Today s bond market is riskier and more volatile than in several generations. As

Fixed Income Approach 2014 Volume 1 Executive Summary Today s bond market is riskier and more volatile than in several generations. As interest rates rise so does the anxiety of fixed income investors who rely on the bonds in their portfolios for consistent long-term income generation and risk reduction. Bonds will always have a place in a thoughtfully managed portfolio, however it's apparent their role, and investors expectations of them, will need to change in accordance with the times. This edition of PortfolioBuilder examines the dynamics of a rising interest rate environment, the expected impact on bond investments, and Cornerstone s active approach to this perennial asset class. 1

Great Expectations Generations of investors have relied on blended stock and fixed income portfolios to deliver consistent long-term returns and sustainable cash flows while mitigating the risk of a stock market correction. The concept of a 60% stock / 40% fixed income portfolio, introduced in the 1950s when Modern Portfolio Theory was first developed, has served investors well. This simple portfolio has seen an annualized return of 8.75%¹ over the past five decades. income continues to have a place in a thoughtfully managed Fixed portfolio..." The market turbulence of the past several years has called into question the validity of a 60/40 portfolio structure. Following the substantial market decline of 2008-2009, many investors shunned stocks while pouring money into fixed income investments. What happened next? From the market lows in March of 2009 to the end of 2012, stocks returned 126.4% while fixed income returned only 19.7%.² In 2013, after missing a substantial portion of this stock market rebound, many investors liquidated fixed income investments and returned to the stock market because they believed the fixed income market would dramatically decline due to a swift rise in interest rates. The Root of the Risk Quantitative easing, an unconventional policy for unconventional times, was the federal government s solution to stimulating the economy in response to the global financial crisis. In the fall of 2008, during the middle of the crisis, the Federal Reserve and other central banks around the globe slashed short-term interest rates to near zero, boosting fixed income prices and reducing their yields. In normal circumstances, this would be the most accommodation they could provide. Since then, as the economy has required even more stimuli, the United States and a number of other countries employed quantitative easing as an additional economic boost. Quantitative easing increases the money supply and suppresses market interest rates with the intention of encouraging economic growth. Quantitative easing cannot continue indefinitely without causing inflation and currency devaluation. 2

The good news is that the U.S. economy appears to be strengthening, as evidenced by a rebound in the housing market, gains in employment, and record highs in the stock market. This is very encouraging, and hopefully sustainable. The bad news is that as the economy stabilizes, quantitative easing will need to be reduced and eventually discontinued. In late December, the Federal Reserve took the first step by announcing a reduction in the pace of quantitative easing from $85 billion per month to $75 billion per month. But exactly how this will play out remains in question, and therefore creates an environment of uncertainty for fixed income investors. Interest rates, as measured by intermediate Government bonds, have already doubled since their lows in July of 2012 and are now only half a percent less than the average yield for the past decade. A likely scenario contemplates a gradual rise in interest rates throughout 2014, with a continued tapering of quantitative easing. A slow rise in rates, rather than another sharp upturn, is anticipated due to modest current economic growth and relatively low inflation. This should allow fixed income investors to reinvest maturing assets at higher yields, mitigating any near-term decline in prices. The Federal Reserve has stated their intention to end quantitative easing later in 2014 while holding out the option of expanding the program if there is a stall in economic growth. Because this is such a dynamic environment, it is critical to continue to diversify investment portfolios across assets and strategies that can perform in any number of eventualities. In these diversified portfolios, fixed income continues to hold a strategic corner, although in a different manner that reflects the realities of the current climate. Fixed Income: Still Relevant, Still Reliable Part of fixed income's appeal has always been the contractual nature. Investors know at the time of initial investment the amount of income that will be disbursed and at what intervals a predictability that allows for accurate cash flow planning. While the value of an existing fixed income investment will fluctuate with market conditions, cash flows generally do not. Even though interest rates currently reside at some of the lowest levels on record, investors can still reasonably expect income and full principal to be received on a known schedule. In this way, fixed income remains a solid source of liquidity and cash flow for strategic investors 3

