The Mid-Cap Equity Opportunity: Hiding in Plain Sight

The Mid-Cap Equity Opportunity: Hiding in Plain Sight February 2014 Michael T. Seeman, CFA, FRM Senior Investment Risk Research Analyst Investment Risk Management Bryant H. VanCronkhite, CFA Portfolio Manager Special Global Equity Executive summary While investors may conclude that they achieve at least a market-like exposure to the mid-cap space indirectly through large-cap managers that reach down and small-cap managers that reach up, they may be missing a golden opportunity to capture more alpha by overweighting the asset class and employing mid-cap specialists who have, as a group, historically exhibited superior alpha generation capabilities. Mid-cap equity: Deserving an overweight allocation with a dedicated manager Mid-cap outperformance is a function of both capital protection in down markets and superior performance in up markets. Typically the ability to protect capital is an attractive quality of large-cap stocks and the ability to outperform in up markets is an attractive quality of small-cap stocks. The mid-cap space has demonstrated the ability to do both, making it the sweet spot of the market-cap spectrum. Mid-cap stocks offer superior risk-adjusted return potential. In essence, they do not pose a significant increase in risk over large-cap stocks, but provide far more style-adjusted alpha than both active large- and small-cap managers. When risk really matters mid-cap stock holds up Over the last 32 years there have been seven episodes of double-digit broad market declines and, on average, mid-cap stocks have experienced trough losses similar to the losses suffered by large-cap stocks, while providing greater downside protection than small-cap stocks. An asset class ripe for stock picking Lack of attention creates opportunities for mid-cap specialists to add value through stock selection. The mid-cap space simply affords more opportunities. The mid-cap universe is a very attractive hunting ground for larger companies looking for growth. Mid-cap companies are through the start-up phase and still in the growth phase an attractive proposition to stodgy large-cap companies looking to grow through acquisition. Investors may be foregoing a significant alpha generation opportunity by not gaining their mid-cap exposure through a dedicated active mid-cap strategy. The findings in this paper suggest that investors would be well-served to increase exposure to, and overweight, mid-cap domestic equity (and to do so) via mid-cap specialists! The conundrum It is a generally accepted principle of investing that, in the long run, money tends to flow to the asset classes offering the most attractive risk/return profile. Strangely, investors seem to have defied this principle by maintaining a persistent underweight to domestic mid-cap equity. In this paper, we review the merits of the domestic mid-cap equity asset class vis-a-vis both large- and small-cap domestic equity. We subject the midcap track record to scrutiny. We quantify the alpha generation opportunity historically afforded active mid-cap managers. We make a case for why mid-cap stock s dominance is likely to persist. And we illustrate the significance of their attractive risk/return profile. Table 1 illustrates the extent to which investors are currently underweight domestic mid-cap equity strategies. The table breaks down the percentage of assets in each capitalization band of the investable domestic equity universe using commonly defined boundaries. Relative to the weight of mid-cap stocks in the investable universe, mid-cap strategies represent a significantly smaller proportion of professionally managed domestic equity assets. Per evestment Alliance data, mid-cap strategies as a percentage of domestic equity assets managed via separate accounts are underweight the market by almost one third. And per Morningstar data, mid-cap strategies as a percentage of domestic equity assets managed via mutual

