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Morningstar Investment Services, Inc.

© 2013 Morningstar Investment Services, Inc. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. All other marks are the property of the respective owners. Morningstar Investment Services, Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc.

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You might have noticed that some of our diversified mutual fund and ETF portfolios have underperformed their blended

benchmarks recently. In this commentary we summarize recent performance, explain the factors that have caused

some portfolios to lag, and place those factors into a broader context.

Executive Summary

Some of our diversified mutual fund and ETF portfolios are lagging their generic blended benchmarks for the

year-to-date and one-year periods ended June 30, 2013.

This underperformance stems largely from differences between the portfolios’ asset allocations and the make-

up of the generic benchmarks against which they’re measured.

o In addition to U.S. stocks, foreign developed stocks, and U.S. bonds, many of the portfolios also

invest in asset classes like emerging markets stocks, foreign bonds, commodities, and REITs.

o These other asset classes have lagged recently, but aren’t part of the generic benchmarks.

o Thus, these underperforming asset classes have held back our portfolios, but not the generic

benchmarks.

o These mismatches largely explain the recent underperformance of our diversified mutual fund and

ETF portfolios.

We believe these performance divergences are temporary.

o Diversification into these areas hasn’t been rewarded recently, but we believe a well-diversified

portfolio will deliver better risk-adjusted returns over the long haul.

Background

Before we review the recent performance of our diversified mutual fund and ETF portfolios, it’s worth reviewing the

composition of the blended benchmarks that we measure these portfolios against. Those benchmarks consist of varying

weights of the following indexes:

Tax-Deferred Mutual Fund Portfolios

S&P 500 Index

MSCI EAFE Index

Barclays Capital U.S. Aggregate Bond Index

Cash

Taxable Mutual Fund Portfolios

S&P 500 Index

MSCI EAFE Index

Barclays Capital 1-10 Year Municipal Bond Index

Cash

Inside Our Recent Performance

Putting Returns in Context

For Financial Advisor Use Only; Not for Use with Clients or General Public



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Diversified ETF Portfolios

S&P 500 Index

MSCI EAFE Index

Barclays Capital U.S. Aggregate Bond Index

Cash

We use these generic blended benchmarks for a few reasons. First, they’re easier to understand—there are only a few

underlying indexes and they’re pretty well-known. Second, the generic blended benchmarks approximate a portfolio’s

state before it’s been more fully diversified across a greater number of asset classes.

It’s important to recognize, though, that we diversify our portfolios across many more asset classes than those

represented in the generic blended benchmarks. For instance, our asset allocations routinely extend to areas like

emerging markets stocks and non-U.S. bonds, which aren’t included in the generic blended benchmark indexes.

Though we expect such differences to moderate over longer periods of time, they can cause significant performance

divergences over shorter periods of time. For instance, if the performance of foreign bonds is markedly different than

that of, say, U.S. investment-grade bonds, then our portfolios’ performance can veer significantly from the generic

blended benchmarks they’re measured against.

Recent Performance

The following chart compares the recent performance of our mutual fund and ETF portfolios against two sets of blended

benchmarks. The first set, “generic”, represent the generic blended benchmarks described above. The second set,

“granular”, are the blended benchmarks that mirror the more expansive strategic asset allocations we follow in our

portfolios.

(Note: “AG” = Aggressive Growth; “G” = Growth; “MG” = Moderate Growth; “IG” = Income & Growth; “C” =

Conservative.)




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Diversified ETF Portfolios

Ibbotson Tax-Deferred Active/Passive Portfolios



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Ibbotson Taxable Active/Passive Portfolios

We can make a few observations about the charts above. First, while our mutual fund portfolios have recently lagged

their generic benchmarks, they’ve generally bested their granular benchmarks. Second, the performance gaps have

been wider over the year-to-date period than the trailing year. In fact, a number of our portfolios have beaten both the



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generic and granular benchmarks over the trailing 12-months. And, finally, the divergences have been larger in our tax-

deferred mutual fund and ETF portfolios than in our taxable mutual fund portfolios.

