Celebrating Eight Years of Absolute Return How our Absolute Return portfolio has fared

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1 For Financial Advisor Use Only Celebrating Eight Years of Absolute Return How our Absolute Return portfolio has fared Venus Phillips Investment Manager Morningstar Investment Services Morningstar Investment Services Commentary Our Absolute Return strategy celebrated its eight-year anniversary on March 31, We think it s a good time to take a look back at the portfolio s original premise, review how it has fared, and take a closer look at some of the funds we use within the portfolio. Ahead of the Curve Absolute return strategies continue to receive a fair share of media attention and attract considerable investor assets. But that wasn t the case eight years ago when we launched our Absolute Return strategy. At that time, the stock market was coming off of solid backto-back years, volatility was subdued, and investors were very willing to take on risk in their portfolios. Consequently, a more conservatively-oriented, downside-protectionoriented strategy wasn t top-of-mind for many investors at the time. When we developed the Absolute Return portfolio, we saw the need for a non-traditional strategy that could help take the edge off. Specifically, we envisioned a solution that aimed to deliver some of the stock market s upside, but without the associated downside and volatility. Little did we know that this risk profile would become especially prized in the subsequent years, when the subprime and real estate bubbles had popped and downside protection became a much greater focus. The Stress Test The financial crisis put the Absolute Return portfolio through a significant stress test. While the portfolio was not immune to losses, it limited the downside more tenaciously than the broad market it suffered a 21% peak-to-trough loss from November 2007 through March 2009, while the S&P 500 Index fell more than 50%.

2 Another stress test came in the spring and summer of 2011 when the S&P 500 tumbled 16.3%, amid Congressional wrangling over the debt ceiling and mounting concerns over the European sovereign debt crisis. Nevertheless, the Absolute Return portfolio held its ground, declining less than 6% over the same time period. Source: Morningstar Direct The chart below shows how the Absolute Return portfolio s risk-adjusted returns stacked up versus the S&P 500. Source: Morningstar Direct The ability to capture some of the upside while helping to protect capital on the downside has led to favorable risk-adjusted results. Since its inception April 1, 2005 through March 31, 2013, the Absolute Return portfolio earned an annualized rate of return of 4.4% (gross of program fees), compared with 5.8% for the S&P 500 Index. While the Absolute Return

3 portfolio has slightly underperformed equities, historically it s been only about one-third as volatile as the broad equity market, suggesting that the portfolio has not been very dependent on the movements of the domestic equity market. The portfolio has also offered considerable diversification benefits since its inception. To illustrate, we assumed an investor allocated 80% of their nest-egg to an equity-sensitive asset allocation strategy like Moderate Growth Tax Deferred and the remaining 20% to Absolute Return. We then compared the risk-adjusted returns to those of an investor who has invested 100% in Moderate Growth. For Illustrative purposes only. The hypothetical 80/20 portfolio s risk-adjusted trailing 36-month returns surpassed the 100% Moderate Growth portfolio s returns in 54 of the 61 periods observed. Portfolio Construction The alternative mutual fund space has expanded significantly since this portfolio s inception. And with all of the new product some of it quite exotic and complicated discernment and rigorous due diligence have become all the more important. In an area with a lot of newcomers, we think it s important to be able to separate the wheat from the chaff. As the alternative mutual fund universe has grown, our Absolute Return portfolio has evolved to incorporate new managers and investment strategies. Our screening process is no different than for traditional managers we meet with the investment team, read the filings, assess the prudence and repeatability of the strategy, evaluate the competitiveness of expenses, and so forth. In constructing our Absolute Return strategy, we have always pursued a risk-managed

4 approach that brings not only alternative-oriented funds together, but also combines traditional managers with unique strategies or an absolute-return orientation. We think that combination of strategies affords the portfolio the opportunity to participate in some of the stock market s upside, but without the associated volatility and drawdowns. One tool (though hardly the only) we use to guide our allocations is a fund s beta. The beta of a fund is the volatility of that fund relative to a benchmark, often the S&P 500. A positive beta would indicate that the fund tends to follow the index, while a negative value would indicate the fund moves opposite the index s returns. A fund with a beta of zero would see its returns move independently of the benchmark. We look at betas over various time periods to assess how particular funds are moving in relation to the S&P 500 and this assessment has served as an organizing principle, of sorts, when we construct the portfolio as a whole. Our funds generally fall into one of three beta categories. The first group, which might include long-only equity managers or other volatile asset classes, are high-beta funds. The next group, medium-beta funds, are those with slightly- to moderately-positive betas in the 0.2 to 0.5 range. The last group, low-beta funds, consists of funds with betas below 0.2. High-Beta Funds The high-beta category is opportunistic in nature, seeking to maximize returns. Here we find our absolute return minded long-only funds, net-long long-short funds and alternative asset classes (commodities, convertibles, real estate, etc.) Looking at the trailing 3-year betas for these funds, we find a range from 0.66 to 1.07, with a group average of This indicates that this group would move directionally with equity markets, but with an average beta of less than 1.0 are less sensitive to market movements. Two core holdings within this bucket are T. Rowe Price Capital Appreciation and IVA Worldwide. T. Rowe Price Capital Appreciation is a moderate allocation fund in which portfolio manager David Giroux has the flexibility to alter the funds exposure to various asset classes, including stocks, bonds, bank loans, convertibles, and cash. The team at IVA Worldwide invests in stocks and bonds around the globe, and also keeps money stashed in cash and gold bullion as a hedge. Aston/River Road Independent Value, a small cap value manager, also falls into this camp. Diamond Hill Long-Short and Wasatch Long/Short each employ a long-short investment strategy in which they buy securities they think will increase in value and short those they believe will decline in value. The Diamond Hill and Wasatch funds have a long bias in their portfolios as their net-long exposure (value of longs less value of shorts) has tended to be around 50% to 60%, so they will court a bit more sensitivity to equity market movements, but the shorts can potentially act as a hedge and dampen the impact of falling stock prices.

