investment strategy commentary

investment strategy commentary 2014 STRATEGIC ASSET ALLOCATION UPDATE July 2014 Peter Mladina Director of Portfolio Research Wealth Management pjm7@ntrs.com Michael DeJuan, CIM, CAIA Head, Portfolio Construction Desk mld2@ntrs.com Daniel Phillips, CFA Investment Strategist dp61@ntrs.com Northern Trust brings together the firm s portfolio strategists and asset class experts annually to refresh longer-term capital market assumptions (CMAs) and update strategic asset allocation. This rigorous process produces return and risk inputs (see Five-Year Outlook: 2014 Edition) that inform optimal pre-tax and after-tax portfolios for the longer-term, strategic investment horizon. The strategic asset allocation process employs forward-looking (but historically aware) return forecasts and historical standard deviation and correlation inputs using data going back to 1990. The 1990 inception represents the longest common period available for our strategic asset classes or for back-filled proxies that closely replicate the strategic asset classes. We believe the 24-year period is sufficiently long for optimization purposes, as it includes three economic cycles, a major stock market bubble and the 2008 financial crisis and recovery. forecasts consider the longest, broadest history of capital market returns, while proprietary quantitative forecasting methods employ factor models, forward curves, historical relationships and implied market equilibrium forecasts to create baseline five-year expected returns for each strategic asset class. Forward-looking expert judgment of political, economic and capital market conditions form inputs to a building-block process that refines the quantitative forecasts. Standard deviation measures return dispersion around the average or expected outcome. It remains the most informative and widely used measure of risk. The standard deviations of asset classes are more stable than returns over the strategic investment horizon, which is why we incorporate historical standard deviations along with forward-looking returns in our portfolio optimizations. Tests of other summary risk measures including conditional value at risk (CVaR) and semi-deviation show they are all highly correlated descriptors of risk for strategic asset classes, and portfolio optimizations using the different risk measures produce very similar results. Other out-of-sample risks such as inflation and illiquidity risk are addressed through a qualitative lens. Correlation is the heart of diversification, as low to negative correlation is the mark of a unique asset class. We address unstable and elevated correlations among Risk Assets by relying on systematic risk factors (independent risk premiums) for primary diversification. Five-year expected return, historical standard deviation and historical correlations serve as inputs to a proprietary multi-step, mean-variance optimization process. The optimization process summarized below incorporates the most contemporary concepts in inter-temporal portfolio theory, robust factor-based asset allocation and after-tax portfolio optimization. northerntrust.com Investment Strategy Commentary 1 of 5

PORTFOLIO OPTIMIZATION PROCESS 1. Categorize Strategic Asset Classes into Systematic Risk Factors: Risk-Control Assets (cash and term risk betas) and Risk Assets (market risk betas) are the two most important independent risk premiums in global capital markets. They offer different return/ risk profiles and are uncorrelated across risk environments the purest definition of true asset classes. Other risk premiums exist, but they are not prevalent in the strategic asset classes and are better targeted (if desired) through investment fulfillment. 2. Determine the Risk-Control Assets Model: Risk-Control Assets include cash, investmentgrade bonds, tax-exempt bonds and Treasury inflation-protected securities (TIPS). They offer a low return/risk profile and low correlations with Risk Assets, which make them powerful diversifiers of Risk Assets. In addition to moderating the risk of Risk Assets, these characteristics make Risk- Control Assets suitable for funding high-value goals in a goals-based or liability-driven investing framework. The optimal combination of Risk- Control Assets is determined by optimization to uncover the maximum Sharpe Ratio (highest return-to-risk mix), subject to pragmatic cash constraints and out-of-sample inflation considerations, given that inflation has not been prevalent over the 1990 2014 time period. 3. Determine the Risk Assets Model: Risk Assets include developed global equity; emerging markets; real estate and infrastructure; natural resources; private equity; hedge funds; and highyield bonds. Risk Assets offer a high return/risk profile and are the portfolio s return engine. The optimal combination of Risk Assets is determined by optimizing to find the maximum Sharpe mix. The market cap-weighted, or equilibrium, portfolio of risky assets provides a natural benchmark to guide constraints. Portfolio theory tells us the market equilibrium portfolio is the maximum Sharpe portfolio of Risk Assets, optimized in real time by the market to account for time-varying expected return, risk and correlations. Therefore, the results of our maximum Sharpe optimization of Risk Assets are constrained around equilibrium market weights. 4. Optimize Risk-Control Assets with Risk Assets: Risk-Control Assets and Risk Assets are independent (uncorrelated) risk premiums with different return/risk profiles that can be relied upon for robust diversification across risk environments. We optimize Risk Control and Risk Assets models to create an efficient frontier of risk-based portfolios that are essentially different combinations of the two systematic risk factors. Risk-based portfolios span the least risky (Risk Control/Stable) to the most risky (Risk Assets/Maximum Growth), with a progression of equidistant portfolios (Income and Moderate Growth, Growth and Income, and Growth and Moderate Income) along the efficient frontier. The Income portfolio uniquely lies between Risk Control and Income and Moderate Growth, and it represents the maximum Sharpe portfolio on this final efficient frontier. 5. Tax Adjustments: Most private investors pay taxes, and this can affect portfolio efficiency, since some asset classes are more tax-efficient than others. We tax-adjust optimization inputs to arrive at after-tax versions of our strategic portfolios for taxable investors. The five-year return forecast for each asset class is reduced by annualized estimates for interest income tax; qualified and unqualified dividend tax; short-term capital gains tax; and long-term capital gains tax (including terminal liquidation). Tax assumptions are based on the highest marginal federal rates as of 2014 for ordinary income, qualified dividends, and shortand long-term capital gains. We do not consider state tax or the health care tax, as these taxes can vary widely depending on client circumstances. However, this omission does not materially affect the relative tax efficiency of asset classes in after-tax optimizations. We also adjust standard deviation for skewed returns associated with asymmetrical tax rules. Correlations between pre-tax and after-tax returns approach 1.0, so we make no tax adjustments to correlations. The after-tax models are the primary strategic portfolios for taxable investors. The pre-tax portfolio models can be used for tax-exempt investors and to aid asset location decisions for taxable investors who have a mix of taxable and tax-deferred accounts. northerntrust.com Investment Strategy Commentary 2 of 5

