CAPTRUST Strategic Research Report, Q2 2013 Wealth Management Edition

WEALTH MANAGEMENT | Q2 13

Strategic research report what The New Medicare Tax Means to You R. Michael Gray, CPA, PFS Senior Vice President, CAPTRUST Financial Advisor

Chris P. Judy, CPA Managing Partner, Thomas, Judy & Tucker, P.A.

With all the attention focused on the tax-rate changes included in the American Taxpayer Relief Act (ATRA), the legislation that narrowly averted the fiscal cliff, some may have forgotten about the new Medicare tax that actually resulted from a piece of legislation passed three years ago — the 2010 Health Care Act. Starting in 2013, high-income taxpayers are subject to a 3.8 percent Medicare “contribution tax on unearned income.” Judging by the number of client conversations and questions we have had on the topic, we thought it might be useful to dedicate some attention to it.

We asked Chris Judy, managing partner and certified public accountant at the Raleigh, N.C.-based accounting firm Thomas, Judy & Tucker, P.A., to provide his perspective on this new tax and share a few specific tax-planning strategies.

Who Pays This Tax? The new 3.8 percent Medicare contribution tax will affect taxpayers whose adjusted gross income (AGI) exceeds certain thresholds—$250,000 for joint filers and surviving spouses, $200,000 for single taxpayers and heads of household, and $125,000 for married individuals filing separately. These threshold amounts are not indexed for inflation. Thus, as time goes by, inflation will cause more taxpayers to become subject to the 3.8 percent tax.

In This Issue Letter from the Editor

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Wealth Management Planning

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Portfolio Strategy

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Your AGI is the bottom line on page one of your Form 1040. It consists of your gross income minus your adjustments to income, such as an IRA deduction.

If your AGI is above the threshold that applies to you, the 3.8 percent tax will apply to the lesser of:

Index Returns

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• Your

net investment income for the tax year, or

• The

excess of your AGI for the tax year over your threshold amount.

Discretionary Research Highlights 18 Investment Asset Classes

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This tax is in addition to the income tax that applies to that same income.

CAPTRUST News

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What is Net Investment Income?

The definition of net investment income subject to the 3.8 percent tax itself seems to be poorly understood. Interest, dividends, annuities, royalties, rents,

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letter from the editor

HALFTIME! Dear Readers, It’s hard to believe that the year is more than half over; it seems like just yesterday that fiscal cliff headlines dominated the newswires, basketball personality Dennis Rodman embarked on his first diplomatic mission to North Korea, and my kids were still in school. 2013’s first half was busy enough for everyone. As always, our goal is to provide private wealth clients with content that is both timely and actionable given the many crosscurrents enveloping the investment and regulatory climate.

Bond market volatility was a significant second quarter development, with fixed income securities hurt by the anticipated Federal Reserve asset purchase slowdown.

I explore this issue in an update to an intra-quarter piece we put out in response to the recent Fed communique. I also discuss portfolio construction and asset class performance in my regular Portfolio Strategy article.

Veteran CAPTRUST advisor Mike Gray teams up with Chris Judy of accounting firm Thomas, Judy & Tucker to explore the newly implemented Medicare contribution tax on investment income. This is an important issue that will impact many of our clients, and getting in front of strategies may help alleviate its impact.

Their article should prove helpful heading into year end. Finally, CAPTRUST’s Mark Paccione weighs in on portfolio management disciplines, using a recent conversation with a friend to highlight all that goes into portfolio construction, asset deployment, and risk management.

We will keep you apprised of what will be an exciting finish to 2013, including whether or not Rodman takes home the Nobel Peace Prize for which he is currently angling. As my teenager would say, don’t hold your breath.

Onward,

Eric J. Freedman CAPTRUST Chief Investment Officer

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Figure One: Summary of Recent Tax Developments Who is Affected?

Details

Social Security Payroll Tax

All taxpayers earning salary or wages

Increase from 4.2% to 6.2% (applies to wages and salary up to $113,700)

Ordinary Income Taxes

Taxpayers with taxable income over $400,000 ($450,000 for couples)

Highest marginal tax rate increases from 35% to 39.6%

Long-Term Capital Gains and Dividend Taxes

Taxpayers with taxable income over $400,000 ($450,000 for couples)

Maximum tax rate increases from 15% to 20%

Phaseout of Itemized Deductions and Personal Exemptions

Taxpayers with adjusted gross income (AGI) above $250,000 ($300,000 for couples)

Tax benefit of itemized deductions (mortgage interest, charitable donations, property taxes, state/local income taxes, etc.) and personal exemptions (e.g., dependent children) are reduced as income increases; itemized deductions are reduced as much as 80%; personal exemptions may be fully eliminated

Medicare Contribution Tax

Taxpayers with over $200,000 of adjusted gross income (AGI), couples with more than $250,000 of AGI; for trusts and estate, the income threshold is $11,950

3.8% tax on investment income, including taxable interest, dividends, capital gains, rental income, royalties, the taxable portion of income from nonqualified annuities, and income from business activity where the taxpayer is not considered an active participant

and net gains from property and securities sales are all considered net investment income for purposes of this tax.

It is important to note that neither income from an active trade or business nor wage income is included in net investment income. However, passive business income is subject to the Medicare contribution tax. This is a very important distinction to recognize when considering strategies for dealing with the Medicare tax.

Source: Putnam Investments

Tax Area

Are Retirement Plan Distributions Taxed?

Distributions from qualified retirement plans, such as pension plans and individual retirement accounts (IRAs), aren’t subject to the Medicare contribution tax. However, keep in mind that those distributions may push your AGI over the threshold that would cause other types of investment income to be subject to the tax.

Tax-Planning Strategies

Are Home Sales Subject to the Tax?

Investments

If you sell your primary residence, you may be able to exclude up to $250,000 of gain, or gain of up to $500,000 for joint filers, when figuring your income tax. This excluded gain won’t be subject to the Medicare contribution tax. However, the amount of the gain that exceeds the limit on the exclusion will be subject to the tax. Gain from the sale of a vacation home or other second residence sale, which doesn’t qualify for the income tax exclusion, will be subject to the Medicare contribution tax.

The income thresholds that trigger this new tax heighten the need to be proactive with your investment portfolio composition and management. Harvesting capital losses to offset gains may add value by allowing you to lower your AGI below the threshold applicable to you. Taking steps to avoid mutual fund capital distributions may also become more important for the same reason. While some year-end actions will always be available, having a clear picture of not only expected income levels but also its components is now far more important.

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Municipal Bonds

Rental Income

Income that is exempt from income tax, such as municipal bond interest, is likewise exempt from the 3.8 percent Medicare contribution tax, making municipal bonds potentially more valuable in a portfolio on a taxable-equivalent basis. Thus, switching some of your taxable investments into tax-exempt bonds can reduce your exposure to the 3.8 percent tax. Of course, this should be done with regard to your income needs, risk tolerance, and other investment considerations.

In the past, some tax advisors have considered it beneficial to deal in passive activities; however, for the purposes of the Medicare tax, it is beneficial to be considered active in your rental or business dealings. Therefore, you may wish to review your activity level in rental and business ventures to consider if aggregation of activities to meet real estate professional and material participation status would be beneficial. By grouping business activities, you may be able to show material participation of over 500 hours, allowing those businesses to be considered active rather than passive. If you are considered active in a business or real estate activity, income from that activity would not ordinarily be subject to the Medicare tax.

Life Insurance and Annuities Deferring income until a later date through the use of life insurance or annuities is another strategy to consider.

Investment vehicles like low-cost variable annuities provide the ability to shield investment earnings from the tax and could make sense for some individuals.

IRAs The Medicare tax also makes Roth IRAs more attractive for higher-income individuals because qualified Roth distributions are neither subject to the Medicare contribution tax nor included in AGI. If eligible, individuals may want to make Roth IRA contributions now so that those funds and any appreciation would not be taxable later.

Distributions from traditional IRAs will be included in AGI, except to the extent of after-tax contributions, although they are not subject to the Medicare contribution tax. If you are not required to take minimum distributions, you may want to limit your withdrawals in an effort to stay below the AGI threshold relevant to you. One way to ensure you stay below the threshold is to make retirement distributions directly payable to a charity of your choice. This option only applies to taxpayers who are over 70 1⁄2 and are making required minimum distributions.

