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THE POLICY PENDULUM SWINGS

OUTLOOK2015

BUYING TIME

B

RIVERFRONT INVESTMENT GROUP

THE ART & SCIENCE OF DYNAMIC INVESTING.

RiverFront’s 2015 Economic Scenarios

and Market Forecasts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Portfolio Changes for 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Positioning US Portfolio for Slower Gains . . . . . . . . . . . 6

The Policy Pendulum Swings Overseas . . . . . . . . . . . . . . . 8

Not Chasing Yields Lower . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

THE POLICY PENDULUM SWINGS

1

RIVERFRONT INVESTMENT GROUP OUTLOOK 2015

THE ART & SCIENCE OF DYNAMIC INVESTING. 1


THE ECONOMY: Euro QE + Cheap oil = Stronger global growth. Our theme for 2015 — THE

POLICY PENDULUM SWINGS — is designed to capture our view that 2015 will see not only a policy swing

from the US to Europe, but also highlight that the global economic clock is always ticking. It is now six

years since markets bottomed and the global economy started to dig its way out of the ‘Great Recession’.

US policymakers were the first among major economies to recognize the deflationary risks posed by the

collapse of property prices and the global financial crisis. Their proactive stance has led to faster

economic growth, higher asset prices and a full recovery in corporate profits and profit margins. When

combined with a stronger dollar and cheap oil, we think non-US developed world growth will accelerate in

2015 and give a greater boost to share prices overseas than in the US, which has enjoyed decent growth

for several years. QE (Quantitative Easing) is central bank purchases of assets, primarily bonds.

US STOCKS: Time to rightsize expectations; the Fed’s pendulum is swinging away from extreme policy easing. We are bullish on US stocks, but we only expect single-digit annual returns

between now and the next US recession. If recession is many years away, as we expect, then we believe the

risk/reward tradeoff for stocks versus bonds or cash remains compelling. We expect the S&P 500 to rise to

around 2200 in 2015 with a potential trading range of 1870 to 2380 versus its current level of 2088.

Our portfolios will continue to favor industries and companies that can deliver superior, dependable

earnings growth relative to the market at reasonable prices. A few of these selection themes we have

chosen to position in the portfolios include: Large Caps over Small and Mid Caps: Large Caps are

more attractively valued and less sensitive to rising interest rates and falling commodity prices than

their Small and Mid Cap peers. Non-Rate Sensitive Dividend Stocks: We have a natural bias toward

dividend stocks especially when they are valued similarly to the broad market, as they are currently.

Consumer-Related: Strong payroll growth, rising wages, low interest rates and the rebate that comes

from falling energy prices should keep consumer spirits high in 2015 and spur spending.

INTERNATIONAL STOCKS: The policy pendulum swings overseas. During most of 2014 the

Federal Reserve continued its Quantitative Easing (balance sheet expansion) program while the ECB’s

(European Central Bank) balance sheet contracted as previous loans to banks rolled off and they did not

add to their holdings. 2015 will be very different, in our view. The Fed’s QE program has ended and they

are likely to raise interest rates in the next year. In contrast ECB chairman Mario Draghi has pledged to

add around 1 trillion euro in QE. We think this leads to a stronger dollar and better stock market returns

in Europe and Japan.

BONDS: Not chasing yields lower – overweight credit, keeping maturities short. At every point

along this year’s journey to lower yields, the risk/reward of buying long-term bonds continued to look

very poor to us. We know how pure momentum strategies can lead to whipsaw; so with our longer

term conviction favoring credit, we have not allowed momentum to drive our decisions. We believe

that buying 10-year Treasuries at 2.25% in the hope that they might fall to 1.75%, when their post-

WWII range is 2% to 16%, borders on irresponsibility. We have sought instead to add value through

credit selection. Short maturity high-yield bonds (5 years or less) currently yield 3 to 4 percentage

points more than the Barclays Aggregate Bond Index, where the weighted average maturity is 7 years.

HIGHLIGHTS

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In this year’s economic scenarios and market forecasts, when talking about equity market ranges we

are including the US, EAFE and Emerging Markets. For example, in our BASELINE scenario, we are

calling for the US stock market to return 5%-10%, and EAFE to rise 15%-20% in local currency terms.

In our OPTIMISTIC scenario, we expect stock markets to return 10%-25% with EAFE outperforming.

In our PESSIMISTIC scenario, we anticipate a decline in stock markets of 10%-25% with Emerging

Markets underperforming.

