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International Equities: Blueprint For A Differentiated Market Environment

We explore the case for including the flexibility to invest across market caps, regions and sectors. International equity market returns have started diverging – at regional, country and market-cap levels – as investors adjust to changing monetary policy, a subdued growth environment and a muted return outlook overall. We believe that this reflects a new reality in markets, in which top-down, country or even sector views may not be enough to achieve favorable risk-adjusted returns. In this paper, we explore the case for including the flexibility to invest across market caps, regions and sectors, as well as the appeal of a quality bias and fundamentals focus, as part of a disciplined investment process. Growing Divergence in the Marketplace For much of the period since the 2008 market crisis, aggressive monetary policy and macro-related issues have tended to dominate international markets, which has contributed to high correlations of returns among regions and market-cap ranges. However, over the past two years, shifting policy issues and varying growth rates have prompted more diverse return patterns (see Figures 1 and 2). Figure 1: Annual Returns by Region, Country Source: FactSet. Indexes are unmanaged and are not available for direct investment. Unless otherwise indicated, returns reflect reinvestment of dividends and distributions. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Figure 2: Annual Returns by Market Capitalization Source: FactSet. Large cap: median market capitalization of USD 14 billion, Mid-cap: median of USD 4 billion, small cap: median of USD 0.5 billion. Indexes are unmanaged and are not available for direct investment. Unless otherwise indicated, returns reflect reinvestment of dividends and distributions. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. We believe this trend is likely to continue. Economies and policies are diverging, potentially exposing fundamental differences among markets, sectors and stocks. U.S. interest rates may have troughed, while the ECB and Bank of Japan continue to lower interest rates to levels below zero. At the same time, lower profitability at brokerage firms is forcing them to provide less individual stock research coverage – in particular for smaller companies where the daily value traded is low. For investors who look beyond the largest companies (in particular the roughly 900 constituents of the MSCI EAFE Index), this could potentially translate into opportunities to generate alpha among the more than 10,000 actively traded developed market stocks outside the U.S. Implications for International Equity Investors How can this more differentiated environment affect the task of investing in international markets? We believe that potential lies in a powerful nexus between active investing, flexibility and quality. Environments in which market-cap ranges and regions traded within tight bands of one another (such as the 2011-12 period) have been challenging for active managers. However, greater return dispersion can often favor flexible strategies that can be opportunistic, with weightings based on bottom-up fundamental analysis rather than overly narrow investment guidelines. Why Market-Cap Flexibility? The ability to invest away from dominant names in large-cap indices may offer opportunities to generate alpha. In assessing the entire value chain in various industries, we are often led to mid- and small-cap companies with niche businesses that are not well known or well understood. These specialized firms are often more profitable, faster growing or less risky than their larger peers. An investment portfolio that can include these companies at attractive valuations could potentially perform well relative to large-cap oriented peers and indices. As shown in Figure 3, in recent years, small-cap stocks have often outperformed large-cap stocks, so it can be useful to have the flexibility to invest there if a bottom-up opportunity is identified. Small and mid-caps can also suffer underperformance, however, so valuation discipline and risk management are key. Figure 3: International Small Caps: An Appealing Source of Stocks Annual Return Difference Between MSCI EAFE Small Cap and EAFE Large Cap Source: FactSet. Indexes are unmanaged and are not available for direct investment. Unless otherwise indicated, returns reflect reinvestment of dividends and distributions. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Investing Beyond the Benchmark We believe the notion of flexibility can apply to countries as well, as individual opportunities in a given market may be disproportionate to the overall size of the market itself. MSCI data shows that a country’s representation in the index often does not reflect its underlying economic weight. For example, the U.K. represents 19.6% of the MSCI EAFE Index, while economically it is only 8.6% of the revenues generated by MSCI EAFE Index constituents. Moreover, given the dominant presence of multinationals, the MSCI EAFE Index has 24% underlying exposure to emerging markets, even though emerging markets are not explicitly represented. In other words, it is important to understand the underlying exposure of the company, rather than just the country domicile of the stock. The flexibility to invest outside the countries that make up the EAFE Index-like Canada or emerging markets, or even foreign-domiciled U.S.