DIVERSIFYING VALUE: THINKING OUTSIDE THE BOX

Legg Mason Thought Leadership DIVERSIFYING VALUE: THINKING OUTSIDE THE BOX Michael J. LaBella, CFA Portfolio Manager Smart beta can be utilized within the traditional style box framework to help investors achieve their desired portfolio outcomes; consider, for example, the use of a defensive equity income strategy in conjunction with a traditional value stock allocation. This document reflects the opinions, views and analysis of QS Investors regarding conditions in the economy and markets, which are subject to change, and may differ from those of other professional investment managers. For financial professional use only. Not for use with the general public. The information found in this document is for illustrative and educational purposes only. This document may not be used in connection with any Legg Mason ETF. MAR 218 INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

The style box framework developed by Morningstar in 1992 provides an intuitive framework for equity investing, splitting the entirety of the opportunity set by size (large, mid small) and the value/growth segments. Since its inception, investors have embraced the style box as a means of balancing risk exposure and gaining diversification within their equity portfolios. However, investor experience has not always been as smooth as advertised, especially during periods of market turmoil when seemingly diversified portfolios have not always lived up to expectations. In an ever more challenging environment to generate long-term alpha net of fees, investors are considering new tools to shore up traditional methods and looking into outcome-based portfolio construction approaches. This need has led to the rapid rise in popularity of smart beta strategies over the past decade. However, some investors have shied away from these approaches, unsure about how to deploy them. Figure 1: Morningstar style box Large Mid Value Core Growth Defensive Equity Income We believe that smart beta can be utilized within the traditional style box construct to help investors achieve their desired portfolio outcomes. Investors can use smart beta approaches designed to identify stocks with certain fundamental characteristics that are not captured in the style box (such as low volatility, dividend yield, quality and momentum, among others). By adding other dimensions to the style box, smart beta can work to further diversify and enhance traditional investing styles. In this piece, we focus on how Defensive can do this within the value sleeve. The challenges of value style investing The value premia has been proven to exist over time, providing investors with the opportunity to earn alpha as stocks that are mispriced by the market appreciate. However, value investing comes with emotional challenges. In order to successfully harvest the value premia, investors must be willing to stomach some discomfort: Cyclicality: Value investing can be in and out of favor for prolonged periods of time; as such, investors must have a long-term view to realize the benefits. Trying to tactically time when the factor is in or out of style can be challenging to realizing long term growth. Drawdowns: Markets ebbs and flows can create value opportunities, however; at times markets can get overly pessimistic or overly optimistic on certain sectors or segments of the market, leading to sharp drawdowns in value stocks Stability: Value stocks may exhibit more volatility than the market, as investors often disagree about their future potential for these out of favor stocks. Small Source: Morningstar 2

The style-ish factor solution: defensive Blending traditional value strategies with a Defensive Equity Income strategy can help investors to weather the short-term emotional challenges associated with value, thus allowing them to fully harvest the value premia. For purposes of this analysis, we are defining a Defensive strategy as one which invests in dividend paying stocks with strong earnings and profitability, while seeking to avoid the riskier ones by penalizing companies with higher price and/or earnings volatility. Figure 2 compares Defensive to active value peers and the Large Cap across four commonly used valuation metrics. Defensive focuses on high earnings yield (E/P) companies, which results in a low overall price-to-earnings (P/E) ratio, this differs from traditional active and passive value funds which tend to focus on low price-to-book (P/B) stocks. The companies that a Defensive strategy tilts towards tend to be in favor at very different times than securities targeted by value and growth funds, thus resulting in different overall sector style exposures as illustrated in the cyclical versus non-cyclical break down in Figure 3. This can lead to enhanced diversification, an increase in the consistency of returns within the value sleeve, and overall portfolio, as well as a reduction in risk. Figure 2: Valuation based on four key metrics Figure 3: Sector exposure (%) Russell 1 Active Large Cap Equity Russell 1 Index Cyclical Non-Cyclical 25x 1 42 26 31 26 2x 8 15x 6 73 69 74 58 1x 4 5x 2 Price/Earnings Price/Cash Flow Price/Sales Price/Book Defensive Equity Income Active Large Cap Equity Peer Median Russell 1 Russell 1 Index Source: Bloomberg, Russell Indices, evestment. Data as of December 31, 217. Valuation data based on trailing 12-month earnings. Defensive is represented by the QS Low Volatility High Dividend Index. Active Large Cap Equity is represented by evestment s Active Large Cap Value Equity universe, a proprietary list of large cap equity mutual funds with a value orientation updated quarterly based on characteristics, allocations, benchmark and performance, with performance data gross of fees. Large Cap is represented by the Russell 1. Large Cap Index represented by the Russell 1 Index. Sector Exposure based on GICS Sector Classification using the following assumption: Non-Cyclical Sectors (Consumer Staples, Health Care, Utilities, Telecommunications) and Cyclical Sectors (Consumer Discretionary, Energy, Financials, Real Estate, Technology, Industrials and Materials). 3