Table 1. Domestic equity investment by market capitalization band 1 U.S. Market Capitalization evestment Alliance Morningstar Asset class Segment Market cap Percent of total Category % of Total Categories % of total Large > $10 Billion $16.95T 76.0% U.S. Large Cap Equity 73.4% Large Value 74.8% Large Blend Large Growth Mid $2B to $10B $4.02T 18.1% U.S. Mid Cap Equity 12.2% Mid Value 14.8% Mid Blend Mid Growth Small $250M to $2B $1.31T 5.9% U.S. Small Cap Equity 14.3% Small Value Small Blend Small Growth 10.5% funds are underweight the market by more than one sixth. Note that large-cap strategies are slightly underweight the market, while small-cap strategies are heavily overweight the market. A frequently-sited explanation for the market-relative underweight of managed mid-cap assets is that large-cap managers tend to reach down into the mid-cap space, while small-cap managers tend to reach up into the mid-cap space and/or let their winners run even after they have been reclassified as mid cap. As we will illustrate later in this paper, investors may be foregoing a significant alpha generation opportunity by not gaining their mid-cap exposure through a dedicated mid-cap strategy. An analysis of the long-term historical risk and return characteristics of mid-cap domestic equity versus its largeand small-cap counterparts demonstrates the conundrum that is the mid-cap underweight. Table 2 quantifies the risk and return characteristics of the S&P market cap-based domestic equity indices over the periods February 1981 through September 2013 (the period of maximum overlap between the mid- and large-cap indices) and February 1995 through September 2013 (the period of maximum overlap among the mid-, large-, and small-cap indices). For Table 2 and all subsequent tables based on index returns, see Appendix A for analogues employing Russell market cap-based indices. Since 1981, The S&P MidCap 400 Index has outperformed the S&P 500 Index by nearly 300 basis points annualized while exhibiting less than 200 basis points of additional annualized volatility. Consequently, the Sharpe ratio of the S&P MidCap 400 Index has been significantly more attractive than the Sharpe ratio of the S&P 500 Index. Since 1995, the S&P MidCap 400 Index has outperformed the S&P SmallCap 600 Index by more than 100 basis points annualized while exhibiting annualized volatility that was more than 100 basis points lower. As a result, the Sharpe ratio of the S&P MidCap 400 Index has been significantly more attractive than the Sharpe ratio the S&P SmallCap 600 Index. Interestingly, the modest betas of both the mid- and smallcap indices relative to the large-cap S&P 500 indicate nearly identical levels of market sensitivity. Mid-cap stock s dominance over both large- and small-cap stocks over the last 32 years is extraordinary. Relative to highly correlated large-cap stocks, mid-cap stocks offer a trade-off of more than one unit of incremental return for less than one unit of incremental volatility a rare concave relative return-risk relationship in the equity band of the return spectrum. And relative to highly correlated small-cap stocks, mid-cap stocks offer a trade-off of incremental return and lower volatility. Does mid-cap dominance hold up under scrutiny? Savvy investors know that annualized standard deviations and returns do not always tell the whole story. Standard deviations often mask episodic risk that can be devastating to certain investors. And annualized returns over a long horizon say little Table 2. Return and risk characteristics of the S&P market cap-based indices since 1981 2 Feb-1981 through Sep-2013 S&P MidCap 400 Index Total Return S&P 500 Index Total Return S&P MidCap 400 Index Total Return Feb-1995 through Sep-2013 S&P 500 Index Total Return S&P SmallCap 600 Index Total Return Annualized geometric mean 14.02% 11.13% 12.72% 9.10% 11.69% Annualized standard deviation 17.17% 15.27% 17.98% 15.53% 19.19% Sharpe ratio 0.49 0.37 0.52 0.38 0.44 Beta relative to the S&P 500 1.02 1.00 1.04 1.00 1.00 WELLS CAPITAL MANAGEMENT 2

about consistency from one sub-period to the next. With that in mind, we subjected the mid-cap track record to additional scrutiny employing an alternative measure of risk and examining the consistency of relative returns over rolling periods. Re-examining the mid-cap track record with an alternative measure of risk Standard deviation is often criticized as a measure of risk due to its failure to discriminate between upside and downside volatility. Table 3 summarizes the relative risk of the capitalizationbased S&P indices purely in the context of downside risk. The first panel of Table 3 compares the drawdown experiences for mid-cap stocks to large-cap stocks over the period of maximum overlap for the S&P MidCap 400 and the S&P 500 indices (the 32+ years between February-1981 and September-2013). The second panel of Table 3 compares the drawdown experiences for mid-cap stocks to both largeand small-cap stocks over the period of maximum overlap among the S&P MidCap 400, the S&P 500 and the S&P Small- Cap 600 indices (the 18+ years between February-1995 and September-2013). Each row in Table 3 details the drawdown experienced by the indices at the trough of a broad market decline exceeding 10% (using the Russell 3000 Index as a proxy for the broad market). All