RiverFront’s 2015 Economic Scenarios and Market Forecasts

PESSIMISTIC BASELINE OPTIMISTIC

Europe & China: too little, too late

Euro QE + Cheap Oil Return of the US Consumer

4.25

Up 15% vs. Europe, up 5% vs. Japan and EM

Fed raises rates faster than anticipated

US, EM: 10 to 15 EAFE*: 20 to 25

ECB QE plus accelerating exports to US

3.00

Up 10% vs. Europe, up 5% vs. Japan and EM

Low gas prices spur consumption

US, EM: 5 to 10 EAFE*: 15 to 20

ECB embraces QE

1.25

Unclear vs. Europe/Japan, up 20% vs. EM

US pulled down with rest of world

US, EAFE*: -10 to -20 EM: -15 to -25

Europe fails to contain deflation

3.63.00.7US GDP (% YEAR- OVER-YEAR GROWTH)

30%

Slight recovery to $60 to $80

55%

Stabilizes at $50 to $70

15%

$40 or below

PROBABILITY

OIL PRICES

US 10-YEAR BOND YIELDS (%)

DOLLAR

POLICY OUTCOME US

LOCAL CURRENCY STOCK MARKET RANGE (%)

POLICY OUTCOME EU (EUROZONE)

Rising tide lifts EM economiesChina buys timeChina hard landing;

Russian defaultPOLICY OUTCOME EM (EMERGING MARKETS)

* Europe, Asia, Far EastSource: RiverFront Investment Group

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Our theme for 2015 — THE POLICY PENDULUM SWINGS — is designed to

capture our view that 2015 will see not only a policy swing from the US to

Europe, but also highlight that the global economic clock is always ticking.

It is now six years since markets bottomed and the global economy started to

dig its way out of the ‘Great Recession’. US policymakers were the first among

major economies to recognize the deflationary risks posed by the collapse of

property prices and the global financial crisis. Their proactive stance has led

to faster economic growth, higher asset prices and a full recovery in

corporate profits and profit margins. Japan followed suit in 2013 and the

Nikkei has now caught up with the Dow, both having bottomed around the

same level. Just as the US is backing off its highly aggressive stance, Europe

seems poised to act somewhat more assertively. When combined with a

stronger dollar and cheap oil, we think non-US developed world growth will

accelerate in 2015 and give a greater boost to share prices overseas than in the

US, which has enjoyed decent growth for several years.

The table on the previous page links our three scenarios (PESSIMISTIC,

BASELINE and OPTIMISTIC) with the major policy issues that we believe will

have the greatest impact on the global economy in 2015. As a result we

focus on the biggest economic blocks: US, Europe and Emerging Markets.

Our assessment of each scenario’s probability is also shown. Each scenario

includes our expectations for GDP, stocks, interest rates and the dollar.

Our baseline scenario envisages a significant acceleration in US consumer

spending, as lower unemployment translates into faster wage gains; and

collapsing oil prices puts more of that money in consumers’ pockets. Energy

investment spending is likely to decline sharply along with oil prices, but a

stronger US consumer and recent mortgage market reforms should prompt

an offsetting acceleration in the housing market, in our opinion.

Although we believe the Fed is likely to raise rates at some point in 2015,

reduced inflationary pressures (thanks to oil) will allow these increases to be

lower and come later than would otherwise be the case. Lower energy prices

will also allow for more aggressive monetary stimulus in developed international

economies and China, further improving their growth prospects, in our opinion.

We place a high probability on our baseline and optimistic scenarios (85%)

and thus a very low probability on a global recession. With China now seeking

ways to improve growth, all the world’s major economic blocks are seeking

faster growth. We think this favors stocks over bonds.

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Portfolio Changes for 2015

“Price Matters®” is our firm mantra and forms the centerpiece of RiverFront’s methodology for estimating

expected returns. Following the gains in US stocks and the weakness in many overseas stock markets,

our US long-term return expectations are lower, our expected returns from international markets are

higher AND the risks of negative returns at the three and five-year time horizons have risen and so

need to be mitigated. In all our portfolios, but especially in our seven and ten-year portfolios, we will

continue to favor international markets. However, with interest rates so low, the cost of seeking to

ensure safety of principal over shorter timeframes has increased. In our opinion, this can be overcome

by slightly lower stock weightings and greater use of short maturity high-yield bonds. Furthermore, in

the event of an unexpected significant decline in stocks, these shorter timeframe strategies will have

plenty of scope to increase stock weightings.

