The case for U.S. mid-cap investing and, more specifically, value

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1 U.S. Equity U.S. equities white paper September 2015 The case for U.S. mid-cap investing and, more specifically, value Despite a long-term and compelling track record of outperformance, mid-cap stocks remain largely under-followed and under-researched by Wall Street analysts and do not receive the attention large-cap names often receive from individual investors. In this white paper, we make the case for mid-cap stock allocation as a downside risk management strategy and a potential method of balancing out the effects of FX earnings risk. We also make the case for active management to exploit the inherent inefficiencies of this portion of the market. Often when a company s business is too complex or boring, it lacks the ability to attract analysts attention, making analysts less inclined to roll up their sleeves to gain greater understanding of these companies. Stocks of mid-sized companies remain largely less publicized and subject to individual investor bias, making them less favored than the more familiar large- and mega-cap names for equity allocations. Markets continue to inefficiently price mid-cap company stocks, despite their success navigating the startup phase of the business cycle and prospects for potential growth as they mature. As recently as 6/30/15, research according to Factset reflects that mid-cap stocks represent approximately 43% of the total market value of U.S. equities. Yet, U.S. retail investors remain significantly underweight the asset class with retail mid-cap stock ownership representing just under 14% of total U.S. equity exposure. What is even more telling is that over the past three decades, mid-cap stocks have been one of the best performing asset classes. Contributors David Wertheim, Senior Product Specialist (Active and Alternative Investments) Bill Andrakakos, Investment Specialist (Equities) Quantitative screens, combined with face-to-face company meetings can help to develop a stronger understanding of management philosophy and objectives. We believe to consistently source attractive investment ideas, experience and a disciplined investment approach are critical to uncover common themes and identifiable catalysts that can contribute to attractive valuations and investment results overall. Outline 1 The case for mid-cap investing (page 2) 1.1 The role of benchmarks in bias (page 2) 2 Overarching attraction (page 2) 3 Long-term track record of outperformance: vs. small- and large-cap stocks (page 2) 3.1 Short- and intermediate-term time horizon (page 3) 3.2 Over full market cycles (page 4) 4 A sweet spot even sweeter in value (page 4) 5 Addressing the effects of international/global portfolios (page 5) 6 Conclusion (page 6)

2 1 The case for mid-cap investing 1.1. The role of benchmarks in creating biases There are many benchmarks for the mid-cap investing arena. Depending on the methodology used by the benchmark to determine security selection, biases among them, geographic region and market capitalization range can occur. We believe the benchmark Russell Midcap Index reflected in the table below provides a good representative sample of the most widely followed stocks in the mid-cap market. Figure 1: Benchmark could lead to potential bias Geographic representation Market capitalization Weighted average market capitalization Market-capitalization range Source: Russell Investment as of July 31, Russell Midcap Index Domestic Mid $12.5 billion $2.4 billion to $28.7 billion Stocks 830 could be somewhat diminished. A lower business volume baseline in mid-cap companies suggests that they may be more nimble to respond quickly to product innovations and changes in the marketplace and are sometimes in the prime growth phase of their business cycle. For this reason, during periods of prolonged slow economic growth, mid-cap companies can potentially become the target of larger, cash-rich companies looking for opportunities to grow. Because mid-cap stocks represent 43% of the securities in the investable universe, exposure to them represents opportunity for potentially even greater portfolio diversification. 1 However, the fact that mid-cap stocks are not receiving their share of investor assets also makes it one of the less congested and under-utilized market segments, with smaller amounts of money flowing into a larger number of stocks. This gives active managers greater latitude to add value in ways not typically afforded by the more popular small, large and mega market capitalizations. Mid-cap stocks history of outperformance vs. other market capitalizations, and during different time horizons and within various market cycles, are covered in greater detail in the following sections. Because mid-cap stocks also have a tendency to exhibit higher earnings and cash flows, these stocks are starting to become recognized as true drivers of longer-term stock performance. 2 Overarching attraction 3 Long-term outperformance For retail and institutional investors who have established space for mid-cap stocks in their asset allocations, it is with good reason. Traditionally mid-cap stocks are defined as companies with market capitalizations that fall between $1.5 billion and $28.1 billon. That places these companies in the middle of two extremes. Mid-cap stocks are not as small as the smaller capitalization companies which tend to be more susceptible to failure, and not as large as the larger capitalization companies which tend to be more mature and stabilized, but whose opportunity for future growth Since the common inception date of 12/29/78, mid-cap stocks have significantly outperformed large- and smallcap U.S. stocks, as measured by the Russell Midcap Index, Russell 1000 Index, and Russell 2000 Index respectively. Over this time period, mid-cap stocks have generated average annualized returns of 13.62% vs.11.96% and 11.78% for large- and small-cap stocks, respectively (as of 7/31/15). And, on a cumulative return basis over nearly 36 years, this has led to 4,453% and 4,806% outperformance respectively vs. large- and small-cap stocks (as of 7/31/15). 2 The case for mid-cap investing and more specifically value

