PNC Investment Perspective

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1 IN THIS ISSUE: Europe s Got that Easing Feeling Drip, Drip, Dropping Oil Prices Active vs. Passive Europe s Got that Easing Feeling For more insights and perspectives on key issues from James Dunigan and other senior PNC investment professionals please visit pnc.com/investmentcorner In January 2015, the European Central Bank (ECB) expanded its monetary policy and announced a quantitative easing program to purchase sovereign bonds of Eurozone countries. The program began in March 2015 with the creation of 60 billion euros monthly to be used to purchase long-term Eurozone assets. Investors wonder how this will impact the Eurozone markets and exchange rates. The parameters regarding the timeframe of the program have been left fairly open-ended. At this point, no ending timeframe for the program has been defined. The ECB has said the program will last until at least September Faced with a potential inflationary environment, the ECB has also stated its intent to continue the program until it sees a sustained adjustment in the path of inflation. In terms of which debt securities qualify for purchase, they were divided between sovereign bonds of Eurozone countries and asset-backed securities (ABS) or covered bonds that were already being purchased through programs initiated by the ECB in late The bulk, 88%, will be purchases of sovereign bonds, allocated in a manner that roughly equates to their share in the Eurozone s GDP. In order to qualify, issuers must have investment-grade ratings. For countries such as Greece or Cyprus, which are below investment grade to obtain funding, they must comply with terms negotiated with the International Monetary Fund, the European Commission and the ECB. The ECB will not be the primary possessor of the purchased bonds. Instead, national central banks will hold the bulk of the bonds. JAMES P. DUNIGAN Mr. Dunigan is Executive Vice President and Managing Executive, Investments for PNC Asset Management Group. He has served in a variety of client advisory, investment management and executive roles with PNC since 1987.

2 Containing Risk By having national banks hold the bulk of its countries sovereign debt, the ECB is attempting to contain the risk. Theoretically, if a country does default, its own central bank would be holding the bonds and bear the impact of the losses. However, if such an event occurred, it would probably result in the bankruptcy of the country s central bank. The effects would still be strongly felt by the other Eurozone countries that had lent to that country s central bank, a situation that occurs fairly regularly. However, a widespread or wholesale default appears unlikely. While countries such as Greece may negotiate extensions on payments and lower interest rates, an actual nonpayment typically does not occur, and the Eurozone has been rigorous in imposing sanctions on troubled countries in the form of spending cuts, tax increases and other measures. By having national banks hold the bulk of its countries sovereign debt, the ECB is attempting to contain the risk. Lower Interest Rates and Exchange Rates Likely We believe that the purchases will likely push Eurozone interest rates lower, which should stimulate demand for credit. The supply of sovereign bonds will decline, which should result in investors looking to other potentially riskier asset classes, which may spur higher prices there also. We believe that the Euro will remain weak versus the dollar, with a projection that the Euro will hover in the $1.05 range through year-end Improved Growth Prospects These actions and their ramifications should help to encourage more fixed capital investment and consumption in the nonfinancial economy. Based on these expectations, we have revised our Eurozone GDP growth estimates upward for 2015 and Overall, we will continue to keep a close eye on the Eurozone and still anticipate a significant divergence between the stronger growth projected for the U.S. versus most European countries. Exchange Rate Should Weaken Further in 2015 and 2016 on a More Aggressive ECB Asset Purchase Program U.S. dollars per euro PNC Forecast Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Sources: ECB, CEIC, The PNC Financial Services Group 2

3 Drip, drip, dropping oil prices Since mid-2014, oil prices have fallen significantly and are now less than half the June 2014 price per barrel of approximately $110. Some states, such as Alaska, are extremely dependent on oil taxes for government funding. Investors are worried that falling prices might have a lasting negative effect on state governments and municipalities, increasing the risk of their bonds. There are a number of states that rely more than others on oil taxes for General Fund revenue. Alaska is probably the most prominent and top of mind for most investors. However, there are other states, such as New Mexico, Louisiana, Texas and North Dakota, that also depend on oil taxes to some extent. Alaska is highly dependent on oil taxes, which account for 89% of Alaska s General Fund revenues. In contrast, North Dakota s General Fund relies on oil taxes for only 6% of its revenues. More Positive Long-Term Outlook for Alaska There is a gap between the funding that was expected from oil tax revenues. Alaska s budget initially forecast an average oil price of approximately $105 a barrel, well above the recently revised price Top Oil Reliant States Credit Rating Credit Outlook* F2014 General Fund Revenue Reliance on Oil Taxes F2015 Budgeted Oil Price Forecast Alaska Aaa/AAA/AAA N/S/S 89% $ New Mexico Aaa/AA+ S/N 19% $92.00 Louisiana Aa2/AA/AA N/N/S 15% $92.44 Texas Aaa/AAA/AAA S/S/S 11% $80.33 North Dakota Aa1/AA+ S/S 6% $80.00 *N = Negative; S = Stable Source: Moody s Investors Service; Bloomberg 3