5 PIMCO Commodity Real Return rounds out this group and had been the most volatile of the bunch. While we have maintained a position in PIMCO Commodity Real Return in the portfolio since its inception, we have adjusted the weighting over time based on our outlook for commodity prices. We ve invested in other high-beta parts of the market before as opportunities have presented themselves. Medium-Beta Funds Our medium-beta category seeks to maximize risk-adjusted returns while maintaining a moderate level of volatility and reasonable correlation to traditional stock and bond markets. In this bucket, we start to see some alternative strategies appear. We also find conservative-minded long-only managers here. The three-year betas of this group range from 0.09 to 0.33 and the group average is In all these funds contribute about 13% of the portfolio s beta. Calamos Market Neutral Income combines two investment strategies convertible arbitrage and covered call. Convertible arbitrage entails the manager taking long positions in convertible bonds and shorting the underlying common stock. The fund looks to earn income from the coupon on convertibles, while the hedging equity market risk via the short stock position. Calamos will adjust their allocation between convertible arbitrage and covered call writing based on their outlook for volatility and the various strategies expected return potential. We tend to be more tactical regarding asset class plays, often attempting to take advantage of market opportunities. For example, we added a position in Aquila Three Peaks High Income during the fourth quarter of 2008 as spreads on high-yield bonds relative to Treasuries were trading at unprecedented levels, creating a compelling investment opportunity. Low-Beta Funds Our final group is comprised of low-volatility and diversifying funds, with low correlation to other strategies in the portfolio. The five funds in this set have betas ranging from a low of to a high of 0.53, and average of a low Overall, this group moves independently of equity markets providing a diversified return experience. Low volatility, alternative strategies and bond-oriented approaches dominate this segment. Arbitrage Fund utilizes merger arbitrage, a fairly low volatility approach in which the manager buys shares in the target company of an announced acquisition in an attempt to profit on the spread between the acquired company s stock price and takeover price. The team will hedge the position through the use of options or by shorting the stock of the acquiring company.

6 For Financial Advisor Use Only The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar Investment Services shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar Investment Services and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar Investment Services. The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without notice, do not constitute investment advice and are provided solely for informational purposes. Morningstar Investment Services shall not be responsible for any trading decisions, damages, or other loses resulting from, or related to, the information data, analyses or opinions or their use. The indices noted are unmanaged and cannot be directly invested in. Individual index performance is provided as a reference only. Since indices and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although index performance data is gathered from reliable sources, Morningstar Investment Services cannot guarantee its accuracy, completeness or reliability. Absolute Strategies is a unique multi-strategy offering that provides access to several different alternative strategies, such as convertible arbitrage, market neutral, long-short equity, global macro, and distressed debt, managed by various sub-advisers in a single offering. The team will adjust its allocation to managers and strategies based on their analysis of expected return, risk, correlation, and exposure of the various strategies. Driehaus Active Income is a fixed-income oriented absolute return fund that engages in a variety of alternative or arbitrage trading strategies, such as capital structure arbitrage, event-driven arbitrage, convertible arbitrage, and pairs trading. The fund seeks to maintain a risk profile comparable with the broad U.S. bond market and to exhibit low correlation with the broad equity and fixed income markets. To help mitigate the impact of inflation, it uses derivative securities to keep its duration close to zero. Eaton Vance Global Macro Absolute Return employs a long/short approach to the global fixed income and currency markets in an attempt to deliver consistent returns that are not highly correlated with major risk factors such as global equity, credit, and duration. In addition to these alternative-oriented strategies, we currently use two bond funds. FPA New Income is our conservative option and used as protection against down markets. While having a flexible mandate, the team s philosophy is not to lose money. Our other fixed-income strategies typically focus on credit or sovereign securities; DoubleLine Total Return brings their mortgage expertise to the portfolio, making it a good complement to other funds we use.