-listed firms – need not add meaningfully to portfolio risk, whether risk is measured by absolute volatility or by tracking error relative to benchmark. Regarding emerging markets in particular, we know that many developed market companies have revenue exposure to emerging markets. Where we believe this exposure can be additive to returns and growth – and where the multinational has a strong and defensible position relative to local competitors – we are happy to have this exposure. Moreover, where one can identify an emerging markets-based firm that is outperforming its global peers in the global or local marketplaces, we believe it could be an attractive holding for portfolios. Rather than country of domicile, in our view, the key is the underlying exposure, quality of the enterprise, and valuation. The Importance of Discipline Especially when including companies that are not part of the index, it is important to monitor risk closely. For example, an investor can combine several narrowly focused industrial firms to replicate the risk profile of a much larger conglomerate. It’s possible to substitute a multinational with emerging markets exposure for smaller firms that operate and are listed in emerging markets themselves. And one can focus attention on smaller caps with very little debt, and so mitigate the risks associated with larger firms that may have taken advantage of low interest rates to make acquisitions. Thus, a differentiated portfolio need not be a more risky one – whether risk is measured by beta or absolute standard deviation. In addition to mitigating risk via diversification, we also believe that portfolio volatility can be reduced by a focus on quality – which for us is largely determined by return on capital. Companies with high returns tend to generate strong cash flow, enabling them to weather tough economic conditions more effectively than their peers. Smaller caps and emerging markets firms tend to be more volatile than their large-cap multinational peers, so a focus on quality can help mitigate the risks associated with investing in niche names. How Quality Can Shape a Portfolio An orientation toward quality and fundamentals does have an influence on the overall weightings of a portfolio, and the effects will vary over time. Using a very simplified example, we looked at our International Equity strategy’s top sector overweight and underweight as of 2007 (before the global financial crisis) and then followed those sectors through to the current market. Figure 4: Fundamentals Can Drive Exposure NB International Equity Strategy: Energy and Utility Sector Weightings and Sector RoE over Time Evolution of Initial-Period Top Overweight (Energy) vs. Top Underweight (Utilities) Source: Neuberger Berman, FactSet. Benchmark is the MSCI EAFE Index. Weightings and ROE are as of December 31 of the respective years. Representative portfolio information (characteristics, holdings, weightings, etc.) is subject to change without notice. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. See additional disclosures at the end of this paper, which are an important part of this material. Figure 4 above shows that, in 2007, the energy sector enjoyed a return on equity (RoE) above that of the index before the crisis, as demand for oil and gas drove up prices, allowing for the development of new geographies, like offshore Brazil and Africa, and giving rise to independent energy explorers and differentiated oil service providers. This led to more individual opportunities for us, and the sector was our largest overweight, driven by bottom-up analysis that identified many attractive companies. Several of these firms, however, were acquired in the M&A boom that ensued, which eliminated some of the most exciting and profitable names from the universe, and dragged down the returns of larger remaining acquirers (even before the price of oil declined). As a result, our energy exposure declined. The utilities weighting tells a very different story: Sector returns have never matched the RoE of the overall index, as the sector’s RoE is designed to be in line with the cost of capital, which explains our consistent underweight. Secondary Benefits Other factors can drive relative returns: Consider mergers and acquisitions. M&A activity has been accelerating globally as many companies with large cash holdings seek to grow revenues but are loathe to expand capacity. At the same time, accommodative monetary policy from central banks has kept interest rates very low. U.S. firms