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Other Considerations for Business Owners Business owners should be aware of several additional opportunities as they plan for the new Medicare tax: • Entity

selection is important when considering the impact of the Medicare tax. Currently, S corporation distributions are not subject to the Medicare tax, whereas distributions from C corporations are.

• One

may wish to consider a Section 1031 Exchange to delay recognition of a gain on the sale of property.

• An

installment sale may be used to spread gains over multiple tax years and avoid generating a large tax hit in a single year.

Our goal is to equip you with a few specific ideas that will help start conversations with your tax advisors about the new Medicare tax. These are conversations you should have as soon as possible so that you are in a position to properly consider strategies that will help minimize its impact going forward.

Time spent now with both tax and investment advisors could yield lower taxes and better after-tax investment results for 2013 and beyond.

WEALTH MANAGEMENT | Q2 13

wealth management planning

WHAT’S NEXT FOR THE BOND MARKET? Eric J. Freedman CAPTRUST Chief Investment Officer

Figure One: “All Things Yield” Q2 2013 Performance 3%

2.0% 0%

-3.0%

-3.2%

-3%

-6%

-3.3%

-7.0%

-9% BarCap Aggregate Bond Index

BarCap Municipal Bond Index

BarCap BarCap U.S. U.S. Corporate Treasury: U.S. High Yield Treasury TIPS Index Index

Following a 30-plus-year bull market in the fixed income or bond market, the path forward is much more uncertain.

While investors await the next move for fixed income, unless bond prices move higher (and, by definition, bond yields move lower), historically low interest rates indicate that bonds will offer lower total returns than most bond investors have experienced during recent periods.

May 2013 represented the worst monthly return for the bond market

S&P U.S. Preferred Stock Index

Alerian MLP Index

Source: Bloomberg, Zephyr

Return

-1.4% -2.3%

Dow Jones U.S. Real Estate Index

since the 2008 financial crisis, with the Barclays Capital Aggregate Bond Index (BarCap Agg) losing 1.78 percent. Fears that the U.S. Federal Reserve would soon begin to rein in its bond-buying program hurt fixed income in general.

The 10-year Treasury yield rose from 1.64 percent on May 1 to 2.16 percent on June 1, which in percentage terms was the largest month-over-month increase in yield history. The 10-year Treasury continued its rise in June,

Figure Two: U.S. 10-Year Treasury Yields (January 2010–June 2013) 4.0% Source: Robert Shiller, U.S. Treasury, Bloomberg

3.5% 3.0%

Yield

2.5% 2.0% 1.5% 1.0% 0.5% 0% 2010

2011

2012

reaching a high of 2.66 percent before closing the quarter at 2.48 percent.

Many yield-sensitive asset classes and sectors fell in sympathy, including corporate bonds, municipal bonds, public real estate, utility stocks, and master limited partnerships. For the quarter, the BarCap Agg was down 2.32 percent. “All things yield” appeared vulnerable as government bond prices sold off and interest rates moved higher.

Where Will Interest Rates Go from Here?

Looking at Figure Two, one can see that since the summer of 2011, 10-year Treasury yields have been firmly below 3 percent. This is due to global central banks’ active suppression of interest rates through buying fixed income securities in the open market in an attempt to encourage lending and spark economic activity. However, the U.S. Federal Reserve has recently hinted that those open market purchases could begin to slow, leaving investors to question who will replace the Fed and buy bonds. This speculation led to the second quarter’s weak bond market returns.

Per Figure Two, it appears we are approaching interest rate levels that are halfway between the lows seen in the summer of 2012 and the higher levels seen before the summer of 2011. From here, rates can do one of three things: move lower, remain flat, or move higher.

2013

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•

Rates move lower This scenario could happen for several reasons, most likely driven by economic weakness that causes the Fed and other central banks to continue their bond purchases. Sticky unemployment, a slowing China, continued European market malaise, and weaker equity and riskier asset classes could all cause this development. While this may seem implausible given where interest rates sit right now, we have seen them at even lower levels; the 10-year Treasury touched below 1.4 percent in July 2012, a full percentage point lower than today.

•

Rates remain flat A goldilocks economy — growing neither too fast nor too slow — where inflation remains tame (the Bureau of Labor Statistics notes that month-over-month change in the Consumer Price Index has fallen over the past two months) and employment and wage growth remain tepid could cause interest rates to hover at or near current levels.1

•

Rates move higher An economy showing resilience, the Fed backing off its recent bond purchase trend (or anticipation thereof), inflationary pressures, or asset allocation movement toward riskier asset classes or foreign bonds could all drive interest rates higher. As described earlier, rising prevailing interest rates tend to hurt bondholders.

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Figure Three: Periods Where 10-Year Treasury Yields Increased More Than 0.3% and Corresponding Barclays Capital Aggregate Index Returns, 1979–2013

Dates

Number of Months

Increase in the 10-year Treasury Yield

BarCap Agg Total Return

6.1.79–2.28.80

9

3.81%

-10.73%

6.1.80–8.31.81

15

5.63%

-5.81%

5.1.83–5.31.84

13

3.42%

-0.85%

1.1.87–9.30.87

9

2.51%

-2.88%

10.1.93–10.31.94

13

2.48%

-3.07%

1.1.96–5.31.96

5

1.20%

-2.53%

10.1.98–12.31.99

15

1.91%

-0.40%

3.1.04–4.30.06

26

1.22%

1.83%

12.1.08–3.31.10

16

1.41%

8.76%

5.1.13–5.31.13

1

0.52%

-1.78%

Our base case scenario is for rates to rise, but to do so at a gradual pace over the next 18 to 24 months subject to numerous fits and starts depending on the economy’s health and central bank involvement. If we are wrong, we suspect it will be because a move higher happens faster than we expect — perhaps accelerated by investor overreaction to market news.

The Need to Gauge Speed While higher interest rates could hurt bond investors, as Figure Three shows, rising yields do not always translate into bond investor losses. Two key variables will likely determine how acutely rising rates may impact bond investors: the magnitude of the rate increase and the speed at which rates increase. The higher rates move and the shorter the time period, the more painful the experience.

Source: Bloomberg, Zephyr

Let’s Explore the Case for Each Scenario:

WEALTH MANAGEMENT | Q2 13

20% 10-year Treasury Yield (beginning of year) Barclays Aggregate (5-year forward return)

18%

16%

Yield/Return

14%

12%

10%

8%

6%

4%

2%

0% 1977

1982

1987

For example, from December 2008 through March 2010, the 10-year Treasury yield rose by almost 1.5 percentage points while the BarCap Agg returned more than 8.7 percent.

This was the result of a modest rate increase (as a percent of the starting yield) and a timeframe long enough for coupon payments to outweigh the price decline. Also, because the BarCap Agg is a diversified index that includes corporate and mortgage bonds, some decoupling from government bonds may have occurred.

1992

1997

2002

By contrast, in May, a mere 0.5 percentage-point increase in 10-year Treasury yields set the bond market back as coupons failed to offset falling bond prices over such a truncated period. In addition, since interest rates are very low, the starting yield did not provide much of a cushion against higher rates.

What Can Bond Investors Expect Moving Forward?

CAPTRUST research suggests that current interest rates often portend future returns. As Figure Four displays,

2007

Source: Federal Reserve Bank of St. Louis (http://research.stlouisfed.org/fred2), Bloomberg

Figure Four: 10-Year U.S. Treasury Yield Vs. Barclays Capital Aggregate Index Five-Year Forward Return, 1977–2012

2012

the prevailing interest rate as measured by the 10-year Treasury provides a reasonable approximation of five-year forward annualized fixed income returns as measured by the BarCap Agg (note that forward returns starting in 2009 are for less than five years and are as of June 7, 2013). So, you would interpret the chart this way: in 1997, the 10-year Treasury started the year yielding 6.43 percent. During the period encompassing 1997–2002, the BarCap Agg delivered a 7.42 percent annualized return.

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Over time, the correlation between the 10-year Treasury’s starting yield and five-year forward return has been over 0.9, a strong, positive relationship. Correlation cannot be higher than 1.0, and a correlation of 0.6 to 0.7 is considered high.

Therefore, given the 10-year Treasury’s current low level, if the relationship described holds, investors should expect bond portfolios to deliver lower nominal (non-inflationadjusted) returns than in prior periods.

