The Cadence Approach to Strategic Beta Investing

Cadence Capital Management 265 Franklin Street, 4th Floor Boston, MA 02110 617-624-3500 cadencecapital.com The Cadence Approach to Strategic Beta Investing Contents An Introduction to Strategic Beta Specific Advantages of the Cadence Approach Overview of Cadence Capital Management Investors have real liabilities that they are trying to satisfy and capital goals that they are trying to meet. Chances are they have a carefully planned asset allocation strategy designed to help them meet these objectives. In the past, investors typically used passive index funds, active management strategies or a combination of both to fulfill each component of their overall strategy. Today, investors can use another approach: strategic beta investing. While some view strategic beta as merely a better way to index, we at Cadence Capital Management see it differently. We believe that strategic beta strategies can combine some of the best features of passive and active investment management into a single investment strategy. While some strategic beta strategies generally offer a blend of active and passive benefits, the Cadence Strategic Beta approach has four specific advantages that further benefit our clients. These are factor focus, beta-specific rule design, the ability to be used as flexible investment tools and client customization. In combination, we believe that these advantages deliver better risk-adjusted investment returns at the individual portfolio level and a more tailored fit with our clients asset allocation strategies at the overall plan level. J. Paul Dokas, CFA Managing Director Robert E. Ginsberg, CFA Managing Director When clients hire Cadence, they can feel confident that they will get a highly focused Strategic Beta portfolio that exploits the desired investment factor to its fullest extent. 1

An Introduction to Strategic Beta What Is Strategic Beta? Strategic beta can be viewed as a modified form of indexing, falling somewhere along the passive-to-active investment spectrum. Also known as smart beta or alternative beta, these are factor portfolios that capture a particular market segment or equity characteristic. Factors vary widely and can be virtually any characteristic, but we believe the more relevant ones include yield, momentum, quality and value. Portfolio managers design a comprehensive set of rules that determines the investable universe, number and type of holdings, and buy/sell criteria. This part of the strategic beta strategy is similar to active management, in that managers use their discretion both in defining the target investment factor(s) and writing the investment rules to capture those factors. Once the initial design has been completed, however, the portfolio takes on passive investment characteristics. Portfolio rules are executed passively over time and typically involve limited ongoing manager discretion or alteration. Implementing the strategy in this way similar to index fund implementation requires fewer human resources and therefore involves lower costs than traditional active portfolio management. While some view this as just a better way to create an index fund, Cadence believes that the best strategic beta strategies leverage proven investment techniques to outperform the market, sometimes thought of as manager skill, more consistently and cost-efficiently. Why Invest in Strategic Beta? Strategic beta strategies are becoming popular because they retain many of the benefits of active and passive investment management while addressing some of the shortcomings of each approach. Like passive index funds, strategic beta strategies are generally low cost, transparent and liquid, with significant capacity. Like active funds, strategic beta strategies employ active investment approaches such as value or growth and therefore have the potential to achieve uncorrelated, excess returns. Additionally, the rules-based implementation used in strategic beta investing helps to reduce the behavioral and operational mistakes that can detract from the performance of traditional active managers. When individual strategic beta portfolios are carefully constructed to target a single factor, they can be used as stand-alone portfolios or work together seamlessly for efficient exposure to desired markets, regions or cohorts of stocks. Strategic beta strategies can be used in place of traditional active portfolios, in place of index funds or as a complement to either as part of a comprehensive investment strategy. Furthermore, when individual strategic beta portfolios are carefully constructed to target a single factor, they can be used as stand-alone portfolios or work together seamlessly for efficient exposure to desired markets, regions or cohorts of stocks. Are All Strategic Beta Strategies Created Equally? While strategic beta portfolios are widespread, they are not all the same. In the same way that strategic beta portfolios can be designed to look different from market indexes, they can look different from other strategic beta portfolios. The factors that a manager recommends exploiting, the way in which he or she defines those factors and the rules he or she designs to capture them during the portfolio construction phase can dramatically affect the characteristics of the portfolio as well as investment performance. These are the active and most critical components of a strategic beta strategy, where skill, experience and depth of knowledge matter. 2

