Capital Markets Expectations

Lessons From the Past

Thoughts About the Future

Examining Historical Capital Markets Returns

» Past is Not Prologue:

» Past Returns are Best when Future Returns are Worst

» Market Yields Predict Future Performance

Looking to the Future

» The “3-D” Hurricane: Our Debt, Demographics and Deficit

Where are the Opportunities Today?

» What are the Near-Term Opportunities and Headwinds?

» Our Asset Allocation Recommendations

2

3

Equally Weighted 16 Asset Classes consist of all of the benchmarks above except for 60/40 S&P/BarCap and MSCI AC World.

Equally Weighted 16 Asset Classes and 60% S&P/40% BarCap Aggregate returns assume monthly rebalancing.

Source: Research Affiliates., based on data from Morningstar Encorr and Bloomberg. All returns are total returns and are reported in USD. MSCI returns information

provided under license through MSCI. All returns based calculations are calculated by Research Affiliates.

2000–2012: A Lost Decade and Counting?

Fixed

Income

Asset

Allocation

Equity

Other

Asset Class Benchmark13 yr Annualized Return

(as of 12/31/2012)

Emerging Markets Bonds JPM EMBI Plus 11.40%

Long Treasury BarCap US Treasury Long 8.98%

Long Credit BarCap US Long Credit 8.88%

TIPS BarCap US Treasury US TIPS 7.97%

High-Yield Bonds BarCap US Corporate High Yield 7.88%

Emerging Local Currency JPM ELMI+ 7.05%

Core Bonds BarCap US Agg Bond 6.30%

Bank Loans Credit Suisse Leveraged Loan 4.92%

Short-Term Bonds ML US Corp&Govt 1-3 Yr 4.13%

Convertibles ML Convertible Bonds All Qualities 4.40%

Equally Weighted 16 Asset Classes EW 16 Asset Classes 7.33%

60/40 60% S&P 500/ 40% BarCap Agg 3.84%

Emerging Markets Equities MSCI Emerging Markets (Gross) 8.90%

Small Cap US Equities Russell 2000 5.47%

Global Equities MSCI AC World 2.32%

Developed ex US Equities MSCI EAFE (Gross) 2.14%

Large Cap US Equities S&P 500 1.66%

REITs FTSE NAREIT All REITs 11.95%

Commodities DJ UBS Commodity 5.46%

US Inflation IA SBBI US Inflation 2.46%

4

Source: Research Affiliates., based on data from Morningstar Encorr and Bloomberg.

Salvaging a Lost Opportunity… In Hindsight

2.46%

1.66%

3.84%

6.76%

7.33%

8.59%

0%

2%

4%

6%

8%

10%

IA SBBI US Inflation S&P 500 60% S&P 500/ 40%

Barclays Agg

60% FTSE RAFI US

1000 / 40% Barclays

Agg

EW 16 Asset Classes EW 16 Assets

Classes - RAFI

Equities

Annualized

Retu

rn

13 Year Annualized Returns as of 12/31/2012

13-Year

Negative Real

Return

Adding Fixed

Income

Replacing 60%

Cap Equity w/

RAFI

Diversify Broadly

(Cap Wtd

Equities)

Diversify Broadly

(RAFI Wtd

Equities)

0

2

4

6

8

10

12

14

16

18

0

2

4

6

8

10

12

14

16

18

Perc

en

t (%

)

Perc

en

t (%

)

BarCap US Aggregate Bond Total Return USD Forward 10-Year Return

BarCap US Aggregate Bond Yield USD (%Yield)

Source: Research Affiliates based on data from Ibbotson and Barclays Capital as of March 31, 2013.

Bond Market Returns Follow Yields

Future long-term bond returns closely follow entry yield

Very strong relationship between

starting yield and future 10-year total

return: Correlation of 0.90.

5

*Actual S&P return (Ibbotson).

As of March 31, 2013.

Source: Ibbotson, Research Affiliates based on data from Ibbotson and Robert Shiller of Yale.

