Questions and answers about Russell Model Strategies allocation changes

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1 JANUARY 15, 2015 Questions and answers about Russell Model Strategies allocation changes Summary: The global financial markets are dynamic, never constant nor predictable. We believe investors should have a well diversified portfolio that is built on a foundation of strong capital markets research. Russell follows a regular, methodical process of evaluating the asset allocation of our multi-asset portfolios. We review the positions of our portfolios in relation to current market conditions and our capital markets forecasts annually to determine if strategic asset allocation shifts are required. As markets are unpredictable, we are committed to a diversified approach, maintaining a global asset allocation that incorporates diversifying asset classes. However, we also acknowledge that macroeconomic themes will influence asset class performance, such as the recent fall in oil prices, the anticipated increase in U.S. interest rates and the expected actions of European and Japanese central bankers. As you read through this, you will see that our allocation changes reflect our beliefs on the direction of key macroeconomic variables that are likely to influence performance over the next 1 to 3 years. In January 2014, Russell increased exposure to U.S. equity, emerging markets, global infrastructure and global opportunistic credit. Our intent was to improve the potential portfolio return for investors. As a result of these changes and market activity, four out of the five models improved their return through December 2014 (see page 2 for more detail). Now, recent analysis has shown that our portfolios long and medium-term outlooks may benefit from another allocation adjustment. Effective on or around March 2, 2015, we will be incorporating our most current views and making adjustments to four of the five Russell Model Strategies to continue to strive to improve the overall return potential of these total portfolio solutions. We believe these allocation changes align with our latest capital market expectations and asset class views, which are, in short, a preference for equities over fixed income, a liking for credit, and a bias against exposure to rising long-term interest rates. The changes include: Equities: An increase in U.S. large cap exposure across all noted strategies to reflect our market expectations of stronger economic conditions in the U.S. relative to other developed countries, and a stronger U.S. dollar relative to other currencies. Meanwhile, we are maintaining our non-u.s. exposure for global diversification purposes. Alternatives: A decrease in real assets, including infrastructure, real estate and commodity strategies, with magnitude depending on the strategy. Those allocations have been shifted to equities that are less sensitive to interest rate increases. THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. RUSSELL INVESTMENTS // QUESTIONS AND ANSWERS ABOUT RUSSELL MODEL STRATEGIES ALLOCATION CHANGES

2 Fixed Income: A shift within the fixed income asset class toward certain types of fixed income securities (high yield bonds and emerging market debt) that are less sensitive to rising interest rates and that offer the potential for higher returns with accompanying higher investment risk than other fixed income securities. This has been achieved by shifting more assets to the Russell Global Opportunistic Credit Fund, primarily in the more conservatively allocated models. Comparison of current vs. new allocations for the Russell Balanced Model Strategy Please see the document titled Comparison of Current and New Allocations for the Russell Model Strategies, Effective on or around March 2, 2015 for the new allocation percentages for all models. What drives portfolio changes? Russell s design of efficient portfolio allocations is based on three criteria: 1. Mean/variance efficiency in terms of total return We want to help ensure that the investor is appropriately rewarded for the risk assumed relative to wealth potential. 2. Magnitude of expected alpha and information ratio The investor is paying for active management. We want the additional return potential to be meaningful in its expected magnitude and efficient in terms of the information ratio (the ratio of expected excess return to the tracking error of expected return). RUSSELL INVESTMENTS // QUESTIONS AND ANSWERS ABOUT RUSSELL MODEL STRATEGIES ALLOCATION CHANGES / P 2

