2015 Capital Markets Forecast

T h e a r t & S c i e n c e o f i n v e st i n g

Capital

Markets

Forecast

2015

1

E xecutive S ummary •••••••••••••••••••••••• 2 L iquid

and

S afe •• •••••••••••••••••••••••• 6

M arket R isk • •••••••••••••••••••••••••• 16 M anager S kill •• •••••••••••••••••••••••• 26 P rivate C apital • •••••••••••••••••••••••• 30

Table of contents

S trategy D esign •••••••••••••••••••••••• 34 G lossary ••••••••••••••••••••••••••••• 45 D isclosures ••••••••••••••••••••••••••• 48

capital markets forecast 2015

Liquid and Safe Executive Summary How Interest Rate Changes May Impact Fixed Income Returns

W

elcome to the 2015 edition of our Capital Markets Forecast. It shares our seven-year forecast for public and private market asset classes1, as they are situated within our building blocks framework:

Liquid – Assets in this building block insulate near-term spending needs while seeking to protect against interest rate and credit risks. An allocation to Liquid reserves helps avoid permanently impairing capital when portfolios need to meet frequent distribution requirements.

Safe2 - Safe assets primarily play a role as a “shock absorber” to strategies, with the goal of providing protection when risk assets experience short-term duress. Secondarily, they provide income while managing against interest rate fluctuations, credit risks, unanticipated movements in inflation and currency movements. Market Risk – The most volatile component of strategies, Market Risk assets seek to capture public market equity returns, as they are driven by exposure to underlying economic growth, earnings and current and expected future interest rates. Manager Skill - Manager Skill assets are allocated to highly active managers who seek to generate excess returns over the medium term by managing towards an absolute return target. Manager Skill can play both an offensive role in generating returns and a defensive role in providing an additional shock absorber to strategies. Private Capital – As they are illiquid, these assets are designed to achieve strong returns over the long term significantly in excess of what public markets offer, to enhance income generation and capital appreciation. Our overarching investment philosophy is to help clients meet their investment goals taking the least amount of risk necessary. We design investment strategies using these five building blocks to maximize the probability of meeting a minimum net (after inflation and fees) absolute return target over a full market cycle for varying levels of risk tolerances and liquidity appetites. By tactically rebalancing our allocations across and within Safe and Market Risk and combining the use of passively and actively managed vehicles to implement strategies efficiently, we target returns in excess of these primary benchmarks. We always seek the most liquid, simple, transparent and cost effective way to implement an asset class.

1 We look at over 30 different underlying asset classes. A full listing of these asset class forecast is available by request. We are always assessing whether our five building blocks are the most efficient and complete description of the investable opportunity set in the light of the current environment.

2

No inference ‘Safe’ assets cannot lose value.

T h e A r t & Sc i e n c e o f I n v e s t i n g

3

Our overarching investment philosophy is to help clients meet their investment goals taking the least amount of risk necessary.

Our annual Capital Markets Forecast asks the following questions: • What returns are realistically possible over the next market cycle (defined as a seven-year horizon)? • To generate those returns, what risks have to be assumed? •C an we diversify and smooth the growth path of a portfolio over time by minimizing the range of expected outcomes and the potential failure to meet an investment goal? • For portfolios with frequent distributions, what is a sustainable spending rate that minimizes the probability of permanently impairing capital after inflation?

Methodology Our Capital Markets Forecast is based on two key assumptions: •A seven-year forecast window, covering a full market cycle. Economies and markets operate in cycles. Forecast of asset class returns and behaviors over a market cycle have been shown to be more reliable than over the short term, as markets are more able to discern fundamental fair value over that horizon. The average historical market cycle duration has been five years, so our forecast window is conservative3. •T he starting point is critical. The dominant factor in forecasting asset class returns over a market cycle is the starting point, or today’s valuation level. All else being equal, today’s lower yield levels imply lower expected returns in the future, as markets show a strong tendency to mean revert to historical average fundamental levels, adjusted for underlying trends. High profits attract investors and drive down future returns in highly valued asset classes. The assumption of mean reversion works especially well at extreme levels of valuation, and there is a wider range of outcomes when valuations are not at extremes. In theory, these assumptions are well supported by extensive academic research over the last three decades4. In practice, they have allowed our Capital Market Forecast to set the stage for the investment results we have generated over the last 15 years, a time period covering more than two market cycles. Figure 1 below shows how the superior, risk-adjusted (slow, but steady) returns compounded the growth of $1 invested in the Balentine Balanced strategy over time.

3 This time period should, at a minimum, capture a full business cycle. Our average annualized forecast should not be expected to be captured linearly. 4 The seminal paper spawning this body of research was Shiller, R (1981) “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” The American Economic Review Vol. 71 No 3.

capital markets forecast 2015

Executive Summary Figure 1: Fully Diversified Balanced Strategies Performance, 2000 - 2014 Public Markets Balanced Strategy

$2.50

Fully Diversified Balanced Strategy Public Markets Balanced Benchmark Fully Diversified Balanced Benchmark

$2.00

SP 500 $1.50

$1.00

$0.50

$0 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Source: Balentine

This track record gives us confidence that our Capital Markets Forecast methodology for diversification remains relevant and can be repeatable in the future.

OUTLINE In the chapter Liquid and Safe: How Interest Rate Changes May Impact Fixed Income Returns, we explore how quickly and to what level real interest rates may travel and the resulting impact on expected returns for fixed income asset classes. This year’s Capital Market Forecast assumes US inflation will average 2% over the next seven years, in line with the Federal Reserve’s explicit target. The difference in yield between nominal and inflation adjusted bonds for seven year maturities is close to 2% today, suggesting the market believes this target to be credible. Our conclusion is that regardless of whether interest rates rise to a new lower level or back to their long-run averages and regardless of whether they do so slowly or quickly, today’s low yield levels imply very low expected real rates of returns. Safe assets today offer primarily a bulwark to strategies when risk assets suffer duress, especially over short horizons. At such low levels of starting yields, the additional duration and credit risk taken to boost the building block’s secondary income generation role needs to be assessed very carefully. The next chapter, Market Risk: The Opportunity International Markets Now Present, discusses how we build up expected returns for global equity markets: the sum of starting dividend yield, expected dividend growth and a prospective valuation adjustment. We look at the major underlying regions of the broadest measure of the global equity market opportunity set and conclude how attractively international markets, such as Japan and several emerging markets, are priced relative to US markets, which increases the likelihood they will deliver superior returns over the next market cycle. We examine the sensitivity of our results to our key assumptions. Those assuming US equity valuations can stay elevated via a lower equity risk premium if fixed income rates were to rise do not have the historical evidence on their side. T h e A r t & Sc i e n c e o f I n v e s t i n g

5

After reviewing the outlook for public markets, Manager Skill: The Role of Active Management in Strategies discusses the benefits and challenges of asking active managers to improve the odds of strategies attaining their goals. We conclude that in today’s environment, Manager Skill can be additive to portfolios in a specialist defensive role, if it is able to provide protection beyond what an allocation to Safe can deliver during times of Market Risk duress. Manager Skill would have to deliver true equity risk mitigation properties (positive returns during a sustained Market Risk bear market) to be worth the complications when investing in hedge funds today. Ultimately, engaging active management to add value to a strategy is based on the assumption that past performance will persist, and the odds of success are increased only if investors are willing to be both very patient and suffer some inconvenience at an implementation level. In the chapter Private Capital: Improving the Odds of Capturing the Illiquidity Premium we acknowledge that while there has been a dramatic increase in assets allocated to Private Capital in recent years, with careful attention to the factors that improve the odds of capturing the illiquidity premium, we believe certain private markets are poised to return a premium to public markets over time, warranting the long lock up of capital. Using our criteria, we remain on the lookout for new managers in interesting areas outside of our core allocation to private equity, such as in natural resources and the health care sectors. In the final chapter, Strategy Design: Maximizing the Probability of Attaining Investor Goals, we use the assumptions developed throughout the Capital Markets Forecast to design strategies that optimize returns for a given level of risk and liquidity appetite under two scenarios for public markets: a more pessimistic scenario (full mean reversion of interest rates back to their long-run average slowly within Safe and full mean reversion of valuation levels within Market Risk); and a more optimistic one (interest rates revert back to half their long-run average quickly and valuation levels within Market Risk only revert back to half their long-run averages). Though the more optimistic scenario is our base case, we show that strategy weights across building blocks are not particularly sensitive to which scenario unfolds. We illustrate how each strategy maximizes the probability of attaining a given absolute return goal for a given risk budget and liquidity appetite. We explore the trade-offs between Public Markets and Fully Diversified strategies and contrast their appropriateness for strategies that need to support spending in a sustainable way. We conclude there are several ways to attain an inflation + 5% goal, but each involves a different journey to the ultimate destination and probability of success. Public Markets strategies are likely to exhibit higher volatility levels than Fully Diversified strategies (which by design should deviate significantly away from public market volatility for extended periods of time) and come with much greater risk of loss in exchange for a higher potential of exceeding a given goal.

CONCLUSION Throughout this year’s Capital Markets Forecast, we present a range of scenarios that may unfold over the next market cycle. There are many unknowns, such as uncertainty surrounding global central bank policy and how interest rates and underlying fundamentals affect valuation levels. This analysis shows how we are able to construct strategies to withstand a variety of outcomes so that our clients will maximize the probability of achieving their goals no matter which scenario unfolds.

capital markets forecast 2015

Liquid and Safe How Interest Rate Changes May Impact Fixed Income Returns

S

afe assets primarily play a role as a “shock absorber” to strategies, with the goal of providing protection when risk assets experience short-term duress. Secondarily, they provide income while managing against interest rate fluctuations, credit risks,

unanticipated movements in inflation and currency movements. The steady return stream from a combination of these assets is an important part of strategy design, as they are normally uncorrelated with other asset classes. Safe tends to be high quality corporate and government bonds with a calculable return. The bulk of the return of fixed income usually derives from “clipping the coupons” of the bond as it is held to maturity. Another (albeit smaller) contributor to return is the change in interest rates while holding the bond. As interest rates fall, bond prices rise. The past 30 years has been anything but typical for fixed income. With interest rates peaking in the early 1980s, markets have seen a continual slide in rates, providing a very accommodative backdrop for fixed income returns. Last year brought a long-awaited signal from the Federal Reserve that the stance of monetary policy may change for the first time since late 2008, as they ended their “quantitative easing” process of buying bonds to keep interest rates at historically low levels. Therefore, as we prepare for 2015 and beyond, the landscape of the bond market and subsequent opportunities it may provide are much different than they have been in the past. Instead of trying to predict what the Federal Reserve is going to do over the coming years and pinpoint how the market will be affected, here we consider an array of future scenarios for expected Safe returns, choosing the role of planner over that of a prophet.

T h e A r t & Sc i e n c e o f I n v e s t i n g

7

The steady return stream from a combination of these assets is an important part of strategy design, as they are normally uncorrelated with other asset classes.

OBSERVATIONS ON THE CURRENT ENVIRONMENT Interest rates are at historical lows and while many believe the first hike in short-term interest rates won’t come before summer or fall of 2015, the timing is unknown. The Federal Reserve has suggested rates will remain there for a “considerable” time following the end of its asset purchase program in October 2014. Three main factors likely will influence this timing: labor market conditions; indicators of inflation pressures; and inflation expectations and readings on financial developments. If these or other factors are to surprise to the upside or downside, they would impact when and how much shortterm interest rates move and how rates in the bond market will react over longer maturities as well. As shown in the figure below, short- and long-term interest rates have been on a secular decline since the mid-1980s. The Federal Reserve spent much of the 1980s fighting inflation, which set up a long period of disinflation in the 1990s. After the stock market bubble burst in 2000, it has fought deflation, resorting to highly unconventional methods in the aftermath of the 2008 financial crisis. In order to analyze the range of potential outcomes for the Liquid and Safe building blocks, we reviewed the three month and 10 year US Treasury yields dating back to 1954, monthly yield to worst levels of the Barclays US Aggregate Index dating back to 1976, the Federal Funds Rate dating back to 1954 and Consumer Price Index inflation data dating back to 1954.

