CHIEF INVESTMENT OFFICE

The Monthly Letter

MAY 2017

Market Disconnects — 
Authors
Rodrigo C. Serrano

Real or a Head Fake?

Vice President
Nicholas Giorgi
Vice President
John Veit
Positive sentiment — mostly led by optimism about pro-growth reforms from Washington Director
that have unleashed “animal spirits” from market participants — has been a key support of the Emmanuel D. Hatzakis
S&P 500 Index. Stronger-than-expected economic growth has boosted sentiment, helping buoy Director

the market even as policy expectations have remained in limbo. However, we have seen breaks
in the market start to appear, and the question is whether this recent optimism will fade or
Recent Publications
increase from real economic growth. We look at these breaks to understand if these market
Weekly Letter
disconnects are warranted or temporary. Oil’s Toil and the VIX Tricks
Mexico: the Global Piñata
The S&P 500 is in record-high territory, up about 13% since the election1. If markets have lost faith in Retailers’ demise greatly
exaggerated
the fiscal policy themes, how is the market up double digits? In our view, the main driver has been the Policy Prognostications
accelerating-growth data since the election countering diminishing policy expectations. Recently, this Monthly Letter
International vs. U.S. Markets — 
has prompted several questions from clients and advisors: The Tide Could Be Turning

• Is the acceleration in growth driven primarily by “soft” data? ISC Viewpoint

The Power of Profits
• Isn’t it circular reasoning to use stronger sentiment to justify higher equity prices, which in turn
creates a positive feedback loop raising sentiment?
In our view, the majority of these market disconnects are unfounded and temporary. Historically, “soft”
data are a larger driver of equity market performance than “hard” data. This is mostly due to the
timeliness of “soft” data, as compared to “hard” data reporting, which is typically delayed. But it should
alleviate client concerns that the recent performance in the equity markets has not been
driven by euphoria; in fact, stronger growth data and the profit cycle have driven the markets.

1
From November 8, 2016, to May 25, 2017.

The Wealth Allocation Framework

The Wealth Allocation Framework helps you put your goals and aspirations at the center
of decisions about allocating your financial resources. Asset categories within the
LIFE framework include:
PRIORITIES Personal: Individual investors have a desire for safety and personal financial
obligations they want to meet regardless of market conditions. To safeguard
essential goals, investors can hold lower-risk assets—but they have to accept lower
returns in exchange.
Market: When we invest, we strive to capture market growth most efficiently. Today,
access to a broadening array of asset classes and types makes diversifying beyond
stocks and bonds easier than ever before.
Aspirational: Investors seek significant wealth mobility. To pursue goals that require
higher-than-market returns, investors often need to take higher and concentrated risks.

Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated
(MLPF&S) and other subsidiaries of Bank of America Corporation (“BofA Corp.”).
Investment products:
Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value
Please see important disclosure information on the last page.
Approaching eight brings debate
Exhibit 1: Tight wallets belie high confidence
As the U.S. economic expansion approaches eight years in
June, a perceived divergence between better “soft” (sentiment- Simple Average of Consumer Confidence Indices Personal Spending (rhs)
115 9
based) economic data and “hard” (more objective) figures
8
has generated heated debate on its near-term trajectory.

Annualized 3-Month Average (%)

110
7
Our belief that it will turn out to be the longest expansion in 105
6
U.S. history is predicated on gradual economic growth and 100 5

Index
steady inflation allowing the Federal Reserve (Fed) to maintain 95 4

accommodative monetary policy. In addition, the prospect of 90

3

curtailed regulation and tax reform, key components of the 2

85
1
Republican administration’s pro-business legislative agenda,
80 0
would encourage private investment, creating a propitious

May-16

Nov-16

Mar-17
Aug-16

Sep-16
Apr-16

Dec-16

Feb-17
Oct-16
Jun-16

Jan-17
Jul-16
setting for a rebound in productivity, which has been a
major factor behind subpar growth. Historically, “hard” data Source: Bloomberg, University of Michigan, Conference Board, Chief Investment
have reaffirmed economic trends first picked up by “soft” Office. Data as of 1Q 2017. See Appendix for index definition.

