Bonds Are Different: Resolving the Active vs. Passive Debate

Transcription

1 s Are Different: Resolving the Active vs. Passive Debate

2 Disclosures A word about risk: All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. s and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. 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. 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3 Overview Why active for bonds? Why does active work in fixed income? (Or, how are bonds different?) Why go active now? Key takeaways 2

4 Why active for bonds? Passive may make sense for equities but bonds are different Investors often have to weigh the pros and cons of allocating to an active or passive strategy. There are, of course, many differences between active and passive but both approaches offer potential benefits, costs and risks. We at PIMCO want to highlight why we believe bonds are different. Unlike the median active equity manager, which has underperformed its passive counterpart, the median active bond manager has outperformed the median passive manager by about 50 basis points over the last 10 years. While these gains may not seem substantial, they compound over time and, if sustained, represent meaningful total return potential. Another key thing to note here is that passive managers typically underperform the index, due to fees. Nevertheless, passive funds typically have lower fees and expenses compared with actively managed funds, which affects performance. 10-YEAR MEDIAN RETURNS OF U.S. ACTIVE AND PASSIVE MANAGERS Returns (after fees) 6.0% 5.0% 4.0% 3.0% 2.0% 4.70% 4.19% Active managers Passive managers Benchmark 1 8.0% 7.0% 4.34% 6.0% Returns (after fees) 5.0% 4.0% 3.0% 6.30% 6.85% 6.95% 2.0% 1.0% 1.0% 0.0% Fixed Income 0.0% Equity Past performance is not a guarantee or a reliable indicator of future results. As of 31 December 2016; Source: Morningstar Based on Morningstar U.S. Intermediate-Term Category for fixed income and Morningstar U.S. Large Cap Blend Category for equities. Institutional share class. 1 Core Fixed Income: Bloomberg Barclays U.S. Aggregate Index; Core Equity: S&P 500 Index Refer to Appendix for additional investment strategy and risk information. 3

5 Why active for bonds? Active bond management works well across a range of categories About 65% of active bond managers outperformed their benchmarks across a range of popular Morningstar categories. In contrast, only about 37% of active managers in popular equity categories have outperformed. It is important to note that for active management, the potential for higher return comes with the potential for greater risk and volatility. PERCENTAGE OF ACTIVE FUNDS WITHIN EACH CATEGORY THAT OUTPERFORM THEIR PRIMARY PROSPECTUS BENCHMARK (5-YEAR RETURN) 100% 95% Morningstar Fixed Income categories Morningstar Equity categories 90% 80% 86% 81% 78% 86% 70% Average across bond categories 70% 60% 56% 50% 40% 30% 20% 27% 25% 38% Average across equity categories 23% 20% 17% 40% 23% 43% 10% 0% Intermediate- Term ST High Yield World Multisector Corporate Inflation- Protected s Bank Loan Large Blend Large Growth Large Value Foreign Large Blend Past performance is not a guarantee nor a reliable indicator of future performance. As of 31 December 2016; Source: Morningstar Direct. Chart shows largest eight Morningstar fixed income and equity categories, arranged by AUM, in descending order. Based on Morningstar U.S. ETF and U.S. Open-End Fund categories (Institutional shares only). Refer to Appendix for additional index and risk information. World Stock Mid-Cap Blend Diversified Emerging Markets Small Blend 4

