weekly market review - CLS Investments, LLC

WEEKLY MARKET REVIEW JULY 26, 2016

Market Performance

In This Edition • Where should income investors look?

Stock Market

LAST WEEK

QTD

YTD ‘16

+0.67%

+3.89%

+7.66%

Domestic Large-Cap Equity2

+0.64%

+3.74%

+7.72%

Domestic Small-Cap Equity3

+0.64%

+5.35%

+7.68%

0.00%

+3.05%

+2.00%

Developed International Equity

0.00%

+2.63%

-1.91%

Emerging Market Equity

+0.24%

+4.50%

+11.20%

LAST WEEK

QTD

YTD ‘16

+0.13%

+0.16%

+5.48%

+0.01%

+0.01%

+0.13%

Total U.S. Market1

• A different strategy for CLS

International Equity4

• A unique source for price appreciation

5

6

Fixed Income U.S. Bonds

7

Cash Equivalent

8

Russell 3000 Index 2S&P 500 Index 3Russell 2000 Index 4MSCI ACWI ex-U.S. Index 5MSCI EAFE Index 6MSCI Emerging Markets Index 7Barclays Capital U.S. Aggregate Bond Index 8Barclays Capital 1-3 Month U.S. Treasury Bill Index 1

Week in Review Global equity markets finished last week in the black, with the S&P 500 closing at a new all-time high. In the U.S., large-cap performance was roughly equal to small-caps. Overseas, developed markets were flat while emerging markets eked out a small positive gain. The domestic bond market had a small positive gain with the yield on the 10-year Treasury bond falling approximately two basis points on the week. Broad commodities were down for a second consecutive week. Despite a rough start to the third quarter, commodities continue to outperform the global equity market year-to-date.

A Great Find in the Search for Income Income investors have struggled to find yield since the financial crisis when the Federal Reserve (Fed) instituted a zero interestrate policy. Even the move by the Fed last December to raise the benchmark rate for the first time in seven years has offered no relief. In fact, things are now arguably worse. The yield on the 10-year Treasury bond has fallen considerably in 2016. With traditional asset classes, such as U.S. stocks and investment-grade bonds, yielding somewhere in the neighborhood of 2.0% – 2.5%, where are income investors to turn? Fortunately, there are still opportunities for savvy investors who can tolerate some market risk. One such opportunity

comes from a relatively small and unloved segment of the investment world, closedend funds (CEF). (For a brief explanation of CEFs, please check out the description in the grey box below.) Aside from a general focus on high-incomegenerating assets within the CEF space (the average taxable CEF has a yield of roughly 9%), the CEF structure offers a few additional benefits for income investors. For instance, some CEFs utilize leverage (increasing the investable assets through borrowing). Others provide access to various incomecentric strategies, such as covered call writing. Finally, CEFs typically trade at a discount to their net asset value (NAV). This allows investors to purchase

an income stream at a cheaper price, effectively increasing the yield. For example, investors can purchase a $10 asset that pays a $0.50 per-year distribution for a yield of 5%. If investors could instead purchase that asset at a 10% discount ($9), the yield becomes 5.56% ($0.50/$9). Indeed one of the most valuable aspects of CEFs may be the potential to purchase them at attractive prices relative to their NAVs; but buyer beware. If investors are not careful, they could end up paying much more for a fund than they would otherwise have to. A heightened level of due diligence is certainly required.

A closed-end fund is a publicly traded investment, such as an openended mutual fund or ETF. Like an ETF, CEFs trade intra-day on an exchange. Unlike an ETF or mutual fund, a CEF has a fixed number of shares. In addition, share prices for a CEF may substantially deviate from the fund’s net asset value (NAV). When demand for shares exceeds the supply, the share prices may trade at a premium (above NAV). When supply exceeds demand, share prices may trade at a discount (below NAV).

Gaining Exposure Through CLS A heightened level of due diligence, such as what is needed when using CEFs, is something CLS is accustomed to, and we have a strategy that seeks to take advantage of this very opportunity: Active Income X. In a nutshell, Active Income X is a series of five globally diversified, multi-asset, income-focused portfolios. Each portfolio is comprised of ETFs and CEFs and targets a specific yield, which ranges from 3% – 7% net of fees. Active Income X provides exposure to traditional asset classes, but in order to generate levels of income higher than the market rate it will also utilize some non-traditional asset classes, often through CEFs. Traditional asset classes generally consist of dividend-oriented stocks and investment-grade bonds, while non-traditional

