Diversify your global asset allocation approach by focusing on income and income growth.

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1 Diversify your global asset allocation approach by focusing on income and income growth. Institutional investors have embraced global asset allocation (GAA) strategies as a way to pursue returns with low correlation to traditional sources of investment results. To date, their searches have been limited to risk-based and tactical, returns-based asset allocation strategies. We believe investors can improve their outcomes by expanding their opportunity set to include global multi-asset class strategies that use income generation and the pursuit of income growth to inform asset allocation decisions. Using an income-oriented discipline to drive the investment process has the potential to provide more attractive riskadjusted returns than the global blended benchmark traditionally used to measure the success of global asset allocation strategies. For institutional prospects, clients and consultants. Not for use with retail investors. Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value. This paper considers the factors driving interest in global asset allocation strategies and explains how an income-oriented approach can inform global asset allocation decisions. In addition, it compares this systematic approach to other GAA strategies and examines how strategies that follow an income discipline can be used within a multi-asset class allocation to provide enhanced diversification and the opportunity for more favorable portfolio outcomes over the long term. 1

2 Understanding the GAA trend In recent years, a growing number of institutions have initiated or increased their allocations to dynamic, global multi-asset class strategies. Motivating this decision is a desire for: Better returns per unit of risk Active management that seeks to opportunistically shift assets to take advantage of changing market conditions A more diverse profile of returns The most widely explored options for meeting these objectives fit into two broad categories: 1 Risk-based asset allocation solutions Risk-based strategies, which include risk parity strategies, attempt to balance the risk contributions of various asset classes within a portfolio. They often do so by leveraging their exposure to traditionally less risky asset classes, particularly fixed income, to pursue a desired level of returns. 2 Tactical, returns-based solutions Tactical, returns-based strategies attempt to outperform by dynamically shifting asset class exposures based on relative valuations or other metrics. The most commonly employed strategies, including global tactical asset allocation (GTAA), use macroeconomic signals to inform asset allocation decisions. In both cases, the success of these solutions is frequently measured against a global blended benchmark, often constructed with 60% in the MSCI All Country World Index (ACWI) and 40% in the Barclays Global Aggregate Bond Index. Our analysis indicates that investors may be well served to consider a third avenue for pursuing returns with lower volatility. 3 Global, income-oriented solutions Global income-oriented strategies seek to provide enhanced, risk-adjusted returns by investing in companies with the ability and willingness to increase their dividend payments over time as well as select fixed-income securities. Having a flexible, systematic approach that uses income generation and the pursuit of income growth to inform asset allocation decisions provides the opportunity to invest in compelling income opportunities, which can potentially enhance yield, diversify risk and capture the long-term capital appreciation and inflation protection that equities provide, with lower volatility. The results of Absolute Income Grower SM our global dividend-focused multi-assetclass strategy provide powerful support for the view that an income discipline can produce attractive results similar to those sought by investors employing a GAA approach. Exhibit 1: Income-oriented strategies can complement other GAA approaches 23% Fixed Income 44% Equities 21% Alternatives Hypothetical asset allocation (for illustration purposes only) 4% Risk parity 4% GTAA 4% Global income strategy 12% Global asset allocation strategies 2

3 Exhibit 2: Absolute Income Grower at a glance Inception June 2003 Assets $867 million Objectives Vehicles Asset classes Seeks to provide current income that will grow over time, as well as capital appreciation Collective investment trust, separately managed account Global equities, convertibles, fixed income and cash Current yield 3.54% Current yield shown is (a) the total estimated dividends to be paid over the next 12 months on securities held in the representative account as of the date indicated, based on each security s declared regular dividend as of the date indicated, divided by (b) the representative account s total market value as of the date indicated. Estimated dividends have been reduced by foreign withholding taxes using rates applicable to the representative account. As of June 30, Exhibit 3: Absolute Income Grower summary statistics YTD 1-year 3-year 5-year 10-year Since inception Return (%) Absolute Income Grower gross of management fees net of management fees Global 60/40 blended benchmark Standard deviation (%) Absolute Income Grower Global 60/40 blended benchmark Sharpe ratio Absolute Income Grower Global 60/40 blended benchmark Up capture vs. MSCI World Index (%) Absolute Income Grower Global 60/40 blended benchmark Down capture vs. MSCI World Index (%) Absolute Income Grower Global 60/40 blended benchmark Sources: Capital Group, Zephyr, evestment Alliance. As of June 30, Global blended benchmark reflects 60% MSCI ACWI/40% Barclays Global Aggregate. Strategy inception: May 31, Composite returns reflect the Capital Group Absolute Income Grower Composite. Returns are in U.S. dollars. Returns for periods greater than one year are annualized. Returns reflect the reinvestment of dividends, interest and other earnings. Composite returns are gross of withholding taxes on dividends, interest and capital gains. Actual withholding tax rates vary according to the country of denomination and tax status of each portfolio. 3

