CAPTRUST Strategic Research Report Q3 2012 Wealth Management Edition

WEALTH MANAGEMENT | Q3 12

Strategic research report Proactive Year-End Discussions for 2013’s Uncertain Tax Environment Mark Paccione, CFA, CFP® Director, CAPTRUST Investment Research

R. Michael Gray, CPA, PFS Senior Vice President, CAPTRUST Financial Advisor

Given the looming “fiscal cliff” and potential rollback of the Bush-era tax cuts, many investors are concerned about future tax rates and may be unsure about what to do as they consider year-end tax planning opportunities. While many of the obvious questions cannot be answered with certainty just yet, proactively discussing the following topics with your tax advisor may help provide clarity around potential outcomes — and possible steps to consider in advance of year-end.

Should I sell concentrated, low-basis stock positions before year-end?

Considerations: The 15% tax rate on long-term capital gains could increase to 23.8% for those individuals also subject to the 3.8% Medicare surcharge on investment income. For individuals planning to sell a long-term holding in the near future, it could make sense to sell before year-end, rather than wait until next year. Use caution, however, since selling for tax reasons alone may negatively affect returns for long-term investors.

Should I sell my dividend-focused stocks and funds?

In This Issue Letter from the Editor

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Wealth Management Planning

4

Portfolio Strategy

12

Index Returns

15

Asset Allocation Research

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Discretionary Research Highlights 18 Investment Asset Classes

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CAPTRUST in the News

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Considerations: If the Bush-era tax cuts expire, the tax rate for qualified dividends could shift from 15% to as high as 43.4%. As a result, high dividendpaying stocks and funds could face short-term selling pressure toward the end of the year as taxable investors conclude that after-tax returns will be less attractive for those stocks and funds in the future. While keeping this in mind, we feel investment decisions should be based on underlying fundamentals such as future growth prospects—rather than tax considerations alone. Additionally, if the concept of linking the dividend tax rate to that of long-term capital gains is continued, any increase in tax rates may be limited.

Should I look at accelerating ordinary income into 2012 to avoid a higher rate in 2013?

Considerations: The highest marginal tax rate on ordinary income may rise from 35% to 39.6% or more, depending on the source, so generating continued on page 3

letter from the editor

“ALL THE NEWS THAT’S FIT TO PRINT” That very tagline first appeared 115 years ago in the New York Times’ upper-left corner.

While the proverbial content “bar” is always high, we found this quarter especially challenging given the fourth quarter’s pending events with far-reaching implications.

The U.S. election season, change in Chinese leadership, ongoing European issues, and a volatile economic picture leave us with plenty of eligible contemporary topics.

We try to avoid the “news” aspect given how much financial narration has permeated mainstream media since the onset of the financial crisis, but this quarter we felt we would be remiss if we did not cover what we see as the most important issue over the next 18 months: the U.S. “fiscal cliff ” and its implications for wealth clients.

Eric J. Freedman

Feature articles this quarter provide perspective on planning decisions one can make in light of an uncertain year-end, plus a piece on behavioral finance, a continued area of interest for us — and author Mark Paccione personally. Expect more on this topic in coming publications.

CAPTRUST Chief Investment Officer

On the capital markets front, we share some of our thinking on bond investing in the wake of recent Federal Reserve and European Central Bank policy changes, and the team and I spent some time with JP Morgan’s Dr. David Kelly, who provides an insightful look at the fiscal cliff and various potential scenarios that could emerge in coming weeks. To close, I summarize our thoughts across asset classes in my regular investment strategy piece.

A client once told me that we are all drowning in information but thirsting for knowledge.

That quote has stuck with me, and comes to mind particularly when thinking about topics to cover in this publication. As a long-time student of the global economy, I am well aware of the opportunity cost of you spending time reading this. We want to reach our readers with pieces that are understandable, actionable, and, ultimately, interesting, so if you decide any part of this quarter’s content was not “fit for print,” please don’t be bashful; my comment box is always open.

Have a great finish to 2012 — it promises to be action-packed.

Onward—

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

©2012 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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WEALTH MANAGEMENT | Q3 12

continued from page 1

ordinary income in 2012 may make sense. Remember, however, that the possibility of legislative activity after the presidential election and prior to yearend exists, so taking action now may be a risk. Two areas ripe for last-minute activity include Roth conversions and stock option exercises. Roth conversions have the additional advantage of having the ability to be “undone” by October 15, 2013, in the event a negative tax scenario does not occur.

Should I defer making taxdeductible payments like charitable contributions?

Considerations: Marginal tax rates could be much higher next year if the Bush-era tax cuts expire—which will affect the tax benefit from taxdeductible payments. Once again, year-end legislative activity may pose a risk. However, many tax-deductible outlays can be made on short notice and right at year-end. Another issue is the return of the phase-out rules for itemized deductions in 2013.

Should I change my approach to municipal bonds currently in my portfolio?

Considerations: While higher tax rates would seem to benefit municipal bond holdings, there is some speculation about potentially altering the tax-exempt treatment of interest from municipal

bonds. Currently, if no action is taken, the favorable tax treatment of municipal bond income will remain intact, so no immediate action may be necessary.

However, several proposals, most notably the Simpson-Bowles Deficit Reduction Plan, recommend eliminating the tax-exempt status of new municipal bond issues. Given the high level of uncertainty surrounding this topic, we feel investors would be wise to closely monitor the issue and protect themselves by diversifying across fixed income subsectors beyond municipal bonds.

Should I realize gains this year to offset capital losses, or should I harvest unrealized losses as I typically do at the end of each year?

Considerations: With the potential for higher rates on capital gains (both long- and short-term), the value of realized and unrealized capital losses may be greater in 2013. If rates are higher next year, a good case can be made for not harvesting losses this year; however, selling positions with unrealized gains solely for the sake of capturing losses may not be a good solution either, since tax expense is just one component of an investor’s net returns. This is another circumstance where post-election legislation could change the recommended course of action and may call for last minute transactions in a portfolio.

Should I move assets into vehicles that are not affected by higher or new taxes?

Considerations: While they provide tax protection, it is not possible to move large sums quickly into Individual Retirement Accounts.

Variable annuities may be another tax-favored option to consider since they allow unlimited contributions and tax-deferred growth. Earnings are taxed as ordinary income at the time they are withdrawn—presumably well into the future. However, investors should be cautious since annuities can be expensive and withdrawals prior to age 59½ may be subject to tax penalties.

In conclusion, the fiscal cliff presents an unusually high level of uncertainty for individual investors heading into 2012’s year-end. At a high level, our recommended approach for clients involves proactively discussing and preparing for multiple potential scenarios with your tax advisor, while keeping up to date on the latest developments, and positioning yourself to be able to move quickly. While CAPTRUST does not provide tax advice, we are certainly available for further discussions on these topics and more as we work toward our shared goal of achieving your ideal outcomes.

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wealth management planning

PERCEPTION VERSUS REALITY Mark Paccione, CFA, CFP® Director, CAPTRUST Investment Research

Enter behavioral finance, a discipline that tries to bridge this gap between theory and reality. Behavioral finance studies the effect of social, cognitive, and emotional forces on economic and investment decisions made by individuals — and how those decisions often contradict the rational behavior assumed by classical economic models.

It is an exciting and relatively new field of study based on the work of three key figures: Amos Tversky, Daniel Kahneman, and Richard Thaler. Starting in the 1960s, cognitive psychologists Kahneman and Tversky researched and published many of the psychological concepts that behavioral finance explores, including popular works on prospect theory and loss aversion which investigate an individual’s tendency to view gains differently from losses.

Research has shown that individuals prefer avoiding losses much more than experiencing gains. In 2002, Kahneman received the Nobel Prize in economics for his groundbreaking work with Tversky.

As active participants in the capital markets, we at CAPTRUST are well aware that economic theory and reality are often two very different things. Traditional economic theory assumes that humans are rational wealth maximizers who make logical decisions with their capital.

