Research Affiliates Newsletter February 2012

DIRT ECONOMICS: DEMOGRAPHICS MATTER!

My maternal grandparents grew up on Midwestern farms. As was typical in those days, they came from large families with seven children each. I like to think that my great-grandparents were Shane Shepherd motivated by a hard-earned grasp of Dirt Economics: knowing the benefits of cheap (and even free!) farm labor, they chose to have large RAFI Managed Assets* families to help work the farm. And, USD in Billions $60 given the economic realities facing $50 a poor South Dakotan farming $40 community, they certainly werent $30 relying on their tiny savings to $20 provide a comfortable retirement. $10 Just as they had done for their 0 4Q05 4Q06 4Q07 4Q08 4Q09 4Q10 4Q11E parents, my great-grandparents hoped their children would run *Includes RAFI assets managed or sub-advised by Research Affiliates or RAFI licensees. the family farm, put food on the table, and pay the doctor and the dry goods store bills once they were too old to work the land. 620 newport center drive, suite 900 My great-grandparents intuitively newport beach, ca 92660 usa understood the concept of support phone +1 (949) 325-8700 fax +1 (949) 554-0192 ratios: having just one or two children info@rallc.com wouldnt guarantee the retirement www.rallc.com security they needed. Despite the MEDIA CONTACTS economic devastation wrought by the Tucker Hewes Great Depression and the Dust Bowl Hewes Communications of the 1930s, the underlying economic +1 (212) 207-9451 tucker@hewescomm.com 4Q05 1Q06potential for their generation 2Q06 3Q06 4Q06 remained quite strong, especially Joel Chernoff following the Second World War. Research Affiliates +1 (949) 325-8729 A growing workforce promised

increasing demands for goods and services, and the production capacity to meet that demand. But a problem was forming on the horizon: Americansmy grandparents among them stopped having so many kids, with long-term implications for the economy and investments. In this issue, we will examine how demographic changes affect portfolios in different economic environments.

The Demographic Bust

If only we found ourselves in such a fortunate situation today as prior generations did. Soaring deficits, massive debt, and worsening demographics our frequently mentioned 3-D Hurricane1leave my generation in a far more dire situation than my grandparents faced. Exceedingly high debt levels and growing deficits across the developed world have attracted much attention, and rightfully so. Deficit spending is by nature a transfer of future consumption to the present. Particularly when built up across generations,2Q07 excessive deficits can 1Q07 powerfully reduce future economic growth when those bills come due. The economic prosperity
continued on page two

chernoff@rallc.com

Research Affiliates Newsletter February 2012

of Generation X will certainly be reduced by the need to pay back the heavy borrowing of the Baby Boomers. Even if we could clean up our current fiscal mess with a wave of Ben Bernankes magic wand, our future prosperity still would decline for an even more powerful and fundamental reason. Simply put, I dont have enough siblings. In addition to running large deficits and spending my generations income ahead of time, my parents generation forgot about Dirt Economicsthey didnt have enough children to support them in their retirement. As we moved from a predominantly single family support system to a national system anchored on Social Security, the incentives to directly replace ones labor value vanished; instead, we shifted the burden to society as a whole. Therefore, if the Boomers begin to retire as anticipated, we wont be able to produce enough goods and services to meet their demand! The core problem faced by the developed world today is not just the disastrous fiscal situation we see headlining the newspapers every day, butlurking beneath the surfaceour impending demographic bust. Examining the deteriorating support ratios for the developed world puts the magnitude of this problem in context. In 1970, there were five working adults for every retiree. Today, that ratio is 3.5:1 and if the retirement age remains constant, that ratio is projected to drop below 2:1 by 2050.2 The demographics trends in Figure 1 show that, in the early 2000s, there were 10 new entrants into the workforce for every retiree; by 2020, that ratio will invert and show one new worker for every 10 retirees. To understand the impact of these numbers, lets first consider the generational effects in a closed single-nation economy. As a large generation such as the Baby Boomers retirees, their consumption demands typically remain relatively unchanged. However, their ability to produce goods and services vanishes; if the following generations are smaller in number, we will see the relative labor pool (and thus its ability to supply goods and services) decline in the economy. We are thereby left with a downward shift in the aggregate supply curve while demand remains relatively constant. If nothing else changes, this causes a shortage of goods and the result is price inflation and reduced Gross Domestic Product. The impact of this retirement wave will not be minor: Arnott and Chaves (2012)3 estimate an

