Allocation Advisors Active/Passive Portfolios

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1 Global Portfolio Management Allocation Advisors Active/Passive Portfolios An Integrated Approach to Managing Active & Passive Investments

2 Introducing the Allocation Advisors Active/Passive Portfolios: What We Will Cover Distinguishing Active and Passive Approaches Why Blend the Two? The Search for Truly Active Managers The Additional Benefits of Integrating Truly Active and Passive Approaches The Allocation Advisors Active/Passive Portfolios 1

3 Active vs. Passive Investing: What distinguishes the two? Objective Active Seek to provide attractive absolute, risk-adjusted or relative-to-benchmark returns through opportunistic investing, active risk management and portfolio differentiation Passive Seek to provide broad market and asset class exposures in correspondence with an identified market or asset class index Portfolio Construction Investment Vehicles Cost Individual manager investment and portfolio construction & rebalancing approaches Generally mutual funds or individually managed portfolios Generally higher based on active management efforts/resources Linked to specific index and generally market-cap weighted ETFs are commonly used, index mutual funds can also be utilized Generally lower given less in way of required resources and trading Return Drivers Generally more focused on assessing individual security fundamentals over longer-term time horizons Generally more macro or broad market oriented and aided by sustained momentum factors Tax Efficiency More varied based on individual manager turnover levels and specific investment approach Lower turnover levels and capital gain distributions can help increase tax efficiency Risk Profile & Management More varied by manager and specific investment approach More consistently dependent on the macro and size risks associated with specific asset classes/indexes 2

4 Active/Passive Portfolios: Why blend the two? Complementary Approaches Academic research often focuses on the virtues or shortcomings of one approach over the other; however, the effective blending of the two can offer a compelling combination of the favored and complementary attributes and return drivers of both approaches. Separating Alpha & Beta Separating sources of Alpha and Beta can be beneficial from a combined investment cost and management standpoint, allowing investors to separately source and better account for the expense of the individual components. More Cost-Effective Alpha Blending Passive with more truly Active approaches can reduce internal fund expenses but maintain the capacity to generate excess returns and actively manage risk. Enhanced Diversification The combined approaches can also further diversify returns, as certain market environments can favor primary Active or Passive return drivers. Benefitting from an Integrated Approach Investors often maintain exposure to both Active and Passive investment vehicles, but lack a truly integrated approach that seeks to enhance results through the synchronized active selection and optimal combination of the individual pieces. Alpha - the ability to achieve excess risk-adjusted returns through Active management Beta replicated broad market exposures that can be provided through lower-cost Passive approaches 3

5 Seeking Combined Active/Passives Attributes Active Active Passive Passive Active Active-Passive Passive Higher-cost approach More potential to outperform & actively manage risk More variety & diversification in investment approaches and return drivers Reduces internal expenses (vs. an all active approach) Maintains the ability to outperform and manage risk Complementary investment approaches and return drivers Lower cost approach Offers market exposure with no active management with respect to risk or potential returns Generally more momentum driven 4

6 Refining the Search for Truly Active Managers: What Distinguishes One Active Manager from Another? Active Share measures the extent to which a manager s current portfolio differs from its index (More Active) Active Share Passive Funds Active Funds Stock Pickers Moderately Active Closet Indexers Tracking Error Factor Bets (More Active) Tracking Error measures the extent to which a manager s historical returns have differed from its index Other Distinguishing Characteristics Information Ratio & Volatility Measures Fund Expense Fund Size Age of Fund Manager Incentives Cremers, Petajisto, 2008; Petajisto, 2013; Wells Fargo Advisors Research 5

7 Blending Passive Investments with Truly Active Managers When compared to more moderately active or closet-index funds, a portfolio that barbells lower-cost passive market exposure (ETFs) with more truly Active managers can offer the potential to achieve desired active characteristics at lower costs. 2 Active-Passive Barbelling Excess Return -2 40% Active 60% Passive Tracking Error Active Fund Universe 0 4 Index Fund Closet Indexer 60% Active 40% Passive Moderately Active Source: Morningstar, Wells Fargo Advisors, BlackRock Data shown for US domestic equity funds, by Active Share, over the period 2007 to 2013 Active Share quintiles are used to define active fund categories: Very Active: 1 st Quintile; Moderately Active: 2 nd & 3 rd ; Closet Indexer: 4 th & 5 th. Very Active 6