•

Jerry Lanzotti, who comanages the Lord Abbett Total Return Fund, thinks the Fed is serious about tapering its bond purchase program and that interest rate volatility will persist along with consequent volatility in other asset classes.

•

Managers at Fidelity’s $13 billion Total Bond Fund are most focused on the Fed’s new data-driven approach.

They believe, if the Fed tapers on the aggressive end of expectations, the worst case scenario for 10-year yields is a climb to 4 percent from their current mid-2-percent range.

Given low core inflation and growth expectations, they expect a much slower climb in rates going forward.

•

Lastly, PIMCO’s Bill Gross believes the Fed’s economic outlook currently driving policy is too optimistic since inflation is running close to 1 percent. Given this view, in his opinion, the recent yield increase appears overdone.

Active Manager Investment Perspective We polled a diverse set of bond portfolio managers for their perspectives on the bond market since the Federal Reserve’s communication, and while their views are subject to change, their perspectives are as follows: •

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TCW MetWest’s Steve Kane, who comanages the $25 billion MetWest Total Return Fund, believes there is a 100 percent probability that the Fed will maintain its zero interest rate policy through 2013 — and a 95 percent probability through 2014.

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These perspectives reflect very conditional and temporal approaches and views, and investors may be left wondering what to do given the uncertain path.

WEALTH MANAGEMENT | Q2 13

Investor Choices Generally speaking, bond investors have several options available to help combat the impact of rising interest rates on their portfolios:

Option One Do nothing. Either hold individual bonds to maturity and ignore price noise, mindful of credit quality, or rely on a diversified mix of bond funds with a long-term view. Remember, barring default, an unexpected early bond call, or poor trading, fixed income delivers positive absolute returns regardless of interest rate moves.

Option Two Reduce interest rate sensitivity by raising cash or seeking shorter-maturity bonds or bond funds.

Option Three Rotate away from fixed income and toward other asset classes while being mindful that other asset classes possess their own risks.

Option Four Attempt to counteract adverse bond market movements through hedging techniques involving inverse bond exchange traded funds, options, or other tools.

Option Five Adopt a combination of options two through four for a portion of the bond portfolio.

In summary, the bond market was especially volatile in the second quarter because of a significant rise in prevailing rates.

While interest rates could move in any direction from here, we believe the path forward will most likely be a gradual rise over the next 18 to 24 months. In the end, bond returns will be impacted by the speed of any rate rise; the faster yields rise, the more adverse for investors. Investors can take a number of actions to reduce the potential interest-rate headwind; though, historically low interest rates have indicated that bond investors should expect total returns to be lower than recent years. We encourage you to reach out to your CAPTRUST financial advisor if you are interested in exploring concepts discussed in this article.

Source: 1

http://www.bls.gov/cpi/cpid1304.pdf

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NO EASY BUTTON: A FIELD GUIDE TO PORTFOLIO MANAGEMENT Mark Paccione, CFA, CFP® Director, CAPTRUST Consulting Research Group

Recently, a friend came to me seeking advice. This friend, a lawyer by trade, has somewhat limited investing knowledge, and despite the rise in the stock market, her investment returns were less than she had expected. In an attempt to invest her portfolio more wisely, she inquired about CAPTRUST’s portfolio management strategies and investment process. The following is a synopsis of our ensuing discussion and CAPTRUST’s philosophy surrounding discretionary portfolio management.

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Begin With the End in Mind1

Identify Key Investment Constraints

Determine whether the portfolio goal is capital preservation, income, growth, or some combination of the three. One approach is to split the portfolio into three distinct buckets: a liquidity or capital preservation bucket, an income bucket, and a growth bucket. The threebucket approach breaks the portfolio down into more manageable pieces and clarifies each investment’s purpose. In addition, it provides confidence that immediate needs are planned for while decreasing anxiety over a portfolio’s more volatile growth components.

Liquidity and time horizon are two key investment constraints. For liquidity, consider immediate spending needs. Funds needed in the next 12 months should be set aside in a capital preservation bucket with only cash and cash-like investments allowed. Liquidity needs also affect the investment vehicle decision. For instance, private equity is an attractive opportunity but has a long lockup period and, thus, should not be seeded with funds needed in the next few years. Time horizon dictates how aggressive a portfolio should be.

Decide How Much Loss is Tolerable Investors must be prepared to lose money — at least temporarily. Unless investments are limited to cash, U.S. Treasurys, or FDIC-insured certificates of deposit, portfolio volatility and capital loss potential are unavoidable investing byproducts. While all investors desire the highest return possible, it is important to strike a balance between desired high returns and tolerable risk of loss.

One approach is to split the portfolio into three distinct buckets: a liquidity or capital preservation bucket, an income bucket, and a growth bucket.

WEALTH MANAGEMENT | Q2 13

Portfolios with longer time horizons can be more aggressive since they have more time to recover from the inevitable market declines. Retirement presents a unique time horizon challenge as retirees must balance two opposing risks: longevity risk (the risk of outliving your money) and market risk (potential portfolio loss due to adverse market movements).

Implement the Investment Strategy CAPTRUST begins with top-down asset allocation — which drives the majority of a portfolio’s returns2 — and utilizes investment vehicles and managers that provide broad exposure to an asset class or sub-asset class, such as U.S. equities or mortgage bonds. In cases where we have discretionary authority, CAPTRUST adds value to client portfolios at three distinct levels: •

The first, strategic asset allocation, is the apportionment of funds among six major asset classes, including U.S. equities, international equities, fixed income, real estate, commodities, and hedge funds and private equity.

•

The second value-add is tactical asset allocation, tilting the portfolio toward asset classes and sub-asset classes that are more attractive and away from those with less

opportunity in a given market environment. CAPTRUST utilizes multiple primary and secondary data sources and proprietary research insights to determine strategic and tactical asset allocations.

•

The third value-add is investment selection. CAPTRUST has a dedicated investment manager due diligence team that focuses on selecting the best managers for discretionary portfolios. With access to world-class asset managers, our due diligence team provides a distinct edge in understanding a manager’s unique value proposition and investment opportunity set.

Risk Management is Critical CAPTRUST spends significant time, energy, and resources on risk management to avoid permanent capital loss and achieve the desired return with the least amount of risk. At the portfolio level, CAPTRUST focuses on numerous investment risks, including interest rate, credit, market, manager, sector, and country risks. Almost all bonds have interest rate risk, which represents the possibility for price decline due to rising rates. To manage interest rate risk, CAPTRUST generates duration reports that quantify the interest rate sensitivity of a particular bond holding and the overall portfolio. To manage

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market risk, CAPTRUST runs beta reports, which measure the tendency of a security’s returns to respond to swings in the market.3 Sector reports detail the U.S. and international equity exposures by sector, such as health care and information technology. Finally, the country risk report decomposes international equity holdings by country of domicile. These risk management reports allow CAPTRUST to anticipate how individual investments — and the complete portfolio — will act in various market environments.

More importantly, the reports enable proactive and deliberate portfolio positioning to take advantage of the current market environment.

At a microscopic level, CAPTRUST monitors the daily performance of discretionary models, accounts, and investment managers. We produce daily model performance reports, which record model and manager returns over several trailing time periods.

Performance attribution is derived from the daily model performance report, detailing which investments or factors are contributing to and which are detracting from overall performance.

Daily account monitoring ensures detection of potential problems quickly and decisively. CAPTRUST also utilizes deviation reports that measure the difference between current positioning and desired positioning. Using accountlevel reports, we can quickly detect discretionary accounts not performing as expected, identify the issue, and resolve it.

The Wisdom of the Crowd is Invaluable CAPTRUST has an investment committee made up of senior investment professionals who talk daily and meet formally on a biweekly basis to collaborate on investment theses, glean insights from others, and generally expand the team’s knowledge base. The committee construct also helps us avoid common behavioral biases. Lively, data-driven discussions based on primary and

secondary research minimize the risk of confirmation bias (the tendency to accept data that confirms existing beliefs while rejecting data that contradicts them).4 Our belief is that investment decisions should be based on all available data and not just data that confirms initial views. Further, we hope to avoid falling prey to herding behavior (the tendency for individuals to follow the group’s actions) and eliminate emotions from playing a role in decision making.5

Our belief is that investment decisions should be based on all available data and not just data that confirms initial views.

