What Factors Make Active Equity Management Successful?

What Factors Make Active Equity Management Successful? Market Commentary February 2015 ACTIVE VERSUS PASSIVE INVESTMENT MANAGEMENT has long been debated. The passive side seemed to be winning in 2014, as few active U.S. large cap equity managers outperformed their benchmarks. While we believe there is room for both approaches in a portfolio, we think the pendulum may have swung too far toward passive investing. In the following pages, we discuss the factors that caused many active managers to underperform recently and why the environment may be changing. And, more importantly, we suggest the qualities we think investors should seek in an active manager. Why Passive Has Been Outperforming The year 2014 was the worst year for active large cap U.S. equity mangers in more than a decade, continuing a notable trend of underperformance. Only 19% of active managers beat the Russell 1000 Index, with the average fund lagging by 2.4%. 1 A number of factors contributed to this underperformance, but here we will focus on three: cash holdings, allocations to non-u.s. equities and a recent trend of low volatility. The Cost of Holding Cash All active managers must hold some cash, but we find it illogical to hold more cash than is needed for trading. From a strategic perspective, when an investor chooses to invest in an equity fund, they have done so as part of a broader asset allocation decision and likely already have a portion of their portfolio allocated to cash. If their active manager is also holding cash, that disrupts the investor s intended asset allocation. Tactically, we also believe there is no reason to keep the powder dry for a potential purchase. We attempt to hold as little cash as possible, and we sell positions in less attractive holdings if a new opportunity emerges. Holding excess cash was a losing strategy in 2014. Since cash essentially returned zero percent, cash holdings dragged performance as the markets advanced. It is impossible to determine the exact performance attribution for a collection of actively managed funds. However, Exhibit 1 approximates the effect of cash on the performance of the Morningstar categories of large cap equity funds. Our calculations show that cash holdings resulted in an average loss of almost half of a percentage point last year. Robert C. Doll, CFA Senior Portfolio Manager, Chief Equity Strategist Scott M. Tonneson, CFA Senior Research Analyst, Portfolio Manager 1 Source: Merrill Lynch Bank of America Research NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

Exhibit 1: Cash Acted as a Drag on 2014 Performance Average Large Cap Fund Cash Holdings 3.1% 2014 Return of the Russell 1000 Index 13.2% 2014 Return of Cash 0.0% Calculated Drag from Cash Holdings -0.4% Source: Nuveen Asset Management and Morningstar. Average cash holdings is calculated as the average of each of the 1,184 funds within Morningstar s Large Cap Blend, Growth and Value Categories in 2014. Cash returns are represented by the BofA Merrill Lynch 3-Month U.S. Treasury Bill Index. Past performance is no guarantee of future returns. It is not possible to invest directly in an index. The Drag from Non-U.S. Equities A similar story can be told about non-u.s. equities. Nearly all of the funds in the Morningstar Large Cap Equity Categories invested at least a fraction of their assets in non-u.s. markets (via multinationals, cross-border mergers or companies domiciling themselves overseas). Some funds, however, were heavily invested in other markets. The average Morningstar Large Cap Equity fund invested 7.3% of holdings outside of the United States in 2014. This hurt performance since most non- U.S. markets underperformed. Exhibit 2 shows results similar to the cash analysis, using the MSCI EAFE Index as a proxy for non-u.s. allocations. Exhibit 2: Non-U.S. Holdings Hurt Even More Average Large Cap Fund Non-U.S. Holdings 7.3% 2014 Return of the Russell 1000 Index 13.2% 2014 Return of the MSCI EAFE Index -4.5% Calculated Drag from Cash Holdings -1.3% Source: Nuveen Asset Management and Morningstar. Average non-u.s. holdings is calculated as the average of each of the 1,184 funds within the Morningstar Large Cap Blend, Growth and Value Categories through 2014. Past performance is no guarantee of future returns. It is not possible to invest directly in an index. The Effect of Low Volatility Market volatility has been relatively low for the last several years. This environment compresses the performance spread between the best-performing and worst-performing stocks, making it more challenging for stock pickers. Even if an active manager picks the best stocks, it makes less of a difference than in a more volatile, disparate environment. It is difficult to quantify the total excess return (alpha) available for active managers to capture, but one method is to consider the spread between the best and worst performing stocks. Exhibit 3 breaks the S&P 500 Index into deciles and compares the relative performance of the best- and worst-performing deciles. A high spread means more return dispersion, and hence more alpha that could potentially be captured. Conversely, when the spread is low, alpha is