However, basic life experience tells us this is not always the case. Experiments have shown, for example, that individuals will drive farther to save $5 on a $15 item than a $100 item.1 Theory would dictate that a rational individual would drive the same amount of time regardless of the price. However, humans don’t always act rationally when it comes to money, and our behavioral quirks create risks, challenges, and opportunities for us as investors.

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The third major figure in behavioral finance is Richard Thaler, a professor at the University of Chicago. Building on the work of Tversky and Kahneman, he published a paper titled “Mental Accounting Matters” in 1999. Mental accounting, which was discussed in our first quarter Strategic Research Report, is a concept that explores how individuals perceive and experience financial outcomes, how decisions are made and subsequently evaluated, and how financial activities are assigned to specific accounts or “buckets.” Anyone who has ever set aside money for a specific purpose—such as saving for a child’s college tuition, creating a vacation fund, or socking money away for an engagement ring—has employed mental accounting.

WEALTH MANAGEMENT | Q3 12

Three themes central to behavioral finance are: heuristics, framing, and market inefficiencies. Heuristics refers to the use of “rules of thumb” in decision making in situations when detailed analysis and exhaustive searches are not practical. One common heuristic is anchoring and adjustment, where estimates are based on an adjustment from an implicit reference point (or anchor). For example, if you ask a general question such as “What will the S&P 500 return next year?” you will get a wide range of answers. If you ask, “How much higher or lower than +10% will the S&P 500 return next year?,” the range of estimates will be in a band that clusters around +10%.

That’s a heuristic at work. Changing the

way a choice is presented can impact what choice is eventually made. This phenomenon is referred to as framing.

For example, when asked if they prefer meat that is 90% lean or 10% fat, most people will say they prefer the former— even though they’re exactly the same thing. Finally, market inefficiencies refer to anomalies that exist due to the behavioral biases of market participants.

Many biases have been uncovered and examined. A few of them are: status quo bias (sticking with what you know), recency bias (assigning a heavier weight to events that just occurred in decision making), fear of losses, and confirmation bias (the tendency to accept data that confirms existing beliefs while rejecting data that contradicts them).

While studying the quirks of human behavior may sound interesting, readers may question the relevance of such information. Knowledge of behavioral finance is important to CAPTRUST and our clients as it enables us to make better financial decisions. By understanding natural mental processes and human decision-making tendencies, we can avoid common mistakes, set up portfolios that are more congruent with how an individual thinks, and make investment decisions that help generate higher returns over the long run. In short, understanding behavioral finance theory increases our chances of success for achieving our main mission, meeting our clients’ financial goals.

Source: 1

Kahneman, D. and Tversky, A. (1984) “Choices, Values, and Frames,” The American Psychologist, 39, 341-350

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JUST A SPOONFUL OF SUGAR Eric J. Freedman CAPTRUST Chief Investment Officer

It is always dangerous to write about a topic that could go in a different direction before your content reaches readers. While we endeavor to get this publication out to readers as soon as possible, paper-and-ink publishing necessarily drives a “time wedge” between when we write and when your eyes hit this page. I recall a period early in my CAPTRUST career when I dutifully penned a 1,500-word article a week before deadline, only to have the Federal Reserve announce an unexpected policy change that rendered my missive, as they say in the business, old hat. “Rookie move,” as the kids say.

The topic of the fiscal cliff presents a similar authorship risk. As I write in early October to a readership that will see this article in late October at the earliest about an event that will occur on December 31, I risk that said “time wedge” may include critical developments that render this article old hat. However, my editorial staff and I agreed that the probability of this

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event being resolved before publication was extremely limited, and since resolution would likely be a positive development, we rolled the dice.

Before we delve into specifics, let’s start with what the fiscal cliff actually is. While the mainstream media has affixed this catchphrase onto potential year-end events, we do not want to presuppose that what the phrase embodies has been well-explained. The fiscal cliff represents tax cut expirations, Medicare tax increases, unemployment benefit program extension terminations, and two rounds of discretionary spending cuts resulting from the 2011 Budget Control Act that are all slated to become effective on December 31, 2012. These various programs clearly represent some political sensitivities, with parties deeply entrenched as we approach year-end.

The fiscal cliff has clear economic implications from a directional standpoint. Economic textbooks

suggest that U.S. government spending as a percentage of Gross Domestic Product (GDP) is normalized in the 15-20% range (while more skeptical sources say the range is highly volatile, more like 10% to 40% over time), so any government spending decreases would impact growth in the very near term. Effective tax increases also impact growth, as less discretionary spending means less available consumption dollars. This year, National Bureau of Economic Research economist Valerie Ramey concluded that — even if higher taxes translate into more government spending — the government spending GDP “multiplier effect” (how a dollar of increased spending reverberates in the economy) has a very wide range of potential outcomes and most likely decreases private (non-governmental) spending.1 In aggregate, the fiscal cliff ’s directional economic impact is clearly negative.

The order of negative magnitude, however, is unclear and a major point of debate among economists.

WEALTH MANAGEMENT | Q3 12

Figure 1: Federal Debt Held by Public, Actual and Projected (CBO) 140% Actual

Projected

120%

Alternative Fiscal Scenario

80%

60% CBO's Baseline Projection

40%

20%

0% 1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

Source: Congressional Budget Office3

Percentage of GDP (%)

100%

2020

Years If current laws governing taxes and spending remain in effect (CBO's baseline projection), debt held by the public will fall from 73% of GDP in fiscal year 2012 to 58% of GDP in 2022. If policymakers altered those laws to maintain many policies that have been in effect in recent years (CBO's alternative fiscal scenario), debt would climb to 90% of GDP by 2022. In either case, debt would be relatively high by historical standards.

So why do we need to go through this? The answer rests on America’s increased reliance on debt financing, within both the public and the private sectors. In prior Strategic Research Reports, we have analyzed consumer debt growth and how that has correlated with economic output. Government debt, however, has become a more topical discussion, particularly given the political climate.

Cumulative deficits (when government expenditures exceed revenues) have brought our debt picture to untenable long-term levels, and both political parties agree that high debt levels are not conducive to economic growth. In a comprehensive analysis that included both developed and developing countries, economists Carmen Reinhart and Kenneth Rogoff noted that median growth rates fall by 1% and average growth rates fall more than that for countries saddled with debt-to-GDP ratios above 90%.2 We have to go through it because, just as Mary Poppins prescribed to Jane and Michael Banks, we need to take our collective medicine, and investors are trying to see how much “sugar” will be included, as the list of policy changes could come all at once (representing sugarless castor oil in the form of a potential downward GDP shock) or in a more piecemeal fashion

(attenuated castor oil that the economy could more easily stomach) should Washington decide to compromise.

Figure 1 shows the non-partisan Congressional Budget Office’s (CBO’s) late August estimates of federal debt held by the public over time (a slightly different debt measure than that cited by Reinhart and Rogoff, but instructive nonetheless) as well as forecasts from fiscal year 2013 (which started on October 1) through 2020.3 As Figure 1 displays, the dotted line represents a figurative fork in the road for the U.S. debt-toGDP ratio. If the full fiscal cliff occurs in early 2013, the CBO projects a drop in debt to GDP to more favorable long-term levels under its baseline scenario. However, should a spoonful of sugar dilute this tough medicine, the “alternative” fiscal scenario shows debt to GDP drift higher and into the 90% of GDP red zone. So the tradeoff is clear when assessing the CBO’s projections: Should the economy endure the “full” fiscal cliff, our debt-to-GDP ratio improves, but the economy likely suffers. If instead Washington compromises and we delay parts of the tax increases or sequestration (a term that encompasses the budget cuts), the economy may experience some shortterm relief at the expense of longer-term debt considerations. continued on page 8

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Given a wide range of potential outcomes and pending the political horse trading in coming weeks, we caught up with Dr. David Kelly, JP Morgan Asset Management’s chief global strategist and head of the Global Market Insights Strategy Team. David and his colleagues penned a lucid piece, describing several scenarios that may play out, and we wanted to share a few takeaways from our conversation with Dr. Kelly.