In the end, while my friend was grateful for the insight, I’m not sure it was the simple answer she had hoped for. The key to success as an investor—as in any endeavor—is to become an expert or hire one to work on your behalf. No shortcut, FastPass, or EZ button for instant success exists when it comes to investment portfolio management. The best practices outlined above require a team of experts working in unison toward a common goal: the successful execution of a client’s investment objectives.

Sources:

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1

Covey, Stephen. The 7 Habits of Highly Effective People. New York: Free Press, 1989.

2

Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower. 1986. “Determinants of Portfolio Performance.” Financial Analysts Journal, vol. 42, no. 4 (July/August): 39–40.

3

http://www.investopedia.com/terms/b/beta.asp

4

Kahneman, D. and Tversky, A. (1984). “Choices, Values, and Frames.” American Psychologist, vol. 39, no. 4: 341–350.

5

Ibid

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WEALTH MANAGEMENT | Q2 13

portfolio Strategy

ALL-TIME HIGHS? Eric J. Freedman CAPTRUST Chief Investment Officer

My oldest daughter, Hailey, started to really concentrate on golf this year. Many readers who chase after “the little white ball” can attest that golf is a cruel game, even recreationally between friends. Tournament golf, however, can be especially punishing, and I am not just talking about juniors facing the same tough greens, pin positions, and, in some cases, distances as players 50 years their elders. A 7:00 am tee time is not in sync with a 13-year-old’s normal sleep schedule; pre-round breakfast, stretching, and warm-ups necessitate waking up long before the sun.

Living in North Carolina provides Hailey with ample opportunities to play at some of the finest courses anywhere, and a few years ago when she first showed interest in playing golf beyond the recreational round with me, my wife, Jamie, and I signed Hailey up for a low-key tournament at a very playable golf course. When the starter announced her name and hometown, followed by claps from the handful of fellow caddie parents standing behind her, Hailey turned to me with

one part anxious, one part proud smile. She ripped her drive down the fairway, and we were off with a spring in our steps.

She loved the experience, and I never had more fun on a golf course than when I was carrying her bag that day, helping her with yardages, raking sand traps, and reading putts.

As her play progressed, we scouted additional tourneys, including one hosted by a tour rumored to be a notch above her initial training tournaments. We found a two-day event in Colonial Williamsburg, and on a warm late June day, we headed up for her first round. Her tee time was early afternoon, and as we drove north, my car’s external thermometer rose to 92 degrees. No worries, I thought. I will subtract a few yards per club to adjust to the high humidity. All she has to do is hit shots and stay hydrated. Piece of cake; I had enough sports drinks with me for the entire Commonwealth.

As we approached the first tee, a tour official stopped me and asked where I was going. I told her I was caddying for my

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daughter, and we were up next. The tour official scowled and spoke into her Secret Service – style microphone, indicating to a colleague that a father was intending to carry his daughter’s bag. “That’s a negative” she quipped.

“No caddies allowed. Parents must remain on the cart path at all times and not interact with their children while playing except to deliver snacks.” It had been a hectic week in the office, and I neglected to read the fine print.

I remember saying to Jamie “We don’t need to bring a push cart with us” just as Hailey’s playing partner strolled by with a shiny red contraption, complete with an umbrella to shade the sun on what turned out to be the hottest June day in Virginia history. “Well, there goes my father-of-the-year nomination,” I muttered sarcastically.

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They called Hailey’s name as I was breaking the news to her. “But Dad, I don’t really remember how far I hit each club.” She quickly wrote down the ranges I had memorized, as if cramming before a midterm. I blurted a stream of advice; this would be the last time Hailey and her advanced tournament neophyte father would speak outside of yours truly pouring Gatorade down her parched throat. Just after invoking timeless morsels straight from Ben Hogan’s Five Lessons, I ended my brain dump with “Remember Hailey, golf is like what Papa says all the time don’t let the highs get too high and the lows get too low. Birdies will happen, double-bogeys will happen.

Just keep a level attitude and have fun out there.” She nodded, looking one part anxious and two parts overheated; I couldn’t tell if the latter was due to the weather or my ineptitude.

Investors have had their share of highs and lows over the past 10 years.

As measured by the S&P 500, U.S. equities hit their all-time high in late May, and as we have documented in several publications, interest rates remain near historical lows despite recent selling pressures. So with U.S. stock and bond prices so high, why are broadly diversified portfolios not following suit? The answer rests in asset class performance outside of the more familiar domestic equity and fixed income asset categories. Before we

explore those asset classes, let’s take a step back and consider some of the core asset allocation tenets that drive our portfolio construction.

First, no one knows with any degree of certainty what the future holds.

While my investment committee and I track key upcoming events like Federal Reserve meetings and macroeconomic statistical releases, we do not know three important things: (1) those events’ outcomes, (2) what the capital market reaction to said events may be, and (3) likelihood of any “unscheduled” events like political tumult in Egypt or an influential company’s surprisingly positive earnings preannouncement.

Because of future uncertainty, we believe investors should have exposure to a variety of asset classes that protect them in the event of both highs (positive earnings preannouncement) and lows (political unrest). Asset classes tend to react differently to various events, and having a mix of asset classes to absorb whatever event permutations unfold should help investors over time.

Second, irrespective of market events, we want to provide investors with what are termed factor exposures or longterm trends that will benefit investors.1 Stocks are a great example; they provide access to corporate profits, and as long as indices and active managers (stock pickers) capture “winning” companies, having exposure to rising

WEALTH MANAGEMENT | Q2 13

Figure One: Individual Asset Class Vs. Asset Allocation Portfolio Returns

2003 MSCI EME 56.3% Russell 2000

2004

2005

REITs

MSCI EME

31.6% MSCI EME

34.5% DJ UBS Cmdty

2006

2007

2008

2009

REITs

MSCI EME

Barclays Agg

MSCI EME

35.1% MSCI EME

39.8% DJ UBS Cmdty

47.3%

26.0%

21.4%

32.6%

16.2%

MSCI EAFE

MSCI EAFE

MSCI EAFE

MSCI EAFE

MSCI EAFE

39.2%

20.7%

REITs

Russell 2000

37.1% S&P 500

18.3%

DJ UBS Cmdty

376.0%

16.9%

S&P 500

S&P 500

REITs

REITs

2.9%

13.8%

204.6%

11.8%

Market Neutral

REITs

Russell 2000

Russell 2000

19.7%

Russell 2000

Barclays Agg

MSCI EME

32.5%

26.9%

7.8%

18.6%

REITs

MSCI EME

Market Neutral

MSCI EAFE

28.0%

18.4%

9.3%

-24.0%

27.2%

16.8%

S&P 500

Asset Allocation

Russell 2000

S&P 500

S&P 500

Cash

S&P 500

26.5%

15.1%

0.1%

16.0%

19.2% DJ UBS Cmdty

4.5%

17.9%

S&P 500

Russell 2000

2.1%

7.4%

-33.8%

Asset Allocation

Barclays Agg

DJ UBS Cmdty

6.1%

15.2%

7.0%

-35.6%

22.2%

12.5%

-0.6%

S&P 500

Market Neutral

S&P 500

S&P 500

DJ UBS Cmdty

MSCI EAFE

Russell 2000

5.5%

-37.0%

4.9%

9.1% Market Neutral

Russell 2000

7.1%

6.5%

4.6%

Barclays Agg

Barclays Agg

1.2%

15.9%

REITs

8.3%

REITs 12.2%

23.9%

Cash

3.1%

REITs

Russell 2000

S&P 500

1.0%

MSCI EME

REITs 27.9%

1.1%

8.3%

Cash

ANN.

MSCI EME

Asset Allocation

Market Neutral

4.3%

CUM.