This process produces six prescribed investment objectives that capture the full span of diversified risk and return across a robustly diversified efficient frontier. For investors pursuing traditional strategic asset allocation, it captures the benefits of diversification while maintaining a consistent return/risk profile. For investors pursuing Goals Driven Investing, it offers an infinite number of custom portfolios along the same efficient frontier that are dynamically mapped along custom glide paths based on time-varying changes in lifetime goals, risk tolerance and the mean-reverting properties of Risk Assets. 2014 STRATEGIC ASSET ALLOCATION CHANGES A Lower Premium for Risk Assets Affects the Income Portfolio: The expected return premium of Risk Assets over Risk-Control Assets is lower in 2014. This results in less return per unit of risk and shifts the income (maximum Sharpe) portfolio more toward Risk Control/Stable along the efficient frontier. The income portfolio therefore has a slightly higher allocation to Risk-Control Assets this year. Recalibration of the Emerging Markets Weight: Developed and emerging market equity weights were adjusted to maintain an appropriate relationship to market equilibrium weights, which shifted toward developed markets in 2013. Emerging-market equities continue to be over-weighted but constrained to 5% above their approximate 10% global market weight. High Yield: The pre-tax portfolios continue to see a slow reduction in the strategic overweight position to High Yield as credit spreads continue their ongoing normalization in the aftermath of the financial crisis (falling from nearly 20% to their current 3.0% to 3.5% levels). After-tax models maintained their High-Yield strategic allocation from the previous year, as they were closer to equilibrium weights. Income Objective: Allocations were broadened to include all non-alternative asset classes (i.e., natural resources and real estate/infrastructure are now included). Alternatives are not viewed as appropriate for an income-oriented portfolio due to potential liquidity needs and the required sizing of higher minimums. Effectively, this results in the Standard/ Accredited Income Objective being the same. Optimized Stable Investment Objective: Stable now represents the Risk-Control model (to complement the Maximum Growth/Risk Asset model and provide the full spectrum of risk-based portfolios, from 100% Risk-Control Asset model to 100% Risk Asset model). Ranges will accommodate 100% cash allocations to meet unique client situations. northerntrust.com Investment Strategy Commentary 3 of 5