3 Figure 2: Historical track record on upward trajectory Growth of hypothetical $10,000 portfolio (12/29/78 7/31/15) 1,200,000 Russell Midcap Index Russell 1000 Index Russell 2000 Index 1,000, , , , , /78 12/80 12/82 12/84 12/86 12/88 12/90 12/92 12/94 12/96 12/98 12/00 12/02 12/04 12/06 12/08 12/10 12/12 Source: Morningstar (as of 7/31/15) Performance is historical and does not guarantee future results. Mid-cap stocks are represented by Russell Midcap Index, large-cap stocks are represented by Russell 1000 Index and small-cap stocks are represented by the Russell 2000 Index. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 7 for index definitions. 7/ Short- and medium-term time horizon Over time, mid-cap stocks have performed well, demonstrating their ability to navigate some of even the most volatile markets with consistency. In reviewing the performance of the Russell Mid-Cap Index over the one-, three-, five-, 10-, 15-, and 20-year periods, as well as since inception, the stocks within the index have historically outperformed their large- and small-cap counterparts as measured by the Russell 1000 Index and Russell 2000 Index during every time period, except the trailing one-year period. Again some of this can be attributed to their capitalization size and effectiveness in adapting to shifting business environments. Though no one can predict what the future may hold, the compelling mid-cap stock track record may be worth consideration. (See Figure 3). Figure 3: Mid-cap delivered consistent performance year 3 year 5 year 10 year 15 year 20 year Since common incep Russell Midcap Index Russell 1000 Index Russell 2000 Index Source: Morningstar as of 7/31/15. Performance is historical and does not guarantee future results. Mid-cap stocks are represented by Russell Midcap Index, large-cap stocks are represented by Russell 1000 Index and small-cap stocks are represented by the Russell 2000 Index. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 7 for index definitions. The case for mid-cap investing and more specifically value 3

4 3.2. Over full market cycles One of the true tests of resiliency is demonstrated through the mid-cap universe s proficiency in generating returns throughout various market cycles. Since 1979, mid-cap stocks have demonstrated a remarkable ability to generate excess return relative to large-cap stocks during bull markets. In fact, during this timeframe, when the S&P 500 Index has experienced a positive monthly return, mid-cap stocks have outperformed large-cap stocks 58% of time. Surprisingly, the results are similar when compared with high-beta small-cap stocks. During monthly periods since 1979, when the market as measured by the S&P 500 Index was up, mid-cap stocks have been able to keep pace with small and often high-beta stocks, outperforming small-cap stocks 48% of the time. And when the markets were down, mid-cap stocks dramatically outperformed small-cap stocks during the monthly periods when the S&P 500 Index was negative, outperforming small-cap stocks 63% of the time. The ability for mid-cap stocks to participate during times when the market is firing on all cylinders and rallying (bull Figure 4: Consider the full market cycles mid-cap monthly outperformance during varying market cycles (1/1/79 7/31/15) market) as well as to offer a measure of capital preservation during negative (bear) markets makes mid-cap stocks a viable contender to win over large- and small-cap stocks (53% of time since 1979) over full market cycles. (See Figure 4). 4 A sweet spot even sweeter in value Additional analysis and research over the past three decades shows that not all stocks in the mid-cap universe generate returns to the same degree. When comparing annualized and risk-adjusted returns, the sweetest spot is in mid-cap value more so than any other style box. (See Figure 5). 2 As Figure 5 indicates, over the past three decades, mid-cap value stocks have returned 11.52% a year, outperforming every other style box by 38 basis points (bps) or more on an annualized basis during this time frame. That is the equivalent of an additional 240% or more of cumulative returns when compared to other style boxes. Figure 5: The sweet spot that satisfies return while managing risk* (Annualized return and Sharpe ratio since common inception, 1/31/86 7/31/15) Up market outperformance vs. large-caps Down markets outperformance vs. small-caps 58% 63% Return Value Core Growth Sharpe ratio Value Core Growth Large 10.76% 10.65% 10.14% Large Full market cycle outperformance vs. large-caps Full market cycle outperformance small-caps Mid 11.52% 11.14% 9.93% Mid % 53% Small 10.63% 9.52% 7.98% Small Source: Morningstar as of 7/31/15. Performance is historical and does not guarantee future results. Mid-cap stocks are represented by Russell Midcap Index, large-cap stocks are represented by Russell 1000 Index and small-cap stocks are represented by the Russell 2000 Index. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 7 for index definitions. Source: Morningstar as of 7/31/15. Performance is historical and does not guarantee future results. Mid-cap stocks are represented by Russell Midcap Index, large-cap stocks are represented by Russell 1000 Index and small-cap stocks are represented by the Russell 2000 Index. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 7 for index definitions. 4 The case for mid-cap investing and more specifically value