Dr. Kelly and team do not anticipate any legislation prior to the election, but instead anticipate the balance of power after presidential and congressional elections to drive further action.4 Based on election outcomes, Kelly sees one of four scenarios playing out: a Democratic sweep of Congress where the Bush-era tax cuts end for wealthy households, a Republican sweep with a focus on spending cuts, a divided government that induces the fiscal “ledge,” or a divided government that results in a fiscal “ladder.” Let’s look at each potential scenario and JP Morgan Asset Management’s investment conclusions for each scenario.

THE DEMOCRATIC SWEEP

THE REPUBLICAN SWEEP

If this scenario occurs, Kelly assumes that:

Assumptions for this scenario include:

• the Bush-era tax cuts would be extended

• extension of all Bush-era tax cuts, along with

only for those households earning less than $250,000/year, • top dividend and capital gains tax rates rise from 15% to 20%, • the payroll tax cut is phased down and eventually eliminated, • extended unemployment benefits expire on

a fix for the Alternative Minimum Tax, • expiration of the payroll tax cut and extended unemployment benefits on schedule, and • no increase in Medicare taxes.

Similar to the Democratic sweep scenario, only the first round of spending cuts takes place and the second does not take effect.7

schedule, and • higher Medicare taxes ensue.

In terms of sequestration, he assumes that only the first round of spending cuts takes effect.5

Kelly sees this scenario as a negative for equities given their diminished after-tax cash flows but potentially positive for municipal bonds. The overall GDP impact would be a one percentage point drop in GDP from current levels if no tax increases or sequestration events happened.6

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Investment implications include a positive impact on equities but the opposite for municipal bonds.

Kelly and team note further that, in this scenario, a Romney administration may seek additional tax and entitlement reform.8

WEALTH MANAGEMENT | Q3 12

DIVIDED GOVERNMENT — THE FISCAL LEDGE

DIVIDED GOVERNMENT — THE FISCAL LADDER

If we see some split at the executive and

This would be a better economic scenario with a

legislative branches of government, JP Morgan

more gradual deficit reduction, with:

anticipates a combination of spending cut

• full extension of the Bush-era tax cuts in 2013

compromises and some higher tax rates that

and for households earning less than $250,000

could include the following:

from 2014 onwards,

• extension of the Bush-era tax cuts only for

• top dividend and capital gains tax rates rise

households earning less than $250,000/year,

from 15% to 20%,

• top dividend and capital gains tax rates rise

• the payroll tax cut is maintained in 2012, phased

from 15% to 20%,

down in 2013, and eliminated in 2014,

• expiration of the payroll tax cut on schedule,

• unemployment benefits expire on schedule,

• higher Medicare taxes to pay for President

• higher Medicare taxes to pay for President

Obama’s healthcare plan, and

Obama’s healthcare plan, and

• both sets of spending cuts are implemented.9

• only the first set of spending cuts is implemented.11

Kelly and team expect that outside of a full fiscal cliff realization, this scenario would have the worst impact on the economy and stocks and would have an uncertain impact on Treasury bonds.10

In our follow-up conversation with Dr. Kelly, we asked him what he was seeing investors do to prepare for this range of outcomes, and David responded that retail investors appear to be voting with their feet, as mutual fund flows out of stocks and into bonds have occurred at the fastest rate in the last five years, a curious development in light of recent equity market performance. He was also seeing some taxable investors take steps to realize some gains this year across asset classes in light of higher anticipated taxes. In summary, though, Dr. Kelly argued that investors who are properly diversified do not need to take action ahead of the uncertain outcomes that await us this year-end. Our view — a solid asset allocation, and a spoonful of sugar, may be the best combination for investors heading into 2013.

Kelly and team see this as a potential positive for equities. Even though tax rates would move higher, GDP would expand and the fiscal deficit would simultaneously decline, potentially boosting investor confidence.12

Sources: 1

Ramey, Valerie A., and NBER (2012). “Government Spending and Private Activity.” http://econ.ucsd.edu/~vramey/research/NBER_Fiscal.pdf

2

Reinhart, Carmen M. and Kenneth S. Rogoff (2010). “Growth in a Time of Debt,” American Economic Review, May. (Revised from NBER working paper 15639, January 2010.)

3

http://www.cbo.gov/publication/43539

4

Kelly, David et al. “The Fiscal Choice: Cliff, Ledge or Ladder.” JP Morgan Asset Management Market Insights, 2012, page 5.

5

Kelly, David et al. “The Fiscal Choice: Cliff, Ledge or Ladder.” JP Morgan Asset Management Market Insights, 2012, page 6

6

Ibid

7

Ibid, page 8

8

Ibid

9

Kelly, David et al. “The Fiscal Choice: Cliff, Ledge or Ladder.” JP Morgan Asset Management Market Insights, 2012, page 10

10

Ibid

11

Ibid, page 12

12

Ibid

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NAVIGATING BONDS IN TODAY’S LOW-RATE ENVIRONMENT Hunter Brackett, CFA Senior Manager, CAPTRUST Investment Research

Under these circumstances, it may be an appropriate time for investors to reassess their portfolios and return expectations, particularly for fixed income assets. Going forward, we expect subdued returns in lower-yielding assets such as certificates of deposit, money market accounts, and fixed income securities for a number of reasons. The Fed actions discussed provide an incentive for investors to move away from lower-yielding assets and toward traditionally riskier areas such as equities. This is one of the reasons why the S&P 500 has rebounded so strongly off its March 2009 lows, recently approaching the all-time-high index level set in October 2007. In addition, many investors are concerned that interest rates can only go higher from today’s historically low levels. While the Fed will likely keep short-term rates anchored in the near term, it has less direct control over longer-term rates.

Nearly four years ago, the Federal Reserve cut its target interest rate to the lower bounds of its policy, where the rate remains today. While low interest rates are not a new phenomenon, two recent events have brought this issue back to the forefront of investors’ minds. First, the 10-Year U.S. Treasury — a useful proxy for interest rates — hit an alltime-low yield of 1.39% on July 24 amidst concerns about Europe’s debt crisis. Second, in September the Federal Reserve stated that it was willing to keep short-term interest rates at the present low levels through at least mid-2015 compared with the previous timeframe of 2014.

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The biggest risk for bond returns is a sharp rise in interest rates, but several factors could prevent this scenario. Despite accommodative monetary policy from both the Fed and European Central Bank in recent months, economic fundamentals still appear weak and risks to global growth remain a concern.

In addition, demographic factors in the United States and a lack of viable substitutes for U.S. Treasurys as a safe haven asset could provide support even as rates rise.

The forward curve, which represents market participants’ expectations for future interest rates, suggests a gradual rise in interest rates over the coming years. We also note that interest rates — which move in the opposite direction of bond prices — have staged short-lived rallies over the past few years, but in each instance have fallen as global

WEALTH MANAGEMENT | Q3 12

this action is supportive of the MBS market, we note that some of the impact may have been priced into the market before the Fed announcement.

While the housing market remains at a depressed level, fundamentals have started to improve, which could also aid the MBS market. growth concerns reemerged. For example, the yield on the 10-Year U.S. Treasury rose to 2.38% in March on stronger economic data, only to fall sharply and reach the previously cited all-time low in July.

We continue to encourage investors to diversify their allocations across subsectors of the bond market. Our research has shown that fixed income returns can remain positive, even during periods of gradually rising rates, although subsectors may behave slightly differently. Given the prospect of higher long-term rates, investors may want to reduce interest rate risk while taking on a modest amount of credit risk. Creditsensitive areas such as high-yield and emerging market debt may perform better than rate-sensitive subsectors such as Treasurys and investment-grade corporate bonds that tend to be more vulnerable to rising rates.

