ETF Portfolios. Affected Portfolios Aggressive Growth Growth Moderate Growth Income and Growth Conservative

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1 Traded on August 21, 2013 For Financial Advisor and Current Client Use Only Morningstar Investment Services, Inc. ETF Portfolios Affected Portfolios Aggressive Growth Growth Moderate Growth Income and Growth Conservative We ve reallocated our diversified ETF portfolios to further reduce our U.S. stocks weighting, pad our foreign-stocks weighting, and raise our stake in short-term bonds and cash, among other changes. In this memo, we summarize these changes and lay out our rationale for making them. What Changed? We ve made a series of changes to the U.S. stocks, foreign stocks, bonds, and alternative allocations in each ETF portfolio, as summarized below: U.S. Stocks We have further lowered our stake in U.S. stocks by reducing our weightings in a U.S. total stock market ETF as well as a U.S. small-cap stock ETF. In addition, we pared, or eliminated altogether, our position in an ETF that invests in U.S. healthcare stocks, replacing it with a morediversified ETF that owns the stocks of high-quality firms that Morningstar, Inc. analysts believe are undervalued. As a result, we are now significantly underweight U.S. stocks across the board. For instance, our Moderate Growth ETF portfolio s 28.5% domestic-stock allocation is nearly twelve percentage points below its target weighting. Within U.S. equity, we continue to favor large-cap stocks over small- and mid-cap stocks (that is, we re more significantly underweight small- and mid-caps than large-caps). The chart on the next page illustrates each portfolio s over- and under-weights (i.e., portfolio weighting less asset allocation policy target) to the various U.S. sub-asset classes.

2 ( Agg. Gr. = Aggressive Growth portfolio; Gr. = Growth portfolio; Mod. Gr. = Moderate Growth portfolio; Inc. Gr. = Income & Growth portfolio; Cons. = Conservative portfolio.) Foreign Stocks We have further raised our stake in foreign developed by hiking our weightings in a Europe- Pacific stock ETF. We have largely maintained our position in an emerging-markets stock ETF as well as our investments in ETFs that own dividend-paying foreign stocks and Japanese smallcompany stocks. As a result, we are heavily overweight foreign stocks across the board. Our Moderate Growth portfolio s 26.7% foreign-stock allocation, for example, is nearly nine percentage points higher than its target weighting. Within foreign equity, we sport the largest overweightings to foreigndeveloped stocks, Europe and Japan remaining a particular focus. The chart below illustrates each portfolio s over- and under-weightings to foreign developed and foreign emerging stocks.

3 Bonds We raised each portfolio s cash stake and padded our weighting in an ETF that invests in shortterm inflation-protected bonds. We also increased our allocation to non-u.s. bonds by adding to our stake in an emerging-markets bond ETF and initiating a position in an ETF that invests in the short-term bonds of developed foreign sovereign issuers. In addition, we modestly lowered our allocation to a bank-loan ETF and largely maintained our weighting in an actively-managed core bond ETF. Consequently, we are decidedly overweight cash, short-term TIPS, and non-u.s. bonds in each portfolio, and remain significantly underweight U.S. Treasuries and agencies. We have also moved from a more-or-less neutral weighting in high-yield bonds to a modest, across the board underweight. The chart immediately below illustrates our Moderate Growth portfolio s percentage over- and under-weights to cash and various bond sub-asset classes. Alternatives We made no significant changes to our position in an ETF that invests in the stocks of naturalgas production and exploration firms, which we consider our commodities allocation. In addition, we did not add any exposure to global REITs. As such, we remain meaningfully overweight commodities in all but our Conservative portfolio and continue to shy away from REITs, to which we have zero exposure.

4 Overall The portfolios have shifted from a roughly neutral stocks/bonds posture to a slight fixed-income overweight. Specifically, the portfolios are about 5% underweight equity-like asset classes stocks, REITs, and commodities. However, it s worth noting that the resultant bond overweight consists largely of cash and short-term inflation-indexed bonds excluding those asset classes, the portfolios are actually underweight bonds. Why did we make the changes? Before we lay-out the rationale for these changes, it s worth taking a moment to review our investment philosophy. We are long-term investors who believe that markets tend to be efficient (i.e., that is, get it right) over long stretches. This informs our approach we diversify widely, pay close attention to costs, try to avoid over-transacting, and attempt to go our own way (i.e., not closet-index).