6 Why active for bonds? Active bond managers have a solid track record vs. their passive peers Notably, 78% of active high yield funds outperformed their median passive peer. As is often true with bonds, liquidity, or the ease with which something can be bought and sold, is a central consideration, and that s especially true in the less liquid high yield market. Active management may be compelling in diversifying categories such as multisector, which doesn t have a passive fund. PERCENTAGE OF ACTIVE FUNDS WITHIN EACH CATEGORY THAT OUTPERFORM THE PASSIVE MEDIAN FUND (5-YEAR RETURN) 100% 90% 80% 70% 60% 50% 40% 30% 20% 87% 63% 78% 80%? 70% 39% 88% 26% Morningstar Fixed Income categories 54% 51% 28% 22% Morningstar Equity categories 74% 38% 31% 10% 0% Intermediate- Term ST High Yield World Multisector Corporate Inflation- Protected s Bank Loan As of 31 December 2016; Source: Morningstar Direct. Past performance is not a guarantee nor a reliable indicator of future performance. Note that in the case of the Short-Term and Corporate categories, the percentage of active funds that outperform the median passive fund is lower than the percentage of active funds that outperform their primary prospective benchmarks. The explanation for this is the range of benchmarks included in Morningstar categories. Some categories (such as Intermediate-Term ) contain funds with largely the same prospectus benchmark; others, such as Short-Term, contain funds with a range of benchmarks. As of 31 December 2016, the Short-Term category contained 11 passive funds, each with differing benchmarks. Some had credit index benchmarks, while other benchmarks had a mix of credit and government debt; some included maturities of up to three years, while others included maturities of up to five years. Of the 11 passive funds in the category, four had a track record of five years or longer, and one had a track record of longer than 10 years. The relative scarcity of passive funds across categories with a 10-year track record contributed to the decision to show 5-year performance data, rather than 10-year performance data. Based on Morningstar U.S. ETF and U.S. Open-End Fund categories (Institutional shares only). Refer to Appendix for additional index and risk information. Large Blend Large Growth Large Value Foreign Large Blend World Stock Mid-Cap Blend Diversified Emerging Markets Small Blend 5

7 How are bonds different? Structural elements create opportunities for active managers GENERAL TAILWINDS FOR ACTIVE HEADWINDS FOR PASSIVE Stocks: Partial ownership of a company, perpetual, adjustable dividend s: Debt security, finite life, fixed coupon Investors know what they are going to get because yields are known at the time of purchase Yield accounts for majority of realized returns in fixed income; this is not true in equities market is large and complex Finite life of bonds means indexes are reconstituted more often Sampling is often required Full replication usually not practical or cost-effective 6

8 How are bonds different? Structural elements create opportunities for active managers Description Stocks Partial ownership of company s Debt, fixed payouts known in advance Global market size* $69 trillion $102 trillion Number of issues** >14,400 >344,000 Life Perpetual security; no maturity date Finite; maturity date is known in advance New issuance Standardization Trading Infrequent High On exchanges (i.e., buyers and sellers interact indirectly); low trade size, high frequency Frequent, due to maturing bonds; index constituents also change frequently s vary according to covenants, maturity, coupon size and embedded options Over the counter (i.e., negotiated directly); large trade size, low frequency Liquidity Generally good Mixed Risk*** Upside is unknown, downside is known Upside is known, downside is unknown Index construction Issuer weight determined by market prices Issuer weight determined by amount of debt the issuer has issued Market participants Generally profit-maximizing Frequently have non-profit-related goals (e.g., central banks stimulating an economy) or are heavily regulated (e.g., life insurance companies subject to changing risk-based capital charges) As of 31 December 2016; Source: MSCI, Bank of International Settlements, World Bank, IMF, PIMCO estimates * Equity market size is the market capitalization of listed domestic companies, in current US$. It is a World Bank estimate, as of 2015, which is based in turn on a World Federation of Exchanges database. Separately, the IMF estimated the size of the global equity market to be $62.5 trillion in The global bond market size is a PIMCO estimate, based on the Bank of International Settlements (BIS) quarterly review of global debt securities. It is the sum of all domestic (i.e., local currency) and international (i.e., non-local currency) debt securities for all issuers that BIS tabulates in each country. Estimate is as of the second quarter, Separately, the IMF estimated the size of the global bond market to be $99 trillion in ** For reference, the MSCI All-Countries World Index (ACWI) had 14,447 constituents, covering approximately 99% of the global equity opportunity set, as of December 30, The 344,000 figure in the Number of issues row refers to the number of fixed income securities currently tracked in PIMCO s databases. *** The maximum downside for a bond in default is the value of the bond at issuance; however, defaulted bonds often have some recovery value. The recovery value, commonly expressed as a percentage of the face value of the bond, is not known in advance. Refer to Appendix for additional investment strategy and risk information. 7

