what does it mean to say you invest in fixed income?...passive indices make sense; passive investing...

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Zeo Capital Advisors │ One Montgomery Street, Suite 3450 │ San Francisco, CA 94104 │ 415-875-5604 │ [email protected]

How to Pick a Bond Fund

Identifying Hidden Costs and Misunderstandings

Presented by:

Venk Reddy

Founder and Chief Investment Officer

Zeo Capital Advisors, LLC

2Confidential—Not for distribution For Investment Professional Use Only

What does it mean to say

you invest in fixed income?

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US Treasury / National Archives and Records Administration

In the 1940s, fixed

income investing

consisted largely of

investing in bonds and

holding them to

maturity. The primary

goal of fixed income is

little changed from

then: preserve capital

and earn income.


Source: Morningstar.com (as of 9/30/2016)

Starting in the 1970s bond mutual funds invested in a

core portfolio of bonds with some tactical trading to

actively manage exposures. Comparison to an aggregate

bond benchmark was used to measure mutual fund

performance.

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Today, a large number of fixed income mutual funds employ

strategies whose objectives are explicitly to beat a benchmark in

short timeframes. The original long-term “capital preservation +

income” investment objectives of fixed income have been

marginalized in favor of short-term trading goals.

© Zeo Capital Advisors, LLC 6Confidential—Not for distribution For Investment Professional Use Only

Asset Class or Risk Profile?

Long-Only Bonds/Loans

Dividend-Paying Equities

Distressed Credit

Unconstrained Fixed Income

Mortgage-Backed Securities

CBOs/CLOs

Rental Property

Long-Short Credit

Don’t mistake a strategy that uses

fixed income securities but exhibits

exposures traditionally associated with

other asset classes for a strategy that

targets a fixed income risk profile!

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Start with client and portfolio goals and timeframes.

Align measurement and metrics with goals.

Evaluate success over appropriate time periods.

For most fixed income investors,

the primary goal is still capital preservation.


Diversify Into Underrepresented Exposures


Cre

dit

Duration

Yield

25.6%7.6%

18.5% 48.3%

91.3% of funds

with core fixed

income returns

used duration as

the primary risk.

563 US fixed

income funds

surveyed

218 funds returned

1.5% to 3.5%

in last 3 years

Only 19 out of the

original 563 funds

offered a core

fixed option that

diversified away

from duration.

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King Kong vs. Godzilla (1962), © Toho Studios

ActiveActiveActiveActiveVs.Vs.Vs.Vs.PassivePassivePassivePassive


Active vs. Passive: It’s Complicated

“Active vs. Passive” is a shortcut –

what really matters is Value for Money.

Active Passive

Management Styles

Active Beta Passive BetaRisk Managed

Strategic Tactical

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Are Passive Investments Always Lower Cost?

Ticker

Ave

Duration

Ave

Credit Rtg

Expense

Ratio

iShares Core U.S. Aggregate Bond AGG 5.13 AA 0.08%

iShares 0-5 Yr IG Corporate Bond SLQD 2.42 A 0.15%

iShares iBoxx $ IG Corporate Bond LQD 8.13 A 0.15%

SPDR Barclays Short Term HY Bond SJNK 2.39 B 0.40%

iShares iBoxx $ HY Corporate Bond HYG 4.06 B 0.50%

PowerShares Senior Loan BKLN ?? B 0.65%

Sources: Bloomberg, Morningstar, Zeo (as of 12/31/2015)


How Does Someone Invest Passively?

Passive indices make sense; passive investing doesn’t.

Inflows = OWIC

Outflows = BWIC

The trend toward passive funds has had unintended consequences!

Lift the OfferLift the OfferLift the OfferLift the Offer

Hit the BidHit the BidHit the BidHit the Bid

Indexed strategies typically

transact in response to

fund flows rather than

market opportunity. As the

use of passive funds has

grown, indices have

become reflections of fund

flows rather than

underlying value, limiting

their utility as benchmarks.