4 The closer look at the income-oriented approach Generating income while protecting investors from downside risk has long been on the minds of the portfolio managers at Capital. Introduced in 2003, Absolute Income Grower was intended as a vehicle for institutional investors to access the disciplined income-oriented process of American Funds Capital Income Builder, which was launched in 1987 at the behest of endowments and foundations. The original goal of Capital Income Builder was to help these institutions generate sufficient income to meet their ongoing spending needs. Over the next 25 years, this approach to income, capital appreciation and capital preservation helped Capital Income Builder become the world s largest incomeoriented mutual fund. Absolute Income Grower invests in global equities and a broad spectrum of the bond universe with the objective of providing current income that will grow over time, as well as capital appreciation. Similar to Capital Income Builder, Absolute Income Grower s focus on income has helped mitigate the volatility of the return stream. As a result, over the past decade, Absolute Income Grower has provided returns that are similar to global asset allocation strategies, with greater upside capture and lower levels of volatility. Like other multi-asset strategies, Absolute Income Grower is unconstrained: portfolio managers may invest in a broad opportunity set to meet their investment objectives. However, unlike many more commonly used multi-asset strategies, Absolute Income Grower is highly liquid and long-only, pursuing its objectives without the use of leverage, complex derivatives or short selling. Investment process and asset allocation The objectives of the strategy current income and growth of that income impose a discipline that drives the investment process and the asset allocation decisions. At the beginning of every 12-month period, an income target for the portfolio is set. Using this target, the strategy s mandate manager determines the allocation of assets between equity and fixed-income managers, which is monitored on an ongoing basis and adjusted as needed. Along with a projected three-year dividend-growth forecast, this income target is also used to generate a proprietary mathematical curve that is the basis for determining equity eligibility. The curve is asymptotic: securities with lower yields than the portfolio target have higher hurdles for income growth, while securities with higher yields have lower hurdles. Potential equity investments are identified using a bottom-up research process that incorporates three-year dividend-growth forecasts from Capital s investment analysts. Securities are evaluated against the mathematical curve, with only those that meet the income and income growth targets being made eligible for investment. Equity managers then construct their portfolios from individual securities that have met the eligibility criteria. The portfolio s income generation is monitored on an ongoing basis with a proprietary income projection application to determine if each manager is on track meeting the income target. Portfolio managers collectively discuss asset allocation adjustments that will best allow the strategy to pursue its income target. For example, if the portfolio is underearning its target, the equity assets may be re-allocated from lower-earning equity managers to higher-earning equity managers, from equities to fixed income, or within fixed income from investmentgrade to high-yield securities. While results are not guaranteed, this dynamic process is highly disciplined and solely driven by the pursuit of meeting the portfolio s income target. 4