seven double-digit declines experienced since 1981 are detailed in Table 3. See Appendix B for a graphical depiction of drawdown performance. Across the seven episodes of double-digit broad market declines over the last 32 years, the S&P MidCap 400 experienced an average drawdown roughly in-line with the broad market, but an average trough loss 150+ basis points less severe than the broad market. By comparison, the S&P 500 experienced a more defensive average broad market-relative drawdown and an average trough loss less severe than the broad market, but more severe than the S&P MidCap 400 s average trough loss. Across the three episodes of double-digit broad market declines over the last 18 years, the S&P MidCap 400 experienced an average drawdown in-line with the broad market, but an average trough loss 400+ basis points less severe than the broad market. By comparison, the S&P Small Cap 600 experienced an average drawdown more severe than the broad market and an average trough loss less severe than the broad market, but more severe than the S&P MidCap 400 s average trough loss. While relative trough losses for the S&P MidCap 400 and the S&P SmallCap 600 are fairly consistent across drawdown episodes, relative trough losses for the S&P MidCap 400 and the S&P 500 were significantly different in two of the seven episodes. Large-cap stocks suffered out-sized losses during the technology-led crash that troughed in 2002. And mid-cap stocks suffered more severe losses during the Asian Contagion that troughed in 1998. To some extent, those two events are offsetting. It is only fair to note, however, that excluding them from the analysis yields average percentage of broad market drawdown per episode statistics that are similar to those reported in Table 4, but the S&P MidCap 400 s 56 basis point trough loss severity advantage over the S&P 500 becomes a 140 basis point disadvantage. Evaluating the consistency of mid-cap dominance Table 4 illustrates the consistency of mid-cap stock s dominance over both large- and small-cap stocks. The first panel of Table 4 compares rolling period returns for mid-cap stocks to large-cap stocks over the period of maximum overlap for the S&P Mid- Cap 400 and the S&P 500 indices. The second panel of Table 4 compares rolling period returns for mid-caps to both large- and small-caps over the period of maximum overlap among the S&P MidCap 400, the S&P 500 and the S&P SmallCap 600 indices. Each row of the table evaluates mid-caps relative performance over all rolling periods of a certain duration (3-, 5-, or 10-years). Table 3. Episodic maximum drawdowns experienced by S&P market cap-based indices since 1981 3 Maximum drawdown per episode of broad market declines of more than 10% Broad Market Russell 3000 Index Episode trough month Episode start date S&P MidCap 400 Index S&P 500 Index July-1982 Apr-1981 to Sep-1982-16.66-12.81-15.10 NA May-1984 Jul-1983 to Jul-1984-10.74-13.28-7.41 NA Nov-1987 Sep-1987 to Apr-1989-29.83-28.81-29.58 NA Oct-1990 Jun-1990 to Jan-1991-16.25-20.28-14.69 NA Aug-1998 Jul-1998 to Oct-1998-16.86-24.82-15.37-29.21 Sep-2002 Sep-2000 to Mar-2006-44.13-24.31-44.73-26.02 Feb-2009 Nov-2007 to Feb-2012-51.20-49.63-50.95-52.15 Feb-1981 through Sep-2013 Average percentage of broad market drawdown per episode 103 92 NA Average return in excess of broad market return per episode 1.68 1.12 NA Feb-1995 through Sep-2013 Average percentage of broad market drawdown per episode 100 97 111 Average return in excess of broad market return per episode 4.48 0.38 1.60 S&P SmallCap 600 Index WELLS CAPITAL MANAGEMENT 3

Table 4. Mid-cap performance relative to large- and small-cap over rolling 3-, 5- and 10-year periods 4 Feb-1981 to Sep-2013 Percentage of periods during which the S&P MidCap 400 outperformed (%) The rolling-period analysis strongly supports the contention that mid-cap stocks have dominated large-cap stocks on a consistent basis. Mid-cap stocks have outperformed large-cap stocks 93% of all rolling 10-year periods since 1981 by an average of 3.20% annualized. And in the 7% of rolling 10-year periods where large-cap stocks outperformed mid-cap stocks, mid-cap stocks only trailed by an average of 0.79% annualized. In other words, not only have mid-cap stocks outperformed large-cap stocks in more than nine out of 10 rolling 10-year periods, they have enjoyed a better than 4-to-1 performance advantage when they outperformed large-cap stocks relative to the advantage large-cap stocks have enjoyed when they outperformed mid-cap stocks. The rolling-period analysis also strongly supports the contention that mid-cap stocks have dominated small-cap stocks