may be looking to use the strong dollar to make acquisitions abroad, while companies based in emerging markets may be looking to gain expertise and technology from companies in the developed world. Prospects for a continued increase in activity appear strong. Figure 5: Global Deal Volume by Target’s Region (USD Billions) Source: Bloomberg However, the benefits of M&A are unlikely to be shared universally. We believe that fundamentally strong businesses trading at attractive prices tend to be the more appealing candidates for acquisition. Another look at our International Equity strategy provides some insight: In 2014, the larger-cap MSCI EAFE Index had 32 names targeted for acquisitions that detracted -0.15% from overall index return, as compared to 11 securities targeted for acquisition in our strategy that contributed positively to overall strategy return. In 2015, the index had 45 names targeted that detracted -0.28% from the overall index return, as compared to six securities targeted in our strategy that contributed positively to overall strategy return. The overall MSCI EAFE Index generated negative returns in both 2014 and 2015, so the value added via M&A – specifically, being invested in acquired firms – was significant. Exposure to small-cap stocks can add potential for portfolio acquisitions. While the percentage of total M&A value is skewed to larger companies, the number of transactions is skewed to smaller deals. For example, in 2015, there were USD 5 trillion worth of deals globally, but the average size of the transaction was just USD 179 million. 1 Purchasing a smaller firm puts less capital at risk for the acquirer, which adds to the attraction of smaller caps. Quality: An Opportune Time for a Secular Choice As we have observed, the current market environment is characterized by return dispersion among regions, sectors and market-cap segments – one that we believe bodes well for a quality-driven all-cap approach. While we believe all-cap quality is a solid long-term philosophy, it may perform better in some periods than in others; in particular, it has often done well when fundamentals drive markets Looking at performance periods after the global financial crisis (see Figure 6), the rally of mid-2012 to mid-2014 presents an example of a monetary-policy driven market. It was a period characterized by the launch of both “Abenomics” in Japan, and the ECB’s quantitative easing, which lifted valuations far more than it did corporate profits (which barely moved during the period). With current valuations in line with long-term averages, we believe we could be entering a period where fundamentals are a key driver of returns. Figure 6: Post Global Financial Crisis – How Fundamentals Can Drive Stock Performance Source: Bloomberg and Neuberger Berman. P/E is Bloomberg compilation of forward earnings estimates for the next four quarters. Earnings is calculated based on the MSCI EAFE index price change divided by P/E change. Neither figure is annualized. Indexes are unmanaged and are not available for direct investment. Unless otherwise indicated, returns reflect reinvestment of dividends and distributions. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Conclusion Following a period of increasing correlations, we believe we are now in a period of divergence for international equity markets. As a result, we believe that active management – focusing on specific areas of opportunity – can outperform a broader approach. In particular, we believe a flexible approach that focuses on quality – one that includes medium – and small-cap as well as the largest firms, includes companies in emerging as well as developed markets, and includes all sectors where economic value can be created – while closely monitoring risk, can generate attractive long-term returns. 1 Source: Bloomberg. This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic, market or security estimates or forecasts discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates or forecasts. Certain products and services may not be available in all jurisdictions or to all client types. Unless otherwise indicated, returns shown reflect reinvestment of dividends and distributions. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Representative portfolio information (characteristics, holdings, weightings, etc.) is based upon the composite or a representative/model account. Representative accounts are selected based on such factors as size, length of time under management and amount of restrictions. Client accounts are individually managed and may vary significantly from composite performance and representative portfolio information. Investing in foreign securities involves greater risks than investing in securities of U.S. issuers, including currency fluctuations, potential political instability, restrictions on foreign investors, less regulation and less market liquidity. Neuberger Berman Investment Advisers LLC is a registered investment adviser. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC © 2009-2016 Neuberger Berman LLC. | All rights reserved