Russell 2000

11.6%

Market Neutral

4.1%

Market Neutral

YTD ’13

Russell 2000

Market Neutral

12.5%

DJ UBS Cmdty

1.8%

2Q ’13

26.9%

15.8%

25.1%

Cash

MSCI EAFE

2012

Russell 2000

Asset Asset Allocation Allocation

10.9%

79.0%

2011

14.0%

28.7% Asset Allocation

5.2%

2010

Cash 3.0%

11.2% Cash

Cash

REITs

4.8%

4.8%

-37.7%

Barclays Agg

Russell 2000

MSCI EAFE

4.3%

Barclays Agg

DJ UBS Cmdty

2.4%

2.1%

-1.6%

-43.1%

REITs

MSCI EME

-15.7%

-53.2%

16.3%

1.4% Cash 0.0% Asset Allocation

5.8%

152.8%

9.7%

Asset Allocation

MSCI EAFE

MSCI EAFE

4.5%

130.3%

8.7%

MSCI EAFE

Asset Asset Allocation Allocation

-0.6%

4.5%

117.7%

8.1%

MSCI EAFE

Market Neutral

S&P 500

S&P 500

2.2%

98.6%

7.1%

11.3%

-0.7%

Barclays Agg

REITs

Cash

Barclays Agg

Barclays Agg

-2.1%

0.0%

Asset Asset Asset Asset Allocation Allocation Allocation Allocation

18.9%

8.2%

-4.2%

4.2%

Barclays Agg

Barclays Agg

MSCI EAFE

Market Neutral

Barclays Agg

Barclays Agg

5.9%

6.5%

-11.7%

0.9%

-2.3%

-2.4%

61.5%

4.9%

Cash

DJ UBS Cmdty

Cash

MSCI EME

MSCI EME

DJ UBS Cmdty

DJ UBS Cmdty

49.3%

4.1%

Cash

Cash

18.2%

1.7%

Market Neutral 4.1% Cash 0.1%

0.1%

-13.3%

0.1%

-8.0%

-9.4%

Market Neutral

MSCI EME

DJ UBS Cmdty

DJ UBS Cmdty

DJ UBS Cmdty

-0.8%

-18.2%

-1.1%

-9.5%

-10.5%

65.7%

5.2%

Market Neutral

Market Neutral

Source: 3Q | 2013, J.P. Morgan Asset Management, Market Insights, Guide to the Markets®, Russell, MSCI, Dow Jones, Standard & Poor’s, Credit Suisse, Barclays Capital, NAREIT, FactSet.

10-yrs. ’03–’12

The “Asset Allocation” portfolio assumes the following weights: 25% in the S&P 500, 10% in the Russell 2000, 15% in the MSCI EAFE, 5% in the MSCI EMI, 25% in the Barclays Capital Aggregate, 5% in the Barclays 1-3m Treasury, 5% in the CS/Tremont Equity Market Neutral Index, 5% in the DJ UBS Commodity Index and 5% in the NAREIT Equity REIT Index. Balanced portfolio assumes annual rebalancing. All data represents total return for stated period. Past performance is not indicative of future returns. Data are as of 6.30.13, except for the CS/Tremont Equity Market Neutral Index, which reflects data through 2.28.13. “10-yrs” returns represent period of 1.1.03–12.31.12 showing both cumulative (Cum.) and annualized (Ann.) over the period. Data are as of 6.30.13.

corporate profits over time should lead to positive returns over inflation. Of course, recessions and other dynamics make stock returns anything but linear, but as long as an investor has an appropriate time horizon to endure stocks’ ebbs and flows, they can add value.

Third, when properly deployed, asset allocation can provide a hedge against costs an investor endures. For example, while not appropriate for all investors, commodity investments fluctuate with prices of assets like oil, industrial metals, agriculture, and other goods. Often these goods are tied directly to inputs that surround an investor’s daily life, so having some offsetting portfolio exposure can help against price fluctuations, especially when input costs move higher.

Aggregating these three considerations, we strive to create portfolios that incorporate both protection against adverse events and long-term factor exposure. Asset classes can have overlapping factor exposure and the correlations or co-movements between asset classes can fluctuate, so by no means is the construction process a static exercise.

Figure One, which provides a snapshot of nine different asset classes and one blended portfolio’s returns over the past decade, reveals why having a portfolio construction process with the three principles highlighted can be additive. If you notice where the broad-based asset allocation portfolio (which incorporates each of Figure One’s standalone asset classes) ranks year after year relative to the individual asset

continued on page 16

15

continued from page 15

classes, it is no worse than sixth place and no better than fourth place. This time period covers a considerably volatile and instructive period in the capital markets for this discussion.

Of course, one cannot directly invest in an index, and these returns are gross of any fees or transaction costs, but many useful takeaways emanate from this illustration. Asset allocation portfolios seek to do what I imparted on Hailey before she began her round that sweltering June day: not allow the highs to get too high or the lows too low. It also shows how individual asset classes can be extremely volatile from year to year and, as a corollary, how fleeting first- and second-place finishes can be. While U.S. stocks as measured by the S&P 500 have had a great year thus far, note they have lagged the broad asset allocation portfolio over the past 10 years by almost 30 percent, and this is a period where U.S. stocks have hit two all-time highs (first in October 2007 and again this May). Note also, emerging market equities, which have had the best cumulative performance of any of these asset classes, have had poor performance so far this year and were sharply negative in 2011. For all the talk of a 30-year-plus bond bull market, broad fixed income returns as measured by the Barclays Capital Aggregate Bond Index are in seventh place out of nine asset classes, including cash.

Behavioral finance, which studies the human mind’s proclivities related to investment choices, provides some clues as to why investors look at trending asset classes and extrapolate how those asset class trends relate to their situation. For example, some investors may look at recent U.S. stock strength and question why their portfolios are not at all-time highs, ignoring other asset class returns. According to psychologists Neal Roese and Kathleen Vohs, hindsight bias occurs when people “knew it all along” or deem an event more predictable after it occurs than before it happens.2 Similarly,

investors may deem that they themselves, their financial advisor, or money manager should have the prescience to know what asset classes will be in first and last place. So, when the financial media cheers all-time highs in a familiar index like the Dow Jones Industrial Average, investors take notice and make inferences about their portfolio performance, perhaps forgetting that other asset classes helped stabilize their portfolios during the dark days of 2000 and 2007.

We continue to see the glass as half full with respect to global capital markets, and we see momentum for both global equities and potential value emerging as the bond market stabilizes. Despite a very experienced investment committee, independent investment research supplemented by outside services, and a deep team at our headquarters and regional offices, we do not have perfect foresight about the path forward. We do, however, strive to provide clients with durable portfolio strategies across market dynamics, remaining mindful of fees and our clients’ objectives. Different asset classes will contribute to those objectives over any given time period, despite their popularity or unpopularity at any given moment.

While all investors would love to have all of their assets in the best-performing asset class at any given time, the market timing path is fraught with peril and usually, as the Wall Street adage goes, ends in tears.

Hailey’s two-day tournament did not end in tears; she had memorable experiences in Williamsburg that furthered her love for the confounding game of golf. She took her grandfather’s words to heart, letting near birdies and near blowups roll off her back, as well as her old man’s pretournament foibles. My eyes get misty whenever I see that ponytail bob up and down as she marches down a tournament fairway sure to present her with challenges and rewards aplenty; I am hard-pressed to find a more beautiful sight.

Sources:

16

1

For further reading, see Fama and French, 1993. “Common Risk Factors in the Returns of Stocks and Bonds.” Journal of Financial Economics, vol. 33, no. 1.

2

Roese, Neal and Kathleen Vohs. “Hindsight Bias.” Perspectives on Psychological Science. September 2012, vol. 7, no. 5, pp 411–426.

WWW.CAPTRUSTADVISORS.COM

WEALTH MANAGEMENT | Q2 13

index returns

2000 1996

2001 1997

2002 1998

2003 1999

2000 2004

2005 2001

2006 2002

2003 2007

2004 2008

2009 2005

2006 2010

2007 2011

2008 2012

YTD YTD’13

Commodities

Real Estate

Commodities

Small Cap Stocks

Real Estate

Commodities

Real Estate

International Equities

Fixed Income

International Equities

Real Estate

Real Estate

Real Estate

Small Cap Stocks

35.92%

17.12%

5.24%

42.14%

28.48%

8.69%

17.77%

15.86%

Cash

Mid Cap Stocks

Small Cap Stocks

Fixed Income

International Equities

Mid Cap Stocks

40.48%

26.85%

7.84%

17.39%

15.45%

31.84%

12.83%

Real Estate

Fixed Income

26.81% Fixed Income

25.90%

Fixed Income

Mid Cap Stocks

Real Estate

Mid Cap Stocks

Mid Cap Stocks

Mid Cap Stocks

Small Cap Stocks

Fund of Funds

Fund of Funds

Real Estate

Mid Cap Stocks

Large Cap Stocks

Mid Cap Stocks

Large Cap Stocks

3.64%

40.06%

20.22%

12.65%

18.37%

10.26%

-21.34%

28.61%

25.48%

1.50%

17.28%

13.91%

Cash

Real Estate

Small Cap Stocks

Real Estate

Large Cap Stocks

Fixed Income

Small Cap Stocks

Cash

Large Cap Stocks

Real Estate

16.42%

6.36%

2.79%

Cash

Small Cap Stocks 2.49%

Fund of Funds

Mid Cap Stocks

4.08%

-5.62%

Small Cap Stocks

Large Cap Stocks -12.45%

Large Cap International Stocks Equities -7.79%

1.51%

Cash

8.25%

-3.02%

International International International International Commodities Equities Equities Equities Equities 16.23% 27.16% 41.41% 17.11% 21.36%