Figure 1. Demographic Trends Bode Ill for the U.S. Economy

Inflection Points, Demographic Seismic Shifts
2.5 The Baby Boom 2.0 The Boomers Retire

One Year U.S. Population Growth, by Age Group, in Millions

1.5 10 1.0

10

0.5

0.0

The Baby Bust

(0.5)

(1.0)

1950

1960

1970

1980 Under 20

1990 Working Age, 20-64

2000

2010 65 and over

2020

2030

Source: Research Affiliates, LLC, based on population data and projections from the U.S. Social Security Administration.
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Research Affiliates Newsletter February 2012

annualized GDP decline in the United States of about 0.752.5%. The demographic impact on GDP to the United States may be rather mild compared to other developed economiesestimates show that Japan may face an annualized GDP decline of 1.55% in coming years. None of these nations is a closed economy, but most of the developed world is facing this demographic problem in unison. Can international trade solve this problem? If so, trade between the developed world and the younger emerging nations must dramatically increase. As we go down this route, countries with a high level of external savings will have the ability to purchase goods from the emerging world to help meet the shortfall in domestic production. Japan, for example, has a Net International Investment Position (external assets minus external debt) of 56% of its GDP. As Japan experiences a GDP decline due to its retirement wave, it can keep its prosperity at constant levels by selling its foreign assets and importing goods. If that GDP decline reaches the worst-case projection of 5% per year, Japans foreign assets would be drained within a mere 11 years. And Japan, as a result of its
Figure 2. Japanese and U.S. Trade Balances on a Downward Trend
Balance of Trade as a Percentage of GDP
6.0%

historically large trade surplus, has been a major saver nation! The United States, by contrast, hasnt run a trade surplus since 1975, and its Net International Investment Position is 17% of GDP. This leaves no room for spending down savingsin fact, to achieve a zero Net International Investment Position over the next 11 years, the United States would have to pay back its shortfall by exporting our already scarce goods to the tune of 1.5% of GDP annually. Given our current trade deficit of 3.7%, this would require an additional 5.2% of GDP to be sent overseas; this almost certainly wont happen. The trend of declining trade balances in both the United States and Japan, shown in Figure 2, will continue to be driven by demographic necessity. Even a tremendous weakening in the strength of the dollar or yen wont fully address the core problem of insufficient labor to produce the surplus goods for export. Will the developed countries be able to adapt? Its not likely. Japan, despite its massive trade surplus, still hasnt saved enough foreign assets to address this problem. And the United States,

4.0%

2.0%

0.0%

-2.0%

-4.0%

-6.0%

-8.0%

Japan Trade Balance as % of GDP

U.S. Trade Balance as % of GDP

Source: Research Affiliates.

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Research Affiliates Newsletter February 2012

