 7.4 — 1.3 14.2 -32.6 0.66 106 11 1,678 11/04 Selected American Shares S SLASX LB É — ÙÙÙ 12.5 14.9 9.1 2.4 7.5 1.2 15.1 -31.2 0.95 77 7 5,833 02/33 Sequoia SEQUX * LB É — ÙÙÙÙÙ 11.1 15.6 16.0 8.2 8.6 0.0 11.4 -23.6 1.00 45 5 6,592 07/70 Vanguard 500 Index Inv VFINX LB È Z ÙÙÙÙ 12.7 16.7 12.6 5.1 7.8 1.9 15.0 -29.6 0.17 508 3 9,480 08/76 Vanguard Dividend Growth Inv VDIGX LB È Z ÙÙÙÙÙ 14.4 17.3 13.7 7.5 10.1 1.9 12.3 -22.6 0.29 52 11 14,760 05/92 Vanguard Institutional Index I VINIX LB È Z ÙÙÙÙ 12.7 16.9 12.8 5.2 7.9 2.0 15.0 -29.6 0.04 506 5 135,125 07/90 Vanguard Tax-Managed Capital App I VTCIX LB È Z ÙÙÙÙ 12.6 16.7 12.8 5.5 8.6 1.8 15.6 -31.5 0.08 654 3 4,620 02/99 Vanguard Tax-Managed Growth & Inc I VTMIX LB È Z ÙÙÙÙ 12.7 16.8 12.8 5.2 7.9 2.0 15.0 -29.6 0.08 503 5 2,843 03/99 Weitz Partners Value WPVLX LB È — ÙÙÙÙ 6.9 15.9 15.8 8.1 8.3 0.0 15.4 -28.7 1.20 36 31 822 05/83 Yacktman Svc YACKX LB È — ÙÙÙÙÙ 8.1 14.9 13.3 12.8 12.1 1.2 12.2 -21.9 0.80 45 3 9,858 07/92 American Funds AMCAP A AMCPX LG É Z ÙÙÙ 12.2 15.1 11.3 6.6 7.9 0.3 15.4 -29.9 0.74 235 27 29,363 05/67 American Funds New Economy A ANEFX LG É Z ÙÙÙÙ 13.9 21.6 13.4 6.7 10.4 0.5 16.5 -32.8 0.87 188 37 9,365 12/83 Harbor Capital Appreciation Instl HACAX LG É — ÙÙÙÙ 9.4 6.8 11.2 6.2 8.4 0.4 16.6 -30.5 0.66 76 41 20,036 12/87 Jensen Quality Growth J JENSX LG É — ÙÙÙÙ 12.6 16.5 10.1 6.6 6.7 1.0 14.3 -23.4 0.91 30 16 4,811 08/92

Lg Growth Morgan Stanley Focus Growth B AMOBX * LG É — ÙÙ 8.5 4.6 10.5 4.0 7.3 0.0 18.4 -44.9 1.71 34 44 1,639 03/80 Morgan Stanley Institutional Growth I MSEQX LG É — ÙÙÙ 8.8 5.8 11.9 4.9 8.6 0.2 17.9 -41.4 0.72 41 49 892 04/91 PRIMECAP Odyssey Growth POGRX LG É Z ÙÙÙÙÙ 18.9 25.0 12.8 9.0 — 0.5 17.8 -32.2 0.67 116 12 2,968 11/04 Vanguard Capital Opportunity Inv VHCOX LG É Z ÙÙÙÙ 19.1 29.4 11.6 6.9 12.2 0.9 18.2 -37.3 0.48 121 9 9,037 08/95 Vanguard PRIMECAP Core Inv VPCCX * LG É Z ÙÙÙÙÙ 15.5 23.1 12.3 7.8 — 1.5 15.5 -31.2 0.50 142 10 5,321 12/04 Vanguard PRIMECAP Inv VPMCX * LG É Z ÙÙÙÙ 17.0 23.8 12.9 6.8 10.9 1.2 16.0 -32.0 0.45 124 6 33,834 11/84 Artisan Mid Cap Value Investor ARTQX * MV Ê — ÙÙÙÙÙ 15.9 19.4 14.0 9.2 13.3 0.5 15.2 -35.7 1.20 60 28 8,858 03/01 Perkins Mid Cap Value L JMIVX * MV Ê X ÙÙÙÙ 11.5 13.6 8.5 5.7 11.2 0.6 14.7 -28.6 0.77 126 54 12,315 08/98 T. Rowe Price Mid-Cap Value TRMCX * MV Ê Z ÙÙÙÙ 12.5 21.5 10.6 8.0 12.0 1.1 15.9 -32.4 0.81 114 44 10,355 06/96 Vanguard Selected Value Inv VASVX MV Ê Z ÙÙÙÙ 14.2 21.3 12.6 8.8 11.5 1.8 15.6 -31.6 0.38 68 18 5,269 02/96

Mid Value Fidelity Spartan Extended Mkt Index Inv FSEMX MB Ë C ÙÙÙÙ 13.8 18.3 13.0 8.0 11.6 1.5 18.7 -37.0 0.10 3,008 10 9,076 11/97 FMI Common Stock FMIMX * MB Ê — ÙÙÙÙÙ 9.8 10.4 10.8 10.4 11.5 0.3 15.2 -29.8 1.20 44 43 1,203 12/81 Longleaf Partners Small-Cap LLSCX * MB Ë — ÙÙÙÙÙ 12.8 27.4 14.9 8.5 12.2 0.1 16.4 -35.5 0.92 22 15 4,172 02/89 Osterweis OSTFX MB É — ÙÙÙÙÙ 15.5 20.8 10.6 6.6 9.6 1.9 13.5 -27.2 0.98 38 31 975 10/93

Mid Blend Vanguard Mid Cap Index I VMCIX MB Ë Z ÙÙÙÙ 14.9 18.2 13.4 7.1 11.3 1.3 17.3 -38.3 0.08 368 17 5,134 05/98

*Closed to new investors.

72 Morningstar Advisor June/July 2013 Name Cat Style Stwd- Morningstar Annualized Total Return % Yield Std Worst Exp # of Turn- Total Incep Box ship Rating % Dev 3-Mo Ratio Hold- over Assets Date Grade YTD 1Yr 3Yr 5Yr 10Yr 3 Yr % Ret % ings % ($Mil) FPA Perennial FPPFX MG Ì — ÙÙÙÙ 13.2 18.1 12.1 8.0 11.0 0.0 18.9 -36.9 1.02 36 2 286 04/84 Morgan Stanley Inst Mid Cap Growth I MPEGX MG Ì — ÙÙÙÙ 12.3 7.6 11.0 6.2 12.8 0.3 17.6 -39.3 0.71 68 26 6,524 03/90 Mid Gr PRIMECAP Odyssey Aggressive Growth POAGX MG Ì Z ÙÙÙÙÙ 17.6 25.8 15.0 13.4 — 0.0 19.2 -33.4 0.68 114 14 2,840 11/04 Royce Premier Invmt RYPRX MG Ï — ÙÙÙÙ 3.9 5.0 9.1 5.8 12.6 1.2 18.5 -33.7 1.06 80 7 6,906 12/91 T. Rowe Price Mid-Cap Growth RPMGX * MG Ì Z ÙÙÙÙÙ 12.3 13.1 12.8 8.1 12.2 0.0 16.8 -37.8 0.80 144 30 19,960 06/92 Westport R WPFRX MG Ì — ÙÙÙÙ 5.6 7.5 13.0 7.2 12.2 0.0 16.2 -29.0 1.25 53 9 640 12/97 DFA US Small Cap Value I DFSVX SV Í — ÙÙÙ 12.5 22.7 11.1 7.9 12.3 1.3 22.2 -36.9 0.52 1,243 15 8,429 03/93 DFA US Targeted Value I DFFVX SV Í — ÙÙÙÙ 12.8 22.1 10.7 8.0 12.4 1.2 21.4 -36.2 0.38 1,578 20 3,757 02/00

Sm Vl Diamond Hill Small Cap A DHSCX SV Í — ÙÙÙÙ 16.8 22.2 9.8 7.1 12.4 0.3 15.7 -29.7 1.31 73 13 982 12/00 Perkins Small Cap Value L JSIVX * SV Í X ÙÙÙÙ 9.2 11.2 6.7 8.3 11.1 1.4 15.2 -24.0 0.79 101 62 2,502 02/85 Artisan Small Cap Value Investor ARTVX * SB Í — ÙÙÙ 5.7 2.8 5.1 5.8 10.8 0.8 18.5 -34.1 1.22 95 28 2,344 09/97 DFA US Micro Cap I DFSCX SB Î — ÙÙÙ 11.2 18.8 12.4 8.1 11.1 1.3 20.0 -36.0 0.52 1,945 15 4,116 12/81 DFA US Small Cap I DFSTX SB Î — ÙÙÙÙ 11.6 18.9 12.5 9.4 11.6 1.4 20.1 -35.9 0.37 2,290 16 5,813 03/92