on a consistent basis. Mid-cap stocks outperformed small-cap stocks in 70% of all rolling 10-year periods by an average of 1.22% annualized. And in the 30% of rolling 10-year periods where small-cap stocks outperformed mid-cap stocks, mid-cap stocks only trailed by an average of 0.29% annualized. So, the dominance of mid-cap stock s risk/return profile apparent in annualized returns and standard deviations holds up well under scrutiny. In general, mid-cap stocks have not been especially vulnerable during broad market declines. And mid-cap stock s performance dominance is consistent across the preponderance of 3-, 5-, and 10-year rolling periods. What about alpha? Conventional wisdom holds that market efficiency decreases, and therefore the opportunity to generate alpha increases, S&P MidCap 400 s average annualized return advantage during periods of outperformance (%) S&P MidCap 400 s average annualized return disadvantage during periods of underperformance (%) Rolling 3-Year Periods (357) Relative to the S&P 500 67 5.11-3.08 Rolling 5-Year Periods (333) Relative to the S&P 500 71 4.55-2.48 Rolling 10-Year Periods (273) Relative to the S&P 500 93 3.20-0.79 Feb-1995 to Sep-2013 Rolling 3-Year Periods (189) Relative to the S&P 500 83 5.99-5.27 Relative to the S&P SmallCap 600 57 4.24-1.81 Rolling 5-Year Periods (106) Relative to the S&P 500 94 5.48-2.11 Relative to the S&P SmallCap 600 64 2.91-1.51 Rolling 10-Year Periods (73) Relative to the S&P 500 100 5.34 NA Relative to the S&P SmallCap 600 70 1.22-0.29 as one descends the market-cap spectrum. Complicating any analysis of alpha generation across market cap bands, though, is the fact that there are virtually no market cap-pure active large-cap, mid-cap, or small-cap strategies. Therefore, we analyzed the question of alpha generation potential by first calculating alpha relative to the blend of cash and market cap band exposures actually held by active domestic equity strategies. 5 This facilitated the calculation of the return of a custom benchmark every month for each fund relative to its specific cash and style box exposures at the beginning of that month. The alphas relative to these custom benchmarks were then evaluated for the strategies assigned to Morningstar categories in each market cap band. Table 5 summarizes the results of this analysis using return data over the 10 years through September-2013. On average, taking into account actual style box exposures, active mid-cap managers generated significantly more alpha than both active large- and small-cap managers. Because this analysis was designed to take style allocation timing as a source of alpha off the table, the only reasonable explanation for the significant gap in alpha generation between active midcap managers and both active large- and small-cap managers is that the mid-cap space simply affords more opportunities to add value through stock selection. So, while investors may conclude that they achieve at least a market-like exposure to mid-cap stocks indirectly through large-cap managers that reach down and small-cap managers that reach up, they may be missing a golden opportunity to capture more alpha by overweighting the asset class and employing mid-cap specialists who have, as a group, historically exhibited superior alpha generation capabilities. WELLS CAPITAL MANAGEMENT 4

Table 5. Cap-band alphas relative to actual beginning of month style box exposures last 10 years Mean gross alpha relative to Morningstar style box index returns weighted by beginning of month actual Periods analyzed Morningstar category group cash and style box exposures (not annualized) Distinct 12-month periods Mid-Cap 1.09% Large-Cap 0.59% Small-Cap 0.77% Rolling 12-month periods Mid-Cap 1.02% Large-Cap 0.52% Small-Cap 0.58% Rolling 36-month periods Mid-Cap 3.76% Large-Cap 1.34% Small-Cap 1.14% Rolling 60-month periods Mid-Cap 8.25% Large-Cap 2.37% Small-Cap 1.64% Why is mid-cap dominance likely to persist? A host of structural advantages inherent to the mid-cap domestic equity asset class explain its superior historical risk/ return profile and support a strong argument that its dominance over large- and small-cap domestic equity will persist. Downside protection and upside potential As quantitatively demonstrated, mid-cap outperformance is a function of both capital protection in down markets and superior performance in up markets. Typically the ability to protect capital is an attractive quality of large-cap stocks and the ability to outperform in up markets is an attractive quality of small-cap stocks. The mid-cap space has demonstrated the ability to do both, making it the sweet