US STOCKS: TIME TO RIGHTSIZE EXPECTATIONS; FED PENDULUM MOVING SLOWLY AWAY FROM EXTREME POLICY EASING

We are bullish on US stocks, but we only expect single-digit annual returns between now and the

next US recession. If recession is many years away, as we expect, then the risk/reward tradeoff for

stocks versus bonds or cash remains compelling. We anticipate a prolonged, but slow expansion

due to global disinflationary forces (excess supply of labor, capital goods, and some commodities).

A subpar global expansion should keep interest rates lower for longer, but will also suppress earnings

growth, especially in countries such as the United States, where margins are near record highs. We

believe the S&P 500’s 6.1% earnings growth trend is sustainable (see chart below), due to the many

globally focused companies in the index and the growth from developing economies — especially

China and India. However, we do not expect earnings growth to be better than its 80-year average.

S&P 500 REPORTED

EARNINGS AND

LONG-TERM TREND

S&P estimates after

September 2014.

Past performance is no

guarantee of future results.

Source: RiverFront Investment

Group, Standard & Poor’s.

FORECAST EARNINGS ARE WELL ABOVE TREND

1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

$128.0

6.1% Trend

$64.0

$32.0

$16.0

$8.0

$4.0

$2.0

$1.0

$0.5

Trend Earnings2012: $78.312013: $83.112014: $88.212015: $93.62

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Standard & Poor’s estimate for the S&P 500’s earnings per share (EPS) at the end of 2015 is

$135. Trend earnings for the same period is $93.62; thus, expectations are that earnings will

be 44% above trend. As the thin grey line above the earnings trend in the chart on page 4 shows,

that would be roughly as far above trend as earnings have been in the last 80 years, which makes

the projected price-to-earnings ratio (PE) of 15.1 misleading. Because earnings have persistently

returned to trend, we prefer to calculate the PE on forward trend earnings to gauge longer-term

investor sentiment. This is shown in our chart below.

With the long-term earnings trend of 6.1%, we can show how much investors have been willing to

pay, in the past, for one-year forward trend earnings. In the stock bubble of the late 1990s, when

actual earnings were well above trend, investors paid $39 for a dollar of trend earnings (see A). By

contrast in 2009, when actual earnings were significantly below trend, investors were only willing

to pay $10 (see B). Such are the swings in investor emotion. Following the S&P 500’s significant

gains over the last two years, the latest price to forward trend earnings ratio is 22, a level

frequently seen between 2004 and 2006.

Our chart shows that valuation changes significantly through time, making it a blunt and imprecise

instrument with which to make forecasts. This is why shorter-term forecasting is so challenging:

one must not only forecast earnings, but also the multiple of earnings that investors will pay.

Assuming that 20 times trend earnings (the October low) is a floor and 24 times forward trend

earnings (the high from 2004 until 2007) is a ceiling, the S&P 500 should trade between 1870

and 2380 next year, compared to the current level of 2088, in our opinion. Our baseline

scenario is for stocks to rise approximately in line with trend earnings and remain at

current multiples for single-digit returns over the next year.

UPSIDE CONSTRAINED BY VALUATIONS&P 500 WITH

TRENDLINES BASED ON

PE MULTIPLES OF 1-YEAR

FORWARD TREND

REPORTED EARNINGS




Group, Standard & Poor’s.

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18

400

500

600

700

800

900

1000

1100

1200

1300

1400

1500

1600

1700

1800

19002000210022002300

18X

16X

20X

24X22X

12X

14X

A

B

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POSITIONING PORTFOLIOS FOR SLOWER GAINS

When we consider the prospects for US equities over the next few years, we are reminded a little

of the domestic market environment for stocks from 2004 to 2007. These were the digestion years

that followed the initial rebound from the technology crisis of 2000-2002. The ‘easy’ gains for stocks

that were spurred on by attractive valuations were in the rear-view mirror, and further gains became

increasingly dependent on earnings growth and could not be supported by additional valuation

multiple expansion.

The old adage that history never repeats itself but often rhymes is certainly applicable to today’s

market conditions. That is because, while there are some similarities between the mid-2000’s and

today, there are also many differences. A decade ago, growth across the developing world was

accelerating, kicking off a commodity super-cycle with broad positive implications for many

companies in the energy, basic materials and industrial sectors. Additionally, there was a

significant increase in financial leverage across the economy, which amplified returns across many

industries, particularly Small and Mid Cap stocks, due to a red-hot mergers and acquisitions

environment. It is difficult to see either condition being repeated to the same degree in 2015; as a

result, we must be selective in finding opportunities.