in aggregate, has neglected to save at all! If the United States is to import the goods and services to meet retiree demand, it will have to do so through a further increase of the already historically high debt levelsalso an unlikely outcome. Furthermore, the nature of the goods and services demanded by retirees is unlikely to be available for purchase abroad. Consumer goods such as cars and textiles and oil are easy enough to import, but retirees will also seek services such as health care and non-importable goods such as housing. International trade looks to be at best a partial fix and at worst no help at all. Because we cant adjust previous birth rates, these demographic curves are a deck of cards already dealt. There are, however, a few options to help prop up declining support ratios. Anything that provides more workers or fewer retirees will do the trick. For example, higher levels of immigration will help. All else being equal, higher nominal developed world wages and projected low unemployment rates will create incentives for workers from emerging countries to fill the demand for open jobs. However, the developed world will demand immigration levels far beyond anything we have witnessed historically. To maintain support ratios at their current level in the United States, we estimate the need for an additional 4 million new workers each year through 20304on top of current legal immigration levels of 1 million annually. Immigration could help ameliorate the problem, but certainly cant solve it by itself. If increasing the working population wont suffice, the other alternative is to decrease the number of retirees. Retiring abroad is one route to improving the support ratio, although incentivizing an additional 1.4 million U.S. residents each year to spend their golden ages overseas wont be easily achieved. The remaining option is for retirees to remain in the workforce longer. A shift in the average retirement age from 65 to 72 over the next 20 years would keep support ratios stable. Realistically, the outcome will be a combination of the options, though the changes will not come without a contentious national debate. an increasing trade deficit, slower GDP growth, delayed retirement, and increased immigration. This world will undoubtedly take some adjustment. Instead of stubbornly high unemployment, we will be faced with a dearth of workers. Instead of historically low inflation and interest rates, we will likely see both rising well above long-term averages. Inflation in particular may be driven higher by two distinct pressures. First, we expect the scarcity of production and labor to drive up wages and prices for goods. Second, the huge debt burdens across the developed world, including unfunded retirement benefits, simply cannot be paid in todays dollars. Given the political difficulty of reducing these benefits, a logical and perhaps unavoidable policy path will be to reduce the real value of these promised benefits through inflation. We see that foundation being laid today with the huge amounts of quantitative easing being conducted by central bankers around the globe.

Implications for Investors

As investors, how can we best position ourselves to respond to these changing conditions? First, we should prepare ourselves for a future with lower expected returns across most major asset classes. Slower GDP growth and rising interest rates are certainly enough to give both stock and bond investors convulsions; coupled with historically low stock and bond yields, there is little hope of growing our way to retirement. Second, we should prepare to work longer, save more, and expect lower consumption levels. Finally, we should seek out a margin of safety in our investments. A period of rising inflation and declining GDP growth is hardly the time to load up on risky assets. Investors should look for lower risk and/or higher returns for given levels of risk. As we have discussed previously, building a 3-D shelter that comprises an inflation hedge in addition to traditional equity and bond allocations is critical.5 And we have noted many times how investors can increase their prospects of obtaining higher equity returns by adding non-price-weighted equity index portfolios to their core equity holdings.6
4

Implications for the Economy

The underlying demographics cannot change; but we expect that, as always, prices can and will adjust to create the proper incentives. The result will be a combination of increased inflation and interest rates,

Research Affiliates Newsletter February 2012

But investors should examine their fixed-income portfolios as well, where the argument for non-priceweighting indices is even stronger. Traditional fixedincome indices allocate the highest weights to the largest debtors, resulting in extreme allocations to those countries and companies least able to service their debt obligations. Our research shows that extending the RAFI methodology to U.S. highyield bonds, U.S. investment grade bonds, and local currency emerging market debt would have generated significant added value over market-capweighted indices.7 Subsequently, we launched the RAFI U.S. corporate bond indices in conjunction with Ryan ALM. The Citi RAFI Bond Index Series applies the methodology to the sovereign debt market, potentially reducing the risk of our fixed income portfolios while providing an opportunity to enhance returns. Instead of using traditional accounting measures to set country weights, the Citi RAFI series uses measures of economic sizeGDP, population, land area, and energy consumptionand thus tends to overweight countries with high debt service capacity. These countries tend to have lower credit risk and lower duration as well, thus lending some protection against both rising interest rates and sovereign defaults. Furthermore, applying the Fundamental Index strategy to fixed income takes advantage of the welldocumented RAFI return advantage that comes from regular rebalancing and contra-trading against noisy price movements. Our research estimates the return advantage to be 80 bps annually in the Sovereign Developed Markets and about 125 bps annually in Sovereign Emerging Markets debt. In a world of slow growth and low expected returns, these advantages are significant indeed.