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The Cost of “Passive” Trading

AUM ($m) Δ AUM Total Return AUM Gain/Loss Fund Flows

12/11/15 $ 14,449.07

12/14/15 $ 13,870.65 (578.42) -0.87% (125.38) (453.04)

12/15/15 $ 14,152.29 281.64 1.64% 226.99 54.65

12/16/15 $ 14,341.28 189.00 0.76% 107.75 81.25

12/17/15 $ 14,370.66 29.38 -1.11% (159.89) 189.27

12/18/15 $ 14,270.03 (100.63) -0.38% (53.99) (46.63)

Step 1: Estimate Daily Fund Flows




AUM ($m) Fund Flows As % of AUM Bid/Offer As % of AUM

12/11/15 $ 14,449.07 0.50% of face value

12/14/15 $ 13,870.65 (453.04) -3.3% 0.0163%

12/15/15 $ 14,152.29 54.65 0.4% 0.0019%

12/16/15 $ 14,341.28 81.25 0.6% 0.0028%

12/17/15 $ 14,370.66 189.27 1.3% 0.0066%

12/18/15 $ 14,270.03 (46.63) -0.3% 0.0016%

Total: 0.0293%

Step 2: Calculate Bid/Offer of Fund Flows


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© Zeo Capital Advisors, LLC

AUM ($m) Trend As % of AUM Bid/Offer As % of AUM

12/11/15 $ 14,449.07 0.50% of face value

12/14/15 $ 13,870.65 (36.30) -0.3% 0.0013%

12/15/15 $ 14,152.29 (36.30) -0.3% 0.0013%

12/16/15 $ 14,341.28 (36.30) -0.2% 0.0012%

12/17/15 $ 14,370.66 (36.30) -0.3% 0.0013%

12/18/15 $ 14,270.03 (36.30) -0.3% 0.0013%

Total: 0.0063%



Step 3: Adjust for Long Term AUM Trend



AUM ($m) Trend As % of AUM Bid/Offer As % of AUM

12/11/15 $ 14,449.07 0.50% of face value

12/14/15 $ 13,870.65 (36.30) -0.3% 0.0013%

12/15/15 $ 14,152.29 (36.30) -0.3% 0.0013%

12/16/15 $ 14,341.28 (36.30) -0.2% 0.0012%

12/17/15 $ 14,370.66 (36.30) -0.3% 0.0013%

12/18/15 $ 14,270.03 (36.30) -0.3% 0.0013%

Total: 0.0063%



Step 3: Adjust for Long Term AUM Trend


Bid/Offer of Fund Flows: 0.0293%

Long Term Trend Adjustment: -0.0063%

Net Estimated Trading Costs: 0.0230%

Annualized: 1.1964%

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Are Passive Investments Always Lower Cost? No!

Ticker

Ave

Duration

Ave

Credit Rtg

Expense

Ratio

Trading

(‘15 est)

Total

Cost

iShares Core U.S. Aggregate Bond AGG 5.13 AA 0.08% 0.09% 0.17%

iShares 0-5 Yr IG Corporate Bond SLQD 2.42 A 0.15% 0.17% 0.32%

iShares iBoxx $ IG Corporate Bond LQD 8.13 A 0.15% 0.47% 0.62%

SPDR Barclays Short Term HY Bond SJNK 2.39 B 0.40% 0.71% 1.11%

iShares iBoxx $ HY Corporate Bond HYG 4.06 B 0.50% 1.01% 1.51%

PowerShares Senior Loan BKLN ?? B 0.65% 0.26% 0.91%




Ticker

Ave

Duration

Ave

Credit Rtg

Expense

Ratio

Trading

(‘15 est)

Total

Cost

AGG 5.13 AA 0.08% 0.09% 0.17%

SLQD 2.42 A 0.15% 0.17% 0.32%

LQD 8.13 A 0.15% 0.47% 0.62%

SJNK 2.39 B 0.40% 0.71% 1.11%

HYG 4.06 B 0.50% 1.01% 1.51%

BKLN ?? B 0.65% 0.26% 0.91%


The highest trading friction happens in the

most underrepresented areas of fixed income.