What elements of a defensive equity income strategy may be complementary to traditional value? Income generation Dividend yield (%) 5. Valuation P/E valuation 25.x Risk/return trailing 1 years Upside/downside market capture (%) 15 4. 4. 2x 21.2x 2.2x 12 9 76 96 1 17.x 6 3. 15.x 3 2. 2.2 2.4 1x -3-6 56 1. 5.x -9-12 86 1 Active Large Cap Equity Peer Median Large Cap Source: Bloomberg, Russell Indices, evestment. Data as of December 31, 217. Trailing 12 month dividend yield calculated as the ratio of net dividends per share and closing price, multiplied by 1 as of the date of the analysis. Harmonic weighted average approach is used with all underlying components. Valuation data based on trailing 12-month earnings. Upside/downside analysis based on 1-year trailing period utilizing monthly total return data. Defensive is represented by the QS Low Volatility High Dividend Index. The actual inception date of the index was November 3, 215. Any data prior to that date is hypothetical back-tested data. The hypothetical back-tested index performance is inherently limited in that it is based on criteria applied retroactively with the benefits of hindsight and knowledge of factors that may have positively affected its performance and cannot account for all financial risk. Active Large Cap Equity is represented by evestment s Active Large Cap Equity universe, a proprietary list of large cap equity mutual funds with a value orientation updated quarterly based on characteristics, allocations, benchmark and performance. Large Cap represented by the Russell 1. 1 Smoother returns stream: x Active Large Cap Equity Peer Median Large Cap Active Large Cap Equity Peer Median Value investing can be in and out of favor for prolonged periods, so investors must have a long-term view to realize the benefits. An allocation to defensive equity income can improve diversification between the value and growth sleeves as well as within the value sleeve, reducing cyclicality in performance. -15 Large Cap A lower correlation to growth Correlation of Return to Large Cap Growth Reduced correlation to traditional value managers, potentially improving the consistency of returns Russell 1 1..8.85.86.6.66 Top 1 Active.66.85.86.8.6.4 Correlation of excess returns relative to Large Cap : Defensive vs. Top 1 Active.4.2-7 -.2 5-year 1-year 5-year 1-year Source: Bloomberg, Russell Indices, evestment. Data as of December 31, 217. Defensive is represented by the QS Low Volatility High Dividend Index. The actual inception date of the index was November 3, 215. Any data prior to that date is hypothetical back-tested data. The hypothetical back-tested index performance is inherently limited in that it is based on criteria applied retroactively with the benefits of hindsight and knowledge of factors that may have positively affected its performance and cannot account for all financial risk. Large Cap Growth Index represented by the Russell 1 Growth Index. Large Cap represented by the Russell 1. Top 1 Active is a subset of the largest active value managers based on Institutional AUM and required 1-year track record within the evestment universe of Active Large Cap Equity managers as of December 31, 217, with performance data gross of fees. This group includes: LSV Large Cap Value, Eagle Equity, Invesco Diversified Dividend, Federated Strategic Value Dividend, John Hancock Disciplined Value Fund, AJO Large Cap Absolute Value, Aristotle Value Equity, Fiduciary Management Large Cap Equity, Vulcan Large Cap Value Partners and Diamond Hill Large Cap. 4.2.1

