February 12, 2014

Presentation To:CFA Society of Nebraska

Tactical Asset Allocation & Financial Market Outlook2014 – The Year the Fed Finally Gets What it Wants

Presented by:

Brent Schutte, CFA, CFP®

Senior Investment Strategist & PMMulti-Asset Solutions Group312-461-3192

Investment Process Overview

Combining Strategic and Tactical Allocations

Strategic Asset Allocation: The Efficient Frontier10 – 25 Year Structural Risk & Secular Return Outlook (Reviewed Annually)Drivers - Potential GDP / Valuation / Political Risk / Inflation Forecasts / DemographicsEfficient Allocation of Assets Based upon Risk, Return & Correlation – Drives Client ExperienceEvolutionary - Investigate & Add Asset Classes that Shift the Efficient Frontier Northwest

Tactical Asset Allocation:12 – 18 Month + Cyclical Outlook (Reviewed Constantly)Drivers – Fiscal & Monetary Policy / Event Risk / Valuation & MomentumRisk Management – Rising Correlations / Return Enhancement

Recommend trades when change in inputs or expected value of the opportunity set is largeenough to cover trading & Implementation costs

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Strategic & Tactical Asset Allocati0n

• 1) Strategic Asset Allocation & The Efficient Frontier - Someone wins a Nobel Prize and it morphs into an “investment law”. It’s an important concept and a starting point for investment decisions but is it a complete investment process? Is going to zero allowed or must you always own all “Strategic” Asset Classes? Does this “protect you” and provide enough diversification & risk mgmt.?

Understanding an optimizer and its sensitivities

What variables are consistent

Setting a framework of minimums & maximums

• 2) Tactical Asset Allocation – This is risky...right? What is risk – Deviation from a benchmark? Hint: Who was taking more risk in the summer of 2012, someone who owned European Stocks or someone who didn’t. If you had to write down what you believe to be your three or four biggest risks, would your portfolios reflect those risks?

What is real and what is artificial? What you can “predict” and what you can’t

Making trade-offs

Building in hedges

The efficient frontier is constantly changing

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Asset Classes Current Alternative Current Alternative Current Alternative Current Alternative Current AlternativeUS Large Cap Equity 0.0% 11.2% 19.7% 9.4% 30.9% 10.2% 39.4% 12.3% 50.6% 15.6%US Small/Mid Equity 0.0% 1.2% 6.6% 5.8% 10.3% 13.2% 13.1% 19.6% 16.9% 29.3%Developed Intl Large Equity 0.0% 0.0% 5.3% 7.8% 8.3% 9.5% 10.5% 10.8% 13.5% 13.6%Developed Intl Small Equity 0.0% 6.7% 1.8% 0.6% 2.8% 1.5% 3.5% 3.6% 4.5% 7.0%Emerging Market Equity 0.0% 4.8% 1.8% 7.7% 2.8% 12.9% 3.5% 15.0% 4.5% 15.0%Municipal Bonds 90.0% 46.7% 65.0% 45.9% 45.0% 36.6% 30.0% 27.0% 10.0% 9.6%US High Yield Bonds 0.0% 10.0% 0.0% 10.0% 0.0% 6.1% 0.0% 1.6% 0.0% 0.0%REITS 0.0% 4.0% 0.0% 2.8% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Commodities 0.0% 10.0% 0.0% 10.0% 0.0% 10.0% 0.0% 10.0% 0.0% 10.0%Cash 10.0% 5.5% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Expected Return 5.33% 6.36% 6.48% 6.72% 7.04% 7.23% 7.46% 7.65% 8.02% 8.23%Risk 6.31% 6.31% 7.24% 7.24% 9.01% 9.01% 10.75% 10.75% 13.37% 13.37%Sharpe 0.24 0.41 0.37 0.40 0.36 0.38 0.34 0.36 0.32 0.33