Figure 2: Interest Rate Comparison: Short- and Long-term Treasury Rates, % 18 16

10 Year Treasury 3 Month T Bill

14 12 10 8 6 4 2 0 1954

1959

1964

1969

1974

1979

1984

1989

1994

1999

2004

2009

-2

Source: Balentine, FactSet

capital markets forecast 2015

2014

Liquid and Safe

We used the 3-month US Benchmark Bond for the Liquid building block; as of the end of November 2014, this had a yield of 0.01% and a duration of .16 years. For Safe, we considered the Barclays US Aggregate Index (yield of 2.2% and duration of 5.5 years as of November 30, 2014) and the Barclays Global Aggregate Index, (yield of 1.6% and duration of 6.5 years as of November 30, 2014). This year’s Capital Market Forecast assumes US inflation will average 2% over the next seven years, in line with the Federal Reserve’s explicit target. The difference in yield between nominal and inflation-adjusted bonds for seven-year maturities is close to 2% today, suggesting the market believes this target to be credible. For our scenario analyses of rising rates, inflation was assumed to move in step with rates ending up at 2.0% in 2021. Inflation remained 1.5% in the scenario where rates dropped. As seen in the figure below, for the past 60 years, the average real yield on the 3-month Treasury is 1.24% and 2.73% on the 10 year. It is important to consider real yields, as it is the true premium over inflation investors demand to bear risk. Figure 3: Real Treasury Yields, %

Real 3 Month Yield Real 10 Year Yield Average 3 Mo. Real Yield Average 10 Year Real Yield

12 10 8 6

2.73

4

1.24

2 0 -2 -4 -6 1955

1960

1965

1970

1975

1980

Source: Balentine, FactSet

T h e A r t & Sc i e n c e o f I n v e s t i n g

1985

1990

1995

2000

2005

2010

9

POTENTIAL FUTURE SCENARIOS While there are myriad potential outcomes that can unfold over the next seven years, we believe each of them would fall into one of the following four broad categories: 1. Rates rise and return to historical averages – a “Normal” scenario 2. Rates rise but to a level lower than that of the historical average – a “New Normal” scenario 3. Rates remained unchanged 4. Rates decrease Given where we have come from over the last three decades, the current long-term trend (Figure 2) gives us reason to believe that while rates may rise, there is a good chance they will peak at a lower level than in the past. We have a much more indebted economy as a whole since the early 1980s, implying that it is much more sensitive to small changes in interest rates today. Within each of these possible categories, there is another variable to consider: time horizon. Rates could either move in a quick and uneven fashion or slowly and smoothly to their new destination over the coming years. In fact, as our simulations show, how they travel to that destination is a more substantial factor in return than where they end up. In order to capture the full range possible outcomes along with the path rates take, we model below these possible scenarios for the Liquid and Safe building blocks: 1. Scenario A - Rates increase to long run average quickly 2. Scenario B - Rates increase to long run average smoothly 3. Scenario C - Rates increase to a new lower level quickly 4. Scenario D - Rates increase to a new lower level smoothly 5. Scenario E - Rates remain unchanged 6. Scenario F - Rates decrease to a lower level quickly (Safe Only as Liquid Rates are at 0% today) 7. Scenario G - Rates decrease to a lower level smoothly (Safe Only as Liquid Rates are at 0% today)

capital markets forecast 2015

Liquid and Safe

ANCHORING ON REAL YIELDS TO approximate A DESTINATION The long-run average for the 3-month and 10-year yields gives us a reasonable approximation of where interest rates could end up. While this would indicate a move back to a “Normal” scenario, we need to account for a “New Normal” scenario too. What could such a “New Normal” look like? While we cannot say for certain, we believe it would be an environment where real cash yields are zero for the foreseeable future and long-term rates stay below their historical averages. This reasoning led us to settle on the following destinations for rates: 1. Liquid Building Block a. Normal: 3.25% - This would indicate a return to a long run average real yield, assuming 2.0% inflation. b. New Normal: 2.0% - This would indicate a real yield of zero, where an investor would only keep pace with inflation. 2. Safe Building Block a. Normal: 4.75% - This would indicate a return to a long run average real yield, assuming 2.0% inflation. b. New Normal: 3.5% - With a zero real yield on cash, this rate assumes a spread of 1.5% on the 10 year compared to the 3 month. It is worth noting we are describing two specific points on the yield curve. It is within the realm of possibilities that the 3-month and 10-year do not move in tandem and that fixed income investors mold the yield curve into a shape we cannot predict. Figure 4 below shows what the yield curve looks like today, compared to what it could look like given these two rising rate scenarios.

7 6

Yield (%)

Figure 4: Yield Curves: Today v. Normal and New Normal Environments

Current Yield Curve Normal The New Normal

Under a “Normal” environment, the yield curve would exhibit a continual upward slope as investors seek incremental yield for holding longer dated bonds.

5 4 3

A “New Normal” curve could be much flatter as investors seek yield in spite of maturity.

2 1 0 3 Mo

5

10

15

20

25

30

T h e A r t & Sc i e n c e o f I n v e s t i n g

Source: Balentine, FactSet

11

ExPECTED RetURN SIMULATIONS The potential destinations and scenarios described above allow us to calculate expected returns over the next seven years for the various benchmarks for our Liquid and Safe building blocks. Figure 5 (below) illustrates this calculation for the Barclays Aggregate Index under a Normal Scenario and shows how expected returns change depending on how quickly or slowly interest rates rise. Figure 5: Illustrative Expected Return for Safe (Barclays Aggregate Index) under a Quick and Slow Adjustment to a Normal Environment (Scenarios A and B) Scenario A: Barclays Aggregate – Rates Returned to Long Run Average Quickly 2014

2015

2016

2017

2018

2019

2020

2021

Year End Yield

2.2%

3.5%

4.1%

4.4%

4.6%

4.7%

4.7%

4.8%

Year End Inflation

1.5%

1.8%

1.9%

1.9%

2.0%

2.0%

2.0%

2.0%

-7.0%

-3.5%

-1.7%

-0.9%

-0.4%

-0.2%

-0.2%

∆Price from Rate Change 1 Year Total Return Including Yield

-4.1%

0.3%

2.5%

Growth of $100

$100

$95.88

$96.18

$98.61

$102.20

3.6%

$106.49

4.2%

$111.25

4.5%

$116.27

4.5%

Inflation Adjusted Growth of $100

$100

$94.11

$92.63

$93.17

$94.73

$96.82

$99.22

$101.71

We use this methodology to calculate expected returns for each of our scenarios for both Liquid and Safe as illustrated in Figure 6 on page 12 and summarized for Safe in Figure 7 on page 14.

Scenario B: Barclays Aggregate – Rates Returned to Long Run Average Smoothly 2014

2015

2016

2017

2018

2019

2020

2021

Year End Yield

2.2%

2.6%

3.0%

3.3%

3.7%

4.0%

4.4%

4.8%

Year End Inflation

1.5%

1.6%

1.7%

1.7%

1.8%

1.9%

1.9%

2.0%

-2.0%

-2.0%

-2.0%

-2.0%

-2.0%

-2.0%

-2.0%

0.4%

0.8%

1.1%

1.5%

1.9%

2.2%

2.6%

∆Price from Rate Change 1 Year Total Return Including Yield Growth of $100

$100

$100.42

$101.21

$102.36

$103.89

$105.82

$108.16

$110.95

Inflation Adjusted Growth of $100

$100

$98.81

$97.93

$97.35

$97.05

$97.04

$97.31

$97.87

Source: Balentine

capital markets forecast 2015

Figure 6: Scenarios on a Year-by-Year Basis Liquid Building Block Long Run Average: Quickly-A End of Year Yield

2014

2015

2016

2017

2018

2019

2020

2021

0.0%

1.6%

2.4%

2.8%

3.0%

3.1%

3.2%

3.2%

Calendar Year Return

--

0.5%

1.9%

2.6%

2.9%

3.1%

3.2%

3.2%

Cumulative Return

--

0.5%

2.5%

5.1%

8.1%

11.5%

15.0%

18.7%

Growth of $100 – Nominal

$100

$100.54

$102.45

$105.09

$108.15

$111.48

$115.01

$118.70

Growth of $100 – Real

$100

$98.77

$98.79

$99.41

$100.34

$101.44

$102.63

$103.87

Long Run Average: Smoothly-B

2014

2015

2016

2017

2018

End of Year Yield

2019

2020

2021

0.0%

0.5%

0.9%

1.4%

1.9%

2.3%

2.8%

3.3%

Calendar Year Return

--

0.2%

0.6%

1.1%

1.6%

2.0%

2.5%

2.9%

Cumulative Return

--

0.2%

0.8%

1.9%

3.5%

5.6%

8.2%

11.3%

Growth of $100 – Nominal

$100

$100.16

$100.79

$101.89

$103.47

$105.55

$108.17

$111.35

Growth of $100 – Real

$100

$98.56

$97.52

$96.89

$96.64

$96.78

$97.31

$98.22

2014

2015

2016

2017

2018

2019

2020

2021

0.0%

1.0%

1.5%

1.8%

1.9%

1.9%

2.0%

2.0%

Increase to lower level: Quickly-C End of Year Yield Calendar Year Return

--

0.3%

1.2%

1.6%

1.8%

1.9%

1.9%

2.0%

Cumulative Return

--

0.3%

1.5%

3.1%

5.0%

7.0%

9.0%

11.2%

Growth of $100 – Nominal

$100

$100.34

$101.51

$103.12

$104.97

$106.96

$109.04

$111.19

Growth of $100 – Real

$100

$98.57

$97.86

$97.51

$97.34

$97.25

$97.21

$97.18

2014

2015

2016

2017

2018

2019

2020

2021

0.0%

0.3%

0.6%

0.9%

1.1%

1.4%

1.7%

2.0%

Increase to lower level: Smoothly-D End of Year Yield Calendar Year Return

--

0.1%

0.4%

0.7%

1.0%

1.2%

1.5%

1.8%

Cumulative Return

--

0.1%

0.5%

1.2%

2.1%

3.4%

5.0%

6.9%

Growth of $100 – Nominal

$100

$100.10

$100.49

$101.17

$102.14

$103.40

$104.98

$106.88

Growth of $100 – Real

$100

$98.50

$97.23

$96.19

$95.38

$94.78

$94.39

$94.21

2014

2015

2016

2017

2018

2019

2020

2021

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

Remain unchanged: E End of Year Yield Calendar Year Return

--

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

Cumulative Return

--

0.0%

0.0%

0.0%

0.0%

0.1%

0.1%

0.1%

Growth of $100 – Nominal

$100

$100.01

$100.02

$100.03

$100.04

$100.05

$100.06

$100.07

Growth of $100 – Real

$100

$98.47

$96.96

$95.47

$94.01

$92.57

$91.15

$89.76

Source: Balentine

T h e A r t & Sc i e n c e o f I n v e s t i n g

13

Safe Building Block Long Run Average: Quickly-A End of Year Yield Calendar Year Return Cumulative Return

2014

2015

2016

2017

2018

2019

2020

2021

2.2%

3.5%

4.1%

4.4%

4.6%

4.7%

4.7%

4.8%

--

-4.1%

0.3%

2.5%

3.6%

4.2%

4.5%

4.5%

-4.1%

-3.8%

-1.4%

2.2%

6.5%

11.3%

16.3%

Growth of $100 – Nominal

$100

$95.88

$96.18

$98.61

$102.20

$106.49

$111.25

$116.27

Growth of $100 – Real

$100

$94.11

$92.63

$93.17

$94.73

$96.82

$99.22

$101.71

2014

2015

2016

2017

2018

2019

2020

2021

2.2%

2.9%

3.2%

3.3%

3.4%

3.5%

3.5%

3.5%

Increase to lower level: Quickly-C End of Year Yield

--

Calendar Year Return

--

-1.0%

1.3%

2.4%

2.9%

3.2%

3.4%

3.4%

Cumulative Return

--

-1.0%

0.3%

2.7%

5.7%

9.1%

12.8%

16.6%

Growth of $100 – Nominal

$100

$99.05

$100.31

$100.70

$105.72

$109.13

$112.80

$116.61

Growth of $100 – Real

$100

$97.27

$96.68

$97.11

$98.05

$99.26

$100.62

$102.01

2014

2015

2016

2017

2018

2019

2020

2021

2.2%

2.4%

2.6%

2.8%

3.0%

3.1%

3.3%

3.5%

Increase to lower level: Smoothly-D End of Year Yield Calendar Year Return

--

1.3%

1.5%

1.7%

1.9%

2.0%

2.2%

2.4%

Cumulative Return

--

1.3%

2.9%

4.6%

6.5%

8.7%

11.1%

13.8%

Growth of $100 – Nominal

$100

$101.33

$102.85

$104.59

$106.54

$108.72

$111.15

$113.19

Growth of $100 – Real

$100

$99.72

$99.55

$99.50

$99.57

$99.74

$100.04

$100.44

2014

2015

2016

2017

2018

2019

2020

2021

2.2%

2.2%

2.2%

2.2%

2.2%

2.2%

2.2%

2.2%

Remain unchanged: E End of Year Yield Calendar Year Return

--

2.2%

2.2%

2.2%

2.2%

2.2%

2.2%

2.2%

Cumulative Return

--

2.2%

4.5%

6.9%

9.3%

11.7%

14.2%

16.8%

Growth of $100 – Nominal

$100

$100.24

$104.53

$106.87

$109.27

$111.71

$114.22

$116.77

Growth of $100 – Real

$100

$100.70

$101.40

$102.11

$102.82

$103.54

$104.26

$104.99

decrease quickly: F End of Year Yield Calendar Year Return Cumulative Return

2014

2015

2016

2017

2018

2019

2020

2021

2.2%

1.7%

1.4%

1.3%

1.2%

1.2%

1.1%

1.1%

--

5.1%

3.1%

2.1%

1.6%

1.4%

1.2%

1.2%

5.1%

8.3%

10.6%

12.4%

13.9%

15.4%

16.7%

Growth of $100 – Nominal

$100

$105.08

$108.34

$110.62

$112.41

$113.95

$115.36

$116.73

Growth of $100 – Real

$100

$103.54

$105.15

$105.75

$105.82

$105.64

$105.32

$104.94

decrease smoothly: G End of Year Yield Calendar Year Return Cumulative Return

--

2014

2015

2016

2017

2018

2019

2020

2021

2.2%

2.1%

1.9%

1.8%

1.6%

1.4%

1.3%

1.1%

--

3.1%

2.9%

2.7%

2.6%

2.4%

2.3%

2.1%

3.1%

6.0%

8.9%

11.7%

14.4%

17.0%

19.4%

Growth of $100 – Nominal

$100

--

$103.05

$106.03

$108.93

$111.73

$114.42

$117.00

$119.44

Growth of $100 – Real

$100

$101.51

$102.88

$104.10

$105.17

$106.09

$106.84

$107.43

Source: Balentine

capital markets forecast 2015

Liquid and Safe

Figure 7: Expected Returns for Safe (Barclays Aggregate Bond Index) under Various Scenarios Scenario