9 How are bonds different? Index replication usually requires sampling Due to the bond market s size and complexity, index replication usually requires sampling. For example, the Bloomberg Barclays U.S. Aggregate Index includes more than 10,054 securities, while the leading ETFs that track the index include only 29% 73% of those securities. Passive managers must take a form of active decision when choosing which securities to include and often without the resources to do it well. indexes also rebalance more often than their equity cousins, which increases transaction costs. Index Index type Number of securities in the index % of index securities in ETFs of leading providers Annualized tracking error of ETFs of leading providers Annualized volatility of the index Tracking error as a % of volatility Bloomberg Barclays US Aggregate Index Broad bond 10,054 29% 73% 3 31 bps 3.0% 1.2% 10.6% S&P 500 Index Broad equity % 3 4 bps 10.6% 0.2% 0.3% Dow Jones US Index Broad equity 1, % 4 bps 10.8% 0.4% Russell 3000 Index Broad equity 2,977 78% 100% 3 10 bps 10.9% 0.3% 0.9% As of 31 December 2016; Source: Bloomberg, provider websites The methodology for compiling the data shown in the chart was to record the actual issues held by four leading index benchmarks, both bond and equity, and compare these to the leading ETF (by overall ETF assets under management), utilizing each index as its benchmark. The range of the percentage of index securities held and tracking error by these ETFs as of the date provided is presented. All information for calculating the figures shown were obtained from publicly available information found on the ETF providers websites. Refer to Appendix for additional index and risk information. 8

10 How are bonds different? Fee dispersion between active and passive is lower for fixed income While active bond managers charge a higher fee than their passive counterparts, the difference between fees is lower for bonds than for equities. And, for active bond managers, that fee, which is typically used to employ credit research teams and risk analytics professionals, has the potential to pay for itself via higher returns over time. COMPARISON OF MEDIAN EXPENSE RATIOS (INSTITUTIONAL SHARES ONLY) Prospectus Net Expenses Ratio Intermediate-Term Medin Median Active Fee Median Passive Fee Short-Term High Yield World Large Blend Mid-Cap Blend Small Blend Foreign Large Blend Morningstar Taxable Categories Morningstar Equity Categories As of 31 December 2016; Source: Morningstar Direct The four categories in the equity asset class were selected in order to represent the largest AUM categories in each market cap group, as well as the largest non-u.s. category by AUM. Selecting only the categories with the largest AUM would have led to showing only Large Value, Large Blend and Large Growth for the U.S. categories. The difference in fees among large-cap categories is modest. In the fixed income asset class, we show the largest three domestic AUM categories, and the largest non-u.s. category. Refer to Appendix for additional index and risk information. 9

11 How are bonds different? Active management fees in action: Credit research can help capture opportunity Credit selection is a critical component of alpha potential, helping active managers identify rising stars industries and companies with attractive valuations and healthy growth prospects before the market and credit rating agencies. Importantly, because rising stars are rated below investment grade, they re not immediately available to non-economic players, giving active managers an opportunity edge. Forward-looking credit analysis can also help mitigate risk, by facilitating the selling or replacing of a bond if the underlying issuer s credit profile is no longer favorable. RISING STARS OUTPERFORM BB- AND BBB-RATED CREDITS UPON UPGRADE 1 8 Rising Star vs. BB Rising Star vs. BBB 7 6 Cumulative excess returns (%) Days before/after IG upgrade Source: Barclays Capital. Past performance is not a guarantee nor a reliable indicator of future performance. 1 Originally published in Barclays Capital, Credit Strategy Focus, When Stars Align, 19 November 2010, p. 6. Rising star is the term given to a bond that shifts from being rated BB to BBB; or, in other words, one that shifts from being high yield to investment grade. As the Barclays research paper notes: The market generally foresees which credits will rise from high yield to investment grade. As a result, rising stars tend to outperform the BB index during the three-month period prior to the ratings change. However, the demand technical from crossing the investment grade threshold still usually results in strong outperformance in the week immediately following the upgrade. Thereafter, rising stars trade like strong BBB credits. Refer to Appendix for additional credit quality and risk information. 10