While credit-sensitive subsectors tend to be more volatile, we believe that their

fundamentals are supportive. Corporate balance sheets are much improved, as companies reduced costs during the recession and took advantage of low rates to refinance their debt. Thus, default rates on high-yield debt are currently below their historical averages and are expected to rise at a modest pace going forward. It may also be useful to look outside of the U.S. market for bond exposure. Emerging market debt benefits from a stronger fiscal position relative to developed economies and favorable demographics, so exposure to this subsector may be appropriate depending on investor risk tolerance.

Another fixed income subsector that has received attention recently is mortgage-backed securities (MBS).

The Fed recently announced another round of quantitative easing in which it will purchase $40 billion of MBS in the open market every month. Importantly, this program is open-ended and will continue until the labor market shows sustained improvement. Although

Following a multi-decade bull market in bonds and facing the prospect of rising interest rates, it may be tempting for investors to abandon this asset class.

However, we continue to believe that bonds have an important role to play in client portfolios. They have historically been a less-volatile asset and provided a cushion during times of economic stress. Nevertheless, we expect subdued returns for fixed income going forward, so investors will need to be more selective with their asset allocation decisions. We also stress the value that active management can play in a more challenging fixed income backdrop.

Having skilled portfolio managers who can profitably source the subsectors mentioned earlier can be additive.

We are constantly reviewing and assessing bond portfolios and money manager talent. If you have specific questions we can answer given these historic times, please do not hesitate to let us know. „

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portfolio Strategy

HASTE YE BACK Eric J. Freedman CAPTRUST Chief Investment Officer

This summer, I was fortunate enough to travel to Scotland with my dad, brother, and a good family friend, Neal Greenfield.

It was a trip I had delayed for too long — new babies, business school, and the financial crisis all contributed to its postponement, each with good reason. At last, on August 18, I found myself in Ayrshire, weary from a redeye flight and devoid of sleep (compliments of a fellow passenger’s cackle at every line from the recent movie version of The Three Stooges; my dad — affectionately referred to as the “Commish” for his selfless event planning — and I marveling at Curly’s enduring comedic prowess at 30,000 feet) but happily teeing up a new and soon-to-be-lost Titleist alongside the Ailsa Craig on Scotland’s southwest shore. I could only hope that the trip would match my long-built expectations and was determined to live every moment to the fullest. Especially considering that my honey-do account would be at an all-time surplus upon returning home. Our day at the Turnberry Golf Resort inaugurated a journey across the beautiful Scottish countryside, with my brother skillfully maneuvering a standardshift passenger van to eight different links courses.

Leaving Turnberry and reflecting on my par on 18 not being good enough to bring the youngsters (my brother and me) a victory over the seasoned veterans (thanks to Neal’s clutch birdie), we passed a sign with the message “Haste Ye Back,” which the Beverly Hillbillies may loosely translate into “Ya’ll come back now, ya hear?” It left us with a warm feeling every time we saw signs donning those three words, succinctly capturing the genuine Scottish hospitality no matter where we went. Caddies, waitresses, passers-by on the street; it didn’t matter whom we encountered, the Scots made us feel at home, except, of course, when an errant golf shot landed in the rough — a rough thickened by the second-wettest quarter in the United Kingdom since recorded history began in 1910.1 While we enjoyed excellent weather, the record spring rains lengthened what was already brutally high grass, causing us to export more golf balls than we would have liked.

The U.S. witnessed its own record in the third quarter, with the 10-Year Treasury hitting an all-time low in late July, touching 1.39% intraday. Uncertainty over Europe, the

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Chinese slowdown’s extent, as well as a consistent thirst for yield in any form, drove up bond prices and, by definition, drove down bond yields. My colleague Hunter Brackett covers this development’s implications for fixed income in this Strategic Research Report, but low bond yields also carry a significant impact across portfolios.

The most important consideration is total return expectations; since most asset allocations, ranging from insurance companies, pension funds, and individual investors to sovereign countries, have notable bond allocations, all else equal, lower nominal (or non-inflation-adjusted) interest rates imply lower total returns.

We don’t rule out a rise in bond prices given major events unfolding over coming months — U.S. election season, the fiscal cliff, a more subdued corporate profit tone, and ongoing European deliberations — but should the global economy “muddle through” or even surprise with growth exceeding expectations, bonds will not enjoy much of a yield cushion.

Figure 1 compares 10-Year U.S. Treasury yields to their equivalents in Germany, Japan, and Switzerland, demonstrating two important points. First, one can see that the yield cushion for all four sovereign countries’ bonds has contracted materially in recent years, with only the U.S. 10-Year above 1.50% at September’s end. Second, precedent exists wherein bond prices could move higher despite historically low yields.

However, since nominal bond yields are bound by zero, at some point, total return expectations must come down as bond yields approach this absolute zero boundary.

While no one can know definitively when bond yields will bottom, the closer we approach zero, the faster investors need to “haste back” their total portfolio return expectations. If bonds move lower in yield (and higher in price), investment theory suggests that a more muted total return expectation should be applied to all asset classes. The theory is best explained by the great Warren Buffett in a 1999 Fortune magazine article, which 13 years later remains one of the most popular media investing interviews of all time. (Please realize how clichéd it is to quote Mr. Buffett in this industry, so you know it’s gotta be good.) Mr. Buffett said that “interest

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the same maturity. This difference, by definition, provides investors with a realtime gauge of inflation expectations. The rates are for 5- and 10-year breakeven rates; in other words, where the market sees inflation 5 and 10 years from now.

Figure 1: Select 10-Year Government Bond Yields, Sept 2007 – Sept 2012 5.0% United States Japan

4.5% 4.0%

Switzerland Germany

2.5% 2.0% Source: Bloomberg

Yield (in %)

3.5% 3.0%

1.5% 1.0% 0.5% 9/1/2012

6/1/2012

3/1/2012

9/1/2011

12/1/2011

6/1/2011

3/1/2011

9/1/2010

12/1/2010

6/1/2010

3/1/2010

12/1/2009

9/1/2009

3/1/2009

6/1/2009

12/1/2008

9/1/2008

6/1/2008

3/1/2008

12/1/2007

9/1/2007

0.0%

Figure 2: Weekly U.S. Breakdown Inflation Expectations, 5 and 10 Years Forward, Jan 2002 – Oct 2012 3.0%

1.5% 1.0%

Source: Bloomberg

0.5% 0.0% 5-Year Breakevens 10-Year Breakevens

-0.5%

rates… act on financial valuations the way gravity acts on matter. The higher the rate, the greater the downward pull… so if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return in line.” 2 Of course, investment theory and reality can diverge over time, so it is not a given that all other asset classes will sell off if interest rates move higher. We have been adamant — in these pages and other client communications — that bond yields will remain low and sticky for some time. While we hear periodic

1/11/2012

1/11/2011

1/11/2010

1/11/2009

1/11/2008

1/11/2007

1/11/2006

1/11/2005

1/11/2004

1/11/2003

-1.0% 1/11/2002

Breakdown Rate (in %)

2.5% 2.0%

inflationary cries (and have for five years), we continue to see the global economy as being too weak in the short term to stoke sustainable inflationary pressures, although we do see it as a potential risk should central banks continue accommodative monetary policy in the form of ongoing bond buying. Even given recent central bank activity, inflation expectations remain subdued.

Figure 2 shows inflation expectations as measured by breakeven inflation rates, calculated as the difference between nominal and real (inflation-adjusted) yields for bonds from the same issuer and

As Figure 2 details, inflationary expectations have risen from the depths of the financial crisis in 2008 and 2009, but current rates are well within the long-term average of 2.5 to 3.0% and are still below pre-crisis levels. Also, while it’s hard to see on the chart, inflation expectations have reversed from the period immediately preceding the Fed’s September policy announcement of open-ended bond purchases. So while inflation could cause bond yields to move higher in a more rapid fashion, for now, we retain our view that inflation is a “high class problem.” We will be watching developments that may cause us to shift this long-standing belief.