7 Year Annualized Return

A. Increase to long run average quickly

2.2%

B. Increase to long run average smoothly

1.5%

C. Increase to new lower level quickly

2.2%

D. Increase to new lower level smoothly

1.9%

E. Rates remain unchanged

2.2%

F. Decrease to lower level quickly

2.2%

G. Decrease to lower level smoothly

2.6%

$120 $115 $110 $105

Scenario A

$100

Scenario B Scenario C

$95

Scenario D Scenario E

$90

Scenario F $85

Scenario G

$80 2014

2015

2016

2017

Source: Balentine

T h e A r t & Sc i e n c e o f I n v e s t i n g

2018

2019

2020

2021

15

CONCLUSIONS Regardless of the level and path of interest rates, due to today’s low level of starting yields, a relatively tight range of outcomes is seen after seven years for the Safe building block. There is not significantly more upside to Safe returns if yields were to decline further from today’s low yield level. There are a handful of scenarios where the volatility of returns on a year-by-year basis is higher, but returns tend to converge around 2%. The reasoning behind this is simple. In the scenarios where rates rise quickly, the investor takes a larger loss on their capital up front but begins clipping coupons at a greater rate. The flip side of that scenario is rates move up slowly, cause a less dramatic decrease in capital, but force the investor to earn less per year due to a lower yield. The other interesting conclusion from this scenario analysis is that the quicker interest rates move, the better off the investor is in the long run. While this is sure to cause some short-term discomfort as a large increase in rates can cause a substantial haircut to asset prices, the investor quickly makes up for the cut by earning higher interest rates. This is an important point to bear in mind in the coming years, as a withdrawal of capital from the Safe building block at the wrong time can have lasting effects. All of these scenarios are possible over the next seven years. Our view is that the most likely outcome that will unfold will be Scenario C: interest rates rising to a new lower level quickly. Figure 2 shows the historical trends in interest rates and how each peak in the interest rate cycle since the mid-1980s has occurred lower than the previous peak, as the economy has become more indebted as a whole. This coupled with rates rarely breaching their long-term average over the past decade leads us to believe rates will increase but to a level below their long run average. We think that the momentum that the economy appears to have picked up in the last two years will lead the Federal Reserve to normalize monetary policy well before 2021. In sum, that suggests an expected return of 1.5% for Liquid building block and an expected return of 2.2% for our Safe building block. That is a real capital loss for Liquid exposure and a barely positive Safe real rate of return given our inflation assumption of 2%. Liquid and Safe assets today offer primarily a bulwark to strategies when risk assets suffer duress, especially over short-horizons. At such low levels of starting yields, the additional duration and credit risk taken to boost Safe’s secondary income generation role needs to be assessed very carefully.

capital markets forecast 2015

MARKET RISK The Opportunity International Equity Markets Now Present

M

arket Risk is the most volatile building block within our strategies. Within it, we seek to capture public market returns as they are driven by exposure to underlying economic growth, earnings and current and expected future interest rates. Our

approach to forecasting such asset classes recognizes that the projected return of any asset is composed of two components: the yield on the asset plus any change in the asset’s price. More specifically for equities, we decompose our projection into three components: the starting dividend yield, expected dividend growth and an expected valuation adjustment. Starting dividend yield reflects the initial income we can anticipate to obtain from the investment, whereas dividend growth and valuation change drive the shift in price we can presume to see. Globally, we see today’s starting dividend yield and projected dividend growth as relatively healthy; however, as in the past few years, we do see risk in valuation adjustment in the US, as we believe the Federal Reserve’s low interest-rate policies have pushed price levels ahead of the recovery in fundamentals. If history is a guide, we believe valuations will revert to levels more in line with historical norms, whether by equity value declines or by more robust earnings growth. The key question in our minds, and thus the key metric in guiding our equity allocations moving forward, is whether this adjustment takes place gradually with meager returns looking out over the long run or rapidly with more reasonable expected rates of return after the sharp initial valuation decline.

T h e A r t & Sc i e n c e o f I n v e s t i n g

17

Market Risk is the most volatile building block within our strategies. Within it, we seek to capture public market returns as they are driven by exposure to underlying economic growth, earnings and current and expected future interest rates.

STARTING DIVIDEND YIELD Despite the emphasis paid toward capital gains since 1982, starting dividend yield continues to provide a large percentage of gains. As can be seen in Figure 8 below, since 1970, dividend yield has provided 300 basis points (bps) of annual return, or around 30% of the 10.1% average annual return of the S&P 500. Figure 8: Return Decomposition of the S&P 500 since 1970 10000% +10.1% Dividend Growth Dividend Yield +6.7%

Total % 1000%

+3.0%

+0.3%

0%

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Cumali ve Return (Logarithmic Scale)

Valua on Adjustment

Source: Balentine using Robert Shiller data.

Most investors find it not surprising that dividend yield was the primary driver of equity returns before 1970 given the overall meager capital returns during that period5. Where we believe many investors are surprised is the amount of return investors achieved from dividend yields during the strong growth years of 1982-2000 given the strong capital gains during that period as well as the shift from dividends to share repurchases as a the preferred method of cash return to shareholders. Our starting dividend yields for 2015 by region are in Figure 9. For the global equity index we use the MSCI All Country World Index (ACWI) benchmark and estimate a starting dividend yield of 2.5%, with yields in the US and Japan at the low end of the range at 1.9%, modestly higher yields of 2.8% in Emerging Markets and with the highest yields in the international developed countries, averaging 4.8%. These figures, in aggregate, compare more favorably to starting yields a year ago; yields in the large cap US and emerging markets are relatively similar whereas yields in US small cap and international developed markets are substantively higher. 5 Though there were some strong up years during that period, overall capital returns averaged only 1.2% between 1970 and 1982, as valuation declines offset earnings growth.

capital markets forecast 2015

Market Risk

Figure 9: Starting Dividend Yields by Region Region

Dividend Yield

Australia

3.7%

Brazil

4.3%

Canada

1.9%

China

3.2%

France

3.3%

Germany

2.7%

Hong Kong

3.9%

India

1.5%

Indonesia

2.7%

Italy

2.7%

Japan

1.6%

Malaysia

3.1%

Mexico

1.7%

Poland

3.4%

Russia

2.8%

South Africa

2.7%

South Korea

1.1%

Spain

4.7%

Sweden

3.7%

Switzerland

3.1%

Taiwan

2.9%

Thailand

3.4%

Turkey

1.5%

United Kingdom

4.6%

United States

2.5%

Source: Balentine using Strategas data

T h e A r t & Sc i e n c e o f I n v e s t i n g

While the US and Japan have similar low yields, we believe the drivers for each country are different. In the US, while dividend payouts have increased steadily over the last few years on the back of record profit margins, valuations have increased even more quickly, thus driving down yields. In Japan, conversely, we believe low yields stem less so from valuation increases and more so from underwhelming dividend growth that has only recently begun to take hold on the back of government economic initiatives.

EXPECTED DIVIDEND GROWTH In deriving our projected dividend growth assumption, we researched and aggregated the projected return on equity and projected dividend payout ratios of over 41,000 global companies. Our assumption was that the companies, on average, should be able to grow their dividends by an amount equal to the prior year’s profit they retained in the firm (retention ratio) multiplied by the amount they project management can return on that incremental equity. What we found is that the growth rates were, in general, surprisingly robust, with most regions projected to grow in excess of 4%. Moreover, several regions are poised to show growth in excess of 6%, with the United States large cap companies leading the way with growth in excess of double digits (Figure 10).

19

Figure 10: Projected Regional Dividend Growth Using Return on Equity and Retention Ratios Return on Equity

Retention Ratio

Projected Growth

17.1%

69.6%

11.9%

4.6%

11.9%

0.6%

15.3%

67.6%

10.3%

Canada

7.6%

16.0%

1.2%

Europe

8.9%

40.8%

3.6%

Japan

7.6%

81.5%

6.2%

Australia

11.2%

14.6%

1.6%

Latin America

10.7%

51.7%

5.5%

Europe/Russia

11.0%

80.1%

8.8%

Africa/Middle East

12.0%

34.2%

4.1%

United States – Large Cap United States – Small Cap United States

Asia

10.4%

62.0%

6.5%

Total

10.9%

59.3%

6.5%

Source: Balentine and Aswath Damodaran (Stern School of Business at NYU)

The conclusion from the data is that the retention ratio is a larger driver of projected growth than the return on equity. Our projected growth rates are 88% correlated with our retention ratio estimates, while only 58% correlated with our projected returns on equity. As a result, it would follow that companies that retained more of their earnings to reinvest into company initiatives were more likely to have more robust growth than those who paid out more capital to shareholders, even in the cases where those companies exhibited superior returns on equity. While this makes theoretical sense, practically speaking this is not the case. Research has shown that companies with larger payouts actually achieve more in earnings growth, owing mainly to poor reinvestment choices as managers reinvest retained earnings in projects that experience diminishing marginal return. As a result, we are more inclined to project dividend growth based on projected economic growth since earnings growth cannot exceed economic growth in the long run. This does not mean that growth in real earnings and/or real dividends in the short run cannot exceed economic growth; it most certainly can, as we have seen in the U.S. over the last few years. However, on a long-term basis, as shown in Figure 11, corporate earnings and dividends, are capped by economic growth per capita.

capital markets forecast 2015

Market Risk Figure 11: In the Long Run, Growth in Earnings and Dividends Cannot Exceed GDP Growth Per Capita

10000

Real GDP Real GDP per Capita Real Earnings Real Dividends

1000

100

1871 1874 1877 1880 1883 1886 1889 1892 1895 1898 1901 1904 1907 1910 1913 1916 1919 1922 1925 1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012

10

Source: Balentine and Robert Shiller and Groningen Growth and Development Centre

At first glance, the relationship between economic growth and earnings growth may seem surprising, with the logical expectation that real earnings growth should track more closely with real economic growth rather than real economic growth per capita. However, upon further inspection, this is not that case, as total economic growth is a function of growth in existing enterprises and also from as-of-yet in-existence enterprises that will require additional capital partially from the population growth of the economy. As a result, growth in real earnings is really a measure of productivity, whereas overall economic growth is a function of economic productivity as well as population growth. Thus, growth in real earnings and real dividends tracks real economic growth per capita, which is also a productivity measure. In fact, dividend growth has never substantively exceeded growth in per capita GDP for a sustained period of time. Moreover, dividend growth has never exceeded per capita GDP growth by more than 10 bps for any 40-year period6.

See Arnott, R. and Bernstein, P. (2002)”What Risk Premium is ‘Normal’?” Financial Analysts Journal March/April Vol. 58 Issue: 2. These estimates for expected future dividend growth can be triangulated from another angle: extensive research conducted by Jeremy Siegel and Jeremy Schwartz has shown that dividend growth on average can be expected to outpace future inflation by 1% (see www.wisdomtree.com) 6

T h e A r t & Sc i e n c e o f I n v e s t i n g

21

Figure 12: Projected Regional Growth Figures using Nominal GDP Per Capita

Growth in Nominal GDP per Capita United States

4.0%

Canada

3.8%

Europe, Australia, Far East Index (EAFE)

3.5%

EAFE ex-Japan, ex-Australia

3.6%

Japan

3.2%

Australia

3.6%

Emerging Markets

6.3%

Latin America

5.2%

Europe/Africa/Middle East

5.7%

Asia

6.8%

All Country World Index (ACWI)

4.1%

Source: Balentine and Economic Research Service at the United States Department of Agriculture and Trading Economics

EXPECTED VALUATION ADJUSTMENT As referenced earlier, valuation adjustment is the key risk in our equity returns assumption. In the 2014 Capital Markets Forecast, we discussed the reliability of using the cyclically adjusted PE ratio (CAPE) to measure this risk. At this juncture, we believe the current US valuation (current CAPE of 27.03) is closer to an extreme than its long-run average (Figure 13). CAPE Price E10 Ra o 50 2000

45

Current level of 27.03 implies large mean reversion

40

Price-Earnings Ra o (CAPE, P/E10)

A year ago, valuations were high relative to economic and earnings potential during the year, and we felt that asset prices were more a function of valuation expansion from central bank intervention. At the end of 2014, valuations have grown more expensive, with the current CAPE valuation ranging from the 80th to 95th percentile, as shown in Figure 14. Historical evidence suggest that investors can expect greater future equity returns at extreme lows and poorer future equity returns at extreme highs, as can be seen in Figure 15.