asset classes might include real estate investment trusts (REITS), preferred stock, high-yield bonds, master limited partnerships, and emerging market debt. The strategy within Active Income X is to remain diversified and generate a consistent income stream by spreading exposures across as many different risk factors as possible. The portfolios also seek an attractive total return and will emphasize assets that are deemed to be particularly attractive. Unlike many strategies at CLS, Active Income X is not Risk Budgeted (though it is certainly risk managed). With Risk Budgeting, portfolios target a specific level of risk over time. Active Income X, on the other hand, targets a specific level of

income. As market conditions change, the level of risk exposure needed to achieve the target yield may also change. Still, Risk Budgeting is a powerful risk management tool, and we would be remiss if Active Income X was not evaluated under that lens. Historically, the portfolios have typically had a Risk Budget of around 65 for the lowerincome model 3, increasing to an 85 on the higher-income model 7. It is important to note these risk levels are consistent with the risk tolerance of a moderately aggressive investor. In order to generate the higherthan-market-rate yields, Active Income X takes risk and should not be thought of in the same category as a core bond fund or money market fund. (More info on Active Income X here).

Josh Jenkins, CFA Portfolio Manager Joshua Jenkins joined CLS in March 2013, and serves as a Portfolio Manager. He is the lead manager of an income-focused separately-managed account strategy and also functions as the lead analyst for the CLS Growth and Income Fund, CLS Flexible Income Fund, and the Milestone Treasury Obligations Fund. In these roles, Mr. Jenkins utilizes fundamental and technical analysis to assist portfolio managers in asset allocation decisions. In addition, due to his extensive knowledge of Exchange Traded Products, he drives CLS’s implementation process and is integral in selecting the appropriate ETPs to gain desired exposure within CLS portfolios. Prior to joining CLS, Mr. Jenkins worked as an Analyst on the private equity desk at Auriga USA, LLC, a small broker-dealer headquartered in New York City.

A Unique Source for Price Appreciation In addition to providing a healthy boost to yield, purchasing assets at a larger-than-normal discount to NAV provides the potential for increased price appreciation. Over the last year, taxable CEFs have traded at an average discount to NAV of about 8.5%. If an investor purchased a basket of CEFs at

the beginning of last year, he or she would have scooped them up at an attractive discount of approximately 9.7%. Over the following 12 months, that discount shrunk to just 6.4%. This would equate to a roughly 3.3% return for the investor, without the underlying investments necessarily changing in price.

Despite that positive outcome, CEFs are still currently trading at a larger discount than they have on average over the last five years. This means there is still some potential for continued benefit, though it is by no means a certainty.

Taxable CEF Discounts

(2.00) (4.00) (6.00) (8.00) (10.00)

Current Discount

1 Yr Avg Discount

5 Yr Avg Discount

6/1/2016

5/1/2016

4/1/2016

3/1/2016

2/1/2016

1/1/2016

12/1/2015

11/1/2015

10/1/2015

9/1/2015

8/1/2015

7/1/2015

(12.00)

The Russell 3000 Index is an unmanaged index considered representative of the U.S. stock market. The index is composed of the 3,000 largest U.S. stocks. The S&P 500 Index is an unmanaged composite of 500-large capitalization companies. This index is widely used by professional investors as a performance benchmark for large-cap stocks. The Russell 2000 Index is an index comprised of the 2,000 smallest companies on the Russell 3000. It serves as a benchmark for small-cap stocks in the U.S. The MSCI All-Countries World Index, excluding U.S. (MSCI ACWI ex US) is an index considered representative of stock markets of developed and emerging markets, excluding those of the U.S. The MSCI EAFE Index is a composite index which tracks performance of international equity securities in 21 developed countries in Europe, Australia, Asia, and the Far East. The MSCI Emerging Markets (or EM) Index is a composite index which tracks performance of large and mid-cap firms across 21 countries classified as emerging market countries. The Barclay’s Capital U.S. Aggregate Bond Index measures the performance of the total United States investment-grade bond market. The Barclay’s Capital 1-3 Month U.S. Treasury Bill Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. An index is an unmanaged group of stocks considered to be representative of different segments of the stock market in general. You cannot invest directly in an index. The views expressed herein are exclusively those of CLS Investments, LLC (CLS), and are not meant as investment advice and are subject to change. CLS is not affiliated with any companies listed above. No part of this report may be reproduced in any manner without the express written permission of CLS. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. CLS is not making any comment as to the suitability of any funds mentioned, or any investment product for use in any portfolio. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Individual client accounts may vary. Investing in any security involves certain non-diversifiable risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk. These risks are in addition to any specific, or diversifiable, risks associated with particular investment styles or strategies. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing.

2196-CLS-7/26/2016