3 3. Behavioral concerns We want to build portfolios that investors will continue to believe in and remain invested in even when capital market conditions are unfavorable. How did the January 2014 reallocations impact the Models? Since the reallocation on January 13, 2014, four out of the five Russell Model Strategies improved their performance. The following chart depicts what the return would have been if the changes had not been made (blue bars) versus the changes that were made (grey bar). Class S shares, as of December See endnotes for standardized performance. Why didn t the Conservative Model Strategy improve its return as a result of the 2014 reallocation? The Conservative Model Strategy shifted from an 18% strategic allocation to the Russell Short Duration Bond Fund in 2013 to a 24% strategic allocation in 2014, while the other Models did not hold an allocation to the Short Duration Bond Fund. The increase in short duration fixed income at the expense of core fixed income was a key driver in the strategic allocation impact. Interest rates fell throughout the year, which benefitted the higher duration fixed income exposure of the previous Conservative Model Strategy allocation. Which Model is not reallocating in March 2015 and why? The Conservative Model Strategy is not being reallocated at this time, as we are conducting further analysis of the underlying fund allocations, including the potential addition of new underlying funds for this Model. If a reallocation for this Model is planned for a future date, financial professionals will be notified well in advance of the effective date to provide sufficient preparation time. How are the 2015 adjustments expected to impact the risk/return aspects of the portfolios? In general, we believe that risk and return potential remain unchanged in the Moderate and Balanced Model Strategies, while the Growth and Equity Growth Model Strategies will see an increase in the total expected risk and RUSSELL INVESTMENTS // QUESTIONS AND ANSWERS ABOUT RUSSELL MODEL STRATEGIES ALLOCATION CHANGES / P 3

4 return potential. The primarily driver of the increase risk and return potential in these Models is an increase in allocations to equities and a decrease in allocations to alternatives. Please see the document titled Comparison of Potential Risk and Returns for Russell Model Strategies Current and New Allocations for further detail. Equities Why the increase in equity allocation across all Model Strategies? Russell maintains a positive outlook for risk assets for 2015, with an expectation that equities will modestly outperform fixed income. We expect that rising interest rates will lead to underperformance of aggregate fixed income. Moreover, with rates at historic low levels, we have recently seen the equity asset class outperform real estate and infrastructure asset classes as interest rates rise. However, we are mindful that this relationship is one of many that influence these asset price relationships. Given this, we have modestly increased our equity exposure, with the majority of the move coming from real assets towards equity. Specifically, regarding the Russell International Developed Markets Fund, why the 2% decrease in the Equity Growth Strategy and yet a 1% increase in the Growth Model Strategy? Barring other considerations, we are typically looking for a consistent expression of our views on U.S. equity relative to international equity. Given other changes in the models, these changes allow us to more consistently express this view. Allocation changes should be viewed in the context of the total portfolio, in addition to specific fund allocations. The Growth Strategy and Equity Growth Strategy each saw an increase in allocation to equities of 6% and 5% respectively. Given the higher growth profile of the Equity Growth Strategy, that portion of the equity increase was allocated to global equities, while decreasing international equities because the outlook for global equities is more positive than international given its exposure to the U.S. market. Alternatives You increased allocations to alternatives last year, why the decrease now? The decrease in real asset and alternative allocations ranges from 2%-5%, depending on the Model. With the expectation that interest rates will begin to rise in the U.S., we are re-evaluating the interest rate sensitivity of our portfolios. As discussed above, with interest rates at low levels, an increase in interest rates likely favors equity over real estate securities and infrastructure. The allocation to the Russell Global Infrastructure Fund was increased in January 2014, but is now decreasing. Why? Reductions are 1% for most Models and 2% for the Moderate Model Strategy. Infrastructure is still viewed as a valuable diversifying asset class in a multi-asset portfolio. However, at the beginning of 2014, we had a bullish outlook for infrastructure over the coming 1-3 years. The increase in this position was rewarded over Moreover, infrastructure performance relative to equity can be more sensitive to rising interest rates. We are realigning our infrastructure weight to be consistent with our long-term position of real assets for a U.S. investor-based multi-asset portfolio. RUSSELL INVESTMENTS // QUESTIONS AND ANSWERS ABOUT RUSSELL MODEL STRATEGIES ALLOCATION CHANGES / P 4