4 forecast of $76 a barrel. This creates a $3.5 billion mid-year budget gap, which will likely eat into financial reserves. While this is negative for the near-term outlook, we believe there are offsetting factors that could result in a more positive long-term outlook. Significant Reserves Provide Cushion Alaska has financial reserves to cover approximately three years of expenditures. In addition, the governor of Alaska has proposed $550 million in budget cuts to help reduce the budget gap. From a debt service standpoint, the state is extremely healthy. As a more drastic measure, it should be noted that Alaska currently has no sales tax. Although there is nothing to indicate this is being considered, implementing one could be a potential option for generating tax revenues in the future. Alaska Annual Financial Reserves $30 $25 SBRF* CBRF* PFER* New Mexico Suffers Additional Problems Even prior to the drop in oil prices, New Mexico had troubles relating to flaws in its financial systems. As a result, Standard & Poor s has revised the state s credit rating outlook to negative. However, it is important to keep in mind that the flaws result in an estimated miscount of only about $100 million, which is less than 2% of fiscal 2014 revenues. New Mexico also has reserves of $671 million. Fund Amount (in billions) $20 $15 $10 New Mexico has taken steps to account for falling oil prices by reducing the budget forecasts for oil tax revenue. State officials have stated their willingness to cut spending and utilize the financial reserve to help fill the gap if necessary. Given the measures the state is taking and its ability to issue debt at a fairly low cost of borrowing, we do not feel falling oil prices will have a material impact in the near term. $5 $0 6/30/2012 6/30/2013 6/30/2014 *SBRF: Statutory Budget Reserve Fund; CBRF: Constitutional Budget Reserve Fund; PFER: Permanent Fund Earnings Reserve Source: Moody s Investors Service, PNC Other Affected States Appear Relatively Safe Louisiana had fiscal issues before the drop in oil prices and is projected to have a budget gap of approximately $1.6 billion in fiscal About a quarter of this gap is due to the drop in oil tax revenues. There is some positive movement in rig count data, which will help offset the falling prices. Further likely budget cuts will also help to fill the budget gap. 4

5 Texas is no longer as dependent on oil tax revenues as it was in the 1980s. Although declining oil prices will have an impact on Texas, there are also potential offsets. Savings from lower gas prices may mean additional money in individuals wallets and could translate into increased consumer spending and related sales tax revenue. The impact on North Dakota should be relatively minor, given that only 6% of its General Fund revenues come from oil taxes. Texas Industries and Share of Employment (December 2014) Information Mining & Logging Other Services Transportation, Warehousing, Utilities Construction Active versus Passive Active versus passive investment management is one of the most hotly debated topics in the investment world, with proponents from both sides putting forth strong arguments. Certainly, 2014 witnessed outflows from actively managed stock mutual funds and inflows into passively managed funds. Many investors wonder whether active or passive is the right approach for them. Defining the Strategies A good place to start is to define the two strategies. A passive strategy seeks to match the return and risk of a specified index by mirroring its composition. In an active strategy, the manager uses his or her insights to make investment choices to fulfill a client s objectives. Financial Activities Manufacturing Passive Investment Strategy Active Investment Strategy Leisure & Hospitality Professional & Business Services Education & Health Services General approach Match return and risk of index by mirroring index composition Use insights to make investment choices to fulfill client s objectives Government Trade 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Source: Real Estate Center at Texas A&M University, Texas Workforce Commission, PNC Investment selection flexibility No individual choice on part of investor or investment manager beyond selection of index Investor or investment manager has freedom to select investments Local Municipalities are Likely to Feel the Impact We believe in the near term, the outlook remains positive for states that rely on oil taxes to a greater extent for General Fund revenue. For local municipalities that are less economically diversified and more dependent on the oil industry for employment and revenues, the impact has the potential to be much greater. We carefully analyze any potential risk such as this when investing in municipal securities. We also remain aware that if this situation does continue for an extended period of time, states will feel a significant impact and will be forced to take more drastic measures. Performance goal Track benchmark returns as closely as possible Although typically there is a set index benchmark against which the strategy s returns can be measured, the goal may vary, depending on client goals (return maximization, risk mitigation, income generation, social causes or other alternatives) 5