We see bond yields as being sticky at current levels, with downside risk to yields in the form of a marketunfriendly election, a failure to reach compromise on the fiscal cliff, a sharp global slowdown, and a variety of other negative catalysts and upside in the form of unforeseen inflation, quicker-than-expected growth, or asset allocation trends reversing from prior years’ bond-market dominance over stocks (see Figure 3 on the next page). Given consistent demand for fixed income assets, the potential for an asset allocation shift out of bonds is real, although U.S. demographics and memories of 2008’s woes would suggest that such a shift would be gradual. continued on page 14

13

continued from page 13

Figure 3: Investment Company Institute: Monthly Net New Flows into Stock and Bond Funds, Jan 2007 – Aug 2012

$40,000 $20,000 $0 -$20,000 -$40,000 Total Equity Total Bond

-$60,000

Given three possible scenarios, 1) a “muddle through” economy where bond yields hover at current levels with a bias for moving higher, 2) a “risk off” scenario where bond yields fall further, approaching the zero bound as investors seek safety, or 3) a “risk on” scenario where bonds are shunned in favor of stocks and traditionally riskier asset classes, portfolio returns could follow very different patterns, depending on their relative allocations. Regardless, only the second scenario would see bond prices head higher, which — despite economic and Buffett theory — may not result in all other asset classes moving higher as well based on recent relationships. While fixed income portfolios may get one last hurrah higher, they get closer and closer to the zero bound.

Please do not read this as me writing the bond market’s epitaph; quite the opposite. We still see a lot of risks in the global economy, including some in the very near term that cause us to recommend and retain a healthy exposure to parts of the bond market that run counter to current consensus views. My main message is that return expectations, for both bond-heavy and bond-light investors, need to be more subdued, given a lower nominal return world. Credit Suisse’s David Zion noted earlier this year that S&P 500 companies’

5/1/2012

1/1/2012

9/1/2011

5/1/2011

1/1/2011

9/1/2010

5/1/2010

1/1/2010

9/1/2009

5/1/2009

1/1/2009

9/1/2008

5/1/2008

1/1/2008

9/1/2007

5/1/2007

1/1/2007

-$80,000

Source: ICI

Net New Cash Flow (in $ Millions)

$60,000

median pension return expectation was 7.79% at the end of 2011, in an environment where U.S. nominal bond yields stood at historically low rates.3 While we don’t think this is an unchallenging return assumption over a long period of time, shorter term it may be difficult to achieve depending on asset allocation and liquidity needs.

Our last round fittingly took place at St. Andrews’ majestic Old Course, golf ’s birthplace. After a memorable day, Neal once again birdied 18 in front of a small crowd to give the old-timers a much-deserved multi-round, carry-over win following a solid finish from the Commish that morning — leaving the youngsters to ponder what could have been (and pick up the evening’s check). On top of the epic loss, I developed elbow tendonitis from having played too many rounds in too short a period (read: I am getting old), but that injury has neither garnered sympathy from my wife, Jamie, nor shortened the honey-do list. Still, the feeling standing on the Old Course’s first tee, playing Muirfield before the Open Championship next year, birdieing 18 at Troon, the jokes, the blinding rain, the non-conceded putts, eccentric caddies, driving on the wrong side of the road, the Scotts’ warm smiles, and a nip or two on the 19th hole will stay with me: Haste Us Back, indeed. n

Sources: http://www.bbc.co.uk/news/uk-18653274

1

http://money.cnn.com/magazines/fortune/fortune_archive/1999/11/22/269071/

2

https://doc.research-and-analytics.csfb.com/docView?sourceid=em&document_id=x430358&serialid=4SZAPm5ppWs68p7uGa6zSSuWzTQo2UkuZfyb20q%2F9pk%3D, page 9

3

14

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WEALTH MANAGEMENT | Q3 12

index returns

2012 3RD QUARTER ASSET CLASS RETURNS 2000 1997

International Commodities Equities 31.84% 30.98% Fund of Funds

Real Estate

26.47%

26.81%

Commodities

Fixed Income

24.35%

2001 1998

2002 1999

2000 2003

2004 2001

2005 2002

2006 2003

2004 2007

2008 2005

2009 2006

2007 2010

2008 2011

YTD

Real Estate

Commodities

Small Cap Stocks

Real Estate

Commodities

Real Estate

International Equities

Fixed Income

International Equities

Real Estate

Real Estate

Large Cap Stocks

35.92%

17.12%

5.24%

42.14%

28.48%

8.69%

16.28%

Cash

Mid Cap Stocks

Small Cap Stocks

Fixed Income

Real Estate

40.48%

26.85%

7.84%

14.89%

12.83% Fixed Income

Mid Cap Stocks

21.26% Large Cap Stocks

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

Small Cap Stocks

3.64%

40.06%

20.22%

12.65%

18.37%

10.26%

-21.34%

28.61%

25.48%

1.50%

14.23%

Cash

Real Estate

Small Cap Stocks

Real Estate

Large Cap Stocks

Fixed Income

Small Cap Stocks

Cash

Mid Cap Stocks

Fund of Funds 2.79%

Cash

Small Cap Stocks 2.49%

Fund of Funds

Mid Cap Stocks

18.23%

4.08%

-5.62%

Cash

Small Cap Stocks

Large Cap Stocks

Fixed Income

Real Estate -4.55%

1.68%

-7.79%

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%

-12.45%

Large Cap International Stocks Equities

-0.82%

1.51%

Real Estate

8.25%

-3.02%

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

Cash 3.64%

Mid Cap Stocks

5.01%

31.49%

10.25%

6.36%

20.91%

Fixed Income

47.25%

21.36%

8.44%

11.63%

Small Cap Stocks

25.90%

-19.50%

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%

4.34%

Small Cap Stocks 4.55%

Cash 3.35%

Fixed Income

Cash

Cash

1.05%

1.44%

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

International Equities

16.10%

-1.55%

10.86%

Small Cap Commodities Stocks 5.63% -4.18%

Fund of Funds

Fixed Income

Fund of Funds

Fixed Income

-37.97%

11.16%

6.54%

-5.51%

3.99%

Mid Cap Stocks

Fixed Income

Fund of Funds

Commodities

Fund of Funds

-41.46%

Commodities

Real Estate

International Equities

-16.82%

14.00%

Real Estate

-1.57%

2.43%

0.10%

Large Cap Stocks

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

4.33%

2.07%

Large Cap Commodities Stocks 16.83% 28.43%

-45.25%

5.93%

5.46%

Cash

Cash

0.21%

0.13%

-13.32%

International Equities -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 (Barclay’s 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)

3.33%

Cash 0.07%

Sources: Markov Processes Inc., Bloomberg, Mobius

1996 1999

2012 3RD QUARTER INDEX PERFORMANCE Q3 12

2012

2011

2010

2009

2008

2007

1-YEAR

3-YEAR

5-YEAR

S&P 500

6.35%

16.44%

2.11%

15.06%

26.46%

-37.00%

5.49%

30.20%

13.20%

1.05%

8.01%

Dow Jones Industrial Average

5.02%

12.19%

8.38%

14.06%

22.68%

-31.93%

8.88%

26.52%

14.45%

2.16%

8.60%

NASDAQ Composite

6.17%

19.62%

-1.80%

16.91%

43.89%

-40.54%

9.81%

29.02%

13.66%

2.90%

10.27%

Russell 1000

6.31%

16.28%

1.50%

16.10%

28.43%

-37.60%

5.77%

30.06%

13.27%

1.22%

8.35%

6.11%

16.80%

2.64%

16.71%

37.21%

-38.44%

11.81%

29.19%

14.73%

3.24%

8.41%

Russell 1000 Value

6.51%

15.75%

0.39%

15.51%

19.69%

-36.85%

-0.17%

30.92%

11.84%

-0.90%

8.17%

Russell Mid Cap Index

5.59%

14.00%

-1.55%

25.48%

40.48%

-41.46%

5.60%

28.03%

14.26%

2.24%

11.18%

Russell 1000 Growth

10-YEAR

Russell 2000

5.25%

14.23%

-4.18%

26.85%

27.17%

-33.79%

-1.57%

31.91%

12.99%

2.21%

10.17%

Russell 2000 Growth

4.84%

14.08%

-2.91%

29.09%

34.47%

-38.54%

7.05%

31.18%

14.19%

2.96%

10.55%

Russell 2000 Value

5.67%

14.37%

-5.50%

24.50%

20.58%

-28.92%

-9.78%

32.63%

11.72%

1.35%

9.68%

AC World Index Free Ex-U.S.