10.25%

Fund of Funds

6.36%

31.49%

8.44%

3.64%

11.63%

47.25%

21.36%

-19.50%

1.68%

36.74%

18.33%

12.13%

15.46%

Fund of Funds

Large Cap Stocks

Large Cap Stocks

Fund of Funds

Mid Cap Stocks

1.01%

29.89%

11.40%

7.45%

15.26%

International Large Cap Commodities Commodities Equities Stocks 9.15% 23.93% -14.67% 6.27% Mid Cap Stocks

Fund of Funds

Fund of Funds

-16.19%

11.62%

6.79%

Small Cap Stocks

Fixed Income

Fixed Income

-20.48%

International Large Cap Commodities Equities Stocks -19.51% -15.11% -21.65%

4.10%

Small Cap Stocks

4.34%

Cash

Cash

1.05%

1.44%

4.55%

Cash 3.35%

Fixed Income

6.97%

-33.79%

Large Cap Small Cap Commodities Stocks Stocks -35.65% 5.77% 27.17%

Fund of Funds

Mid Cap Stocks

10.34%

5.60%

Cash

Cash

5.08%

4.71%

Fixed Income

Small Cap Stocks

Mid Cap Stocks

Small Cap Stocks

Fund of Funds

16.10%

-1.55%

16.35%

3.28%

Small Cap Stocks

Fund of Funds

International Equities

-4.18%

5.25%

0.27%

Real Estate

Fund of Funds

Fixed Income

Fund of Funds

Fixed Income

-37.97%

11.16%

6.54%

-5.51%

4.22%

Mid Cap Stocks

Fixed Income

Fund of Funds

Commodities

Cash

-13.32%

0.11%

-1.57%

-41.46%

Commodities

Real Estate

International Equities

2.07%

-16.82%

0.10%

Large Cap Stocks

International Large Cap Commodities Equities Stocks 18.91% 11.60% -37.60%

4.33%

2.43%

Large Cap Commodities Stocks 16.83% 28.43%

-45.25%

5.93%

5.46%

Cash

Cash

0.21%

0.13%

Cash 0.04%

Fixed Income -2.44%

International Commodities Commodities Equities -1.06% -10.47% -13.33%

Small-Cap Stocks (Russell 2000 Index)

Real Estate (MSCI U.S. REIT Index)

International Equities (ACWI Ex-U.S. Index)

Large-Cap Stocks (Russell 1000 Index)

Fund of Funds (HFRI FoF Composite Index)

Fixed Income (Barclays Capital U.S. Aggregate Index)

Commodities (Dow Jones UBS Commodity Index)

Mid-Cap Stocks (Russell Mid-Cap Index)

Cash (Merrill Lynch 3-Month Treasury Bill)

Sources: Markov Processes Inc., Bloomberg, Mobius

2013 2ND QUARTER ASSET CLASS RETURNS

INDICES

Q2 ’13

YTD ’13

2012

2011

2010

2009

2008

1-YEAR

3-YEAR

5-YEAR

10-YEAR

S&P 500

2.91%

13.82%

16.00%

2.11%

15.06%

26.46%

-37.00%

20.60%

18.45%

7.01%

7.30%

Dow Jones Industrial Average

2.92%

15.20%

10.24%

8.38%

14.06%

22.68%

-31.93%

18.87%

18.23%

8.64%

7.92%

NASDAQ Composite

4.15%

12.71%

15.91%

-1.80%

16.91%

43.89%

-40.54%

15.95%

17.29%

8.22%

7.69%

Russell 1000

2.65%

13.91%

16.42%

1.50%

16.10%

28.43%

-37.60%

21.24%

18.63%

7.12%

7.67%

Russell 1000 Growth

2.06%

11.80%

15.26%

2.64%

16.71%

37.21%

-38.44%

17.07%

18.68%

7.47%

7.40%

Russell 1000 Value

3.20%

15.90%

17.51%

0.39%

15.51%

19.69%

-36.85%

25.32%

18.51%

6.67%

7.79%

2.21%

15.45%

17.28%

-1.55%

25.48%

40.48%

-41.46%

25.41%

19.53%

8.28%

10.65%

Russell 2000

3.08%

15.86%

16.35%

-4.18%

26.85%

27.17%

-33.79%

24.21%

18.67%

8.77%

9.53%

Russell 2000 Growth

3.74%

17.44%

14.59%

-2.91%

29.09%

34.47%

-38.54%

23.67%

19.97%

8.89%

9.62%

Russell Mid-Cap Index

2.47%

14.39%

18.05%

-5.50%

24.50%

20.58%

-28.92%

24.76%

17.33%

8.59%

9.30%

AC World Index Free Ex-U.S.

-2.90%

0.27%

17.39%

-13.33%

11.60%

42.14%

-45.24%

14.14%

8.48%

-0.34%

9.09%

HFRI Fund of Funds

-0.04%

3.28%

4.79%

-5.72%

5.70%

11.47%

-21.37%

7.18%

2.97%

-0.63%

3.44%

Wilshire REIT Index

-1.39%

5.94%

17.59%

9.24%

28.60%

28.60%

-39.20%

8.41%

18.50%

7.20%

10.80% 3.70%

Russell 2000 Value

Barclays Govt Intermediate Bond

-1.37%

-1.23%

1.73%

6.08%

4.98%

-0.32%

10.43%

-0.59%

2.33%

3.80%

Barclays Corporate IG Bond

-3.31%

-3.41%

9.82%

8.15%

9.00%

18.68%

-4.94%

1.36%

5.73%

7.30%

5.18%

Barclays Aggregate Bond

-2.32%

-2.44%

4.22%

7.84%

6.54%

5.93%

5.24%

-0.69%

3.51%

5.19%

4.52%

Barclays Intermediate Govt/Credit

-1.70%

-1.45%

3.89%

5.80%

5.89%

5.24%

5.08%

0.28%

3.14%

4.57%

4.03%

Barclays Muni Bond

-2.97%

-2.69%

6.78%

10.70%

2.38%

12.91%

-2.47%

0.24%

4.46%

5.33%

4.42%

Barclays High Yield

-1.44%

1.42%

15.81%

4.98%

15.12%

58.21%

-26.16%

9.49%

10.74%

10.94%

8.91%

90-Day U.S. Treasury

0.02%

0.04%

0.11%

0.10%

0.13%

0.21%

2.06%

0.11%

0.11%

0.29%

1.72%

Consumer Price Index (Inflation)

0.27%

1.66%

1.74%

2.96%

1.50%

2.72%

0.09%

1.71%

2.31%

1.30%

2.42%

Sources: Morningstar, Mobius, MPI

2013 2ND QUARTER INDEX PERFORMANCE

The information contained in this report is from sources believed to be reliable but are not warranted by CAPTRUST Financial Advisors to be accurate or complete. Index performance depicts historical performance and is not meant to predict future results.

17

CAPTRUST Discretionary research highlights

U.S. EQUITIES • We have carried a bullish posturing on U.S. stocks over the

• We continue to view the U.S. as the most attractive global

past year, emphasizing growth-focused sectors and a bias

equity market, one that we will likely allocate more capital

toward large-cap over mid-cap and small-cap based on

to pending further developments in the bond market.

more attractive fundamental attributes, particularly valuation.

• Our bias has been to avoid rebalancing our stock exposure through the recent upturn in equities. We have recently shored up our sector exposures, deploying a more balanced orientation but still favoring large-cap and high quality.

INTERNATIONAL EQUITIES • Growth prospects have improved across several regions relative to a year ago, but we remain concerned about

picture more muddied than in past environments with similar valuation profiles.

Southern Europe as well as more sluggish performance in emerging market equities, which are down for the year.