Forward Stock Returns Set to be Less than Past

» 30-year returns of S&P 500 stocks: 11%!*

» Should we expect that for the next decade?? No!

6

3.1% 3.0%

4.2%

2.7%

1.9%

2.0%

0.8% 3.1%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Return DecompositionSince 1926: Mar-2013

30-Year ReturnDecomposition: Mar-2013

Reasonable ForwardExpectations

Valuation Expansion

Real Earnings Growth

Dividends

Inflation

~ 2.5%

~ 2%

~ 1.5%

6%

10%

11%

Source: Research Affiliates, LLC., based on data from Robert Shiller and the Bureau of Economic Analysis.

Long-Term Real Growth in EPS Follows

Per Capita GDP, not Headline GDP

7

Long-Term Real Growth, 10-Year Rolling Averages

1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Log

Sca

le

GDP = 3.4%

PC GDP = 1.9%

EPS = 1.7%

Earnings per share grow less than GDP.

New companies are formed and new shares

issued as the population grows.

EPS growth is just below per capita GDP growth.

Source: Research Affiliates, LLC., based on data from the BEA, Corporate Profits with Inventory Valuation and Capital Consumption Adjustments divided by GDP

Seasonally Adjusted at Annual Rates. As of March 31, 2013.

Corporate Profit Margins Are Near All Time Highs

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013

Corporate Profits as a Percentage of GDP (1948 - 2013Q1)

Current level of 12.7% back to

the historical average of 9.6%

would mean a 25% collapse in

corporate earnings.

Historical Average: 9.6%

*Data as of March 31, 2013.

Sources: Research Affiliates, based on data from Robert Shiller, Federal Reserve, and BEA.

Past Average Return of 60/40 Portfolio = 7.1%

Current Expected Return of 60/40 Portfolio = 4.2%

Beginning Real Expected Beginning Expected Realized Expected

Dividend Long-Term Implied Equity Bond 60/40 60/40 Minus

Decades Yield EPS Growth Inflation Return Yield Return Return Realized

1871 - 1880 5.9% 2.0% 2.4% 10.6% 5.3% 8.5% 8.3% -0.2%

1881 - 1890 4.5% 2.0% 0.8% 7.4% 3.7% 5.9% 3.1% -2.8%

1891 - 1900 4.8% 2.0% 0.5% 7.4% 3.4% 5.8% 6.9% 1.1%

1901 - 1910 4.4% 2.3% 0.0% 6.7% 2.9% 5.2% 5.7% 0.6%

1911 - 1920 5.2% 2.3% 0.4% 8.1% 3.3% 6.2% 2.9% -3.3%

1921 - 1930 7.5% 0.5% 2.8% 11.0% 5.7% 8.9% 11.6% 2.7%

1931 - 1940 6.3% 1.1% 0.1% 7.5% 3.0% 5.7% 3.9% -1.8%

1941 - 1950 6.4% 1.2% -1.3% 6.2% 1.6% 4.3% 8.6% 4.2%

1951 - 1960 7.4% 1.6% -0.7% 8.4% 2.2% 5.9% 10.6% 4.7%

1961 - 1970 3.4% 1.4% 0.9% 5.8% 3.8% 5.0% 6.3% 1.2%

1971 - 1980 3.5% 1.4% 3.5% 8.6% 6.4% 7.7% 6.9% -0.9%

1981 - 1990 4.6% 1.5% 9.9% 16.8% 12.8% 15.2% 14.3% -0.9%

1991 - 2000 3.7% 1.3% 5.2% 10.5% 8.1% 9.5% 14.4% 4.8%

2001 - 2010 1.2% 1.7% 2.3% 5.3% 5.2% 5.3% 3.8% -1.5%

Average 4.9% 1.6% 1.9% 8.6% 4.8% 7.1% 7.6% 0.6%

Current* 2.1% 1.3% 2.5% 5.9% 1.8% 4.2%

Looking to the future

� A 3-D Hurricane:

our deficit, debt, and demographics

-5%

0%

5%

10%

15%

20%

-5%

0%

5%

10%

15%

20%

195

3

195

5

195

7

195

9

196

1

196

3

196

5

196

7

196

9

197

1

197

3

197

5

197

7

197

9

198

1

198

3

198

5

198

7

198

9

199

1

199

3

199

5

199

7

199

9

200

1

200

3

200

5

200

7

200

9

201

1

Official Deficit ∆debt/GDP ∆debt+GSE GAAP Deficit, Incl Entitl.