35

1929

30

2007 1901

1966

25 20

2003

15 2009

10 5

Figure 13: Current Valuation of the US Market is Closer to an Extreme Than Fair Value

1921

1982

1932

0 1880

1900

1920

1940

1960

1980

2000

Source: Balentine and Robert Shiller

capital markets forecast 2015

2020

Market Risk

Figure 14: Current US Equity Valuations Look Pricey in a Historical Context Across Multiple Eras Time Period

Current CAPE Percentile

Median CAPE

Implied Overvaluation

1881 – Present

95th

16.0

69%

1921 – Present

92nd

16.2

67%

1969 – Present

86th

18.4

47%

1982 – Present

80th

21.6

25%

Source: Balentine and Robert Shiller

Figure 15: The Inverse Relationship between Future Equity Returns and Valuation is more Significant at Extreme Valuations 7

Relationship between Starting Valuation and 7-Year Equity Returns between 1970 and 2007 R-Squared All Years

24.4%

Years between 25th and 75th Percentile

28.8%

Years between 5th and 95th Percentile

90.3%

Source: Balentine and Robert Shiller

EXPECTED RETURNS FOR GLOBAL EQUITY MARKETS Figure 16 summarizes the results of using this methodology to forecast equity returns for the developed and developing countries that constitute the MSCI All Country World benchmark. Given the importance of the valuation risk component, we simulate the sensitivity of our results under three scenarios: where a full valuation adjustment occurs over the next seven years; where only half of the valuation adjustment occurs over the next seven years; and where no valuation adjustment occurs over the next seven years (as if markets were fairly priced today).

The R-Squared statistic measures the percentage of variation in a variable that can be explained by its dependency on another. 7

T h e A r t & Sc i e n c e o f I n v e s t i n g

23

Figure 16: Expected Returns for Market Risk (All Country World Index) Under Three Scenarios Market

Current Shiller PE

Max Shiller PE

Median Shiller PE

Min Shiller PE

25th Percentile Shiller PE

75th Percentile Shiller PE

EPS Inception Date

Valuation Adj. (7 Year Half)

Valuation Adj. (7 Year Half)

Dividend Yield

Div. Growth Rate

Nominal GDP Cap

Expected Return (Full)

Expected Return (Half)

Expected Return (No Val Adj.)

ACWI Weight (Est.)

United States

26.32

44.2

18.4

6.6

11.8

24.9

1969

-5.0%

-2.3%

2.5%

7.3%

4.1%

1.4%

4.2%

6.7%

54.36%

Canada

20.25

60.3

19.1

6

14.1

27.9

1969

-0.8%

-0.4%

1.9%

1.2%

4.3%

5.4%

5.9%

6.3%

3.60%

Australia

16.38

30.4

16.4

7.5

14.1

19.8

1969

0.0%

0.0%

3.7%

1.5%

3.9%

7.8%

7.8%

7.7%

2.48%

Japan

23.55

91.6

38.4

15.4

23.6

60.7

1969

7.2%

4.0%

1.6%

6.2%

4.1%

13.4%

10.0%

5.8%

9.30%

Hong Kong

18.96

32.4

18.1

8.2

14.6

19.9

1972

-0.7%

-0.3%

3.9%

6.4%

8.8%

12.3%

12.7%

13.0%

1.09%

France

14.26

57.3

19.3

6.1

14.4

27.2

1971

4.4%

2.4%

3.3%

3.0%

1.5%

9.5%

7.3%

4.8%

3.35%

Germany

16.37

57.0

17.8

7.8

14.9

22.9

1969

1.2%

0.6%

2.7%

4.3%

2.4%

6.4%

5.8%

5.2%

3.15%

9.93

53.5

22.2

6.4

10.2

25.8

1984

12.2%

7.1%

2.7%

(7.0%)

1.1%

16.5%

11.2%

3.8%

0.83%

Spain

11.98

39.1

15.8

6.9

12.3

23.5

1980

4.0%

2.1%

4.7%

(4.1%)

0.5%

9.5%

7.5%

5.2%

1.20%

Sweden

19/13

81

20.6

4.8

16.6

26.5

1969

1.1%

0.5%

3.7%

6.1%

1.0%

5.9%

5.3%

4.7%

1.06%

Switzerland

22.6

56.8

19.3

7.0

15.5

26

1969

-2.2%

-1.1%

3.1%

1.4%

0.7%

1.5%

2.7%

3.8%

3.23%

United Kingdom

12.49

26.2

14.7

6.0

12.3

17.4

1969

2.4%

1.2%

4.6%

5.0%

3.2%

10.5%

9.3%

7.9%

7.22%

China

14.63

48.6

18.5

10.6

15.7

26.0

1995

3.4%

1.8%

3.2%

7.2%

8.3%

15.6%

13.8%

11.8%

2.20%

India

20.04

48.8

23.1

16.0

18.6

29.0

1994

2.1%

1.1%

1.5%

5.0%

10.5%

14.5%

13.3%

12.2%

0.63%

Indonesia

21.49

69.2

24.3

9.9

20.3

29.4

1992

1.8%

0.9%

2.7%

8.1%

10.8%

15.8%

14.8%

13.8%

0.32%

Malaysia

19.76

35.2

21.6

16.3

20.5

23.9

1992

1.3%

0.7%

3.1%

5.1%

6.0%

10.7%

10.0%

9.3%

0.34%

South Korea

12.92

28.6

16.7

12.1

14.3

23.0

1995

3.7%

2.0%

1.1%

7.4%

5.3%

10.4%

8.6%

6.5%

1.39%

Taiwan

19.27

28.6

19

11.2

17.4

22.2

1995

-0.2%

-0.1%

2.9%

4.6%

4.6%

7.4%

7.5%

7.6%

1.16%

Thailand

18.7

147.9

20.8

11.7

18.4

64.5

1992

1.5%

0.8%

3.4%

7.3%

5.8%

11.1%

10.3%

9.4%

0.25%

Brazil

10.85

28.5

16.4

9.2

12.2

19.8

1994

6.1%

3.3%

4.3%

1.0%

9.9%

21.6%

18.4%

14.6%

0.84%

Mexico

23.38

39.3

23.7

12.4

20.2

25.7

1992

0.2%

0.1%

1.7%

10.3%

7.2%

9.2%

9.1%

9.0%

0.54%

Poland

11.02

28.0

14.7

9.3

11.4

20.6

1995

4.2%

2.2%

3.45

3.2%

3.6%

11.6%

9.5%

7.1%

0.15%

Russia

5.12

24.3

7.4

5.0

6.2

8.9

1996

5.4%

2.9%

2.8%

8.6%

13.0%

22.4%

19.5%

16.2%

0.38%

South Africa

20.95

26.9

18.7

14.5

17.4

21.7

1995

-1.6%

-0.8%

2.7%

5.0%

10.0%

11.2%

12.1%

13.0%

0.75%

Turkey

11.19

25.6

13.6

6.5

11.2

16.4

1992

2.8%

1.5%

1.5%

9.1%

12.6%

17.5%

16.0%

14.3%

0.19%

Italy

100%

ACWI Weighted Avg. Expected Return (Full)

ACWI Weighted Avg. Expected Return (Half)

ACWI Weighted Avg. Expected Return (No Val Adj.)

5.4%

6.3%

6.9%

Source: Aswath Damodaran (NYU Stern School of Business), USDA Economic Research Service, Trading Economics, Strategas, Cambria Quantitative Research, Research Affiliates, Balentine

capital markets forecast 2015

Market Risk CONCLUSIONS The analysis yields several interesting conclusions. Global equity returns are expected to be in the range of 5.4% - 6.9%, regardless of which valuation adjustment scenario unfolds. Consistent with our base case that interest rates will only rise to half their long-run average, our view is that the most likely outcome is for valuations to revert back to half their long-term mean, generating an expected return of 6.3% for the Market Risk All Country World benchmark. Eighty percent of the markets by number do not face a valuation headwind: the glaring exception is the large US market. While anticipated returns for US equities benefit from higher than average expected dividend growth from productivity gains, today’s price levels have moved furthest ahead of the recovery in global equity fundamentals since the lows of 2009. Generally speaking, markets in the developing world (Emerging Markets) offer the highest expected returns through a combination of above-average starting yields and expected dividend growth, and a strong valuation tailwind, especially in the larger Brazilian, Russian, Indian and Chinese markets. Within the large developed international markets, Japan is a standout in terms of higher expected returns over the next market cycle, boosted by higher than average expected dividend growth and very attractive valuation levels. European markets in general also look priced to outperform US equities over the next market cycle, with a higher than average starting dividend yield and moderately attractive valuations. However, unlike Japan, expected returns there continue to be constrained by weaker dividend growth from inferior productivity gains. These observations only serve to highlight the importance of policies aiming to boost long-run productivity growth as a source of equity returns. Today Japan appears to be introducing more aggressive structural reforms in this regard than Europe. While we are confident that US valuations will revert toward a long run average well below where they are today, we are unsure about which path they will take to get there. On the one hand, they may revert slowly over time through some combination of equity price declines and earnings growth, while on the other hand they may revert quickly. While the latter scenario may ostensibly be worse for near-term equity returns, it increases the likelihood of above-average, longer–run returns if valuations revert to a more normalized level sooner. The single largest driver of which scenario will unfold is the level of interest rates. If the risk-free rate remains low like it does today, then market risk assets could likely remain elevated, thus delivering lower future returns. If, however, the risk-free rate appreciates to a more normalized level, then while asset values in the short term may decline to reprice the discount rate, the assets would then be priced for better expected returns over the long run. Another measure of equity valuation, the equity risk premium (the difference between the expected return for Market Risk and Safe), currently hovers around 4%. This figure is in line with historical averages, implying that stocks could be fairly valued. However, we do not believe that this 4% is analogous to the 4% we have seen throughout history. Instead, we believe today’s 4% equity risk premium is induced by abnormal Federal Reserve interest rate policy over the last five years (very low expected returns from Safe). In the absence of the Fed’s zero interest rate policy, we believe current valuations would have to be lower in order to justify the 4% historical equity risk premium. Otherwise, we suspect the equity risk premium would likely be far lower.

T h e A r t & Sc i e n c e o f I n v e s t i n g

25

Empirical data over the last 50 years suggests that lower risk-free interest rates generally beget a lower equity risk premium. We believe this relationship has weakened somewhat over the last 10 years as the Federal Reserve has effected lower-than-normal interest rates in the wake of the bursting of the Internet bubble and the subsequent bursting of the housing bubble. It is our view that investors during the last 10 years have felt the need to chase risk given the alternative of ever-lower risk-free rates, thus spawning an artificially high equity risk premium that has been more representative of investors chasing yield than of their belief in compelling equity valuations. As the Federal Reserve is potentially poised to unwind some of its interest rate policies, we believe the equity risk premium may be poised to go higher as historical evidence suggests. This likely would be the result of substantive valuation adjustments. Those assuming US equity valuations can stay elevated via a lower equity risk premium if fixed income rates were to rise do not have the historical evidence on their side.

capital markets forecast 2015

Manager Skill The Role of Active Management in Strategies

M

anager Skill assets are allocated to highly active managers who seek to generate excess returns over the medium term by managing towards an absolute return target8. Key to success in investing in Manager Skill is to recognize that the value

of such “pure” active management takes several years, often close to a full market cycle, to capture. Another factor for success is the manager’s ability and willingness to be out of lock step with the market for extended periods of time in order to profit from long-term contrarian thinking. Broad global mandates, a concentrated expression of their views and the ability to buy securities “long” and sell them “short” are often hallmarks of this approach. Manager Skill can play both the role of offense in generating returns and defense in providing an additional shock absorber to strategies. Which role we ask them to play depends on our view of the starting point for the investable opportunity set. For example, when Market Risk assets are priced for above-average returns, such as in early 2009, long-only concentrated active managers would have a tailwind for enhancing returns and the odds of success. Since 2010, when risk assets have generally been priced for average prospective returns, we have asked Manager Skill to play both offense and defense simultaneously, with varying degrees of emphasis (slightly more offense in 2010 – 2012, slightly more defense in 2012 – 2014) through a diversified program of hedge funds. For this reason we have used the HFRI Fund of Funds benchmark as a broad measure of the opportunity set.

Managers who manage to a benchmark relative to a market index in our view should be viewed as candidates for implementation within Public Market Safe and Market Risk exposure against an efficient and representative index vehicle where available. Concentrated “long-only” active managers or hedge funds are the most commonly found expressions of Manager Skill. 8

T h e A r t & Sc i e n c e o f I n v e s t i n g

27

Key to success in investing in Manager Skill is to recognize that the value of such “pure� active management takes several years, often close to a full market cycle, to capture.