5 When it comes to mid-cap value security selection, we believe that an active evaluation process featuring intensive bottom-up research, financial analysis and company visits, along with a long-term investment horizon are essential to discerning fundamentally sound companies with strong management and strategies. To identify catalysts (e.g. acquisitions or new products) and other signs that a company is undergoing positive change, we believe individual security selection across all economic sectors, rather than industry selection, plus consideration of investor biases are key. Earlier, we alluded to benchmarks, complexity of companies and unexciting businesses as potential contributors to investor bias. Each can be a cause for Wall Street to under follow, and investors to under appreciate or overlook companies. Other biases to consider: momentum precipitated by real or perceived market issues and news flows, and investor time horizons. The overemphasis of near-term data points causes longer-term positive company developments to be missed. By taking the time to fully understand companies, it could lead to further identification of sweetest spots in the mid-cap universe, and specifically the companies with the most attractive valuations and, more importantly, offering potential to deliver returns consistent with risk.* Figure 6: A strategy to help balance FX earnings risk (total revenues exposure: international vs. domestic share as of 12/31/14) Domestic revenues Russell 2000 Index 79% 21% International revenues Russell Midcap Index 72% 28% Russell 1000 Index 66% 34% Source: Factset as of 12/31/14. Performance is historical and does not guarantee Midcap future results. Mid-cap stocks are represented by Russell Midcap Index, large-cap stocks are represented by Russell 1000 Index and small-cap stocks are represented by the Russell 2000 Index. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 7 for index definitions. 5 Addressing the effects of international/global portfolios Finally, in an international or global portfolio, international revenue exposure is a concern for U.S. investors, especially when the U.S. dollar is much stronger than other currencies. In general, large-cap companies tend to generate more of their revenue from international sales than mid-cap companies. In fact, as of the end of 2014, U.S. mid-cap companies, as measured by the Russell Midcap Index, derived a smaller portion of their total revenues from international sales than large-cap stocks, as measured by the Russell 1000 Index. (See Figure 6). During this timeframe, mid-cap stocks had 18% less exposure to international revenues than large-cap stocks. With less exposure to international revenues, it stands to reason that during periods when the U.S. dollar strengthens vs. other foreign currencies, mid-cap stocks could potentially be more insulated from: Negative foreign currency translation effects Increased global competition, due to rising prices of U.S. goods sold internationally Potential declines in revenue due to international sales Given this background, it is not all that surprising, when comparing the performance of U.S. mid-cap equities vs. large- and small-cap stocks since 1988, that during periods when the U.S. dollar strengthened or weakened vs. a basket of international developed-nation currencies, mid-cap equities had a remarkable ability to outperform large- and small-cap stocks. (See Figure 7). In fact, when the U.S. dollar strengthened, we found that mid-cap stocks outperformed large- and small-cap stocks by 190 basis points and 8 basis points respectively. Likewise, when the U.S. dollar weakened, mid-cap stocks outperformed large- and small-cap stocks by 130 basis points and 385 basis points respectively. The case for mid-cap investing and more specifically value 5