This is due to concerns about forward growth prospects and capital flight out of emerging assets including stocks, bonds, and currencies.

• We increased exposure to Japan in light of its aggressive monetary policy early in the year but have since dialed back that exposure as we see a more challenging landscape going forward.

• While European valuations appear attractive from a historical perspective, underlying consumer demand and employment remain sluggish, leaving the corporate profit

FIXED INCOME • We deemphasized fixed income in the second half of 2010

• Active management continues to be our preferred access

despite anticipating further federal stimulus in the form of

method, although we have decreased our overall fixed

quantitative easing and open-market bond purchases.

income weighting within portfolios, feeling that better opportunities lie elsewhere. We have also meaningfully

• We increased our weighting to fixed income during mid-2011, incorporating a diversified approach by sector and geography using a combination of active and passive management. We expected a few persistent themes to endure within the space that are accessible via highly skilled managers and were pleased with those results.

18

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reduced duration and increased exposure to floating rate instruments, anticipating further interest rate volatility as markets debate the Federal Reserve’s bond-buying commitment.

WEALTH MANAGEMENT | Q2 13

HEDGE FUNDS / PRIVATE EQUITY • Hedge fund strategies have had a challenging backdrop in

the start of this year we opted for more directional hedge

which to operate over the past three years given market

fund strategies that would capture more potential upside

oscillations, yet we see investment merit in certain hedge

in riskier asset classes.

fund sub-strategies, particularly those that are less reliant on overall market direction.

• We see hedge fund exposure as a decent portfolio complement to global fixed income exposure as interest

• We had emphasized a more conservative hedge fund

rates oscillate, and the past quarter showed how several

orientation recently with a goal of preserving capital

hedge fund strategies can add value in light of market

during large down periods in riskier asset classes, but at

choppiness in May and June.

COMMODITIES • We remain long-term bullish on commodities due not

• We have recently deemphasized actively managed

only to the demand story but also because of a lack of

strategies with the view that commodities present

infrastructure investment across many key commodities.

considerable challenges for most active managers to

We acknowledge that recent price weakness has been

successfully navigate. Correlations between commodities

disappointing.

and more crowded active manager positions leave us happy to invest in broad commodity mandates and

• Given the challenging macroeconomic environment and the potential for further growth scares, we expect to see considerable volatility within commodities. We would like

control the overall exposure levels versus leaving that to an active manager. Commodities remain a small portfolio component for us right now.

to see commodities decouple from equity returns and give investors more of a correlation boost than we have experienced since the financial crisis.

REAL ESTATE • We added to real estate positions in mid-2010 based on

• 2013 has been more challenging for REITs, with broad

improved fundamentals as well as attractive yields given

REITs selling off in sympathy with interest rates’ ascent.

subdued interest rates.

We could become more constructive on REITs following their sharp decline from late May through late June,

• In a low-yield world, REITs retain a strong distribution

especially if the interest rate picture stabilizes.

profile while offering some growth potential, an attractive combination for a variety of investors that should provide an underlying bid to the space. However, valuation metrics appear to be on the richer side, with REITs delivering a strong 2012 total return.

The foregoing comments demonstrate our firm’s strategic and forward-looking views as they are implemented in cases where clients have contractually granted CAPTRUST sole tactical discretion over portfolio decisions.

19

investment asset classes

U.S. EQUITIES Market Performance, 2nd Quarter 2013

• U.S. stocks continued their ascent higher in the second quarter with the S&P 500 closing up 2.9% for the quarter Q2 ’13

2013

3.20%

15.90%

and 3.1% respectively for the quarter, bringing both of

2.91%

13.82%

them up over 15% for the year-to-date period.

2.06%

11.80%

Mid Value (Russell)

1.65%

16.10%

Mid Blend (Russell)

2.21%

15.45%

Mid Growth (Russell)

2.87%

14.70%

Small Value (R2000 Value)

2.47%

14.39%

Small Blend (R2000 Blend)

3.08%

15.86%

Small Growth (R2000 Growth)

3.74%

17.44%

Large Blend (S&P 500) Large Growth (R1000 Growth)

and 13.8% for the year. Mid- and small-caps were up 2.2%

• Seven out of the 10 major S&P 500 sectors were positive in the second quarter, and financials (the second largest sector) was the clear leader, up 7.3%, while consumer Source: MPI Stylus Pro

Large Value (R1000 Value)

discretionary stocks rose 6.8%. Interest-rate-sensitive utilities fell 2.7% to lead losing sectors.

• Since the U.S. equity market touched its March 2009 low, large-caps, mid-caps, and small-caps are up 160%, 211%, and 202%, respectively, including reinvested dividends.

INTERNATIONAL EQUITIES Market Performance, 2nd Quarter 2013

• Developed and emerging international equities both fell in U.S. dollar terms in the second quarter, with the former 2013

-0.73%

4.47%

-10.88%

-4.60%

European Stocks (MSCI Europe Ex-UK)

0.92%

3.96%

Japanese Stocks (MSCI Japan)

4.42%

16.64%

UK Stocks (MSCI UK)

-2.15%

0.29%

Emerging Markets (MSCI EME)

-7.95%

-9.40%

International Equities (MSCI EAFE) Pacific Stocks (MSCI Pacific Ex-Japan)

still positive (+4.5%) and the latter more deeply negative (-9.4%) for the year-to-date period. The developed equity-focused MSCI EAFE Index has been higher 13 out Source: MPI Stylus Pro

Q2 ’13

of the last 17 quarters, while the MSCI Emerging Markets Index has been higher 12 out of the last 18 quarters.

• Japan continued to rally in the second quarter, but not without considerable volatility. Japan has rallied 34% this year in local currency, but thanks to a sliding yen it has gained only half as much in dollar terms.

• Emerging markets were noticeably weak within the quarter, with China (-6.5% following a -4.5% first quarter), Russia (-8.3%), India (-5.6%), and standout Brazil (-17.8%) all posting negative returns. Adverse currency movements and concerns about growth prospects hurt EM investors in the second quarter, especially from midMay through the end of June.

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WEALTH MANAGEMENT | Q2 13

FIXED INCOME Market Performance, 2nd Quarter 2013

• The Barclays Aggregate Bond Index fell for only the third quarter out of the past 19, falling 2.3% in the second 2013

Broad Market (Barclays Capital U.S. Aggregate) -2.32%

-2.44%

Barclays Capital U.S. Treasurys

-1.92%

-2.11%

Barclays Capital Mortgage Backed Securities

-1.96%

-2.01%

Barclays Capital Municipals

-2.97%

-2.69%

Barclays Capital Intermediate Corporates

-2.38%

-1.82%

Barclays Capital High Yield

-1.44%

1.42%

quarter and 2.4% year-to-date, primarily due to concerns about the Federal Reserve’s potential bond-buying slowdown. Note that the index has not had a negative Source: MPI Stylus Pro

Q2 ’13

annual return in 13 years.

• Within the broad fixed income space, historically riskier parts of the bond market were mixed this past quarter despite the run-up in global stocks, with emerging market debt falling 5.1% but high yield only off by 1.4%. Treasurys fell almost 2%, and Treasury inflation-protected securities (TIPS) fell 7% in the quarter as investors’ inflation expectations moved lower.

• Research firm ICI’s mutual fund flow data in the second quarter reflected the sharpest outflow in bonds since October of 2008, perhaps a harbinger of things to come.

HEDGE FUNDS / PRIVATE EQUITY Market Performance, 2nd Quarter 2013

• Hedge fund strategies posted a solid start to 2013, with the HFRI Fund Weighted Composite Index posting a 3.6% 2013

HFRI Fund Weighted Composite Index

-0.01%

3.59%

HFRI Equity Hedge Index

0.40%

5.34%

HFRI Relative Value Index

0.17%

3.26%

-0.04%

3.28%

1.41%

4.25%

HFRI Fund of Funds Composite Index HFRI Fund of Funds Conservative Index

return through the end of June following a slight decline in the second quarter.

• Global macro remained a challenging sub-strategy Source: HFRI

Q2 ’13

(-1.07% year-to-date) after losing 1% for 2012 and also registering weak 2010 and 2011 calendar years as global central bank policy and unstable trends continue to impact managers. Equity hedged strategies continued their streak of comparable returns to their global longonly peers. Event-driven strategies, particularly special situations, are standouts thus far in 2013.