Specific Advantages of the Cadence Approach Overview Cadence Strategic Beta portfolios are co-managed by J. Paul Dokas, CFA and Robert E. Ginsberg, CFA. Together, Paul and Rob lead a team that designs, develops and implements strategies that can exploit specific investment opportunities in the U.S., international and emerging equity markets. All of Cadence s Strategic Beta portfolios combine the benefits of active and passive management. They are actively designed portfolios that look meaningfully different from market benchmarks, but they are constructed using rules-based methodology, allowing them to preserve the benefits of index investing. Passive Investing DESCRIPTION Portfolio of stocks replicating widely held market index, weighted based on market capitalization No judgment involved BENEFITS Broad market exposure Diversification Liquidity Transparency Low cost Low turnover Cadence Strategic Beta DESCRIPTION Portfolio designed to capture specific factors or style risk premiums Proprietary factor definitions Beta-specific rule design Perspective on attractiveness of Beta Portfolios Rules-based implementation Active client service approach offering partial or complete customization BENEFITS Targeted market exposure/factor focus Diversification Liquidity Transparency Low cost Potential outperformance vs. index Flexible investment tools Greater ability to meet specific client needs Traditional Active Management DESCRIPTION Portfolio based on portfolio manager s investment criteria, style and selection process Highly dependent on manager judgment and skill BENEFITS Potential long-term outperformance Potential outperformance due to individual stock selection Ability to customize While some view strategic beta as just a better way to create an index fund, Cadence believes the best strategic beta strategies leverage proven investment techniques more consistently and cost-efficiently. 3

Building Block Approach Cadence takes an intuitive, common sense approach to strategic beta investing. Each Cadence Strategic Beta portfolio targets a specific objective or factor (i.e., Beta ) that possesses a durable advantage, such as value, yield, momentum or quality. Each of these four Betas can be applied across three regions U.S., international or emerging markets forming a total of 12 base strategies. (See Figure 1.) Our Beta strategies are designed to complement one another. Like Lego TM pieces, the portfolios can stand alone, be integrated into an existing portfolio or be bundled together to provide a comprehensive and consistent approach to equity investing across the globe. This building block approach allows investors to achieve diversification without owning the entire market, retaining potential excess, uncorrelated return while minimizing overlap risk. Higher Volatility Lower Volatility Value Figure 1. Four Main Beta Strategies Applied across U.S., International and Emerging Markets Meaningful Advantages Growth While some strategic beta strategies generally offer a blend of active and passive benefits, Cadence Strategic Beta portfolios have four specifi c competitive advantages that further benefit our clients. These are factor focus, beta-specific rule design, the ability to be used as flexible investment tools and client customization. We believe that, in combination, our four competitive advantages produce better risk-adjusted investment returns for our clients at the individual portfolio level and make them a better fit with our clients asset allocation strategies at the overall plan level. 1 Morningstar, Being Smart About Strategic Beta, Alex Bryan, April 10, 2014. Cadence Strategic Beta Advantage #1: Factor Focus Exploits the targeted factor ( Beta ) to its fullest extent Reduces unintended exposures Maintains the integrity of the client s asset allocation strategy In an effort to differentiate a product or to offer more sophisticated solutions, some strategic beta strategies have become highly complex. Morningstar, in fact, has noted a growing disparity between how the strategies are pitched by their creators and the actual investment results the strategies produce. 1 Multi-factor models are, in part, to blame. When a manager solves for multiple exposures within a single beta strategy, he or she dilutes the effect of each factor and introduces varying tilts into the portfolio that may or may not be expected or desired. Some single-factor strategies can also be guilty of this confusion. An investor may think that he or she is getting a single-factor strategy, but in reality, the portfolio has exposure to other factors or tilts as well. This may be unintentional on the manager s part, such as when his or her momentum strategy also imparts a small cap tilt. It can also be intentional. The manager of a yield strategy, for example, may also screen for characteristics such as low valuation or earnings quality, in an effort to hedge performance when yield is out of favor. Since factor performance ebbs and flows, some managers may sacrifice concentrated factor exposure in an attempt to smooth returns. Although it may appear that the strategy possesses the desired factor tilt, the portfolio may fail to deliver the desired factor return because of the influence of the additional exposures. This means that, over time, beta strategies that blend factors or introduce other exposures may be at odds with an investor s goal of capturing a very specific investment characteristic. Cadence has taken a different approach. We have purposely stripped away much of the complexity of factor portfolios to deliver the chosen factor. We do not use multi-factor models, and we look to reduce unintentional exposures that could dilute the results that should be obtained from the targeted investment factor. For example, if a client wants to exploit yield, we construct a portfolio that delivers broad exposure to yield. While we are cognizant of risk and establish limits on position sizes, sector weights or country weights, each stock in the portfolio is included because it 4