5 With that as a backdrop, it s worth clarifying that this reallocation didn t come in response to recent market movements. In fact, we re shifting assets away from areas that have excelled recently (i.e., U.S. stocks) and toward asset classes that have lagged (i.e., foreign stocks, cash and short-term bonds). This is part and parcel with our approach, which strives to be thoughtfully contrarian based on our reading of various fundamental factors. Foremost among those factors is valuation the bang that we feel we re likely to get for our buck when putting capital to work in an asset class or segment. When we view prices as lofty, we re less likely to get much mileage out of our investment. Conversely, if an asset appears cheaper, chances are better that it will deliver above average future returns. In a nutshell, that s why you re likelier to find us backing away from areas that have prospered, and sidling up to those that have languished. That brings us to this reallocation, which finds us continuing the process of rotating away from what we believe to be pricier asset classes and towards those that look more reasonably priced. That process began with our most recent reallocation in November What makes this reallocation a bit different, however, is that, in the absence of plentiful bargains, we re allowing our stake in cash and short-term bonds to build. Does that mean we think markets are on the brink of a steep selloff? No. To be sure, we think markets look pretty fairly valued, if not expensive, though the degree of overvaluation varies widely. But we don t see the sorts of dramatic excesses that marked previous peaks in 2000 and For instance, by most measures valuations are nowhere near the levels they touched in those peak years. We re also not seeing the sort of stark supply/demand imbalances whether it be telecom fiber, real estate inventory, or credit extended that plagued those earlier periods. (We acknowledge, though, that there is quite a bit of liquidity swishing around markets amid coordinated central-bank easing.) But at time when there are fewer fat pitches to swing at we think it can make sense to keep the bat on our shoulder. That s the stance we re more fully adopting with this reallocation, details of which we elaborate on below. U.S. Stocks We ve moved to a heavier U.S. stocks underweight for valuation reasons. We trimmed smalland mid-caps to a greater extent than we did large-caps, reflecting an increasing valuation disparity between the two. (It s worth noting that our sale of a health-care ETF did push down the portfolios large-cap weighting a bit given the prevalence of mega-cap pharma, biotech, and device names in that fund.) We used a portion of the proceeds to take a position in an ETF that we expect will deliver consistent exposure to some of the cheapest, highest-quality stocks that Morningstar, Inc. s

6 analysts cover. In aggregate, that wide moat ETF s holdings are meaningfully less expensive, in Morningstar, Inc. s view, than those of the healthcare ETF, explaining our decision to sell the healthcare ETF and initiate a position in the wide-moat ETF. The U.S. equity valuation picture is mixed, in our opinion. On the plus side, traditional market valuation multiples, such as trailing price/earnings and forward price/earnings, do not look badly out of whack, as they approximate, or at worst slightly exceed, historical norms. What s more, companies remain flush and have used that wherewithal to hike dividends and buyback shares. However, with profit margins still quite wide by historical standards and top-line growth remaining anemic, there are legitimate questions about the sustainability of corporate profit growth, even from its recent less-than-torrid pace. In addition, more-conservative valuation measures, such as the so-called Shiller price/earnings ratio, suggest that stocks are meaningfully overvalued. Taken together, we think that these signs argue for increasing caution, explaining our underweight. Foreign Stocks We ve moved to a larger foreign stocks overweight for valuation reasons. We added to our position in an ETF that invests in a diversified mix of foreign-developed stocks. In addition, we largely maintained our explore positions in several thematic or regionally focused ETFs, including a fund that invests in dividend-paying foreign-developed stocks and another that owns the stocks of Japanese small companies. In general, foreign stocks have been left behind by U.S. stocks in this latest phase of the rally, that divergence accentuated by the brief tapering -induced selloff in May and June of this year. Of course, that divergence alone is hardly justification to raise our stake. But valuations appear more attractive in selected regions, or afford us a reasonably-priced opportunity to participate in future profit growth. With respect to emerging markets, we have modestly reduced our position in a dedicated emerging-markets stocks ETF. This reflects our belief that while, on the whole, the region is undervalued, restraint is still warranted given the greater opacity of these markets, and the wellchronicled risks that some, like China, face in making the difficult transition from export- to consumer-driven economies. Given this, we demand a larger margin of safety than we would otherwise, explaining the measured pace at which we ve adjusted our weightings. It s worth noting that, even after this slight reduction in our emerging-markets weighting, we re still overweight such stocks.

