INVESTED. TOGETHER.®

i

WINTER 2018

ALSO IN THIS ISSUE:

Managing success: How do active managers handle increasing AUM?

4 What are reasonable outcomes to expect from a target date glide path?

10 Is the active management community diverse enough?

12 Q&A: Enhancements in factor-based portfolio construction

Russell Investments

Russell Investments Communiqué p / 2

EXECUTIVE VIEW

3 Success by Ten, Chapter three By: Bryan Weeks, CFA, Head of Americas Institutional

INVESTMENT FOCUS

4 What are reasonable outcomes to expect from a target date glide path?

By: Steve Murray, Ph.D., CFA, Head of Defined Contribution Solutions and Ly Tran, Ph.D.,

Research Analyst

Participants in 401(k) plans and plan sponsors may be challenged to understand whether their future savings and investment plans are consistent with their planned retirement income. In this article, we investigate a simple approach to compare the ambitiousness of the participant’s plan with the reality of growth available from existing target date solutions.

CLIENT FOCUS

7 Managing success: How do active managers handle increasing AUM?

By: Leola Ross, Ph.D., CFA, Director, Investment Strategy Research, John Forrest, CFA, Head, Research Practice and Yuki Xi, Ph.D., Portfolio Analyst

When market impact, costly trading and illiquidity are constantly nipping at active managers heels, how do they manage their success? Through our years of manager research, since 1969, we’ve identified some of the better techniques used by managers to increase their chances of success. This article lists these seven techniques to effectively accommodate AUM growth.

OPINION

10 Is the active management community diverse enough? By: Megan Roach, CFA, Portfolio Manager

This article explores the collective actions of diversity and their effect on active and passive portfolio management. The three factors of active management diversity explored include: the use of factor exposures, investment professionals’ varied experiences and backgrounds, and their job incentives.

Q&A

12 Enhancements in factor-based portfolio construction With: Evgenia Gvozdeva, Ph.D., Senior Quantitative Research Analyst and Nick Zylkowski, CFA,

Portfolio Manager

There has been a growing emphasis on factor exposure management (smart beta) in recent years. In this interview, Evgenia Gvozdeva and Nick Zylkowski discuss the portfolio optimization techniques to support dynamic factor allocations and constructing more concentrated factor portfolios.

14 GREAT MOMENTS IN FINANCIAL HISTORY

301: Diocletian tries (and fails) to regulate inflation By: Tom Llewellyn, Director, Content Marketing

15 RESEARCH FOCUS

Latest research

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Bryan Weeks

EXECUTIVE VIEW

Success by Ten, Chapter threeBy: Bryan Weeks, CFA, Head of Americas Institutional

I was lucky enough to join Russell Investments when George Russell was still at the helm and showing us how to build a business. One of the keys, George taught, was to “simply” hire people who are smarter than you are. A few years ago, when George sat down to write a collection of the lessons he'd learned throughout his career, he dedicated an entire chapter to this principle.

In this issue of Communiqué, we have authors who certainly fit George's definition (from my perspective, at least) writing on investment topics that all touch on the subject of success. Megan Roach looks at diversity in the investment management community, and questions whether that community is positioned for success. Steve Murray and Ly Tran examine target date glide paths and the constituent design and return elements needed to produce a successful outcome. Leola Ross, John Forrest, and Yuki Xi take an objective look at the perils of success in the realm of active management, analyzing the performance impact of a manager’s growing base of assets under management in a variety of asset classes.

Rounding out this issue, we take a look at factor-based portfolio construction and at one Roman emperor’s (painfully unsuccessful) attempt to control inflation through the use of the death penalty.

I hope you find these articles as insightful as I have. To me, they also serve as evidence that George’s wisdom and his hiring and developing philosophy remain deeply ingrained in the DNA of our firm.

Wishing you great success in 2018,

Bryan Weeks

For more insights, subscribe to our Fiduciary Matters blog

Russell Investments Communiqué p / 4

Ly Tran

INVESTMENT FOCUS

401(k) participants and plan sponsors may be challenged to understand whether their future savings and investment plans, combined with the range of likely market outcomes, are consistent with their planned retirement income. We investigate a simple approach to compare the ambitiousness of the participant’s plan with the reality of growth available from existing target date solutions.