WHAT TYPE OF MANAGER SKILL IS NEEDED TODAY? Investing in hedge funds adds a layer of complexity, especially for taxable clients. We have mitigated some of their lack of liquidity and opacity in the vehicles we use, staying true to our philosophy of implementing using the most liquid, simple and transparent vehicles possible. Given this and the changing environment we see, what role should Manager Skill play today to be worth the potential inconvenience? As we have argued in the previous chapters on Safe and Market Risk expected returns, for the first time in several years we see a clear opportunity for above-average returns from investing in selected international stock markets within Market Risk. We expect returns to fall somewhere between 5.4% and 6.9% from investing in that area, depending on how future valuation levels revert back to their average values. We concluded that Safe assets are most likely to yield an expected return between 1.5% and 2.2% depending on how quickly and how much interest rates normalize. The answer to our question lies in whether adding Manager Skill to a strategy investing in public market Safe and Market Risk only can significantly improve the probability of a strategy attaining its goals (essentially by improving its expected returns, or by lowering its risk without compromising on expected returns). Figure 17 below examines the relationship between various benchmarks across the investable opportunity set over the last 10 years, by calculating their correlation and sensitivity to the direction of domestic stocks (Beta) as measured by the S&P 500 index, using monthly data. Figure 17: Correlation of Various Benchmarks within Liquid, Safe, Market Risk and Manager Skill and sensitivity to domestic stocks, 2005 - 2014

Indicates statistical significance at the 95% confidence level

10 YEAR Volatility and CORRELATION TABLE 10 Yr. Volatility

3 Mth. T-Bill

0.5%

1.00

3.2%

0.00

Barclays US Aggregate

Barclays Global Aggregate

Barclays Municipal

S&P 500

MSCI ACWI

60/40 S&P 500/Agg

HFRI Fund of Funds

HFRX Macro/ CTA

HFRI Defensive

10 Year Beta with MSCI ACWI

10 Yr. Beta with S&P 500

Liquid 3 Month T-Bill

0.00

0.00

0.02

0.01

0.15

0.13

0.03

0.03

Safe Barclays US Aggregate

1.00

Barclays Global Aggregate

5.7%

0.04

0.70

1.00

Barclays Municipal

4.4%

-0.08

0.54

0.32

1.00

Market Risk S&P 500

14.7%

-0.07

0.04

0.32

0.11

1.00

MSCI ACWI

16.5%

0.00

0.09

0.44

0.13

0.96

1.00

60/40 S&P 500/Agg

8.9%

-0.07

0.19

0.42

0.19

0.99

0.95

1.00

HFRI Fund of Funds

5.5%

0.10

-0.04

0.23

0.13

0.70

0.80

0.68

1.00

HFRX Macro/CTA

7.3%

0.15

0.02

0.16

-0.10

0.06

0.16

0.06

0.43

1.00

HFRI Defensive

5.2%

0.21

-0.03

0.25

-0.04

0.19

0.31

0.18

0.58

0.75

0.85

1.00

1.00

1.08

0.52

0.60

0.27

0.26

0.07

0.03

0.10

0.07

Manager Skill

Source: Balentine using Factset data

1.00

capital markets forecast 2015

manager skill

Several important observations stand out. Clearly Liquid (3-month Treasury Bill) and high quality domestic Safe (Barclays US Aggregate, Barclays Municipal bond index) exposure provide the most uncorrelated risk, reducing exposure to a strategy invested only in Market Risk (the domestic S&P 500 index or the global ACWI index). Adding 40% Safe exposure to Market Risk remains the most efficient first step in diversifying a portfolio but only lowers its sensitivity to the stock market direction by 40% and volatility to 8.9%. Stock market volatility is so much higher than other asset classes that even a 60% allocation to stocks still allows it to dominate the risk profile of a public market 60% stock /40% bond strategy. When considering hedge funds, the most diversifying type of Manager Skill to add to strategies emphasizes global Macro Traders and Commodity Trading Advisors (as measured by the HFRX Macro / CTA benchmark), as they are uncorrelated with both Safe and Market Risk. Defensive hedge funds (HFRI Defensive) offer similar diversifying properties, but they have not offered as much return as the HFRI Macro/CTA index over time. Crucially, the broad hedge fund index, the HFRI Fund of Funds Index, is highly correlated with both Market Risk and the 60% stock/ 40% bond portfolio, calling into question the value of adding such broadly diversified Manager Skill into the mix (the HFRI Fund of Funds Index has generated a seven year average annualized return of 5.1%, albeit at lower volatility). Figure 18: Diversifying Power of Various Types of Defensive Manager Skill

10 Year Rolling Correla ons – S&P 500 Index 1.0

0.5

0.0 Barclays Aggregate 60/40 Stock Bond HFRI FOF

-0.5

HFRX Macro/CTA HFRI Defensive

-1.0

2008

2009

2010

2011

2012

Source: Balentine using Factset and Hedge Fund Research data

T h e A r t & Sc i e n c e o f I n v e s t i n g

2013

2014

29

CONCLUSIONS Given the expected returns of 5.4% - 6.9% for Market Risk from today’s starting point, Manager Skill can be additive to portfolios in a specialist defensive role, if it is able to provide protection beyond what an allocation to Safe can provide during times of Market Risk duress. Manager Skill would have to generate returns in the range of 5%-7% and offer negative correlations (for example positive returns of 3%-5% in a sustained Market Risk bear environment) to warrant the additional complications that arise when investing in hedge funds. Figure 17 suggests that can be achieved with a volatility of no more than 7%. Today, it no longer seems worthwhile trying to play both offense and defense through Manager Skill using hedge funds when there are now clearer opportunities to capitalize on in Market Risk more simply and efficiently from today’s starting point in international markets. Not all hedge fund strategies offer a high probability of playing that true equity risk mitigation role. Broadly diversified hedge funds (as measured by the HFRI Fund of Fund Index) are too correlated with public markets given the opportunities they offer today. A greater emphasis towards Defensive and Global Macro/CTA strategies is more consistent with our more specialist defensive expectations for Manager Skill to be additive to strategies today. For this reason the HFRX Macro/CTA benchmark should be used in addition to the HFRI Fund of Fund index when evaluating how Manager Skill fulfills its role. Selecting and combining managers to execute on these customized objectives for Manager Skill involves deep due diligence and a conservative evaluation of their track records over several market cycles. Each manager’s response to different types of environments in the past is key to building confidence in their ability to repeat past performance in the expected future environment and that their skill or edge has not eroded over time. Attention should be paid to simulating portfolio construction to maximize the probability of attaining the expected return of 5%, risk of 7% and low to negative correlation with equities properties of Manager Skill. Ultimately engaging active management to add value to a strategy is based on the assumption that past performance will persist, and the odds of success are increased only if investors are willing to be very patient and suffer some inconvenience at an implementation level.

capital markets forecast 2015

Private Capital Improving the Odds of Capturing the Illiquidity Premium

I

nvestments in Private Capital are highly illiquid and in exchange for that are expected to achieve strong returns over the long term significantly in excess of what public markets offer to enhance income generation and capital appreciation. We have always advocated

for the merits of a Private Capital allocation for clients with time horizons of 10 years or more and who have an appropriate allocation across their remaining assets to withstand market volatility and meet spending needs. The environment that bolstered public market equities over the last two years has also benefited private market returns. Low interest rates have facilitated recapitalizations, and strong equity and IPO markets have supported exit strategies. As can be seen from the increasing spread between private and public market returns in Figure 19 below, the longer the investment horizon, the more the illiquidity premium remains evident.

Figure 19: US Private Equity and Venture Index Returns v. Public Markets through 12/31/2013 For the Periods Ending December 31, 2013

1 Year

3 Years

5 Years

CA US Private Equity

20.6

14.9

15.8

CA US Venture Capital

27.2

15.4

12.5

10 Years

15 Years

20 Years

25 Years

14.0

12.1

13.6

13.6

9.7

22.6

30.8

20.7

6.5

10.2

11.2

Other Indices DJIA

29.7

15.7

16.7

7.4

NASDAQ Composite*

38.3

16.3

21.5

7.6

4.4

8.8

10.0

Russell 2000 Composite

38.8

15.7

20.1

9.1

8.4

9.3

10.2

S&P 500

32.4

16.2

17.9

7.4

4.7

9.2

10.3

Sources: Cambridge Associates LLC, Dow Jones & Company, Inc., Frank Russell Company, Standard and Poor’s , and Thomson Datastream * Capital Changes Only

T h e A r t & Sc i e n c e o f I n v e s t i n g

31

We have always advocated for the merits of a Private Capital allocation for clients with time horizons of

10 years or more and who have an appropriate allocation across their remaining

assets to withstand market volatility and meet spending needs.

CAPTURING THE ILLIQUIDITY PREMIUM As Figure 19 also illustrates, staying committed to a private capital allocation is important to capture the full benefit it provides. We view Private Capital as a strategic allocation, not a tactical one, and an income and return enhancer, less so a diversifier. Of course the components of returns will vary by the type of strategy. For example, within private natural resources, income generation is a key component to its expected total return. Some of the other factors that are key to improving the success of capturing the illiquidity premium are as follows: •A ccess – looking to managers whom we expect to provide top quartile returns among their peer group over time (typically an annualized 4%-5% premium to public market returns, or 1.5-1.6 times that of public markets over time). •T erms – looking to managers who are closely aligned with their investors with thoughtful fee structures. •A differentiated approach - looking to managers who access their given space with a different mindset and criteria. •P atience – looking to managers who will forego the opportunity to launch a fund or deploy capital. •D iversification – diversifying exposure over several vintage years (the year in which a fund begins making investments) as an allocation is built up over time. How we are able to balance these factors drives our decision to implement using a diversified fund-of-funds or a more concentrated direct approach. To account for return of capital that often occurs before the capital committed to a Private Allocation has been fully invested, we recommend an overcommitment of 1.3-1.5 times our target allocations. Within Private Capital, we consider the opportunity to surround a significant core allocation to private equity (buy-out, venture and special situations) with exposure to other private asset class strategies. In the past we have allocated to private real estate and today are emphasizing an allocation to diversified private natural resources for its inflation hedging and yield generating attributes. We also recommend what we believe to be a unique allocation to the health care sector in appropriate circumstances.

capital markets forecast 2015

Private Capital INFLATION HEDGING: NATURAL RESOURCES We currently recommend a targeting weight of 30% of Private Capital to natural resources. Given the many discrete and varied sub sectors in this asset class, we feel that a fund of funds approach is the most efficient way to deploy assets, allowing underlying managers to focus their expertise across mining, timber, farmland and oil and gas. We chose a manager who we have known for some time and who possesses a deep history of expertise in the asset class emanating from the mid-1990s. Along with their expertise in the asset class, we selected this particular manager because they have a differentiated approach. Rather than gain value through more traditional financial re-engineering frequently seen in private equity, they place diversification at the forefront and look to invest in the operators of real assets, offering protection in an inflation surprise but also collecting yield along the way. As such, the portfolio is constructed to have a positive correlation to inflation but a negative correlation to equities and bonds. The foray into natural resources was based upon the general premise that there is an increasing demand for resources that are generally limited in supply. There are several reasons for the demand side picture including, but not limited to: increased demand for resources from a growing global middle class, increased infrastructure development in the developing world, political instability in countries rich in natural resources which can further limit supply and the impacts of increased regulation and environmental concerns. Of course this supply/demand picture is not constant. The ability to innovate, such as the recent U.S. fracking boom, can change that balance dramatically. Seasoned managers, particularly those who have the benefit of a longer time horizon through private capital, can capitalize on these innovations and look at the investment opportunities fracking might create. For example, during the height of the shale boom, many larger companies divested more conventional production operation properties which were not what shareholders were looking for them to own. Smaller private oil and gas companies were able to purchase these properties, improve efficiency and create profitable businesses.

SPECIAL SITUATION: HEALTH CARE Today we also recommend a fund that we believe has a unique approach to investing in private healthcare companies, a high growth sector of the economy, in appropriate circumstances. One of the many appealing traits we found with this strategy was their differentiated process. In their structure, limited partners utilize their own expertise to catalyze change at the company level and facilitate the outcome of the underlying investments. While this is not a requirement of investors, the premise that an investor can have an influence creates what we perceive to be a unique format and network of expertise that may better the odds of underlying company success. It also may create an incentive for a portfolio company to choose this team over others, which can be a valuable differentiator as an increasing number of investors look to deploy capital in the private markets. The firm’s overarching premise is to marry investments with operational expertise. In order to achieve that end, it enhances the expertise of its general partners by surrounding them with a strong group of limited partners who invest both their personal and intellectual capital to further the fund’s success.