contributes to the portfolio s goal of capturing yield. In other words, Cadence Strategic Beta portfolios are designed for factor specificity and not hedged return. They will participate fully in both the upswings and the downswings of the target factor. It is this focus on delivering the target factor that allows each Cadence Strategic Beta model to stand on its own as a robust portfolio or to fit together with our other Strategic Beta portfolios with limited overlap. Cadence Strategic Beta Advantage #2: Beta-Specific Rule Design Captures the idiosyncrasies of the desired factor, market or cohort efficiently Reduces concentration and momentum aspects of indexing Provides high degree of confidence that portfolio will achieve its objective Some beta strategies apply a standard set of rules to an investment universe, regardless of the characteristic the manager is seeking to exploit or the market in which he or she is investing. At first blush, this may seem like an efficient approach to beta investing: once a manager determines what he or she considers optimal rules, including maximum position weights, rebalancing frequency and the like, he or she can apply them to any portfolio in any region. One-size-fits-all rules, however, do not allow for the fact that each investment factor and each global region is different. Capturing each factor efficiently may require different techniques because of the varying opportunity sets and risks involved. An appropriate maximum position size for a momentum beta, for example, may be different than the maximum position size for a yield beta. This is also true for the weighting structure, number of stocks in the portfolio, sectors, industries, countries and capitalizations, among other fundamental factors. In a yield beta strategy, for example, a standard rule set may result in a preponderance of REITs and utilities stocks. A similar issue could arise in a non-u.s. beta strategy, where applying a standard rule set to a portfolio could result in an imprudent concentration in a particular country. Some managers attempt to control for these outcomes by applying risk models and building transaction costs into optimizers. While these tools can be useful, they have some serious pitfalls. Optimizers, for example, require forecasted inputs regarding individual security parameters, which necessarily involve error. They also tend to be error maximizers that mechanically seize on extreme numbers, loading up on certain stocks because they reflect the target characteristic and potentially ignoring the misestimation risk or concentration effect on the total portfolio. Cadence approaches rule design differently. We tailor the investment rules for each Beta strategy and employ portfolio construction and management techniques that reduce the concentration and momentum aspects of indexing. Although we do not use optimizers or risk models in our strategic beta construction process, our portfolios are risk-conscious. The rules used to construct our Beta portfolios have sector, industry, country and capitalization adjustments that all serve to manage risk. In addition, while we do not use risk models as an explicit part of the portfolio construction process, we use them to validate our construction rules and confirm that the execution of the portfolio was successful. In combination, our beta-specific rule design and risk management techniques capture the idiosyncrasies of the target factor efficiently, while reducing hidden, frictional costs. Cadence Strategic Beta Advantage #3: Flexible Investment Tools Efficient way to capture risk premiums Can be used to express an insight or to meet a need or goal Efficiently accommodates movement of capital Can be used in place of active management, index funds or as a complement to both Cadence Strategic Beta strategies offer an efficient way to capture risk premiums. With portfolio construction and management techniques that reduce implementation shortfall such as market impact, illiquidity and opportunity cost, our Beta portfolios are designed to accommodate the movement of capital. This allows investors to use our Beta strategies to express their insights into the relative attractiveness of different investment strategies and to capture those insights in a low-cost, transparent and efficient manner. If one believes that high-quality U.S. stocks are currently an attractive asset, for example, the Cadence U.S. Quality Strategic Beta portfolio would provide a way to exploit this opportunity and to capture its return to the fullest extent. 5