data, which is why equities, as an asset class focused on

earnings potential, have rallied strongly this year despite the
divergence. It is therefore important to take stock of the
argument today. Eventually, more “hard” data will need to
reaffirm the positive economic trend, or investors may become
concerned on its short-term prospects and the potential
implications for corporate earnings.
The “hard” versus “soft” contest has significance…
Since the turn of the year, strong readings from surveys
measuring economic prospects in the eyes of consumers
and business owners have been a major contributor to
Bloomberg’s U.S. Economic Surprise Index, which measures
the results of economic data versus analysts’ expectations.
A decidedly optimistic cohort has been the U.S. consumer.
Both the University of Michigan and the Conference Board
report that their respective consumer confidence indices have
surpassed pre-recession levels to arrive at their highest levels
since early 2001. However, analysts who have estimated “hard”
data capturing consumption trends commensurate with these
lofty readings have largely been disappointed. U.S. personal
spending, a key aggregate indicator measuring dollars spent,
has undershot the Bloomberg consensus estimate every
month this year through March (see Exhibit 1). Supporting
the trend of tightened wallets have been domestic car sales,
which underperformed expectations in three of the past four
months through April, as well as retail sales excluding auto
and gas purchases, which disappointed in February and March.
The diverging trends have left analysts as bewildered as the
development of a 4.4% unemployment rate failing to pull
wages out of their slumber.
The “soft” versus “hard” data divergence has also been detected in
the U.S. industrial sector, though to a lesser degree. After President
Trump’s election, through the first quarter of this year, sentiment-
based indices in industrial hubs located in New York, Virginia,
Texas and Pennsylvania rose more than expected, feeding into
broader national Purchasing Manager Indices (PMI) published by
the Institute of Supply Management (ISM) and Markit Economics.
Yet, “hard” data, such as industrial production and construction
spending, generally lagged during this period. The former produced
one positive growth surprise in December’s report, followed by
discouraging readings for January and February. Meanwhile, growth
in the latter has consistently fallen short since November.
In the broader economy, there are other examples of disparity.
Within “hard” data, the most obvious disappointment is the
seasonally adjusted 1.2% annualized growth rate in real gross
domestic product during the first quarter. Concurrently, growth
of loans from banks for commercial and industrial projects has
quickened its deceleration throughout the year. However, “soft”
data contradict the gloomy scenario. A gauge of small business
optimism, published by the National Federation of Independent
Business, is at a level surpassed only three times in its history
going back to 1975. In addition, the ISM’s service PMI has been
flagging acceleration and remains in solid territory (see Exhibit 2).
It’s not only “soft” data that are outperforming “hard”; the
reverse can be seen in inflation and inflation expectations.
Year-over-year growth in consumer prices has rebounded since
mid-2015 and stands at 2.2% (as of April). However, market
expectations of inflation over the coming 12 months have
notably declined since peaking late February (see Exhibit 3).

CIO REPORTS • The Monthly Letter 2

 better-than-forecast expansion in factory orders. What’s more,
Exhibit 2: If the economy is improving, why is loan
capital goods shipments, a proxy for business investment, have
growth slowing?
performed better than estimated in four of the six months from
ISM Services Index Bank Loans to Commercial and Industrial Enterprises (rhs)
November to April. In housing, new and pending home sales have
58 12
11 recently increased more than expected, confirming stellar data in
57 10
the National Homebuilders Association’s Housing Index, another
Index, 3-Month Average

Year-Over-Year (%)
56 8 sentiment-based indicator. Finally, the “hard” data that trump
7
55 6
all, corporate earnings growth, have accelerated to nearly 14%
5 year-over-year for the S&P 500, reflecting improving investment
54 4
3
spending at home and stronger-than-expected growth in non-U.S.
53 2 economies. In fact, the Bank of America Merrill Lynch (BofAML)
1
52 0 Global Research Global Earnings Revisions Ratio is flagging more

Apr-17
Jul-16

Mar-17
Oct-16

Nov-16
May-16

Aug-16

Feb-17
Jun-16

Sep-16

Jan-17
Dec-16

upward than downward revisions for the first time in many years,
suggesting that future quarters should also exhibit good growth.
Source: Bloomberg, Board of Governors of the Federal Reserve System, Chief
Investment Office. Data as of April 30, 2017. See Appendix for index definition. Some digression in Europe
With some exceptions, the “soft” versus “hard” division has not
Exhibit 3: Markets see inflation moving lower, been as stark in Europe. One of these exceptions can be seen
not higher in the French consumer sector, where “soft” data in consumer
Consumer Price Index U.S. Breakeven 1 Year confidence do not fully corroborate with “hard” data such as
3.0 household consumption. Meanwhile, on a Europe-wide basis,
we see some distinction in the industrial sector with surging
2.5
Trump elected optimism reflected in Markit’s industry PMI juxtaposed to
November 8th
Year-Over-Year (%)