T h e A r t & Sc i e n c e o f I n v e s t i n g

33

CONCLUSIONS While past performance is not predictive of future returns and one cannot ignore the dramatic increase in assets allocated to Private Capital in recent years, with careful attention to the factors that improve the odds of capturing the illiquidity premium, we believe certain private markets are still poised to return a premium to public markets over time, warranting the long lock up of capital. We remain continually on the lookout for new managers in interesting areas using our criteria. Building a thoughtful allocation to Private Capital may be especially relevant to entrepreneurs who have sold their operating business and are looking to replace its return and income generation properties.

capital markets forecast 2015

Strategy Design Maximizing the Probability of Attaining Investor Goals

I

n this final chapter, we use the assumptions developed in Safe, Market Risk, Manager Skill and Private Capital to design strategies that optimize returns for a given level of risk and liquidity appetite. We explore two scenarios:

Scenario 1: Full mean reversion of interest rates back to their long-run average slowly within Safe and full mean reversion of valuation levels within Market Risk (more pessimistic for expected returns). Scenario 2: Interest rates revert back to half their long-run average quickly and valuation levels within Market Risk only revert back to half their long-run averages (more optimistic for expected returns). While we think Scenario 2 is most likely to occur for reasons already discussed, we think it prudent to build in a margin of safety by examining if strategies should be designed differently in case the more pessimistic Scenario 1 unfolds.

CAPITAL MARKET ASSUMPTIONS We use the expected returns developed for each scenario for the Barclays Aggregate Bond Index for Safe and the All Country World Index for Market Risk9. The attribution of our 15-year track record for our Public Markets strategies shows that it is reasonable to expect us to be able to add an annualized 0.5% outperformance within Safe and 2% outperformance within Market Risk over a full market cycle through our active rebalancing and implementation decisions. We estimate risk by calculating the standard deviation of each of the benchmarks using monthly data over the last 10 years. We use a 5% expected return with 7% risk for actively managed strategies within Manager Skill, as we require today. The expected return for Private Capital is a weighted average of our expectation for private equity and private natural resources. We assume we are able to capture a 5% premium to Market Risk from investing in private equity and a 10% internal rate of return to investing in private natural resources and develop an expected return based on a 70%: 30% mix between the two10. We estimate risk by calculating the standard deviation of the Cambridge Associates Private Equity index and the MSCI Commodity Producer’s Index using quarterly data over the last 10 years. We do not use the Barclays Aggregate Global Bond index as the benchmark for Safe as its risk and correlation properties against Market Risk are too high for the objectives we have set for Safe for US based investors, as shown in the chapter discussing Manager Skill. Currency risk is an active decision we take within Safe today.

9

These return assumptions are motivated by the criteria we use to maximize the odds of capturing the illiquidity premium we discussed in the chapter on Private Capital. They are also supported by evaluating the blended track record of the managers we use in this area and our expectations of their ability to repeat that performance in the future environment.

10

T h e A r t & Sc i e n c e o f I n v e s t i n g

35

Despite the strong performance of domestic stocks and bonds in 2012-2014, a broadly diversified strategy that is proactively rebalanced through time has a much higher probability of success and lower risk of impairment of capital when the goal is to attain or exceed inflation

+ 5% over the next market cycle.

These are summarized in Figure 20. Figure 20: Expected Return and Risk Assumptions Across Building Blocks Scenario 1:

Safe

Market Risk

Manager Skill

Private Capital

Expected Return

2.0%

7.4%

5.0%

10.4%

Expected Volatility

3.2%

16.5%

7.0%

11.1%

Safe

Market Risk

Manager Skill

Private Capital

Expected Return

2.7%

8.3%

5.0%

11.0%

Expected Volatility

3.2%

16.5%

7.0%

11.1%

Scenario 2:

Sources: Balentine

Figure 21 summarizes the correlation matrix we used. It recognizes the explicit equity risk mitigation role we are asking Manager Skill to play with a negative correlation against Market Risk. It also acknowledges that Private Capital returns are likely to depend significantly on Market Risk returns with a positive correlation, as they require healthy equity markets to exit strategies and capture the illiquidity premium. Since the premise behind our building block approach is to group up asset classes with similar underlying return drivers and risk characteristics, we assume a zero correlation for Safe across all other building blocks. Figure 21: Correlation Assumptions Across Building Blocks

Correlation Matrix

Safe

Market Risk

Manager Skill

Private Capital

Safe

1

0.0

0.0

0.0

Market Risk

0.0

1

-0.2

0.8

Manager Skill

0.0

-0.2

1

-0.2

Private Capital

0.0

0.8

-0.2

1

Sources: Balentine

capital markets forecast 2015

Strategy Design PUBLIC MARKETS AND FULLY DIVERSIFIED STRATEGIES We first optimized expected returns for a variety of risk budgets by blending the Safe and Market Risk building blocks only to explore the Public Markets strategy opportunity set. To create Fully Diversified strategies, we re-optimized by including Manager Skill in the opportunity set (to a maximum of 25%) and then included Private Capital (to a maximum of 10%, 15% and 20% respectively). Figure 22 shows the risk budgets we used to design Public Markets and Fully Diversified strategies. Figure 22: Public Markets and Fully Diversified Strategy Risk Budget.

Public Market

Fully Diversified

Aggressive

25%

20%

Growth

20%

15%

Balanced

15%

10%

Conservative

10%

5%

Maximum peak to trough drawdown in value on a rolling annual basis with 95% probability. Sources: Balentine

Figure 23 summarizes the results.

T h e A r t & Sc i e n c e o f I n v e s t i n g

37 Figure 23: Public Markets and Fully Diversified Strategies

Scenario 1

Scenario 2

(Full Equity Valuation Adj, Rates to

(Half Equity Valuation Adj, Rates to half of

long term average slowly)

long term average quickly)

Public Markets Aggressive Safe Market Risk

Expected Return Expected Volatility Expected Yield

Expected Drawdown

Public Markets

Growth

Balanced

Conservative

Aggressive

0.0%

20.0%

40.0%

60.0%

Safe

100.0%

80.0%

60.0%

40.0%

Market Risk

7.4%

6.3%

5.2%

4.2%

Expected Return

16.5%

13.2%

10.0%

6.9%

Expected Volatility

2.5%

2.3%

2.1%

1.9%

Expected Yield

-25.6%

-20.1%

-14.7%

-9.6%

Expected Drawdown

Public Markets w/Private Capital @10% Aggressive

Balanced

Conservative

0.0%

15.0%

35.0%

55.0%

Safe

90.0%

75.0%

55.0%

35.0%

Market Risk

Manager Skill

0.0%

0.0%

0.0%

0.0%

Private Capital

10.0%

10.0%

10.0%

10.0%

Market Risk

Expected Return Expected Volatility Expected Yield

Expected Drawdown

-24.7%

-19.3%

-15.2%

-10.0%

40.0%

0.0%

0.0%

0.0%

Private Capital

10.0%

10.0%

10.0%

10.0%

6.9%

5.8%

4.7%

Expected Return

13.3%

10.0%

6.9%

Expected Volatility

2.3%

2.1%

1.9%

1.7%

Expected Yield

-23.8%

-19.7%

-14.3%

-9.1%

Expected Drawdown

8.6%

8.0%

6.9%

5.8%

15.8%

14.1%

10.9%

7.7%

2.3%

2.2%

2.2%

2.1$

-22.9%

-20.2%

-14.8%

-9.6%

Public Markets w/Private Capital @15%

55.0%

35.0%

Market Risk

Manager Skill

0.0%

0.0%

0.0%

0.0%

Private Capital

15.0%

15.0%

15.0%

15.0%

Aggressive

Growth

Balanced

Conservative

0.0%

10.0%

25.0%

45.0%

85.0%

75.0%

60.0%

40.0%

Manager Skill

0.0%

0.0%

0.0%

0.0%

Private Capital

15.0%

15.0%

15.0%

15.0%

7.9%

7.3%

6.2%

5.2%

Expected Return

15.4%

13.7%

10.5%

7.4%

Expected Volatility

2.1%

2.0%

1.8%

1.6%

Expected Yield

-22.9%

-20.2%

-14.8%

-9.6%

Expected Drawdown

Public Markets w/Private Capital @20%

8.7%

8.1%

7.3%

6.2%

15.4%

13.7%

11.3%

8.1%

2.1%

2.1%

2.1%

2.0%

-22.1%

-19.3%

-15.3%

-10.1%

Public Markets w/Private Capital @20%

Growth

Balanced

0.0%

10.0%

25.0%

45.0%

Safe

80.0%

70.0%

55.0%

35.0%

Market Risk

Manager Skill

0.0%

0.0%

0.0%

0.0%

Private Capital

20.0%

20.0%

20.0%

20.0%

Expected Drawdown

2.3%

0.0%

75.0%

Expected Yield

2.4%

Manager Skill

85.0%

Expected Volatility

2.4%

50.0%

Safe

Expected Return

7.6%

2.5%

60.0%

50.0%

Market Risk

5.2%

80.0%

30.0%

Safe

6.3% 10.8%

90.0%

7.7%

Aggressive

7.2% 13.2%

Conservative

10.0%

Expected Drawdown

8.3% 16.5%

30.0%

0.0%

Expected Yield

45.0%

Balanced

Conservative

Expected Return

65.0%

10.0%

Balanced

Expected Volatility

80.0%

Growth

Growth

Market Risk

55.0%

100.0%

0.0%

Public Markets w/Private Capital @15% Safe

Conservative

35.0%

Aggressive

15.8%

Aggressive

Balanced

20.0%

Public Markets w/Private Capital @10%

Growth

Safe

Growth

0.0%

Conservative

Aggressive

Balanced

Conservative

0.0%

5.0%

25.0%

45.0%

80.0%

75.0%

55.0%

35.0%

Manager Skill

0.0%

0.0%

0.0%

0.0%

Private Capital

20.0%

20.0%

20.0%

20.0%

8.0%

7.5%

6.7%

5.6%

Expected Return

15.0%

13.4%

11.0%

7.8%

Expected Volatility

2.0%

1.9%

1.8%

1.6%

Expected Yield

-22.1%

-19.3%

-15.3%

-10.0%

Expected Drawdown

Growth

8.8%

8.6%

7.4%

6.3%

15.0%

14.2%

11.0%

7.8%

2.0%

2.0%

1.9%

1.9%

-19.9%

-14.5%

-9.3%

-21.2

These strategic weights provide a guidepost for current tactical policy. We rebalance portfolios around these strategic weights opportunistically within the ranges noted in Figure 25. Sources: Balentine

capital markets forecast 2015

Figure 23: Public Markets and Fully Diversified Strategies

Scenario 1

Scenario 2

(Full Equity Valuation Adj, Rates to

(Half Equity Valuation Adj, Rates to half of

long term average slowly)

long term average quickly)