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Ticker

Ave

Duration

Ave

Credit Rtg

Expense

Ratio

Trading

(‘15 est)

Total

Cost

AGG 5.13 AA 0.08% 0.09% 0.17%

SLQD 2.42 A 0.15% 0.17% 0.32%

LQD 8.13 A 0.15% 0.47% 0.62%

SJNK 2.39 B 0.40% 0.71% 1.11%

HYG 4.06 B 0.50% 1.01% 1.51%

BKLN ?? B 0.65% 0.26% 0.91%


It may be optimal to use both active and passive strategies

in a portfolio of diversified exposures.

Understand what you are paying for –

Deliberate portfolio management is a good start!


Active Management Makes a Difference

Source: Bloomberg Finance L.P.

Small price differences

between dealers can lead

to widely varying yields.

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Being patient can make a

big difference to the price

and yield in a portfolio.




Hitting bids and lifting offers can sometimes have the opposite effect!

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Communicating about

fixed income to clients is

difficult because most

people learned about

investing using equities.


It’s an Equity Investor’s World

Bonds Mutual Funds

YTM / YTW Ave. not allowed (“confusing”)

Current Yield (not useful)TTM Yield (hindsight using divs)

30-Day SEC Yield (short-term)

Total Return Growth of $10,000

Interest Rate Duration Ave. Duration (self-reported)

Credit Spread Duration Ave. Maturity (self-reported)

Performance Measures

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What If You Succeed?

What if you create

a portfolio

that behaves more

like a bond?

Total Return: +3.57%

Std Deviation: 1.35%

vs.

AGG Only: +3.51%

Std Deviation: 2.87%

The data above reflects actual performance of an

equal-weighted portfolio of four fixed income funds.

Month-End Account NAV

12/31/2014 $10,000.00

3/31/2015 $10,145.06

6/30/2015 $10,121.33

9/30/2015 $10,235.74

12/31/2015 $10,214.73

3/31/2016 $10,384.85

6/30/2016 $10,526.41

9/30/2016 $10,633.53


“Why Are We Down?” Wait. What?

Where’s the missing performance?

Your clients may be seeing something else:

Quantity Last Price Cost Basis Current Value Total Gain/Loss

251.51 $9.94 $9.94/share $2,500.00 $0.00

$2,500.00 0.00%

274.73 $9.18 $9.10/share $2,521.98 $21.98

$2,500.00 0.88%

227.89 $10.92 $10.97/share $2,488.61 ($11.39)

$2,500.00 -0.46%

22.70 $112.42 $110.12/share $2,552.22 $52.22

$2,500.00 2.09%

Account Total $10,000.00 $10,062.80 $62.80

0.63%

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251.51 $9.94 $9.94/share $2,500.00 $0.00

$2,500.00 0.00%

274.73 $9.18 $9.10/share $2,521.98 $21.98

$2,500.00 0.88%

227.89 $10.92 $10.97/share $2,488.61 ($11.39)

$2,500.00 -0.46%

22.70 $112.42 $110.12/share $2,552.22 $52.22

$2,500.00 2.09%

Account Total $10,000.00 $10,062.80 $62.80

0.63%



Where’s the missing performance?

Your clients may be seeing something else:

Most client reports only show price return.

Dividends credited to cash are not included!