5 Dividends-focused equity can increase return potential and lower volatility The search for dividends and dividend growth is critical to the success of the strategy. In our experience, corporate managements that pursue consistent dividend policies tend to be more disciplined in other aspects of their business. To grow dividends over time, companies need to do two things: increase earnings and practice fiscal discipline. Thus, a natural byproduct of a systematic research process focused on income growth is an investment opportunity set that tends toward high-quality companies with sustainable earnings that are generally more efficient allocators of capital over longer periods. It is this fiscal discipline that has allowed global companies that consistently pay and raise dividends to produce significantly higher total returns with lower volatility than nondividend payers, as shown in Exhibit 4. It should be no surprise then that the equity component of the Absolute Income Grower strategy, with its focus on this select group of companies, has, since inception, produced better returns with only 83% of the volatility of the broader equity market, as shown in Exhibit 5 on the next page. Exhibit 4: Dividend growers have provided superior long-term returns around the globe Total returns indexed to 100, December 31, 1989 through December 31, ,000 Dividend growers Global universe 800 Dividend payers with no change Dividend cutters 600 Non-dividend payers Dividend growers Dividend payers with no change Dividend cutters Non-dividend payers Global universe Annualized returns (%) Volatility Returns for global universe are total returns in U.S. dollars (with gross dividends reinvested) calculated as a weighted average of regional portfolio returns. The regional portfolios are defined as follows: from end of December 1989 to December 2004, the 1000 largest companies in the respective S&P Global BMI indexes for each of the North America (50% weight), Europe (25%) and Japan (10%) and the 500 largest companies in the Emerging Market (10%) and Pacific ex. Japan (5%). From December 2004 onwards, the regional portfolios consist of the 1000 largest companies in the respective MSCI Investable Market Indexes for North America, Europe and Japan and of the 500 largest companies in the Emerging Markets and Pacific ex. Japan indexes. Sources: FactSet, Compustat, Worldscope, MSCI, CII Quant. 5

6 Fixed income can help buffer volatility While dividends and dividend growth are a focus of Absolute Income Grower, the strategy allows for the combination of equities and fixed income to provide a compelling risk-reward framework. Fixed income functions as an anchor to the portfolio and can prevent managers from having to reach for yield in order to meet income targets. It can also act to cushion overall market declines and mitigate risk in excess of the volatility dampening benefit that dividends have historically provided. Additionally, when yields are high, the allocation to fixed income allows portfolio managers to pursue lower yielding, faster growing equities. While Absolute Income Grower does have the ability to allocate to high-yield fixed income, managers tend to allocate only a small percentage of the portfolio in below-investment-grade assets so as not to introduce unnecessary volatility. When the allocation to high-yield fixed income has been increased, it has typically been because managers believed it provided a more attractive risk/reward tradeoff than investment-grade fixed-income or equity opportunities. This selective use of high yield has allowed the fixed-income component of the strategy to generate significantly better returns than the global and U.S. fixed-income benchmarks with lower risk than the global fixed-income benchmark as shown in Exhibit 5. Exhibit 5: A search for income can moderate risk without sacrificing return potential Lifetime return (%) Lifetime volatility (%) Absolute Income Grower equity component (gross of management fees) MSCI World Index % MSCI ACWI/40% Barclays Global Aggregate Bond Index Absolute Income Grower fixed-income component (gross of management fees) Barclays Global Aggregate Bond Index Barclays U.S. Aggregate Bond Index Sources: Capital Group, Zephyr, evestment Alliance. Since strategy inception, May 31, As of June 30,

7 Absolute Income Grower in the GAA context While a systematic process that pursues rising income over time can help reduce volatility and act as a buffer against inflation, a tactical allocation of portfolio resources is required to thoughtfully balance risk, return and income. These active decisions result in portfolio allocation shifts that serve to moderate risk without sacrificing returns, effectively producing outcomes similar to what institutional investors are seeking from top-down, tactical asset allocation, risk parity and global balanced strategies. To illustrate, we compared Absolute Income Grower to the universe of global tactical asset allocation and global balanced strategies in the evestment Alliance database (evestment All Global Balanced/TAA). As of June 30, 2013, this universe consisted of 195 strategies, 29% of which had a track record of at least 10 years. For the purposes of this analysis we compared results to a global blended benchmark consisting of a 60% equity and 40% fixed income portfolio (60% ACWI and 40% Barclays Global Aggregate). Our analysis of the available strategies presents a strong case for Absolute Income Grower broadly. As shown in Exhibit 6, Absolute Income Grower has outperformed the 60/40 benchmark over both short and long-term periods. Over the three-, five- and 10-year periods ended June 30, 2013, the strategy has outperformed the benchmark by 460, 320 and 130 basis points, respectively. In the 121 months since its inception, Absolute Income Grower has bested the index more than 61% of the time, averaging 13 basis points of outperformance per month. On a rolling one-year basis since the strategy s inception, Absolute Income Grower has outperformed the blended benchmark nearly three-quarters of the time; on a rolling three-year basis, more than half of the time. This compares favorably to the evestment All Global Balanced/TAA universe median, which failed to generate returns in excess of the benchmark over the past one and three years. Exhibit 6: Excess returns vs. the global 60/40 blended benchmark over the lifetime of the fund Monthly excess return summary v. global 60/40 blended benchmark # of months % positive High Low Average % 0.5% % 2.66% 4.21% 0.13% 39% Rolling one-year excess returns Rolling three-year excess returns Excess return annualized 0% 3% 0% 3% One-year Three-year Five-year 10-year 74% 45% 55% 28% 7.2% 4.6% 3.2% 1.3% Since strategy inception, May 31, As of June 30, Source: Capital Group. Global blended benchmark reflects 60% MSCI ACWI/40% Barclays Global Aggregate. 7