Conclusion
The incentives of Dirt Economics from my grandparents generation have been left behind at least in most developed countriesso my generation faces a challenging road to maintain our standard of living. As we travel that path, we all need to position our portfolios for turbulent economic timesones that promise to be very different from the post-World War II expansionary period to which most of us are accustomed. Low expected returns, significantly higher inflation and interest rates, rising deficits and debts, and worsening demographics all figure into a New Normal. Adding a third pillar of inflation protection to our portfolios and creating the possibility of significantly enhancing index returns through application of the Fundamental Index strategy to stocks and bonds alike strengthen our hopes of avoiding a future of diminishing prosperity.

Endnotes

1. For example, see the following Fundamentals: The 3-D Hurricane Force Headwind, November 2009; Debt Be Not Proud, August 2010; and The Long ViewBuilding the 3-D Shelter, October 2011. http://www.researchaffiliates.com/ideas/fundamentals.htm 2. Research Affiliates, based on data from the U.S. Census and United Nations. 3. Arnott, Robert D., and Denis B. Chaves. 2012. Demographic Changes, Financial Markets, and the Economy. Financial Analysts Journal, vol. 68, no. 1 (January/February):23-46. http://www.researchaffiliates.com/ideas/pdf/FAJ_Jan_Feb_2012_Demographic_Changes_Financial_Markets_and_the_Economy.pdf 4. Arnott, Robert D., and Anne Casscells. 2003. Demographics and Capital Market Returns. Financial Analysts Journal , vol. 59, no. 2 (March/April):2029. http://www.researchaffiliates.com/ideas/pdf/FAJ_Mar_Apr_2003_Demographics_and_Capital_Market_Returns.pdf 5. In addition to the Fundamentals cited above, please see A Complete Toolkit for Fighting Inflation, June 2009; Are 401(k) Investors Fighting Yesterdays War? September 2010; and King of the Mountain, September 2011 6. For example, see the November 2010 Fundamentals, The Glad Game. 7. Arnott, Robert D., Jason C. Hsu, Feifei Li, and Shane D. Shepherd. 2010. Valuation-Indifferent Weighting for Bonds. Journal of Portfolio Management, vol. 36, no. 3 (Spring):117-130. http://www.iinews.com/site/pdfs/JPM_Spring_2010_Rallc.pdf
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Research Affiliates Newsletter February 2012

Performance Update
FTSE RAFI Equity Index Series*
TOTAL RETURN AS OF 1/31/12 BLOOMBERG TICKER YTD 12 MONTH -6.58% -2.97% -12.96% -8.88% -7.22% -9.00% -7.11% -6.35% 1.83% 3.95% 4.22% 1.15% 2.86% -11.54% -7.42% -5.81% -6.17% -6.37% -6.48% -17.55% -16.63% -1.25% 0.46% ANNUALIZED 3 YEAR 21.27% 18.21% 16.15% 14.16% 23.65% 22.46% 29.18% 27.60% 25.70% 20.01% 19.24% 32.18% 23.03% 14.53% 11.58% 12.09% 11.21% 18.32% 13.75% 1.41% 0.16% 16.30% 15.33% ANNUALIZED 5 YEAR 0.93% -0.48% -2.22% -2.70% 1.73% -1.71% 8.17% 5.16% 1.46% 0.55% 0.33% 4.13% 1.19% -4.28% -3.41% -0.83% -1.70% 3.08% 1.59% -12.52% -14.07% 0.94% 1.84% ANNUALIZED 10 YEAR 9.49% 5.65% 8.31% 6.21% 14.48% 10.90% 21.66% 15.05% 5.89% 3.97% 3.52% 10.39% 6.45% 3.18% 2.35% 6.94% 6.55% 8.60% 7.34% 0.96% -1.29% 5.22% 4.47% FTSE RAFI All World 30001 TFRAW3 5.59% MSCI All Country World2 GDUEACWF 5.84% FTSE RAFI Developed ex US 10003 FRX1XTR 5.79% MSCI World ex US Large Cap4 MLCUWXUG 5.28% FTSE RAFI Developed ex US Mid Small5 TFRDXUSU 6.92% MSCI World ex US Small Cap6 GCUDWXUS 8.27% FTSE RAFI Emerging Markets7 TFREMU 12.32% MSCI Emerging Markets8 GDUEEGF 11.36% FTSE RAFI 10009 FR10XTR 4.14% Russell 100010 RU10INTR 4.87% S&P 50011 SPTR 4.48% FTSE RAFI US 150012 FR15USTR 7.60% Russell 200013 RU20INTR 7.07% FTSE RAFI Europe14 TFREUE 4.53% MSCI Europe15 GDDLE15 3.46% FTSE RAFI Australia16 FRAUSTR 3.89% S&P/ASX 20017 ASA51 5.08% FTSE RAFI Canada18 FRCANTR 3.32% S&P/TSX 6019 TX60AR 4.37% FTSE RAFI Japan20 FRJPNTR 3.52% MSCI Japan21 GDDLJN 3.58% FTSE RAFI UK22 FRGBRTR 1.77% MSCI UK23 GDDLUK 1.96% *To see the complete series, please go to: http://www.ftse.com/Indices/FTSE_RAFI_Index_Series/index.jsp. ANNUALIZED 10 YEAR VOLATILITY 19.21% 17.52% 20.51% 18.63% 19.02% 20.59% 24.96% 24.47% 18.32% 16.20% 15.97% 22.91% 21.18% 19.26% 16.91% 13.19% 13.44% 14.27% 14.55% 18.49% 18.07% 17.11% 15.13%