5 The allocation to the Global Real Estate Securities Fund is decreasing across the models, why? While we still believe that real estate is an important diversifying asset in a multi asset portfolio, our outlook for key macroeconomic variables cause us to favor other asset classes. In recent years, real estate investments have been more sensitive to interest rate movements than equity, while they have had similar volatility. As our central view is increasing interest rates, we have modestly decreased real estate in our multi-asset portfolios. The allocation to Commodities is either being reduced or remaining neutral depending on the model, why? What is our outlook on commodities? The reduction to the Russell Commodity Strategies Fund is slight or neutral (0-2%), depending on the model. Commodities remain an important component of our strategies as a diversifying asset class. Commodities have experienced a difficult year when various segments of the commodity market have hit long-term oversold levels. We remain cautious regarding the outlook for commodities. In particular, there is significant uncertainty in oil prices. Given the risk, we don t see a reason to increase our exposure to commodities. Given that a barrel of oil dropped in price by more than 40% over the last six months of 2014, we also don t see a reason to materially cut our exposure. And, importantly, we still highly value the diversification benefits commodities can provide a multi-asset portfolio. Fixed income Why the shift within the fixed income asset class? Russell s 2015 outlook is an environment where firms continue profit growth, a modest rise in the 10-year treasury, and for credit to outperform within fixed income amid low default rates. The shift within fixed income is primarily to the Russell Global Opportunistic Credit Fund, and away from core fixed income in order to express an expectation for credit to outperform and to reduce rate sensitivity within the fixed income portion of the Models. Why the increased allocation to the Global Opportunistic Credit Fund in the Moderate and Balanced Models, but a decrease in the Growth and Equity Growth Models? The allocation to this fund increased by 3% in the Balanced Model Strategy and 4% in the Moderate Model Strategy. Model Strategies that will increase allocation to the Russell Global Opportunistic Credit Fund are primarily funding the exposure from core fixed income. This positioning is in line with our view for continued modest economic growth, low defaults, and modestly rising interest rates that should benefit credit strategies relative to core fixed income. This view is expressed in Models that carry a higher weight to fixed income, which are the most sensitive to rising rates. In more aggressive Models where there is less core fixed income, and the Global Opportunistic Credit Fund represents more of the sensitivity to rates, we reduced that exposure in favor of other areas that we believe would benefit based on our market expectations. Why the decrease to the Russell Strategic Bond Fund in the Balanced Model but an increase in the Growth Model? The allocation to the Russell Strategic Bond Fund is decreasing in the Balanced Strategy, but is increasing for the Growth Model Strategy, which may seem like a conflicting signal. However, it should be viewed in the context of the overall allocation to fixed income (which is increasing relative to real assets) in each strategy, and relative to the composition of assets within the fixed income asset class. RUSSELL INVESTMENTS // QUESTIONS AND ANSWERS ABOUT RUSSELL MODEL STRATEGIES ALLOCATION CHANGES / P 5

6 How are the weighted average expenses of the Russell Model Strategies changing? The Model Strategies weighted expense ratios are expected to remain flat compared to the current expense ratios. Following is a list of the net weighted expense ratios for the new allocations vs. the current allocations, using Russell Fund expense ratios as listed in the current prospectus. Weighted Expense Ratios Moderate Balanced Growth Equity Growth New 0.90% 0.99% 1.05% 1.10% Current 0.90% 1.00% 1.08% 1.12% The net expense ratios listed are the estimated weighted average net expense ratios of underlying Russell Mutual Funds, Class S. Ratios are calculated by multiplying each funds' percentage allocation in the strategy by the funds' net expense ratio and then summing these values. When will the Model Strategy quarterly fund performance fact sheets reflect the March allocation changes? The first quarter, 2015 (March 31, 2015) Russell Model Strategy fact sheets, which will be published around the second week of April, will reflect the new allocations that will take effect on or around March 2. The performance data will be as of March 31, 2015 and will reflect the performance incorporating the historical and new underlying fund allocations. What are the tax implications of the reallocation to shareholders in the Russell Model Strategies? The tax consequences of the Russell Model Strategy reallocation will vary based on the individual investor situation, the specific model strategy invested in, and the timing of the actual reallocation of the client accounts. The target allocation increases or decreases to any individual fund vary by model. Specific questions about tax consequences of the clients Model Strategy account reallocation should be directed to your home office or a tax advisor. Why are the Russell Tax-Managed Model Strategies not reallocating? We are conducting further analysis of the underlying fund allocations for these Models. The potential inclusion of a new fund that is not yet available for investment will be part of the analysis. If a reallocation for these Models is planned for a future date, financial professionals will be notified well in advance of the effective date to provide sufficient preparation time. RUSSELL INVESTMENTS // QUESTIONS AND ANSWERS ABOUT RUSSELL MODEL STRATEGIES ALLOCATION CHANGES / P 6