8 Returns In addition to delivering attractive results relative to the global blended benchmark, Absolute Income Grower has also produced results that compare favorably to other global asset allocation strategies over both short and long periods of time. When compared to peers in the evestment All Global Balanced/TAA universe, Absolute Income Grower s returns have been in the top quartile over the one-, three- and five-year periods, and only slightly below median on a 10-year basis, as shown in Exhibit 7. Exhibit 7: Attractive returns over the short and long term Annualized returns vs. the evestment All Global Balanced/TAA universe (%) year Rank 3 years Rank 5 years Rank 10 years Rank Fifth percentile Twenty-fifth percentile Median Seventy-fifth percentile Ninety-fifth percentile Number of strategies Absolute Income Grower Global 60/40 blended benchmark Sources: Capital Group, Zephyr, evestment Alliance. As of June 30, Global blended benchmark reflects 60% MSCI ACWI/40% Barclays Global Aggregate. 8

9 Volatility While Absolute Income Grower s results have bested the 60/40 benchmark and the majority of its peers over standard time periods, this fact is far less important than the strategy s ability to achieve these results while also limiting risk. Absolute Income Grower s standard deviation is lower than the 60/40 benchmark and well below the volatility of the larger universe of managers over the three-, five- and 10-year periods ended June 30, 2013, as illustrated in Exhibit 8. Exhibit 8: Lower volatility than the universe of global asset allocation strategies Standard deviation vs. the evestment All Global Balanced/TAA universe (%) years Rank 5 years Rank 10 years Rank Fifth percentile Twenty-fifth percentile Median Seventy-fifth percentile Ninety-fifth percentile Number of strategies Absolute Income Grower Global 60/40 blended benchmark Source: evestment Alliance. As of June 30, Note: Y-axis values go from high to low. Higher percentile ranks indicate lower standard deviation. Global blended benchmark reflects 60% MSCI ACWI/40% Barclays Global Aggregate. 9

10 Sharpe ratio Finally, it is often the case that strategies in the global asset allocation universe provide excess return at the expense of a disproportionate increase in volatility. However, Absolute Income Grower has better compensated investors for the risks it takes than the median strategy in the universe. This more favorable risk efficiency is evident in the strategy s Sharpe ratio, which bests the median universe manager over the three-, five- and 10-year periods ended June 30, 2013, as seen in Exhibit 9. Exhibit 9: More attractive risk-adjusted performance than global benchmarks and global asset allocation strategies Sharpe ratio vs. the evestment All Global Balanced/TAA universe (% rate) years Rank 5 years Rank 10 years Rank Fifth percentile Twenty-fifth percentile Median Seventy-fifth percentile Ninety-fifth percentile Number of strategies Absolute Income Grower Global 60/40 blended benchmark Source: evestment Alliance. As of June 30, Global blended benchmark reflects 60% MSCI ACWI/40% Barclays Global Aggregate. 10