2014 strategic asset allocation models Pre-Tax Risk-Based Models Full Detail Stable/RC Income I & MG G & I G & MI Max Growth Acc. Std. Acc. Std. Acc. Std. Acc. Std. Acc. Std. Acc. Std. Cash 5% 5% 4% 4% 3% 3% 2% 2% 1% 1% TIPS 10% 10% 8% 8% 6% 6% 4% 4% 2% 2% US Aggregate 85% 85% 74% 74% 51% 52% 32% 34% 16% 17% Municipal Risk Control Model 100% 100% 86% 86% 60% 61% 38% 40% 19% 20% 0% 0% High Yield 1% 1% 3% 3% 5% 5% 7% 7% 8% 8% U.S. Equities 5% 5% 11% 14% 16% 21% 20% 27% 26% 35% Dev ex-u.s. Equities 4% 4% 8% 11% 14% 17% 18% 24% 21% 29% Emerging Market Eq. 2% 2% 3% 4% 5% 7% 7% 9% 8% 11% Natural Resources 1% 1% 3% 3% 4% 4% 5% 5% 7% 7% Global RE/LI 1% 1% 4% 4% 6% 6% 8% 8% 10% 10% Hedge Funds 4% 6% 8% 10% Private Equity 4% 6% 8% 10% Risk Asset Model 0% 0% 14% 14% 40% 39% 62% 60% 81% 80% 100% 100% Expected * 2.9% 2.9% 3.7% 3.7% 5.0% 5.0% 6.0% 6.2% 6.9% 6.8% 7.6% 7.6% Expected Risk 3.6% 3.6% 3.8% 3.8% 5.7% 6.2% 8.3% 9.4% 10.5% 11.7% 13.0% 14.6% Efficiency 0.82 0.82 0.98 0.98 0.87 0.80 0.73 0.66 0.65 0.58 0.59 0.52 After-Tax Risk-Based Models - Full Detail Stable/RC Income I & MG G & I G & MI Max Growth Acc. Std. Acc. Std. Acc. Std. Acc. Std. Acc. Std. Acc. Std. Cash 5% 5% 4% 4% 3% 3% 2% 2% 1% 1% TIPS 10% 10% 8% 8% 6% 6% 4% 4% 2% 2% U.S. Aggregate Municipal 85% 85% 77% 77% 52% 53% 34% 35% 17% 17% Risk Control Model 100% 100% 89% 89% 61% 62% 40% 41% 20% 20% 0% 0% High Yield 1% 1% 2% 2% 3% 3% 4% 4% 5% 5% U.S. Equities 4% 4% 13% 15% 20% 23% 26% 32% 32% 40% Dev ex-u.s. Equities 3% 3% 10% 12% 16% 19% 22% 26% 27% 32% Emerging Market Eq. 1% 1% 4% 5% 6% 8% 8% 10% 11% 13% Natural Resources 1% 1% 2% 2% 3% 3% 4% 4% 5% 5% Global RE/LI 1% 1% 2% 2% 3% 3% 4% 4% 5% 5% Hedge Funds 2% 3% 4% 5% Private Equity 4% 6% 8% 10% Risk Assets Model 0% 0% 11% 11% 39% 38% 60% 59% 80% 80% 100% 100% Expected * 2.9% 2.9% 3.7% 3.7% 4.4% 4.4% 5.1% 5.1% 5.7% 5.7% 6.4% 6.2% Expected Risk 3.0% 3.0% 3.2% 3.2% 5.2% 5.6% 7.6% 8.3% 10.0% 11.0% 12.7% 13.8% Efficiency 0.98 0.98 1.16 1.16 0.85 0.78 0.67 0.61 0.57 0.51 0.50 0.45 northerntrust.com Investment Strategy Commentary 4 of 5

2014 return & inflation assumptions Pre-Tax After-Tax Asset Class Risk Category Index Proxy Geometric Arithmetic Inc./Div. Component Geometric Arithmetic Cash Fixed Income U.S. Cash Risk Control 3-Month Treasury Bill 0.9% 0.9% 0.9% 0.5% 0.5% U.S. Investment Grade Risk Control Barclays U.S. Aggregate 3.0% 3.1% 3.0% 1.8% 1.9% U.S. Inflation-Linked Risk Control Barclays U.S. TIPS 3.0% 3.2% 3.0% 1.8% 2.0% U.S. Municipal Risk Control Barclays Municipal 3.2% 3.2% 3.2% 3.2% 3.2% U.S. High Yield Risk Asset Barclays U.S. Corporate HY 5.5% 5.9% 5.5% 3.3% 3.7% Equity Global Developed Risk Asset MSCI World 7.2% 8.4% 2.5% 5.9% 6.9% U.S. Equities Risk Asset MSCI United States 6.6% 7.7% 2.0% 5.4% 6.3% Dev ex-u.s. Equities Risk Asset MSCI Developed ex-u.s. 7.9% 9.4% 3.1% 6.5% 7.7% Emerging Markets Risk Asset MSCI Emerging Markets 9.0% 11.8% 2.7% 7.4% 9.7% Real Assets Natural Resource Stocks Risk Asset Morningstar GUNR 7.0% 8.9% 2.0% 5.7% 7.3% Global Real Estate Risk Asset FTSE NAREIT Global RE 8.0% 9.7% 3.5% 6.2% 7.7% Global Listed Infra. Risk Asset S&P Global Infrastructure 7.0% 8.0% 3.8% 5.6% 6.5% GRE/GLI Blend Risk Asset 50/50 FTSE NAREIT GRE/S&P GLI 7.5% 8.7% 3.7% 5.9% 6.9% Alternatives Hedge Funds Risk Asset HFRI Fund Weighted Comp. 4.3% 4.5% 0.0% 3.2% 3.4% Private Equity Risk Asset Cambridge Blend: 75% buyout/25% Venture Capital 9.4% 11.3% 0.0% 8.0% 9.6% Inflation Consumer Price Index All Urban Consumers 1.8% 1.8% N/A 1.8% 1.8% northern trust 2014 northerntrust.com Investment Strategy Commentary 5 of 5 Q56026 (7/14)