2. Agenda
□ Review of First Quarter (what happened);
□ Investment Outlook (what is happening now);
□ Our Portfolio Positioning (what we’re doing about It).
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3. Key Takeaways
o Stocks and other risk assets were up sharply:
This further reduces our five-year return expectations;
o Rising Treasury yields resulted in flat first quarter returns for core bonds:
Our flexible fixed-income strategies did well, given their latitude to invest;
differently than the core bond benchmark
o The euro-zone averted a crisis but did not resolve the longer-term
structural problems that threaten the EU system;
o Our portfolios continue to be underweight stocks/equity-risk and core
bonds/interest-rate risk.
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5. Drivers of October-March Stock Market Rally
o Successful intervention that took a European financial crisis off the table, at
least for the time being;
o Positive U.S. economic data points, particularly with respect to
employment;
o Encouraging results of the Fed’s recent banking stress tests;
o As a result, stocks had one of the strongest gains over that six-month period
in many decades.
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7. Developed World is Still Struggling to Climb Out of Debt
o High debt levels create economic
headwinds;
o High debt levels increase risk;
o There is no solution that does not
involve economic pain.
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8. Refinancing Operations Slowed Europe’s Financial Crisis (For Now)
o Liquidity injection reduced risk of a run on the banking system;
o Government bond yields have fallen, reducing these countries’ borrowing
costs:
Allows countries to borrow cheaply to finance deficits and reduce overall debt;
o Provides countries additional time and space to enact difficult economic
and political reforms;
o However, the markets are recognizing that underlying problems remain:
Yield on Spanish debt has been moving sharply higher on renewed concerns
about government’s ability to meet deficit reduction targets;
New Greek debt is trading at prices that reflect a high probability of another
default/restructuring.
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9. Problems at Home: The Looming U.S. “Fiscal Cliff”
o January 1, 2013: “massive fiscal cliff of large spending cuts and tax
increases”:
Expiration of Bush-era tax cuts, the temporary payroll tax cut, extended
unemployment benefits ;
$1.2 trillion of automatic spending cuts will begin to kick in as a result of last
year’s Congressional Super Committee’s failure to reach consensus;
o Impact would be roughly 3.5% hit to GDP next year;
o Seems unlikely it will play out that way, but risk of policy errors and political
dysfunction—particularly in an election year—remain high!
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11. Portfolio Positioning Reflects our Longer-Term Concerns
o Core bonds are set to generate very low returns over the next five years:
Underweighted to core bonds in favor of flexible fixed-income and alternative strategies;
o Stocks also offer subpar returns over our long-term investment horizon:
o Underweighted to stocks/equity-risk;
o Continue to see attractive tactical opportunities in emerging-markets local-
currency bonds, absolute-return-oriented fixed-income and alternative
strategies;
o Expect periods of heightened volatility along the lines of what we saw last
year:
o These environments can create opportunities to increase our weightings to riskier asset
classes at lower prices.
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12. Future Returns of Stocks and Bonds Will be Lower than
We’re Used To Seeing
1
1 Projections under our base case, subpar economic scenario as of 3/31/12 2
2 As measured by the Barclays Aggregate Bond Index .
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1 Projections as 10/1/11.
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2 As measured by the Barclays Aggregate Bond Index .
13. We Remain Underweighted to Stocks
o We expect low returns from U.S. and developed international market stocks
over the next five years;
o Emerging-markets stocks look attractive on a long-term basis, but, given
higher short-term downside, we aren’t increasing our weightings;
o Periods of short-term volatility should create opportunities for skilled
managers to take advantage of shorter-term mispricing at the individual
stock level.
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14. We Remain Underweighted to Core Bonds
o We expect low returns in all our five-year scenarios, with minimal downside
protection;
o We favor flexible and absolute-return-oriented fixed-income managers:
Managers have wide latitude to adjust portfolio characteristics. such as
duration, credit quality, sector, currency and foreign bond exposure;
o We expect inflationary pressures to increase toward the end of our five-
year horizon:
Our non-core bonds funds should do much better than the core bond index if
inflation heats up.
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15. Traditional Role of Core Bonds in a Portfolio
o Core bonds (investment-grade bond funds) traditionally:
Reduce portfolio risk because they are far less volatile than stocks;
Provide protection against a major economic shock/recession;
Generate current income;
o There are two major risks inherent in bonds:
Credit risk;
Interest-rate risk;
• The longer until a bond is repaid (maturity), the more its value falls due to a rise in
interest rates.
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16. Current Bond Market Environment Argues for Investing
Outside of Core Bonds
o Treasury yields are near all-time
lows and we expect to see rates rise
within the next five years:
When rates do rise, bond values
will fall;
o Flexible and absolute-return-
oriented fixed-income managers
have more latitude to pursue return
and lessen impact of rising rates;
o It is important to maintain some
exposure to core bonds as
protection in a very negative
scenario.
