May 2014 Investment Update

Two Types of Diversification

Diversification works on the principle that not all assetclasses react the same way to market events. Forexample, when stocks go down, bonds have a tendencyto go up, and vice versa. This way, by combiningvarious assets in a portfolio, investors may be able toprotect themselves from extreme market fluctuations.

Classic diversification involves combining differentasset classes: stocks, bonds, cash, gold, and so on.However, it is also possible to diversify within acertain asset class; by size, for example. Within thestock portion of a portfolio, an investor could combinelarge-, small-, and mid-cap stocks and obtain potentialdiversification benefits, because stocks may behavedifferently based on their market capitalization.

Investment Update May 2014 2

The Great Yield Chase

With Treasury yields still relatively low and worryabout the eventuality of rising rates ever present, manyinvestors have been moving away from Treasuries andinto other fixed-income sectors in their quest forincome. Two fixed-income segments seeing activityfrom this migration are corporate and emerging-markets bonds.

Corporate bonds: Many investors have bumped uptheir allocations to corporate bonds for reasons thatare pretty straightforward. Company balance sheetsare about as healthy as they've been for many years,with cash holdings high and default rates at multiyearlows. In addition to these attractive fundamentals,buying has been strongly encouraged by central bankpolicies, including the Federal Reserve's quantitative-easing programs. They have played a major role insuppressing agency mortgage and Treasury yields,which in turn has pushed investors to take on morecredit risk in search of more yield.

Emerging-markets bonds: The trend of holdingemerging-markets bonds has gained popularity inrecent years. Again, investors have been givenincentive to hold higher-risk assets because developed-markets central bank policies have pushed Treasuryyields down. A byproduct of these central-bankpolicies is that assets have not only poured into U.S.-based investments but also into emerging-marketsbonds of all kinds, including both sovereign andcorporate sectors. Further boosting their attractiveness,emerging-markets credit ratings have been risingbased on a number of factors, including economicstructural reforms and growth rates that aremeaningfully higher than in developed markets. Totop it off, the underlying balance sheets of manyemerging economies look increasingly appealing whencompared with the debt-laden, major economies of theWest.

With greater return potential comes greater risk. Theultimate questions for investors moving out ofTreasuries are whether their investment alternativeswill stand up to potential trouble down the road andwhether their portfolios still line up with their risk andreturn expectations. There's a tension between tryingto provide the best possible returns when things are

going well and maintaining the kind of portfolio thatshould provide better diversification in the case ofvolatile equity markets. In recent years, investordemand has significantly pushed prices up and yieldsdown. Those new lower yield levels suggest that, evenunder the best circumstances, the prospect for futurereturns is muted. While currently attractive, there'sreason to be wary of how these sectors will performunder stress scenarios. Most investors aren't expectinga repeat of 2008, when Treasuries rallied and riskyassets sold off, but it's nearly certain that bumps in theroad will appear at some point. It is important to beaware that a dearth of yield may be causing someinvestors to take on more risk than they realize.

Investment Update May 2014 3

Quick Facts: Retirement

1. According to Aon Hewitt’s “The Real Deal” 2012study, an average full-career contributing employeeneeds 11.0 times pay at age 65, after Social Security, toexpect to have sufficient assets to last throughretirement. For example, if your salary is $80,000, youwill need to have accumulated $880,000 by the timeyou’re 65 and ready to retire.

2. In reality, the same employee is expected to haveonly 8.8 times pay in resources at retirement, whichtranslates into a 2.2 times pay shortfall. To reuse theexample above, this means you’d be $176,000 short.

3. The 2013 Transamerica Retirement Survey foundthat the percentage of participants who have taken aloan from their 401(k) plan has increased from 16% in2008/2009 to 21% in 2012, then slightly decreased to17% in 2013.

4. Wells Fargo conducted a survey of 1,000 middle-class Americans. The study shows that across middleclass members of all generations, only 24% areconfident in the stock market as a place to invest forretirement. The apprehension about the market isstronger for those age 25 to 29, with 56% expressingfear of losing their nest egg. When asked if given$5,000 for retirement where they would invest, 58% ofthose age 25 to 29 said they would invest in a savingsaccount/CD.

5. Only 18% of workers are very confident they willhave enough money to live comfortably in retirement(according to the EBRI 2014 Retirement ConfidenceSurvey).

Sources: Aon Hewitt’s “The Real Deal: 2012Retirement Income Adequacy at Large Companies.”“14th Annual Transamerica Retirement Survey ofAmerican Workers,” Transamerica Center forRetirement Studies, July 2013. Wells Fargo newsrelease, “Middle Class Americans Face a RetirementShutdown,” October 2013.