6 Passive Strategies Can Deliver Lower Cost and Less Complexity The most obvious advantage to passive investing is relative cost. Expense ratios for many passively managed index funds can be quite low. The lower cost of an index fund mitigates the reduction of returns due to expenses. In addition, passive funds are simpler. The only decision an investor must make is to select the index (and the index fund manager). All buy and sell decisions are made based on changes in the index itself. For investors who do not have the time or the inclination to research active managers or individual investments, passive investing may be appropriate. But Offer Inherent Underperformance and Lack of Flexibility Although costs are typically less than in an active strategy, they still exist, including trading costs and taxes. These expenses lower returns and the result is that an index fund must underperform its index by some amount. In addition, with simplicity comes a level of rigidity that investors may not anticipate. There may be limits on accessibility and liquidity for some passive investments. The potential range of strategies is not as wide as for active investments. Finally, in index funds, transactions take place when the composition of the underlying index changes, not based on the valuation potential for a stock. If a stock is experiencing a run-up in price, regardless of the reason, a capitalizationweighted index would dictate increased exposure. also choose the extent to which and how they diversify, which may help to lower the impact of a market downturn. There are also a significantly greater number of active strategies available. Active managers have the ability to create a strategy based on almost any criteria that comes to mind, giving them the ability to create highly specialized or customized strategies to meet investor need. There is a Price for Active Management Perhaps the most apparent downside to active management are the expenses. Active management by a team that may include portfolio managers, research analysts and other professionals result in higher fees and operating expenses, increasing the return a manager must realize in order to beat the benchmark net of fees and expenses. Another potential disadvantage is the human factor. An investor might pick an underperforming manager and even the best manager might make a bad call sometime, which could have a large impact on returns. This can be managed to some extent through a rigorous manager selection process and vigilant monitoring of managers. Active Investing May Increase Return Potential and Provide Risk Management For active strategies, unlike passive investing strategies, there is the potential to beat the benchmark. In addition, if one assumes a certain degree of inefficiency in even the most developed markets, an active manager can try to benefit from mispricing of individual stocks in the market, which can benefit returns. Active funds can manage holdings in order to try and mitigate risk, which can help to protect against market downturns. Active managers can 6

7 Active Manager Selection Considerations This chart below and discussion above point out one of the most important areas to focus on if an investor is going to use an active manager; manager selection. While past performance is a consideration in helping to understand how a manager might perform under different market conditions, we believe that one examining both quantitative and qualitative factors is a more effective way to help assess an investment manager s performance potential. When we select investment management firms, we look at five key areas: Investment professionals Investment process Strategy performance Business and operational structure Legal and compliance Ongoing review and monitoring is also critical to see if performance is on track versus the benchmark and peers and to uncover any changes to the investment management firm, team or process that may affect performance. Another area to focus on is confirming that the investment manager selected is truly an active manager. Research by Cremers and Petajisto attempts to quantify how active a manager is through a calculation of their active share. Based on active share, managers were then classified into five quintiles ranging from Stock Pickers (most active) to Closet Indexers (least active). Those managers that had a high active share typically outperformed the benchmark while those with a low active share underperformed. This is not surprising, as investors are essentially paying active management fees for benchmark performance. Top Quartiles Managers 10 Years Ended June 30, 2012 Percentage of Funds For at Least One Rolling 3-Year Period in Rolling 3-Year Periods in Quartile Fourth Quartile Bottom Half First Second Third Fourth Large-Cap Blend 49.5% 83.2% 58.9% 21.7% 10.7% 8.8% Large-Cap Value Large-Cap Growth For at Least One Rolling 1-Year Period in Rolling 1-Year Periods in Quartile Fourth Quartile Bottom Half First Second Third Fourth Large-Cap Blend 93.2% 99.1% 46.4% 23.7% 15.4% 14.6% Large-Cap Value Large-Cap Growth Source: Morningstar, PNC 7