25-Year Averages, as % of GDP:Federal Fiscal Deficit: 3.0%Change in National Debt: 5.0%Change in National + GSE Debt: 7.9%Change in Debt + Entitlements: 15.3%(Excluding 2003 Adoption of Medicare "D")

Medicare "A" Adopted →

Medicare "D" Adopted →

Medicare "B" Adopted →

11

Source: Research Affiliates, based on data and projections from the U.S. Treasury Department. Through 2012 Q4.

What’s the True Deficit? Under GAAP Accounting,

Far Higher Than Official Statistics

The Debt and the Deficit: Comparing the Deficit with the Growth of

the National Debt, GSE Debt, and Unfunded Entitlements

0%

100%

200%

300%

400%

500%

600%

700%19

45

19

47

19

49

19

51

19

53

19

55

19

57

19

59

19

61

19

63

19

65

19

67

19

69

19

71

19

73

19

75

19

77

19

79

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

20

11

Medicaid Medicare Parts A, B & D Medicare Part A Social Security

Govt Sponsored Ents State and Local Gov't National Debt

12

Source: Research Affiliates, based on data from Federal Reserve Flow of Funds, 2012 Q4.

Public Debt and Entitlement Obligations are Growing

at a Frightful Pace

Public Debt and Unfunded Obligations, Percent of GDP, from 1945

13

Source: Research Affiliates, based on data from CIA World Fact Book 2010, International Monetary Fund. Note: RAFI® Scale is defined as the equal weighted average of

four measures of a country’s ability to repay its debt obligations: capital (GDP), labor (population), resources (land mass), and energy (energy consumption). This average is

compared to the amount of a country’s net debt outstanding to determine its overall debt service capability relative to the rest of the world.

Comparing Debt Levels:

Developed vs. Emerging CountriesNet Debt / Debt Service Capacity, Relative to World Average

Excludes All Off-Balance-Sheet Debt and Entitlement Programs

Net Debt is More than Double Debt Capacity Net Debt is less than 20% of Debt Capacity Negative Net Debt

14

Source: Research Affiliates, based on data from U.S. Census, United Nations.

And Demographics Won’t Make This

Any Easier in the Years AheadG8 versus BRIC Economies

Source: Research Affiliates, LLC, based on data from CIA World Fact Book 2012, International Monetary Fund, Penn World Table, World Bank.

Rising Debt Goes Hand in Hand With Slow Growth

Spanning 30 Countries and 30 Years, 1982–2011

Does More Debt Help After a Year or Two?

No, Dr. Krugman, It Does Not!

-12

-9

-6

-3

0

3

6

9

12

15

-15 -10 -5 0 5 10 15 20

On

e Y

ear

Real

GD

P G

row

th (

%)

Concurrent Growth in External Debt (%)

Developed Countries G5 CountriesEmerging Countries Linear (Developed Countries)

Correl = -0.59

-12

-9

-6

-3

0

3

6

9

12

15

-15 -10 -5 0 5 10 15 20

On

e Y

ea

r R

eal

GD

P G

row

th, fr

om

t t

o t

+1 (

%)

Growth in External Debt, t-1 to t (%)

Developed Countries G5 Countries Emerging Countries Linear (Developed Countries)

Correl = -0.25

-12

-9

-6

-3

0

3

6

9

12

15

-15 -10 -5 0 5 10 15 20

On

e Y

ea

r R

eal G

DP

Gro

wth

, fr

om

t +

1to

t+

2 (

%)

Growth in External Debt, t-1 to t (%)

Developed Countries G5 Countries Emerging Countries Linear (Developed Countries)

Correl = -0.02

16

Source: Research Affiliates, based on data from United Nations, Penn World Table, and Global Financial Data.

