Investment Insights. Market Periods For Active Investment Management

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1 Market Periods For Active Investment Management Anticipated market trends lead us to currently favor active management styles over passive indexing approaches. Executive Summary Since the turn of the millennium investors have been forced to accept an environment where returns are hard earned. Equity markets have demonstrated dramatic volatility and multiple periods where significant market corrections occurred. Fixed income investors have had to deal with an extended period of declining interest rates, leading to extremely low yields on their savings. The reality that money is not as easy to make in the market as it once was raises the question of whether a passive investment style, centered on index investing, is the best alternative for investors. Can active management of portfolios make a difference for investors in a period when markets are not flourishing? U.S. Bank has examined results for passive and active managers in both the fixed income and equity markets over the past two decades. The research shows that active managers have historically generated superior returns in periods when markets are flat or down. By contrast, passive investors have historically had the edge when markets were moving in a significantly positive direction. When hedging strategies are incorporated into the active management approach, the differences in results during different types of markets have been even more dramatic. In our opinion, the results demonstrate that investors should not settle for a passive investment approach in a period when the market appears to present many challenges, as has been the case in recent years.

2 Page 2 Using active investing to capitalize on today s market trends As they experience a period of volatile and unpredictable markets, many investors are uncertain how to position their portfolios in response. Some resolve their indecision by choosing to settle for a more passive approach investing in index funds. These individuals may believe that in unpredictable times, they are best served by putting their money in a mutual fund or exchange-traded fund (ETF) that seeks to replicate the movement of the broad market, such as one that invests in stocks of the S&P 500 Index. The perception is that volatile markets are a challenging time to try to identify inefficiencies in the market that may allow them to generate superior performance. But do investors have to settle for returns that mimic the markets in an environment where markets appear to be subject to unpredictable and dramatic up and down movements? The answer is no. While past performance is no guarantee of future returns, history indicates that it is possible for investors to generate an advantage by considering an active management approach to try to capture mispricing that can exist during periods of uncertainty. Our review of results on actual performance was based on different types of equity market conditions. The results indicated that in many circumstances, particularly in periods when stocks were in a trading range or when markets were generally trending lower, active managers with a selective approach tended to outperform passive managers who focused on buying all of the stocks represented in an index. The question of active versus passive investment approaches also is relevant for fixed income investors. Research indicated that when interest rates were stable or rising, active investors historically had enjoyed an advantage over passive investors. Passive investors tended to benefit most in an environment where interest rates were declining. Differentiating trends in equity markets Passive investing implies an approach where money is put to work in index-type investments (index funds or index ETFs). The goal is for the investment to generally replicate the performance of the market itself (such as an index tracking the S&P 500), or a specific segment of the market. Diversification is achieved, in effect, by owning a broad cross section of securities represented in a particular market or a variety of index products Avg. Annualized Return % This may be one of the main obstacles to achieving long-term success with a passive approach. In a market environment where there is no rising tide to lift all boats, passive investors are forced to accept what the market gives them. In turn, they could sacrifice the opportunity to benefit from areas of the market that can weather a strong downward trend. Additionally, investors are not able to eliminate stocks that are likely to suffer more than the average stock in a negative environment. Active managers research and select specific stocks they believe are best positioned to benefit from the current environment and expected future market conditions. Likewise, they seek to avoid stocks that may be the least attractive based on anticipated trends in the market and economy. In an environment where stocks as a whole are trending higher, it can be difficult to generate an advantage over an indexed investing approach using a more selective style. However, there may be a significant payoff in the event the stock market is moving in a sideways pattern or is declining in value Traditional Equity Styles: Historical Returns in Varying Markets Up Markets S&P 500 >10% 63% of periods S&P 500 Sideways Markets S&P 500 0%-10% 100% of periods Morningstar Universe of Active Large Cap Core Managers Down Markets S&P 500 <0% 100% of periods Hypothetical Portfolio of Third-Party SMA Large Cap Core Managers Source: U.S. Bank Asset Management. Additional details provided on page 6.