6 Figure 7: Mid-cap performance continues to shine despite variable currency valuations (Annualized returns during months of U.S. dollar strength and weakness, Data as of 1/1/88 to 7/31/15) Russell Midcap Index Russell 1000 Index Russell 2000 Index 11.30% 9.40% 11.22% Dollar strengthening periods 13.41% 12.11% 9.56% Dollar weakening periods Source: Morningstar as of 12/31/14. Performance is historical and does not guarantee future results. Mid-cap stocks are represented by Russell Midcap Index, large-cap stocks are represented by Russell 1000 Index and small-cap stocks are represented by the Russell 2000 Index. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 7 for index definitions. Dollar strengthening periods were considered during the monthly periods when the returns of the MSCI EAFE 100% Hedged to USD Index were greater than zero. Dollar weakening periods where considered when the returns of the MSCI EAFE 100% Hedged to USD index were less than zero (negative). 6 Conclusion U.S. mid-cap investing has historically produced consistently strong, long-term investment results relative to small- and large-cap stocks. Notably, in the three decades observed in this document, mid-cap stocks were able to accomplish this amid a wide range of market cycles, including three major bear markets and four bull market rallies, making the case to consider a mid-cap stock allocation for their strong absolute returns and favorable risk/reward profile in a variety of markets. Such a strategic allocation can provide the potential for an additional layer of diversification, plus the ability to help capitalize on the upside potential, while mitigating downside risk when combined with large- and small-cap stocks in portfolios. 1 Diversification can neither ensure a profit nor guarantee against loss. 2 Value stocks are stocks that tend to trade at lower prices relative to their fundamentals (earnings, dividends etc.). * Sweet Spot is the point at which a strategy provides the optimal balance of benefit and cost. In other words, it is the point where there is maximum return without excessive risk. The opinions and forecasts expressed herein by the fund managers and product specialist do not necessarily reflect those of Deutsche Asset & Wealth Management, are as of 7/31/15 and may not come to pass. 6 The case for mid-cap investing and more specifically value

7 Index definitions The Russell 1000 Index tracks the performance of the 1,000 largest stocks in the Russell 3000 Index, which consists of the 3,000 largest U.S. companies as measured by market capitalization. The Russell 2000 Index tracks the performance of the 2,000 smallest stocks in the Russell 3000 Index. The Russell Midcap Index tracks the performance of the mid-cap segment of the U.S. equity universe. The S&P 500 Index tracks the performance of 500 leading U.S. stocks and is widely considered representative of the U.S. equity market. The MSCI EAFE Hedged to USD index represents a close estimation of the performance that can be achieved by hedging the currency exposure of its parent index, the MSCI EAFE Index to the USD, the home currency for the hedged index. The index is hedged to USD by selling each foreign currency forward at the one-month Forward weight. The parent MSCI EAFE Index is composed of large- and mid-cap stocks across 21 developed markets (DM) countries (including Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK) and its local performance is calculated in 13 different currencies, including the euro. Term definitions One basis point equals 1/100 of a percentage point. Sharpe ratio is a risk-adjusted measure which is calculated using standard deviation and excess return to measure an investment s performance per unit of risk for a given period. The higher the Sharpe ratio, the better the fund s historical risk-adjusted performance. Standard deviation is often used to represent the volatility of an investment. It depicts how widely an investment s returns vary from the investment s average return over a certain period. Important risk information Any fund that concentrates in a particular segment of the market will generally be more volatile than a fund that invests more broadly. The fund may use derivatives, including as part of its global alpha strategy. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. Investing in foreign securities, particularly those of emerging markets, presents certain risks, such as currency fluctuations, political and economic changes, and market risks. Dividends are not guaranteed. The fund lends securities to approved institutions. Any decline in value of a portfolio security that is out on loan by the fund will adversely affect performance. Financial failure of the borrower may mean a delay in recovery or loss of rights in the collateral. Stocks may decline in value. See the prospectus for details. Obtain a prospectus To obtain a summary prospectus, if available, or prospectus, download one from deutschefunds.com, or call (800) We advise you to carefully consider the product s objectives, risks, charges and expenses before investing. The summary prospectus and prospectus contain this and other important information about the investment product. Please read the prospectus carefully before you invest. Investment products: No bank guarantee Not FDIC insured May lose value The case for mid-cap investing and more specifically value 7

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