Explaining Recent Performance

As the charts imply, the recent underperformance of our portfolios is more a function of asset allocation differences than

security selection. Put another way, the recent performance gaps stem largely from differences between what’s

included in the generic blended benchmarks and what we own in our portfolios by virtue of our policy asset allocations.

An example might help to better explain this point. Below, we have compared the strategic asset class weightings of

our tax-deferred Moderate Growth mutual fund portfolio (represented by its granular blended benchmark) and the

weightings of the generic blended benchmark it’s compared against. The example does not necessarily represent the

weightings and performance of all portfolios managed by Morningstar Investment Services.

As you can see, the Moderate Growth portfolio’s asset allocation (as represented by the granular benchmark) extends

to a number of areas that aren’t part of the generic benchmark, such as small- and mid-cap U.S. stocks, emerging

markets stocks, high-yield bonds, foreign bonds, REITs, commodities, and absolute return.



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Now let’s take a look at how these different asset classes have performed over the year-to-date and trailing one-year

periods ended June 30, 2013. The charts below compare the recent performance of the various asset classes that

comprise the Moderate Growth portfolio’s granular blended benchmark to the indexes that make up the generic

benchmark (namely, the S&P 500, Barclays Capital U.S. Aggregate Bond, and MSCI EAFE indexes, which are shown in

the rightmost columns of each chart).

U.S. Stock Indexes

Foreign Stock Indexes



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Bond Indexes

Commodities and REITs

Absolute Return



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(Note: We compare our absolute-return allocation to a 50 /50 mix of the S&P 500 and Barcap U.S. Aggregate Bond

indexes.)

From these charts, we can make a few observations. First, the performance gaps between the asset classes and the

S&P, MSCI EAFE, or BarCap indexes tended to be widest over the year-to-date period. Second, the gaps were most

evident among the foreign-stock indexes (where emerging markets stocks significantly lagged foreign developed market

equities), commodities and REITs (which badly lagged the S&P 500), as well as foreign bonds (which trailed the BarCap

Aggregate index).

In the chart below, we quantify those differences by multiplying the weighting of each asset class in the granular

benchmark by its recent performance differential (i.e., its returns vs. the S&P 500, MSCI EAFE, and BarCap Aggregate

indexes, respectively).

As is evident from the chart, while allocations to value and small-cap U.S. stocks and certain types of U.S. bonds

generally aided performance, the portfolio’s stake in foreign bonds, emerging markets stocks, commodities, and REITs

hindered performance, as these areas lagged. All told, we estimate that these asset allocation effects subtracted

around 1.75% in returns for the year-to-date period ended June 30, 2013, and 1.12% over the trailing year. Essentially,

by mandate, the Moderate Growth portfolio owned less of what performed well than the generic blended benchmarks

did and we owned more of what performed poorly than the generic benchmark did.

It’s worth noting, though, that the Moderate Growth portfolio lagged its generic benchmark by only 0.47% for the year-

to-date and beat the benchmark by around 0.82% over the trailing year. What this implies is that fund selection was a

positive offset—i.e., the mutual funds that we chose for these different asset classes delivered better performance than

their benchmarks over these periods. In the chart below we present an attribution that estimates the asset allocation

and fund selection effects for the year-to-date and trailing one-year periods.



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Performance Differences: In Context

The story for the Moderate Growth (tax-deferred) mutual fund portfolio largely holds for the other diversified mutual fund

and ETF portfolios. The charts below estimate the asset allocation and fund selection effects for all of the other

diversified mutual fund and ETF portfolios:




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Ibbotson Tax-Deferred Active/Passive Portfolios



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Ibbotson Taxable Active/Passive Portfolios

(We estimate “allocation” as the difference between a portfolio’s granular blended benchmark return and its generic

benchmark’s return. We estimate “selection” as the difference between a portfolio’s gross return and its granular

benchmark’s return. Taken together, the two effects explain a portfolio’s performance versus its generic benchmark.)



