Active Multi-Sector Fixed Income Investing in an Uncertain Yield Environment

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1 leadership series market perspectives Active Multi-Sector Fixed Income Investing in an Uncertain Yield Environment November 2013 As bond yields hover around historical lows, institutional investors are increasingly considering alternative investment approaches to replace a portion of their traditional investment-grade fixed-income allocations. There is evidence to suggest that many of these investors have increased portfolio concentration risk by stretching for yield in certain fixed-income sectors. Such positioning can make portfolios susceptible to periods of heightened volatility and severe drawdowns peak to trough returns that can more than offset attractive yields. Markets experienced such an episode of volatility earlier this year when speculation surrounding the timing and magnitude of changes in Federal Reserve (Fed) monetary policy unnerved investors. Fed comments in May ignited a sell-off in fixed-income sectors, sending longer-term rates higher. We do not think a more dramatic increase in rates over a short period is likely (see Leadership Series paper Outlook for Bonds in a Challenging Yield Environment, May 2013). While a sudden spike in inflation could drive longer-term interest rates up, the persistent economic conditions of low growth, slack labor markets, and low wage inflation do not lend themselves to prompt, aggressive Fed actions. Rather, we believe that a rise in rates is likely to be more gradual as the Fed balances the tapering of its accommodative stance with policies intended to continue fostering economic growth. In this paper, we explain why fixed income continues to have a role in a diversified portfolio, and why, rather than stretching for yield and weathering concentration risk, an active multi-sector fixed-income investment approach should be considered by institutional investors as they seek to maintain their desired risk-and-return profiles and meet their long-term objectives. Exhibit 1: After a historic long-term rate decline, investors are used to exceptional returns. Yield (%) year treasury yield /30/2013 Chris Pariseault, CFA SVP, Director of Bonds, U.S. Jeff Moore, CFA Portfolio Manager Philip Sun, PhD, CFA Quantitative Analyst key takeaways For institutional investors that rely on fixed income for its yield, diversification, and capital preservation attributes, the interest rate environment is posing unique challenges. Investors find themselves reevaluating the role of investment-grade fixed income in their asset allocations. There is increasing evidence that institutional investors are reaching for yield in certain fixed-income sectors and assuming higher risks from lack of diversification. An actively managed, multisector investment approach within the fixed-income universe has the potential to meet investors objectives without necessarily exposing them to exceptional volatility. Source: Bloomberg Financial L.P., U.S. Treasury, monthly data, as of Sep. 30, 2013.

2 Exhibit 2: Across holding periods, bond returns have been positive but below the long-term average when starting from low yields. Investment-Grade Bond Annualized Total Return (%) Below 2.6% 2.6% 3.6% Current Yield as of 9/30/13 = 2.61% bond returns at different starting yields Holding Period 1-Year 3-Year 5-Year 10-Year Long-Term Average Total Return = 5.5% 3.6% 5% 5% 7.4% Above 7.4% Starting 10-Year Yield, Quintiles Past performance is no guarantee of future results. Bond returns represented by the performance of the Barclays Aggregate Bond Index from January 1976 and by a composite of the IA SBBI Intermediate-Term Government Bond Index (67%) and the IA SBBI Long-Term Corporate Bond Index (33%) from January 1926 through December Source: Morningstar EnCorr, Federal Reserve Board, Haver Analytics, Fidelity Investments (AART), as of Sep. 30, Setting realistic return expectations The current backdrop for fixed-income investors is much more challenging today than it has been in recent history (see Exhibit 1, page 1). During the course of the past three decades, investors grew accustomed to high-quality bonds consistently producing positive real total returns (i.e., returns adjusted for inflation). The long-term trend of declining yields, combined with moderating inflation, produced 9% annualized average investment-grade bond total returns since 1981, outpacing inflation by nearly six percentage points per year. 1 As of Sep. 30, 2013, the 10-year Treasury yield was 2.61%, low by historical standards and just above the current inflation rate of 1.5%. Investors face a difficult challenge in trying to generate returns that will outpace