SELECTION MATTERS

With our baseline assumptions not anticipating valuation multiple expansion, security selection

should become increasingly important since earnings growth rates and risks will vary across industries

and companies. This means that although we believe broad market index returns will be single

digit, opportunities for better returns exist underneath the surface. Our portfolios will continue to

favor industries and companies that can deliver superior, dependable earnings growth relative to

the market at reasonable prices.

2015 THEMES:

Large Caps over Small and Mid Caps: Large Caps are more attractively valued and less sensitive

to rising interest rates and falling commodity prices than their Small and Mid Cap peers. However, they

are also more exposed to economies outside the United States and could be hurt by a strong US dollar.

For this reason, we think success in 2015 will be a function of being more creative in our approach

to Large Caps, which will likely involve a move to more targeted Large Cap securities and indexes.

Non-Rate-Sensitive Dividend Stocks: We have a natural bias toward dividend stocks, especially

when they are valued similarly to the broad market, as they are currently. Our bias toward dividend

stocks stems from the fact that they have historically been better stewards of shareholder capital

than their non-dividend paying peers. We believe this trait of being a good steward of capital will

become increasingly important as the siren song of low interest rates tempts the undisciplined into

stupid acquisitions, or other historic destroyers of shareholder capital. Similar to our Large Cap

implementation strategy, we believe its important to be ‘picky’ when buying dividend indexes or

stocks. A large portion of the dividend stock universe, such as Real Estate Investment Trusts (REITs)

and Utilities, are interest rate sensitive and will likely underperform if interest rates rise as they

did in 2013.

Consumer-Related: Strong payroll growth, rising wages, low interest rates and the rebate that

comes from falling energy prices should keep consumer spirits high in 2015 and spur spending.

• Homebuilders: We see the homebuilders as the greatest beneficiaries of this trend, since more

plentiful jobs and rising wages have nearly always led to a rising demand for homes. We do not buy

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into the thesis that the millenial generation is ‘different’ and are lifetime renters. Instead, we believe

that the severe economic recession experienced after the financial crisis caused a delay in household

formation and temporarily disrupted the typical home-buying patterns of Americans. Eventually,

first-time buyers will come back to the market for the same reasons they have for generations.

• Consumer Services: While we view the homebuilders as the greatest beneficiary, the consumer

service companies will probably be the most immediate. This includes retailers, restaurants, auto

repair, credit card and other related companies. From a simplistic point of view, the companies

that should benefit from job growth, wage growth and cheaper gas are those companies that

cater to the most financially strapped consumers. It was these consumers that were most

affected when jobs were scarce, wages were suppressed and gasoline prices were rising, so

it stands to reason that they should be the first to benefit as these trends reverse. To that

end, we have positioned our portfolios in consumer-related companies that include credit card

issuers, supermarket and drug stores, dollar retailers and the auto repair industry.

Energy, a 2015 ‘dark horse’: Low Energy Prices have historically been the cure for Low Energy

Prices. However, the natural forces that bring supply and demand back into balance nearly always

take time. If oil prices stay low, energy producers will ultimately accept the new reality and respond

by cutting production. If and when this occurs, supply and demand will come back into balance and

oil prices will begin to move back toward the cost of production, which we believe exceeds $70 a

barrel. Somewhat higher oil prices should lead to higher prices for energy stocks. Recognizing that

the balancing process between supply and demand will take time, we have positioned our

portfolios in high-quality oil and gas infrastructure companies and Master Limited Partnerships

(MLPs) to ‘wait it out’. Since these companies operate pipelines and storage facilities, they are

less exposed to volatile commodity prices and they pay attractive dividends (4-6%) while you wait.

As 2015 progresses, we anticipate moving into those industries more sensitive to commodity prices,

such as those operating in the oilfield services or exploration and production industries.



Source: Intrinsic Research

LARGE CAP ENERGY STOCKS ARE NEAR HISTORICAL VALUATION FLOORS

Current price to tangible book = 1.4

BUYING TIME

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International: The Policy Pendulum Swings Overseas

During most of 2014 the Federal Reserve continued its Quantitative Easing (balance sheet expansion)

program while the ECB’s (European Central Bank) balance sheet contracted as previous loans to

banks rolled off and they did not add to their holdings. 2015 will be very different, in our view. The

Fed’s QE program has ended and they are likely to raise interest rates in the next year. In contrast

ECB chairman Mario Draghi has pledged to add around 1 trillion euro in QE. We think this leads to a

stronger dollar and better stock market returns in Europe and Japan.