fully diversified

fully diversified

Aggressive

Growth

Balanced

Conservative

0.0%

10.0%

30.0%

50.0%

Safe

Market Risk

80.0%

65.0%

45.0%

25.0%

Manager skill

20.0%

25.0%

25.0%

25.0%

Safe

Expected Return Expected Volatility Expected Yield

Expected Drawdown

Aggressive

Balanced

Conservative

0.0%

5.0%

25.0%

45.0%

Market Risk

85.0%

70.0%

50.0%

30.0%

Manager skill

15.0%

25.0%

25.0%

25.0%

6.9%

6.3%

5.2%

4.1%

Expected Return

13.0%

10.5%

7.3%

4.4%

Expected Volatility

2.0%

1.8%

1.6%

1.4%

Expected Yield

-19.1%

-14.8%

-9.5%

-4.8%

Expected Drawdown

fully diversified w/Private Capital @10% Aggressive Safe

Growth

Conservative

25.0%

25.0%

Manager Skill

10.0%

25.0%

25.0%

25.0%

10.0%

10.0%

Private Capital

10.0%

10.0%

10.0%

10.0%

25.0%

25.0%

Private Capital

10.0%

10.0%

7.3%

6.8%

6.0%

4.7%

Expected Return

13.1%

10.6%

8.2%

4.5%

Expected Volatility

1.9%

1.6%

1.4%

1.2%

Expected Yield

-18.9%

-14.4%

-10.4%

-4.3%

Expected Drawdown

fully diversified w/Private Capital @15% Conservative

1.6%

1.6%

1.5%

-19.7%

-15.1%

-9.8%

-4.8%

Conservative 35.0%

Market Risk

75.0%

60.0%

45.0%

25.0%

25.0%

Manager Skill

10.0%

25.0%

25.0%

25.0%

15.0%

15.0%

Private Capital

15.0%

15.0%

15.0%

15.0%

75.0%

60.0%

40.0%

20.0%

Manager Skill

10.0%

25.0%

25.0%

Private Capital

15.0%

15.0%

7.6%

7.3%

6.2%

5.1%

Expected Return

13.6%

11.1%

7.9%

4.9%

Expected Volatility

1.9%

1.5%

1.3%

1.1%

Expected Yield

-19.6%

-14.9%

-9.5%

-4.7%

Expected Drawdown

fully diversified w/Private Capital @20%

Growth

8.4%

7.9%

7.0%

5.9%

13.6%

11.1%

8.6%

5.6%

1.9%

1.5%

1.5%

1.4%

-18.9%

-14.2%

-10.2%

-5.2%

fully diversified w/Private Capital @20%

Balanced

Conservative

Aggressive

Balanced

Conservative

0.0%

0.0%

15.0%

35.0%

75.0%

60.0%

40.0%

20.0%

Manager Skill

5.0%

20.0%

25.0%

25.0%

Private Capital

20.0%

20.0%

20.0%

20.0%

0.0%

0.0%

15.0%

35.0%

Safe

75.0%

55.0%

40.0%

20.0%

Market Risk

Manager Skill

5.0%

25.0%

25.0%

25.0%

Private Capital

20.0%

20.0%

20.0%

20.0%

Expected Drawdown

5.2%

2.0%

15.0%

Market Risk

Expected Yield

5.5%

8.2%

Balanced

Safe

Expected Return

6.6%

0.0%

40.0%

Expected Volatility

7.8% 11.4%

0.0%

20.0%

Market Risk

8.2% 14.0%

Aggressive

0.0%

Safe

Growth

fully diversified w/Private Capital @15%

Balanced

0.0%

Growth

-5.3%

40.0%

15.0%

Aggressive

-10.2%

45.0%

Manager Skill

Expected Drawdown

-15.5%

65.0%

20.0%

Expected Yield

-19.9%

80.0%

45.0%

Expected Return

1.7%

Market Risk

60.0%

Expected Volatility

1.8%

Conservative

75.0%

Safe

1.9%

20.0%

Market Risk

Growth

5.1%

2.1%

Balanced

Safe

Aggressive

5.0%

8.1%

0.0%

45.0%

Expected Drawdown

6.1%

0.0%

20.0%

Expected Yield

7.2% 11.3%

Aggressive

5.0%

Expected Return

7.8% 13.9%

fully diversified w/Private Capital @10%

Balanced

0.0%

Expected Volatility

Growth

7.9%

7.4%

6.6%

5.5%

Expected Return

14.2%

10.7%

8.3%

5.3%

Expected Volatility

1.9%

1.4%

1.2%

1.0%

Expected Yield

-20.4%

-14.0%

-10.0%

-5.1%

Expected Drawdown

Sources: Balentine

T h e A r t & Sc i e n c e o f I n v e s t i n g

Growth

8.7%

8.2%

7.2%

6.1%

14.2%

11.5%

8.3%

5.3%

1.9%

1.5%

1.3%

1.3%

-14.9%

-9.4%

-4.5%

-19.6

39

Strategy Design OBSERVATIONS The recommended weights across building blocks are not particularly sensitive to whether the more pessimistic Scenario 1 or more optimistic Scenario 2, our base case, develops. At the margin, slightly more Safe and less Market Risk are required under Scenario 1 than Scenario 2 where in certain instances expected returns and volatility are higher. Outside of Aggressive strategies, the optimization reaches for the maximum allocation for Manager Skill, which we constrained to a maximum of 25%11. Due to its diversifying properties (negative correlation with Market Risk), introducing Manager Skill makes Fully Diversified strategies about 15 – 30% less volatile than their Public Markets counterparts at approximately the same level of expected return. The introduction of Private Capital boosts returns more than it increases risk and is funded from allocations to Market Risk. For Aggressive and Growth strategies, Private Capital allocations at 15% or more are funded partially from Manager Skill as well. When making allocations to Private Capital, careful consideration to a strategic liquidity policy is required. Our recommended liquidity policy is to keep one year’s worth of expected spending (including capital calls) net of strategy yield in Liquid reserves and a further one year’s worth in Safe assets12.

THE EFFECT OF SPENDING ON A PORTFOLIO The higher expected return per unit of risk for Fully Diversified strategies means spending is more sustainable from such strategies than their Public Markets counterparts. Figure 24 below illustrates how the probability of invading capital in real terms while supporting spending is reduced significantly by deploying a Fully Diversified Growth strategy over a Public Markets Growth Strategy. It simulates the Best, Median and Worst-case outcomes of the two strategies when the goal is to maintain the value of a portfolio of $5,000,000 in real terms while supporting annual withdrawals of 5%. Figure 24: Sustainability of 5% Spending Fully Diversified Growth v. Public Markets Growth Strategy

Public Markets Growth 5% Spending Rate 1 Year

10 Year

0%

$7,997,579

$29,297,920

$71,909,327

25%

$5,476,254

$7,161,021

$9,443,850

50%

$5,017,664

$5,143,526

$5,201,134

75%

$4,598,398

$3,594,676

$2,394,697

100%

BEST Median WORST

20 Year

$3,341,615

$285,397

$0

Average

$5,056,968

$5,680,854

$6,916,756

Goal

$5,000,000

$5,000,000

$5,000,000

% Success

51%

52%

52%

Sources: Balentine

11 This constraint reflects our view that though Manager Skill improves the efficiency of our strategies, an additional layer of risk to our forecast of it reaching its objectives is introduced by relying solely on active management (“alpha”, not “beta”) to fulfill its potential. 12 Our Liquidity Policy means that Aggressive strategies with a zero strategic target to Safe assets are not appropriate to support spending needs.

capital markets forecast 2015

Strategy Design

Figure 24: Sustainability of 5% Spending Fully Diversified Growth v. Public Markets Growth Strategy

Fully Diversified Growth 5% Spending Rate 1 Year

10 Year

0%

$7,541,036

$24,827,008

$59,353,554

25%

$5,439,786

$7,325,154

$10,272,570

50%

$5,045,009

$5,525,772

$6,282,788

75%

$4,679,899

$4,084,382

$3,478,324

100%

BEST Median WORST

20 Year

$3,557,026

$680,291

$0

Average

$5,074,329

$5,936,330

$7,652,932

Goal

$5,000,000

$5,000,000

$5,000,000

% Success

53%

59%

61%

Sources: Balentine

BUILDING BLOCK STRATEGIC RANGES AND CONSTRUCTION RULES Figure 25 lists the minimum and maximum ranges across our building blocks around these strategic weights set for each strategy. These ranges balance our desire to rebalance across building blocks over the next market cycle based on tactical opportunities we see against the need to ensure that strategies remain on course to reach their objectives without breaching their risk budgets. All but our most Aggressive strategies have some minimum allocation to Safe.

T h e A r t & Sc i e n c e o f I n v e s t i n g

41 Figure 25: Minimum and Maximum Ranges for Building Blocks By Strategy

Strategic Weight*, Public Markets Portfolios (%) Aggressive

Growth

Minimum

2015 Strategic

Maximum

Minimum

2015 Strategic

Maximum

SAFE

0

0

50

5

20

60

MARKET RISK

50

100

100

40

80

95

EXPECTED RETURN

8.3%

7.2%

EXPECTED MAXIMUM DRAWDOWN

-25%

-19%

BALANCED

CONSERVATIVE

Minimum

2015 Strategic

Maximum

Minimum

2015 Strategic

Maximum

SAFE

20

35

75

35

55

100

MARKET RISK

25

65

80

0

45

65

EXPECTED RETURN

6.3%

5.2%

EXPECTED MAXIMUM DRAWDOWN

-15%

-10%

*Allocations of Private Capital up to 25% are funded from Market Risk and are subject to Liquidity Policy

Strategic Weight*, Fully Diversified Portfolios (%) Aggressive Minimum

2015 Strategic

Growth Maximum

Minimum

2015 Strategic

Maximum

SAFE

0

0

50

5

5

50

MARKET RISK

50

85

100

40

70

85

MANAGER SKILL

0

15

50

10

25

55

EXPECTED RETURN

7.8%

7.2%

EXPECTED MAXIMUM DRAWDOWN

-20%

-15%

BALANCED

CONSERVATIVE

Minimum

2015 Strategic

Maximum

Minimum

2015 Strategic

Maximum

SAFE

20

25

65

30

45

90

MARKET RISK

25

50

70

0

30

60

MANAGER SKILL

10

25

55

10

25

70

EXPECTED RETURN

6.1%

5.0%

EXPECTED MAXIMUM DRAWDOWN

-10%

-5%

*Allocations of Private Capital up to 25% are funded from Market Risk and Manager Skill and are subject to Liquidity Policy

Sources: Balentine

capital markets forecast 2015

Strategy Design

Additionally, our Safe and Market Risk construction rules (Figure 26) balance our desire to capture mispriced opportunities within building blocks against the need to ensure that they fulfill their objectives within strategy design. Safe No more than a 5% expected peak to trough drawdown on a rolling annual basis and a minimum of 70% investment grade quality. Figure 26: Market Risk Portfolio Construction Rules

Market Risk

Minimum Allocation

Maximum Allocation

US Large Cap (Value/Growth)

30%

60%

International Developed Large Cap Stocks

20%

40%

US Small Cap (Value/Growth)

0%

10%

Emerging Markets

0%

25%

REITs

0%

15%

10%

25%

Other Asset Classes*

*Such potential “Art themes” may be included as long as their expected return is +2% over the MSCI All Country World Index and the addition does not increase the expected volatility of Market Risk over the MSCI All Country World Index. The maximum overall weight to all Art themes may not exceed 50% of the building block.

Sources: Balentine

CONCLUSIONS: PROBABILITIES OF OBTAINING GOALS In conclusion, we simulated the probability of each of the strategies we designed in attaining various goals and the likely path along the journey to that destination. We express these goals as an absolute return target of inflation + risk premium (1 – 5%) and compare the risk of loss over a one, three and seven-year horizon. Strategies with Private Capital assume a 15% allocation to Private Capital. The results are summarized in Figure 27.

T h e A r t & Sc i e n c e o f I n v e s t i n g

43

Figure 27: Probabilities of Attaining Various Absolute Return Goals Goals Strategy

CPI+1%

CPI+2%

Risk

CPI+3%

CPI+4%

CPI+5%

Risk of Loss in 1 Year

Risk of Loss in 3 Years

Risk of Loss in 7 Years

Public Markets Aggressive

82.1%

77.6%

72.3%

66.4%

59.7%

29.1%

16.7%

8.1%

Public Markets Growth

80.1%

73.9%

66.3%

58.9%

51.2%

28.0%

15.1%

6.2%

Public Markets Balanced

79.3%

71.2%

62.2%

53.0%

43.1%

26.7%

13.6%

4.0%

Public Markets Conservative

77.7%

65.2%

52.6%

38.9%

26.2%

23.7%

10.5%

1.5%

Public Markets Aggressive w/Private Capital

86.4%

81.7%

76.3%

70.5%

63.9%

27.0%

14.0%

4.8%

Public Markets Growth w/Private Capital

86.5%

81.2%

75.0%

68.3%

61.2%

26.2%

12.8%

4.2%

Public Markets Balanced w/Private Capital

86.5%

80.2%

72.4%

63.9%

55.1%

24.7%

11.4%

3.2%

Public Markets Conservative w/Private Capital

86.5%

77.8%

66.6%

54.3%

40.9%

21.1%

7.9%

1.6%

Fully Diversified Aggressive

84.5%

79.0%

72.5%

65.4%

58.7%

27.4%

14.5%

5.2%

Fully Diversified Growth

85.8%

79.4%

71.6%

62.9%

53.9%

25.0%

11.7%

3.3%

Fully Diversified Balanced

86.0%

76.8%

65.2%

52.9%

39.5%

21.5%

8.2%

1.8%

Fully Diversified Conservative

86.0%

70.6%

50.5%

31.1%

15.6%

15.7%

3.9%

0.3%

Fully Diversified Aggressive w/Private Capital

86.9%

81.3%

74.7%

68.7%

60.7%

26.7%

13.6%

3.6%

Fully Diversified Growth w/Private Capital

88.8%

83.2%

75.4%

67.8%

58.2%

23.7%

10.6%

2.0%

Fully Diversified Balanced w/Private Capital

90.2%

83.2%

73.3%

62.1%

50.6%

20.5%

7.3%

1.0%

Fully Diversified Conservative w/Private Capital

92.7%

82.1%

66.8%

48.3%

29.6%

13.8%

3.3%

0.1%

60% S&P 500/40% Barclays Aggregate

67.1%

56.6%

46.2%

34.8%

26.2%

32.3%

21.3%

9.8%

Sources: Balentine

The table shows how there are several ways of attaining or exceeding a certain absolute return goal, such as inflation + 5%. Each strategy is likely to involve a different journey to that destination and probability of success. Though the differences in probabilities in Figure 27 may at first glance look relatively small, each simulation assumed no net contributions or withdrawals over the investment horizon. Cash flows make simulations path dependent and can exacerbate the spread in potential outcomes significantly. See Figure 24 for an example illustrating the sustainability of spending at 5% across two different strategies. Public Markets strategies are likely to exhibit higher volatility levels than Fully Diversified strategies (which by design should deviate significantly away from public market volatility for extended periods of time) and come with much greater risk of loss in exchange for a higher potential for exceeding the goal. Significant and frequent contributions over distributions and a long time horizon will minimize the odds of Public Markets strategies experiencing such a risk of loss while attaining a goal over time13. Similarly, the probability of success increases significantly with the introduction of Private Capital, but that should only be considered after careful attention has been paid to developing a formal liquidity policy14.