THE INDUSTRY PROVIDES A RANGE OF TARGET DATE GLIDE PATHS ... AND A RANGE OF DIFFERENT OUTCOMES

With close to 40 providers of target-date funds in 2017, as detailed by Morningstar, the marketplace provides many options from which to choose. Each target date series is associated with a glide path which assigns an asset allocation between growth and capital preservation assets for each year (or particular age of a participant). While all glide paths assign a higher allocation to growth assets when the investors are further from their retirement date, allocations across providers may differ by as much as 40% for participants at the same age.1

Exhibit 1 shows the available glide paths from Russell Investments (orange line) and its largest competitors.2 The gray silhouette illustrates the range of the growth allocation before, at and during retirement. While we consider the extremes to mark the boundaries of available3 choices, it is worth noting that no single glide path maps to either the upper or lower limits of the gray range. We refer to the allocations along the upper boundary of the gray silhouette as the “Maximum” glide path and those falling along the lower boundary as the “Minimum” glide path.

Exhibit 1: Range of industry glide paths from largest competitors Russell Investments & competitors’ glide paths

STRATEGY TIMING IMPLEMENTATION

What are reasonable outcomes to expect from a target date glide path?By: Steve Murray, Ph.D., CFA, Head of Defined Contribution Solutions and Ly Tran, Ph.D., Research Analyst

1 According to the most recently updated prospectuses collected in 2017Q1 from the top 20 Target Date Funds providers in terms of AUM.

2 The largest 20 competitors’ glide paths were collected from their prospectuses dated around 2017Q1.

3 Of course, plan sponsors can work with an advisor to identify a custom glide path that may fall outside of the silhouetted range, but we limit our analysis to large, publicly available funds.

Steve Murray

0%

20%

40%

60%

80%

100%

-17-12-7-23813182328333843Years before Retirement

Target Retirement Date

Gro

wth

Allo

catio

n

Russell Investments

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RUSSELL INVESTMENTS

A dollar saved early in one’s career will initially have relatively high exposure to growth assets—this exposure declines to a lower allocation as retirement nears. The expected growth of each contributed dollar depends not only on which glide path it follows, but also on how many years of compounding it will experience prior to retirement. Using Russell Investments’ 20-year market forecasts as of December 2016, we estimate that a dollar contributed 40 years before retirement will grow at an annualized inflation-adjusted rate of 3.5% for the Minimum glide path, 3.8% for the Russell Investments’ glide path and 4.0% for the Maximum glide path. These are average numbers over the entire 40-year period with growth in the early years expected to be higher than in later years due to the more aggressive allocation. A dollar contributed 20 years prior to retirement is expected to have lower annualized growth rates of 3.1% for the Minimum glide path, 3.4% for the Russell Investments’ glide path and 3.9% for the Maximum glide path. While the rates of growth are only a little lower for the dollar saved 20 years prior to retirement compared with the dollar that is saved for 40 years prior, the impact on retirement income from the earlier dollar is roughly two-and-a-half times as much as the dollar saved with only 20 years remaining, underlining the importance of early savings.

Overall, the expected rates of return provided by the glide paths fall in the range of about 1.5% (for savings that occur with only a small number of years remaining before retirement) to around 4% for a dollar contributed early in one’s career. These are inflation-adjusted rates of return to support an easy comparison of purchasing power in today’s dollars to purchasing power at retirement.

Custom glide paths, active management and higher return assumptions can influence the range of available returns. However, 1.5% to 4% provides a range for evaluating the reasonableness of a participant’s plan for savings and the retirement income that it is likely to support.

HOW TO EVALUATE THE VIABILITY OF THE PARTICIPANT’S PLAN

A simple way to evaluate the ambitiousness of a participant’s plan is to calculate the rate of return required to grow the ongoing savings to an accumulated amount that will support the desired retirement income.4 If the required return falls outside of the range provided by glide paths, success may be unlikely.

Exhibit 2 provides the rate of return necessary for combinations of savings rates (as a percentage of contemporaneous salary) to cover the indicated retirement income level (expressed as a percentage of final salary) for a participant who starts saving at age 25 and plans to retire at age 65.5

The dark green and red lines bound the range of required returns that fall within the expected outcomes of equities (5.7%) and cash (1.3%) – the most aggressive and most conservative available portfolios, but are not representative of any industry glide paths. The orange shaded cells correspond to required rates of return that fall within the expected returns available from industry glide paths, and the blue shaded cells correspond to required rates of return that can be achieved with 75% confidence by a glide path in the range from Maximum to Minimum of the industry silhouette.

4 The account balance at retirement that can provide $1 of retirement income (adjusted for inflation each year during retirement) can be determined through an annuity calculation and is approximately $18 for a 65-year-old woman. It will vary somewhat with interest rate levels.

5 For simplicity, we assume that salary grows with inflation as measured by the Consumer Price Index over the participant’s career.

1.5% to 4% provides a range for evaluating the reasonableness of a participant’s plan for savings and the retirement income that it is likely to support.