7.49%

10.86%

-13.33%

11.60%

42.14%

-45.24%

17.12%

15.04%

3.63%

-3.67%

10.32%

HFRI Fund of Funds

2.34%

3.33%

-5.72%

5.70%

11.47%

-21.37%

10.25%

2.84%

1.48%

-1.65%

3.62%

Wilshire REIT Index

-0.15%

14.74%

9.24%

28.60%

28.60%

-39.20%

-17.55%

32.43%

20.72%

1.73%

11.35%

Barclays Govt. Intermediate Bond

0.62%

1.70%

6.08%

4.98%

-0.32%

10.43%

8.47%

2.39%

4.09%

5.20%

4.20%

Barclays Corporate IG Bond

3.83%

8.66%

8.15%

9.00%

18.68%

-4.94%

4.56%

10.76%

9.09%

8.06%

6.56%

Barclays Aggregate Bond

1.59%

3.99%

7.84%

6.54%

5.93%

5.24%

6.97%

5.16%

6.19%

6.53%

5.32%

Barclays Intermediate Govt./Credit

1.40%

3.53%

5.80%

5.89%

5.24%

5.08%

7.39%

4.40%

5.18%

5.71%

4.76%

Barclays Muni Bond

2.31%

6.06%

10.70%

2.38%

12.91%

-2.47%

3.36%

8.32%

5.99%

6.06%

5.03%

Barclays High Yield

4.53%

12.13%

4.98%

15.12%

58.21%

-26.16%

1.87%

19.37%

12.90%

9.34%

10.98%

90-Day U.S. Treasury

0.03%

0.07%

0.10%

0.13%

0.21%

2.06%

5.00%

0.07%

0.11%

0.72%

1.82%

Consumer Price Index (Inflation)

0.59%

2.29%

2.96%

1.50%

2.72%

0.09%

4.08%

1.74%

2.24%

2.06%

2.46%

Sources: Morningstar, Mobius, MPI

INDICES

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

15

asset allocation research

We include our asset allocation research for illustrative purposes only. These recommendations are being implemented only in instances where CAPTRUST has been granted full trading discretion on asset allocation decisions within client portfolios.

10.0%

U.S. Equities

STRATEGY 1

International Equities Fixed Income Hedge Funds / Private Equity Commodities Real Estate

MIN

TARGET

MAX

U.S. Equities

0.0%

0.0%

0.0%

International Equities

0.0%

0.0%

0.0%

Fixed Income

75.0%

90.0%

100.0%

Hedge Funds / Private Equity

0.0%

10.0%

20.0%

Commodities

0.0%

0.0%

0.0%

Real Estate

0.0%

0.0%

0.0%

MIN

TARGET

MAX

0.0%

6.0%

10.0%

90.0%

3.0% 3.0%

6.0% 3.0%

U.S. Equities

STRATEGY 2

20.0%

International Equities Fixed Income

U.S. Equities International Equities

Hedge Funds / Private Equity Commodities Real Estate

65.0%

4.0%

0.0%

3.0%

6.0%

50.0%

65.0%

75.0%

Hedge Funds / Private Equity

5.0%

20.0%

25.0%

Commodities

0.0%

3.0%

6.0%

Real Estate

0.0%

3.0%

6.0%

Fixed Income

3.0% 17.0%

U.S. Equities

STRATEGY 3

16.0%

International Equities 10.0%

Fixed Income Hedge Funds / Private Equity Commodities Real Estate

50.0%

16

WWW.CAPTRUSTADVISORS.COM

MIN

TARGET

MAX

U.S. Equities

10.0%

17.0%

21.0%

International Equities

4.0%

10.0%

14.0%

Fixed Income

30.0%

50.0%

60.0%

Hedge Funds / Private Equity

7.0%

16.0%

21.0%

Commodities

0.0%

4.0%

8.0%

Real Estate

0.0%

3.0%

6.0%

WEALTH MANAGEMENT | Q3 12

4.0%

U.S. Equities

STRATEGY 4

International Equities Fixed Income

U.S. Equities International Equities

Hedge Funds / Private Equity Commodities Real Estate

3.0% 24.0%

MIN

TARGET

MAX

15.0%

24.0%

29.0%

8.0%

16.0%

28.0%

Fixed Income

20.0%

32.0%

38.0%

Hedge Funds / Private Equity

10.0%

21.0%

26.0%

Commodities

0.0%

4.0%

8.0%

Real Estate

0.0%

3.0%

6.0%

21.0%

16.0%

32.0%

U.S. Equities

5.0%

STRATEGY 5

4.0% 28.5%

International Equities

MIN

TARGET

MAX

20.0%

28.5%

35.0%

International Equities

12.0%

20.0%

25.0%

Fixed Income

15.0%

21.0%

25.0%

Hedge Funds / Private Equity

12.0%

21.5%

26.5%

Commodities

0.0%

5.0%

10.0%

Real Estate

0.0%

4.0%

8.0%

21.5%

Fixed Income Hedge Funds / Private Equity Commodities Real Estate

U.S. Equities

20.0% 21.0%

U.S. Equities International Equities Fixed Income Hedge Funds / Private Equity Commodities Real Estate

5.0%

STRATEGY 6 MIN

TARGET

MAX

U.S. Equities

25.0%

32.5%

40.0%

International Equities

16.0%

24.0%

30.0%

Fixed Income

0.0%

11.0%

20.0%

Hedge Funds / Private Equity

15.0%

23.5%

28.5%

Commodities

0.0%

5.0%

10.0%

Real Estate

0.0%

4.0%

8.0%

4.0%

32.5% 23.5%

11.0% 24.0%

5.0%

U.S. Equities

STRATEGY 7

International Equities Fixed Income Hedge Funds / Private Equity Commodities Real Estate

6.0%

MIN

TARGET

MAX

U.S. Equities

26.0%

36.5%

44.0%

International Equities

18.0%

28.0%

34.0%

Fixed Income

0.0%

4.5%

7.0%

Hedge Funds / Private Equity

12.0%

20.0%

25.0%

Commodities

0.0%

6.0%

12.0%

Real Estate

0.0%

5.0%

10.0%

36.5% 20.0%

4.5%

28.0%

17

CAPTRUST Discretionary research highlights

U.S. EQUITIES • We switched from a more defensive posturing early in the

• After the initial sharp sell-off in August 2011, we deployed

second quarter of 2010 to a more optimistic orientation

some more capital into small- and mid-capitalization

in August 2010 and then an even more optimistic view in

stocks in a contrarian fashion but reversed that positioning

early October 2010, feeling that the market had overshot

a month later fearing more potential downside. While we

to the downside.

have not deployed fresh capital into the U.S., we have not rebalanced portfolios in the recent equity market rally,

• In mid-May 2011, we ratcheted back to a more neutral

deploying a slightly bullish tilt to our portfolios.

posturing, anticipating a potential growth slowdown as well as taking profits on our previously held constructive positioning.