even today s below-average rate of inflation. Against such a low-yield backdrop, investors have had to adjust their return expectations accordingly. For high-quality bonds, yields have historically offered reasonable reference points for expected returns. Since 1926, lower starting points for bond yields tended to result in lower future bond returns across all holding-periods from one to 10 years (see Exhibit 2, above). Today s 10-year Treasury bond yield is in the second lowest quintile of historical observations, which has been consistent with positive subsequent returns that have lagged the long-term average. Potential consequences of stretching for yield In the face of low yields and the prospect for muted fixedincome returns, many investors have moved a portion of their core fixed-income holdings into higher-yielding sectors. During Exhibit 3: Moving from a diversified strategy to a concentrated portfolio may result in a meaningful increase in volatility. Standard Deviation Mean Return Sharpe Ratio 3-Year 5-Year 10-Year 3-Year 5-Year 10-Year 3-Year 5-Year 10-Year Stocks Investment-Grade Bonds Corporate Bonds U.S. High-Yield Bonds Emerging-Market Debt Leveraged Loans Source: Fidelity Investments, Bloomberg Financial L.P. Annualized data, periods ending Jun. 30, All asset classes throughout paper represented by: Stocks S&P 500 Index; Investment Grade Bonds Barclays Aggregate Bond Index; Credit Barclays U.S. Credit Bond Index; U.S. High Yield Barclays Corporate High Yield Index; Emerging Market Debt Barclays Emerging Market Hard Currency Bond Index; Leveraged Loans S&P/LSTA Performing Leveraged Loans. Index definitions in endnotes. 2

3 Exhibit 4: Peak-to-trough drawdowns demonstrate concentration risks that can result from stretching for yield. Worst Peak-to-Trough Return Drawdowns During 3- and 10-Year Periods Ending June Years Date of Trough 10 Years Date of Trough Stocks 16.3% Sep % Feb Investment-Grade Bonds 3.3% Jun % Oct Corporate Bonds 5.1% Jun % Oct U. S. High-Yield Bonds 7.1% Sep % Nov Emerging-Market Debt 6.5% Jun % Oct Leveraged Loans 4.7% Aug % Dec Source: Fidelity Investments, Bloomberg Financial L.P., monthly data, periods ending Jun. 30, Past performance is no guarantee of future results. the 18 months ending Jun. 30, 2013, institutional net inflows to leveraged loans were $23.1 billion, and flows into high yield equaled $12.5 billion. 2 The high-yield sector has exhibited generally strong corporate health with solid fundamentals, low projected default rates, and relatively attractive yields. As of Sep. 30, 2013, the Bank of America Merrill Lynch U.S. High Yield Index yield to worst was 6.24%, which is a significant premium to the 3.19% Barclays U.S. Credit Index yield. Although there is potential for riskier asset classes to generate attractive returns over the longer term, their potential volatility should not be overlooked, especially when considered as replacements for investment-grade fixed income (see Exhibit 3, page 2). For the five years ending Jun. 30, 2013, high yield generated a standard deviation of return of 13.9%, which was 10.2% higher than investment-grade bonds. Portfolio concentration in riskier asset classes without appropriate allocation management can result in significant return drawdowns in the event of a flight to quality. While non-investment-grade sectors have performed well relative to investment-grade sectors during the past 10 years, they have experienced periods of significant drawdowns, which weighed on the returns of nondiversified portfolios (see Exhibit 4, above). During the 10-year period ending Jun. 30, 2013, the worst monthly drawdowns for high-yield and leveraged loans were 33.3% and 30.1%, respectively. Emerging-markets debt was also not immune; its worst monthly drawdown was 24.6% during the same period. Institutional investor focus: mitigating downside risk and adding diversification to overall portfolio As investors consider options to benefit from their fixed-income allocations in the current environment, they want the core of their fixed-income allocation to mitigate downside risk while providing diversification to their overall portfolio. There is little tolerance for unexpected volatility that results in sizable drawdowns; this being the case, there should be a degree of caution taken in evaluating What institutional investors and consultants are saying about the role of fixed income Over the past 12 to 18 months, Pyramis has spoken with a large number of clients (see Exhibit 5, below) and engaged with consultants and industry participants regarding the role of fixed income in their portfolios. There has been significant interest in bond strategies that allow managers greater discretion compared