Dividend Income: Not So Fixed

Since interest rates are still relatively low right now,many investors looking for income and yield havebegun to assess switching a portion of their investmentallocation from bonds into dividend-paying stocks.However, it is important to remember that the interestpayment of a bond is a contractual obligation of thecompany, whereas dividend payments are not. If abond issuer does not pay either interest or principal ontime, the company will be in default, and likely will beplaced into bankruptcy. However, dividend paymentsare not a contractual obligation of a company and canbe either cut or raised by its board of directors at will.When times are tough, companies may cut dividendsto conserve cash, such as during the 2008 credit crisis.Conversely, when times are good, companies mayincrease their dividend payments, providing investorswith additional upside.

Investment Update May 2014 4

Mutual Fund Tax Bills Are Rising

Mutual fund investors' tax bills have been on the riseagain recently. The average capital gains distribution(a payment to shareholders of profits realized on thesale of a fund’s securities) for U.S. equity funds basedon data as of April 2014 is 19.3% of assets, comparedwith, for example, 6.9% back in 2007. These recentdistributions are among the largest seen since the startof the financial crisis in 2008.

The reason for those payouts is of course a good thing.The payouts mean that funds have produced solidreturns for a few years running. The distributions weresmall in 2008, 2009, and 2010 because capital gainswere offset by realized losses during the financial crisis.However, most of those losses are long gone.

Mutual funds are required to distribute their capitalgains once a year. All of the realized gains are talliedwhile the realized losses and loss carry forwards fromthe previous year are subtracted to arrive at the totalsum to be paid out. The distributions are made inequal proportions to all shareholders regardless ofwhen they bought the fund. Then all the fund holderswho own the fund in a taxable account have to paytaxes on those distributions—even if they reinvesttheir distribution.

What does all of this mean? Well, mutual fundinvestors should consider strategies for dealing withfuture payments. Most funds may still be sitting onsizable gains, so it's quite likely that payouts willcontinue to grow as funds sell their winners. Thus,fund tax bills can be expected to grow. That's a badthing, because you'll have more money at the end ofthe day if you can postpone paying capital gains as farinto the future as possible. The reasons are twofold:First, the time value of money means that money intoday's dollars is worth more than in the futurebecause inflation will have eroded its value. Inaddition, if you hold on to the money, it cancompound over time in your fund, thus earning youmore money.

Here, then, are a few things you can do to limit yourtax bill.

1) Max out on tax-sheltered accounts. Taxable

distributions are not a problem for 401(k)s, 403(b)s,and IRAs, so invest as much as the law will allowbefore you put money in taxable accounts.

2) Consider tax-managed funds for your taxableaccounts. Tax-managed funds do a great job ofavoiding making distributions because they realizelosses on some holdings when they have to realizegains on others. After taxes are figured in, these fundsgenerally put up superior returns.

3) Consider exchange-traded funds (ETFs). Theydon't have all the strategies available as tax-managedfunds, but they do have some unique features that helpreduce their tax bills. Just make sure you've chosen onethat is diversified, has low costs, and has low turnover.

4) Don't buy funds that have had huge returns overthe past three years. Buy a fund with huge gains andyou're going to get a huge tax bill regardless ofwhether you make any money yourself. So, treadcarefully in hot areas. If you have your heart set onsuch a fund, at least put it in an IRA or 401(k).

Investors should read the prospectus and carefullyconsider a fund’s investment objectives, risks, fees, andexpenses before investing. It is important to note thatETFs are not immune from capital gains distributions;ETFs may make capital gains distributions if changesin the underlying index occur. 401(k) and IRA plansare long-term retirement-savings vehicles. Withdrawalof pretax contributions and/or earnings will be subjectto ordinary income tax and, if taken prior to age 591/2, may be subject to a 10% federal tax penalty.Please consult with a legal, financial, or taxprofessional for advice specific to your situation.

Investment Update May 2014 5

Quarterly Market Barometer

3 Month, ending March 31, 2014. The U.S. Marketreturned 2.00%.

The Morningstar Market Barometer provides avisualization of the performance of various stockmarket indexes. The color scale (red for losses andgreen for gains) allows you to assess which areas of themarket performed strongly and which areas showedweakness for the time period analyzed. The nine-square grid represents stocks classified by size (verticalaxis) and style (horizontal axis). There are threeinvestment styles for each size category: small, midand large. Two of the three style categories are “value”and “growth” while the central column represents thecore style (neither value nor growth characteristicsdominate). Large-caps account for the top 70% of thecapitalization; mid-caps represent the next 20%; andsmall-caps represent the balance.

©2013 Morningstar, Inc. All Rights Reserved. The information contained herein (1) is intended solely for informational purposes; (2) is proprietary to Morningstar and/or the content providers; (3) is notwarranted to be accurate, complete, or timely; and (4) does not constitute investment advice of any kind. Neither Morningstar nor the content providers are responsible for any damages or losses arisingfrom any use of this information. Past performance is no guarantee of future results. "Morningstar" and the Morningstar logo are registered trademarks of Morningstar, Inc. Morningstar MarketCommentary originally published by Robert Johnson, CFA, Director of Economic Analysis with Morningstar and has been modified for Morningstar Newsletter Builder.