Relationship between GDP Growth and Demographic

Composition (R2 = 0.30), Net of Valuation Effects

GDP Growth and Demographic Shares

Demographic

Sweet Spot: Fastest

GDP Growth, Age 20–44

Demographic

Trouble,

Age 55 & Up

Terrible

Twos

Recap of the headwinds and investment implications

» Our Debt burden must be addressed:

» Pay the debt, abrogate, or reflate

» Demographic aging slows real GDP growth

» Slower labor force growth and an aging labor force, both hurt GDP growth

» 2.7% past 50 years, 1% is far more likely. New Normal, Indeed!

» Most investors over rely on two “pillars,” stocks and bonds

» Both pillars, already weakened by low yield, crumble with inflation

» Investors urgently need to establish a “Third Pillar”

» Diversifying into EM and alternative markets

» Seek markets with higher yield or growth or both

» Focus on markets that can hedge our inflation risk

17

Three (or Four) Paths to Improved Return Potential

Consider Other Asset Classes

» Stocks and bonds are not the only choices

» “Unconventional assets” may at times be priced to offer better return

potential

Seek Alpha

» Conservatively, focusing on avoiding negative alpha, or

» Aggressively, if you have confidence in the opportunities

Actively Manage the Asset Mix

» Include alternative markets in these decisions

» Seek assets which are out of favor, priced for better returns

We Believe All Three Paths Can Be Pursued in Parallel!

Our fourth set of tools – modest leverage and shorting – may enhance

portfolio efficiency by amplifying some risks while reducing others

18

Where are the opportunities today?

� Building a third pillar

20

Long treasury: Barclays U.S. Long Treasury; Core fixed income: Barclays U.S. Aggregate Index; Long credit: Barclays U.S. Long Credit; Short-term bonds: Barclays U.S.

Aggregate 1-3 yrs; Large cap U.S. equities: S&P 500; Emerging market bonds: JPM EMBIG Diversified; Developed ex U.S. equities: MSCI EAFE (Gross); Small cap U.S.

equities: Russell 2000; Emerging market equities: MSCI Emerging Markets (Gross); REITs: FTSE NAREIT All REITs; Local currency EM: JPMorgan ELMI+; TIPS: Barclays

U.S. TIPS; High yield: Barclays U.S. Corporate High Yield; Bank loans: Credit Suisse Leveraged Loan Index; Commodities: DJ UBS Commodity Total Return Index

Source: Research Affiliates, LLC., based on data from Bloomberg and Encorr.

Identifying “Stealth Inflation Fighters” to Build a

Third Pillar

-0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6

Commodities

Bank Loans

REITs

Convertibles

High Yield

Emg Mkts Equities

Small Cap US Equities

Developed ex US Equities

Large Cap US Equities

Local Currency EM

Emg Mkts Bonds

TIPS

Long Credit

Long Treasury

Core Fixed Income

Short Term Bonds

Quarterly Correlation of real returns to U.S. Inflation, March 1997 - March 2013

21

*Measured by the standard deviation of monthly returns, annualized, for the 5 years ended March 31, 2013.

Emerging markets is represented by the Barclays Global Emerging Markets Index; EM local is represented by JPMorgan GBI-EM Global Diversified Unhedged Index; high

yield is represented by Barclays High Yield Index; bank loans measured by YTM of Powershares BKLN ETF; U.S. equities are represented by the S&P 500 Index; EM

equities represented by MSCI EM Index; REITS represented by the FTSE NAREIT Index ; U.S. core bonds represented by the Barclays U.S. Aggregate Index; IG

corporates represented by the Barclays U.S. Aggregate Credit Index; short-term represented by T-bills; TIPS represented by the Barclays U.S. TIPS Index

Source: Research Affiliates, LLC., based on data from Bloomberg and Encorr. As of March 31, 2013.