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17. Positioning of Our Fixed-Income Strategies
Our fixed-income portfolios have less interest-rate sensitivity and
higher yields than traditional core bond portfolios
9.0%
Source: Morningstar
8.0%
Double Line Total Return
7.0%
D
I
The longer the duration, the greater
S 6.0%
a fund's interest-rate sensitivity
T
Y
R
I 5.0% Osterweis Strategic Income
I
E
B
L 4.0%
U
D
T
Pimco Total Return
I 3.0%
O
VBMFX
N
2.0% Pimco Unconstrained Bond The core bond index is
generally lower yielding
1.0% and has more interest-rate
sensitivity
0.0%
0 1 2 3 4 5 6 7 8
INTEREST-RATE SENSITIVITY (DURATION—IN YEARS)
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18. Alternatives Provide Further Portfolio Diversification
o Arbitrage positions could potentially earn mid-single-digit returns over the
next five years with relatively low risk over the shorter term;
o We view these positions as “dry powder” that can generate better returns
than core bonds in the meantime (not subject to the risk of rising rates).
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19. Looking Ahead
o We remain confident in our portfolio positioning;
o We are focused on the long term, while remaining flexible and nimble
through this highly unstable and uncertain environment;
o We will take on more risk when our research convinces us it is prudent and,
in so doing, we believe we can get better returns than just what the market
yields.
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20. Asset Class Returns
Asset Class
12 5 Years
(current tactical overweighting or Index 1Q 2012
Months (Ann.)
underweighting )
U.S. Larger-Cap Blend ( since Nov-08) Vanguard 500 12.54% 8.37% 1.94%
U.S. Larger-Cap Growth iShares Russell 1000 Growth 14.61% 10.83% 4.93%
U.S. Larger-Cap Value iShares Russell 1000 Value 11.05% 4.60% -0.91%
U.S. Smaller-Cap Blend ( since Sep-06) iShares Russell 2000 12.42% -0.18% 2.18%
U.S. Smaller-Cap Growth iShares Russell 2000 Growth 13.28% 0.75% 4.17%
U.S. Smaller-Cap Value iShares Russell 2000 Value 11.55% -1.20% -0.05%
Developed Int'l Stocks ( since May-09) Vanguard MSCI EAFE ETF 11.50% -5.43% -3.05%
Emerging-Markets Stocks ( since Jan-12) Vanguard Emerging Market ETF 13.96% -9.02% 4.55%
REITs Vanguard REIT 10.71% 12.74% 0.31%
Investment-Grade Bonds (since Dec-09) Vanguard Total Bond 0.23% 7.56% 6.12%
Absolute-Return-Oriented Bonds (since Dec-09) Citigroup 3 Month T-Bill Index 0.04% 0.07% 1.12%
High-Yield Bonds Merrill Lynch High-Yield 5.04% 5.70% 7.74%
Inflation-Protected Bonds iShares Barclays TIPS Bond 0.78% 11.98% 7.46%
Floating-Rate Loans (since Mar-11) S&P/LSTA Leveraged Loan 3.74% 2.80% 4.52%
Commodity Futures Dow Jones-UBS Commodities 0.89% -16.27% -2.78%
Global Investment-Grade Bonds Citigroup World Gov’t Bond -0.51% 5.12% 6.78%
Emerging-Markets Local-Currency Bonds (since Aug-09) JPMorgan GBI-EM Global Div. 8.29% 3.44% 10.05%
21. We Expect to See More Volatility Ahead
The Chicago Board Options Exchange Volatility Index, or VIX, is a commonly used indicator of market
volatility. Often referred to as the “fear index” it is a measure of investors’ expectations of S&P 500
volatility over the near term.
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22. Our Fixed-Income Positions Are Likely to Outperform Core
Bonds in Most Long Term Environments
Litman Gregory’s Five-Year Scenario Analysis
Short-Term “Flight
to Quality” Period Severe Recession Stagflation Subpar Recovery Average Recovery
(e.g. 3rd Quarter 2011)
Best
Barclays Capital Floating-Rate Floating-Rate Emerging-Markets Emerging-Markets Returns
Aggregate Bond Loan Funds Loan Funds Local-Currency Local-Currency
Index Bond Funds Bond Funds
Investment-Grade Multi-Sector Emerging-Markets Multi-Sector Multi-Sector
Bond Funds Bond Funds Local-Currency Bond Funds Bond Funds
Bond Funds
Absolute-Return- Investment-Grade Multi-Sector Floating-Rate Floating-Rate
Oriented Bond Funds Bond Funds Bond Funds Loan Funds Loan Funds
Floating-Rate Barclays Capital Absolute-Return- Absolute-Return- Absolute-Return-
Loan Funds Aggregate Bond Oriented Bond Funds Oriented Bond Funds Oriented Bond Funds
Index
Multi-Sector Absolute-Return- Investment-Grade Investment-Grade Investment-Grade
Bond Funds Oriented Bond Funds Bond Funds Bond Funds Bond Funds
Worst
Emerging-Markets Emerging-Markets Barclays Capital Barclays Capital Barclays Capital
Returns
Local-Currency Local-Currency Aggregate Bond Aggregate Bond Aggregate Bond
Bond Funds Bond Funds Index Index Index
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23. Reminder: Our Portfolio Management Approach
Maximize risk-adjusted returns through tactical asset
allocation and “best-in-class” active manager selection.