2007 2008 2009 2010 2011 2012 2013 2014 2015

80

70

60

50

40

30

20

10

0

Projection

Bank of Japan

ECB

Federal ReserveBank of England

UNPRECEDENTED STIMULUS — JAPAN’S QE PROGRAM DWARFS THAT OF THE US

TOTAL CENTRAL BANK

ASSETS (% OF GDP)

Source: Thomson

Reuters Datastream



JAPAN

Currencies are often accurate barometers of policy action and we believe the dollar’s rise versus

the yen (see top chart on page 9) is accurately reflecting the unprecedented determination of the

Abe administration to reignite a recovery in economic growth and corporate earnings. Both charts

on page 9 show the policy is working.

In a world of zero interest rates, we believe the best way to measure central bank policy is to look

at its balance sheet as a percentage of the size of the economy. The policy known as Quantitative

Easing has been used in varying degrees by all developed central banks to support overly

indebted economies. We think it is no coincidence that the US and Japan have seen earnings

growth, whereas the Eurozone has been unable to revive the corporate sector. We also think

Europe is in the process of changing policy to a more pro-growth stance.

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120

110

100

90

80

70

60

120

110

100

90

80

70

602010 2011 2012 2013 2014

US DOLLAR INDEX EURO TO US $ JAPANESE YEN TO US $

DOLLAR SOARS VERSUS YEN; CLOSE TO BREAKOUT VERSUS EURO

Source: Thomson

Reuters Datastream



NIKKEI HAS CAUGHT UP WITH DOW FOLLOWING JAPAN’S QE AND YEN DECLINE

Source: Thomson

Reuters Datastream



BUYING TIME

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EUROPE

Europe’s balance sheet has contracted in the last two years as chairman Draghi has, until recently,

been unable to convince his colleagues on the ECB, especially the Germans, that a similar focus

on growth and liquidity was necessary to prevent the Eurozone growth remaining moribund. In the

last six months, however, the euro has also begun to weaken against the dollar and the dollar

index appears to be breaking out to new highs following a long consolidation. We believe the euro

is correctly anticipating a much more assertive central bank and Draghi now has a stated goal,

supported by a majority of ECB governors, to add 1 trillion euro to the ECB balance sheet just as

the US has ended its QE program. Here is his commitment to support growth: “We will do what

we must to raise inflation and inflation expectations as fast as possible, as our price-

stability mandate requires... If on its current trajectory our policy is not effective enough to

achieve this, or further risks to the inflation outlook materialize, we would step up the

pressure and broaden even more the channels through which we intervene, by altering

accordingly the size, pace and composition of our purchases.”

Stocks and earnings follow QEEarnings in Europe explain why its stocks have underperformed. Following the initial revival in

2010, US and European earnings have opened up a significant gap, one that we believe is about

to start closing. The third quarter offered some encouraging evidence with European earnings

outpacing those in the US, as euro weakness started to kick in for companies with significant

operating leverage. Japan, by contrast, has out-earned the US in the last few years, which we

believe explains why Japanese stocks, in yen terms, have responded.

EARNINGS IN EUROPE ARE AT CYCLICAL LOWS IN CONTRAST TO THE US AND JAPAN…

Source: Thomson

Reuters Datastream

Past performance is no guarantee

of future results.

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…WHICH EXPLAINS WHY EUROPE HAS LAGGED SINCE MID 2011

Source: Thomson

Reuters Datastream



EMERGING MARKETS: HURT BY WEAK COMMODITY PRICES AND STRONG DOLLAR

We expect emerging markets (EM) to have a difficult time in 2015, and are forecasting total return

and reward-to-risk ratios that are inferior to developed international stocks for the upcoming year.

However, this broad view comes with an important nuance; we strongly favor emerging Asia over

Latin America, Africa, and Eastern Europe. This preference is primarily due to the differing effects

that commodity prices, changes in US interest rates, and currency fluctuation will have on Asia

versus the rest of EM. We also believe that structural economic reform is more likely to take hold

in Asia than in other emerging areas.