Sm Blend Fidelity Small Cap Discovery FSCRX * SB Î C ÙÙÙÙÙ 14.1 26.7 16.6 15.8 13.8 0.8 19.5 -34.5 1.07 78 20 5,664 09/00 Royce Special Equity Invmt RYSEX * SB Î — ÙÙÙÙ 8.0 13.3 10.5 10.2 10.0 1.9 15.4 -23.5 1.13 50 31 3,338 05/98 Vanguard Small Cap Index Inv NAESX SB Î Z ÙÙÙÙ 13.0 19.2 12.7 8.5 11.7 1.5 19.5 -37.1 0.24 1,443 14 2,379 10/60 Vanguard Tax-Managed Small Cap Adm VTMSX SB Ï Z ÙÙÙÙ 11.4 17.0 12.8 8.3 11.5 1.4 18.6 -34.1 0.12 603 42 2,615 03/99 Brown Capital Mgmt Small Co Inv BCSIX SG Ï — ÙÙÙÙÙ 10.6 15.8 15.6 11.6 12.7 0.0 18.9 -33.2 1.21 40 21 1,953 07/92 Morgan Stanley Inst Small Company Gr I MSSGX * SG Ï — ÙÙÙÙ 16.0 23.4 14.5 7.9 11.2 0.0 19.0 -33.5 1.05 69 22 1,658 11/89

Sm Gr Wasatch Small Cap Growth WAAEX * SG Ï — ÙÙÙÙÙ 5.1 10.0 17.3 10.0 11.3 0.0 16.6 -34.5 1.24 93 20 2,055 12/86 Dodge & Cox Balanced DODBX MA È Z ÙÙÙ 10.6 19.1 10.6 5.0 7.7 1.9 13.3 -29.2 0.53 343 16 13,048 06/31 FPA Crescent FPACX MA È — ÙÙÙÙÙ 8.9 13.1 9.9 6.7 9.7 0.5 9.7 -22.7 1.16 84 26 11,744 06/93 Manning & Napier Pro-Blend Cnsrv Term S EXDAX CA È — ÙÙÙÙ 4.8 9.3 7.2 6.1 6.1 1.4 4.7 -6.4 0.88 899 54 1,547 11/95 Manning & Napier Pro-Blend Extnd Term S MNBAX MA É — ÙÙÙÙ 7.4 13.1 8.7 5.3 8.3 0.8 11.0 -22.5 1.07 755 58 1,489 10/93

Allocation Manning & Napier Pro-Blend Max Term S EXHAX AA É — ÙÙÙ 10.0 16.5 8.6 4.6 8.9 0.2 16.2 -30.3 1.09 392 64 919 11/95 Manning & Napier Pro-Blend Mod Term S EXBAX CA É — ÙÙÙÙ 5.7 10.4 7.7 5.2 7.3 1.0 8.6 -16.8 1.07 772 47 1,476 09/93 T. Rowe Price Capital Appreciation PRWCX MA È Z ÙÙÙÙÙ 9.2 15.1 11.1 7.4 10.0 1.6 10.8 -28.9 0.71 258 60 15,549 06/86 T. Rowe Price Retirement 2010 TRRAX TA È Z ÙÙÙÙ 5.6 10.1 8.5 5.3 7.9 2.2 9.8 -23.6 0.00 19 23 6,018 09/02 T. Rowe Price Retirement 2015 TRRGX TD È Z ÙÙÙÙ 6.5 11.2 9.1 5.3 — 2.0 11.3 -26.7 0.00 19 26 8,150 02/04 T. Rowe Price Retirement 2020 TRRBX TE É Z ÙÙÙÙ 7.3 12.1 9.6 5.3 8.5 1.8 12.7 -29.4 0.00 19 22 18,006 09/02 T. Rowe Price Retirement 2025 TRRHX TG É Z ÙÙÙ 7.9 12.8 9.9 5.2 — 1.5 13.9 -31.5 0.00 19 26 10,837 02/04 T. Rowe Price Retirement 2030 TRRCX TH É Z ÙÙÙÙ 8.5 13.5 10.2 5.1 9.0 1.5 14.9 -33.1 0.00 18 22 15,899 09/02 T. Rowe Price Retirement 2035 TRRJX TI É Z ÙÙÙÙ 8.8 13.8 10.4 5.0 — 1.4 15.6 -34.0 0.00 18 27 7,560 02/04 T. Rowe Price Retirement 2040 TRRDX TJ É Z ÙÙÙÙ 9.1 14.0 10.4 5.1 9.0 1.2 15.9 -34.0 0.00 18 22 10,666 09/02 T. Rowe Price Retirement 2045 TRRKX TK É Z ÙÙÙÙ 9.0 14.0 10.4 5.1 — 1.2 15.9 -34.1 0.00 18 28 4,230 05/05 T. Rowe Price Retirement 2050 Adv PARFX TY É Z ÙÙÙÙ 9.0 13.8 10.2 4.8 — 1.0 15.8 -34.1 0.25 18 32 2,691 12/06 T. Rowe Price Retirement 2055 TRRNX TX É Z ÙÙÙÙ 9.0 14.0 10.5 5.1 — 1.2 15.8 -34.0 0.00 18 37 706 12/06 T. Rowe Price Retirement Income TRRIX RI È Z ÙÙÙÙ 4.5 8.2 7.2 5.2 6.6 1.7 7.6 -17.1 0.00 17 21 3,171 09/02 Vanguard Balanced Index Inv VBINX MA È Z ÙÙÙÙ 8.0 11.6 10.1 6.2 7.5 1.9 8.9 -19.8 0.24 9,674 43 19,193 11/92 Vanguard LifeStrategy Cnsrv Gr Inv VSCGX CA È Z ÙÙÙÙ 4.9 8.7 7.4 4.4 6.3 2.1 6.5 -17.0 0.00 4 15 8,093 09/94 Vanguard LifeStrategy Growth Inv VASGX AA È Z ÙÙÙ 8.9 13.8 9.7 3.7 7.9 2.1 13.2 -28.6 0.00 4 10 8,819 09/94 Vanguard LifeStrategy Income Inv VASIX CA È Z ÙÙÙ 2.9 6.1 6.1 4.6 5.4 2.1 3.3 -10.5 0.00 4 8 2,902 09/94 Vanguard LifeStrategy Moderate Gr Inv VSMGX MA È Z ÙÙÙ 6.9 11.2 8.8 4.3 7.2 2.1 9.7 -22.4 0.00 4 15 9,767 09/94 Vanguard Target Retirement 2010 Inv VTENX TA È Z ÙÙÙÙ 5.0 9.0 8.3 5.1 — 2.1 7.3 -18.8 0.00 6 12 7,008 06/06 Vanguard Target Retirement 2015 Inv VTXVX TD È Z ÙÙÙÙ 6.3 10.5 8.8 5.0 — 2.1 9.1 -21.0 0.00 5 13 20,002 10/03 Vanguard Target Retirement 2020 Inv VTWNX TE È Z ÙÙÙÙ 7.2 11.6 9.1 4.8 — 2.0 10.5 -23.3 0.00 4 8 20,904 06/06 Vanguard Target Retirement 2025 Inv VTTVX TG È Z ÙÙÙÙ 7.9 12.6 9.5 4.6 — 2.0 11.8 -25.6 0.00 4 9 25,231 10/03 Vanguard Target Retirement 2030 Inv VTHRX TH È Z ÙÙÙÙ 8.7 13.5 9.8 4.4 — 2.0 13.1 -27.8 0.00 4 4 16,941 06/06 Vanguard Target Retirement 2035 Inv VTTHX TI È Z ÙÙÙÙ 9.5 14.5 10.1 4.3 — 2.0 14.4 -29.3 0.00 4 6 18,264 10/03 Vanguard Target Retirement 2040 Inv VFORX TJ È Z ÙÙÙÙ 9.9 15.0 10.3 4.5 — 1.9 14.6 -29.2 0.00 4 3 10,978 06/06 Vanguard Target Retirement 2045 Inv VTIVX TK È Z ÙÙÙÙ 10.0 15.0 10.3 4.5 — 2.0 14.7 -29.2 0.00 4 7 10,627 10/03 Vanguard Target Retirement 2050 Inv VFIFX TY È Z ÙÙÙÙ 9.9 15.0 10.3 4.5 — 1.9 14.6 -29.2 0.00 4 4 4,807 06/06

MorningstarAdvisor.com 73

By the Numbers: Funds

Name Cat Style Stwd- Morningstar Annualized Total Return % Yield Std Worst Exp # of Turn- Total Incep Box ship Rating % Dev 3-Mo Ratio Hold- over Assets Date Grade YTD 1Yr 3Yr 5Yr 10Yr 3 Yr % Ret % ings % ($Mil) Vanguard Target Retirement 2055 Inv VFFVX TX È Z — 9.9 15.0 — — — 1.6 — -14.8 0.00 4 3 723 08/10 Vanguard Target Retirement 2060 Inv VTTSX TX È Z — 9.9 15.1 — — — 1.3 — -5.7 0.00 4 40 136 01/12 Vanguard Target Retirement Income Inv VTINX RI È Z ÙÙÙÙÙ 3.8 7.4 7.6 5.6 — 2.1 4.6 -12.6 0.00 6 7 10,565 10/03 Vanguard Tax-Managed Balanced Adm VTMFX CA È Z ÙÙÙÙ 6.6 10.3 9.2 6.1 6.8 2.2 7.1 -16.8 0.12 1,625 7 1,163 09/94 Allocation cont. Vanguard Wellesley Income Inv VWINX CA Ç Z ÙÙÙÙÙ 6.0 11.5 10.7 8.3 7.6 2.9 4.9 -10.1 0.25 1,549 33 35,307 07/70 Vanguard Wellington Inv VWELX MA Ç Z ÙÙÙÙÙ 4.4 10.9 10.7 5.9 9.0 2.7 9.8 -20.3 0.25 1,190 31 68,863 07/29 Davis Financial A RPFGX SF È — ÙÙÙÙ 13.6 18.3 8.9 3.3 6.9 0.9 15.0 -33.8 0.91 28 10 615 05/91 Franklin Utilities A FKUTX SU Ç X ÙÙÙ 17.9 21.5 17.2 7.4 12.0 3.1 9.3 -19.6 0.76 55 1 5,215 09/48