with traditional bond mandates using the Barclays U.S. Aggregate Index as a benchmark. These more flexible mandates can range from being completely benchmark agnostic to being traditional core plus, with moderately more risk. Exhibit 5: Defined benefit plans are seeking more flexible mandates to... Better manage volatility Increase returns U.S. Corporate 19% 18% U.S. Public 41% 30% Rest of World* 25% 16% Source: Pyramis Global Advisors as of July * Rest of World includes Canada, China, Denmark, Finland, Hong Kong, Iceland, Japan, the Netherlands, Norway, Singapore, South Korea, Sweden, Switzerland, Taiwan, and the United Kingdom. alternative approaches (see What institutional investors and consultants are saying about the role of fixed income, above). Does the fixed-income universe offer what institutional investors are seeking? In our view, the answer is yes through a multi-sector approach with the flexibility to allocate assets across a broad group of key global fixed-income sectors. Such a strategy relies on the ability to diversify the sources of risk and return across sectors. Diversification attributes Historically, investment-grade bonds have provided downside risk mitigation and diversification benefits when combined with equities. For example, since 1926, whenever the S&P 500 posted an annual negative return, investment-grade bond returns were in each instance better, and in 22 out of these 24 periods, returns were positive on an absolute basis (see Exhibit 6, page 4). Through various interest rate regimes since 1926, bonds have consistently exhibited less volatility than equities. These diversification characteristics can be captured, and perhaps further enhanced, through a tactical fixed-income approach that invests in a broad group of fixed-income sectors. As Exhibit 7 (page 4) illustrates, the traditional benchmark for institutional bond portfolios, the Barclays Aggregate Index, has had a low correlation to the S&P 500 Index. If a multi-sector strategy were to diversify beyond this index s allocations by opportunistically increasing exposure to sectors where the risk/ 3

4 Exhibit 6: Bonds have typically generated positive returns during years when stocks declined. Returns 20% 10% 0% 10% 20% 30% 40% 50% 10-year treasury yield S&P 500 Investment-Grade Bonds Past performance is no guarantee of future results. Bond returns represented by the performance of the Barclays Aggregate Bond Index from January 1976 and by a composite of the IA SBBI Intermediate-Term Government Bond Index (67%) and the IA SBBI Long-Term Corporate Bond Index (33%) from January 1926 through December Stock returns represented by the performance of the S&P 500 Index. Source: Morningstar EnCorr, Fidelity Investments (AART), as of Mar. 31, return trade-off is optimal and reducing allocations where the trade-off is asymmetric, there is the potential for increased longterm returns. This can have important implications for investors concerned about the challenges of a low-yield environment. Exploiting diversification through a tactical investment approach The diversification characteristics of fixed-income sectors can translate into compelling reasons to explore multi-sector bond strategies. Actively allocating across broad fixed-income sectors based on shifting market valuations requires manager discretion and a relatively higher degree of flexibility that can result in bond exposures that are appropriate for meeting investor objectives. As markets evolve and performance leadership changes, an active approach can potentially benefit from tactical moves across diverse sectors. As Exhibit 8 (page 5) reflects, returns by fixedincome sectors are not consistent year to year. For example, from 2003 to 2007, returns for the investment-grade bond sector were relatively stable: 4.1%, 4.3%, 2.4%, 4.3% and 7.0% annually. During those same periods, the return dispersion from highest to lowest return across major fixed-income sectors was quite dramatic, from 25.8% in 2003 to 7.5% in A manager with the skill set and flexibility to exploit relative value mispricings within an expanded universe of sectors has the opportunity to capitalize on dispersion. The Barclays U.S. Aggregate Index and the Barclays Universal Index have been the dominant benchmark choices (the Universal includes high-yield and emerging-markets debt, unlike the U.S. Aggregate) for many U.S. institutional investors that want broad exposure to the fixed-income market. For investors wishing to expand the opportunity set to non-benchmark sectors, such as unhedged global bonds or leveraged loans, a key consideration should be defining a proper risk-controlled framework. There must be a mutual expectation between the client and the