Russell Investments Communiqué p / 6

INVESTMENT FOCUS (continued)

Exhibit 2: Required rate of return for a given savings rate and retirement income target for an employee working from age 25 to age 65

Retirement Income Target (% Final Salary)

Sav

ings

Rat

e (a

ll so

urce

s)

20 30 40 50 60 70 80 90 100

5% 2.7% 4.5% 5.6% 6.5% 7.2% 7.8% 8.3% 8.7% 9.1%

6% 1.9% 3.7% 4.9% 5.8% 6.5% 7.1% 7.6% 8.0% 8.4%

7% 1.2% 3.0% 4.3% 5.2% 5.9% 6.5% 7.0% 7.4% 7.8%

8% 0.6% 2.5% 3.7% 4.6% 5.4% 6.0% 6.5% 6.9% 7.3%

9% 0.0% 1.9% 3.2% 4.1% 4.9% 5.5% 6.0% 6.5% 6.9%

10% -0.5% 1.5% 2.7% 3.7% 4.5% 5.1% 5.6% 6.1% 6.5%

11% -1.0% 1.0% 2.3% 3.3% 4.1% 4.7% 5.2% 5.7% 6.1%

12% -1.5% 0.6% 1.9% 2.9% 3.7% 4.3% 4.9% 5.4% 5.8%

13% -1.9% 0.2% 1.6% 2.6% 3.4% 4.0% 4.6% 5.0% 5.5%

14% -2.4% -0.2% 1.2% 2.2% 3.0% 3.7% 4.3% 4.7% 5.2%

15% -2.8% -0.5% 0.9% 1.9% 2.7% 3.4% 4.0% 4.5% 4.9%

Combinations above the dark green line will only be accomplished with a healthy dose of luck, and they do not represent a reasonable plan while those falling below the red line signal the possibility of setting retirement income aspirations somewhat higher.

Of course, a similar required rate of return exercise could be pursued for participants who are older than 25 and/or who may already have accumulated a balance.

REPEAT AS NECESSARY

The simple calculation of the return required for a participant’s plan to be successful can easily be compared with the reality of returns available from industry glide paths to understand if the plan is well targeted without extensive and possibly costly analysis. Plans that are unlikely to have the desired outcome are quickly identified as are those that can aim higher.

The attractiveness of potential modifications (higher savings, lower retirement spending, deferred retirement, etc.) can be evaluated in the same manner with a consistent process allowing participants to evaluate the impact of different choices that will lead them to a promising plan.

Russell Investments has evaluated the rate of return required for participants in plans of our clients. These analyses have led to discussions of the actions that can be taken by both the plan sponsor and the participants to increase the likelihood of success. If you are interested in receiving this analysis for your own plan, please contact your account representative.

The attractiveness of potential modifications (higher savings, lower retirement spending, deferred retirement, etc.) can be evaluated in the same manner with a consistent process allowing participants to evaluate the impact of different choices that will lead them to a promising plan.

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RUSSELL INVESTMENTS

STRATEGY TIMING IMPLEMENTATION

CLIENT FOCUS

Managing success: How do active managers handle increasing AUM?By: Leola Ross, Ph.D., CFA, Director, Investment Strategy Research, John Forrest, CFA, Head, Research Practice and Yuki Xi, Ph.D., Portfolio Analyst

We’ve been talking a great deal recently about the debate between active management and passive investing. In our multi-asset approach, we take an active and passive approach to building portfolios. We firmly believe active has a place, but only when you have skill in selecting active managers. Finding the right managers is hard work.Toward that end, we have our own sets of preferences, which we believe contribute to active manager outperformavnce. And it’s no secret that we believe, all else being equal, active managers will do better with a relatively small amount of assets under management (AUM). The reasoning behind this is a combination of science (in the form of 15 years of data and in-depth analysis) and art (in the form of face-to-face meetings with managers, for nearly 50 years, and assessing multiple more nuanced factors). Less AUM to manage means, in the simplest terms, more nimbleness when it comes to finding upside opportunities and managing against uncompensated risk. This is especially true in portfolios with liquidity constraints.

Our early research on the “Perils of Success,”6 and University of California Professor Jonathan Berk's7 well-known 2005 conclusion that "competition between them increases the size of the fund and drives the alpha to zero. Instead the manager himself captures this value through the fee he charges" both support the preference for smaller AUM managers.

In all of these examples, the presumption is that size alone can erode success. The most damning, however, is Berk’s conclusion. Is it true? Can active managers kill the goose that lays the golden egg? And why would investors continue to fund the active manager once the manager has extracted all value?