spot of the marketcap spectrum. The ability to protect the downside typically comes from the stability of a company s cash flow and the strength of its balance sheet. The consistency and stability of cash flow is largely a function of the ability of a company s customers to delay, or forego completely, the purchase of products or services offered. This sensitivity to customer behavior is generally associated with a company s industry, not its size. However, having multiple products and/or services across multiple end markets in many geographic regions can vastly improve the stability of cash flows. If one product is competitively challenged, it can be offset by others that are flourishing. And if one region of the world is experiencing a recession it can be offset by economic expansion in another region. Diversity of products and geographic exposure is typical of larger companies. Smaller companies tend to sell a limited number of products and/or services into one geographically-concentrated end market. While not as diversified as large-cap companies, mid-cap companies have sufficient internal diversification to achieve the benefits large-cap companies enjoy, and tend to be significantly more diversified than small-cap companies. Balance sheet strength can be exhibited by companies of all sizes, but the ability to access capital markets during times of stress can be the difference between closing the doors and living to fight another day. A company with a longer operating history and greater cash flow generation will be viewed as a more credible debtor with a higher probability of being able to satisfy debt service expense and, ultimately, debt repayment. In almost all cases, when comparing companies within the same industry, mid-cap companies generate greater and more stable cash flow than small-cap companies, facilitating better access to capital in times of need. Cash flow stability and balance sheet strength are two of the attractive features typically cited by large-cap investors. However, size is not always an advantage. We must also consider that companies of all sizes find themselves in rough water at one time or another. Although not universally true, it has been our experience that the larger the company, the more difficult it is to fix a troubled business or segment. On a relative basis, a large company will have more employees, factories, geographical diversification, etc. all adding to the degree of difficulty associated with overcoming problems. Relative to large-cap companies, mid-cap companies benefit from being more nimble, and find the path to recovery simpler and faster. Another drawback to size is the impact the law of large numbers has on a management teams ability to create shareholder value through organic growth. In large-cap companies, WELLS CAPITAL MANAGEMENT 5

incremental R&D spending does not always move the growth needle, and most attractive geographic expansion opportunities have already been exploited. As a result, companies often look to acquisitions as a growth catalyst. Unfortunately, large-cap companies relegated to M&A as the only source of growth will tend to overpay for acquisition targets ultimately destroying shareholder value as opposed to growing it. Thus large-cap investors typically trade-off limited growth or value creation potential for perceived stability. But what if investors could find the best of both worlds and live in the sweet spot of the market-cap spectrum? Mid-cap stocks offer the protection provided by large-cap stocks (stable cash flows and strong balance sheets providing valuable access to the capital markets) with the small-cap stock potential to meaningfully grow the business (M&A, increased R&D, geographical expansion, etc.). Index construction The mid-cap universe benefits when struggling and shrinking companies fall back into the small-cap universe, leaving the associated underperformance to weigh down small-cap index returns. And just as mid-cap companies are reaching the point at which it becomes increasingly difficult to grow, they graduate to the large-cap universe. Mid-cap stocks, by definition, live in the most attractive part of the enterprise life cycle. Value realization through acquisition Shareholder value can be created slowly over time or it can be realized quickly by having a business acquired at a premium valuation. The mid-cap universe is a very attractive hunting ground for larger companies looking for growth. Mid-cap companies are through the start-up phase and still in the growth phase an attractive proposition to stodgy large-cap companies looking to grow through acquisition. That tendency for largecap