Max. GrowthCapital Preservation Current Income Balanced Capital Growth

Asset Classes Current Alternative Current Alternative Current Alternative Current Alternative Current AlternativeUS Large Cap Equity 0.0% 11.2% 19.7% 12.9% 30.9% 14.5% 39.4% 17.4% 50.6% 21.8%US Small/Mid Equity 0.0% 1.2% 6.6% 4.4% 10.3% 11.7% 13.1% 18.2% 16.9% 27.3%Developed Intl Large Equity 0.0% 0.0% 5.3% 0.0% 8.3% 0.0% 10.5% 0.0% 13.5% 0.0%Developed Intl Small Equity 0.0% 6.7% 1.8% 5.1% 2.8% 7.0% 3.5% 10.0% 4.5% 14.8%Emerging Market Equity 0.0% 4.8% 1.8% 7.8% 2.8% 13.2% 3.5% 15.0% 4.5% 15.0%Municipal Bonds 90.0% 46.7% 65.0% 46.7% 45.0% 38.6% 30.0% 29.1% 10.0% 11.1%US High Yield Bonds 0.0% 10.0% 0.0% 10.0% 0.0% 4.8% 0.0% 0.3% 0.0% 0.0%REITS 0.0% 4.0% 0.0% 3.1% 0.0% 0.2% 0.0% 0.0% 0.0% 0.0%Commodities 0.0% 10.0% 0.0% 10.0% 0.0% 10.0% 0.0% 10.0% 0.0% 10.0%Cash 10.0% 5.5% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Expected Return 5.33% 6.36% 6.48% 6.71% 7.04% 7.22% 7.46% 7.64% 8.02% 8.22%Risk 6.31% 6.31% 7.24% 7.24% 9.01% 9.01% 10.75% 10.75% 13.37% 13.37%Sharpe 0.24 0.41 0.37 0.40 0.36 0.38 0.34 0.36 0.32 0.33

Capital Growth Max. GrowthCapital Preservation Current Income Balanced

Increase Intl Equity Return by

25 bps

Source: BMO Private Bank 2007 Capital Markets Assumptions & Optimization Review

FOR ILLUSTRATIVE PURPOSES ONLY

The Efficient Frontier & Strategic Asset AllocationMixing the Art & Science

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An Optimizer makes trade-offs between

Risk vs. Return & Correlation.

Question: How do we think of

our forecasts & trade-offs to determine minimums.

Answer: Test for which forecasts are historically

persistent.

The S&P 500 has outperformed the Emerging Markets

during various rolling 10 year

periods.

Testing for Persistency Return Patterns are Not Persistent / Risk is Persistent

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The S&P 500 has a persistently lower standard deviation

than Emerging Markets over rolling

10 year periods.

Minimum Variance High Volatility Portfolio

Summary:

Returns Shift / Risk is Persistent / Correlations Rising?

Conclusion

Solving by using the Apparent Constant Variable - Standard Deviation

Minimum Variance Portfolio

Assumptions: All Asset Classes Same Expected Return - Solve for Recommended Portfolio

No Constraints

Partially Constrained

Fully Constrained Mins

S&P 500 33.6% S&P 500 59.7% S&P 500 57.7%Russell 2500 0.0% Russell 2500 0.0% Russell 2500 1.8% 1.8%

EAFE Large Cap 0.0% EAFE Large Cap 2.8% EAFE Large Cap 3.1% 2.3%EAFE Small Cap 0.0% EAFE Small Cap 7.5% EAFE Small Cap 6.2% 1.1%Emerging Markets 0.0% Emerging Markets 0.0% Emerging Markets 1.1% 1.1%

REITS 20.4% REITS 15.0% REITS 15.0%Commodities 46.0% 11.71% Commodities 15.0% 13.10% Commodities 15.0% 13.18%

* Partially Constrained ‐ Only Commodities & REITs are constrained at 15% Maximum ‐ 0 Minimum on each asset class** Fully Constrained ‐ All Current Model Constraints are Included (Minimums & Maximums on each asset class) .  This forces the Optimizer to put some in each asset class. 

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Broad Asset Classes“Benefits Still Available”