Yet, we note that some active managers have demonstrated the potential to generate strong performance, even with large AUM, across several equity and fixed income strategies and regions. The general data also show us that increasing AUM is not necessarily the kiss of death.

Exhibit 1 displays the interquartile ranges of one-year returns (2001-2015), broken out by AUM quintiles, for active managers across various equity regions and fixed income strategies. While we observe a (mostly) downward trend for the range of excess returns as AUM increases in the equity regions, the third quartile performers have positive excess returns. Additionally, the median performers are mostly positive.

Leola Ross

John Forrest

6 Christopherson, Jon, Zhuanxin Ding, Greenwood, Paul. (2001). “Perils of Success”. Russell Investments.

7 Berk, Jonathon B., (2005). “Five Myths of Active Portfolio Management,” The Journal of Portfolio Management, Vol. 31, Issue 3, Pages 27-31.

Yuki Xi

Russell Investments Communiqué p / 8

In the case of equity, we find the negative AUM size effect is strongest for U.S. small cap and emerging markets equity where, as investors would expect, liquidity is more of an issue. Yet even in the U.S. small cap space, we find that increasing AUM is not as strong a detractor as it was 15 years ago when we did our first study.

In the case of fixed income, a trend is not so clear. Yet, in the case of fixed income strategies, we also observe strong upside for the third quartile performers.

Exhibit 1: Can managers with more assets outperform?

CLIENT FOCUS (continued)

Excess Return (%)Managersby AUM(quintiles)

Asset Class

Smallest

Small

Mid-sized

Large

Largest

EmergingMarket AllCap Equity

Smallest

Small

Mid-sized

Large

Largest

EmergingMarket FixedIncome

Smallest

Small

Mid-sized

Large

Largest

U.S. HighYield Bond

Smallest

Small

Mid-sized

Large

Largest

U.S. CoreFixed Income

Smallest

Small

Mid-sized

Large

Largest

Global LargeCap Equity

Smallest

Small

Mid-sized

Large

Largest

U.S. SmallCap Equity

Smallest

Small

Mid-sized

Large

Largest

86420-2-4

U.S. LargeCap Equity

3rd quartile performers: Represents the opportunity to select outperforming managers across asset classes and AUM tiers.

Median: Represents the negatively sloping median as AUM increases.

2nd quartile performers

While we observe a (mostly) downward trend for the range of excess returns as AUM increases in the equity regions, the third quartile performers have positive excess returns. Additionally, the median performers are mostly positive.

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RUSSELL INVESTMENTS

Why? We suspect that skilled active managers may carefully manage their AUM to have it both ways. A reasonable strategy for them is to collect profits while also providing value to their clients in the long run. In a way, they are self regulating.

So, if we have evidence of larger AUM managers producing strong returns (and indications that it’s in their best interests to do so), how do these active managers manage their success? Especially when market impact, costly trading and illiquidity are constantly nipping at their heels.

We put these questions to our own team of specialist manager research analysts and captured a number of insights. We learned that the differences between an analysts’ AUM “watchpoint” and the reasonable upper limit of capacity—and indicators of rising AUM causing negative return impacts—vary considerably across asset classes and strategies.

Our analysts typically see active managers seek to accommodate and manage rising AUM by increasing the number of holdings, reducing their active share, reducing turnover, moving toward more liquid stocks and even closing products to new AUM at reasonable capacity limits. Some managers do this better than others and, through our 48 years of researching managers, we’ve identified some of the better techniques used by managers to increase their chances of success. Managers who accommodate AUM growth effectively tend to:

1. Manage growth, so that it doesn't come too quickly

2. Don’t hide growth in multiple, similar products

3. Stay in their habitat (e.g., capitalization, risk profile)

4. Stay invested (i.e., less in cash)

5. Play liquidity well, and are mindful of their investment horizon

6. Are mindful of cash flow requirements

7. Employ wise use of derivatives and other capacity expanding securities

Ultimately, our conclusions support an investment community that is mindful of AUM limitations and has learned to manage AUM growth well.

When market impact, costly trading and illiquidity are constantly nipping at their heels, how do these active managers manage their success?