companies to overpay only benefits mid-cap investors. Active management Despite the evidence supporting the superiority of mid-cap stocks, the mid-cap universe is underfollowed by Wall Street, institutional, and individual investors, as compared to the large-cap universe. This lack of attention creates opportunities for mid-cap specialists to add value through stock selection. It isn t lost on us that the long-run returns and risk profiles of the S&P indices are superior to those of their Russell brethren. S&P employs a modest quality filter whereas Russell s index construction methodology is quality agnostic. Since a modest quality filter offers improved risk-adjusted performance, by extrapolation, stock selection techniques that focus on quality and the characteristics discussed above should be expected to generate incremental alpha. This seems to be borne out by the alpha generation analysis presented earlier. Why does recognition of mid-cap dominance matter? To fully understand how impactful it can be to embrace midcap stock s superior risk/return proposition, consider a couple of simple efficient frontiers 6 : one constructed by blending a broad domestic bond index with a large-cap domestic equity index (the S&P 500) and one constructed by blending the same bond index with a mid-cap domestic equity index (the S&P MidCap 400). Chart 1 illustrates the results of this exercise. The broad domestic fixed income index employed is the Barclays Aggregate Bond Index. The blue line is the efficient frontier derived using the large-cap index as the domestic equity component and the gold line is the efficient frontier derived using the mid-cap index as the domestic equity component. The color-coordinated dots represent the equity weight at each point along the respective efficient frontier. See Appendix A for an analogous chart constructed with Russell market cap-based indices. Chart 1. Efficient frontier: Feb-1981 through Sep-2013 S&P 400/Barclays Aggregate Balanced Portfolio vs. S&P 500/ Barclays Aggregate Balanced Portfolio Annualized Return 18.0% 17.0% 16.0% 15.0% 14.0% 13.0% 12.0% 11.0% 10.0% 9.0% 100.0% 80.0% 60.0% 40.0% 20.0% 8.0% 0.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% Annualized Standard Deviation Return Vs Risk: S&P 400 / Barclays Aggregate Efficient Frontier Return Vs Risk: S&P 500 / Barclays Aggregate Efficient Frontier Equity Weight: S&P 400 / Barclays Aggregate Equity Weight: S&P 500 / Barclays Aggregate Note that the efficient frontier derived using the mid-cap index plots well-above the frontier derived using the large-cap index. Furthermore, far smaller equity allocations are necessary to achieve any return target when using the mid-cap index. Clearly, more than 32 years of historical returns indicate that supplanting large-cap exposure with mid-cap exposure may dramatically decrease the risk necessary to achieve any reasonable level of return. Equity Weight WELLS CAPITAL MANAGEMENT 6

Conclusion Quantitative analysis of more than 30 years of historical returns indicates that mid-cap domestic equity has dominated both its large- and small-cap counterparts on a risk-adjusted basis. The relative attractiveness of the mid-cap track record holds up well under scrutiny focused on both downside risk and consistency. And the icing on the mid-cap cake is that active mid-cap managers have demonstrated the ability to generate far more style-adjusted alpha over the last 10 years than both large- and small-cap active managers. These findings suggest that investors would be well-served to increase their exposure to, and overweight, mid-cap domestic equity. Furthermore, investors should consider gaining their mid-cap exposure through mid-cap specialists with a record of taking advantage of the alpha generation opportunity unique to the mid-cap space. The fact that mid-cap stock s historical dominance is readily explained by structural advantages inherent to the asset class and therefore likely to persist should provide investors the confidence to do so. WELLS CAPITAL MANAGEMENT 7