Specialty Harbor Commodity Real Return ST Instl HACMX BB — — ÙÙÙÙÙ -3.2 -1.9 5.1 — — 1.6 18.7 -32.9 0.94 141 474 369 09/08 PIMCO Commodity Real Ret Strat Instl PCRIX BB — — ÙÙÙÙ -3.0 -1.6 5.3 -4.4 7.0 2.3 18.9 -47.4 0.74 570 177 19,691 06/02 T. Rowe Price Real Estate TRREX SR Ì Z ÙÙÙ 12.5 13.8 15.2 6.4 12.5 1.9 17.2 -48.2 0.78 40 6 4,076 10/97 TFS Market Neutral TFSMX * NU Î — ÙÙÙÙÙ 0.8 4.4 4.3 4.3 — 0.0 6.3 -13.6 2.42 2,117 607 1,835 09/04 Third Avenue Real Estate Value Instl TAREX GR Ë — ÙÙÙ 8.7 22.9 12.7 3.7 10.4 3.1 17.9 -41.3 1.09 44 4 1,972 09/98 Vanguard Energy Inv VGENX SE Ç Z ÙÙÙÙ 5.4 5.2 5.6 -2.1 15.0 2.3 23.5 -38.4 0.31 132 18 11,791 05/84 Vanguard Health Care Inv VGHCX SH È Z ÙÙÙÙ 18.2 26.6 17.5 11.6 11.1 1.6 10.9 -22.2 0.35 99 8 27,549 05/84 Vanguard Precious Metals and Mining Inv SP Ë Z ÙÙÙ -23.0 -32.3 -11.5 -12.9 10.8 3.3 30.2 -58.3 0.26 48 30 2,519 05/84 Vanguard REIT Index Inv VGSIX SR Ì Z ÙÙÙ 15.3 18.9 17.0 7.3 12.6 3.0 17.0 -47.4 0.24 124 9 20,656 05/96

American Funds EuroPacific Gr A AEPGX FB É Z ÙÙÙÙ 6.4 13.4 6.5 0.6 10.8 1.6 18.4 -33.3 0.84 405 24 110,810 04/84 American Funds Intl Gr And Inc 529A CGIAX FB È Z ÙÙÙÙ 7.5 18.8 9.1 — — 2.5 16.7 -17.1 1.00 184 24 6,505 10/08 Artisan International Small Cap Investor ARTJX * FR Ì — ÙÙÙÙ 10.1 25.2 13.2 3.5 15.8 0.9 19.5 -40.6 1.50 57 42 865 12/01

Foreign Stock Artisan International Value Investor ARTKX * FB È — ÙÙÙÙÙ 9.4 23.1 12.4 7.5 14.6 0.9 16.8 -26.0 1.17 58 20 8,751 09/02 Causeway International Value Instl CIVIX FV È — ÙÙÙÙ 5.3 17.5 8.7 0.6 10.2 2.0 21.5 -36.2 0.99 64 21 2,530 10/01 Dodge & Cox International Stock DODFX FB È Z ÙÙÙÙ 7.9 18.7 6.8 0.4 12.6 2.0 20.6 -40.4 0.64 92 10 44,296 05/01 Harbor International Instl HAINX FB È — ÙÙÙÙ 5.7 12.9 8.6 0.3 12.6 1.9 20.6 -36.7 0.77 98 11 44,651 12/87 Litman Gregory Masters Intl Instl MSILX FB É — ÙÙÙÙ 9.3 19.6 7.8 0.5 10.7 0.4 20.2 -37.6 1.15 89 107 1,504 12/97 Manning & Napier World Opportunities A EXWAX FB É — ÙÙÙÙ 6.3 12.3 4.2 0.0 10.5 1.5 21.2 -36.5 1.08 79 45 7,583 09/96 Oakmark International I OAKIX FB È — ÙÙÙÙÙ 11.3 29.2 10.9 7.2 12.4 1.9 19.9 -31.3 1.06 60 38 16,594 09/92 Vanguard Developed Markets Index Inv VDMIX FB È Z ÙÙÙ 9.7 19.6 7.8 -0.8 9.3 3.2 19.9 -34.6 0.20 922 8 14,040 05/00 Vanguard Tax-Managed Intl Adm VTMGX FB È Z ÙÙÙÙ 9.9 19.6 7.7 -0.7 9.4 3.1 19.8 -34.4 0.10 869 7 13,932 08/99 Vanguard Total Intl Stock Index Inv VGTSX FB È Z ÙÙÙÙ 6.5 14.5 6.2 -1.1 10.0 3.0 19.7 -36.5 0.22 6,146 3 1,679 04/96 American Funds Capital World G/I A CWGIX IS È Z ÙÙÙÙ 10.4 19.1 9.5 2.0 11.1 2.5 16.8 -31.6 0.82 400 23 77,085 03/93 American Funds New Perspective A ANWPX IS É Z ÙÙÙÙ 9.1 16.0 10.5 4.0 10.9 1.0 16.1 -31.4 0.80 262 16 48,381 03/73 American Funds New World A NEWFX DE É Z ÙÙÙÙ 3.9 10.6 6.6 1.1 14.0 1.3 17.2 -40.1 1.07 495 25 21,129 06/99 BlackRock Global Allocation Inv B MBLOX * IA È C ÙÙÙ 6.2 8.9 5.8 2.8 9.2 0.3 11.0 -19.5 1.86 794 39 56,998 02/89

Regional & World Dodge & Cox Global Stock DODWX IS Ç Z ÙÙÙ 11.0 20.8 8.7 — — 1.4 19.0 -41.6 0.65 102 12 3,192 05/08 Matthews Asia Dividend Investor MAPIX DP Ç — ÙÙÙÙ 13.1 23.0 11.5 10.3 — 3.9 13.0 -26.7 1.09 61 9 5,490 10/06 Matthews China Investor MCHFX CR È — ÙÙÙÙ -2.9 -1.3 0.2 1.3 17.0 1.5 19.4 -49.1 1.12 56 10 1,772 02/98 Matthews Pacific Tiger Investor MAPTX PJ É — ÙÙÙÙ 6.3 16.2 10.6 7.0 18.6 0.6 17.7 -39.0 1.11 71 7 7,746 09/94 MFS Global Equity B MWEBX IS É X ÙÙÙÙ 10.1 19.0 11.5 4.4 9.7 0.3 17.6 -29.0 2.09 96 13 1,237 12/86 Mutual European Z MEURX ES Ç X ÙÙÙÙÙ 6.5 17.9 6.7 2.1 11.1 3.0 13.9 -21.7 1.13 92 42 2,022 07/96 Oakmark Global I OAKGX IS È — ÙÙÙÙ 13.2 20.5 8.8 4.4 11.5 1.4 18.7 -33.3 1.16 45 26 2,569 08/99 PIMCO All Asset Instl PAAIX IA È — ÙÙÙÙ 3.0 11.1 9.5 7.3 8.1 5.6 7.6 -22.3 0.15 45 56 35,278 07/02 Vanguard European Stock Index Inv VEURX ES È Z ÙÙÙ 6.4 18.2 7.6 -1.9 8.9 3.1 22.6 -37.0 0.26 506 7 5,826 06/90