8 The Allocation Advisors Active/Passive Portfolios Five Portfolios The five portfolios are distinguished by investment objectives and accompanying risk/return profiles and strategic asset allocations. The five investment objectives are: Conservative Growth & Income, Moderate Growth & Income, Conservative Growth, Moderate Growth, and Long-Term Growth. Levels of Active vs. Passive Levels of Active and Passive exposures are generally expected to range between 40% and 60% based on assessed opportunities and risks and related current portfolio, asset class, market environment, fee and underlying manager and pairing considerations. Active vs. Passive by Asset Class While there will be biases toward either Active or Passive by asset class, both approaches will be utilized across a wide array of asset classes given combined investment and fee considerations. Asset classes where a bias toward Active will generally exist include REITs, Commodities, Small Caps and Emerging Market Equities and Debt. The Search for More Truly Active Managers With broad, diversified market (beta) exposure gained through ETFs, the remainder of the portfolio will focus on more truly Active and differentiating managers those that studies have shown offer a greater propensity to outperform. 1 An Integrated Approach With full transparency to the underlying pieces, the portfolios seek to effectively combine these two complementary investment approaches in consideration of the combined costs and desired investment attributes 1 Cremers, Petajisto, 2008; Petajisto, 2013; Wells Fargo Advisors Research 7

9 Who should consider investing in these portfolios? Investors seeking to benefit from the lower cost, broad market and momentum-oriented exposures offered through passive approaches, but wanting to also maintain a longerterm, more opportunistic and active risk management lens on the remainder of their portfolio. Market forces in recent years have largely favored lower-cost and more momentum-oriented approaches, but it is during such times that unexpected events and longer-term opportunities offered by going against the herd can arise. Having exposure to both approaches can make good current and longer-term investment sense. As opposed to a non-integrated approach, these portfolios may appeal to those investors that already have exposure to both, but are seeking to more effectively combine these complementary investment approaches within an integrated, diversified and costconscious framework. The effective blending of Active and Passive approaches involves both art and science with full transparency to the underlying pieces and their specific intent from a combined risk/return perspective. 8

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15 Disclosures: Mutual funds and Exchange-Traded Funds (ETF) are sold by prospectus. You should consider the investment objectives, risks, charges and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained by calling the mutual fund wholesaler or the ETF sponsor. You should read it carefully before investing. All investing involves risk including the possible loss of principal. There is no assurance any investment strategy will be successful or that a fund will meet its investment objective. An investment in a mutual fund or exchange traded fund will fluctuate and shares, when sold, may be worth more or less than their original cost. Exchange-Traded Funds are subject to risks similar to those of stocks and may yield investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched. Each fund within the Allocation Advisors Program is subject to its own specific risks which are fully describe in the prospectus for the fund. The asset class risks are described on the next page. 14

16 Asset Class Risks: Commodities: Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks. Equity Investments: Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations. Fixed Income: Investments in fixed-income securities are subject to interest rate and credit risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. Government bonds are guaranteed as to payment of principal and interest by the U.S. government if held to maturity. Although government bonds are considered free from credit risk, they are subject to interest rate risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. Foreign Investments: Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets. Real Estate: There are special risks associated with an investment in real estate, including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Small-and Mid-Cap Companies: The prices of small- and mid-company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions. Information Ratio measures the excess returns of a manager relative to a specific benchmark index in consideration of the level of tracking error vs. that benchmark (the standard deviation of the difference between the returns of the portfolio vs. the index). It is a measure of a manager s ability and level of consistency in beating a given benchmark. The higher the number, the more consistent a manager has been in adding value through active management. 15

17 General Disclosures Global Portfolio Management ( GPM ) is a division of Wells Fargo Investment Institute, Inc. ( WFII ). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company. GPM provides model investment advice based upon the universe of products researched by Global Manager Research ( GMR ) and asset allocation advice provided by Global Investment Strategy ( GIS ). Both GMR and GIS are affiliated divisions of Wells Fargo Investment Institute. GMR may provide research analysis for Wells Fargo affiliated mutual funds, private funds and other products, which may also be advised by WFII or a Wells Fargo affiliate ( Wells Fargo ). The analysis utilizes the same processes and scrutiny as for non-affiliated products and WFII is committed to providing research that is fair and unbiased, but a conflict may arise as Wells Fargo may benefit from a favorable recommendation for an affiliated product. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions and estimates are as of a certain date and subject to change without notice. In certain instances, individual mutual funds in the portfolio may close to new investors. In these instances, WFII may choose to use its investment process to recommend alternate mutual funds, in the same asset class, and or recommend a new portfolio version to accommodate new accounts. In addition, at WFII s discretion, new capital market assumptions and a new portfolio allocation may be recommended and existing accounts and models may be rebalanced to the new allocation at the discretion of your financial adviser. The Models assume all mutual funds and capital market assumptions change at the time of program recommendation and therefore individual accounts and performance may vary. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including you existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPCO, non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. 16