despite the shifting economic climate. Fixed income investments provide a smart hedge against steep declines in the equity markets, bringing balance and assurance to owners of a diversified portfolio. They also offer the investor a level of protection against deflation in ways other investments cannot. Deflation, defined as a general decline in prices, can be very damaging to the economy and most investments. However, high quality fixed income with its contractual rate of interest is one of the only investments that actually becomes more valuable during deflationary periods. income remains a solid source of liquidity and income Fixed for strategic investors..." One truth has not changed, no matter what the economic outlook: fixed income remains one of the most reliable means of dampening the volatility of a portfolio. Our Proactive Approach While fixed income continues to play an important role in a diversified portfolio, fixed income market opportunities are likely to be far less robust than they have been over recent decades. While the U.S. fixed income market averaged nearly an 8.0% return over the past 30 years, Cornerstone forecasts a 3.0% return for the decade to come.³ With this in mind, investors must make prudent decisions on how to approach the fixed income market of the future. Just as the market environment has been evolving for many years, so has Cornerstone s strategic approach to fixed income investments. Since market opportunities began to decline over five years ago, we have steadily reduced our core U.S. fixed income exposure4 in favor of other income producing and risk-diversifying asset classes.5 In 2008, our fixed income allocation was 100% in core U.S. fixed income; by 2012 within our fixed income equivalents allocation core U.S. fixed income was reduced to just over 50%. Going Global & Hedging Inflation Risk (2009) In March of 2009, Cornerstone recommended clients allocate 15% of their fixed income portfolio to global 4

fixed income strategies. Our team managing this portion of client portfolios had a strong preference to allocate away from the largest developed markets in favor of smaller and emerging economies that were paying relatively high interest on fixed income assets maturing over short time periods. This strategy provided geographic diversification, an increase in income, and a reduction in sensitivity to rising U.S. rates. At the same time, we recommended clients incorporate real asset strategies that could appreciate during periods of increasing inflation. One-third of the real asset strategies were funded from fixed income. Global Encore (2010) As quantitative easing continued to lower interest rates in developed countries, we increased our portfolio allocation recommendation for global fixed income from 15% to 25%. This further enhanced geographic diversification, increased income and reduced sensitivity to rising rates. Portfolio Building Blocks (2012) In August of 2012, Cornerstone launched our Portfolio Building Blocks a set of new strategies to increase diversification, provide for specific investor solutions, and mitigate certain risks. A further reduction in U.S. fixed income was merited in order to fund these new strategies. This effectively cut the weighting of U.S. fixed income to half of its original 2008 weight. Figure 1 Cornerstone Fixed Income Allocation Over Time 2008 2009 2010 2012 U.S. Bonds 100% U.S. Bonds 80.7% Global Bonds 14.3% Real Assets 5.0% U.S. Bonds 71.2% Global Bonds 23.8% Real Assets 5.0% U.S. Bonds 50.6% Global Bonds 16.9% Real Assets 5.0% Income Opportunities 7.5% Public Alternatives 20.0% 5

This proactive and strategic approach to portfolio evolution came about through our commitment to active management. The active management of our investment solutions allows us to carefully balance the risks and benefits of investing. This is in contrast to passive fixed income strategies that simply determine holdings based on the amount of outstanding debt. In other words, the most indebted borrowers become the largest weights in the passive index. Our belief is this method is the exact opposite of how investors should approach investing in fixed income. Figure 2 Cornerstone Fixed Income Solutions Versus the Bond Market $1.45 $1.40 $1.35 $1.30 $1.25 $1.20 $1.15 $1.10 $1.05 $1.00 CAI - Taxable Global Fixed Income Model Investible Benchmark Index Cornerstone hires managers who make active strategic decisions on what geographic regions, sectors, companies, rates, curve exposure, and countries provide the best opportunity for success. Over time, our managers increase or decrease exposure to interest rates, find opportunities in currencies other than the U.S. dollar, and determine appropriate levels of credit risk to assume. 6

Conclusion While interest rate pressure currently remains in check, we believe a meaningful rise is inevitable but not imminent. The U.S. Federal Reserve has indicated their target rate will stay at zero for a considerable amount of time after quantitative easing concludes. This policy is likely to tether short-term interest rates for years to come. Although fixed income investments face challenging conditions, they remain a core component of any durable portfolio. At Cornerstone we recognize investing in fixed income in today s environment is sufficiently different from the past three decades and a thoughtful, proactive approach is paramount. This is why our strategy has methodically evolved over time, enabling us to increase diversification and provide sources of income above levels achievable in a traditional fixed income portfolio. As more clarity is established on interest rate policy and the quantitative easing program, so too will the outlook for the global economy. Expect our fixed income strategy to continue to evolve proactively over time, so we can continue to optimize the income generation and risk reduction benefits of fixed income in our portfolios appropriate for the economic climate. 7