Russell Investments Communiqué p / 10

Liabilities

STRATEGY TIMING IMPLEMENTATION

OPINION

Is the active management community diverse enough?By: Megan Roach, CFA, Portfolio Manager

As the portion of passive investment in the United States has grown to account for approximately 40% of equity assets under management8, asset owners grapple with questions of if and when further growth could undermine the very foundation of its success. A key dynamic to consider in investigating these questions is the composition of the active management community and its collective ability to effectively allocate capital and to facilitate accurate price discovery. James Surowiecki argued in his 2004 work The Wisdom of Crowds that collective judgement is at its best when three conditions apply: diversity, independence and decentralization. When it comes to the first of these, I believe now is a critical juncture for the active management community to take meaningful steps toward improving its diversity for the betterment of active managers, their clients and society at large.While it is widely agreed that teams composed of individuals with varied experiences and backgrounds can improve both investment and business results, not a week goes by without my inbox serving up an article or two lamenting the dismal state of the investment management industry’s diversity metrics along the dimensions of both race and gender. In a 2017 report published by FundFire and the Money Management Institute, it was cited that only 1.1% of the industry’s $71.4 trillion in assets are managed by firms owned by women and/or minorities. Additionally, of the 23 firms representing more than $5.3 trillion in assets surveyed for their study, 84% and 88% of senior portfolio managers and executive committee members, respectively, were white. In short, while there has been much industry lip service about diversity efforts, the bulk of both investment decisions and hiring practices continue to be driven by a relatively homogenous group of similarly educated and credentialed white men.

Coupled with the growth of traditional passive vehicles (weighted by market capitalization), investors have also embraced smart beta strategies that are designed to systematically capture exposures related to equity factors such as value, momentum and quality. As asset managers and owners continue to sort out the ambiguity of how factor exposures should be packaged and priced, the prevalence of these common factors across many active products is another likely contributor to compressed differentiation between active investment results. The upside of this current sorting is that, moving

Megan Roach

8 Source: Global Markets Institute. (2017, January). “Directors’ dilemma: responding to the rise of passive investing”. Goldman Sachs. Available at: http://www.goldmansachs.com/our-thinking/public-policy/directors-dilemma-f/report.pdf

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RUSSELL INVESTMENTS

forward, the value of an active manager’s stock-selection skill will be increasingly quantifiable and priced accordingly as it is disentangled from passive factor exposure.

According to Dalbar’s annually updated “Quantitative Analysis of Investor Behavior” (QAIB) study, the average retention rate for equity funds has hovered between just two-and-a-half and four-and-a-half years over the past two decades. Coupled with the competitive pressures of passive management within our maturing industry, a perverse consequence has manifested – the gradual but distinct shift in investment professional incentives toward those tailored to minimizing career risk rather than maximizing client results. This progression from an initial focus on absolute returns to index-relative returns and now to competitive peer-relative results means that a vicious cycle has been created. This cycle likely dissuades active managers from pursuing potentially lucrative investment decisions due to the mismatch in their clients’ patience and the reality of payback periods for long-term capital allocation decisions made by public companies.

The collective effect of these three factors is that we have a group of similar investors providing exposure to similar factor dimensions using similar systems and approaches with incentives increasingly aligned toward caring more about what one another are doing than what’s happening in the world economy and with the companies in their portfolio.

As is taught in business schools the world over, firms under competitive pressures are best served by honestly identifying their weaknesses and moving swiftly to mitigate them. In my view, this lack of diversity is a collective weakness and one of the contributing factors in the loss of market share to passive investing. While the benefits of passive in providing more investors with low cost exposure to capital markets should not be disregarded, the role of diverse active management processes and results is an important one in its unique ability to facilitate efficient price discovery and effective capital allocation within the global economy. Through proactive efforts to remedy team diversity and to focus on differentiated security selection, active managers have an opportunity to communicate an improved value proposition to asset owners. In return, the re-establishment of trust between asset managers and owners should lengthen the investment horizon allowed to assess that value.

The collective effect of these three factors is that we have a group of similar investors providing exposure to similar factor dimensions using similar systems and approaches with incentives increasingly aligned toward caring more about what one another are doing than what’s happening in the world economy and with the companies in their portfolio.

Russell Investments Communiqué p / 12

STRATEGY TIMING IMPLEMENTATION

Q&A

Enhancements in factor-based portfolio constructionWith: Evgenia Gvozdeva, Ph.D., Senior Quantitative Research Analyst and Nick Zylkowski, CFA, Portfolio Manager

Q: THERE HAS BEEN A SIGNIFICANTLY GROWING EMPHASIS ON FACTOR EXPOSURE MANAGEMENT (SMART BETA) IN RECENT YEARS. YOU’VE BEEN EXPLORING WAYS TO ENHANCE THE CONSTRUCTION OF FACTOR PORTFOLIOS. HOW HAVE YOU GONE ABOUT DOING THIS?

A: Our latest work has been focused on using thoughtful portfolio optimization techniques to support dynamic factor allocations, and on constructing more concentrated factor portfolios without materially increasing idiosyncratic risk and active drawdowns. Reasonable portfolio concentration is important as it allows more flexible and efficient factor allocations, and ultimately allows for better management of transaction costs. However, it can lead to unrewarded stock-specific risks, among other things. So we’ve been looking for ways to increase the concentration of factor exposures without introducing unwanted baggage, and portfolio optimization techniques are an effective way to address reasonable concentration for multi-factor portfolios.