Notes 1. U.S. market capitalization data was gathered via FactSet screens. Professionally managed AUM data were gathered via evestment Alliance and Morningstar Direct screens. 2. Data source: Morningstar Direct. Annualized standard deviations were calculated by scaling monthly standard deviations by the square root of 12 (months per year). Sharpe ratios were calculated using monthly excess returns defined as index return less T-bill return (as proxied by the B of A Merrill Lynch 3-month U.S. Treasury Bill Index). Betas were calculated as the ratio of the covariance of the index and the market benchmark (e.g. the S&P 500) to the variance of the market benchmark. 3. Data source: Morningstar Direct. For a specific index, a given month s drawdown was calculated as the ratio of the current month s cumulative value of a $1 investment made at inception less the maximum cumulative value of a $1 investment made at inception over all preceding months to the maximum cumulative value of a $1 investment made at inception over all preceding months (i.e. the decline since the high water mark). Episode troughs were identified as the largest drawdown observed over a span of months during which since inception returns remained below the previous high water mark and the pull-back (from the high water mark) exceeded 10% at the end of at least one month during the drawdown episode. 4. Data source: Morningstar Direct. 5. The specifics of our methodology are as follows. Using Morningstar Direct, we downloaded the monthly gross returns and cash and nine style box exposures of the oldest share class of each currently active diversified domestic equity mutual fund over the 120-month period October 2003 through September 2013. Unreported exposures (due to holdings submissions reported less frequently than monthly) were estimated by searching (backward and forward) for the nearest reported exposure. Reported/ estimated exposures were then time-shifted (backward one month) to represent beginning-of-month exposures. When the exposures did not sum to 100%, we allocated the residual exposure to cash and style box exposures on a pro rata basis. In effect, we made the assumption that, from a market cap point of view, the residual exposure was similar to the rest of the portfolio. If the residual exposure exceeded 5% of the portfolio, the fund was excluded from the data set for that month. For every month, we calculated each fund s custom benchmark return as the sum of the returns of a T-bill index and the Morningstar style box indices weighted by the fund s beginning-of-month cash and style box exposures. For each period length studied, each fund s exposure-relative alpha was computed by subtracting the geometrically linked return of the fund s monthly custom benchmark returns from the fund s geometrically linked gross return. All returns and alphas were computed by a proprietary program. The averages reported in Table 5 are for all funds within a specific (currently assigned) cap-band across all periods of the specified length. The 95% confidence intervals associated with the alphas reported in Table 5 are detailed in Appendix C. 6. Data source: Morningstar Direct. Each efficient frontier was constructed by identifying the mean-variance efficient blends of the fixed income index and the domestic equity index necessary to achieve a series of return targets using historical return and covariance expectations (derived from the 392 monthly returns observed over the period February 1981 through September 2013). Mean-variance optimizations were performed using Excel Solver. WELLS CAPITAL MANAGEMENT 8

Appendix A. Table and chart analogues employing Russell market cap-based indices Table 2. Analogue: Return and Risk Characteristics of Market Cap-Based Indices Since 1981 Russell MidCap Index Total Return Russell Top 200 Index Total Return Russell 2000 Index Total Return Annualized geometric mean 12.67% 10.62% 10.39% Annualized standard deviation 16.94% 15.17% 19.50% Sharpe ratio 0.42 0.34 0.26 Beta relative to the Russell top 200 1.01 1.00 1.02 Table 3. Analogue: Episodic maximum drawdowns experienced by S&P market cap-based indices since 1981 3 Maximum drawdown per episode of broad market declines of more than 10% Broad Market Russell 3000 Index Episode trough month Episode start date Russell MidCap Index Russell Top 200 Index July-1982 Apr-1981 to Sep-1982-16.66-18.60-16.41-21.82 May-1984 Jul-1983 to Jul-1984-10.74-15.13-6.55-19.59 Nov-1987 Sep-1987 to Apr-1989-29.83-30.17-28.91-35.54 Oct-1990 Jun-1990 to Jan-1991-16.25-24.63-12.49-31.58 Aug-1998 Jul-1998 to Oct-1998-16.86-21.40-14.57-29.78 Sep-2002 Sep-2000 to Mar-2006-44.13-30.34-49.06-35.06 Feb-2009 Nov-2007 to Feb-2012-51.20-54.15-50.12-52.89 Average percentage of broad market drawdown per episode 115 90 141 Average return in excess of broad market return per episode -1.25 1.08-5.80 Table 4. Mid-cap performance relative to large- and small-cap over rolling 3-, 5- and 10-year periods 6 Percentage of periods during which the Russell MidCap outperformed Russell MidCap s average annualized return advantage during periods of outperformance Russell 2000 Index Russell MidCap s average annualized return disadvantage during periods of underperformance Rolling 