3 Page 3 Our research compared annualized returns of the S&P 500 from 1996 through In ten of those years, the market gained 10% or more. The average performance of active managers over those ten combined years trailed the returns generated by passive investors, but by less than 0.5% per year. However, active managers still outperformed passive managers 50% of the time during these strong market periods. In five years during that period, the return of the S&P 500 was positive, but less than 10%. Active managers generated an average annual return advantage of 1.5% compared to passive managers. In 80% of these periods, active managers showed a performance advantage. in a way that is designed to benefit from downward price movements in an individual security, sector, or the market as a whole. The general trends identified in the research of active versus passive long-only managers were the same when comparing hedge fund managers to passive investors. Passive investors performed better during strong periods for stocks. When markets were flat or down, actively managed hedge funds performed better. 30 Hedged Equity Managers: Historical Returns in Varying Markets Up Markets S&P 500 >10% Sideways Markets S&P 500 0%-10% Down Markets S&P 500 <0% In the four years during this span when markets declined in value, the advantage for active managers was more significant. Relative returns for active managers outpaced those of passive managers by 4.3% per year, and active managers as a group generated higher returns in each of the four years. While past market performance is not a guarantee of future results, the inference that can be drawn from the research is that in times of volatility, active management appears to provide an advantage for investors. In periods of strong market performance, the advantage that passive investors hold over active managers is evident, but marginal. Incorporating hedging into an active management strategy Can an approach that incorporates hedging provide any advantage as part of an active management strategy? The past performance record of hedge funds indicates that the benefit of active management may be more pronounced when hedging strategies are incorporated. Active managers that employ hedging strategies are not as constrained as traditional long-only managers and may simply use traditional instruments in less traditional ways in order to generate returns. An important distinction for purposes of this comparison is that hedge fund managers have the ability to utilize shorting strategies. In other words, they can invest Avg. Annualized Return % % of periods S&P % of periods HFRI Index of Hedge Fund Managers 100% of periods Hypothetical Portfolio of Third-Party Hedge Fund Managers Source: U.S. Bank Asset Management. Additional details provided on page 6. In this chart, you see the differences in performance during the three different types of markets are significant. This may indicate that the ability to use hedging strategies (such as shorting) creates an unfavorable comparison during strong markets, but helps accentuate the potential advantage for active investors in flatter or negative markets. In all but one of the ten years when the S&P 500 returned 10% or more, passive investing outpaced active hedged management. On average, during periods of strong market performance, passive investing held an average annual advantage of 10%. In the other nine years of the market test, active managers using hedging strategies gained a sizable advantage. During years of relatively flat market performance, hedge funds performed better than passive investors 80% of the time and over the five-year period, enjoyed a performance advantage averaging 10% per year.

4 Page 4 In the four years when the S&P 500 was in negative territory, hedge managers outperformed passive managers each time, and always by a substantial margin. The average performance edge for hedge fund managers during down market years was 24% Hedged Debt Styles: Historical Returns in Stable to Rising Interest Rate Cycles Conclusions for equity investors The historical data for equity investors indicates that active management may be an effective strategy in all markets, but may be particularly so when expectations are for an unpredictable and volatile market that seem to have no discernible trend or a significant risk of negative returns. This is the type of market environment that has been common in recent years. Our research backs up the idea that having the ability to use a selective approach to portfolio management may work to the benefit of the investor at times when markets are flat or moving lower. Since not all stocks perform in line with the market as a whole, the odds of choosing securities that can enjoy a performance edge in flat or down periods is greater than would be the case if markets were moving higher Cumulative Return % Hedged Debt Yields RISING (Falling Market) (110 Months) U.S. Corp. Inv. Grade U.S. Gov t Bonds Yields FALLING (Rising Market) (126 Months) Source: U.S. Bank Asset Management. Additional details provided on page 6. The research indicated that when bonds have lost value (during periods of rising interest rates), actively managed hedged debt styles have provided a return advantage compared to passive styles. This is true whether the indices used for comparison are for U.S. investment-grade corporate bonds or U.S. government bonds. A hedged approach, in particular one that can combine both long and short investment strategies, may provide qualified investors with greater opportunity during periods of market uncertainty. Passive versus active fixed income investing A primary driver of performance in the broad fixed income market is the direction of interest rates. This is due to the inverse relationship between interest rates and bond prices. In an environment where interest rates are declining, bond values tend to rise. If interest rates are on the rise, bond prices tend to drop. In periods when interest rates are declining and bond prices are on the rise, passive investments have provided a return advantage, just as was the case with passive equity managers during a period of rising stock markets. In the case of fixed income markets, U.S. government bond indices tended to perform slightly better than U.S. investment-grade corporate bonds. Both passive approaches enjoyed only a modest edge over active hedged debt management. Using interest rate trends as the defining factor, it is possible to compare performance of passive and active styles in different types of fixed income markets. For purposes of this presentation, since active fixed income managers have the ability to incorporate hedging strategies into their standard process, our research compared passive styles to hedged styles.

5 Page 5 Conclusions for fixed income investors It should be noted that based on the research provided, hedged management styles showed an advantage over passive management in periods of rising interest rates. Yet the performance difference between passive and active styles has been marginal during periods of declining interest rates, when bonds were performing their best. In 1980, interest rates on government bonds were at double-digit levels, while recently the dominant trend for interest rates has been to move lower. In 2011, yields on the benchmark ten-year Treasury note dropped below 2% (interest rates on ten-year Treasury notes peaked at 15.8% in 1981). Generally, the environment for bond investors has been favorable for more than a three-decade span. With yields reaching historic lows, there may be very little opportunity for bonds to improve on that performance in the next few years to come. Given the current environment, it seems more likely that we could move into a period of stable-to-rising interest rates. Based on historical research results, if this trend persists, the results may favor an active management approach to fixed income investing, based on historical results. Key Definitions Active Management The practice of money managers making selective decisions about which securities to include in portfolios or funds. Active management normally involves regular trading of securities in an attempt to maximize returns by buying or selling securities on a regular basis. Active management is predicated on the belief that it is possible to beat the market average on a consistent basis by trading securities to take advantage of market opportunities. Passive Management A method of managing a portfolio that seeks to select a well-diversified set of securities that will remain relatively unchanged over long periods of time. It involves minimal trading, based on the belief that it is difficult to consistently beat market averages on a risk-adjusted basis. Index funds are a typical example of a passive investment. Hedge Funds A managed portfolio of investments that uses advanced investment strategies with the goal of generating high returns. Investment dollars are pooled and professionally managed and have the ability to use shorting strategies that seek to profit from price declines. Hedge funds are only available to sophisticated, qualified investors.