12 Why go active now? Lower expected returns make alpha more important than ever Forward-looking returns are closely correlated with today s yields, which are near all-time lows. By going passive today, your bond portfolio will return approximately today s yield (less than 3%) on the index, minus fees, annually. By contrast, an active manager may be able to outperform over time, after fees. It s important to keep in mind that in a low-returning environment, even modest outperformance, which compounds annually, can have a substantial impact on long-term returns. 25% Bloomberg Barclays U.S. Aggregate yield USD (% yield) Bloomberg Barclays U.S. Aggregate total return USD forward 5 yr return 20% 15% 10% 5% 0% Past performance is not a guarantee nor a reliable indicator of future performance. As of 31 December 2016; Source: Bloomberg, Barclays. Yield and return are for the Bloomberg Barclays U.S. Aggregate Index. It is not possible to invest directly in an unmanaged index. Refer to Appendix for additional outlook and risk information. 11

13 Why go active now? The compounding value of active bond management With lower expected returns, alpha will account for a larger portion of total return going forward. As the hypothetical chart below shows, an excess return of 50 basis points annually (the amount that the median active bond manager has outperformed the median passive manager over the last 10 years) will deliver $7,544 in total return, after fees, over a 10-year period. This shows that even a small gain over the benchmark can dramatically improve investment returns over the long term. CUMULATIVE 10-YEAR RETURNS OF MEDIAN ACTIVE AND PASSIVE FIXED INCOME MANAGERS, BASED ON $100,000 STARTING INVESTMENT $170,000 Median Active Manager Median Passive Manager Bloomberg Barclays US Aggregate Index $160,000 $150,000 $158,295 $152,936 $150,751 $140,000 $130,000 $120,000 A hypothetical investment of $100,000 in 2006 would have grown to $158,295 in an active bond strategy and $150,751 in a passive strategy a gain of $7,544 $110,000 $100, As of 31 December 2016; Source: PIMCO Hypothetical example for illustrative purposes only. Not recommended as a recommendation, nor does it represent any specific PIMCO products or strategies. Based on Morningstar U.S. Intermediate-Term Category for fixed income. Institutional share class. It is not possible to invest directly in an unmanaged index. Refer to Appendix for additional investment strategy and risk information. 12

14 Why go active now? Risk/return profile of fixed income benchmarks has become less attractive When yields are low, passive benchmarks can end up taking on more risk (e.g., by increasing duration) without compensating investors. And, in the current interest rate environment, investors are actually taking on more interest rate risk than they have historically taken while earning a lower yield. An active manager can take limited and uncorrelated exposures outside the benchmark to defend against this dynamic and, if the manager believes rates are going to rise, she can choose simply to hold less duration in her portfolio. PASSIVE INVESTORS ARE TAKING ON MORE RISK FOR LESS RETURN POTENTIAL 6.5 Duration Yield 5% Duration has increased by 2.1 years, or about 20%, since % 3% Years 5.0 Yield Yield has decreased by 1.7%, or about 20%, since % 1% % As of 31 December 2016; Source: Barclays, duration and yield statistics represented by Bloomberg Barclays U.S. Aggregate Index Textbook bond math holds that lower market-wide yields increase the duration of bonds. Some readers will wonder why at certain points such as the most recent few months yields and duration have risen together. The explanation is that the average maturity of the index has not remained constant; in fact, it has generally increased over time. On 31 December 2009, average maturity was 6.83 years, on 29 September 2016, it was 7.75 years, and on 30 December 2016, it was 8.19 years. Refer to Appendix for additional investment strategy and risk information. 13

15 Why go active now? Passive indexes often exclude attractively valued sectors of the bond market With lower expected returns going forward, access to the broadest possible opportunity set, combined with individual security selection, are key to finding attractively priced securities. Tapping into this broader opportunity set can increase tracking error, so active managers will generally add off-benchmark positions that are modest in size. SECTOR DECOMPOSITION BLOOMBERG BARCLAYS U.S. AGGREGATE BOND INDEX GLOBAL FIXED INCOME MARKET US Gov't 47% US IG Credit 21% US Securitized 32% Canada: 1% France: 2% Germany: 2% Italy: 2% Japan: 1% UK: 2% Australia: 0% Other/eurozone/Dev. Europe: 6% Other Treasuries: 6% Global other gov't related: 7% Global IG corporate: 5% Global securitized: 3% Global inflation-linked non USD: 2% Global HY Corporate: 1% EM local sovereign: 11% EM local corporates: 8% U.S. TIPS: 2% ABS floating rate: 0% High yield: 3% EM external sovereign: 1% EM external corporate: 2% U.S. gov't: 15% U.S. IG credit: 7% U.S. securitized: 10% As of 31 December 2016; Source: SIFMA Refer to Appendix for additional index and risk information. 14