3-Year Periods (382) Relative to the Russell Top 200 60% 5.78% -4.01% Relative to the Russell 2000 73% 3.71% -1.79% Rolling 5-Year Periods (358) Relative to the Russell Top 200 66% 4.11% -3.17% Relative to the Russell 2000 88% 2.88% -1.07% Rolling 10-Year Periods (298) Relative to the Russell Top 200 68% 3.19% -1.28% Relative to the Russell 2000 100% 2.63% NA Chart 1. Analogue: Efficient frontiers constructed using large- and mid-cap indices Efficient frontier: Feb-1981 through Sep-2013 Russell MidCap/Barclays Aggregate Balanced Portfolio vs. Russell Top 200/Barclays Aggregate Balanced Portfolio Annualized Return 18.0% 100.0% 17.0% 16.0% 80.0% 15.0% 14.0% 60.0% 13.0% 12.0% 40.0% 11.0% 10.0% 20.0% 9.0% 8.0% 0.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% Annualized Standard Deviation Equity Weight Return Vs Risk: RMidCap / Barclays Aggregate Efficient Frontier Return Vs Risk: RT200 / Barclays Aggregate Efficient Frontier Equity Weight: RMidCap / Barclays Aggregate Equity Weight: RT200 / Barclays Aggregate WELLS CAPITAL MANAGEMENT 9

Appendix B. Plot of the value of $1 invested at month-end Jan-1981 Value of a $1 investment Feb-1981 through Sep-2013 75 70 65 60 55 50 45 40 $ 35 30 25 Period of Broad Market Drawdown Value of $1 Russell 3000 Value of $1 S&P MidCap 400 Value of $1 S&P 500 20 15 10 5 0 Appendix C. 95% confidence intervals for style-adjusted alphas by market cap-band (listed in Table 5) Lower boundary of 95% confidence interval of mean gross alpha relative to Morningstar Style Box Index returns Morningstar weighted by beginning of month actual category group cash and style box exposures (%) Periods analyzed Distinct 12-month periods Rolling 12-month periods Rolling 36-month periods Rolling 60-month periods Upper boundary of 95% confidence interval of mean gross alpha relative to Morningstar Style Box Index returns weighted by beginning of month actual cash and style box exposures (%) Mid-Cap 0.89 1.29 Large-Cap 0.57 0.60 Small-Cap 0.56 0.98 Mid-Cap 0.96 1.09 Large-Cap 0.49 0.55 Small-Cap 0.52 0.65 Mid-Cap 3.58 3.94 Large-Cap 1.26 1.42 Small-Cap 0.95 1.33 Mid-Cap 7.91 8.60 Large-Cap 2.24 2.50 Small-Cap 1.28 2.01 WELLS CAPITAL MANAGEMENT 10

Michael T. Seeman, CFA, FRM Senior Investment Risk Research Analyst, Investment Risk Management Michael Seeman is a senior investment risk research analyst at Wells Capital Management. Before assuming this role in 2012, Michael was the chief investment risk officer for WellsCap. He joined WellsCap from Strong Capital Management, where he held a similar position since 1999. Previously, Michael was with Schneider National in a senior technical role. Prior to this, he was a portfolio engineer for First Quadrant. Michael began his investment industry career in 1991, as a software engineer for Strong Capital Management, where he eventually led the investment systems development team. Before entering the investment management industry, Michael worked as a software engineer for GE Medical Systems. Michael received a bachelor s degree in electrical and computer engineering from Marquette University and a master s degree in finance from the University of Wisconsin-Milwaukee. He is a member of the CFA Institute, the CFA Society of Milwaukee, Inc. and the Global Association of Risk Professionals. Michael has earned the right to use the CFA and FRM designations. Bryant H. VanCronkhite, CFA Portfolio Manager, Special Global Equity Bryant VanCronkhite is a portfolio manager for the Special Global Equity team at Wells Capital Management. Bryant serves as a co-portfolio manager for the Special U.S. Small Cap Value, Special U.S. Mid Cap Value, Special Global Small Cap, Special International Small Cap, and Special Dividend Focused Equity portfolios. Prior to this, Bryant was a senior research analyst on the team, which he joined in 2004 before the acquisition of Strong Capital Management. Earlier, Bryant was a mutual fund accountant for Strong. He earned a bachelor s degree and a master s degree in professional accountancy from the University of Wisconsin, Whitewater, and is a Certified Public Accountant (CPA). He is a member of the Milwaukee Society of Financial Analysts and the AICPA. Bryant has earned the right to use the CFA designation. This paper benefited from the efforts of Gary Barutzke, product manager at Wells Capital Management. The authors thank him for his helpful comments and suggestions. CFA and Chartered Financial Analyst are trademarks owned by the CFA Institute. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000. WELLS CAPITAL MANAGEMENT is a registered service mark of Wells Capital Management, Inc. WELLS CAPITAL MANAGEMENT 11