7 Bonds We ve moved from a roughly neutral overall fixed-income/cash weighting to a slight, across-theboard overweight. However, this does not reflect any deep affection for cash and bonds. Rather, it is largely a byproduct of a climate in which we re finding bargains increasingly scarce. Thus, our stake in cash and short-term bonds has risen and, with it, our fixed-income overweight. Our positioning in cash and short-term inflation-protected bonds deserves particular focus. With this reallocation, we ve raised each portfolio s stake in a short-term TIPS ETF. We ve done so largely in view of the guaranteed negative after-inflation return we d suffer if we left assets in cash for any extended period of time. While short-term TIPS yields are hardly anything to write home about, they at least boast one attribute that cash does not inflation protection. Put another way, we d rather earn a bit less than inflation in short-term TIPS than quite a bit less than inflation in cash, explaining our thinking here. In addition to these changes, we also slightly raised our non-u.s. bond weighting, which indicates our slight preference for the bonds of selected foreign sovereigns as well our desire to modestly raise our foreign currency exposure. Of particular note, we initiated a position in an ETF that invests in local-currency denominated short-term foreign bonds. This position helps us to widen our regional exposure (from emerging-markets only to developed sovereigns), shorten our duration a bit (as it invests in short-tenor bonds), and modestly reduce the cost of our foreign exposure (as the new ETF is less expensive). We largely funded these purchases using the proceeds raised by trimming our stake in certain U.S. stock ETFs (as previously described) and by modestly reducing our stake in a bank-loan ETF. Aggressive Growth N New Market Vectors Wide Moat We added MOAT to increase our exposure to cheap, high-quality stocks N New PIMCO 1-5 Year US TIPS Index ETF We added STPZ in the absence of plentiful bargains ] Increase Vanguard Europe Pacific ETF We increased VEA to ratchet our foreign-developed exposure higher ] Increase WisdomTree Japan We slightly increased DFJ to rebalance back to target SmallCap Dividend [ Decrease Vanguard Total Stock We reduced VTI to pare back our exposure to U.S. stocks [ Decrease Vanguard Emerging Markets We reduced VWO to keep our foreign stock exposure in line ETF [ Decrease Vanguard Small Cap ETF We reduced VB to pare back our exposure to small-cap U.S. stocks [ Decrease First Trust ISE-Revere Natural Gas Idx We slightly reduced FCG to rebalance back to target

8 [ Decrease Health Care Select Sector We reduced XLV for valuation reasons SPDR [ Decrease CASH We slightly reduced our cash stake but added to STPZ Growth N New Market Vectors Wide Moat We added MOAT to increase our exposure to cheap, high-quality stocks N New PIMCO 1-5 Year US TIPS Index ETF We added STPZ in the absence of plentiful bargains ] Increase Vanguard Europe Pacific ETF We increased VEA to ratchet our foreign-developed exposure higher ] Increase CASH We added to our cash stake in the absence of plentiful bargains [ Decrease Vanguard Total Stock We reduced VTI to pare back our exposure to U.S. stocks [ Decrease Vanguard Emerging Markets We reduced VWO to keep our foreign stock exposure in line ETF [ Decrease Vanguard Small Cap ETF We reduced VB to pare back our exposure to small-cap U.S. stocks [ Decrease Vanguard Total Bond [ Decrease First Trust ISE-Revere Natural Gas Idx M Replace Health Care Select Sector SPDR We reduced BND to increase cash and short-term TIPS We slightly reduced FCG to rebalance back to target We sold XLV for valuation reasons Moderate Growth N New Market Vectors Wide Moat We added MOAT to increase our exposure to cheap, high-quality stocks ] Increase Vanguard Europe Pacific ETF We increased VEA to ratchet our foreign-developed exposure higher ] Increase PIMCO 1-5 Year US TIPS We increased STPZ in the absence of plentiful bargains Index ETF ] Increase WisdomTree Emerging We increased ELD to increase our exposure to foreign bonds Markets Local Debt ] Increase SPDR S&P International We slightly increased DWX to rebalance back to target Dividend ] Increase PIMCO Total Return ETF We slightly increased BOND to rebalance back to target ] Increase CASH We added to our cash stake in the absence of plentiful bargains [ Decrease Vanguard Total Stock We reduced VTI to pare back our exposure to U.S. stocks [ Decrease Vanguard Emerging Markets We reduced VWO to keep our foreign stock exposure in line ETF