scarce. Interestingly, the performance spread reached its lowest level in decades in mid-2014, before rebounding closer to the historic norm in the fourth quarter when volatility increased. Exhibit 3: Low Volatility Makes Alpha Scarce 100% 80% 60% 40% Spread Between Top and Bottom S&P 500 Index Deciles Long-Term Average Abundant Alpha Scarce Alpha 20% 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Merrill Lynch U.S. Quantitative Strategy. Data is based on the performance spread between the top and bottom deciles of the S&P 500 Index. It is not possible to invest directly in an index. This chart does not represent the peformance of any Nuveen products. A Possible Active Management Turnaround Some factors that caused active managers to underperform recently are likely to persist, such as cash holdings and non-u.s. allocations. However, we believe that equities particularly U.S. equities have room to advance. Gains may be more difficult and the market is likely to advance more slowly than in the past few years, but we still believe equities will outperform most other asset classes. Therefore, we think it makes sense for investors who are investing in equities to focus on selecting active U.S. equity managers who are as fully invested as possible and have clear and transparent mandates. However, we believe some changes in the macro environment may allow active managers room for better performance going forward. Rising Volatility We expect volatility will rise in 2015, and this has already become evident. Higher volatility tends to provide more opportunities for active managers to add value, as discussed in Exhibit 3. Furthermore, we believe that the current bull market is maturing as it closes in on its sixth year. In some ways, the easy money in this bull market has already been made, and we expect selectivity will become increasingly critical in the coming years. 2

Higher Interest Rates We believe rates will rise in the coming years due to improving global growth, an easing of deflation fears and the beginning of rate hikes from the Federal Reserve. As shown in Exhibit 4, there has been a strong correlation between rising interest rates and outperformance of active managers over the last 50 years. Exhibit 4: When Rates Rise, Active Managers Have Outperformed 20% 15% 10-year treasury yield (%) Active Fund Excess Return (median) 80% 60% HIGHER VOLATILITY AND RISING RATES may mean that active managers are poised for a better performance environment. 10% 40% 20% 5% 0% 0% 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009-20% 2014 Source: Nomura Research. The chart shows the cumulative median excess return of U.S. active funds relative to a benchmark overlaid with the 10-year U.S. Treasury yield from January 1962 through June 2014. The funds consist of the U.S. growth, growth & income, and income funds based on the University of Chicago s Center for Research in Security Price (CSRP) fund objective codes from January 1962 to November 1999, and U.S. large-cap core, large-cap growth, and large-cap value funds based on Lipper fund classifications from December 1999. Before December 1999, the S&P 500 Index is used for the U.S. growth, growth & income, and income funds and after December 1999, the S&P 500 Index is used for U.S. core funds, the Russell 1000 Growth Index for growth funds, and the Russell 1000 Value Index for value funds. Past performance is no guarantee of future results. It is not possible to invest directly in an index. This chart does not represent the peformance of any Nuveen products. This correlation exists for several reasons. First, rising interest rates tend to help active approaches. When rates rise, smaller capitalization companies tend to outperform since they are generally more sensitive to changes in liquidity. Active managers have flexibility to move within the capitalization ranges of their universes, which provides room for potential outperformance. Conversely, the largest mega-cap companies tend to perform better in falling rate environments. Indexes and passive index funds are skewed toward the largest companies. Second, rising rates typically signal accelerating economic growth. Stronger economic growth leads to more market breadth, and hence more performance dispersion. This benefits active managers, similar to the volatility connection discussed earlier. Selecting the Right Active Managers We believe the environment for active managers is set to improve. Given that, how should investors position their portfolios for this possible shift? There are several factors investors should consider. Most importantly, investors should take care to select a true active manager. Many managers claiming to be active actually only modestly deviate from their benchmarks. This disparity can be quantified using active share, a statistic that measures how widely a fund s holdings differ from the benchmark. Historically, there has been a strong correlation between high active share and outperformance. Mutual funds with high active share outperformed their benchmarks by 1.26% (after fees) and their peers by 2.17%, per year, as shown in Exhibit 5. 3