The largest Latin American countries are all significant commodity exporters. Thus, Latin American

equities and currencies have historically been positively correlated with commodity prices and,

inversely, with the US dollar. As our chart shows on page 12, Latin America outperformed the US

during the commodity boom of the 2000s. This was a period when China demand was surging,

thereby improving LATAM trade balances. The result was stronger currencies and declining

inflation. All that has changed and the forces that were working in their favor are now working

against them.

BUYING TIME

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THE RELATIVE PERFORMANCE OF LATIN AMERICA IS CLOSELY TIED TO COMMODITY PRICES

REFORM: HOPE FOR ASIA, A WASTED OPPORTUNITY FOR LATIN AMERICA

As in developed markets, emerging markets are dividing themselves into those willing or unwilling

to take on structural reform. In 2014, emerging markets witnessed a number of major presidential

elections with the ability to meaningfully shape future economic policy. In Asian areas like India

and Indonesia, market-friendly, reform-minded candidates won the day, boosting stock markets

and hope for the future. This contrasts with Latin American geographies like Chile and Brazil,

where the sway of populism proved just too compelling for the electorate. While we are adopting a

‘wait-and-see’ attitude towards both India and Indonesia’s reform efforts, we believe that each is a

major step in the right direction. Specifically, India finds itself in a much more stable situation than

just a year ago, with an improved current account balance and a more benign inflation outlook, as

well as a growth-minded leader.

Source: Thomson

Reuters Datastream;

Bloomberg



13



CHINA: THE X-FACTOR

Harder to gauge is the extent of China’s slowdown in 2015, and how much of China’s own reform

initiatives may be sidelined as a result. Economic consensus appears to be gravitating to a lower

growth target of 7% from 7.5%, which would constitute a ‘soft landing’. However, belying such a

relatively gradual slowdown is a major structural rebalancing away from heavy industry and

property investment to services and consumption as the drivers for Chinese growth. In our view,

successful structural reforms and rebalancing in China would be positive for EM in general over

the long run and Asia in particular, given China’s large weighting and outsized influence. However,

we are also cognizant of the risks involved if the credit boom evident in China — which Chinese

authorities have only succeeded at slowing, not safely defusing — is mismanaged and were to

start unraveling.

For now, it looks as if China’s credit risk is contained, but our conviction level that it will stay this

way throughout 2015 is lower than we’d like. This dynamic is likely to keep China’s central bank

and government on their recent path of more accommodative monetary policy, as evidenced by

recent targeted stimulus and rate cuts. These measures, combined with China equities’ low

valuation relative to history, suggest Chinese markets could potentially be a positive surprise in

2015 despite negative headlines, though longer-term trends are cloudy and will depend on the

government’s willingness to continue to structurally reform and liberalize market policies.

FAVORED EM MARKETS: Emerging Asia, with an emphasis on North Asia and India

UNDERWEIGHTS: Brazil, South Africa, Russia, Turkey

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Bonds: Not Chasing Yields Lower — Overweight Credit; Maturities Short

At every point along this year’s journey to lower yields, the risk/reward of buying long-term bonds

continued to look very poor to us. We know how pure momentum strategies can lead to whipsaw;

so with our longer term conviction favoring credit, we have not allowed momentum to drive our

decisions. We believe that buying 10-year Treasuries at 2.25% in the hope that they might fall to

1.75%, when their post-WWII range is 2% to 16% (see chart below), borders on irresponsibility.

We have sought instead to add value through credit selection. Short maturity high-yield bonds

(5 years or less) currently yield 3 to 4 percentage points more than the Barclays Aggregate Bond

Index, where the weighted average maturity is 7 years. We think their shorter maturities and

higher yields means they will outperform in 2015.

10-YEAR US

TREASURY YIELD.

In percentage points.




Group, Federal Reserve

EXTREMELY LOW RATES = POOR RISK/REWARD

’40 ’45 ’50 ’55 ’60 ’65 ’70 ’75 ’80 ’85 ’90 ’95 ’00 ’05 ’10

15

13

11

9

7

5

3

1

Over the past 15 years, investors have witnessed the end of long bull markets in both US

equities and real estate. While the timing hinges on the magnitude of global growth, current

global bond yields are set up for either a prolonged period of low returns (the best case in our

view) or outright negative returns. Subtracting inflation only makes the outlook worse. This is a

time for managing risks and trying to preserve purchasing power, in our view, and not a time to

chase price momentum.