Year S&P 500 Barclays Aggregate Bond

GSCI Commodity S&P 500 Barclays

Aggregate BondGSCI

Commodity1976 23.68% 15.60% -11.92%1977 -7.31% 3.03% 10.37% # Positive Years 30 35 271978 6.56% 1.40% 31.61% # Negative Years 7 2 101979 18.65% 1.92% 33.81%1980 32.45% 2.71% 11.08% Negative Years 2008 1994 20081981 -4.97% 6.26% -23.01% (In order of 2002 1999 19981982 21.55% 32.64% 11.56% Severity): 2001 20011983 22.56% 8.37% 16.26% 2000 19811984 6.19% 15.15% 1.05% 1977 20061985 31.73% 22.13% 10.01% 1981 19971986 18.67% 15.25% 2.04% 19931987 5.25% 2.76% 23.77% 19761988 16.61% 7.88% 27.93% 19911989 31.69% 14.53% 38.28% 20111990 -3.10% 8.95% 29.08% # of Years At Least 1 Asset Negative 161991 30.46% 16.00% -6.13% # of Years At Least 2 Assets Negative 31992 7.62% 7.40% 4.42% # of Years All 3 Assets Negative 01993 10.08% 9.75% -12.33%1994 1.32% -2.92% 5.29%1995 37.58% 18.48% 20.33%1996 22.96% 3.61% 33.92%1997 33.36% 9.68% -14.07%1998 28.58% 8.67% -35.75% Stocks and Bonds 0.221999 21.04% -0.83% 40.92%2000 -9.11% 11.63% 49.74% -0.032001 -11.88% 8.42% -31.93%2002 -22.10% 10.27% 32.07% 0.162003 28.68% 4.11% 20.72%2004 10.88% 4.34% 17.28%2005 4.91% 2.43% 25.55%2006 15.79% 4.33% -15.09%2007 5.49% 6.96% 32.67%2008 -37.93% 6.04% -46.49%2009 26.46% 5.93% 28.23%2010 15.06% 6.56% 9.03%2011 2.11% 7.84% -1.18%2012 16.00% 4.21% 0.08%

Source: Zephyr. Data: 12/31/1975 - 12/31/12 / Table 1102

Benefits of Asset Allocation: Diversification

Why did down years in one asset class tend to occur while the other two were rising? These asset classes are largely independent of each other:

Bonds and Commodities

Stocks and Commodities

Correlation Between…

Diversification is not dead…it is just not defined correctly and

relied upon too heavily by most.

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Meeting our Typical Clients NeedsThe Negative Wealth Effects of Volatility

As you increase the deviation you increase the variability of end outcomes and lower the most likely ending wealth value.

This study is understated because individuals usually take dollar amounts not % amounts (& 3% is low). Once a standard of living (dollar based) is established it is hard to cut back. This is further understated because it also assumes annual draws – not monthly or quarterly.

Ending Portfolio Value with Same Return but Different Standard Deviation

Assumptions: 1mm Initial Value Maximum Growth Portfolio / 3% Inflation / 3% Draw Rate Per Annum / 7.28% Return

Year 10 Year 20 Year 30

Standard Deviation Standard Deviation Standard Deviation13.65% 15% 17% 13.65% 15% 17% 13.65% 15% 17%

% ile % ile % ile10% 2,292,947 2,349,818 2,497,759 10% 3,893,001 4,022,313 4,303,757 10% 6,186,669 6,498,002 7,043,03850% 1,376,053 1,346,718 1,312,500 50% 1,880,302 1,812,281 1,739,122 50% 2,576,696 2,449,229 2,263,60290% 824,003 772,729 700,780 90% 909,000 818,763 714,419 90% 1,057,297 921,056 768,325

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Strategic Asset AllocationA Long-Term Foundation

Strategic Asset Allocation or Efficient Frontier – Beta and other risk measures between asset classes work well in the longer term. Strategic Asset Allocation

provides A LONG-TERM FOUNDATION & STARTING POINT. Realize the ASSUMPTIONS that are embedded in it.

Have constraints (at the highest levels) built in to your process but allow flexibility...Some asset classes have stronger diversification benefits & should be treated accordingly. Other asset classes should be allowed to go to zero during

extraordinary time periods.

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Tactical Asset AllocationTools to Manage Risk in the Short to Intermediate Term

• Understand the Current Market Environment – what is priced in vs. what isn’t....what is real and what isn’t. If an artificial tailwind goes away, you are left with valuation to bail you out. (Stocks vs. Bonds, Emerging Market & High Yield Bonds, REITs etc.).

• Define Current Risks - A Fed experiment gone wrong....a currency union breaking up....middle east strife.

• Hedge/Own Risks – Diversification means owning something that will help protect you if the risk comes true. (Inverse treasury/ commodities/ currency hedge).

• Weigh Risk vs. Reward – The reward may be large, but what about the downside...is there a “safer way to get the exposure”. Make trade-offs.

• Context - Convey to your clients what you are attempting to do & why it is important (risk adjusted returns!). Managing Client emotions and keeping them “in the game and on path” is a huge part of our jobs. Yes- you will be wrong sometimes so COMMUNICATE.