Russell Fundamental Index Series*

TOTAL RETURN AS OF 1/31/12 BLOOMBERG TICKER YTD 12 MONTH ANNUALIZED 3 YEAR ANNUALIZED 5 YEAR 1.74% -0.52% -1.01% -2.70% 0.87% -1.71% 9.54% 5.16% 2.20% 0.55% 0.33% 5.33% 1.19% -1.85% -3.41% ANNUALIZED 10 YEAR 9.60% 5.09% 9.93% 6.21% 13.54% 10.90% 21.13% 15.05% 6.56% 3.97% 3.52% 11.24% 6.45% 6.03% 2.35% Russell Fundamental Global Index Large Company24 RUFGLTU 5.44% -3.75% 20.04% MSCI All Country World Large Cap25 MLCUAWOG 5.66% -2.71% 17.47% Russell Fundamental Developed ex US Index Large Company26 RUFDXLTU 5.62% -11.25% 14.35% MSCI World ex US Large Cap27 MLCUWXUG 5.28% -8.88% 14.16% Russell Fundamental Developed ex US Index Small Company28 RUFDXSTU 6.92% -6.29% 21.04% MSCI World ex US Small Cap6 GCUDWXUS 8.27% -9.00% 22.46% Russell Fundamental Emerging Markets29 RUFGETRU 12.30% -5.67% 30.53% MSCI Emerging Markets8 GDUEEGF 11.36% -6.35% 27.60% Russell Fundamental US Index Large Company30 RUFUSLTU 4.05% 4.09% 22.92% Russell 100010 RU10INTR 4.87% 3.95% 20.01% S&P 50011 SPTR 4.48% 4.22% 19.24% Russell Fundamental US Index Small Company31 RUFUSSTU 7.52% 2.47% 31.98% Russell 200013 RU20INTR 7.07% 2.86% 23.03% Russell Fundamental Europe32 RUFEUTE 5.63% -8.28% 16.03% MSCI Europe15 GDDLE15 3.46% -7.42% 11.58% *To see the complete series, please go to: http://www.russell.com/indexes/data/Fundamental/About_Russell_Fundamental_indexes.asp. ANNUALIZED 10 YEAR VOLATILITY 17.89% 17.18% 18.92% 18.63% 18.60% 20.59% 24.74% 24.47% 16.80% 16.20% 15.97% 21.60% 21.18% 18.16% 16.91%