To support robust portfolio optimization, one area we have looked at closely is the distribution of factor exposures. Most industry standard models are based on a distribution of factor scores that roughly follows a normal distribution. This leads to a majority of the universe having scores close to the mean, with fewer securities in the tails. In addition, the tails of these factor distributions are long with larger score magnitudes for the highest and lowest ranked securities. While this distribution may be fine for estimating total risk, it is problematic for constructing portfolios.

For the purposes of factor portfolio construction, a security having high or low exposure to a factor is a meaningful signal. However, distinguishing between the highest of the high and the lowest of the low is less important.9 In other words, the weight of the first percentile stock in a factor portfolio should not have to be significantly greater than that of the tenth percentile stock.

We address this by using non-linear probability (NLP) transformation to push the normally-distributed factor exposure distribution into a more bi-modal type of distribution.

Exhibit 1 shows an example of the Value factor distribution under the normal and bi-modal models.

Exhibit 1: Value factor scores for Global Large Cap universe as of Dec 2016

Evgenia Gvozdeva

Nick Zylkowski

9 See Maslov and Rytchkov (2013) and Bennett et al. (2014)

Normal distribution:

Securities in the universe

Sco

res

5

2.5

0

-2.5

-5Securities in the universe

Sco

res

5

2.5

0

-2.5

-5

Bi-modal

Securities in the universe

Sco

res

5

2.5

0

-2.5

-5Securities in the universe

Sco

res

5

2.5

0

-2.5

-5

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RUSSELL INVESTMENTS

10 Historical data is not indicative of future results.

Q: WHAT IS THE IMPACT OF MODELING THE FACTOR DISTRIBUTIONS THIS WAY?

A: By moderating how much active weight stocks receive at the tails of the factor distribution, portfolios are able to trade off idiosyncratic risk for higher factor exposure. Portfolios see an increased overall position in the factor exposure itself by owning a broad set of high value (for example) securities rather than over-concentrating in the highest of high value stocks (i.e., deep value). Since there are more similar (high) exposure securities in the bi-modal distribution than in the normal distribution, these portfolios are expected to achieve the desired factor exposure in a diversified way.

Q: HAS THIS BEEN BORNE OUT BY THE HISTORICAL RESULTS?10

A: Yes. Consider, for example, a three factor allocation to Value, Momentum and Quality. We compared portfolios based on the Russell Global Large Capitalization universe with different concentration levels (from 200 to 2000 securities) using a portfolio optimization approach, and compared them to a portfolio constructed by our standard rules-based approach with 2400 securities. We found that in concentrated optimized portfolios (down to around a third of the holdings of the rules-based approach), returns were preserved and active drawdowns were consistent. Concentrating beyond these levels would have had detrimental impacts to performance and risk due to higher levels of unrewarded stock-specific risk.

The interaction between the number of securities and the choice of factor score distribution is worth noting. Using a normal distribution, achieving higher exposures generally requires more concentration in terms of the number of stocks chosen along with higher levels of stock-specific risk. This, however, is not the case when we use factor scores from a bi-modal distribution. We see in portfolios constructed with increasing number of securities, 200 to 2000, average factor exposure for portfolios would remain

consistent while returns would increase, stock-specific risk decreases and active drawdowns decrease quite significantly as more securities are added. Because of Russell Investments’ bi-modal distribution, we can build portfolios with higher levels of factor capture and lower levels of stock-specific risk.

Another outcome of using factor distributions and a custom risk model built for these purposes, is our estimates of risk on an ex-ante basis are vastly improved. When using a bi-modal factor distribution, and building factor portfolios in the way we’ve described focusing on broad factor capture, the estimates of overall risk are generally quite close to ex-post realized risk. When constructing portfolios using ‘standard’ factor models with skewed distributions, we see much higher estimation errors for pure factor portfolios – the difference between estimated risk and realized risk. This leads us to believe that the idiosyncratic risk that comes with skewed distributions is not being appropriately accounted for.

Q: WHAT OTHER AREAS HAVE YOU BEEN LOOKING AT?

A: We have also been looking closely at how we will translate these findings into our Dynamic Multi-Factor and Active Positioning Strategies (APS). These portfolios require dynamic adjustments to factor, industry and country signals, and relies on optimization methods to construct a final portfolio. APS portfolios are customized exposures directly managed by Russell Investments, they’re intended for use within the total portfolio are complementary exposures to third party active managers. The portfolio optimization approaches we’ve developed will be critical for translating dynamic insights into invested portfolios. It’s a more precise way of using active positioning, and the historical results are encouraging.