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Context – Communication & Current Outlook“Normalization” Leads To Volatility

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Today’s Agenda

• The economy is improving and could be accelerating over the coming quarters. Foreign economic headwinds are declining and most importantly US political dysfunction may have reached a peak.

• The taper needs to continue and you shouldn’t fear it.... A steeper yield curve may actually help the economy. The Fed has successfully convinced the market of their “new policy” of anchoring short term rates at 0 for longer.

• We’ve been saying it for years but find it worth repeating frequently. Globalization will be a tailwind to an increasingly cost competitive US labor force.

• Bonds are for cash needs only and not for returns. Investors should position accordingly.

• We continue to overweight the US but returns going forward will increasingly require economic growth. FCF remains large and is a downside buffer.

• We continue to advise employing currency hedged vehicles when allocating to EAFE developed....will the last auto company out of Australia please turn off the lights.

• The Fed is guaranteeing they are going to stick around too long and we believe its likely they will get too much of a good thing...might the next recession be caused by a sharp removal of policy in the future? Until then we continue to overweight risk assets.

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Expect More VolatilityWill 2013/14 approximate the 2003/04 Script?

The 10 Year Treasury rose 1.5% (from 3.11%) …fell back nearly 1% and then rose again 1.2%, etc….before

ultimately climbing into the 5s by 2006.

The equity markets experienced three sell-

off in excess of 5%.

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EconomyPutting Some of the Recent “Weak” Data in Context

Yes the ISM weakened in January but this forward

looking component remained strong.

As an aside This was a very good

leading indicator before the 1974 and

2008 recessions

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ISM New Orders Less Inventories Led 9 Months-5 or Less 0 to -5 0 to 5 5 to 12 12 to 16 16 to 20 20+

Median YOY GDP -1.8 0.5 2.15 3.3 4.1 3.8 3.4Average YOY GDP -1.5 0.8 1.7 3.3 3.9 4.1 4.0# of Observations 20 54 80 227 92 53 25# of Negative GDP Prints 15 20 19 7 1 1 0# Less than 2% GDP Growth 20 38 37 42 9 4 3Maximum 1.7 4.6 5.8 7.6 8 8.5 6.2Minimum -4.1 -4.1 -3.5 -1.6 -0.2 -0.2 1.6

EconomyHeadwinds Abating

Fiscal Headwinds will likely abate in 2014.

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Europe and Japan continue to abate as

headwinds. We continue to expect the ECB to pick

up the stimulus slack...

The US Consumer – Healthier than AdvertisedTotal Debt Includes Principal & Interest

Yes the US consumer was over-indebted

but it was over-stated.

A simple math example to explain our

contention with a chart that has gotten too much

press.

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The US Consumer – Healthier than Advertised Monthly Cash Flow Relief

The interest rate experiment that the Fed

is running has kept rates low and help

improved the cash flow health of the US

consumer.

72% of HH Debt is Mortgage Debt...Given

our interest rate outlook, this is the right

decision and likely speaks to housing

affordability.

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EmploymentSmall Business is Ramping Up

We believe the BLS reports have been

heavily skewed by weather

(ADP).

This indicator pushed to closer

to “normal levels”...

Additionally sales

expectations spiked.

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Labor Markets Tightening?The Fed May Have less Slack then They Believe

Monetary policy can’t cure structural

unemployment…only education and training can....these take time.

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The Fed acknowledges the structural

commentary but points to little wage pressure. We watch these indicators

intently and believe wage pressures/inflation will

emerge.

Fiscal & Economic Policies - EntitlementsIncentives are Crucial to Labor Supply & Capital Accumulation

Eliminating Deductions

“If some capital investments receive more favorable tax treatment than others, additional resources will be directed to those types of investments even if other types would be more productive. The limit on itemized deductions for home mtg. interest & property taxes….raising the effective tax on owner-occupied housing closer to that on business investments…..ADDS .07% TO REAL GNP by 2022

Source: CBO – The Economic Impact of the President’s 2013 Budget

Incentives to Supply Labor

“……the government’s budgetary policies affect potential output primarily by affecting the amount of public saving (deficit = negative public saving) and the incentives for individuals to work, save and invest.”

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Business InvestmentWashington Dysfunction has Peaked

Small business owners have been citing

regulation and the uncertain political

environment as reasons to not expand business

investment.

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While it is a small step forward, we have a

budget and debt ceiling deal. The “unkowns” of the ACA are becoming

knowns.