Dividend reinvestment doesn’t fix the problem:




266.02 $9.94 $9.94/share $2,644.21 ($0.14)

$2,644.35 -0.01%

291.04 $9.18 $9.10/share $2,671.75 $22.39

$2,649.36 0.84%

243.79 $10.92 $10.97/share $2,662.15 ($11.95)

$2,674.10 -0.45%

23.62 $112.42 $110.13/share $2,655.42 $54.14

$2,601.28 2.08%

Account Total $10,569.10 $10,633.53 $64.44

0.61%

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266.02 $9.94 $9.94/share $2,644.21 ($0.14)

$2,644.35 -0.01%

291.04 $9.18 $9.10/share $2,671.75 $22.39

$2,649.36 0.84%

243.79 $10.92 $10.97/share $2,662.15 ($11.95)

$2,674.10 -0.45%

23.62 $112.42 $110.13/share $2,655.42 $54.14

$2,601.28 2.08%

Account Total $10,569.10 $10,633.53 $64.44

0.61%

Dividend reinvestment doesn’t fix the problem:



Most clients’ view of performance has an equity

mindset – price appreciation is the driver.

For fixed income, clients should be educated about

the important of total return.


Summary

Align measurement and metrics with goals

Diversify into underrepresented exposures

Focus on value for money

Avoid looking at fixed income through an equity lens

Hidden costs and misunderstandings

arise from heuristics and shortcuts –

You can avoid this by asking why.

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Questions?

Venk ReddyFounder and CIOO: 415-875-5604E: [email protected]

Paige UherDirector Investor RelationsO: 415-875-5614E: [email protected]

Thank you!

© Zeo Capital Advisors, LLC 32

Disclosures and Definitions

Disclosures

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it

should not be assumed that future performance of any specific investment or investment strategy (including the investments and/orinvestment strategies recommended and/or undertaken by Zeo Capital Advisors, LLC), will be profitable, equal any historical

performance level(s), be suitable for your portfolio or individual situation, or prove successful. Moreover, you should not assume thatany discussion or information contained in this deck serves as the receipt of, or as a substitute for, personalized investment advice from

Zeo Capital Advisors, LLC. Please remember that it remains your responsibility to advise Zeo Capital Advisors, LLC, in writing, if there areany changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous

recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investmentadvisory services. A copy of our current written disclosure statement discussing our advisory services and fees is available upon request.

The performance data quoted represents past performance. Data are believed to be accurate at the time of printing but are unaudited

and may differ from prior or subsequent communications covering the same period.

Performance shown within, including hypothetical net asset values and performance, is calculated from market values for theoreticalpositions only. Prospective and current clients should be aware of a resulting degree of subjectivity in the data presented.

Definitions

Standard deviation (Std Dev): measures the volatility or the variability around the average return.The Barclays Capital U.S. Aggregate Bond Index: covers the USD-denominated, investment-grade, fixed-rate, taxable bond market of

SEC-registered securities. The index includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate andhybrid ARM pass-throughs), ABS, and CMBS sectors. The U.S. Aggregate Index is a component of the U.S. Universal Index in its entirety.

Unmanaged index returns do not reflect any fees, expenses or sales charges.

Confidential—Not for distribution For Investment Professional Use Only

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Exchange Traded Products (ETPs) make up a category of exchange-traded securities that includes ETFs (exchange traded funds); an ETFis a type of investment company whose investment objective is to achieve the same return as a particular market index. An ETF is

similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. An ETFwill invest in either all of the securities or a representative sample of the securities included in the index. ETF’s are subject to specific

risks, depending on the nature of the underlying strategy of the fund. These risks could include liquidity risk, sector risk, as well as risksassociated with fixed income securities, real estate investments, and commodities, to name a few.

In general, ETFs can be expected to move up or down in value with the value of the applicable index. Although ETF shares may be

bought and sold on the exchange through any brokerage account, ETF shares are not individually redeemable from the fund. In somecases, investors may acquire ETFs and tender them for redemption through the fund. Please see the individual fund prospectus for

more details.

Typically, a rise in interest rates causes a decline in the value of fixed income securities. The overall fixed income market risk may affectthe value of individual instruments. The price of equity securities may rise or fall because of changes in the broad market or changes in

a company's financial condition, sometimes rapidly or unpredictably.

Investing in high yield fixed income securities, otherwise known as "junk bonds" is considered speculative and involves greater risk ofloss of principal and interest than investing in investment grade fixed income securities. These lower-quality debt securities involve

greater risk of default or price change due to potential changes in the credit quality of the issuer.