74 Morningstar Advisor June/July 2013 Name Cat Style Stwd- Morningstar Annualized Total Return % Yield Std Worst Exp # of Turn- Total Incep Box ship Rating % Dev 3-Mo Ratio Hold- over Assets Date Grade YTD 1Yr 3Yr 5Yr 10Yr 3 Yr % Ret % ings % ($Mil) Dodge & Cox Income DODIX CI Ë Z ÙÙÙÙ 1.3 5.5 6.0 6.9 5.5 3.3 2.4 -6.3 0.43 689 26 26,950 01/89 Fidelity GNMA Fund FGMNX GI Ç C ÙÙÙÙÙ 0.8 2.6 5.3 6.1 5.2 2.0 2.0 -1.8 0.45 249 263 10,042 11/85 Fidelity Government Income FGOVX GI È C ÙÙÙÙ 0.6 2.7 4.7 5.1 4.6 1.3 2.7 -4.2 0.45 510 222 4,952 04/79 Fidelity Total Bond FTBFX CI Ë C ÙÙÙÙ 1.5 5.6 6.6 7.1 5.6 2.6 2.3 -9.3 0.45 1,334 155 13,927 10/02 Hi Quality Bond Harbor Bond Instl HABDX CI Ë — ÙÙÙÙ 1.7 7.0 6.3 7.1 6.2 2.5 3.1 -3.6 0.54 1,683 473 7,866 12/87 Harbor Real Return Instl HARRX PB — — ÙÙÙÙ 0.8 5.7 8.0 6.8 — 2.0 4.2 -15.0 0.59 138 287 513 12/05 Loomis Sayles Investment Grade Bond A LIGRX CI Ë — ÙÙÙÙ 3.1 9.4 8.4 8.2 8.2 4.6 5.0 -17.2 0.84 575 19 12,283 12/96 Managers PIMCO Bond MBDFX CI Ë — ÙÙÙÙ 1.2 6.1 6.2 7.1 6.1 2.9 2.9 -5.4 0.58 752 375 1,476 04/93 Metropolitan West Total Return Bond M MWTRX CI Î — ÙÙÙÙÙ 2.1 9.6 7.9 8.8 7.5 3.4 2.3 -6.5 0.63 1,208 156 25,660 03/97 PIMCO GNMA Instl PDMIX GI — — ÙÙÙÙÙ 0.8 2.5 5.4 6.4 5.7 2.9 2.0 -1.3 0.50 724 1,669 07/97 PIMCO Low Duration Instl PTLDX CS — — ÙÙÙÙÙ 0.9 4.4 3.7 4.7 4.2 2.7 2.0 -5.6 0.46 4,750 437 24,880 05/87 PIMCO Real Return A PRTNX PB — — ÙÙÙ 0.8 5.9 8.0 6.9 6.5 2.2 4.4 -17.2 0.85 795 129 24,442 01/97 PIMCO Short-Term Instl PTSHX UB — — ÙÙÙÙÙ 0.6 2.3 1.7 2.6 2.9 1.0 0.9 -4.2 0.45 1,285 307 11,953 10/87 PIMCO Total Return Instl PTTRX CI — — ÙÙÙÙÙ 1.8 7.6 7.0 7.9 6.7 3.9 3.2 -3.1 0.46 19,938 584 292,876 05/87 T. Rowe Price Short-Term Bond PRWBX CS Ê Z ÙÙÙ 0.3 1.7 2.1 3.2 3.2 1.9 0.9 -3.0 0.53 722 92 6,788 03/84 Vanguard GNMA Inv VFIIX GI È Z ÙÙÙÙ 0.7 2.0 5.0 5.6 5.0 2.4 2.0 -2.5 0.21 25,064 130 37,649 06/80 Vanguard Inflation-Protected Secs Inv VIPSX PB É Z ÙÙÙÙ 0.4 4.4 7.8 6.1 6.2 2.3 4.2 -12.2 0.20 37 33 43,138 06/00 Vanguard Short-Term Federal Inv VSGBX GS Ç Z ÙÙÙÙ 0.3 1.0 2.1 3.0 3.3 0.5 1.1 -1.5 0.20 394 436 5,661 12/87 Vanguard Total Bond Market Index Inv VBMFX CI È Z ÙÙÙ 0.8 3.5 5.3 5.6 4.9 2.4 2.5 -2.9 0.20 15,783 80 18,097 12/86 Eaton Vance Floating Rate I EIBLX BL Í — ÙÙÙ 2.6 6.8 5.6 5.6 4.6 4.3 3.7 -25.3 0.77 685 42 11,519 01/01 Fidelity High Income SPHIX HB Í C ÙÙÙÙ 4.5 12.4 9.8 9.8 9.0 5.2 7.5 -27.5 0.76 635 35 6,635 08/90 Loomis Sayles Bond Instl LSBDX MU Î — ÙÙÙÙ 4.9 12.6 10.0 8.6 9.5 5.5 7.1 -25.2 0.63 658 20 23,478 05/91 PIMCO Emerging Local Bond Instl PELBX EB — — ÙÙ 3.1 9.8 8.4 8.8 — 5.7 12.0 -24.4 0.90 523 22 15,642 12/06 PIMCO Emerging Markets Bond A PAEMX EB — — ÙÙ 0.7 10.6 10.0 8.7 9.6 4.7 6.3 -29.2 1.25 766 12 7,784 07/97 Hi Yield & Specialty Hi Yield Templeton Global Bond A TPINX IB Ê X ÙÙÙÙÙ 3.3 11.6 6.7 9.5 10.1 5.3 9.5 -7.8 0.89 272 42 73,111 09/86 Vanguard Convertible Securities Inv VCVSX CV Î Z ÙÙÙÙ 7.7 13.6 8.6 6.5 9.0 3.3 11.5 -30.7 0.52 206 82 1,746 06/86

Fidelity Advisor Municipal Income T FAHIX ML Ì C ÙÙÙ 1.6 5.8 6.4 5.9 4.8 3.2 3.8 -7.1 0.76 707 6 1,191 09/87 Fidelity CA S/I Tax-Free Bond FCSTX MZ Ê C ÙÙÙ 0.9 2.2 3.0 3.8 — 2.1 1.6 -1.6 0.34 379 17 790 10/05 Fidelity California Municipal Income FCTFX MX Ë C ÙÙÙ 1.9 6.5 6.9 6.0 4.9 3.6 4.1 -7.1 0.46 567 9 1,967 07/84 Fidelity Intermediate Municipal Income FLTMX MI Ë C ÙÙÙÙ 1.2 3.9 4.9 5.0 4.4 2.8 2.6 -2.9 0.37 1,098 15 5,280 04/77 Municipal Bond Fidelity Municipal Income FHIGX ML Ì C ÙÙÙÙ 1.5 5.9 6.6 6.1 5.0 3.5 3.8 -6.8 0.46 1,198 10 6,789 12/77 Fidelity New York Municipal Income FTFMX MN É C ÙÙÙ 1.4 5.2 5.7 5.7 4.7 3.2 3.8 -5.7 0.46 312 16 2,068 07/84 Fidelity Short-Intermediate Muni Income FSTFX MS Ê C ÙÙÙÙ 0.7 1.9 2.8 3.3 3.0 1.8 1.4 -1.9 0.47 830 21 4,392 12/86 Fidelity Tax-Free Bond FTABX ML Ì C ÙÙÙÙ 1.6 6.2 6.7 6.3 5.3 3.5 3.9 -6.1 0.25 905 5 2,574 04/01 Franklin High Yield Tax-Free Inc A FRHIX HM — X ÙÙÙÙ 1.7 7.2 7.8 6.8 5.9 4.1 4.9 -14.2 0.65 837 10 10,166 03/86 T. Rowe Price Tax-Free High Yield PRFHX HM Î Z ÙÙÙÙ 2.5 9.8 8.8 6.9 5.7 4.2 4.4 -16.0 0.67 583 12 2,656 03/85 T. Rowe Price Tax-Free Shrt-Interm PRFSX MS Ê Z ÙÙÙÙ 1.0 2.0 2.9 3.7 3.2 1.6 1.5 -1.9 0.49 542 17 2,025 12/83

*Closed to new investors.

AA Aggressive Allocation SF Financial CI Intermediate-Term Bond MN Muni New York Long TH Target-Date 2026-2030 Equity Style Box BL Bank Loan FB Foreign Large Blend LS Latin America Stock MZ Muni Single State Short TI Target-Date 2031-2035 Val Blnd Grth Lrg CR China Region FG Foreign Large Growth GL Long Government SN Natural Resources TJ Target-Date 2036-2040 Mid CA Conservative Allocation FV Foreign Large Value LO Long/Short Equity PJ Pacific/Asia ex-Japan Stk TK Target-Date 2041-2045 Sm BB Commodities Broad Basket FR Foreign Small/Mid Growth CL Long-Term Bond SR Real Estate TY Target-Date 2046-2050 SC Communications FA Foreign Small/Mid Value MA Moderate Allocation RI Retirement Income TX Target-Date 2051+ CV Convertibles GR Global Real Estate MU Multisector Bond GS Short Government ST Technology Fixed-Income Style Box DE Diversified Emerging Mkts SH Health MC Muni California Interm CS Short-Term Bond UB Ultrashort Bond Ltd Mod Ext Hi EB Emerging Markets Bond HB High Yield Bond MX Muni California Long TA Target-Date 2000-2010 SU Utilities Med SE Equity Energy HM High Yield Muni MI Muni National Interm TD Target-Date 2011-2015 IA World Allocation Lo SP Equity Precious Metals PB Inflation-Protected Bond ML Muni National Long TE Target-Date 2016-2020 IB World Bond ES Europe Stock GI Intermediate Government MS Muni National Short TG Target-Date 2021-2025 IS World Stock