2.0
positive, but ho-hum “hard” data with year-over-year growth
1.5 in manufacturing (see Exhibit 4). Overall, we believe the
truth in these dissimilarities regarding economic growth lie
1.0
somewhere in the middle, with “soft” data drifting lower, but
0.5
“hard” data rising to meet it.
0.0
Apr-17
Mar-17
Oct-16

Nov-16
May-16

Aug-16

Feb-17
Jun-16

Sep-16

Jan-17
Dec-16

Exhibit 4: Optimism has surged, but “hard” data is

Jul-16

slow to catch-up
Source: Bloomberg, Bureau of Labor Statistics, Chief Investment Office.
Data as of April 28, 2017. See Appendix for index definition. Markit Manufacturing PMI
Past performance is no guarantee of future results. Industrial Production (Ex-Construction & Working Day Adjusted)

56 4
Year-Over-Year, 3-Month Average (%)
55
… but let’s not get carried away 54
3
Index, 3-month average

While the “soft” versus “hard” data debate is significant, the 53 2

divergence is not as palpable as it may seem. On aggregate, “hard” 52

1
data from the labor market have outperformed expectations since 51
50 0
the turn of the year, according to Bloomberg’s U.S. Surprise Index.
49
The four-week average of initial jobless claims has hovered near -1
48
its lowest level since 1973. The dip in firings has been reflected 47 -2
Apr-15

Apr-16
Oct-15

Oct-16
Aug-15

Aug-16
Feb-15

Feb-16

Feb-17
Jun-15

Jun-16

in better-than-expected performance in the unemployment

Dec-14

Dec-15

Dec-16

rate, which has matched its lowest reading in a decade at 4.4%.

Source: Bloomberg and Chief Investment Office. Data as of 1Q 2017. See Appendix
Meanwhile, a strong rise in industrial production in March surprised for index definition.
the consensus estimate, potentially affirming a consistently

CIO REPORTS • The Monthly Letter 3

Divergence between global policy uncertainty
and market volatility
As profits continue to paint an optimistic picture, the
financial markets have responded with resounding applause.
Broad equity indexes, domestic and international alike, have
advanced, and bond indexes have also booked gains for the
year. However, while the breadth of encouraging market gains
has been wide, the differential in performance between certain
segments of the market has at times confounded observers.
Certain markets once poised to produce within the context
of the current economic backdrop may have stalled, while
others seemingly bereft of upside have charted impressive
gains. Furthermore, in contrast to an environment rife with
political and economic uncertainty, volatility has remained
subdued. Markets also seem unconcerned about the risk
from rising geopolitical tensions. As an example, the standoff
with North Korea has significantly escalated since the new
U.S. administration took over and began pursuing a more
aggressive policy toward that regime. While that small hostile
nation is believed to be far from having the ability to strike the
mainland U.S. with ballistic missiles carrying nuclear warheads,
it can cause nuclear catastrophes to neighboring countries,
such as South Korea. Yet, the equity markets in such countries,
and the region as a whole, have been trending up (see Exhibit
5). How do we reconcile all of this?
Exhibit 5: Asia Pacific stock markets are rising amid
tensions in the Korean peninsula
MSCI Korea Index (KRW) MSCI Taiwan Index (TWD)
MSCI Japan Index (JPY) MSCI All Country Asia Pacific Index (USD)
120
115
Indexed to 100
110
105
100
95
12/31/2016 1/31/2017 2/28/2017 3/31/2017 4/30/2017
Source: Chief Investment Office, Bloomberg. Country indices in local currency;
regional index in USD. See Appendix for index definitions. Data as of May 22, 2017.
Past performance is no guarantee of future results.
2
BofAML Global Research, European Equity Strategy, April 28, 2017.
CIO REPORTS • The Monthly Letter
Is now Europe’s time to shine?
After trailing the S&P 500 by more than 12% last year, European
equities (MSCI Europe TR USD) have enjoyed strong performance
this year, with returns of 11% through April, approximately 400
basis points (bps) greater than the S&P 500 (see Exhibit 6).
Impressively, the European equity markets posted these gains
during a period in which the implications of Brexit remained
in flux and the political calendar threatened to imperil the
conceptual foundations of the Eurozone. To that point, a portion
of the region’s market bounce can be fairly attributed to more
clarity within the political calendar; benign election results in the
Netherlands and France tempered fears of budding populism. In
addition, these welcomed political results have been buttressed
by strong earnings momentum generated within the European
corporate — sector first-quarter earnings have been strong and
BofAML Global Research projects 2017 earnings per share
growth of 15% (see Exhibit 6). For their part, market participants
have joined in on the excitement, with retail inflows of $6 billion
in recent weeks after $103 billion of outflows in 20162.
In the U.S., a slightly different setup has emerged —strong
corporate profits have powered growth, but the political
landscape has become murkier, as the timing and passage of
policy remain in flux. This dual narrative has been illustrated
in the diverging performance of large and small cap stocks.
Small caps were expected to be natural beneficiaries of policy
prescriptions such as deregulation and tax reform, while
remaining more insulated from negative ramifications of
trade frictions and a stronger dollar. Alternatively, companies
enjoying a higher market cap typically average lower
marginal tax rates and earn a significant portion of revenues
abroad, features that appeared less likely to induce upside.
As the political ambitions of policymakers have collided
with the infrastructural needs hampered by Washington
bureaucracy, the pace and magnitude of reform have been
challenged. International commerce has also remained
largely uninterrupted, with strong revenues earned abroad by
companies exposed to these regions. To this point, large cap
equities have benefited, with a double-digit earnings growth
for the S&P 500 in the first quarter, while small cap earnings
have stalled but are projected to pick up in the later portion
of the year. The equity markets have rewarded performance
in kind, with large cap stocks handily outperforming small cap
stocks by over 350bps through April.
4
 behind this observation is that investor value is unlocked
Exhibit 6: Regions outside the U.S. are projected to
through periods of increasing profit. Likewise, investors are
have the highest earnings growth
more willing to pay for growth when profits are deficient.
2016 2017E 2018E
As the U.S. economic backdrop is one of cyclical expansion,
20
20% value equities had been expected to be best positioned; yet,
18 the market experience has been quite different, with growth
16 15% building a sizable advantage over value. Through April, the
14
12 11% Russell 3000 Growth Index generated returns of 11.1%, while
Percent (%)