investment manager regarding the appropriate level of risk that will govern the exposures of a portfolio. The exercise of actively reducing risk in overvalued sectors and increasing risk in undervalued sectors relative to a static allocation to these same sectors traditional benchmarks is a form of diversification and risk mitigation that has the potential to maximize returns for a given level of risk. Exhibit 7: An active multi-sector fixed-income strategy may exploit correlations or diversification characteristics and maintain an acceptable risk-return profile. Correlations (10 Years Ending Jun. 30, 2013) Stocks Investment Grade Corporate Bonds U.S. High Yield Global Sovereign Global Credit European Credit Emerging- Market Debt Leveraged Loans Stocks Investment Grade Corporate Bonds U.S. High Yield Global Sovereign Global Credit European Credit Emerging-Market Debt Leveraged Loans Source: Fidelity Investments, Bloomberg Financial L.P., as of Jun. 30, Past performance is no guarantee of future results. 4

5 Exhibit 8: Active management can be tactical as leadership among fixed-income categories changes. Returns for Various Fixed-Income Categories ( ) High 16.50% 28.20% 11.90% 12.30% 11.20% 9.50% 12.40% 58.10% 15.10% 9.00% 18.00% Emerging-Market Debt 12.30% 26.90% 10.90% 5.30% 10.00% 8.70% 5.20% 52.50% 12.80% 8.40% 15.60% U.S. High-Yield Bonds 11.50% 12.50% 9.30% 2.70% 6.90% 7.00% 5.00% 34.20% 10.40% 7.80% 9.70% Floating-Rate Loans 10.50% 9.80% 5.30% 2.70% 6.60% 6.80% 4.80% 16.00% 8.50% 7.00% 9.40% Corporate Bonds 10.30% 7.70% 5.20% 2.40% 4.30% 5.20% 3.10% 6.90% 6.50% 5.60% 4.30% Global Bonds 6.30% 4.10% 4.30% 2.00% 4.30% 5.10% 14.80% 5.90% 5.50% 4.40% 4.20% Investment-Grade Bonds 2.60% 2.80% 3.50% 1.80% 4.30% 2.50% 26.10% 3.80% 5.50% 1.60% 2.00% Government Bonds Low 1.90% 2.40% 1.30% 4.50% 3.50% 2.00% 29.30% 2.20% 2.80% 1.50% 1.30% Short-Term Bonds Past performance is no guarantee of future results. Source: Barclays. Investment-grade bonds (Barclays Aggregate Bond Index), global bonds (Barclays Global Aggregate Bond Index Unhedged ), emerging-markets debt (Barclays Emerging Markets Index), U.S. high-yield bonds (BofA ML U.S. High Yield Master II Constrained Index), floating-rate loans (S&P/LSTA Leveraged Loan Index), corporate bonds (Barclays Credit Bond Index), government bonds (Barclays Government Bond Index) and short-term bonds (Barclays 1-3 Gov/Cred Bond Index). Calendar year performance from 2002 to Relative to traditional fixed-income approaches that might contain a high allocation to government sectors, an active multi-sector investment approach within the proper riskcontrolled framework may help investors achieve higher yields and thus higher expected returns without necessarily incurring an undesired amount of concentration risk. An opportunistic manager can complement security and sector selection with yield-curve and duration strategies and tactically allocate to try to take advantage of opportunities that evolve across the full spectrum of fixed-income asset classes. Multi-sector approach versus traditional U.S. core Whereas a benchmark-relative strategy may express a preference for a sector or a security by looking at its weight relative to the benchmark, most multi-sector strategies take a broader and more flexible view. Within a defined risk framework, a multi-sector bond manager looks across a more diverse set of sectors, measures portfolio weights relative to other sectors, and considers overall portfolio risk and correlations. This has the potential to allow for increased returns relative to traditional strategies, depending on the level of volatility the investor is willing to accept. Managers in traditional strategies employ tools such as yield-curve management, credit-curve analysis, empirical credit behavior, rolldown strategies, and other fundamental and technical inputs into the decision-making process. When managers are able to apply these tools and tactically shift allocations within an expanded opportunity set, the ability to add value has the potential to expand for a given level of risk. Analyzing multi-sector investment approaches There has been a proliferation of multi-sector strategies introduced into the market, each strategy having unique characteristics. With such a diverse menu of offerings absolute return, unconstrained, opportunistic, dynamic, tactical it can be difficult to judge the competence of a manager in using a wider array of tools, or the competitive advantage a manager might have in employing them. For example, strategies can have duration ranges from 3 to +8 years, others allow for up to 50% in active currency, while some allow 70% or more in non-investment-grade bonds. With regard to benchmarks, absolute return