MorningstarAdvisor.com 75 By the Numbers: ETFs

Name Morningstar Style Box Morningstar Valuation Market Fair Annualized Yield % Std Dev Worst Avg # of % Asset Exp Turnover Net Incep 50 Most-Popular Category Rating Rating Price Value Total Return % 3 Yr % 3-Mo Market Holdings in top 10 Ratio % Assets Date Ret % Cap ($Mil) ($Mil) Equity ETFs SPDR S&P 500 SPY Large Blend È ÙÙÙÙ Fairly Valued 163.5 163.7 12.7 16.7 12.7 2.0 15.0 -29.6 58,893 501 18.2 0.09 4 140,734 01/93 Vanguard FTSE Emerging Markets ETF VWO Diversified Emerging Mkts È ÙÙÙ — 43.8 — -1.3 4.7 3.4 2.4 21.5 -44.2 19,355 1,037 12.1 0.18 8 58,509 03/05 iShares MSCI Emerging Markets Index EEM Diversified Emerging Mkts È ÙÙÙ — 43.3 — -1.2 3.1 2.3 1.7 21.5 -42.8 19,183 847 16.0 0.68 15 45,338 04/03 Morningstar’s analysis of exchange-traded iShares Core S&P 500 ETF IVV Large Blend È ÙÙÙÙ Fairly Valued 164.4 164.6 12.7 16.8 12.7 1.9 15.0 -29.6 58,852 503 18.1 0.09 5 43,498 05/00 funds now harnesses the rigorous, iShares MSCI EAFE Index EFA Foreign Large Blend È ÙÙÙ — 61.9 — 10.6 19.3 7.4 2.8 19.4 -35.2 35,042 929 13.3 0.34 5 43,363 08/01 bottom-up research that our 100-plus equity PowerShares QQQ QQQ Large Growth É ÙÙÙÙÙ Fairly Valued 73.1 76.9 8.8 7.3 14.0 1.2 16.8 -38.6 71,634 101 49.7 0.20 9 34,717 03/99 analysts conduct in order to estimate Vanguard Total Stock Market ETF VTI Large Blend È ÙÙÙÙ Fairly Valued 84.3 84.1 12.9 17.1 12.9 2.0 15.7 -31.1 32,637 3,250 15.0 0.05 3 30,922 05/01 the fair value of stock ETFs. By comparing iShares Russell 2000 Index IWM Small Blend Î ÙÙÙ — 94.1 — 12.0 17.8 11.2 1.8 19.9 -35.6 1,215 1,957 3.1 0.20 21 20,791 05/00 Vanguard REIT Index ETF VNQ Real Estate Ì ÙÙÙ — 75.3 — 15.3 19.1 17.1 3.2 17.0 -47.3 8,430 124 42.5 0.10 9 20,656 09/04 our fair value estimate for an ETF’s iShares Russell 1000 Growth Index IWF Large Growth É ÙÙÙÙ Fairly Valued 74.9 73.4 11.8 12.4 13.2 1.5 15.4 -32.9 47,556 577 24.1 0.20 19 19,626 05/00 portfolio with the fund’s market price, we iShares Russell 1000 Value Index IWD Large Value Ç ÙÙÙ Fairly Valued 84.2 85.4 13.9 21.5 12.1 2.1 15.6 -28.8 41,981 699 26.6 0.20 21 17,927 05/00 can better gauge whether an ETF is cheap, iShares Core S&P Mid-Cap ETF IJH Mid-Cap Blend Ë ÙÙÙÙ — 115.8 — 14.1 18.7 13.6 1.3 17.8 -36.5 4,086 402 7.8 0.20 14 16,337 05/00 dear, or reasonably priced. In so doing, Vanguard Dividend Appreciation ETF VIG Large Blend È ÙÙÙÙÙ Fairly Valued 68.1 65.9 12.7 17.2 12.7 2.1 12.9 -21.9 47,884 149 39.4 0.10 15 15,965 04/06 we can help you profit from inviting opportuni- Vanguard MSCI EAFE ETF VEA Foreign Large Blend È ÙÙÙ — 38.3 — 9.9 19.6 7.7 3.1 19.9 -34.4 32,811 869 13.3 0.10 7 13,932 07/07 ties as they arise. Financial Select Sector SPDR XLF Financial Ç ÙÙ Fairly Valued 19.3 19.4 14.4 23.5 6.6 1.6 20.6 -39.8 52,512 83 50.1 0.18 8 12,861 12/98 iShares Dow Jones Select Dividend Index DVY Mid-Cap Value Ê ÙÙÙÙ Overvalued 65.6 62.0 15.3 19.8 15.5 3.3 11.5 -30.1 12,540 103 20.7 0.40 16 12,595 11/03 The table lists the 50 most-popular equity ETFs, SPDR Dow Jones Industrial Average DIA Large Value Ç ÙÙÙÙ Fairly Valued 150.9 149.9 14.0 15.2 13.3 2.3 13.5 -22.8 126,676 31 54.8 0.17 6 12,465 01/98 SPDR S&P MidCap 400 MDY Mid-Cap Blend Ë ÙÙÙÙ — 211.0 — 14.0 18.5 13.4 1.1 17.8 -36.6 4,117 400 7.7 0.25 14 12,408 05/95 ranked by assets under management. A SPDR S&P Dividend SDY Large Value È ÙÙÙÙÙ Fairly Valued 68.6 66.0 16.4 22.6 13.9 2.8 12.5 -25.5 18,406 85 20.4 0.35 94 12,225 11/05 Morningstar Valuation Rating of Undervalued iShares MSCI Japan Index EWJ Japan Stock È ÙÙÙ — 11.7 — 21.1 21.3 5.7 1.6 15.4 -27.4 19,109 315 23.8 0.53 3 11,511 03/96 means the ETF is trading at a significant Vanguard Growth ETF VUG Large Growth É ÙÙÙÙ Fairly Valued 81.2 80.4 10.9 13.0 13.3 1.4 16.0 -33.3 45,355 417 22.9 0.10 21 10,497 01/04 discount to our estimate of its intrinsic Technology Select Sector SPDR XLK Technology É ÙÙÙÙ Fairly Valued 31.5 32.2 6.9 5.1 11.3 1.7 16.0 -38.2 97,756 78 62.7 0.18 5 10,465 12/98 worth. A rating of Overvalued means the ETF iShares Core S&P Small-Cap ETF IJR Small Blend Î ÙÙÙÙ — 86.9 — 11.5 17.3 12.8 1.5 18.6 -34.3 1,258 602 5.4 0.20 18 10,345 05/00 is trading at a significant premium to our Vanguard Value ETF VTV Large Value Ç ÙÙÙ Fairly Valued 68.2 68.7 14.7 20.5 12.2 2.5 15.0 -27.2 50,596 417 28.8 0.10 22 9,899 01/04 fair value estimate. We rate Fairly Valued any Vanguard FTSE All-World ex-US ETF VEU Foreign Large Blend È ÙÙÙ — 48.1 — 6.1 14.6 6.3 3.1 19.7 -37.1 26,972 2,336 9.0 0.15 6 9,863 03/07 ETF that trades in between. Vanguard S&P 500 ETF VOO Large Blend È — Fairly Valued 74.9 74.9 12.7 16.9 — 2.0 — -13.9 58,058 508 18.4 0.05 3 9,480 09/10 WisdomTree Japan Hedged Equity DXJ Japan Stock È ÙÙÙ — 47.6 — 30.5 39.8 6.0 1.2 18.5 -24.0 17,103 264 35.6 0.48 41 9,062 06/06 iShares Russell Midcap Index IWR Mid-Cap Blend Ë ÙÙÙÙ Fairly Valued 132.4 127.8 14.3 19.0 13.5 1.6 17.1 -38.7 8,489 799 4.7 0.20 13 7,786 07/01 The fair value estimate is the aggregate, iShares Russell 1000 Index IWB Large Blend È ÙÙÙÙ Fairly Valued 91.0 90.8 12.9 17.0 12.8 1.9 15.3 -30.9 44,561 996 16.0 0.15 6 7,734 05/00 asset-weighted fair value of the stocks in an Energy Select Sector SPDR XLE Equity Energy Ç ÙÙÙÙÙ Fairly Valued 80.3 88.0 10.2 12.1 11.2 1.8 23.4 -32.1 58,554 44 60.2 0.18 5 7,598 12/98 ETF portfolio that are under coverage by iShares S&P 500 Growth Index IVW Large Growth É ÙÙÙÙÙ Fairly Valued 86.5 85.6 11.5 13.7 13.4 1.7 14.5 -29.1 64,984 294 24.8 0.18 23 7,504 05/00 Morningstar equity analysts, divided by the iShares MSCI Brazil Capped Index EWZ Latin America Stock È ÙÙ — 55.2 — 0.4 -5.9 -5.8 2.8 27.1 -53.4 13,145 86 — 0.61 7 7,405 07/00 ETF’s shares outstanding. Depending on Health Care Select Sector SPDR XLV Health É ÙÙ Fairly Valued 48.6 48.8 19.0 28.7 17.6 1.7 12.2 -23.0 59,640 54 57.3 0.18 5 7,203 12/98 the coverage rate, the fair value estimate may iShares FTSE China 25 Index Fund FXI China Region Ç ÙÙ — 37.7 — -5.6 0.8 -1.6 2.5 23.1 -44.9 83,874 27 61.3 0.74 21 6,804 10/04 not include all of the stocks in the portfolio. Consumer Staples Select Sector SPDR XLP Consumer Defensive È ÙÙÙÙ Overvalued 41.2 37.5 18.0 23.5 17.4 2.6 10.2 -17.5 68,677 43 64.7 0.18 12 6,758 12/98 As such, when calculating our estimate, we Vanguard Small Cap ETF VB Small Blend Î ÙÙÙÙ — 91.4 — 13.0 19.4 12.8 1.6 19.5 -37.0 2,294 1,443 2.7 0.10 14 6,305 01/04 ALPS Alerian MLP ETF AMLP Equity Energy Ê — Fairly Valued 17.8 18.2 13.0 12.6 — 5.7 — -6.4 10,863 26 64.6 0.85 12 6,221 08/10 assume that all stocks not under coverage are Utilities Select Sector SPDR XLU Utilities Ç ÙÙÙ Fairly Valued 39.6 37.7 19.6 20.8 15.4 3.5 10.0 -22.8 20,575 32 57.4 0.18 4 6,067 12/98 trading at fair value. iShares S&P 500 Value Index IVE Large Value Ç ÙÙÙ Fairly Valued 76.6 77.6 13.9 20.1 11.9 2.1 15.9 -30.1 52,967 358 26.0 0.18 22 6,018 05/00 Vanguard High Dividend Yield Indx ETF VYM Large Value Ç ÙÙÙÙ Fairly Valued 57.0 56.9 15.2 20.3 15.4 2.9 12.8 -24.7 69,067 397 34.7 0.10 11 5,995 11/06 Morningstar’s exchange-traded securities JPMorgan Alerian MLP Index ETN AMJ Equity Energy — ÙÙÙÙÙ — 46.4 — 22.5 20.6 19.6 4.5 15.5 -9.3 — — — 0.85 0 5,896 04/09 team analyzes the fundamental attractiveness Vanguard FTSE Europe ETF VGK Europe Stock È ÙÙÙ — 51.4 — 6.5 18.3 7.7 3.3 22.6 -37.0 41,090 506 20.2 0.12 7 5,826 03/05 of hundreds of ETFs. Our extensive ETF iShares Dow Jones US Real Estate IYR Real Estate Ë ÙÙÙ — 73.5 — 14.4 19.4 15.8 3.3 16.1 -47.3 10,780 93 39.5 0.47 14 5,727 06/00 research is available in Morningstar Principia Market Vectors Gold Miners ETF GDX Equity Precious Metals Ì ÙÙÙ Fairly Valued 29.0 34.8 -34.5 -33.9 -15.1 1.5 28.7 -52.0 8,128 32 64.1 0.52 5 5,699 05/06 WisdomTree Emerging Markets Equity Inc DEM Diversified Emerging Mkts Ç ÙÙÙÙÙ — 56.0 — -0.8 1.2 5.7 3.3 19.1 -35.9 16,346 236 32.0 0.63 37 5,690 07/07 and Morningstar Office. Market Vectors Agribusiness ETF MOO Natural Res È ÙÙÙÙ — 54.3 — 2.6 6.0 9.3 1.8 22.4 -51.4 15,291 52 58.2 0.54 19 5,458 08/07 iShares Russell 2000 Value Index IWN Small Value Í ÙÙÙ — 83.8 — 11.5 19.6 9.4 2.3 19.4 -32.5 1,049 1,409 4.6 0.25 32 5,306 07/00 Consumer Discret Select Sector SPDR XLY Consumer Cyclical É ÙÙÙÙ Fairly Valued 56.8 54.1 15.4 21.5 18.0 1.4 16.6 -32.5 36,891 83 46.9 0.18 5 5,213 12/98 Vanguard Mid-Cap ETF VO Mid-Cap Blend Ë ÙÙÙ Fairly Valued 97.0 91.1 14.8 18.2 13.4 1.2 17.3 -38.3 8,680 368 5.9 0.10 17 5,134 01/04 PowerShares S&P 500 Low Volatility SPLV Large Value Ç — Fairly Valued 32.0 29.4 17.4 22.7 — 2.6 — -4.4 24,537 100 13.2 0.25 17 5,119 05/11

