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Fundamental Bond Indexes for Smarter Investing

July 27, 2011

Shane Shepherd, Ph.D.

4 ©Research Affiliates, LLC Global RAFI Bonds

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Mission

Concentrate on Research and product development

Partner with world-class Affiliates to bring product to market

Global leader in Global tactical asset allocation (GTAA)

Innovative indexation

Profile Approximately $83 billion in assets managed using RA investment strategies as of June 30, 20111

Founded in 2002 by Rob Arnott

Majority employee-owned

Research Affiliates, LLC

1As of 3/31/2011: Based on estimates. Includes assets managed or sub-advised by Research Affiliates or licensees using RAFI, eRAFI®, or GTAA strategies. Note: please refer to the disclosure slide at the end for all relevant disclaimers, disclosures, and information

on our intellectual property.


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The Advantages of Passive Investing

Index funds are a compelling choice for investors

Broad market exposures

Diversification

Large investment capacity

Low fees and expenses

Low due diligence and monitoring costs

Superior performance over time relative to most active managers


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Frame of Reference: Two Views on the Markets

Cap-Weight Market Centric View

Graham & Dodd Economy-Centric View

• Markets are efficient—prices reflect true valuations

• Departures from cap weight are active bets, inherently a zero-sum game

• Invest in companies proportional to market valuation

• Seek equity risk premium not alpha

• Markets are constantly seeking fair value, but prices are rarely right

• Some companies can get overpriced, some underpriced

• The market itself makes active bets

• Create valuation model of the company and invest in ones which offer the best rate of return

Impossible to beat cap-weighted index, except by luck; value premium and size premium are anomalies, contradicting EMH and CAPM theories, unless there are hidden risks or different discount rates.

Cap-weighted index overweights the overpriced and underweights the underpriced; result is a return drag, relative to its opportunity set. Cap-weighted index favors popularity and comfort; not sensible.


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Bubbles are clinical symptoms of mispricing Tulip Mania (1637)

John Law’s Mississippi Company (1719–21)

The South Sea Company (1720)

Railway Mania (1840s)

Roaring Twenties (1922–1929)

Recent bubbles Nifty Fifty (early 1970s)

Japanese Asset Prices Bubble (1980s)

Dot-com (1997–2000)

Real Estate (2005–2007)

Commodities (2008)

Note: All Bubbles Crash!… Which one is next?

Are Markets Becoming More Efficient With Time?

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RAFI®

Efficient Indexing for an Inefficient Market®


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The RAFI approach

Select and weight stocks by non-price measures of firm size

Sales, cash flow, dividends, and book value

Achieve excess returns over cap weighting1

2–4% in developed markets

Greater in less efficient markets

Preserve the advantages of passive investing

Diversification

Liquidity

Transparency

Broad economic representation

Low cost access to equity markets

The RAFI Approach

1Based on Research Affiliates historical simulated data using CRSP, Compustat, Worldscope and Datastream, on universe of U.S. equities 1962-2009 and

International equities 1984-2009.


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Simulated RAFI Developed 1000 1984–2010

Source: Research Affiliates, LLC. based on data from Bloomberg, Datastream and Worldscope. THE INDEX DATA PUBLISHED HEREIN IS

SIMULATED, UNMANAGED AND CANNOT BE INVESTED IN DIRECTLY. PAST SIMULATED PERFORMANCE IS NO GUARANTEE OF FUTURE PERFORMANCE AND IS NOT INDICATIVE OF ANY SPECIFIC INVESTMENT. ACTUAL INVESTMENT RESULTS MAY DIFFER.


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Simulated RAFI Concept Works Globally 23 Country Returns, December 2010

Note: 23- Country Average values are determined from the return series of the average country, not the average of each respective statistic in the above table.