10% the Russell 3000 Value Index accrued 2.8%, a difference of

10 9%
8 8%
6% 830bps. To what can we attribute the difference? The answer
6
lies in the sector distribution of returns. Financials (1.7%),
4
2 Energy (-9.4%), and Utilities (7.2%) represent the greatest
0% 0%
0 allocations within the value style, while Technology (15.4%),
S&P 500 S&P 600 SC Euro Stoxx 600
Health Care (10.0%), and Consumer Discretionary (11.1%)
Source: BofAML Global Research, Chief Investment Office. carry the largest allocations within the growth style3. While
Data as of May 2017. See Appendix for index definitions.
Past performance is no guarantee of future results. the logic underpinning a bullish outlook towards value relative
to growth has been sound, idiosyncratic risks have punished
certain value sectors, including Financials and Energy, while
Sector reflation takes a pause: Sector and cyclicals
versus defensives dispersion exceptional profit growth within the Technology sector has
The story of dispersion within pockets of the U.S. equity helped buoy growth.
market does not end at capitalization; sectors have
also experienced a broad spectrum of returns in 2017. Exhibit 7: Selection matters, dispersion is high
Corresponding to our position within the growth phase
R1000 Value Sector Weight R1000 Growth Sector Weight YTD Performance
of the profit cycle, cyclical sectors have been expected
to flourish, while defensive sectors are expected to trail. 25
The market has largely affirmed this position, but with some 20
notable outliers. For example, cyclical sectors, including 15
25 Percentage Points

Technology and Consumer Discretionary, have been rewarded 10

Percent (%)

by investors, while Financials have struggled — again, due 5

to the overhang of darkened clouds of political uncertainty. 0
Certain defensive sectors have performed in line with the
ls

re

ls

ls

gy

na er
tie

le
rg
ia

ria

ia
co
ca

tio m
lo

ry
ap
e
nc

er
ili

re su
le

o
th

st
En

-5
St
at

hn
Ut
na

Te
du

sc on
al

c
Fi

He

In

broader market, while Telecom and Energy have experienced Di C

Te
Co

-10
sizable losses, contributing to a performance spread greater
-15
than 5% between the MSCI USA Cyclical Sectors and MSCI
Source: FTSE Russell, Chief Investment Office.
USA Defensive Sectors through April. In fact, the dispersion Data as of May 27, 2017. See Appendix for index definition.
between the best-performing sector (Technology) and the Past performance is no guarantee of future results.

worst-performing sector (Energy) totaled 25% (see Exhibit 7).