INVESTMENT MANAGEMENT APPROACH
Active Passive/Indexing
Litman Gregory
Tactical
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ASSET ALLOCATION
APPROACH
Static
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24. Our “Fat Pitch” Tactical Allocation Strategy
When Long-Term Fundamentals and Current Valuations Diverge…
We May Find a “Fat Pitch” Investment Opportunity
Current
Valuations
Asset Class Valuations
Fair Value
Based
on Fundamentals
Shifting allocation
back down to
neutral
Potential “fat pitch” shift
to allocation above neutral
Years
Over the long term we expect valuations and fundamentals to converge.
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25. Our Four Broad Economic Scenarios*
SCENARIO DEFINITION
• We experience a severe recession, e.g., due to another financial crisis or
debt crisis
Severe Recession • Weak recovery in the later years
• Assumes inflation is around 1% and the 10-year Treasury yield is around
2% at end of year 5
• Subpar economic growth
Stagflation • Strong inflation spike at the end of our forecasting period
• Assumes inflation is around 6% and the 10-year Treasury yield is around
7% at end of year 5
• Recovery that began late in 2009/early 2010 continues, a recession is
Subpar Recovery probable within the five-year horizon
• Assumes inflation is around 3% and the 10-year Treasury yield is around
5% at end of year 5
• Recession is avoided and the economy recovers due to a combination of
effective government policy and positive self-reinforcing economic and
Average Recovery business cycle dynamics
• Re-flation works, but Fed avoids monetary inflation
• Assumes inflation is around 3% and the 10-year Treasury yield is around
6% at end of year 5
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26. Scenario Analysis: Asset Class Return Estimates
More Pessimistic More Optimistic
Economic Scenario Severe Recession Stagflation Subpar Recovery Average Recovery
As of 3/31/12 S&P 500 at 1409, Barclays Aggregate yield at 2.0%, MSCI EM Index at 1041, BofA Merrill Lynch High-Yield Cash Pay Index at 7.0%.
Equity Asset Classes Estimated Average Annual Returns over Next Five Years
U.S. Equities -4.9% -3.5% 2.9% 11.2%
Developed International Similar to U.S. Equities
Emerging Markets 0.8% n/a 9.6% 18.9%
REITs -0.4% -2.0% 1.5% 1.9%
Fixed Income Asset Classes
Investment-Grade Bonds 1.9% -0.4% 0.6% 0.2%
High-Yield Bonds 1.7% 4.2% 3.5% 2.1%
Floating-Rate Loans 3.7% 3.5% 4.0% 4.1%
TIPS 2.4% 0.0% 0.0% -1.0%
Emerging-Markets Low single-digit Low/Mid single-digit Mid/High single-digit Mid/High single-digit
Local-Currency Bonds returns returns returns returns
Alternative Asset Classes
Arbitrage Strategies Mid single-digit returns in most scenarios
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27. Of Our Four Broad Economic Scenarios, We Believe “Subpar
Recovery” is the Most Likely
Economic Scenario: Subpar Recovery
Equity Asset Classes
U.S. Equities 2.9%
Developed International Similar to U.S. Equities
Emerging Markets 9.6%
REITs 1.5%
Fixed-Income Asset Classes
Investment-Grade Bonds 0.6%
High-Yield Bonds 3.5%
Floating-Rate Loans 4.0%
TIPS 0.0%
Emerging-Markets Local-Currency Bonds Mid/High single-digit returns
Alternative Asset Classes
Mid-to-upper single-digit returns in
Alternative Strategies
most scenarios
Chart is as of 3/31/12 S&P 500 at 1409, Barclays Aggregate yield at 2.0%, MSCI EM Index at 1041, BofA ML High Yield Cash Pay Index at 7.0%.
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28. Tactical Positioning of Conservative Balanced Portfolio
% Underweight Current Neutral % Overweight
of Current from Neutral Weight Weight of Current from Neutral
30 25 20 15 10 5 5 10 15 20 25 30
Fixed Income
Core fixed income 37% 60%
Floating-Rate Loans 6% 0
Absolute-return-oriented/Flexible 24% 0
Emerging-markets local-currency 5% 0
bonds
Alternatives
Arbitrage 5%
Equities
Larger cap 16% 20%
Smaller cap 1.5% 4%
Developed international 2.0% 8%
Emerging-markets 3.5% 8%
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