Exhibit 5: High Active Share Has Been Associated with Outperformance Outperformance vs. Benchmark Gross return 3% 2.61 2% 1% 0% -1% Net return 1.26 Stock Pickers High Active Share 0.82-0.52 Moderately Active 0.44-0.91 Closet Indexers Low Active Share Source: Active Share and Mutual Fund Performance, Antti Petajisto, January 15, 2013. Period studies covers 1990 through 2009. Stock Pickers = Top Quintile Active Share; Moderately Active = 2nd, 3rd and 4th Quintile Active Share; Closet Indexers = Bottom Quintile Active Share. These results do not depict the performance of any Nuveen products. Past performance is no guarantee of future results. There is no assurance that any asset class or index will provide positive performance over time. Different benchmarks, economic periods, methodologies and market conditions will produce different results. Current maximum sales charges, expenses and fees will lower the return of the funds. It is not possible to invest directly in an index. An additional factor that we believe is important is looking at the extent to which active managers actually invest their personal assets in the funds they manage (fund managers are required to disclose this information in SEC filing statements). Morningstar has periodically conducted studies to determine the correlation between manager ownership and the number of Morningstar stars they receive for their respective categories, and not surprisingly, has consistently determined that funds with high degrees of manager ownership have tended to receive more stars. The results of one of their studies is presented in Exhibit 6. ACTIVE SHARE AND MANAGER OWNERSHIP are two of the many factors we believe investors should consider when selecting an active manager Exhibit 6: Manager Ownership Makes a Difference 4 Average Morningstar Star Rating 3.51 3 2.93 2 Zero Manager Ownership Over $1 Million Owned by Manager Source: Morningstar. More Evidence Supports Manager Ownership, 2011. Based on average stars in the Morningstar Core Stock Fund Categories based on reported manager ownership. For funds with at least a three-year history, a Morningstar Rating is based on a risk-adjusted return measure (including the effects of sales charges, loads, and redemption fees) with emphasis on downward variations and consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% 4 stars, the next 35% 3 stars, the next 22.5% 2 stars, and the bottom 10% 1 star. Data is not intended to represent the performance of any product managed by Nuveen. The below exhibit summarizes some of the most important factors we believe investors should consider when selecting an actively managed fund. Exhibit 7: Identifying the Right Active Manager Factor Consistent Approach and Style Low Cash Levels Transparent and Proven Investment Process High Degree of Manager Ownership True Active Management Rationale Managers should stay true to their stated approach, making it easier to know what you own. Managers should be fully invested in equities rather than holding high cash positions. The stock selection process should be clear, consistent, repeatable and proven successful in different market environments. Managers who invest their own net worth in their strategies are better aligned with the interests of their clients. Factors such as high active share can help identify managers seeking more ways to generate outperformance. 4

The Large Cap Equity Series The Large Cap Equity Series is an actively managed group of investment strategies spanning traditional, specialty and alternative approaches to investing in large cap U.S. equities. Our investment approach is based on our belief that a disciplined combination of fundamental research and quantitative analysis raise the probability of long-term outperformance. For information on the Large Cap Equity Series, please contact your financial advisor or visit nuveen.com. Large Cap Equity Series: One Investment Process, Nine Ways to Implement STRATEGY INVESTMENT OBJECTIVE 1 BENCHMARK NUMBER OF POSITIONS TARGET ALPHA / MARKET CYCLE (BASIS POINTS) INVESTMENT VEHICLE TRADITIONAL SPECIALTY Large Cap Value Russell 1000 Value Index Large Cap Core Long-term capital appreciation Russell 1000 Index 90 120 2 200 300 Large Cap Growth Russell 1000 Growth Index Core Dividend Concentrated Core Total return from dividend income and long-term capital appreciation Long-term capital appreciation Russell 1000 Index 90 120 2 200 300 (100 from yield) Russell 1000 Index Approx. 20 200 400 (with high variability) Stable Growth Russell 1000 Growth Index 40 60 200 300 Large Cap Core Plus Long-term capital appreciation Russell 1000 Index 300 500 ALTERNATIVE Equity Long/Short Equity Market Neutral Long-term capital appreciation with moderate correlation to U.S. equity markets Long-term capital appreciation independent of the U.S. equity markets Russell 1000 Index 90-Day T-Bills Approx. 100 Long 100 Short 400 600 (beta adjusted) 400 600 (over T-bills) Available as an Institutional Account Available as a Retail Managed Account Available as an Open-End Mutual Fund Managed accounts may differ from the mutual fund in terms of specific holdings, sector weights and portfolio characteristics. Client portfolios may vary depending upon the size of the account, investment objectives and restrictions, inception date, related fees and costs. The mutual fund has substantially the same investment strategy as the managed account portfolio but the fund is subject to different investment restrictions, inflows, outflows and distribution requirements. 1 Not a comprehensive statement of the objectives and policies of the strategies. 2 Positions for Retail Managed Accounts range from 45-65. 5