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As shown above, asset allocation plays a meaningful role in explaining recent performance shortfalls versus the generic

benchmarks, with fund selection partially or entirely plugging those gaps (ETFs excepted). That said, a few quirks are

worth further elaboration:

Aggressive vs. Conservative: The gaps between our portfolios and their generic blended benchmarks tend to

be wider in more aggressive portfolios and narrower in more conservative portfolios. Asset allocation

differences again largely explain this—emerging markets stocks, commodities, and real estate play a bigger

role in more aggressive portfolios than they do in more conservative strategies and those areas were among

the worst recent performers.

Tax-Deferred vs. Taxable: The gaps tend to be narrower in our taxable portfolios than the analogous tax-

deferred portfolios. The main reason is that whereas we own commodities, TIPs, and foreign bonds in our tax-

deferred portfolios, we don’t invest in these punitively-taxed areas in the taxable portfolios. Since these asset

classes have underperformed recently, owning less of them in the taxable portfolios translated to smaller

gaps.

Mutual funds vs. ETFs: Generally speaking, the gaps were widest in our ETF portfolios. The reason is two-fold.

For one, these portfolios invest almost exclusively in passively-managed ETFs and, thus, do not derive benefits

from traditional active security selection, like the mutual fund portfolios do. Thus, whereas the mutual fund

portfolios enjoyed a positive “selection” effect from active investment, the ETF portfolios did not. In addition,

the ETF portfolios generally sported larger overweights to foreign stocks and commodities in recent periods,

which detracted from performance given those asset classes’ lackluster returns.

MIS Portfolios vs. Ibbotson Active/Passive Portfolios: Though the Ibbotson Active/Passive portfolios suffered

from the same allocation effect (whereby diversification was punished, not rewarded), fund selection was a

more decidedly positive. Thus, many of the Ibbotson Active/Passive portfolios fared better versus their generic

benchmarks than the comparable MIS portfolio.

Year-to-date vs. trailing one-year: In general, the performance gaps are wider over the year-to-date period

than the trailing year ended June 30, 2013. The reason is again two-fold. First, the disparity between areas

like emerging markets stocks, commodities, and REITs and the broad asset classes has been widest in recent

months. Second, active security selection has been a more pronounced positive over the trailing 12-months

than year-to-date.

In summary, recent performance issues largely stem from differences between the make up of our portfolios and the

generic benchmarks against which they’re measured. We believe these performance differences are likely to prove

temporary, as the generic benchmark and granular benchmark have routinely traded the lead over shorter periods of

time. Indeed, when we tallied-up rolling 12-month return differentials for the generic and granular benchmarks (i.e.,

generic benchmark return minus granular benchmark return for every rolling 12-month period), we found it wasn’t

uncommon for one benchmark to jump ahead, only to cede the advantage in a subsequent period and so forth.



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Given this, we don’t think it’s prudent to draw conclusions about a portfolio’s merit based on its short-term performance

versus a generic benchmark. Rather, we think it’s more appropriate to maintain a long-term perspective, a time horizon

over which we believe investors are likelier to reap the benefits of diversification through a more varied asset allocation.



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For Financial Advisor Use Only; Not for Use with Clients or General Public

The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational

purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions

expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar Investment

Services shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data,

analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar Investment Services and may

not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar Investment Services.

The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without

notice, do not constitute investment advice and are provided solely for informational purposes. Morningstar Investment Services shall not be

responsible for any trading decisions, damages, or other loses resulting from, or related to, the information data, analyses or opinions or their

use.

The indices noted are unmanaged and cannot be directly invested in. Individual index performance is provided as a reference only. Since

indices and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented.

Although index performance data is gathered from reliable sources, Morningstar Investment Services cannot guarantee its accuracy,

completeness or reliability.

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