Source: Research Affiliates, LLC. Based on data from Worldscope, Datastream, CRSP and Compustat. THE INDEX DATA PUBLISHED HEREIN IS SIMULATED, UNMANAGED AND CANNOT BE INVESTED IN DIRECTLY. PAST SIMULATED PERFORMANCE IS NO GUARANTEE OF FUTURE

PERFORMANCE AND IS NOT INDICATIVE OF ANY SPECIFIC INVESTMENT. ACTUAL INVESTMENT RESULTS MAY DIFFER.

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Fixed Income Philosophy

Indexing is a Great Strategy

(but only if properly designed)


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How Well Do Passive Indexes Carry Their Weights?

Most fixed income indexes base their bond weights on debt outstanding

Do we really want to buy more of a company’s or country’s debt solely because it increases its issuance?

Cap-weighted indexes are neither liquid nor investable Typical cap-weighted indexes include too many bonds to replicate.

Low liquidity screens allow inclusion of many bonds that are difficult to price and purchase.

Require you to invest in many bonds from the same issuer, when only a couple would provide adequate exposure to that credit risk.

Cap-weighted indexes are difficult to correctly calculate Treasuries and agencies are commonly stripped and reported delinquently or not at all.

Some corporates have sinking funds and put features which are reported only annually.

MBS principle payments are reported only at end of month, and stale prices lead to inaccurate weights.

The proper weights for the index are impossible to determine accurately.


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The RAFI approach

Corporate: select and weight bonds by non-price measures of firm size

Sales, cash flow, dividends, and book value of assets

Sovereign: select and weight bonds by non-price measures of country size

Population, land area, GDP, and energy consumption

Preserve the advantages of passive investing

Diversification

Liquidity

Transparency

Broad economic representation

Low cost access to securities markets

The RAFI Approach


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These metrics are not correlated with market value Pricing errors are uncorrelated with portfolio weights (and, therefore, cancel in aggregate)

Both overvalued and undervalued bonds will be overweighted and underweighted, and the errors largely offset each other

They reflect objective measures of relative size Widely acceptable measures of company/country size

Less susceptible to gaming

Easily accessible data

Not intended to be predictive of future size or value

Broadly available across countries

Consistent with the equity application of the RAFI strategy Both stocks and bonds are simple claims to future cash flows of a corporation. A method of measuring the size of a corporation should work consistently well for both assets.

RAFI Factors: Why These Metrics?


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Only Fundamentals Impact RAFI Weights


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Market Price Does Not Impact RAFI Weights


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Any single-metric index works, but has a structural bias

Sales—overexposed to large companies with thin margins

Cash flow—overexposed to cyclical companies at cyclical peaks

Dividends—overexposed to mature, high-yield companies and excludes growth companies

Book value of assets—overexposed to companies with aggressive accounting

Composite approach improves methodology

Diversifies exposure to data source, sectors, and other risks

Improves robustness of methodology

Improves stability of factors

Superior risk–return performance

Helps keep turnover lower

Benefits of a Composite Approach


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Five-Year Averaging is Better than Current Data

Averaging over five years helps smooth peaks and valleys in financial data

Less susceptible to aggressive accounting, earnings management, etc., in any single year

Latest financial data is more correlated with recent price moves. We’re trying to eliminate that linkage

Keeps turnover lower than just using the last years data

Provides a solid, stable anchor to rebalance back to and contra-trade against the markets’ gyrations

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Appendix


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Growth of $10,000 US High Yield




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Growth of $10,000 US Investment Grade 1-10




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Growth of $10,000 EM Sovereign USD Denominated Debt

ML EM Sovereign is the Merrill Lynch USD EM Sovereign Plus Index (IGOV)Source: Research Affiliates based on data from Bloomberg. Returns



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Growth of $10,000 EM Corporate Debt

ML EM Corporate is the Merrill Lynch USD EM Corporate Credit Plus Index (ICPD) Source: Research Affiliates based on data from Bloomberg.



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Index Characteristics – Developed Sovereign March 31, 2011

ML Developed Sovereign is the Merrill Lynch Developed World Sovereign Bond Index (W0G1

Source: Research Affiliates based on data from Bloomberg.