Because of Russell Investments’ bi-modal distribution, we can build portfolios with higher levels of factor capture and lower levels of stock-specific risk.

Russell Investments Communiqué p / 14

GREAT MOMENTS IN FINANCIAL HISTORY

301: Diocletian tries (and fails) to regulate inflationBy: Tom Llewellyn, Director, Content Marketing

Whether discussing rate increases by the U.S. Federal Reserve (the Fed) or quantitative easing by the European Central Bank (ECB), the challenge of central control of an economy is a tricky one.

It’s also an ancient challenge, as shown by Roman Emperor Diocletian in the year 301 AD and his infamous Edict on Maximum Prices. Diocletian started his career as a soldier of lowly birth from modern-day Croatia, but rose all the way to the rank of emperor in the year 284. He was an activist leader, as shown by his splitting of the Empire into four regions, each with its own Caesar, its own capital, and its own independent army.

While Diocletian was in power, inflation grew out of control and the cost of both commodities and wages reached record heights. The cause for the inflation? It’s officially unknown, but, in a document called De Moribus Persecutorum, an anonymous-and-very-opinionated author in Asia Minor laid the blame on Diocletian and his decentralized government. That author claimed that each of the regional armies and courts were larger than the previous single central government. The resulting taxes were so high, said the author, that farmers no longer found it profitable to till their fields. On the other hand, Diocletian, in the preamble of his edict, blamed greedy merchants. He had long hoped, he said, that prices would settle down to their natural level, without any governmental interference, but since this hope had proved futile, he chose to regulate prices for the welfare of his subjects.

So, in 301, Diocletian issued his edict, setting maximum prices for nearly all goods and services. If anyone was found in violation of the edict, the penalty was death.

The edict set maximum prices for the typical commodities of the day, including wheat, rye, oats, barley, aged wine, olive oil, beer, vinegar and salt. It set prices for nearly every kind of meat, from beef, bacon and ham, to partridges, oysters and peacocks. It also set wages for all kinds of tradespeople, including masons, carpenters, sailors and barbers. Then list goes on and on and gets very specific: women’s shoes, patrician’s shoes, country worker’s shoes, leopard skins, beaver skins and seal skins. It set the maximum hourly rate for lawyer services before a trial and lawyer services during a trial and set the cost of transporting a person one mile.

Clearly, Diocletian was not a fan of deregulation.

Did it work? In De Moribus Persecutorum, our anonymous author stated, “Then much blood was shed over trifling and cheap articles; through fear, wares were withheld from market, and the rise in prices became much worse, until after the death of many men the law was through very necessity rescinded."

In other words, even the threat of a death penalty didn’t make the edict work. Many merchants ignored the price limits. When would-be consumers found that these merchants were charging prices above the legal limit, they formed mobs, looted the stores and killed the traders. Other traders hoarded their goods, hoping they could wait out the edict. This hoarding created greater scarcity and an even greater increase in prices, resulting in a massive black market.

No one knows precisely how long the edict remained in effect. But in 305, four years after the edict was enacted, records show that Diocletian stepped down from power. The official cause: ill-health resulting from the strain of government.

Tom Llewellyn

Source: “The Edict of Diocletian Fixing Maximum Prices”. University of Pennsylvania Law Review. p.35-47. Available at: http://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=7817&context=penn_law_review

In 301, Diocletian issued his edict, setting maximum prices for nearly all goods and services. If anyone was found in violation of the edict, the penalty was death.

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RUSSELL INVESTMENTS

RESEARCH FOCUS

Latest research“MANAGED ACCOUNTS: THE OTHER QDIA”

Russell Investments // Managed accounts: The other QDIA NOVEMBER 2017

Managed accounts: The other QDIA Kevin Knowles, CFA, Director, Defined Contribution Steve Murray, Ph.D., CFA, Head of Defined Contribution Solutions

Popularity of managed accounts in defined contribution (DC) plans is growing; however, they currently represent a small portion of assets and have been infrequently chosen as the qualified default investment alternative (QDIA) option. With participant-specific information becoming more readily available, managed account solutions have the ability to tailor investment strategies to the characteristics of each participant. This strong link to each participant’s situation is an important advantage relative to other QDIA options and properly-designed managed accounts will continue to gain popularity as QDIAs because of it.

Ten years ago, the Pension Protection Act (PPA) granted balanced funds, target date funds and managed accounts safe-harbor status for participants who do not elect a fund allocation on their own.