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We continue to believe that investment success in this challenging interest rate environment

will require a flexible, tactical approach to managing fixed income portfolios. Historically, many

equity and real estate holders who did not sell during bear markets eventually saw their portfolios

recover. Even when a bond portfolio ultimately recovered its nominal value following a bear market,

its losses relative to inflation were permanent. Thus, fixed income investors may have an even

greater need for tactical risk management strategies than equity investors.

RIVERFRONT’S TACTICAL APPROACH TO FIXED INCOME

Tactical fixed income management requires the flexibility to significantly alter the maturity structure

of a portfolio. Maturities can be shortened when there is an overwhelming risk of rising rates and

lengthened during periods of perceived interest rate and price stability. Additionally, RiverFront’s

tactical mandate permits substantial variation in credit quality and currency composition,

encompassing a wide spectrum of fixed income markets.

Our flexible approach contrasts sharply with common fixed income portfolio practice, which typically

restricts managers to a narrow range of maturities, sectors, and/or credit quality. Buy and hold

fixed income strategies have been successful during the 30-year bond bull market. We believe a

tactical fixed income strategy will now be required.

RiverFront’s Price Matters® process for estimating potential returns and downside risks is the

primary driver of our fixed income strategy. With interest rates near record lows, our Price Matters

calculations indicate a nearly 100% probability that longer-maturity bonds will lose money relative

to inflation over the next ten years. This is similar to the level of overvaluation equities reached at

the end of the 1999-2000 technology bubble. Therefore, we are prepared for an extended period

of poor returns from most fixed income investments, and our current strategy is primarily focused

on capital preservation.

TWO STRATEGIES TO COMPENSATE FOR LOW YIELDS AND LOW POTENTIAL RETURNS

The challenge presented by a short maturity bond strategy is that short investment grade bonds

have low yields and potential returns are low. We are currently using the following strategies to

help us compensate.

1 Allow Bonds To Mature

First, we do not manage our fixed income portfolio to a constant maturity, unlike typical

bond funds or ETFs; we can allow our bonds to mature. A 3-year bond that has aged into a

2-year bond is typically priced at a lower interest rate. This provides a modest price appreciation

that adds incremental return to the yield as the bond “rolls down” the yield curve.

An added benefit of allowing bonds to mature is that bonds get less risky as they

approach maturity. This offers some protection from rising interest rates but will be

especially important in our high-yield portfolios where we place a strong emphasis on

minimizing defaults.

16



2 Short Maturity High-Yield Bonds

Short maturity high-yield bonds are the second and, in our view, more powerful

augmentation to our strategy. As our chart shows, this strategy under-performed in 2014

as yields on high-yield bonds rose. From current yields, we believe the case is even more

compelling as we believe defaults in the next few years will end up being very low. The

energy sector is a potential exception, but our exposure here is very low. With yields on

short maturity bonds now comparable to those of longer maturity in the high-yield sector,

we find them very attractive as we believe they have less interest rate and credit risks.

Companies have issued record amounts of high-yield debt and amassed substantial cash reserves

thanks to the liquidity provided by QE. In many cases, high-yield borrowers have more than enough

cash to pay off all of their short-maturity bonds. Therefore, we believe that short maturity high-

yield bonds have far less risk than their ratings suggest. With low interest rate and credit risks and

yields of up to 6%, we think short maturity high-yield bonds are the most attractive investment in

the fixed income markets.

12/31/2012 6/30/2013 12/31/2013 6/30/2014 DATE

Yie

ld to

Wor

st

7.50

7.20

6.90

6.60

6.30

6.00

5.70

5.40

5.10

4.80

4.50

4.20

Short maturity High-Yield (0-5 years)All maturity High-Yield (0-10 years)

YIELD-TO-WORST (YTW)

The lowest of a bond’s

yield to maturity or

its yield to all possible

call dates.

Source: Bank of America

Merrill Lynch

RARE OPPORTUNITY: SHORT MATURITY NOW YIELDS THE SAME AS LONG

17



RiverFront’s Price Matters® discipline compares inflation-adjusted current prices relative to their long-term trend to help identify extremes in valuation.

Dividends are not guaranteed and are subject to change or elimination.

Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability.

Small, Mid, and Micro Cap companies may be hindered as a result of limited resources or less diverse products or services and have therefore historically been more volatile than the stocks of larger, more established companies.

There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations and the impact of varied economic conditions.