Disclosures PortfolioBuilder is the name Cornerstone uses for its method of blending components from complementary asset classes together to create client portfolios capable of achieving expected returns that meet client objectives, while controlling risk. Building Blocks is the convention Cornerstone uses to describe a group of similar assets or strategies designed to achieve specific objectives and mitigate certain risks. The variables used to calculate return figures come from a variety of credible financial research studies and historical return data sources, such as the Ibbotson Associates Stocks Bonds Bills and Inflation (SBBI) return series and other index providers. Results are compared with published forecasts from leading institutional investment firms for reasonableness. The underlying data for this report have been based on third-party data & performance. While we believe this information to be reliable, Cornerstone bears no responsibility for errors or omissions. Cornerstone s forecast should not be relied upon as a predictor of future investment performance. Performance is for illustrative purposes only. It does not represent an actual client portfolio. Individual client portfolios will differ depending on inception date, existing holdings, account size, tax/cash-flow considerations or other account restrictions. The possibility of profit and loss exists. 1 Stocks representative of the Ibbotson Associates SBBI S&P 500 Index Total Return 60% weight, Bonds representative of the Ibbotson Associates SBBI Intermediate Government Bond Index Total Return 40% weight, rebalanced annually at year end. Data through 9/30/2013 2 Stocks representative of the S&P 500 Index Total Return, Bonds representative of the Barclay s U.S. Aggregate Bond Index Total Return, rebalanced annually at year end. Data through 12/31/2012 3 Bonds representative of the Barclay s U.S. Aggregate Bond Index Total Return. Cornerstone forecast for U.S. Bonds is based on an inflation assumption of 3.0% reduced by 1% due to negative real yields, plus a 1.0% bond horizon premium and a 0.50% credit premium. This is not an offer or solicitation with respect to the purchase or sale of any security. Opinions expressed are our present opinions only. The material is based upon information which we consider reliable, but we do not represent that such information is accurate or complete, and it should not be relied upon as such. This information is subject to change. There is no guarantee that the forecasts made will come to pass. Investment involves risk. The advice may not be appropriate for the reader s specific situation, risk tolerance and financial goals and they should consult with a Cornerstone representative for specific advice. 4,5 FIGURE 1 - Cornerstone s Fixed Income approach and allocation modifications are based on the Cornerstone Liquid Global Model 60/40 portfolio from 12/31/2008-11/30/2013. FIGURE 2 CAI Taxable Global Fixed Income Model net of underlying investment expenses. CAI Taxable Global Fixed Income Model (Net CAI Fees) includes both underlying investment expenses and Cornerstone s maximum advisory fee of 1.00%. Investible Benchmark Index represented by the ishares U.S. Aggregate Bond ETF (AGG). Performance results portrayed are recommended model investment portfolios and are not actual returns an investor has earned. The possibility of profits or loss exists. There are inherent limitations on model results as they may not reflect the impact that material economic and market factors might have had on investment decision-making and they do not represent actual trading. Results do not reflect the effect of paying taxes. There is no guarantee of future results and there is the potential for loss of capital. Future securities market conditions may be impacted by factors that cannot be accounted for using these techniques. No representation is being made that any investor will, or is likely to achieve results similar to those shown. The results shown are hypothetical and are not an indicator of the returns a Cornerstone client will realize in relying on Cornerstone s methodology, or any allocation or model mentioned. Certain securities contained in the model portfolio do not relate, or only partially relate to the type of advisory services currently offered by Cornerstone. The allocations or models mentioned do not take into account financial, investment, or other objectives, and may not be suitable for any particular investor. Before investing, investors should consider whether the investment is suitable for themselves and their portfolio. Additional information about this analysis is available upon request. Certain securities contained in the model portfolio do not relate or only partially relate to the type of advisory services currently offered by Cornerstone. This presentation is intended for a one-on-one basis only. Past Performance is no guarantee of future results. Performance of individual accounts may vary from Model results. Results shown as of 12/31/13. Model Pre-Tax Returns are net of fees of the underlying Mutual Funds. They do not include Cornerstone s management fee nor the impact of taxation on any purchases, sales, income, short-term capital gains or long-term capital gains, all of which would reduce results. Cornerstone s advisory fees are discussed in Part II of the Form ADV. Results reflect reinvestment of dividends and other earnings. The Liquid Global Taxable Fixed Income Model is currently composed of Mutual Funds. The inception date is December 31, 1999. The following model components are used with differing weights over time: US Intermediate and Global Bonds (see below). The performance displayed herein represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor s shares, when redeemed, may be worth more or less than their original cost, and current performance may be higher or lower than the performance quoted. Liquid Global Taxable Fixed Income Model The Policy Benchmark is the Barclays U.S. Aggregate Index and represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Indices are unmanaged and not available for direct investment. Model Portfolio over time (all are annually rebalanced): Asset Class Cornerstone Liquid Global Taxable Model Time Period 12/99-3/09 3/09-6/10 6/10-Current U.S. Intermediate Bonds 100% 85% 75% Global Bonds --- 15% 25% 8