Data as of Apr. 30, 2013

76 Morningstar Advisor June/July 2013 Name Morningstar Style Box Morningstar Valuation Market Fair Annualized Yield % Std Dev Worst Avg # of % Asset Exp Turnover Net Incep Category Rating Rating Price Value Total Return % 3 Yr % 3-Mo Market Holdings in top 10 Ratio % Assets Date YTD 1Yr 3Yr Ret % Cap ($Mil) ($Mil) SPDR S&P 500 SPY Large Blend È ÙÙÙÙ Fairly Valued 163.5 163.7 12.7 16.7 12.7 2.0 15.0 -29.6 58,893 501 18.2 0.09 4 140,734 01/93 Vanguard FTSE Emerging Markets ETF VWO Diversified Emerging Mkts È ÙÙÙ — 43.8 — -1.3 4.7 3.4 2.4 21.5 -44.2 19,355 1,037 12.1 0.18 8 58,509 03/05 iShares MSCI Emerging Markets Index EEM Diversified Emerging Mkts È ÙÙÙ — 43.3 — -1.2 3.1 2.3 1.7 21.5 -42.8 19,183 847 16.0 0.68 15 45,338 04/03 iShares Core S&P 500 ETF IVV Large Blend È ÙÙÙÙ Fairly Valued 164.4 164.6 12.7 16.8 12.7 1.9 15.0 -29.6 58,852 503 18.1 0.09 5 43,498 05/00 iShares MSCI EAFE Index EFA Foreign Large Blend È ÙÙÙ — 61.9 — 10.6 19.3 7.4 2.8 19.4 -35.2 35,042 929 13.3 0.34 5 43,363 08/01 PowerShares QQQ QQQ Large Growth É ÙÙÙÙÙ Fairly Valued 73.1 76.9 8.8 7.3 14.0 1.2 16.8 -38.6 71,634 101 49.7 0.20 9 34,717 03/99 Vanguard Total Stock Market ETF VTI Large Blend È ÙÙÙÙ Fairly Valued 84.3 84.1 12.9 17.1 12.9 2.0 15.7 -31.1 32,637 3,250 15.0 0.05 3 30,922 05/01 iShares Russell 2000 Index IWM Small Blend Î ÙÙÙ — 94.1 — 12.0 17.8 11.2 1.8 19.9 -35.6 1,215 1,957 3.1 0.20 21 20,791 05/00 Vanguard REIT Index ETF VNQ Real Estate Ì ÙÙÙ — 75.3 — 15.3 19.1 17.1 3.2 17.0 -47.3 8,430 124 42.5 0.10 9 20,656 09/04 iShares Russell 1000 Growth Index IWF Large Growth É ÙÙÙÙ Fairly Valued 74.9 73.4 11.8 12.4 13.2 1.5 15.4 -32.9 47,556 577 24.1 0.20 19 19,626 05/00 iShares Russell 1000 Value Index IWD Large Value Ç ÙÙÙ Fairly Valued 84.2 85.4 13.9 21.5 12.1 2.1 15.6 -28.8 41,981 699 26.6 0.20 21 17,927 05/00 iShares Core S&P Mid-Cap ETF IJH Mid-Cap Blend Ë ÙÙÙÙ — 115.8 — 14.1 18.7 13.6 1.3 17.8 -36.5 4,086 402 7.8 0.20 14 16,337 05/00 Vanguard Dividend Appreciation ETF VIG Large Blend È ÙÙÙÙÙ Fairly Valued 68.1 65.9 12.7 17.2 12.7 2.1 12.9 -21.9 47,884 149 39.4 0.10 15 15,965 04/06 Vanguard MSCI EAFE ETF VEA Foreign Large Blend È ÙÙÙ — 38.3 — 9.9 19.6 7.7 3.1 19.9 -34.4 32,811 869 13.3 0.10 7 13,932 07/07 Financial Select Sector SPDR XLF Financial Ç ÙÙ Fairly Valued 19.3 19.4 14.4 23.5 6.6 1.6 20.6 -39.8 52,512 83 50.1 0.18 8 12,861 12/98 iShares Dow Jones Select Dividend Index DVY Mid-Cap Value Ê ÙÙÙÙ Overvalued 65.6 62.0 15.3 19.8 15.5 3.3 11.5 -30.1 12,540 103 20.7 0.40 16 12,595 11/03 SPDR Dow Jones Industrial Average DIA Large Value Ç ÙÙÙÙ Fairly Valued 150.9 149.9 14.0 15.2 13.3 2.3 13.5 -22.8 126,676 31 54.8 0.17 6 12,465 01/98 SPDR S&P MidCap 400 MDY Mid-Cap Blend Ë ÙÙÙÙ — 211.0 — 14.0 18.5 13.4 1.1 17.8 -36.6 4,117 400 7.7 0.25 14 12,408 05/95 SPDR S&P Dividend SDY Large Value È ÙÙÙÙÙ Fairly Valued 68.6 66.0 16.4 22.6 13.9 2.8 12.5 -25.5 18,406 85 20.4 0.35 94 12,225 11/05 iShares MSCI Japan Index EWJ Japan Stock È ÙÙÙ — 11.7 — 21.1 21.3 5.7 1.6 15.4 -27.4 19,109 315 23.8 0.53 3 11,511 03/96 Vanguard Growth ETF VUG Large Growth É ÙÙÙÙ Fairly Valued 81.2 80.4 10.9 13.0 13.3 1.4 16.0 -33.3 45,355 417 22.9 0.10 21 10,497 01/04 Technology Select Sector SPDR XLK Technology É ÙÙÙÙ Fairly Valued 31.5 32.2 6.9 5.1 11.3 1.7 16.0 -38.2 97,756 78 62.7 0.18 5 10,465 12/98 iShares Core S&P Small-Cap ETF IJR Small Blend Î ÙÙÙÙ — 86.9 — 11.5 17.3 12.8 1.5 18.6 -34.3 1,258 602 5.4 0.20 18 10,345 05/00 Vanguard Value ETF VTV Large Value Ç ÙÙÙ Fairly Valued 68.2 68.7 14.7 20.5 12.2 2.5 15.0 -27.2 50,596 417 28.8 0.10 22 9,899 01/04 Vanguard FTSE All-World ex-US ETF VEU Foreign Large Blend È ÙÙÙ — 48.1 — 6.1 14.6 6.3 3.1 19.7 -37.1 26,972 2,336 9.0 0.15 6 9,863 03/07 Vanguard S&P 500 ETF VOO Large Blend È — Fairly Valued 74.9 74.9 12.7 16.9 — 2.0 — -13.9 58,058 508 18.4 0.05 3 9,480 09/10 WisdomTree Japan Hedged Equity DXJ Japan Stock È ÙÙÙ — 47.6 — 30.5 39.8 6.0 1.2 18.5 -24.0 17,103 264 35.6 0.48 41 9,062 06/06 iShares Russell Midcap Index IWR Mid-Cap Blend Ë ÙÙÙÙ Fairly Valued 132.4 127.8 14.3 19.0 13.5 1.6 17.1 -38.7 8,489 799 4.7 0.20 13 7,786 07/01 iShares Russell 1000 Index IWB Large Blend È ÙÙÙÙ Fairly Valued 91.0 90.8 12.9 17.0 12.8 1.9 15.3 -30.9 44,561 996 16.0 0.15 6 7,734 05/00 Energy Select Sector SPDR XLE Equity Energy Ç ÙÙÙÙÙ Fairly Valued 80.3 88.0 10.2 12.1 11.2 1.8 23.4 -32.1 58,554 44 60.2 0.18 5 7,598 12/98 iShares S&P 500 Growth Index IVW Large Growth É ÙÙÙÙÙ Fairly Valued 86.5 85.6 11.5 13.7 13.4 1.7 14.5 -29.1 64,984 294 24.8 0.18 