8 Somewhere in the Middle: Smart Beta In the past decade, new strategies have appeared that incorporate elements from both passive and active investing. Strategies known as smart beta will replicate the composition of an index, but will deviate from the traditional market-capitalization-weighted approach typically found in an index fund. Smart beta attempts to benefit from the value an active strategy is able to add through systematic, repeatable processes. There are many forms of smart beta and some may possess some of the advantages of passive investing, in the form of lower fees than active, and some of the advantages of active management, through exposure to factors and weightings that are not found in traditional passive investing. A Place for Both Approaches So if there are advantages and disadvantages to both passive and active strategies, what is the appropriate proportion of each in a portfolio? This will depend on each investor and a careful analysis of his or her risk profile, goals and unique considerations. More aggressive investors with longer-term goals may benefit from a higher allocation to active strategies. They may be able to better tolerate greater short-term volatility, downturns and tracking error in exchange for longer-term outperformance. Conversely, an individual with a shorter timeframe who is less willing to risk loss of principal or wide deviations from the benchmark may be more comfortable with a passive investing strategy. Tolerance for tracking error may be one way to assess what strategies are appropriate for an investor. However, it is key to keep in mind that while most investors are disturbed only by downside tracking error, upside error is also a cause for concern as it may be an indicator of future downside tracking error. Also, in the case of active management, tracking error is often intentional and part of the active management process. Long-term outperformance typically does not mean that there are not some periods of underperformance. Research indicates that selling during these periods (selling low) can be a costly decision, as can be seen in the table on page seven which shows that about half of the top performers fell into the last performance quartile based on three-year rolling periods. When looked at on a decile basis, long-term top performers also suffer poor performance years versus their peers, with more than 50% of managers appearing at least once in the ninth or tenth decile. 8

9 The material presented in this newsletter is of a general nature and does not constitute the provision by PNC of investment, legal, tax, or accounting advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions expressed herein are subject to change without notice. The information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs. For more information, please contact PNC at For more information, please contact your PNC investment professional. The PNC Financial Services Group, Inc. ( PNC ) uses the marketing names PNC Wealth Management and Hawthorn, PNC Family Wealth to provide investment, wealth management, and fiduciary services through its subsidiary, PNC Bank, National Association ( PNC Bank ), which is a Member FDIC, and to provide specific fiduciary and agency services through its subsidiary, PNC Delaware Trust Company. PNC also uses the marketing names PNC Institutional Asset Management SM, PNC Retirement Solutions SM, Vested Interest, and PNC Institutional Advisory Solutions SM for the various discretionary and non-discretionary institutional investment activities conducted through PNC Bank and through PNC s subsidiary PNC Capital Advisors, LLC, a registered investment adviser ( PNC Capital Advisors ). Standalone custody, escrow, and directed trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. Securities products, brokerage services, and managed account advisory services are offered by PNC Investments LLC, a registered broker-dealer and a registered investment adviser and member of FINRA and SIPC. Insurance products may be provided through PNC Insurance Services, LLC, a licensed insurance agency affiliate of PNC, or through licensed insurance agencies that are not affiliated with PNC; in either case a licensed insurance affiliate may receive compensation if you choose to purchase insurance through these programs. A decision to purchase insurance will not affect the cost or availability of other products or services from PNC or its affiliates. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products and services provided to a municipal entity or obligated person regarding proceeds of municipal securities (as such terms are defined in the Act) will be provided by PNC Capital Advisors. pnc.com PNC Wealth Management, Hawthorn, PNC Family Wealth, and Vested Interest are registered trademarks and PNC Institutional Asset Management, PNC Retirement Solutions, and PNC Institutional Advisory Solutions are service marks of The PNC Financial Services Group, Inc. Investments: Not FDIC Insured. No Bank Guarantee. May Lose Value. Insurance: Not FDIC Insured. No Bank or Federal Government Guarantee. Not a Deposit. May Lose Value The PNC Financial Services Group, Inc. All rights reserved. 9