11 Upside potential with downside resilience A focus on dividends and dividend growth has historically allowed Absolute Income Grower to participate more in up markets than in down markets. When compared to the evestment All Global Balanced/TAA universe on a five-year basis, Absolute Income Grower has captured 125% of the upside of the 60/40 benchmark, while the median universe manager has only captured 98%. More importantly, the strategy has only participated in 80% of the downside over this period, while the median manager has captured 98%. Over a five-year period, the upside and downside capture are compelling, as shown in Exhibit 10. Exhibit 10: Attractive relative results on the upside, resilience on the downside 3 year upside vs. downside capture vs. the global 60/40 blended benchmark Up-market capture Absolute Income Grower GTAA/global balanced universe median Global 60/40 blended benchmark Down-market capture year upside vs. downside capture vs. the global 60/40 blended benchmark Up-market capture Absolute Income Grower GTAA/global balanced universe median Global 60/40 blended benchmark Down-market capture Source: evestment Alliance. As of June 30, Global blended benchmark reflects 60% MSCI ACWI/40% Barclays Global Aggregate. 11

12 Diversifying multi-asset allocations with Absolute Income Grower Absolute Income Grower can act as a potential diversifier within an existing multi-asset allocation because its results are driven by factors that are different from those that drive other multi-asset strategies. Additionally, Absolute Income Grower can provide diversification away from global asset allocation strategies that leverage fixed income, which may prove to be a better approach in an environment of rising interest rates. Exhibit 11 illustrates the correlation of excess returns versus a blended benchmark between Absolute Income Grower and the 10 largest strategies in the GTAA/ global balanced universe on a five-year basis. Absolute Income Grower s excess returns have little to no correlation to these strategies, meaning its inclusion in an opportunistic asset allocation may be able to provide enhanced diversification and the opportunity for a more favorable portfolio outcome over the long term. Exhibit 11: Absolute Income Grower can help diversify a multi-asset class allocation Correlation of excess returns vs. global 60/40 blended benchmark over a five-year period ending June 30, 2013 AQR Global Risk Premium Fund BlackRock-Global Allocation Fund BlackRock Dynamic Diversified Growth First Pacific Advisors Contrarian Value GMO Global Asset Allocation Strategy Invesco Balanced-Risk Allocation Mellon Capital Global Alpha Strategy PIMCO All Asset Strategy PIMCO Global Multi- Asset Strategy Thornburg Investment Income Builder Absolute Income Grower AQR Global Risk Premium Fund BlackRockGlobal Allocation Fund BlackRock Dynamic Diversified Growth First Pacific Advisors Contrarian Value GMO Global Strategy Invesco Balanced-Risk Allocation Mellon Capital Global Alpha Strategy PIMCO All Asset Strategy PIMCO Global Multi-Asset Strategy 0.27 Moderate (0.40 to 0.79) - potential complements, moderate diversification benefits Low or Negative ( 1.00 to 0.39) - potential complements, high diversification benefits Sources: evestment Alliance, Capital Group. Management returns supplied by evestment Alliance for the 10 largest managers of GTAA/global balanced strategies by assets under management as of June 30,

13 Conclusion Absolute Income Grower offers investors a tool for employing assets in a way that can mitigate volatility and provide an attractive source of return potential that is uncorrelated with alternative approaches. Because the strategy is not benchmark-driven, it has the flexibility to move between asset classes as opportunities within equity markets change, helping it to produce outcomes similar to those sought by investors in more commonly used global asset allocation strategies. Importantly, as a long-only strategy, Absolute Income Grower can provide these results in a liquid, transparent and cost-efficient manner, without the use of leverage, complex derivatives or short selling. In addition, its bottom-up approach and pursuit of income and income growth impose a discipline that can complement macroeconomic and risk-balancing strategies within a diversified multi-asset class allocation. For this reason, investors looking to incorporate opportunistic global asset allocation strategies into their plans may benefit from expanding their opportunity set to include income-oriented strategies like Absolute Income Grower. Exhibit 12: Absolute Income Grower can complement other global asset allocation strategies 23% Fixed Income 21% Alternatives 12% Global asset allocation strategies Absolute Income Grower GTAA 44% Equities Risk parity Past results are not predictive of results in future periods. Securities offered through American Funds Distributors, Inc. 09/ The Capital Group Companies, Inc. 13

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