23 7,504 05/00 iShares MSCI Brazil Capped Index EWZ Latin America Stock È ÙÙ — 55.2 — 0.4 -5.9 -5.8 2.8 27.1 -53.4 13,145 86 — 0.61 7 7,405 07/00 Health Care Select Sector SPDR XLV Health É ÙÙ Fairly Valued 48.6 48.8 19.0 28.7 17.6 1.7 12.2 -23.0 59,640 54 57.3 0.18 5 7,203 12/98 iShares FTSE China 25 Index Fund FXI China Region Ç ÙÙ — 37.7 — -5.6 0.8 -1.6 2.5 23.1 -44.9 83,874 27 61.3 0.74 21 6,804 10/04 Consumer Staples Select Sector SPDR XLP Consumer Defensive È ÙÙÙÙ Overvalued 41.2 37.5 18.0 23.5 17.4 2.6 10.2 -17.5 68,677 43 64.7 0.18 12 6,758 12/98 Vanguard Small Cap ETF VB Small Blend Î ÙÙÙÙ — 91.4 — 13.0 19.4 12.8 1.6 19.5 -37.0 2,294 1,443 2.7 0.10 14 6,305 01/04 ALPS Alerian MLP ETF AMLP Equity Energy Ê — Fairly Valued 17.8 18.2 13.0 12.6 — 5.7 — -6.4 10,863 26 64.6 0.85 12 6,221 08/10 Utilities Select Sector SPDR XLU Utilities Ç ÙÙÙ Fairly Valued 39.6 37.7 19.6 20.8 15.4 3.5 10.0 -22.8 20,575 32 57.4 0.18 4 6,067 12/98 iShares S&P 500 Value Index IVE Large Value Ç ÙÙÙ Fairly Valued 76.6 77.6 13.9 20.1 11.9 2.1 15.9 -30.1 52,967 358 26.0 0.18 22 6,018 05/00 Vanguard High Dividend Yield Indx ETF VYM Large Value Ç ÙÙÙÙ Fairly Valued 57.0 56.9 15.2 20.3 15.4 2.9 12.8 -24.7 69,067 397 34.7 0.10 11 5,995 11/06 JPMorgan Alerian MLP Index ETN AMJ Equity Energy — ÙÙÙÙÙ — 46.4 — 22.5 20.6 19.6 4.5 15.5 -9.3 — — — 0.85 0 5,896 04/09 Vanguard FTSE Europe ETF VGK Europe Stock È ÙÙÙ — 51.4 — 6.5 18.3 7.7 3.3 22.6 -37.0 41,090 506 20.2 0.12 7 5,826 03/05 iShares Dow Jones US Real Estate IYR Real Estate Ë ÙÙÙ — 73.5 — 14.4 19.4 15.8 3.3 16.1 -47.3 10,780 93 39.5 0.47 14 5,727 06/00 Market Vectors Gold Miners ETF GDX Equity Precious Metals Ì ÙÙÙ Fairly Valued 29.0 34.8 -34.5 -33.9 -15.1 1.5 28.7 -52.0 8,128 32 64.1 0.52 5 5,699 05/06 WisdomTree Emerging Markets Equity Inc DEM Diversified Emerging Mkts Ç ÙÙÙÙÙ — 56.0 — -0.8 1.2 5.7 3.3 19.1 -35.9 16,346 236 32.0 0.63 37 5,690 07/07 Market Vectors Agribusiness ETF MOO Natural Res È ÙÙÙÙ — 54.3 — 2.6 6.0 9.3 1.8 22.4 -51.4 15,291 52 58.2 0.54 19 5,458 08/07 iShares Russell 2000 Value Index IWN Small Value Í ÙÙÙ — 83.8 — 11.5 19.6 9.4 2.3 19.4 -32.5 1,049 1,409 4.6 0.25 32 5,306 07/00 Consumer Discret Select Sector SPDR XLY Consumer Cyclical É ÙÙÙÙ Fairly Valued 56.8 54.1 15.4 21.5 18.0 1.4 16.6 -32.5 36,891 83 46.9 0.18 5 5,213 12/98 Vanguard Mid-Cap ETF VO Mid-Cap Blend Ë ÙÙÙ Fairly Valued 97.0 91.1 14.8 18.2 13.4 1.2 17.3 -38.3 8,680 368 5.9 0.10 17 5,134 01/04 PowerShares S&P 500 Low Volatility SPLV Large Value Ç — Fairly Valued 32.0 29.4 17.4 22.7 — 2.6 — -4.4 24,537 100 13.2 0.25 17 5,119 05/11

Data as of Apr. 30, 2013

MorningstarAdvisor.com 77

By the Numbers: Stocks

Undervalued Stocks With Wide Moats

Undervalued stocks with significant competitive analysts). Our analysts award wide economic it 4 or 5 stars. The wider the discount, the advantages can make attractive long-term moats to companies they believe possess higher the star rating, and vice versa. There holdings. With that in mind, we scoured durable competitive advantages that are likely were 31 stocks that fit that profile as our 2,000-plus stock coverage universe for high- to provide economic profits well into the future. of Apr. 30, 2013, three more than made the list quality stocks (those boasting wide on Feb. 28, 2013. Morningstar Economic Moat Ratings) that are When a stock trades at a suitably wide trading on the cheap (rated 4 or 5 stars by our discount to our estimate, we award

Name Industry Market EPS P/E Ratio Revenue EPS Dividend Yield ROE % Cap TTM (trailing) Growth % Growth % % Current (trailing) ($Mil) 3 Yr 3 Yr Applied Materials, Inc. AMAT Semiconductor Equipment & Materials 17,749 0.02 714.29 20.26 — 2.46 0.33 Bank of New York Mellon Corp BK Asset Management 34,761 1.32 13.91 23.89 — 1.80 7.06 Baxter International Inc. BAX Medical Instruments & Supplies 38,202 4.14 16.72 4.15 5.20 2.39 34.40 Berkshire Hathaway Inc Class B BRK.B Insurance - Diversified 263,319 6.99 16.92 13.03 20.02 — 8.41 CH Robinson Worldwide, Inc. CHRW Integrated Shipping & Logistics 9,131 3.66 16.18 14.45 19.88 2.39 43.14

Cisco Systems Inc CSCO Communication Equipment 113,411 1.73 12.06 8.44 12.37 2.49 17.79 eBay Inc EBAY Specialty Retail 73,027 2.06 25.38 17.26 2.83 — 13.64 Enbridge, Inc. ENB Oil & Gas Midstream 37,754 0.76 61.35 26.62 -28.40 2.56 8.37 Exelon Corp EXC Utilities - Diversified 29,955 1.12 26.39 10.69 -29.72 5.39 6.48 Expeditors International of Washington, Inc. EXPD Integrated Shipping & Logistics 7,998 1.60 22.88 13.48 12.25 1.45 16.54