7 Endnotes: RUSSELL INVESTMENTS // QUESTIONS AND ANSWERS ABOUT RUSSELL MODEL STRATEGIES ALLOCATION CHANGES / P 7

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9 For more information: Call Russell at or visit Fund objectives, risks, charges and expenses should be carefully considered before investing. A summary prospectus, if available, or a prospectus containing this and other important information can be obtained by calling Please read a prospectus carefully before investing. Mutual fund investing involves risk. Principal loss is possible. Global equity involves risk associated with investments primarily in equity securities of companies located around the world, including the United States. International securities can involve risks relating to political and economic instability or regulatory conditions. Investments in emerging or developing markets involve exposure to economic structures that are generally less diverse and mature, and to political systems which have less stability than those of more developed countries. Small capitalization (small cap) investments generally involve stocks of companies with a market capitalization based on the Russell 2000 Index. Small cap investments are subject to considerable price fluctuations and are more volatile than large company stocks. Investors should consider the additional risks involved in small cap investments. Bond investors should carefully consider risks such as interest rate, credit, default and duration risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield ("junk") bonds or mortgage-backed securities, especially mortgage-backed securities with exposure to sub-prime mortgages. Generally, when interest rates rise, prices of fixed income securities fall. Interest rates in the United States are at, or near, historic lows, which may increase a Fund's exposure to risks associated with rising rates. Investment in non-u.s. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries. Alternative strategies may be subject to risks related to equity securities; fixed income securities, including non-investment grade fixed income securities, which involve higher volatility and higher risk of default than investment grade fixed income securities; non-u.s. and emerging markets securities, which involve risks such as currency fluctuation, political and economic instability, immature economic structures that could result in additional volatility; derivatives, which are subject to a number of risks such as liquidity risk, market risk, credit risk, default risk, counterparty risk (the risk that the other party in an agreement will fail to perform its obligations) and management risk; currency trading, which may involve instruments that have volatile prices, are illiquid or create economic leverage; commodity investments, which may have greater volatility than investments in traditional securities; and liquidity, because certain investments may become illiquid under adverse or volatile market or economic conditions. Additionally, the Fund may enter into short sales and certain of the Fund money managers may utilize a short-only strategy. The making of short sales exposes the Fund to the risk of liability equal to the market value of the security that is sold, in addition to the costs associated with establishing, maintaining and closing out the short position. Short sales have the potential for unlimited loss. Investments in infrastructure-related companies have greater exposure to the potential adverse economic, regulatory, political and other changes affecting such entities. Investment in infrastructure related companies are subject to various risks including governmental regulations, high interest costs associated with capital construction programs, costs associated with compliance and changes in environmental regulation, economic slowdown and surplus capacity, competition from other providers of services and other factors. Investment in non-u.s. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries. Exposure to the commodities markets may subject the Fund to greater volatility than investments in traditional securities, particularly if the investments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or sectors affecting a particular industry or commodity and international economic, political and regulatory developments. The use of leveraged commodity-linked derivatives creates an opportunity for increased return, but also creates the possibility for a greater loss.. Investments that are allocated across multiple types of securities may be exposed to a variety of risks based on the asset classes, investment styles, market sectors, and size of companies preferred by the investment managers. Investors should consider how the combined risks impact their total investment portfolio and understand that different risks can lead to varying financial consequences, including loss of principal. RUSSELL INVESTMENTS // QUESTIONS AND ANSWERS ABOUT RUSSELL MODEL STRATEGIES ALLOCATION CHANGES / P 9

10 Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets. Model Strategies represent target allocations of Russell funds; these models are not managed and cannot be invested in directly. Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide and is part of London Stock Exchange Group. Copyright Russell Investments All rights reserved. Securities products and services offered through Russell Financial Services, Inc., member FINRA, part of Russell Investments. First used: January 2015 RFS RUSSELL INVESTMENTS // QUESTIONS AND ANSWERS ABOUT RUSSELL MODEL STRATEGIES ALLOCATION CHANGES / P 10