or tactical strategies could use cash as measured by LIBOR plus a spread, while other approaches could have a standard benchmark but with far fewer constraints than a traditional benchmark-relative or active strategy. Many of the multi-sector or opportunistic strategies currently offered by fixed-income managers do not have long track records, so it is difficult to get a sense of the endurance of a particular manager s skills. In these cases, it is important for investors to consider a manager s investment process and whether the proposed new strategy leverages the manager s core strengths (see Important considerations when adding a tactical, multisector investment approach to an asset allocation, page 6). For instance, it may be intuitive that managers with a tradition of using fundamental research as a consistent source of returns in the investment-grade universe would apply the same research approach in non-investment-grade sectors to identify investment opportunities within a multi-sector approach. Alternatively, investors should question a manager s approach that relies on wide duration bands as a significant source of return when the manager does not have a record of successfully managing duration to generate returns. Investment implications Against the current low-yield backdrop, institutional investors are struggling with how to optimize their fixed-income allocations to enhance portfolio results. The diversification benefits of tactically combining multiple fixed-income sectors can be a critical building block in an overall portfolio allocation. Active multi-sector fixed-income mandates are attracting investor attention because they can provide expanded sources of bond 5

6 risk and return. With flexibility, broader diversification, and fewer benchmark constraints, there can be opportunities to capture risk-adjusted returns in sectors that are not part of traditional fixed-income mandates. This broader discretion can present more opportunities to play offense and defense, and should be aligned with a manager s proven strengths and experience. Given the diversity of fixed-income strategies available today, successful manager selection will require a clear understanding of a manager s strengths and weaknesses. Important considerations when adding a tactical, multi-sector fixed-income strategy How does the manager measure success in the strategy? Does the strategy leverage a manager s demonstrated capabilities? Is this approach more opportunistic in nature and should it be aligned with the alternative asset classes in the overall portfolio mix? Does the strategy seek to maintain a volatility level commensurate with investment-grade bonds? How transparent is the strategy? Is there a heavy reliance on derivatives? How does this affect liquidity? Does a manager use financial leverage to amplify returns? What are the related costs? Is there a focus on expenses relative to potential total returns? Is the manager sacrificing liquidity to deliver yield? Authors Chris Pariseault, CFA SVP, Director of Bonds, U.S. Chris Pariseault is an institutional portfolio manager in Fidelity s fixed-income division. In this role, he is responsible for driving the U.S. institutional fixed-income business and for leading the institutional portfolio management team. Jeff Moore, CFA Portfolio Manager Jeff Moore is a portfolio manager for Fidelity Investments. He currently manages investment-grade portfolios across retail and institutional assets. Mr. Moore joined Fidelity as an analyst in 1995 and began managing portfolios in Philip Sun, PhD, CFA Quantitative Analyst Philip Sun is a quantitative analyst at Fidelity Investments, focusing on quantitative aspects of portfolio management and investment research in U.S. core bond and core plus sectors. Fidelity Thought Leadership Vice President and Senior Investment Writer Geri Sheehan, CFA, provided editorial direction for this article. 6

7 Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. Past performance is no guarantee of future results. Neither asset allocation nor diversification ensures a profit or guarantees against a loss. In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Any fixed income security sold or redeemed prior to maturity may be subject to loss. High-yield/non-investment grade bonds involve greater price volatility and risk of default than investment grade bonds. Increases in real interest rates can cause the price of inflation-protected debt securities to decrease. High-yield/non-investment grade bonds involve greater price volatility and risk of default than investment grade bonds. Endnotes 1 Performance from Oct through Apr Source: Morningstar EnCorr, Fidelity Investments (AART). 