The stark contrast in performance between certain sectors
within the U.S. equity market has also permeated styles.
Historically, value often outperforms growth through periods
in which profit growth is more abundant, while growth
outperforms value when earnings are scarce. The intuition
Changing landscape for active managers
Finally, it is worth noting the impressive performance of active
equity managers thus far in 2017, set against a canvas of
negative flows, doomsday media coverage, and the public ire
of Warrren Buffett, the world’s most famous investor from
Omaha. Through April, 52% of U.S. mutual fund managers

3
FTSE Russell, 2016 Reconstitution Analysis, June 10, 2016.

CIO REPORTS • The Monthly Letter 5

beat their benchmarks, versus only 22% at this point last
year4. As the public perception of active managers seems to
have turned negative, asset outflows have followed. However,
the environment for active managers to exercise their value
proposition has become more favorable by some measures,
including pair-wise correlations, which are at or near pre-Global
Financial Crisis lows. The rise of passive vehicles has introduced
innovation and increased accessibility to many investors, but
active management also retains value in many circumstances.
Therefore, don’t pen active management’s epitaph just yet.

Portfolio Positioning: In our view, most of these market disconnects are temporary and likely to reverse. We continue to have a
cautiously optimistic outlook, supported by economic growth and the profit cycle, and to expect the “hard” data to catch up to the
“soft” data in the coming months. In our view, markets have overreacted to spots of weak data and have come to the conclusion
that, given the weakness, the Fed will not raise rates in the medium term. We have seen the Fed take a very cautious and gradual
approach to rate hikes, and we believe the overall picture continues to point to that approach. In our view, the combination of a
gradual Fed, stronger economic growth and the profit cycle continues to favor equities over bonds.
As we move through the remainder of the year, we expect profits to remain healthy, the “hard” data to trend higher and equities
to climb the wall of worry toward new highs. Continue to stay the course and rebalance portfolios upward in equities during
weaker periods.

4
BofAML Global Research, U.S. Mutual Fund Performance Update, May 2, 2017.

CIO REPORTS • The Monthly Letter 6

 CIO Insights A Conversation with Cliff Asness*
Insights and the best thinking from distinguished investors around the world.

Cliff is a Founder, Managing Principal and Chief Investment Officer at AQR Capital Management. He is an active researcher and has
authored articles on a variety of financial topics for many publications, including The Journal of Portfolio Management, Financial Analysts
Journal and The Journal of Finance. He has received five Bernstein Fabozzi/Jacobs Levy Awards from The Journal of Portfolio Management, in
2002, 2004, 2005, 2014 and 2015. Financial Analysts Journal has twice awarded him the Graham and Dodd Award for the year’s best paper,
as well as a Graham and Dodd Excellence Award, the award for the best perspectives piece, and the Graham and Dodd Readers’ Choice
Award. In 2006, CFA Institute presented Cliff with the James R. Vertin Award, which is periodically given to individuals who have produced a
body of research notable for its relevance and enduring value to investment professionals. Prior to cofounding AQR Capital Management,
he was a managing director and director of quantitative research for the Asset Management Division of Goldman, Sachs & Co. He is on the
editorial board of The Journal of Portfolio Management, the governing board of the Courant Institute of Mathematical Finance at New York
University, the board of directors of the Q-Group and the board of the International Rescue Committee. Cliff received a B.S. in economics
from the Wharton School and a B.S. in engineering from the Moore School of Electrical Engineering at the University of Pennsylvania,
graduating summa cum laude in both. He received an M.B.A. with high honors and a Ph.D. in finance from the University of Chicago, where
he was Eugene Fama’s student and teaching assistant for two years (so he still feels guilty when trying to beat the market).

GWIM CIO: In the past several years, hedge fund investing has been challenging. What are some of the
biggest misconceptions investors have about hedge funds, and where do you think the biggest opportunities
and value proposition lie in this space?