Fixed Income/Alternatives
TOTAL RETURN AS OF 1/31/12 RAFI Bonds Investment Grade Master33 ML Corporate Master34 RAFI Bonds High Yield Master35 ML Corporate Master II High Yield BB-B36 RAFI US Equity Long/Short37 1-Month T-Bill38 FTSE RAFI Global ex US Real Estate39 FTSE EPRA/NAREIT Global ex US40 FTSE RAFI US 100 Real Estate41 FTSE EPRA/NAREIT United States42 BLOOMBERG TICKER C0A0 H0A4 GB1M FRXR EGXU FRUR UNUS YTD 2.08% 2.18% 3.00% 2.56% -1.24% 0.00% 8.95% 8.77% 7.87% 6.33% 12 MONTH 11.08% 9.60% 8.47% 6.09% -7.72% 0.04% -15.83% -11.54% 1.66% 7.25% ANNUALIZED 3 YEAR 12.17% 12.82% 23.05% 19.15% 13.51% 0.09% 18.38% 14.78% 33.42% 26.50% ANNUALIZED 5 YEAR 8.13% 7.03% 10.21% 7.05% 1.27% 1.14% -8.75% -10.02% -7.36% -6.73% ANNUALIZED 10 YEAR 6.81% 6.47% 9.65% 7.97% 4.82% 1.75% 9.04% 6.68% 4.88% 5.42% ANNUALIZED 10 YEAR VOLATILITY 6.08% 6.26% 10.97% 9.87% 11.75% 0.49% 23.35% 20.99% 27.83% 26.13%