• Alternatives research firm Prequin highlights that private equity fundraising was strong for the second quarter, although heavily concentrated within the industry’s largest players. Only 154 funds received commitments in the second quarter, the fewest in a quarter since 2003.

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COMMODITIES Market Performance, 2nd Quarter 2013 Q2 ’13

2013

Dow Jones UBS Commodity Index

-9.45%

-10.47%

S&P GSCI Commodity Index

-5.93%

-5.41%

-22.78%

-26.31%

Natural Gas (U.S. Spot Henry Hub)

-11.38%

4.28%

Crude Oil (U.S. Spot, WTI Cushing)

-0.69%

5.16%

Gold (Spot, $/oz)

Sources: MPI Stylus Pro, Bloomberg

• The Dow Jones UBS Commodity Index fell 9.5% in the second quarter after falling 1.1% in the first quarter. Dollar strength has hurt so far this year, as has brent crude falling over 8%.

• At the sub-index level, energy was weak across the board, as were industrial metals on global growth concerns, particularly regarding China, Latin America, and India.

• Precious metals were also hit by dollar strength, with the index falling 5.5% after posting a 6% return in 2012. Individually, gold and silver fell 22.8% and 30.5%, respectively, in the quarter as some of the more popular commodity trades over the past few years fell out of favor.

Market Performance, 2nd Quarter 2013 Q2 ’13

2013

MSCI U.S. REIT Index

-1.58%

6.36%

Wilshire REIT Index

-1.39%

5.94%

Source: MPI Stylus Pro

REAL ESTATE • Public real estate, as measured by the MSCI U.S. REIT Index, fell 1.6% for the quarter. REITs underperformed U.S. equities for only the fourth quarter out of the last nine.

REITs are still positive for the year (+5.94%) and are up a staggering 204.6% cumulative over the past 10 years ended December 31.

• Higher interest rates hurt REIT performance as the 10-year U.S. Treasury yield rose from 1.8% to 2.5% in the second quarter, causing investors to revalue REIT distributions in light of higher interest rates.

• Several REIT subsectors exhibit attractive fundamentals, and overall capital positioning is strong for REITs, but should interest rates continue to migrate higher, performance could again be vulnerable.

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WEALTH MANAGEMENT | Q2 13

captrust news

CAPTRUST GROWTH CAPTRUST grew in the second quarter with the following new additions to the team

GIVING BACK We are honored to have supported these charities during the second quarter of 2013: • Junior Achievement of Central Virginia

Rush Benton joined CAPTRUST as a senior director of strategic wealth and is responsible for growing the firm’s private wealth assets both organically and through acquisition of independent, fee-based registered investment advisors. Prior to joining the firm, Rush served as cofounder and chairman of WealthTrust, one of the first consolidators of registered investment advisors. Rush received a Bachelor of Arts degree in economics from Vanderbilt University.

• The Salvation Army of Wake County • Youth Homes of MidAmerica • American Heart Association’s Heart Walk • Ronald McDonald House Iowa • John Owen’s Adventure • Big Brothers Big Sisters of the Triangle • Dallas Arthritis Walk • Angelman Syndrome Foundation • Hit it Farr for Kirby • Salvation Army — Raleigh (Youth Basketball sponsorship) • Upper Room Christian Academy • Hope Reins • St. Baldrick’s Foundation

Danny Lowe joined CAPTRUST as a senior manager, Nonqualified Executive Benefits, and oversees the firm’s nonqualified deferred compensation offering to include plan design, implementation, financing, integration, and administration. Prior to joining our firm, he worked at the Principal Financial Group as senior executive benefits consultant. Danny received a Bachelor of Arts degree in management and society from the University of North Carolina at Chapel Hill and a Master of Business Administration from East Carolina University.

• Pediatric Brain Tumor Foundation • Tisch Brain Tumor Center (at Duke University Children’s Hospital) • North Carolina Foundation for Public School Children • Wildwood Hills Ranch • Read & Feed • Raleigh Food Bank • Food Bank of Eastern Michigan

FAREWELL TO A DEAR FRIEND Just shy of her 105th birthday, we lost our dear friend Ruby Merritt of Chapel Hill, N.C. Ms. Merritt had known our CEO Fielding Miller since he was a rookie stock broker in 1987.

Richard Rush joined CAPTRUST as a senior manager, Investment Research, and manages the firm’s emerging market client relationships by providing investment management and consulting services. Prior to joining our firm, he worked at CIG Corporation as the director of Wealth Management. Richard received a Bachelor of Arts degree in political science from St. Mary’s College and a Master of Arts in mathematics from Wayne State University.

“I have never known a finer person than Ruby Merritt. For 26 years I have had the wonderful privilege of meeting with Ms. Merritt and her family in her home — and many times I brought home one of her priceless pearls of wisdom to share with my own family. I vividly remember our first encounter, sitting at her kitchen table. She had her mind made up that she wanted to invest in tax-free bonds — at the highest interest rate going. Ms. Merritt was 78 at the time so I reminded her that the highest interest rates would be with bonds that wouldn’t mature for 20 years or more. She just smiled and said, ‘I plan to be around for a while so let’s get those good rates.’ And that we did. Since then I have been blessed with a friendship that I will cherish for my lifetime.”

— Fielding Miller

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WEALTH MANAGEMENT | Q2 13

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UPCOMING INDUSTRY INVOLVEMENT The following is a list of topical discussions to be led by CAPTRUST at upcoming industry events in the third quarter of 2013.

July 21, 2013 | San Diego Western Benefits Conference

PAPERLESS STRATEGIC RESEARCH REPORT We’ve added an electronic Strategic Research Report offering in response to our readers’ requests for an eco-friendly alternative.

Going forward, you can access our publication on a desktop computer, a tablet, and mobile devices, while also enjoying a robust set of enhanced digital viewing and sharing features. It is our hope that your reading experience will be enhanced through this electronic medium. Please contact your financial advisor or client relationship manager if you would like to subscribe to our electronic Strategic Research Report.

QDIA Due Diligence, New Realities of Cash Equivalents in Plans Speaker: Mark Davis, Financial Advisor September 10, 2013 | New York

RECOGNITION

Global Alpha Forum Risk Debate: Long-Term Asset Allocation Trends–Risk Allocation vs.

Strategic Asset Allocation Speaker: Ernest Liebre, Financial Advisor

CAPTRUST Honored by the Greater Raleigh Chamber of Commerce The Greater Raleigh Chamber of Commerce awarded CAPTRUST with an Entrepreneurial Company Award for companies with 101 or more employees at the 29th annual Pinnacle Business Awards event. The event honored local businesses that have showed courage, commitment, and conviction. Entrepreneurial businesses based in the Triangle such as CAPTRUST received awards for their staying power, business growth, community involvement, and innovation along with their steady growth and profitability.

September 15–18, 2013 | Las Vegas 2013 Las Vegas Mid-Sized Retirement & Healthcare Plan Management Conference Best Practices for Conducting an Advisor Request for Proposal Speaker: Greg Middleton, Senior Manager Enhancing Retirement Readiness through a Focus on Total Retirement Speaker: Pam Popp, Financial Advisor September 19, 2013 | New York Liability Driven Investing Conference Speaker: Grant Verhaeghe, Senior Manager Speaker: Ernest Liebre, Financial Advisor

CAPTRUST CEO Named as Regional Finalist for the 2013 E&Y Entrepreneur of the Year Award® J. Fielding Miller joined a list of esteemed visionaries nominated as a finalist for the coveted Ernst & Young Entrepreneur of the Year Award® for the Southeast region. The Entrepreneur of the Year Program recognizes business owners who demonstrate creativity, innovation, and personal commitment in turning an idea into a successful and sustainable enterprise.

All Publication Rights Reserved. None of the

The opinions expressed in this report are subject to change without notice. This material has

material in this publication may be reproduced

been prepared or is distributed solely for informational purposes and is not a solicitation

in any form without the express written

or an offer to buy any security or instrument or to participate in any trading strategy. The

permission of CAPTRUST: 919.870.6822.

information and statistics in this report are from sources believed to be reliable but are not warranted by CAPTRUST Financial Advisors to be accurate or complete. Performance

©2013 CAPTRUST Financial Advisors

data depicts historical performance and is not meant to predict future results. CAPTRUST Financial Advisors, Member FINRA/SIPC.

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