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Index Characteristics – EM Sovereign USD Denominated Debt - March 31, 2011

ML EM Sovereign is the Merrill Lynch USD EM Sovereign Plus Index (IGOV



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Index Characteristics – EM Sovereign Local Currency - March, 31 2011

JPM EM Sovereign Local Currency Index is the JP Morgan GBI-EM Global Local Currency Index

Source: Research Affiliates based on data from Bloomberg and JPM.


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Index Characteristics – Developed Investment Grade – March 31, 2011

ML Developed Investment Grade is the Merrill Lynch Global Broad Market Corporate Index (G0BC)



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Index Characteristics – Developed High Yield March, 31 2011

ML Developed High Yield is the Merrill Lynch Global High Yield Index (HW00) Source: Research Affiliates based on data from Bloomberg.


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Index Characteristics – EM Corporate March 31, 2011

ML EM Corporate is the Merrill Lynch USD EM Corporate Credit Plus Index (ICPD) Source: Research Affiliates based on data from Bloomberg.


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Index Characteristics – US High Yield March 31, 2011


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Index Characteristics – US Investment Grade 1-10 March - 31, 2011


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Important Information

By accepting this document you agree to keep its contents confidential and not to use the information contained in this document, and in the other materials you will be provided with, for any purpose other than for considering a participation in the proposed transactions. You also agree not to disclose information regarding the transactions to anyone within your organization other than those required to know such information for the purpose of analyzing or approving such participation. No disclosure may be made to third parties (including potential co-investors) regarding any information disclosed in this presentation without the prior permission of Research Affiliates, LLC.

The material contained in this document is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Research Affiliates and its related entities do not warrant the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this material should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

THE INDEX DATA PUBLISHED HEREIN IS SIMULATED, UNMANAGED AND CANNOT BE INVESTED IN DIRECTLY. PAST SIMULATED PERFORMANCE IS NO GUARANTEE OF FUTURE PERFORMANCE AND IS NOT INDICATIVE OF ANY SPECIFIC INVESTMENT. ACTUAL INVESTMENT RESULTS MAY DIFFER. The simulated data contained herein is based on the patented non-capitalization weighted indexing system, method and computer program product (see Robert D. Arnott, Jason Hsu and Philip Moore. 2005. “Fundamental Indexation.” Financial Analysts Journal [March/April]:83-99).

Any information and data pertaining to indexes contained in this document relates only to the index itself and not to any asset management product based on the index. No allowance has been made for trading costs, management fees, or other costs associated with asset management as the information provided relates only to the index itself. With the exception of the data on Research Affiliates Fundamental Index, all other information and data are based on information and data available from public sources.

Any inquiries relating to the transactions should be directed to Research Affiliates, LLC.

The trade names Fundamental Index®, RAFI®, the RAFI logo, and the Research Affiliates corporate name and logo are registered trademarks and are the exclusive intellectual property of Research Affiliates, LLC. Any use of these trade names and logos without the prior written permission of Research Affiliates, LLC is expressly prohibited. Research Affiliates, LLC reserves the right to take any and all necessary action to preserve all of its rights, title and interest in and to these marks.

Fundamental Index®, the non-capitalization method for creating and weighting of an index of securities, is patented and patent-pending proprietary intellectual property of Research Affiliates, LLC (US Patent No. 7,620,577; 7,747,502; and 7,792,719; Patent Pending Publ. Nos. US-2007-0055598-A1, US-2008-0288416-A1, US-2010-0191628, US-2010-0262563, WO 2005/076812, WO 2007/078399 A2, WO 2008/118372, EPN 1733352, and HK1099110).

©2011, Research Affiliates, LLC. All rights reserved. Duplication or dissemination prohibited without prior written permission.

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Program Name: Fundamental Bond Indices For Smarter Investing - 7/28/11

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