13 See our research paper “To Diversify or Not to Diversify: What Are the Questions?” available at www.balentine.com for a complete set of criteria to consider when choosing whether to use a Public Market or Fully Diversified strategy to attain a certain goal. 14

See our research paper “The Case for Cash” available at www.balentine.com for gidance on how to develop such a Liquidity Policy.

capital markets forecast 2015

Strategy Design Figure 27 also illustrates how we have set our minimum acceptable primary inflation + benchmarks across our strategies. We set these as: Inflation +1 % for Conservative; Inflation + 2% for Balanced; Inflation + 3% for Growth; and Inflation + 4% for Aggressive. The probabilities highlighted in bold show that in each case our strategies have a two-thirds or higher probability of meeting or exceeding these primary benchmarks. Figure 27 also shows how Public Markets Balanced and Conservative strategies have relatively low odds of attaining or exceeding an Inflation + 5% goal. Aggressive and Growth strategies that include both Manager Skill (Fully Diversified) and Private Capital have a materially better chance of success when setting that goal from today’s starting point. Figure 28 illustrates this. It simulates the expected growth of $1 invested in three diversified strategies compared to the simple strategy of investing 60% in the S&P500 stock index and 40% in the Barclays Aggregate Bond index15. The Public Market Aggressive and two diversified strategies have 50% or more of the simulated outcomes exceeding the goal of inflation + 5% over the next market cycle, while the simple domestic stock / bond strategy only does so under the 25% best case outcomes. The diversified strategies also substantially reduce the risk of loss relative to the simple stock / bond strategy. In other words, despite the strong performance of domestic stocks and bonds in 2012-2014, a broadly diversified strategy that is proactively rebalanced through time has a much higher probability of success and lower risk of impairment of capital when the goal is to attain or exceed inflation + 5% over the next market cycle. Figure 28: Three Ways of Aiming For a Goal of Inflation + 5% Using Diversified Strategies

Simulations

Risk of Loss

Risk of Loss

Risk of Loss in 7 Years

0 Year

1 Year

2 Year

3 Year

4 Year

5 Year

6 Year

7 Year

in 1 Year

in 3 Years

Public Markets Aggressive (25th Percentile)

$1.00

$1.20

$1.37

$1.53

$1.71

$1.89

$2.10

$2.34

29.1%

16.7%

8.1%

Public Markets Aggressive (50th Percentile)

$1.00

$1.09

$1.18

$1.29

$1.39

$1.51

$1.65

$1.79

25.0%

11.7%

3.3%

24.7%

11.4%

3.2%

12.4%

21.3%

9.8%

Public Markets Aggressive (75th Percentile)

$1.00

$0.98

$1.02

$1.08

$1.14

$1.20

$1.29

$1.37

Inflation +5%

$1.00

$1.07

$1.14

$1.23

$1.31

$1.40

$1.50

$1.61

Fully Diversified Growth (25th Percentile)

$1.00

$1.15

$1.28

$1.40

$1.53

$1.67

$1.82

$1.99

Fully Diversified Growth (50th Percentile)

$1.00

$1.08

$1.15

$1.24

$1.33

$1.42

$1.54

$1.65

Fully Diversified Growth (75th Percentile)

$1.00

$1.00

$1.04

$1.10

$1.15

$1.22

$1.29

$1.37

Inflation +5%

$1.00

$1.07

$1.14

$1.23

$1.31

$1.40

$1.50

$1.61

Fully Diversified Balance w/Private Capital (25th Percentile)

$1.00

$1.15

$1.28

$1.40

$1.54

$1.68

$1.83

$2.00

Fully Diversified Balance w/Private Capital (50th Percentile)

$1.00

$1.08

$1.16

$1.25

$1.34

$1.43

$1.54

$1.66

Fully Diversified Balance w/Private Capital (75th Percentile)

$1.00

$1.00

$1.05

$1.10

$1.16

$1.22

$1.30

$1.38

Inflation +5%

$1.00

$1.07

$1.14

$1.23

$1.31

$1.40

$1.50

$1.61

60% S&P 500/40% Barclays Aggregate Bond Index (25th Percentile)

$1.00

$1.11

$1.19

$1.27

$1.35

$1.44

$1.52

$1.62

60% S&P 500/40% Barclays Aggregate Bond Index (50th Percentile)

$1.00

$1.04

$1.09

$1.14

$1.19

$1.25

$1.31

$1.38

60% S&P 500/40% Barclays Aggregate Bond Index (75th Percentile)

$1.00

$0.98

$1.00

$1.02

$1.05

$1.08

$1.12

$1.16

Inflation +5%

$1.00

$1.07

$1.14

$1.23

$1.31

$1.40

$1.50

$1.61

Sources: Balentine 15 We use the expected return and risk assumptions developed within the chapters on Safe and Market Risk for the 60% S&P500/40% Baclays Aggregated Bond strategy.

T h e A r t & Sc i e n c e o f I n v e s t i n g

45

Glossary

capital markets forecast 2015

Glossary Absolute Return Refers to investment strategies that target a positive return—as opposed to relative returns in which an investment portfolio’s returns are measured against a theoretical portfolio or benchmark. Absolute return can also refer to the total return (total gain or loss) of a portfolio or fund, as opposed to its relative return (relative gain or loss). Alpha A measure of an asset’s expected return that cannot be attributed to the overall market return. A high value for alpha implies that a stock has performed better than would have been expected given its beta (market relationship). Annualized Return Adjusting a return to an annual, rather than a calendar year, basis. Beta A measure of an asset’s expected return compared to the overall market. The market’s beta coefficient is 1.00. Any asset with a beta higher than 1.00 should increase more than the market when the market rises, whereas a stock with a beta lower than 1.00 is expected to rise or fall more slowly than the market. Benchmark/Index A standard used for comparison. For example, the S&P 500 may be used as a benchmark against which a portfolio of domestic stocks could be compared. Building Blocks Balentine’s building blocks approach to asset management provides greater diversification than found through traditional strategies, providing greater opportunities to sustain and grow wealth. Our five building blocks include Liquid, Safe, Market Risk, Manager Skill and Private Capital. Dynamic Rebalancing Making adjustments to counteract the fact that different assets have generated different returns and now comprise different percentages of the portfolio than they were intended. Dynamic rebalancing stresses making adjustments as needed, as opposed to calendar-driven rebalancing, when a portfolio is rebalanced at regularly scheduled times, often quarterly or annually. Expected Return The total return that investors expect to receive from an investment—capital gain plus income. Liquidity Cash, cash equivalents and other assets that can be readily converted to cash. In the case of a market, a stock, or a commodity, the extent to which there are sufficient buyers and sellers to ensure that trades are able to clear the market with limited impact on market prices.

T h e A r t & Sc i e n c e o f I n v e s t i n g

47

Macroeconomic Risks Risks associated with economic, financial or political events. Max Drawdown The maximum reduction in a portfolio’s value based on the returns of the assets within the portfolio. Private Equity Equity securities of companies that are not listed on a public exchange. Private equity investors provide capital to private companies with the aim of achieving higher rates of return than available in the public markets as compensation for less liquidity. Relative Return The ratio between the return realized on a fund or asset and the return realized by a designated benchmark. Relative returns are often used to grade fund managers, who are expected to achieve returns above the movement of an unmanaged index (example: S&P 500). Standard Deviation A statistical measure of historical volatility of an asset or a portfolio, usually computed using 36 monthly returns. More generally, a measure of the extent to which results are spread around their average. Tracking Error When using an indexing or any other benchmarking strategy, the amount by which the performance of the portfolio differed from that of the benchmark. The tracking error technically quantifies the degree to which the strategy differed from the index or benchmark, by measuring the standard deviation between the two values. Volatility The extent to which the price of a security, commodity, or market changes over time. Volatility is found by calculating the annualized standard deviation of daily change in price. As an example, if the price of a stock moves up or down rapidly over short time periods, it has high volatility. If the price rarely changes, it has low volatility.

capital markets forecast 2015

Legal General This information has been prepared by Balentine LLC (“Balentine”) and is intended for informational purposes only. This information should not be construed as investment, legal, and/ or tax advice. Additionally, this content is not intended as an offer to sell, or a solicitation of any investment product or service. Outlook Opinions expressed are solely the opinion of Balentine and should not be relied upon for investment decisions. Certain statements contained herein may constitute projections, forecast, and other forward-looking statements that do not reflect actual results, and are based primarily upon applying retroactively a hypothetical set of assumptions to certain historical financial information. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. These statements are based on available information and Balentine’s view as of the time of these statements, are subject to change, and are not intended as a forecast or guarantee of future results. Actual results, performance, or events may differ materially from those expressed or implied in such statements. Third-Party Data The information presented in this publication has been obtained with the greatest of care from sources believed to be reliable. However, stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. Some material may contain information and data provided by independent, third party sources. While Balentine uses sources it considers to be reliable, no guarantee is made regarding the accuracy of information or data provided by third-party sources. Balentine expressly disclaims any liability, including incidental or consequential damages, arising from errors or omissions in this publication. Risk Investing in securities involves risks, including the potential loss of principal. While equity securities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. The appropriateness of an investment or strategy will depend on an investor’s circumstances and objectives. These opinions may not fit to your financial status, risk, and return preferences. Investment recommendations may change, and readers are urged to check with their investment advisors before making any investment decisions.

T h e A r t & Sc i e n c e o f I n v e s t i n g

49

Terminology Balentine utilizes a building blocks approach to asset management. Our five building blocks include Liquid, Safe, Market Risk, Manager Skill and Private Capital. While each building block plays a role in diversification and risk management, all building blocks are subject to their own risks and may lose value. Specifically, the assets in the Safe building block are designed to protect against interest rate fluctuations, credit risks and unanticipated movements in inflation and currency valuations. Safe assets play an important role as a short-term shock absorber, but there is no inference these assets cannot lose value. More information on our building blocks strategy can be found on our website. Balentine Strategies Performance Data Performance information for Balentine Strategies (“Strategies”) is computed using weighted average performance of portfolio components (which may include public indices and/or specific investments managed by third-party providers) based on the recommended target weighting for each Strategy during the specified time period. Given that investors cannot invest directly in the indices, Balentine selects passive index funds as proxies for the underlying indices to manage the Strategies. These index funds may be changed from time to time in Balentine’s judgment to best reflect the performance of the indices. Performance is presented net of (after deducting) the actual embedded expenses of the active or passive funds or vehicles in which investments were assumed to be made (2000-2009) or actually made (2010-Forward), but before deducting a) Balentine’s investment advisory fees which will vary depending on each client’s circumstances and b) transaction costs of implementation (between .15% and .20% per annum). Balentine’s investment advisory fees are described in Part 2 of Balentine’s Form ADV. As an example of the compounding effect on advisory fees, a Balentine client paying an annual advisory fee of .90% (deducted monthly in arrears) would have experienced an average annual reduction of .904% from the performance data displayed. The results of the Strategies reflect the reinvestment of dividends and other earnings. Performance information presented for the Strategies for 2000-2009 represents back-tested information for the periods indicated, using monthly rebalancing. Back-testing of performance is prepared using Balentine proprietary asset allocation models that start with the first day of the given time period and evaluate the weighted average performance of the stated indices based on the recommended target weighting for each Strategy. The presentation of Public Markets (PM) strategies represents the fully diversified strategies excluding the allocation to hedge funds where the allocation to hedge funds is proportionally allocated to remaining asset classes. This performance information reflects asset allocation recommendations made to clients but assuming use of index funds only to implement. Accordingly, this information does not represent actual account performance and should not be interpreted as an indication of such performance. Investment decisions during this period were made by members of Balentine’s Investment Strategy Team while employed by Wilmington Trust Company through 2009. Conversely, all Balentine performance information presented beginning January 1, 2010 represents actual model performance rebalancing decisions in the investments for each Strategy as and when decided by Balentine’s Investment Strategy Team. Each Strategy is invested in the active or passive investment vehicles selected by the Investment Strategy Team and then implemented across all client portfolios. Individual client results may differ by reason of investment in underlying vehicles different than those assumed for the strategy. As with any investment strategy, there is potential for profit as well as possibility of loss. Past performance is not a guarantee of future results.

capital markets forecast 2015

Copyright Notice Copyright ©2015 Balentine LLC. All rights reserved. No part of this publication may be reproduced or used in any form or by any means — graphic, electronic, or mechanical, including photocopying, recording, taping, or information storage and retrieval systems — without written permission from Balentine. To obtain permission, please write to the address below or contact us through electronic mail at info@balentine.com. Please specify the data or other information you wish to use and the manner in which it will be used, and attach a copy of any charts, tables, or figures derived from the information. The information presented in this publication has been obtained with the greatest of care from sources believed to be reliable. However, Balentine does not guarantee the accuracy of information provided by third-party sources. Balentine expressly disclaims any liability, including incidental or consequential damages, arising from errors or omissions in this publication. Third-party data sources include FactSet, Standard & Poor’s, Preqin, National Council of Real Estate Investment Fiduciaries, Robert Shiller, Morningstar, Ibbotson Associates, Ned Davis Research, Hedge Fund Research (HRI) and Cambridge Associates. Published by: Balentine 3344 Peachtree Road Suite 2200 Atlanta, Georgia 30326 Telephone: 404.537.4800 Online: www.balentine.com

T h e A r t & Sc i e n c e o f I n v e s t i n g

T h e a r t & S c i e n c e o f i n v e st i n g

www.balentine.com