16 Why go active now? Access to a variety of sectors is key in rising rate environments With the Federal Reserve poised to continue its hiking cycle in 2017, it s important to note that past fed funds rate increases have had varied effects on different sectors of the bond markets. While rate hikes can challenge some areas of the bond market, active managers with the ability to access different parts of the global bond market can take advantage of bonds that are not affected (or indeed may be rising in price). PERFORMANCE DURING PAST PERIODS OF FED TIGHTENING Rate Hike (Basis Points) U.S. Treasuries MBS Credit Munis High Yield Emerging Markets Senior Floating Rate 29 March 1988 to 24 February % 5.27% 5.21% 7.44% n/a n/a n/a 4 February 1994 to 1 February % -0.49% -3.93% -3.56% -1.74% % n/a 30 June 1999 to 16-May % 2.27% 0.10% -0.16% -2.27% 14.92% n/a 30 June 2004 to 29 Jun % 6.80% 5.85% 9.30% 14.88% 25.44% 12.38% Past performance is not a guarantee or a reliable indicator of future results. As of 31 December 2016; Source: BofA Merrill Lynch U.S. Treasury Master Index; Bloomberg Barclays U.S. Agency Fixed Rate MBS Index; Bloomberg Barclays U.S. Credit Index; Bloomberg Barclays Municipal Index; Barclays U.S. High Yield 1% Issuer Cap Index; JP Morgan EMBI Global Index (measures external debt); Credit Suisse Institutional Leveraged Loan Index; JP Morgan GBI Global Ex-U.S. USD Hedged Index. The high yield, EM and senior floating rate indexes did not exist during periods marked n/a. Non-U.S. developed data is through the nearest month end. It is not possible to invest directly in an unmanaged index. Refer to Appendix for additional index and risk information. 15

17 Key takeaways Why active for bonds? The median active bond manager has outperformed passive alternatives over time and in various Morningstar categories Why does active work in fixed income? (Or, how are bonds different?) The bond market is larger and more complex than the equity market Active tailwinds: Yield helps active bond managers estimate return potential Passive headwinds: Non-economic actors, and replication is generally achieved by sampling Why go active now? Low starting yields; historical levels of outperformance, if repeated, would amount to a larger fraction of total returns Fed hiking cycle 16

18 Appendix More and more investors are turning to passive equity strategies, prompted by evidence that suggests that most active managers have failed to beat their benchmarks. They charge steeper fees too, which sets the bar higher for actively managed funds to outperform. The trend into passive fixed income has also accelerated recently, but while research indicates passive may make sense for stocks, it tells a wholly different story for bonds QUARTERLY FLOWS IN TAXABLE BOND FUNDS $120 $100 $80 $60 Passive Flows Active Flows Passive Percentage of total assets 30% 25% 20% Billions ($) $40 $20 $0 -$20 -$40 15% 10% 5% -$60 0% As of 31 December 2016; Source: Morningstar Direct Refer to Appendix for additional outlook and risk information. 17

19 Appendix Past performance is not a guarantee or a reliable indicator of future results. CHART Performance results for certain charts and graphs may be limited by date ranges specified on those charts and graphs; different time periods may produce different results. CREDIT QUALITY The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody s, and Fitch, respectively. HYPOTHETICAL EXAMPLE No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks, such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. INVESTMENT STRATEGY Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors, and each investor should evaluate their ability to invest long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. ISSUER References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included. RISK All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. s and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. 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. Management risk is the risk that the investment techniques and risk analyses applied by the investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. OUTLOOK Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. 2017, PIMCO 18