Robert C. Doll, CFA Senior Portfolio Manager, Chief Equity Strategist Bob Doll is a senior portfolio manager and chief equity strategist at Nuveen Asset Management. Bob manages the Large Cap Equity Series, which includes traditional large cap equities, specialty categories and alternative strategies. He is a highly-respected authority on the equities markets among investors, advisors and the media. As the author of widely-followed weekly commentaries and annual market predictions, Bob provides ongoing, timely market perspectives. Prior to joining Nuveen Asset Management, Bob held similar roles at other large asset management firms, including serving as chief equity strategist at Blackrock, president and chief investment officer of Merrill Lynch Investment Managers and chief investment officer of Oppenheimer Funds, Inc. He has 35 years of portfolio management experience, received a B.S. in accounting and a B.A. in economics from Lehigh University and an M.B.A. from the Wharton School of the University of Pennsylvania. He is a Certified Public Accountant and holds the Chartered Financial Analyst designation from the CFA Institute. Scott M. Tonneson, CFA Senior Research Analyst, Portfolio Manager Scott is the lead fundamental research analyst for the Nuveen Large Cap Equity Series, which launched in June 2013. The Series delivers traditional, specialty, and alternative strategies across the domestic large cap equity universe. He has also been a member of the management team for the firm s Equity Long/Short Strategy since 2013. Scott began working in the financial services industry in 1994 and joined the firm in 2007. Prior to his current role, Scott served as a senior quantitative research analyst responsible for building models to deliver relevant quantitative data to the equity portfolio teams. Previously, he worked at Ameriprise Financial as a quantitative equity analyst, business analyst, and account analyst. Scott received a B.A. in accounting from the University of St. Thomas and an M.B.A. from the University of Minnesota s Carlson School of Management. He also holds the Chartered Financial Analyst designation and is a member of the CFA Institute and the Chicago Quantitative Alliance. Bob appears regularly on CNBC, Bloomberg TV and Fox Business News discussing the economy and markets. He has also been quoted in major business publications such as The Wall Street Journal, Barron s and Financial Times. Follow @BobDollNuveen on Twitter For more information or to subscribe, please visit nuveen.com/weekly-commentary. Subscribe This information represents the opinion of and is not intended to be a forecast of future events and this is no guarantee of any future result. It is not intended to provide specific advice and should not be considered investment advice of any kind. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell specific securities or investment products. Prices of equity securities may change significantly over short or extended periods of time. Alternative strategies sell securities that have been borrowed but are not owned ( short sales ), which is a speculative technique. A strategy will suffer a loss when the price of a security that it holds long decreases or the price of a security that it has sold short increases. Losses on short sales arise from increases in the value of the security sold short, and therefore are theoretically unlimited. Because a strategy invests in both long and short equity positions, the strategy has overall exposure to changes in value of equity securities that is far greater than its net asset value. This may magnify gains and losses and increase the volatility of the Fund s returns. In addition, the use of short sales will increase expenses. All investments carry a certain degree of risk, including possible loss principal and there is no assurance that an investment will provide positive performance over any period of time. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager. Before investing, carefully consider fund investment objectives, risks, charges and expenses. For this and other information that should be read carefully, please request a prospectus or summary prospectus from your financial advisor or Nuveen Investments at 800.257.8787 or visit nuveen.com. The Russell 1000 Index is an unmanaged index considered representative of large cap stocks. The BofA Merrill Lynch 3-Month U.S. Treasury Bill Index is an unmanaged market index of U.S. Treasury securities maturing in 90 days that assumes reinvestment of all income. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada. The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Morningstar data is 2015 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. is a registered investment adviser and an affiliate of Nuveen Securities, LLC. 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