Research Affiliates Newsletter February 2012

(1) The FTSE RAFI All World 3000 Index is a measure of the largest 3,000 companies, selected and weighted using fundamental factors; (sales, cash flow, dividends, book value), across both developed and emerging markets. (2) The MSCI All Country World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. (3) The FTSE RAFI Developed ex US 1000 Index is a measure of the largest 1000 non U.S. listed, developed market companies, selected and weighted using fundamental factors; (sales, cash flow, dividends, book value). (4) The MSCI World ex US Large Cap Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets, excluding the United States. (5) The FTSE RAFI Developed ex US Mid Small Index tracks the performance of small and mid-cap companies domiciled in developed international markets (excluding the United States), selected and weighted based on the following four fundamental measures of firm size: sales, cash flow, dividends and book value. (6) The MSCI World ex US Small Cap Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of small cap developed markets, excluding the United States. (7) The FTSE RAFI Emerging Markets Index comprises the largest 350 Emerging Market companies selected and weighted using fundamental factors (sales, cash flow, dividends, book value). (8) The MSCI Emerging Markets Index is an unmanaged, free-float-adjusted cap-weighted index designed to measure equity market performance of emerging markets. (9) The FTSE RAFI 1000 Index is a measure of the largest 1,000 U.S. listed companies, selected and weighted using fundamental factors; (sales, cash flow, dividends, book value). (10) The Russell 1000 Index is a market-capitalization-weighted benchmark index made up of the 1,000 highest-ranking U.S. stocks in the Russell 3000. (11) The S&P 500 Index is an unmanaged market index that focuses on the large-cap segment of the U.S. equities market. (12) The FTSE RAFI US 1500 Index is a measure of the 1,001st to 2,500th largest U.S. listed companies, selected and weighted using fundamental factors; (sales, cash flow, dividends, book value). (13) The Russell 2000 is a market-capitalization weighted benchmark index made up of the 2,000 smallest U.S. companies in the Russell 3000. (14) The FTSE RAFI Europe Index is comprised of all European companies listed in the FTSE RAFI Developed ex U.S. 1000 Index, which in turn is comprised of the largest 1,000 non U.S. listed developed market companies, selected and weighted using fundamental factors; (sales, cash flow, dividends, book value). (15) The MSCI Europe Index is a free-float adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe. (16) The FTSE RAFI Australia Index is comprised of all Australian companies listed in the FTSE RAFI Developed ex U.S. 1000 Index, which in turn is comprised of the largest 1,000 non U.S. listed developed market companies, selected and weighted using fundamental factors; (sales, cash flow, dividends, book value). (17) The S&P/ASX 200 Index, representing approximately 78% of the Australian equity market, is a free-float-adjusted, cap-weighted index. (18) The FTSE RAFI Canada Index is comprised of all Canadian companies listed in the FTSE RAFI Developed ex U.S. 1000 Index, which in turn is comprised of the largest 1,000 non U.S. listed developed market companies, selected and weighted using fundamental factors; (sales, cash flow, dividends, book value). (19) The S&P/Toronto Stock Exchange (TSX) 60 is a cap-weighted index consisting of 60 of the largest and most liquid (heavily traded) stocks listed on the TSX, usually domestic or multinational industry leaders. (20) The FTSE RAFI Japan Index is comprised of all Japanese companies listed in the FTSE RAFI Developed ex U.S. 1000 Index, which in turn is comprised of the largest 1,000 non U.S. listed developed market companies, selected and weighted using fundamental factors; (sales, cash flow, dividends, book value). (21) The MSCI Japan Index is an unmanaged, free-float-adjusted cap-weighted index that aims to capture 85% of the publicly available total market capitalization of the Japanese equity market. (22) The FTSE RAFI UK Index is comprised of all UK companies listed in the FTSE RAFI Developed ex U.S. 1000 Index, which in turn is comprised of the largest 1,000 non U.S. listed developed market companies, selected and weighted using fundamental factors; (sales, cash flow, dividends, book value). (23) The MSCI UK Index is an unmanaged, free-float-adjusted cap-weighted index that aims to capture 85% of the publicly available total market capitalization of the British equity market. (24) The Russell Fundamental Global Index Large Company is a measure of the largest companies, selected and weighted using fundamental factors; (adjusted sales, retained cash flow, dividends + buybacks), across both developed and emerging markets. (25) The MSCI All Country World Large Cap Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. (26) The Russell Fundamental Developed ex US Large Company is a subset of the Russell Fundamental Developed ex US Index, and is a measure of the largest non-U.S. listed developed country companies, selected and weighted using fundamental factors; (adjusted sales, retained cash flow, dividends + buybacks). (27) The MSCI World ex US Large Cap Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of large cap-developed markets, excluding the United States. (28) The Russell Fundamental Developed ex US Index Small Company is a subset of the Russell Fundamental Developed ex US Index, and is a measure of small non-U.S. listed developed country companies, selected and weighted using fundamental factors; (adjusted sales, retained cash flow, dividends + buybacks). (29) The Russell Fundamental Emerging Markets Index is a measure of Emerging Market companies, selected and weighted using fundamental factors; (adjusted sales, retained cash flow, dividends + buybacks). (30) The Russell Fundamental U.S. Index Large Company is a subset of the Russell Fundamental US Index, and is a measure of the largest U.S. listed companies, selected and weighted using fundamental measures; (adjusted sales, retained cash flow, dividends + buybacks). (31) The Russell Fundamental US Index Small Company is a subset of the Russell Fundamental US Index, and is a measure of U.S. listed small companies, selected and weighted using fundamental measures; (adjusted sales, retained cash flow, dividends + buybacks). (32) The Russell Fundamental Europe Index is a measure of European companies, selected and weighted using fundamental factors; (adjusted sales, retained cash flow, dividends + buybacks). (33) The RAFI Bonds Investment Grade Master Index is a U.S. investment-grade corporate bond index comprised of non-zero fixed coupon debt with maturities ranging from 1 to 30 years issued by publicly traded companies. The issuers held in the index are weighted by a combination of four measures of their fundamental sizesales, cash flow, dividends, and book value of assets. (34) The Merrill Lynch U.S. Corporate Master Index is representative of the entire U.S. corporate bond market. The index includes dollar-denominated investment-grade corporate public debt issued in the U.S. bond market. (35) The RAFI Bonds High Yield Master is a U.S. high-yield corporate bond index comprised of non-zero fixed coupon debt with maturities ranging from 1 to 30 years issued by publicly traded companies. The issuers held in the index are weighted by a combination of four measures of their fundamental sizesales, cash flow, dividends, and book value of assets. (36) The Merrill Lynch Corporate Master II High Yield BB-B Index is representative of the U.S. high yield bond market. The index includes domestic high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3, but are not in default. (37) The RAFI US Equity Long/Short Index utilizes the Research Affiliates Fundamental Index (RAFI) methodology to identify opportunities that are implemented through long and short securities positions for a selection of U.S. domiciled publicly traded companies listed on major exchanges. Returns for the index are collateralized and represent the return of the strategy plus the return of a cash collateral yield. (38) The 1-Month T-bill return is calculated using the Bloomberg Generic 1-month T-bill. The index is interpolated based off of the currently active U.S. 1 Month T-bill and the cash management bill closest to maturing 30 days from today. (39) The FTSE RAFI Global ex US Real Estate Index comprises 150 companies with the largest RAFI fundamental values selected from the constituents of the FTSE Global All Cap ex U.S. Index that are classified by the Industry Classification Benchmark (ICB) as Real Estate. (40) The FTSE EPRA/NAREIT Global ex US Index is a free float-adjusted index, and is designed to represent general trends in eligible listed real estate stocks worldwide, excluding the United State. Relevant real estate activities are defined as the ownership, trading and development of income-producing real estate. (41) The FTSE RAFI US 100 Real Estate Index comprises of the 100 U.S. companies with the largest RAFI fundamental values selected from the constituents of the FTSE USA All Cap Index that are classified by the Industry Classification Benchmark (ICB) as Real Estate. (42) The FTSE EPRA/NAREIT United States Index is a free float-adjusted index, is a subset of the EPRA/NARIET Global Index and the EPRA/NAREIT North America Index and contains publicly quoted real estate companies that meet the EPRA Ground Rules. EPRA/NARIET Index series is seen as the representative benchmark for the real estate sector.