Balanced funds have historic familiarity as an investment solution, offering diversified exposures to a variety of financial markets; however, they fail to account for the particular situation of each participant and on their own don’t provide a transition from more aggressive allocations for younger participants scaling to more conservative ones for those approaching retirement. The absence of a link to the end-investor goals creates a mismatch of objectives that allows for the possibility that the manager of the balanced fund successfully outperforms the benchmark while the DC participant simultaneously finds the investment insufficient to support desired retirement income.

Shortly following the passage of PPA, by realizing the shortcomings of balanced funds for DC participants, many plan sponsors adopted target date funds as their default investment selection. The idea of managing towards the single greatest risk factor (age) is compelling and, relative to balanced funds, it shifts participant allocations closer to the asset allocation they would receive from a customized solution. However, aside from grouping participants by age, target date funds are designed to serve a more-or-less homogeneous herd. The percentage of plans offering target date funds increased from 63% in 2005 to 96% in 20151. Over this same period, the percentage of DC participants invested in target date funds increased from 9%2 to 47%3. Managed accounts have not yet enjoyed the broad adoption that target date funds have.

By Kevin Knowles and Steve Murray The forgotten QDIA option that offers a customized asset allocation strategy. Read more about some of the managed account advantages that are designed to help keep participants on track to meet their retirement income goals.

“BORROW TO FUND”

Russell Investments // Borrow to fund: The changed dynamics of NPV analysis of pension plan funding DECEMBER 2017

Borrow to fund The changed dynamics of NPV analysis of pension plan funding Joshua Barbash, CFA, ASA, EA, Asset Allocation Strategist

The most common funding policy for U.S. defined benefit (DB) pension plan sponsors has traditionally been to contribute the minimum required by the IRS. This is no longer the case. Many large sponsors are choosing to make discretionary contributions, a decision that – either explicitly or implicitly – is based on net present value (NPV) analysis. The primary factors that cause NPV analysis to favor discretionary contributions are Pension Benefit Guaranty Corporation (PBGC) premiums and tax considerations. In this note, we will expand on why this is.

Background: minimum contribution policy versus discretionary funding U.S.-listed corporations have a combined shortfall of pension plan assets below liabilities of roughly $465 billion.1 This represents in effect an obligation, or debt, of the plan sponsors to the pension trusts and, ultimately, to the plan beneficiaries. Compared to other forms of debt, however, there are significant advantages from the sponsors’ point of view: It is generally not counted against debt covenants and allows for considerable flexibility in paying it off. Further, by deferring contributions the sponsors also reduce the likelihood of capital becoming trapped in the plan in the event of an improvement in funded status as a result of market movements.2

For these reasons, most sponsors have preferred to fund their plans only to the extent that they are required to by the IRS.3 And, although the Pension Protection Act of 2006 (PPA) introduced a stronger funding regime than was previously in place, those requirements have subsequently been watered down on several occasions.4 Indeed, 15 of the 19 largest listed U.S. plan sponsors indicated in their 2014 annual reports that there was no material minimum contribution expected to be required for

their primary U.S. plans in 2015.5 This was despite a net aggregate shortfall of assets below liabilities totaling $183 billion6 and a benefit accrual run rate of around $13 billion.7

Although sponsors are not required to fund above the minimum level (which is frequently zero), many are increasingly choosing to do so. For example:

• In February 2017, GM announced that the net proceeds of a $2 billion debt issuance had been used to fund discretionary contributions to the U.S. hourly pension plan.8

• Also in February 2017, Pfizer announced that it had made a voluntary contribution of $1 billion to its U.S. qualified plans.9

• In March 2017, FedEx announced that it had made $2 billion of funding ($1.5 billion above the minimum required), partially funded by a debt offering.10

• In April 2017, Verizon Communications announced $3.4 billion of discretionary pension contributions (in addition to the $600 million required), funded by new debt issuances.11

By Joshua BarbashWhy are large DB plan sponsors no longer making the minimum contributions required by the IRS? Read about the contributing factors.

DEFINED CONTRIBUTION

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HEALTH SYSTEMS

For more information:

To learn more about our services for institutional investors or topics in this issue of Communiqué, contact your Russell Investments representative or one of these associates.

Eric Macy Managing Director U.S. Institutional

212-702-7941 emacy@russellinvestments.com

U.S. contact

Andrew Kitchen Managing Director, Institutional Canada

416-640-2482 akitchen@russellinvestments.com

Canadian contact

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Although steps can be taken to help reduce risk, it cannot be completely removed. Investments typically do not grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document.

Diversification does not assure a profit and does not protect against loss in declining markets.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

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