20 Appendix INDEX DESCRIPTION Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indexes that are calculated and reported on a regular basis. MSCI All-Countries World Index (ACWI) is a market capitalization weighted index that is designed to provide a broad measure of equity-market performance throughout the world. The index contains stocks from 46 different countries; 23 countries are classified as developed markets and 23 countries are classified as emerging markets. Dow Jones U.S. Market Index is a market-capitalization-weighted index maintained by Dow Jones Indexes providing broad-based coverage of the U.S. stock market. The Russell 3000 Index is an unmanaged index generally representative of the U.S. market for large domestic stocks as determined by total market capitalization, which represents approximately 98% of the investable U.S. equity market. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. CORPORATE BOND Corporate portfolios concentrate on bonds issued by corporations. These tend to have more credit risk than government or agency-backed bonds. These portfolios hold more than 65% of their assets in corporate bonds, less than 40% of their assets in foreign bonds, less than 35% in high yield bonds, and have an effective duration of more than 75% of the Morningstar Core Index. FOREIGN LARGE-VALUE Foreign large-value portfolios invest mainly in big international stocks that are less expensive or growing more slowly than other large-cap stocks. Most of these portfolios divide their assets among a dozen or more developed markets, including Japan, Britain, France, and Germany. These portfolios primarily invest in stocks that have market caps in the top 70% of each economically integrated market (such as Europe or Asia ex-japan). Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow). These portfolios typically will have less than 20% of assets invested in U.S. stocks. HIGH-YIELD BOND High-yield bond portfolios concentrate on lower-quality bonds, which are riskier than those of higher-quality companies. These portfolios generally offer higher yields than other types of portfolios, but they are also more vulnerable to economic and credit risk. These portfolios primarily invest in U.S. high-income debt securities where at least 65% or more of bond assets are not rated or are rated by a major agency such as Standard & Poor s or Moody s at the level of BB (considered speculative for taxable bonds) and below. INTERMEDIATE-TERM BOND Intermediate-term bond portfolios invest primarily in corporate and other investment-grade U.S. fixed-income issues and typically have durations of 3.5 to 6.0 years. These portfolios are less sensitive to interest rates, and therefore less volatile, than portfolios that have longer durations. Morningstar calculates monthly breakpoints using the effective duration of the Morningstar Core Index in determining duration assignment. Intermediate-term is defined as 75% to 125% of the three-year average effective duration of the MCBI. LARGE BLEND Large-blend portfolios are fairly representative of the overall U.S. stock market in size, growth rates and price. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate. These portfolios tend to invest across the spectrum of U.S. industries, and owing to their broad exposure, the portfolios returns are often similar to those of the S&P 500 Index 19

21 Appendix LARGE VALUE Large-value portfolios invest primarily in big U.S. companies that are less expensive or growing more slowly than other large-cap stocks. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow). MULTISECTOR BOND Multisector-bond portfolios seek income by diversifying their assets among several fixed-income sectors, usually U.S. government obligations, U.S. corporate bonds, foreign bonds, and high-yield U.S. debt securities. These portfolios typically hold 35% to 65% of bond assets in securities that are not rated or are rated by a major agency such as Standard & Poor s or Moody s at the level of BB (considered speculative for taxable bonds) and below. SMALL BLEND Small-blend portfolios favor U.S. firms at the smaller end of the market-capitalization range. Some aim to own an array of value and growth stocks while others employ a discipline that leads to holdings with valuations and growth rates close to the small-cap averages. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate. SMALL GROWTH Small-growth portfolios focus on faster-growing companies whose shares are at the lower end of the market-capitalization range. These portfolios tend to favor companies in up-and-coming industries or young firms in their early growth stages. Because these businesses are fast-growing and often richly valued, their stocks tend to be volatile. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields). SMALL VALUE Small-value portfolios invest in small U.S. companies with valuations and growth rates below other small-cap peers. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow). WORLD BOND World-bond portfolios invest 40% or more of their assets in foreign bonds. Some world-bond portfolios follow a conservative approach, favoring high-quality bonds from developed markets. Others are more adventurous and own some lower-quality bonds from developed or emerging markets. Some portfolios invest exclusively outside the U.S., while others regularly invest in both U.S. and non- U.S. bonds. It is not possible to directly invest in an unmanaged index. PBDD_49869 CMR