Business InvestmentThe Next Stage of US Growth may be led by Investment

Companies are flush with cash they have been hoarding....The old age of the

plants at the left meets the reality

that manufacturing is moving back to

the US.

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A Positive US BackdropThe Energy Situation is Friendly to Employment & Commodity Prices

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The Globe and Mail – Oct , 7 2013 “But it isn’t just clothing and textiles. More

than half of U.S. executives at manufacturers with sales of at least $1-billion (U.S.) say

they are planning to repatriate some production to the United States from China, according to an August survey by Boston Consulting Group. Respondents cited

factors such as proximity to customers, product quality and lower transportation costs, competitive wage rates and skilled

labour.”.

Surprise!The “Pie” is Bigger - Globalization is a US Tailwind

A rising currency increases

purchasing power and improves

citizen’s lives.

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China is serious about re-balancing its economy....while

GDP may be slowing - wealth is

growing.

Current Market Realities Experimental Policies & Asymmetric Inflation Tolerance

“No Central Banker anywhere on the planet has the experience of successfully navigating a return home from the place in which we now find ourselves.”

Richard FisherPresident Dallas Federal Reserve

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The BEGINNING of the End?Hide in the Front End – “Replace” the Intermediate /Long End

While tapering began in December, it could be years before the

yield curve fully normalizes...the Fed wants the front end

anchored!

A steeper yield would likely help coax out excess

bank reserves. A QE exit should push up

long term rates.

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Lower Volatility Higher Volatility

Short Duration Intermediate Duration Long Duration1-3/4 Year Duration 3/4-10 Year Duration

“Maturity” Focus Inflation Protection

Lower Price Risk Diversification Benefits

Municipal Bonds Market Neutral Investment Grade Bonds Convertible Arbitrage

Merger ArbitrageAbsolute StrategiesCovered Call StrategiesHigh Yield BondsLeveraged / Bank LoansInternational DebtConvertible BondsStructured NotesLong/ Short Equity

Preferred Stock

10 Year + Duration

Return Focused

Retirement Funding

Long Equity (U.S and Foreign)CommoditiesREITSHedge FundsPrivate Equity

Don’t Sell Everything but Think DifferentlyFilling the Bond Void

Investors Must “Accept” Low to Negative Real Yields in Return for Cash Flow

Certainty & Risk Management

With Negative Real Returns Likely, Investors Need to Find

“Substitute” Investments for this Part of the Curve

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BMO Multi-Asset Income FundReplacing the Bond Void – A Dual Mandate of Inflation Protection & Income

US Equity Market ValuationsSomewhere Near Fair Value – Growth Needed

This measure shows the market as slightly

above its median “inflation adjusted PE”.

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There are earnings that get reported to

shareholders and then there are the ones that

you report to the government to pay taxes

off of.

US Equity ValuationGetting “Paid” to Wait for Earnings Growth

Earnings growth should accelerate....we believe it will be off the backs of increased revenue

rather than margin expansion.

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CASH IS KING

Harley Davidson CFO John Olin,“we clearly are not going to be

funding the pension plan, so that excess cash can be returned to

our shareholders.”WSJ Feb 11

For those of you waiting for the dollar to collapse – it already happened (see 2002 to 2008).

Fact: Couple this with labor wage constraint & the US is now globally competitive....

Today’s Reality: Many Foreign central banks now want/need to use the same recipe. If Europe doesn’t it might break anyway.

Re-Entering/ Increasing EAFE but Hedging RiskOwn the Companies not the Currencies

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CommoditiesPatience! - Supply & Demand Imbalance

Longer term and for diversification purposes commodities fill a portfolio role.However, tactically the asset class continues to be hampered by oversupply in many markets.

“The truth is that the China resource

boom is over.” Australian PM Kevin Rudd

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Emerging Market ValuationIf a Contagion is Avoided They are Cheap

Emerging Markets have returned to discounts they traded at during the beginning of the century. If contagion is avoided, future outperformance may be in order.

Emerging MarketsLessons Learned from 1997 / 1998

We all cite the Asian Contagion but does anyone recall that Emerging sold off ferociously in 2004, only to

rally just as ferociously after contagion was

avoided.

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While currency intervention isn’t the sole

answer, EM countries have bigger “war chests”

this go around. Dollar pegs have been

reduced.

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Disclosure

Brent Schutte is a Senior Market Strategist for BMO Global Asset Management, a Part of BMO Financial Group.

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