9 [ Decrease Vanguard Small Cap ETF We reduced VB to pare back our exposure to small-cap U.S. stocks [ Decrease Vanguard Total Bond [ Decrease WisdomTree Japan SmallCap Dividend M Replace Health Care Select Sector SPDR We reduced BND to increase cash and short-term TIPS We slightly reduced DFJ to rebalance back to target We sold XLV for valuation reasons. Income & Growth N New ishares S&P/Citi 1-3 Yr Intl We added ISHG to further diversify our foreign bond stake Treasury Bd N New Market Vectors Wide Moat We added MOAT to increase our exposure to cheap, high-quality stocks ] Increase Vanguard Europe Pacific ETF We increased VEA to ratchet our foreign-developed exposure higher ] Increase PIMCO 1-5 Year US TIPS We increased STPZ in the absence of plentiful bargains Index ETF ] Increase SPDR S&P International We slightly increased DWX to rebalance back to target Dividend ] Increase PIMCO Total Return ETF We slightly increased BOND to rebalance back to target ] Increase CASH We added to our cash stake in the absence of plentiful bargains. [ Decrease Vanguard Total Stock [ Decrease Vanguard Total Bond [ Decrease WisdomTree Emerging Markets Local Debt [ Decrease PowerShares Senior Loan Port M Replace Health Care Select Sector SPDR We reduced VTI to pare back our exposure to U.S. stocks We reduced BND to increase cash and short-term TIPS We reduced ELD to make room for our new foreign bond holding, ISHG We reduced BKLN to increase cash and short-term TIPS We sold XLV for valuation reasons Conservative N New ishares S&P/Citi 1-3 Yr Intl We added ISHG to further diversify our foreign bond stake Treasury Bd N New Market Vectors Wide Moat We added MOAT to increase our exposure to cheap, high-quality stocks ] Increase Vanguard Europe Pacific ETF We increased VEA to ratchet our foreign-developed exposure higher ] Increase PIMCO 1-5 Year US TIPS We increased STPZ in the absence of plentiful bargains Index ETF ] Increase PIMCO Total Return ETF We slightly increased BOND to rebalance back to target

10 [ Decrease Vanguard Total Stock We reduced VTI to pare back our exposure to U.S. stocks [ Decrease First Trust ISE-Revere We reduced VWO to keep our foreign stock exposure in line Natural Gas Idx [ Decrease WisdomTree Emerging We reduced ELD to make room for our new foreign bond holding, ISHG Markets Local Debt [ Decrease PowerShares Senior Loan We reduced BKLN to increase cash and short-term TIPS Port [ Decrease CASH We slightly reduced our cash stake but added to STPZ M Replace Health Care Select Sector SPDR We sold XLV for valuation reasons. New Fund Information Market Vectors Wide Moat MOAT This ETF passively tracks the Morningstar Wide Moat Focus Index, a rules-based, equalweighted benchmark that consists of the twenty cheapest wide-moat stocks that Morningstar, Inc. s analysts cover. The Wide Moat Focus Index reconstitutes and rebalances on a quarterly basis. ishares S&P/Citi 1-3 Yr Intl Treasury Bd ISHG This ETF passively tracks the S&P/Citigroup International Treasury Bond Index ex-u.s. 1-3 Year Index, a diverse market-value-weighted benchmarked that measures the performance of treasury bonds issued in local currencies by developed market countries outside the U.S. with a maturity of 1 to 3 years. For Financial Advisor and Current Client Use Only This communication is for Morningstar Investment Services clients ONLY. It contains important information about their investment advisory account. Please note references to specific mutual funds within this piece should not be considered an offer (as defined by the Securities and Exchange Act) to purchase or sell that specific mutual fund. Past performance does not indicate or guarantee future returns. A mutual fund s net asset value, yield and return will fluctuate, in which case an individual s investment, when redeemed, may be worth more or less than the original investment. Mutual funds investing in foreign securities incur risk greater than domestic securities due to such risks as political, economic, and currency fluctuation. Mutual funds investing in high yield bonds involve greater risk due to lower credit quality of the issuers. In certain situations, MIS may recommend an exchange-traded fund(s) whose investment objective is to track indexes created and maintained by Morningstar, Inc. In those cases, the sponsor of the exchange-traded fund ( ETF Sponsor ) enters into a licensing agreement with Morningstar, Inc. To mitigate any conflicts of interest arising from MIS usage of such ETFs, Morningstar, Inc. s compensation from the ETF Sponsor will not be based on nor will it include assets that are a result of your investment in those ETFs. In addition, Morningstar, Inc. does not and will not have any input into MIS investment decisions, including what ETFs will be recommended for its portfolios. Opinions expressed are as of the current date; such opinions are subject to change without notice. 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.