Express Scripts ESRX Health Care Plans 49,812 1.70 34.13 56.00 4.10 — 10.75 Exxon Mobil Corporation XOM Oil & Gas Integrated 405,109 9.83 9.17 15.80 34.57 2.57 28.03 Facebook Inc Class A FB Internet Content & Information 65,453 0.05 588.20 — — — 0.40 General Electric Co GE Diversified Industrials 237,926 1.34 16.03 -1.73 8.50 3.13 11.39 ITC Holdings Corp ITC Utilities - Regulated Electric 4,602 3.71 24.88 10.18 11.74 1.69 13.98 John Wiley & Sons, Inc. Class A JW.A Publishing 2,297 3.05 12.53 3.43 17.30 2.48 17.41 Kinder Morgan Energy Partners LP KMP Oil & Gas Midstream 22,897 1.38 — 7.26 — 5.74 -0.83 Kinder Morgan Management LLC KMR Oil & Gas Midstream 10,102 0.65 — 0.00 — — -0.67 National Oilwell Varco, Inc. NOV Oil & Gas Equipment & Services 29,072 5.58 11.19 16.39 18.32 0.73 13.16 Novo Nordisk A/S ADR NVO Biotechnology 96,118 41.38 28.01 15.17 29.67 1.30 57.30

ONEOK Partners, L.P. OKS Oil & Gas Midstream 11,655 2.56 17.79 16.29 -5.48 5.23 16.71 Oracle Corporation ORCL Software - Infrastructure 158,608 2.15 15.22 16.87 21.60 0.53 25.33 Potash Corporation of Saskatchewan, Inc. POT Agricultural Inputs 37,276 2.45 17.61 25.85 29.95 1.95 23.41 Praxair, Inc. PX Chemicals 33,798 5.53 20.66 7.81 11.84 1.97 27.48 Qualcomm, Inc. QCOM Communication Equipment 112,862 3.56 17.33 22.44 54.59 1.53 17.99

Sanofi ADR SNY Drug Manufacturers - Major 146,911 1.56 21.79 5.35 -2.46 2.38 8.75 Schlumberger NV SLB Oil & Gas Equipment & Services 102,182 4.07 18.38 22.58 16.55 1.48 16.02 Spectra Energy Corp SE Oil & Gas Midstream 20,859 1.44 22.03 3.69 2.70 3.83 11.03 Vulcan Materials Company VMC Building Materials 7,112 -0.43 — -1.55 — 0.07 -1.39 Weight Watchers International, Inc. WTW Personal Services 2,475 4.46 9.97 9.30 22.52 1.58 —

Western Union Company WU Credit Services 9,120 1.67 8.76 3.67 11.78 2.75 111.79

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Tap into the industry’s best source Educational. your field of potential options and enhance of information on ETF strategies for Master the fundamentals of ETF managed your due diligence process. financial advisors. portfolios and discover how Morningstar’s robust strategy classification can Current. help you navigate this growing universe Tap into recent trends and opportunities Sponsored by Vanguard of offerings. with video interviews and commentary featuring a handpicked group of Comprehensive. asset managers, ETF providers, and indus- Get access to profiles on500 individual try executives. strategies, which include performance and category data, and get insight on invest- Visit MorningstarAdvisor.com today to ment philosophy, portfolio construction, and get started: more (when provided by the firm). www.morningstar.com/goto/etf-mp

Screenable. Test-drive our multi-option screener for ETF managed portfolio strategies to narrow Phillips Curve

Mutual Fund Urban Myths

By Don Phillips

Like all areas of human endeavor, the fund stock price up when buying or down when by its expense ratio plus about 39 basis points. industry is prone to its share of urban myths— selling. The estimates of this frictional cost are Over the past five years, this figure shrinks to stories that simply aren’t true but which what send the projections of the total hidden 25 basis points. This means that the total contain enough of a basis in reality to make costs soaring. hidden cost in funds must be less than one fifth them seem plausible. These untruths get retold the oft-quoted estimates. Put another way, the with such passion and frequency that people Trading friction is a real cost, but the notion thing lurking in the shadows of your mutual eventually accept them as gospel, and they that it totals 140 to 200 basis points is fund is a squirrel, not a werewolf. become part of the industry’s shared beliefs. preposterous. The early champions of this myth were salesmen for separate-account wrap To embrace the 140-basis-point-hidden-fee One urban myth circulating among investors is programs who wanted to inflate the costs of claim, one would have to accept that that mutual funds have hidden fees of 140 to mutual fund ownership to justify the high fees the average equity fund manager somehow 200 basis points that are omitted from expense of their services. These critics are easy enough adds more than 100 basis points of value ratios. When these hidden fees are added to dismiss. But there have been a couple of through stock picks before the cost of to a fund’s stated expense ratio, they presum- academic studies that prop up this notion of transacting is considered—an assumption that ably bring overall annual fund expenses to high hidden fees. To these, one should be more would fly in the face of financial theory. If this something in the 2.5% to 3% range. When the gracious. It is conceivable that a single fund were true, then one must also conclude that additional toll of taxation is taken into account, that did a very bad job at trading could run up indexing is an irresponsible investment choice, the total cost of fund ownership is supposedly hidden trading costs of 140 basis points, but for because in choosing an equity index fund, close to 5% for some funds. It’s enough to send that figure to be an industry average is absurd. one would leave behind more than 100 basis shivers down your spine. points of readily accessible value. The most The obvious example that dispels these claims prudent investment choices would be actively While the terror of taxation on fund shares one is index funds. If trading costs were anywhere managed, but very-low-turnover strategies, continues to hold is real, the 140 to 200 basis near this magnitude, funds like Vanguard 500 not index funds. This is the logical conclusion if points in hidden costs are largely fiction. Index VFINX would not be able to so closely index proponents want to claim that active The idea does have a basis in reality, however. mirror their assigned index’s performance. funds have these high hidden costs. Mutual funds do omit the cost of trading Index proponents have been quick to point this securities from their expense ratios. Funds do out, but they often want the charge of high Clearly, these cost estimates must be disclose in their financial statements the dollar hidden fees still to stick against actively recognized as being grossly overstated. At the amount spent on brokerage commissions, and managed funds. That’s not kosher. If the claim same time, it’s key to note that what’s wrong Morningstar translates this number into a is overstated for index funds, it must also be for with these estimates is their magnitude, not percentage of assets that can be appended to active funds. what they expose. Trading is often counterpro- the expense ratio to get a truer sense of a ductive, no matter how convinced one is that fund’s all-in costs. However, the median Let’s do the math. If actively managed stock the next trade will add value. That’s a lesson brokerage cost for large-cap U.S. equity funds funds really had these costs, the average for both fund managers picking stocks and for is nowhere near 200 basis points. For large-cap fund would trail an appropriate index, which advisors moving between funds. In many cases, funds, it clocks in at less than seven basis has no trading costs, by its expense ratio the best approach, as Jack Bogle likes to say, is points. (Small-cap funds have somewhat higher plus 140 basis points. It doesn’t. Over the don’t just do something, sit there! K brokerage costs.) But this number is just the trailing 10 years ending March 31, 2013, the dollars spent on commissions; it doesn’t average U.S. large-cap equity fund, on an Don Phillips is president of Morningstar’s account for the friction of a manager pushing a asset-weighted basis, trails the market index Research group.

80 Morningstar Advisor June/July 2013 CLIENT: Davis/Selected Funds TITLE: Beach Dog: Digging Deep PUB: Morningstar August/September 2012 Issue SIZE: Full-page w/bleed: 8.75" x 10.75" CONTACT: Kelley Cancio, cisneros Design VEU Vanguard FTSE All-World ex-U.S. ETF VEU has a 58% lower expense ratio than the industry average.*

Every client’s portfolio could use some Vanguarding.®

Lower expense ratios mean your clients can keep more of their returns. So take a closer look at the Vanguard FTSE All-World ex-U.S. ETF. With a lower expense ratio than the industry average, it can have a real impact on your clients’ portfolio.

Take a closer look at advisors.vanguard.com/ VEU 800 523-1145

All investments are subject to risk. To buy or sell Vanguard ETF Shares, contact your financial advisor. Usual commissions apply. Not redeemable. Market price may be more or less than NAV. For more information about Vanguard ETF Shares, visit advisors.vanguard.com/VEU, call 800 523-1145, or contact your broker to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing. Foreign investing involves additional risks including currency fluctuations and political uncertainty. Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries. *Source: Morningstar as of 5/1/2012. Based on 2012 ETF industry average expense ratio for FTSE All-World ex-U.S. ETFs of 0.43% and Vanguard VEU expense ratio of 0.18%. Morningstar data © 2012 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (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. All rights in the FTSE All-World ex-U.S. Index (the “Index”) vest in FTSE International Limited (“FTSE”). “FTSE®” is a trademark of London Stock Exchange Group companies and is used by FTSE under licence. The Vanguard FTSE All-World ex-U.S. ETF (the “Product”) has been developed solely by Vanguard. The Index is calculated by FTSE or its agent. FTSE and its licensors are not connected to and do not sponsor, advise, recommend, endorse or promote the Product and do not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b )investment in or operation of the Product. FTSE makes no claim, prediction, warranty or representation either as to the results to be obtained from the Product or the suitability of the Index for the purpose to which it is being put by Vanguard. © 2013 The Vanguard Group, Inc. All rights reserved. U.S. Pat. No. 6,879,964 B2; 7,337,138; 7,720,749; 7,925,573; 8,090,646. Vanguard Marketing Corporation, Distributor.