MLP investing includes risks such as equity and commodity like volatility. Also, distribution payouts sometimes include the return of principal and, in these instances, references to these payouts as “dividends” or “yields” may be inaccurate and may overstate the profitability/success of the MLP. Additionally, there are potentially complex and adverse tax consequences associated with investing in MLPs. This is largely dependent on how the MLPs are structured and the vehicle used to invest in the MLPs. It is strongly recommended that an investor consider and understand these characteristics of MLPs and consult with a financial and tax professional prior to investment.

In a rising interest rate environment, the value of fixed-income securities generally declines.

High-yield securities are subject to greater risk of loss of principal and interest, including default risk, than higher-rated securities.

Technical analysis is based on the study of historical price movements and past trend patterns. There are also no assurances that movements or trends can or will be duplicated in the future.

Exchange Traded Funds (ETFs) are sold by prospectus. Please consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus or summary prospectus, which contains this and other information, can be obtained by calling your financial advisor. Read it carefully before you invest.

RiverFront Investment Group, LLC, is an investment advisor registered with the Securities Exchange Commission under the Investment Advisors Act of 1940. The company manages a variety of portfolios utilizing stocks, bonds, and exchange-traded funds (ETFs). Any discussion of the individual securities that comprise the portfolios is provided for informational purposes only and should not be deemed as a recommendation to buy or sell any individual security mentioned.

Riverfront is affiliated with Robert W. Baird & Co., member FINRA/SIPC, from its minority ownership interest in RiverFront.

Opinions expressed are current as of the date shown and are subject to change. They are not intended as investment recommendations.

RiverFront’s expectations and outlook discussed in this piece are based on information that is currently available to us, and in no way are a guarantee of how our strategies, the markets, or specific securities will perform in the future.

Published on December 26th, 2014 | © 2014 RiverFront Investment Group, LLC

IMPORTANT DISCLOSURES

INDEX DEFINITIONS

It is not possible to invest directly in an index

The Standard & Poor’s (S&P) 500 Index measures the performance of 500 large cap stocks, which together represent about 75% of the total US equities market.

Barclays US Aggregate Bond Index — an unmanaged index that covers the investment grade fixed rate bond market with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. The issues must be rated investment grade, be publicly traded, and meet certain maturity and issue size requirements.

Dow Jones Industrial Average Index – measures the stock performance of thirty leading blue-chip U.S. companies.

Nikkei 225 Stock Index is a stock market index for the Tokyo Stock Exchange (TSE)

Bloomberg – Spot Commodity Index (formerly known as Dow Jones-UBS Commodity Spot Index) measures the price movements of commodities included in the Bloomberg Commodity Index and select subindexes.

INVESTMENT

Tim Anderson, CFA® [email protected]

Rebecca Felton [email protected]

Rob Glownia, CFA® [email protected]

Adam Grossman, CFA® [email protected]

Michael Jones, CFA® [email protected]

Chris Konstantinos, CFA® [email protected]

Ken Liu [email protected]

Paul Louie [email protected]

Deva Meenakshisundaram, FRM [email protected]

Kevin Nicholson, CFA® [email protected]

Bill Ryder, CFA®, CMTTM

[email protected]

Doug Sandler, CFA® [email protected]

Rod Smyth [email protected]

Sam Turner, CMTTM [email protected]

SALES & MARKETING

Bart Farinholt [email protected]

Tyler Finney [email protected]

Brian Gaertner, CIMA® [email protected]

Brian Glavin [email protected]

Chakira [email protected]

Beth Johnson [email protected]

Jim Martin, CIMA® [email protected]

Stuart Porterfield [email protected]

Pete Quinn [email protected]

Brad Wear, CDFA®, CFS® [email protected]

Kathy Wommack

[email protected]

TECHNOLOGY & INNOVATION

Marc Cheatham [email protected]

Shane McNamee [email protected]

OPERATIONS & TRADING

Willene Bellamy [email protected]

Karrie Southall, CIPM® [email protected]

Sam S. Turner [email protected]

Will Wall [email protected]

ADMINISTRATION

Tia Abrams [email protected]

Karen Basalay [email protected]

Heather Houser [email protected]

Lora Scott [email protected]

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RIVERFRONT INVESTMENT GROUP –

The art & science of dynamic investing.

1214 East Cary Street, Richmond, Virginia 23219 TEL 804) 549-4800 TOLL FREE 866) 583-0744 RIVERFRONTIG.COM | http://linkd.in/1oF5kER | @RiverFrontIG

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