INTERNATIONAL EQUITIES • We continue to have a footing in international equities

“muddle through” type of recovery. Recent concerns

yet remain concerned about the overhang surrounding

about whether Spain or Italy will submit to more stringent

the European Union as well as the potential for Chinese

fiscal measures could continue to cast a shadow over

growth deceleration. We have seen some progress on the

European stocks.

former but the latter remains an open-ended question.

• Given demographic factors, international equities remain • Valuation is very attractive from a historical standpoint;

an important part of our long-term asset allocation

however, valuation metrics could prove irrelevant should

strategies, but it is challenging to be tactical in such a

the European Union’s structure unravel or additional

reactionary market environment. Therefore, we continue

financial system stress unhinge the potential for a

to retain a quality bias and await better risk/reward setups.

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

• The consensus view is for higher interest rates, and we

despite anticipating further Federal Reserve stimulus in

have been contrarian in our thinking that bond yields are

the form of quantitative easing and open-market bond

unlikely to rise quickly as capital markets will likely remain

purchases.

uneasy as 2012 unfolds. Unease regarding European policymaker decisions, the fiscal cliff and the U.S. election

• We have since increased our weighting to fixed income, incorporating a diversified approach by sector and geography, using a combination of active and passive management. We expect a few persistent themes to endure within the space that are accessible via highly skilled managers.

18

WWW.CAPTRUSTADVISORS.COM

all factor into our thinking that bonds should retain a prominent place in portfolios.

WEALTH MANAGEMENT | Q3 12

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

• Should risk assets overshoot to the downside following

which to operate over the past three years given market

our expectation for additional macroeconomic headline

oscillations, yet we see investment merit in certain hedge

concerns and the potential for more subdued earnings-

fund sub-categories, particularly those that are less reliant

season guidance from global companies, we may look to

on overall market direction.

deploy capital into more market directional strategies as we have found some strong manager fits after a recent search.

• We have emphasized more conservative hedge fund strategies recently with a goal of preserving capital during large down periods in riskier asset classes versus strategies that have higher equity market gearing or economic sensitivity.

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

• We have recently deemphasized actively managed

to the demand story but also to a lack of infrastructure

strategies with the view that commodities present

investment across many key commodities.

considerable challenges for most active managers to successfully navigate. Correlations between commodities

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

and more “crowded” active manager positions leave us happy to invest in broad commodity mandates and control the overall exposure levels versus leaving that to an active manager.

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

• Recent capital-raising success across the REIT complex

improved fundamentals as well as attractive yields given

in late 2011 and thus far in 2012 leave operators poised

subdued interest rates.

for opportunistic purchases and increased flexibility, but we remain watchful of investors chasing what has been

• In a low-yield world, REITs retain a strong distribution profile while offering some growth potential, an attractive combination for a variety of investors that should provide an underlying bid to the space.

a strong asset class since the financial crisis; we did see REITs trail public equities in the third quarter, which could be healthy pending developments later this year.

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, 3rd Quarter 2012

• U.S. equities recorded their third positive quarter in the last four with the S&P 500 rising 6.4%, outpacing both small- and mid-cap stocks in the third quarter.

Q3 12

2012

Large Value (R1000 Value)

6.51%

15.75%

Large Blend (S&P 500)

6.35%

16.44%

the third quarter with utilities being the sole negative

6.11%

16.80%

performer, falling a modest 0.5%. Energy (+10.1%) and

Mid Value (Russell)

5.80%

14.03%

telecom (+8.1%) were the strongest sectors, with the

Mid Blend (Russell)

5.59%

14.00%

latter leading all S&P 500 sectors year-to-date with an

Mid Growth (Russell)

5.35%

13.88%

Small Value (R2000 Value)

5.67%

14.37%

Small Blend (R2000 Blend)

5.25%

14.23%

Small Growth (R2000 Growth)

4.84%

14.08%

impressive 26% gain.

Source: MPI Stylus Pro

Large Growth (R1000 Growth)

• Nine of the ten major S&P 500 sectors were positive in

• Since the U.S. equity market peaked in October 2007, the only style that has not fully recovered from the two-anda-half-year market malaise (after incorporating reinvested dividends) is large cap value, due to its large weighting in the financial sector.

INTERNATIONAL EQUITIES Market Performance, 3rd Quarter 2012

• Developed and emerging international equities both rallied in the third quarter and have been higher 11 out of Q3 12

2012

the last 14, and 11 out of the last 15 quarters, respectively.

International Equities (MSCI EAFE)

6.98%

10.59%

Pacific Stocks (MSCI Pacific Ex-Japan)

11.03%

17.58%

and 4.7% in local currency terms, led by Germany (+13.9%

European Stocks (MSCI Europe Ex-UK)

9.73%

12.79%

in dollars). Japan was a laggard, falling 3.2% in local

-0.77%

2.43%

UK Stocks (MSCI UK)

7.06%

10.67%

Emerging Markets (MSCI EME)

7.89%

12.33%

Source: MPI Stylus Pro

Japanese Stocks (MSCI Japan)

• Developed international equities rose 7% in dollar terms

currency terms but down just 0.8% in dollar terms thanks to yen appreciation.

• Emerging markets finished up 6% in local terms and up 7.9% in dollars due to relative currency strength. China and Brazil were up 4.7 and 4.8% respectively, but recently weak India posted a +15.4% dollar return after a strong rally in both stocks and the rupee.

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WEALTH MANAGEMENT | Q3 12

FIXED INCOME Market Performance, 3rd Quarter 2012

• The Barclays Aggregate Bond Index had its 15th positive quarter in its past 16, closing up 1.6% in the third quarter of 2012. The index was up every quarter in 2011.

Q3 12

2012

Broad Market (Barclays Capital U.S. Aggregate)

1.59%

3.99%

Barclays Capital U.S. Treasurys

0.57%

2.08%

parts of the bond market were stronger this past quarter,

1.13%

2.80%

with emerging market debt (+6.8%), high yield (+4.5%), and

Barclays Capital Municipals

2.31%

6.06%

Barclays Capital Intermediate Corporates

3.18%

7.69%

4.53%

12.13%

Barclays Capital High Yield

Source: MPI Stylus Pro

Barclays Capital Mortgage Backed Securities

• Within the broad fixed income space, historically riskier

investment grade corporates (+3.8%) all marking strong returns. Mortgages and Treasurys lagged in the quarter.

• Despite relentless calls for interest rates to rise, 10-Year Treasury rates hit an all-time intraday low on July 24, touching 1.39% and closing at 1.64% for the quarter.

HEDGE FUNDS / PRIVATE EQUITY Market Performance, 3rd Quarter 2012

• Hedge fund strategies continue to post lackluster returns and the third quarter was no exception. The HFRX Global Q3 12

2012

Hedge Fund index was up 0.39% in September after a

HFRI Fund Weighted Composite Index

2.86%

4.65%

+0.51% August, bringing the index to just over 2.6% for

HFRI Equity Hedge Index

3.47%

5.51%

HFRI Relative Value Index

3.68%

8.08%

• The weakest sub-categories include global macro and

HFRI Fund of Funds Composite Index

2.34%

3.33%

relative value strategies, while event driven is up close

HFRI Fund of Funds Conservative Index

1.65%

2.36%

Source: HFRI

the year.

to 5% through September and equity hedged strategies have meaningfully underperformed their long-only peers.

• Alternatives research firm Prequin reported that, based on preliminary data for the quarter, private equity had a slow sequential quarter capital-raising season (but better than the comparable quarter in 2011), as did infrastructure and venture capital despite an otherwise strong year.