Definition Indices: of

Source: All index returns are calculated using total return data from Bloomberg, except for the real estate indices and benchmarks, which use price return data. Returns for all single country strategies and Europe regional strategies are in local currency. All other returns are in USD.
2012 Research Affiliates, LLC. The material contained in this document is for general information purposes only. It relates only to a hypothetical model of past performance of the Fundamental Index strategy itself, and not to any asset management products based on this index. No allowance has been made for trading costs or management fees which would reduce investment performance. Actual results may differ. This material is not intended as an offer or a solicitation for the purchase and/or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. This material is based on information that is considered to be reliable, but Research Affiliates and its related entities (collectively RA) make this information available on an as is basis and make no warranties, express or implied regarding the accuracy of the information contained herein, for any particular purpose. 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Subject to Research Affiliates, LLCs intellectual property rights in certain content, Russell Investments is the owner of all copyrights related to the Russell Fundamental Indexes. Russell Investments and Research Affiliates, LLC jointly own all trademark and service mark rights in and to the Russell Fundamental Indexes. Research Affiliates, LLC is the owner of the trademarks, service marks, patents and copyrights related to the Fundamental Index and the Fundamental Index methodology. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination, or redistribution is strictly prohibited. This is a presentation of Research Affiliates, LLC. Russell Investments is not responsible for the formatting or configuration of this material or for any inaccuracy in Research Affiliates presentation thereof. The trade names Fundamental Index, RAFI, the RAFI logo, and the Research Affiliates corporate name and logo are registered trademarks and are the exclusive intellectual property of RA. Any use of these trade names and logos without the prior written permission of RA is expressly prohibited. RA reserves the right to take any and all necessary action to preserve all of its rights, title and interest in and to these marks. Fundamental Index concept, the non-capitalization method for creating and weighting of an index of securities, is patented and patent-pending proprietary intellectual property of RA. (US Patent No. 7,620,577; 7,747,502; 7,792,719; 7,778,905; and 8,005,740; Patent Pending Publ. Nos. US-2007-0055598-A1, US-2008-0288416-A1, US-2010-0191628, US-2010-0262563, WO 2005/076812, WO 2007/078399 A2, WO 2008/118372,EPN 1733352, and HK1099110). The views and opinions expressed are those of the author and not necessarily those of Research Affiliates, LLC. 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