Cadence Strategic Beta portfolios can also be used to meet specific needs or goals. For example, if an endowment requires extra income, it could allocate to the U.S., EAFE or Emerging Market Yield Beta or to all three to achieve that objective. For plans and investors seeking a comprehensive global strategy, a Cadence Strategic Beta portfolio that allocates across all 12 base strategies may be an attractive investment solution. Given their inherent flexibility, we believe that Cadence Strategic Beta portfolios can help to enhance returns, reduce costs and protect investors from overvalued markets, segments or strategies. Cadence Strategic Beta Advantage #4: Client Customization Enables client to meet highly specific investment objectives Accommodates needs and goals particular to client s organization Can develop new strategies to achieve specific client goals Cadence is different. We actively partner with our clients to pinpoint the factors that will best serve their specific investment goals. Our boutique size allows us to understand our clients and their overall investment approach, helping us to target their needs more effectively and forming the basis of long-lasting relationships. Additionally, our established, institutional platform allows us to customize our Beta strategies for certain mandates. At the individual portfolio level, there are several ways we can do this, including modifying sectors, capitalization, geography and security type. For example, we can customize our yield beta strategy to eliminate REITs. We can design a beta strategy to exploit the bottom three- quarters of the Russell 2000 Index. We can customize a program to avoid investing in Russia. For one recent mandate, we worked closely with our client to develop, design and implement a Global Commodity Beta strategy, all within the client s accelerated timeframe. Our ability to customize our beta strategies enables our clients to meet specific investment objectives while accommodating their needs and goals. We believe that the four specific advantages of the Cadence Strategic Beta approach produce better risk-adjusted results for our clients at the individual portfolio level and ensure a better asset-allocation fit at the total plan level. Conclusion Strategic beta portfolios are attractive investment options because they combine some of the best features of active and passive investment strategies. All strategic beta portfolios, however, are not created equally. The Cadence Strategic Beta approach has four primary advantages over many other strategies namely, factor focus, beta-specific rule design, the ability to be used as flexible investment tools and client customization. When clients hire Cadence, they can feel confident that they will get a highly focused beta strategy that exploits the desired investment factor to its fullest extent. In this way, we believe we can produce better risk-adjusted investment results for our clients at the individual portfolio level and ensure a better fit with our clients asset allocation strategies at the total plan level. CADENCE ADVANTAGE 1. FACTOR FOCUS 2. BETA-SPECIFIC RULE DESIGN 3. FLEXIBLE INVESTMENT TOOLS 4. CLIENT CUSTOMIZATION CLIENT BENEFIT Exploits the targeted factor ( Beta ) to its fullest extent Limits unintended exposures Maintains the integrity of the client s asset allocation strategy Captures the idiosyncrasies of the desired factor, market or cohort efficiently Reduces concentration and momentum aspects of indexing Provides high degree of confidence that portfolio will achieve its objective Efficient way to capture risk premiums Can be used to express an insight or to meet a need or goal Efficiently accommodates movement of capital Can be used in place of active management, index funds or as a complement to both Enables client to meet highly specific investment objectives Accommodates needs and goals particular to client s organization Can develop new strategies to achieve specific client goals 6

Overview of Cadence Capital Management Cadence Capital Management is a 25-year-old investment boutique offering a range of equity strategies across the activeto-passive investing spectrum. We re a small firm where every client has a direct-dial connection to the people managing their money. The investment strategies we offer today are diverse, but they share a common principle: Each is focused on identifying and exploiting the factors that drive stock performance over time. These include our Strategic Beta strategies, Growth-at-a-Reasonable Price traditional alpha strategies and our Long/Short Equity Limited Partnerships. Cadence delivers customizable Strategic Beta strategies to institutional and retail investors. Led by J. Paul Dokas, CFA and Robert E. Ginsberg, CFA, the Strategic Beta team designs, develops and implements investment strategies to exploit specific investment opportunities in U.S., international and emerging equity markets. For further information, please contact Barbara Graves at (617) 624-3500 or info@cadencecapital.com. 7