The Middle of the Volatility Spectrum Offers the

Highest Real Yield Potential

5-Year Annual

Volatility* (%) 1.2 3.7 7.6 8.1 10.9 11.6 15.7 16.1 20.4 30.2 34.8

-2.3%

-0.7% -0.6%

0.3%

3.0%

2.0%

3.2% 3.1%

-0.4%

0.2%

1.6%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

Short-termbonds

U.S. corebonds

TIPS Inv GradeCorporates

Bank Loans EmergingExternalBonds

High Yield EM LocalBonds

U.S. equities EM equities REITs

Asset class real yields ranked by volatility

**EAFE and EM long run historic averages inferred from U.S. long run and EAFE and EM short run histories.

Source: Research Affiliates, LLC, based on data from Bloomberg and Robert Shiller.

Peak Valuations and Peak Profits in the U.S.

Less so outside the U.S.

22.6

15.514.9

16.5 16.2

14.5

10.0

12.0

14.0

16.0

18.0

20.0

22.0

24.0

S&P 500 Shiller PE EAFE Shiller PE EM Shiller PE

Current vs Long Term Average P/E Ratios

Current: 3/31/13 Long Run Historic PE Average

21.9%

-20.4%

-2.4%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

S&P 500 EAFE EM

Current Level of Earnings Relative to Long Term EPS Trend

*Include 23 DM and 14 EM bond issuers, where data are available; countries are defined by the IMF. High debt countries is defined by >70% debt-to-GDP; low debt defined

by <40% debt-to-GDP.

**We removed one large outlier from each sample to avoid data skewness.

Note: Debt : GDP figures are as of 12/31/2011. All other data as of 3/31/2013.

Source: Research Affiliates, LLC, based on data from Bloomberg, the Yield Book, and the IMF.

EM vs. Developed Sovereign Bonds

Who has the debt servicing capacity?

Debt : GDP

Yield to

Maturity

5-Year CDS

Spread Credit Rating

Country Groups*

High Debt Countries 101.5% 2.0% 1.3% AA

Low Debt Countries 30.1% 4.4% 0.9% A+/A

Developed vs. Emerging**

Developed Market 77.2% 1.8% 0.8% AA+/AA

Emerging Market 39.3% 4.8% 1.1% A-

24

Source: Research Affiliates., based on data from Bloomberg.

Fundamental Index Strategies:

Eliminating the Performance Drag of Cap-Weight

4/30/2013 3 Month 1 Year 3 Year Since Launch* Launch Date

FTSE RAFI All World 3000 4.8% 18.6% 8.3% 15.1% 10/6/2008

MSCI All World 4.9% 15.7% 9.3% 13.6%

Value Added -0.1% 2.9% -1.0% 1.5%

FTSE RAFI US 1000 8.2% 22.5% 13.1% 7.4% 11/28/2005

Russell 1000 7.2% 17.2% 12.9% 5.8%

Value Added 1.1% 5.3% 0.2% 1.6%

FTSE RAFI US MS 1500 5.4% 18.8% 10.7% 8.0% 5/4/2006

Russell 2000 5.4% 17.7% 11.3% 5.5%

Value Added 0.0% 1.1% -0.6% 2.5%

FTSE RAFI Developed ex-US 1000 3.4% 18.5% 5.3% 5.1% 11/28/2005

MSCI EAFE 5.3% 20.0% 8.0% 4.6%

Value Added -1.9% -1.4% -2.6% 0.5%

FTSE RAFI Dev. ex-US MS 1500 5.1% 15.2% 7.9% 3.6% 8/6/2007

MSCI EAFE Small 6.9% 18.3% 9.4% 1.0%

Value Added -1.7% -3.1% -1.5% 2.6%

FTSE RAFI Emerging Markets -4.1% 1.2% 2.0% 2.5% 7/9/2007

MSCI Emerging Markets -2.2% 4.3% 3.4% 1.4%

Value Added -1.9% -3.1% -1.4% 1.1%

Note: The index version of the RAFI methodology, or the FTSE RAFI Indexes, is licensed globally by our partner the FTSE Group. All returns are Total Returns in USD. This material relates only to

a hypothetical model of past performance of the Fundamental Index strategy itself, and not to any asset management products based on this index. No allow ance has been made for trading

costs or management fees w hich w ould reduce investment performance. Actual results may dif fer. Indexes are not managed investment products, and, as such cannot be invested in directly.