2 Drawdown management, more balanced portfolio profile: Markets can become pessimistic, creating value opportunities; however, at times markets can get overly pessimistic leading to sharp drawdowns. Defensive equity income can help reduce average drawdowns, proving portfolios with a more balanced profile. Passive value managers (%) Average drawdown trailing 1-year -.2 Active value managers (%) Average drawdown trailing 1-year -.2 -.4 -.6-4.4-6.5-5.9 -.4 -.6-4.4-6.4-4.8 -.8 -.8-1. Russell 1 5% Defensive 5% Russell 1-1. Top 1 Active 5% Defensive 5% Top 1 Active Source: Bloomberg, Russell Indices, evestment. Data as of December 31, 217. Defensive is represented by the QS Low Volatility High Dividend Index. The actual inception date of the index was November 3, 215. Any data prior to that date is hypothetical back-tested data. The hypothetical back-tested index performance is inherently limited in that it is based on criteria applied retroactively with the benefits of hindsight and knowledge of factors that may have positively affected its performance and cannot account for all financial risk. Large Cap represented by the Russell 1. Top 1 Active is a subset of the largest active value managers based on Institutional AUM and required 1-year track record as of December 31, 217, with performance data gross of fees. This group includes: LSV Large Cap Value, Eagle Equity, Invesco Diversified Dividend, Federated Strategic Value Dividend, John Hancock Disciplined Value Fund, AJO Large Cap Absolute Value, Aristotle Value Equity, Fiduciary Management Large Cap Equity, Vulcan Large Cap Value Partners and Diamond Hill Large Cap. Calculation based on evestment methodology. Data for 5%/5% portfolios shown above reflects quarterly rebalancing. 3 Stability: Value stocks may exhibit more volatility than the market as investors often disagree about their future potential for these out of favor stocks. An allocation to Defensive can provide a favorable balance between absolute return and relative risk/return characteristics. Passive value managers Trailing 1-year standard deviation 2 Active value managers Trailing 1-year standard deviation 2 16 12 12.6 15.9 13.7 16 12 12.6 15.6 13.6 8 8 4 4 Large Cap 5% Defensive, 5% Large Cap Top 1 Active 5% Defensive, 5% Top 1 Active Source: Bloomberg, Russell Indices, evestment. Data as of December 31, 217. Defensive is represented by the QS Low Volatility High Dividend Index. The actual inception date of the index was November 3, 215. Any data prior to that date is hypothetical back-tested data. The hypothetical back-tested index performance is inherently limited in that it is based on criteria applied retroactively with the benefits of hindsight and knowledge of factors that may have positively affected its performance and cannot account for all financial risk. Large Cap represented by the Russell 1. Top 1 Active is a subset of the largest active value managers based on Institutional AUM and required 1-year track record as of December 31, 217, with performance data gross of fees. This group includes: LSV Large Cap Value, Eagle Equity, Invesco Diversified Dividend, Federated Strategic Value Dividend, John Hancock Disciplined Value Fund, AJO Large Cap Absolute Value, Aristotle Value Equity, Fiduciary Management Large Cap Equity, Vulcan Large Cap Value Partners and Diamond Hill Large Cap. Calculation based on evestment methodology. Data for 5%/5% portfolios shown above reflects quarterly rebalancing. 5

Conclusion: thinking outside the box To address today s market challenges, it appears investors will increasingly need to think outside of the box to meet their goals. With an ever-increasing number of tools at their disposal investors will need to seize the opportunity to consider new ways to deploy them. Looking at styles in conjunction with smart beta allows investors to further refine their equity portfolios, allowing them a better chance at achieving their long-term objectives. Definitions The Russell 1 Index is an unmanaged index of the 1, largest U.S. companies. The Russell 1 Growth Index is an unmanaged index of those companies in the large-cap Russell 1 Index chosen for their growth orientation. The Russell 1 is an unmanaged index of those companies in the large-cap Russell 1 Index chosen for their value orientation. The QS Low Volatility High Dividend Index is based on a proprietary rules-based methodology created and sponsored by QS Investors, LLC (QS), the sub-adviser. The methodology calculates a composite stable yield score, with the yield of stocks with relatively high price and earnings volatility adjusted downward and the yield of stocks with relatively low price and earnings volatility adjusted upward. The composition of the Index after annual reconstitution and rebalancing may fluctuate and exceed the aforementioned limits due to market movements. The components of the Underlying Index, and the degree to which these components represent certain sectors and industries, may change over time. 6

Investment risks Index performance for Hypothetical Backtested QS Low Volatility High Dividend Index is provided by QS Investors and Solactive. Solactive is paid by QS Investors, which a Legg Mason affiliated company. The hypothetical backtested index performance is inherently limited in that it is based on criteria applied retroactively with the benefits of hindsight and knowledge of factors that may have positively affected its performance and cannot account for all financial risk. Within the confines of the existing rulebook, which outlines the methodology of the index, there may be methodology adjustments that may result in changes to performance over time. Yields and dividends represent past performance and there is no guarantee they will continue to be paid. Investments in small-cap and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies. Outperformance does not imply positive results. Equity securities are subject to price fluctuation and possible loss of principal. Average annualized total returns, gross of fees (%) 1-year 5-year 1-year Russell 1 Growth Index 3.21 17.33 1 Russell 1 13.66 14.4 7.1 13.58 15.2 11.11 Median: US Active Large Cap Value Equity fund universe 17.1 14.56 8.8 Source: QS Investors, Solactive. Past performance is no guarantee of future returns. All returns are for periods ending December 31, 217 and are gross of fees. evestment s U.S. Active Large Cap Value Equity fund universe is a proprietary list of large cap equity mutual funds with a value orientation updated quarterly based on characteristics, allocations, benchmark and performance. 7

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