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COMMODITIES Market Performance, 3rd Quarter 2012

• The Dow Jones UBS Commodity index rallied 9.7% in the third quarter after falling 4.6% in the second quarter, 2012

Dow Jones UBS Index

9.69%

5.63%

S&P GSCI Commodity Index

11.54%

3.47%

10.94%

13.33%

Natural Gas (U.S. Spot Henry Hub)

11.68%

2.68%

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

8.51%

-6.72%

Gold (Spot, $/oz)

moving to positive territory for the year-to-date period.

Source: MPI Stylus Pro, Bloomberg

Q3 12

• Several subsectors demonstrated considerable strength.

Metals were strong across the board, with lead up 28.1% and silver +25.4%. Sugar and cotton were the only weak agricultural components and the energy complex demonstrated its typical volatility; WTI and Brent Crude returns were both positive yet highly divergent, and gasoline was up for the quarter.

• Commodities continue to show more elevated correlations to other asset classes than in most periods before the financial crisis, and those correlations did not abate in the third quarter.

REAL ESTATE Market Performance, 3rd Quarter 2012

Wilshire REIT Index

Q3 12

2012

0.01%

14.89%

-0.15%

14.74%

Source: MPI Stylus Pro

MSCI U.S. REIT Index

• Public real estate, as measured by the NAREIT Equity REIT index, increased a modest 1% in the third quarter but REITs have still outperformed U.S. equities four out of the last six quarters. REITs were up a whopping 164.2% cumulative over the past 10 years, ending September 30.

• Capital raising continues to be easy for REITs, with NAREIT data showing that REITs have raised just shy of $45 billion as of the end of August 2012, which is 88% of what the industry raised in a record-setting 2011.

• Several REIT subsectors sport attractive fundamentals based on changes in buyer behavior. NAREIT research suggests that apartment REIT supply lags demand by some four million units despite early signs of stabilizing housing demand.

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WEALTH MANAGEMENT | Q3 12

captrust in the news

CAPTRUST GROWTH The CAPTRUST team grew in the third quarter with the addition of four new financial advisors and new offices in Boston and New York City.

Boston Office Bob Auditore joined the firm in August 2012 as Vice President, Financial Advisor with over 24 years of experience in design, implementation, and administration of qualified retirement plans for corporate fiduciaries. Previously, Bob was one of the founding principals of Bay Colony Partners, a group of specialists focused on qualified and nonqualified corporate retirement plans and individual wealth management, located in Boston, Massachusetts. There, Bob served as managing partner of the firm’s retirement plan practice. Prior to the formation of Bay Colony Partners, Bob was a principal of L&M Securities, Inc. A recognized leader in the industry, Bob frequently serves as a speaker to professional groups and was named to 401k Wire’s “300 Most Influential DC Plan Advisors” in 2010. Bob is a graduate of Tufts University with a bachelor’s degree in economics.

Gary Cowles joined our team in August 2012 as Vice President, Financial Advisor with over 21 years of experience in retirement investment advisory services in the area of nonqualified deferred compensation plans. Previously, Gary was one of the founding principals of Bay Colony Partners and served as managing partner of the firm’s executive benefits practice. Gary also previously held executive-level positions with a large benefits consulting firm, John Hancock and Scudder, Stevens & Clark. Gary is a graduate of the University of New Hampshire with a bachelor’s degree in mathematics and performed graduate studies in taxation at Bentley College.

He has obtained the Chartered Life Underwriter (CLU®) and Chartered Financial Consultant (ChFC®) designations from the American College and is a member of the Association for Advanced Life Underwriting in Washington D.C., and the Society of Financial Services Professionals.

New York City Office

Los Angeles Office

John Davenport joined CAPTRUST in 2012 from Barclays Capital, where he was responsible for analysis and approval of over $11 billion of the bank’s balance sheet exposure to U.S. industrial, healthcare, consumer, and retail companies. He currently provides investment advisory services to fiduciaries of corporate retirement plans. John received top honors from the University of North Carolina Wilmington’s Cameron School of Business, where he graduated summa cum laude with a Bachelor of Science degree in finance and economics and was awarded the 2008 E.M. West Award for most outstanding graduate. John is a CFA charter holder.

Debbie Basch joined us as a Financial Advisor Relationship Manager and will be responsible for providing investment management and consulting services to institutional investors and corporate retirement plan fiduciaries. Debbie joins CAPTRUST from Diversified Investment Advisors, where she managed a diverse client base of corporate and not-for-profit retirement plans. Prior to that, she was a vice president, relationship manager at Union Bank of California and director of institutional retirement consulting at Fidelity Investments.

Debbie is a graduate of the University of Massachusetts with a bachelor’s degree in communication studies. continued on page 24

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WEALTH MANAGEMENT | Q3 12

continued from page 23

RECENT NEWS

INDUSTRY INVOLVEMENT

In the third quarter of 2012, CAPTRUST launched captrustnonqualified.com, a website that offers an objective and holistic perspective on best practices for nonqualified deferred compensation plans. The website offers a concise overview of what CAPTRUST calls the “Five Components of a Successful Nonqualified Plan Strategy.” In addition to providing a rare unbiased perspective, the site offers nonqualified plan sponsors a number of interactive tools.

The following is a list of topical discussions led by CAPTRUST at industry events in the fourth quarter.

One highlight of the website is the Benchmark My Plan feature, an interactive tool that allows nonqualified plan sponsors to see how their plan stacks up against others. Built using a combination of CAPTRUST proprietary and non-proprietary databases, this tool provides valuable insight not easily available elsewhere.

The website also offers the NQIQuiz, a test to gauge a plan sponsor’s knowledge of nonqualified plans, and a Plan Review tool that allows plan sponsors to upload plan-related documents and receive a complimentary nonqualified plan due diligence review.

UNDERSTANDING THE FIVE COMPONENTS OF A SUCCESSFUL NONQUALIFIED DEFERRED COMPENSATION PLAN October 3, 2012 | Portland, ME (Cumberland Club) October 10, 2012 | Chicago, IL (University Club of Chicago) October 11, 2012 | Des Moines, IA (Sheraton West Des Moines) November 28, 2012 | Washington, D.C. (National Press Club) Presented by Mike Curran, SVP, CAPTRUST Nonqualified Executive Benefits “ASK THE EXPERTS” WORKSHOP October 2, 2012 | Atlanta, GA Southern Employee Benefits Conference Presented by Vic Bell, SVP, CAPTRUST Financial Advisor FIDUCIARY OVERVIEW November 12, 2012 | Troy, NY (Emma Willard School) Association of Business Officers of Private Schools (ABOPS) Presented by Patrick Marlatt, VP, CAPTRUST Financial Advisor, and Phyllis Klein, Senior Director, CAPTRUST Consulting Research Group

CONGRATULATIONS FirstEnergy Repeats Honor of Top Utility for Economic Development For the ninth time in the past 11 years, Site Selection magazine has named FirstEnergy Corp. one of the top utilities in the country for promoting economic development. FirstEnergy is a diversified energy company dedicated to safety, reliability, and operational excellence. In 2011, the company helped attract more than $1.7 billion in capital investment to its Ohio, Pennsylvania, New Jersey, West Virginia, and Maryland service areas that is expected to create more than 7,400 new jobs.

GIVING BACK CAPTRUST continued its charitable efforts this past quarter through the CAPCommunity Foundation’s involvement with the following organizations and causes: • North Carolina Food Bank • The Salvation Army • Raleigh Rescue Mission • 519 Heart Haiti • Ronald McDonald House • Variety—The Children’s Charity • JOA, Inc.

The designation recognizes utility companies that complement reliable power delivery to their customers with a hands-on approach to encouraging business development in their operational areas. Using 2011 data, the award is based on a mix of objective and subjective criteria, including what the utility does to help create jobs and facilitate investment in its area, available website tools and data that can be used to help business development, and survey input from corporate end users and site consultants.

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• Habitat for Humanity of Summit County • Jonathan Brookins Memorial Scholarship • Special Olympics NC • Foundation of Hope • Super Cooper’s Little Red Wagon