2 Source: evestment. Definitions The IA SBBI U.S. Intermediate-Term Government Bond Index is an unweighted index that measures the performance of five-year maturity U.S. Treasury bonds. Each year a one-bond portfolio containing the shortest noncallable bond having a maturity of not less than five years is constructed. The IA SBBI U.S. Long-Term Corporate Bond Index is a custom index designed to measure the performance of long-term U.S. corporate bonds. Barclays U.S. Aggregate Bond Index is an unmanaged, market valueweighted performance benchmark for investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgagebacked securities with maturities of at least one year. Barclays U.S. Credit Bond Index is designed to cover publicly issued U.S. corporate and specified non-u.s. debentures and secured notes that meet the specified maturity, liquidity, and quality requirements; bonds must be SEC-registered to qualify. Barclays Corporate High Yield Index measures the market of USD-denominated, non-investment-grade, fixed-rate, taxable corporate bonds. Barclays U.S. Intermediate Credit Bond Index is a market value-weighted index of investment-grade fixed-rate corporate debt and sovereign, supranational, local authorities, and non-u.s. agency debt with intermediate range maturities. Barclays U.S. 1 3 Year Credit Bond Index is a market value-weighted index of investment-grade fixed-rate debt securities with maturities from one to three years from the U.S. Corporate Indices. Barclays U.S. Government Index is designed to cover public obligations of the U.S. government with a remaining maturity of one year or more. Barclays Emerging Markets Hard Currency Bond Index measures the performance of USD, EUR, and GBP-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. Barclays Universal Index covers USD-denominated, taxable bonds that are rated either investment grade or high yield. Bank of America Merrill Lynch (BofA ML) High Yield Bond Master II Index is an unmanaged index that tracks the performance of below-investmentgrade, U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. BofA ML Corporate Real Estate Index, a subset of BofA Merrill Lynch U.S. Corporate Index, is a market-capitalization-weighted index of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market by real estate issuers. Qualifying securities must have an investment-grade rating (based on an average of Moody s, S&P, and Fitch). In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule, and a minimum amount outstanding of $250 million. JPM EMBI Global Index, and its country subindices, tracks total returns for traded external debt instruments issued by emerging-market sovereign and quasi-sovereign entities. S&P/LSTA Leveraged Performing Loan Index (Standard & Poor s/loan Syndications and Trading Association Leveraged Performing Loan Index) is a market value-weighted index designed to represent the performance of U.S. dollar-denominated, institutional leveraged performing loan portfolios (excluding loans in payment default) using current market weightings, spreads, and interest payments. Citigroup Non-USD Group-of-Seven (G7) Index is designed to measure the unhedged performance of the government bond markets of the Group of 7, excluding the U.S., which are Japan, Germany, France, Britain, Italy, and Canada. Issues included in the index have fixed-rate coupons and maturities of one year or more. S&P 500 Index, a market-capitalization-weighted index of common stocks, is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation and its affiliates. Sharpe ratio compares portfolio returns above the risk-free rate relative to overall portfolio volatility. A higher Sharpe ratio implies better risk-adjusted returns. Yield to worst is the yield earned if prepayment happens for a bond with call or put provisions. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC. If receiving this piece through your relationship with Fidelity Financial Advisor Solutions (FFAS), this publication is provided to investment professionals, plan sponsors, institutional investors, and individual investors by Fidelity Investments Institutional Services Company, Inc. If receiving this piece through your relationship with Fidelity Personal & Workplace Investing (PWI), Fidelity Family Office Services (FFOS), or Fidelity Institutional Wealth Services (IWS), this publication is provided through Fidelity Brokerage Services LLC, Member NYSE, SIPC. If receiving this piece through your relationship with National Financial or Fidelity Capital Markets, this publication is FOR INSTITUTIONAL INVESTOR USE ONLY. Clearing and custody services are provided through National Financial Services LLC, Member NYSE, SIPC. 7

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