5 Low-Cost ETFs Poised For Long-Term Wins

The global ETF industry has been growing by leaps and bounds and has already accumulated almost $4.5 trillion in assets, as per ETFGI data. ETFs gained popularity over mutual funds because of their flexibility, liquidity and low cost among other factors. In fact, low cost has been one of the biggest drivers for the ETFs, enhancing their total returns. This is primarily because fund managers generally don’t actively manage an ETF. As these products often engage in passive index-based investing, they charge a much smaller fee. Several research reports have shown that only a handful of fund managers outperform the market over the long term. This gives a major boost to passive investing strategies. As per the 2015 SPIVA U.S. Scorecard , over the last five years, 84.2% of large-cap managers, 76.7% of mid-cap managers, and 90.1% of small-cap managers underperformed the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600, respectively. The number of managers outperforming the benchmark index is equally bleak over the 10-year investment horizon. Roughly 82.14% of large-cap managers, 87.61% of mid-cap managers, and 88.42% of small-cap managers lagged their respective benchmarks. Additionally, managers across all international equity categories failed to outperform their benchmarks in the above mentioned time frame. Although there are several cost components to an ETF like trading commissions and bid/ask spreads, expense ratios are paid the foremost attention by investors. With several ETF providers including iShares, Vanguard and Charles Schwab vying with each other, ETFs have gotten cheaper every year (read: 5 Costly ETF Mistakes You Can Easily Avoid ). Knowing how important the expense ratio is, we have highlighted five of the cheapest ETFs for long-term investors (see: all the ETFs with Low Expense Ratios here ): iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA: ITOT ) – Expense ratio: 0.03% This fund provides a broad exposure to the U.S. equity market by tracking the S&P Total Market Index and is one of the low-cost choices in the equity ETF world, charging just 3 bps in annual fees. Holding 3,819 securities, the fund is widely diversified across sectors and securities. Information technology is the top sector accounting for less than 20% while Apple (NASDAQ: AAPL ) is the top firm taking 2.7% share of the basket. Large caps account for 74% of the assets while mid and small caps take the remainder. ITOT is a popular and liquid ETF with AUM of $3.6 billion and average daily volume of 286,000 shares. The product has delivered 70.9% returns over the last five-year period. Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) – Expense ratio: 0.03% This fund also provides a broad exposure to the U.S. equity market. The fund tracks the Dow Jones U.S. Broad Stock Market Index and charges just 3 bps in annual fees. Holding 2,077 securities, the fund is widely diversified across sectors and securities. Like ITOT, information technology is the top sector accounting for less than 20% while Apple is the top firm taking 3.3% share of the basket. Large caps account for 73% of the assets while mid and small caps take the remainder. SCHB is one of the popular and liquid ETFs with AUM of $5.8 billion and average daily volume of 927,000 shares. The product has delivered 70.7% returns over the last five-year period. Schwab U.S. Large-Cap ETF (NYSEARCA: SCHX ) – Expense ratio: 0.03% This fund targets the large-cap segment of the U.S. equity market by tracking the Dow Jones U.S. Large-Cap Total Stock Market Index and holds 777 securities in its basket. Here again, information technology is the top sector with just over 20% share while Apple is the top firm at 3%. With an expense ratio of 0.03%, the fund has amassed $5.3 billion in its asset base and volume is solid at over 783,000 shares. While this is a large-cap fund, mid and small caps take minor portions each in the basket. The fund has gained about 72.4% over the past five-year period. Vanguard Total Stock Market ETF (NYSEARCA: VTI ) – Expense ratio: 0.05% This ETF follows the CRSP US Total Market Index, holding a large basket of 3,712 securities. Each security holds no more than 2.5% of total assets while financials, technology, consumer services and health care make up for a nice sector mix in the portfolio. It is one of the largest and a popular fund with AUM of nearly $57.9 billion and average daily volume of nearly 3.5 million shares. It charges 5 bps in fees and expenses and has gained 70.3% over the past five years. Vanguard S&P 500 ETF (NYSEARCA: VOO ) – Expense ratio: 0.05% This is another low-cost, well-diversified large-cap fund tracking the S&P 500 index. It holds 505 securities in its basket with each taking less than 3.2% share while sector-wise too, none accounts for more than 21% of assets. The fund has AUM of $43.5 billion and trades in heavy volume of 2.7 million shares per day on average. Expense ratio came in at 0.05%. The ETF returned about 74.5% in the same period. Link to the original post on Zacks.com