The iShares Core U.S. Aggregate Bond ETF (”AGG”) seeks to track the investment results of an index composed of the total U.S.investment-grade bond market.

The iShares 0-5 Year Investment Grade Corporate Bond ETF (“SLQD”) seeks to track the investment results of an index composed of U.S.

dollar-denominated, investment-grade corporate bonds with remaining maturities of less than five years.

The iShares iBoxx $ Investment Grade Corporate Bond ETF (“LQD”) seeks to track the investment results of an index composed of U.S.dollar-denominated, investment grade corporate bonds.

The iShares iBoxx $ High Yield Corporate Bond ETF (“HYG”) seeks to track the investment results of an index composed of U.S. dollar-

denominated, high yield corporate bonds.

Before investing, consider each fund’s investment objectives, risks, charges and expenses. To obtain a prospectus or summaryprospectus which contains this and other information, call 1-800-983-0903. Read it carefully before investing.


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The SPDR® Barclays Short Term High Yield Bond ETF (“SJNK”) is an exchange traded fund that seeks to provide investment results that,before fees and expenses, correspond generally to the price and yield performance of the Barclays US High Yield 350mn Cash Pay 0-5 Yr

2% Capped Index (“SJNK Index”).

The Barclays US High Yield 350mn Cash Pay 0-5 Yr 2% Capped Index includes short-term publicly issued U.S. dollar-denominated highyield corporate bonds. High yield securities are generally rated below investment-grade and are commonly referred to as "junk" bonds.

The Index includes publicly issued U.S. dollar denominated, non-investment-grade, fixed rate, taxable corporate bonds that have aremaining maturity of less than 5 years regardless of optionality, are rated high-yield (Ba1/BB+/BB+ or below) using the middle rating of

Moody's Investors Service, Inc., Fitch, Inc., or Standard & Poor's, Inc., respectively, and have $350 million or more of issuance. The Indexincludes only corporate sectors. The corporate sectors are Industrial, Utility and Financial Institutions. Excluded from the Index are non-

corporate bonds, structured notes with embedded swaps or other special features, bonds with equity-type features (e.g., warrants,convertibility), floating-rate issues, Eurobonds, defaulted bonds, zero coupon bonds and payment in kind securities. The Index is issuer-

capped and the securities in the Index are updated on the index rebalancing date. Unmanaged index returns do not reflect any fees,expenses or sales charges.

SJNK invests by sampling the SJNK Index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key

risk factors and other characteristics which may cause the fund to experience tracking errors relative to performance of the SJNK Index.

Before investing, consider SJNK’s investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectuswhich contains this and other information, call 1-866-787-2257. Read it carefully before investing.




The PowerShares® Senior Loan Portfolio (“BKLN”) is an exchange traded fund based on the S&P/LSTA U.S. Leveraged Loan 100 Index(“BKLN Index”). BKLN will normally invest at least 80% of its total assets in the component securities that comprise the BKLN Index. The

BKLN Index is designed to track the market-weighted performance of the largest institutional leveraged loans based on marketweightings, spreads and interest payments. BKLN and the BKLN Index are rebalanced and reconstituted bi-annually, in June and

December.

The S&P/LSTA U.S. Leveraged Loan 100 Index comprises the 100 largest bank loans with floating rate coupons.includes short-termpublicly issued U.S. dollar-denominated high yield corporate bonds. Most senior loans are made to corporations with below investment-

grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may notbe sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower

under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may beilliquid. Unmanaged index returns do not reflect any fees, expenses or sales charges.

BKLN’s use of a representative sampling approach will result in its holding a smaller number of bonds than are in the underlying Index,

and may be subject to greater volatility.

Before investing, consider BKLN’s investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectuswhich contains this and other information, call 1-888-678-4667. Read it carefully before investing.


what does it mean to say you invest in fixed income?...passive indices make sense; passive investing...

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