6 Page 6 Disclosures This information was prepared on December 9, 2011 and represents the opinion of U.S. Bank. It does not constitute investment advice and is issued without regard to specific investment objectives or the financial situation of any particular individual. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts will come to pass. The information presented is for discussion purposes only and is not intended to serve as a recommendation or solicitation for the purchase or sale of any type of security. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not responsible for and does guarantee the products, services or performance of its affiliates or third-party providers. Managers mentioned are not affiliated with U.S. Bank in any way. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Hedged equity and hedged fixed income investment strategies are typically available via hedge funds which may not be appropriate for all clients due to the speculative nature and high degree of risk involved in these investments. Past performance is not a guarantee of future results. Indexes mentioned are unmanaged and are not available for investment. The S&P 500 Index is a capitalization weighted index of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The HFRI Index of Hedge Funds is composed of hedge funds which maintain both long and short in primarily equity and equity derivative strategies. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Investment in fixed income debt securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer term debt securities. Alternative investments very often use speculative investment and trading strategies. There is no guarantee the investment program will be successful. Alternative investments may not be suitable for every investor, even if the investor does meet the financial requirements. It is important for investors to consult with their investment professional prior to investment in these investments. Hedge funds are speculative and involve a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem units in a hedge fund. Exchange-traded funds (ETFs) are baskets of securities that are traded on an exchange like individual stocks at negotiated prices and are not individually redeemable. Shares of ETFs may trade at a premium or a discount to the net asset value of the underlying securities. CHART DETAILS: Traditional Equity Styles Morningstar is an independent research firm which provides a wide range of services and data, including stock market analysis, equity and mutual fund research, ratings, and portfolio tools. The hypothetical portfolio includes model portfolios managed by the following third-party Separately Managed Account (SMA) large cap core managers available for use in U.S. Bank client portfolios. The managers were selected due to their similar investment approaches. Argent Capital Large Cap Growth BRC Investment Management Large Cap Concentrated Equity/Value Cornerstone Investment Partners Large Cap Core Equity Dana Investment Advisors Large Cap Equity Golden Capital Large Cap Core Performance calculations for the hypothetical portfolio are comprised of equally weighted performance returns, gross of fees, for each manager listed above. Individual year calculations included the following managers, based on dates model return information became available: : BRC Investment, Golden Capital 1999: Argent Capital, BRC Investment, Golden Capital : Argent Capital, BRC Investment, Dana Investment, Golden Capital : Argent Capital, BRC Investment, Cornerstone Investment, Dana Investment, Golden Capital Hypothetical portfolio is not available for investment Hedged Equity Managers The Hedge Fund Research Index (HFRI) includes hedge funds which maintain both long and short positions in primarily equity and equity derivative strategies. The hypothetical portfolio includes the following third-party funds of long/short equity hedge fund managers available for use in U.S. Bank client portfolios. ABS Investment Management Offshore Global Portfolio Ascendant Capital Partners Strategic Opportunities Fund Cadogan Management Opportunistic Alternatives Fund Common Sense Investment Management Long-Biased Limited Partner Fund Pointer Management Offshore Fund (QP) Performance calculations for the hypothetical portfolio are comprised of equally weighted performance returns, net of fees, for each manager listed above. Individual year calculations included the following funds, based on date fund return information became available: July : Pointer Management : Common Sense, Pointer Management 2003-August 2007: ABS Investment, Ascendant Capital, Common Sense, Pointer Management August : ABS Investment, Ascendant Capital, Cadogan Management, Common Sense, Pointer Management Hypothetical portfolio is not available for investment. Hedged Debt Hedged Debt data is represented by the Hedge Fund Research Relative Value Fixed Income Index (HFRI) which is comprised of investment managers who employ strategies designed to isolate attractive opportunities between a variety of fixed income instruments, typically attempting to realize an attractive spread between multiple corporate bonds or between a corporate and risk-free government bond. U.S. Corporate Investment-Grade Bonds data is represented by the Barclays Capital Corporate Bond Index which includes all publicly issued, fixed-rate, nonconvertible, dollardenominated, SEC registered investment-grade corporate debt. U.S. Government Bond data is represented by the Barclays Capital Government Index which is comprised of Treasuries (public obligations of the U.S. Treasury that have maturities of more than one year) and U.S. agency debentures (publicly issued debt of U.S. government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. government). privateclientreserve.usbank.com 2011 U.S. Bancorp PCR-IP11