Tax Efficiency: A Decisive Advantage For Some Index Stock Funds

Key highlights “Tax cost”-the difference between the before-tax return of a fund and its preliquidation after-tax return-is a way to gauge a fund’s tax efficiency. Vanguard analysis found that, for the 15 years ended November 30, 2015, the median tax cost of domestic actively managed stock funds was 27 basis points higher than that of domestic index stock funds. Some index stock funds can be tax-inefficient as well, especially those that seek to track more narrowly focused benchmarks, such as those in the mid- and small-capitalization markets. Broad-market index stock funds and ETFs may be more tax-efficient than actively managed stock funds and ETFs. Just as some ways of managing investments are more tax-efficient than others, certain types of investments are, by their nature, more tax-efficient as well. What makes one mutual fund more tax-efficient than another? Some relevant factors include a portfolio’s management strategy, the turnover or trading strategy, the accounting methodology used, and the activity of the fund’s investors. “One way that a fund’s tax efficiency can be measured is with its ‘tax cost,’ ” said Scott Donaldson of Vanguard Investment Strategy Group. “Tax cost refers to the before-tax return of a fund minus its preliquidation after-tax return. It represents a very high hurdle for active fund managers to overcome, in addition to their ongoing fund management expenses.” The illustration below shows a decisive tax advantage for index stock funds: The median tax cost for index stock funds (left side, green) was 71 basis points, whereas the median tax cost for actively managed stock funds (right side, green) was 98 basis points. Thus, for the funds in the data set, the median tax cost of domestic actively managed stock funds was 27 basis points higher than that of domestic index stock funds. The gap can be even larger: Note the 295 basis-point difference between the worst tax costs (shown in blue) of domestic actively managed and index stock funds. Moreover, the chart shows a much narrower range in tax cost in the index category. Why index stock funds may have the upper hand Because active managers make decisions based on a security’s potential to outperform, they can be more inclined to make specific, concentrated purchases in fewer stocks and to liquidate entire holdings more often than managers of broad-market index stock funds would. In making wholesale liquidations, active managers can be much more likely to realize capital gains, since an entire position’s gain could be realized at once. The tax efficiency of actively managed stock funds could, therefore, be much less stable, and the lack of depth and breadth of share lots in actively managed stock funds could negatively affect their future tax efficiency. Actively managed stock funds also have the potential for manager changes, resulting in new managers completely restructuring the portfolio, which could cause realization of gains from past investment success. Granted, some index stock funds can be tax-inefficient as well (see chart above). For example, stock funds that seek to track more narrowly focused benchmarks, such as those in the mid- and small-capitalization markets, fall into the bottom quartile in Vanguard’s tax-cost analysis. “Much more broadly based index stock funds will typically be more tax-efficient because they change their holdings less often,” Donaldson said. “Moreover, not all ETFs or conventional index stock funds are the same. Even stock funds that seek to track the same index can have different performance. The bottom line is, while Vanguard believes it’s much more important to manage the overall allocation of assets in your portfolio than it is to manage exclusively for taxes, your portfolio’s tax efficiency is important to take into account.” Aside from choosing stock funds that are more tax-efficient, investors can also engage in other best practices to minimize their taxes: Use tax-advantaged accounts. Maximize the use of tax-advantaged accounts, such as 401(k) plans and IRAs (both traditional and Roth) and 529 college savings plans. Be a tax-efficient investor. Use tax-advantaged accounts to rebalance an asset allocation or to sell appreciated positions that may provide better after-tax returns than completing similar transactions in a taxable account. Pay attention to asset location. Purchase tax-efficient investments in taxable accounts and tax-inefficient investments in tax-advantaged accounts, which can help you keep additional returns. Those incremental differences can have a powerful compounding effect over the long run. Notes: All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. We recommend you consult an independent tax advisor for specific advice about your individual situation. Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.