Returns represent performance based on rules used in the creation of the index, are not a guarantee of future performance and are not indicative of any specific investment. Returns listed

prior to the individual indexes launch dates are simulated.

*Launch date returns are calculated using the f irst full month of returns follow ing index inception.

MSCI returns information provided under license through MSCI. All returns based calculations are calculated by Research Affiliates, LLC.

Source: Research Affiliates, LLC, and Morningstar Encorr. From “The Rationale for Global Tactical Asset Allocation,” Investments & Wealth Monitor, John West and Rob

Arnott, November/December 2009. The illustration is of a six asset class portfolio including stocks (S&P 500 Index), bonds (Barclays Aggregate), high yield bonds (Barclays

Corporate High Yield), emerging market bonds (JPM EMBI+), REITs (FTSE NAREIT), and TIPS (Barclays U.S. TIPS). These figures are optimized using Encorr based on

target standard deviations. The asset class expected returns are based on our building block approach of beginning yield + real growth + inflation – defaults.

Crisis Brings Opportunity – Be Tactical

5.5%

9.5%

10.5%

3.5%

4.5% 4.6%

3%

4%

5%

6%

7%

8%

9%

10%

11%

5% 6% 7% 8% 9% 10% 11% 12% 13%

An

nu

ali

ze

d R

eal

Retu

rn

Annualized Standard Deviation

Expected Portfolio Real Return at 6%, 9% & 12% Volatility

2/27/2009

7/31/2008

26

Past performance is no guarantee of future results. Emerging Markets Stocks represented by MSCI Emerging Markets Gross Index. Commodities represented by Dow Jones

UBS/AIG Commodity Index. REITS represented by Wilshire REIT Index. Emerging Markets Bonds represented by JP Morgan Emerging Markets Bond Index Global. TIPS

represented by Barclays U.S. TIPS Index. High Yield Bonds represented by Merrill Lynch High Yield Master II Index. Long Term Govt Bonds represented by Barclays Long-

Term Treasury Index. Mortgage Bonds represented by Barclays Mortgage Index. Convertible Bonds represented by Merrill Lynch ALL US Convertible Securities Index.

Unhedged Foreign Bonds represented by Citigroup World ex-U.S. Government Bond Index. Money Markets represented by Citigroup 3-Month T-Bill Index. Intl Stocks

represented by MSCI EAFE Gross Index. S&P 500 Equal Weighted (SPEW) reflects the performance of the S&P 500 Index with component stocks equally weighted rather

than capitalization weighted. The Standard & Poor’s 500 Stock Index (S&P 500) is an unmanaged, capitalization-weighted index of U.S. companies generally representative

of the U.S. Stock Market. The Barclays US Aggregate Bond Index is generally considered to be representative of the domestic, investment-grade, fixed-rate, taxable bond

market. Returns are not indicative of the past or future performance of any investment product.

A Spectrum of Returns

“The First Shall Be Last and the Last Shall Be First”

Asset Class 2008-2012 2003–2007 1998–2002 1993–1997

Emerging Markets Stocks -3 391 -21 44

International Stocks -15 171 -12 74

REITs 29 131 23 118

Large Cap U.S. Stocks 9 83 -3 152

Commodities -23 95 21 58

Convertibles 22 66 20 92

Unhedged Foreign Bonds 32 43 27 47

TIPS 41 36 52 —

High Yield Bonds 61 67 3 75

Long Government Bonds 58 32 52 62

Emerging Markets Bonds 64 82 44 —

Core Bonds 33 24 44 43

Mortgages 32 25 43 42

Money Market 2 16 23 26

Red = worst three Blue = best three

Cumulative Returns

Thank You

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