Cliff Asness
Managing and Founding
Principal
AQR Capital Management, LLC
Selected Contributions
• Received the James R. Vertin
Award from CFA Institute in
recognition of his lifetime
contribution to research.
• Five-time winner of the
Bernstein Fabozzi/ Jacobs
Levy Award and two-time
winner of the Graham and
Dodd Award for his research.
• Member of the governing
board of the Courant
Institute of Mathematical
Finance at NYU.
Cliff Asness: For more than 15 years, I’ve been saying that, as a whole, most hedge funds are too correlated with equity
markets and too expensive, given that too much of their return comes from long exposure to equity markets — something
that isn’t bad but is available at a very low fee. I took a lot of grief for being early with this opinion!
I also believe that hedge funds tend to set expectations too high, especially for the tough times that inevitably occur. If you
tell people you make magic returns that rarely lose, they are justifiably upset when they do lose! Reasonable fees, true
hedging, and honesty about expectations go a long way.
However, after years of being a leading critic, I believe that much of what we hear today is an overblown case against hedge
funds. It’s just bad math. The major reason for this is the failure of many to understand how to evaluate hedge fund returns.
Most often, hedge funds are (wrongly) compared to the S&P 500 Index, and many have pointed out that they’ve trailed since
the market hit bottom in 2009. However, even though the average hedge fund tends to be “net long” stocks, most are much
less long stocks than a typical mutual fund (that is, hedge funds are hedging some, though not as much as I would advocate!),
and so should not be compared to being fully invested in the equity market. Ironically my long-term complaint is that hedge
funds are too “net long” for no reason, and now I’m complaining that although they’re “net long” it’s still not nearly as much
as the market they’re being compared to. I know that can sound odd but I think both points are valid. Our research shows
that the average hedge fund should instead be compared, net of fees, to a 35-40% investment in the equity market, which
is roughly how much they are exposed to it on average. The question is then whether they add return past that 35-40%
exposure. If so, usually they’re a valuable investment. If you compare hedge fund returns to this measure, while they haven’t
been spectacular, they have not been as bad as some claim. I know, I know, it’s not a ringing endorsement, I’m really saying
they have not been nearly as bad as others say they are, not that they’ve been good. That’s why I call it a tepid defense**.
Regarding value propositions in this space, to me, a very important one is fees. We can take the above discussion one step
further and decompose hedge fund returns into three sources: traditional beta (which is exposure to traditional markets
like the S&P 500); hedge fund beta (which is exposure to well-known, dynamic sources of alternative returns like merger
arbitrage or value and momentum); and true alpha (which describes the portion of returns that are derived from idiosyncratic
investment processes and cannot be explained by the first two). I have already discussed how traditional beta coming from
hedge funds should carry a very low fee (Vanguard can do this for you). True alpha is often elusive and capacity-constrained
and should carry the highest fee if you think you’ve found it. Finally, the middle part, hedge fund betas are not some magical
proprietary secret, but they do offer good long-term, risk-adjusted returns that are uncorrelated to traditional assets
and should carry a fee somewhere in between traditional beta and true alpha. As investors become more aware of these
distinctions, they should more precisely get what they are paying for (I hope AQR is helping along these lines). To me, that’s a
good value proposition.

CIO REPORTS • The Monthly Letter 7

 CIO Insights A Conversation with Cliff Asness* (cont’d)
Insights and the best thinking from distinguished investors around the world.

In your journal articles you’ve often talked about how people tend to invest in separate styles without consideration of the benefits of
diversification. Can you elaborate on this?

While it’s admittedly difficult to consider everything at once, we should all try to do more in this direction. Individual strategies are often evaluated solely on how
they look standalone, and that’s often wrong. A strategy that looks very good but is very correlated with what you’re doing already is often not nearly as important
to you as a strategy that looks good, but not quite as good, but instead of being correlated with your portfolio it actually hedges it. While it’s hard to be specific,
we think the benefits of diversification are often not as sexy and obvious as top line return, but are often as or more important. We try to bring that focus to
everything we do.

In the liquid alternatives space, AQR has been an outlier for positive net flows over the last year. To what do you attribute that trend?

The short answer is that we’ve taken the value proposition that I mentioned above to heart. Let me go back to the decomposition of hedge fund returns into the
three parts that I described above (traditional beta, alternative beta, and true alpha). All three parts are things investors should want in their portfolio. However, while
traditional beta is something that you can easily get for low fees in other places, for a long time the only way to get alternative betas was through hedge funds (at
hedge fund fees). So, if you liked these alternative betas, you could only buy them as a tie-in-sale with a given hedge fund’s attempt at true alpha and you had to
pay fees as if it were all true alpha. In fact, when we started AQR we did the same. In the early days, these strategies were less well known and certainly not easily
accessible by investors in any format (at that point they were more like true alpha), so running them in a traditional hedge fund format made sense. However, the
market place is pretty smart and good ideas have a way of getting out there. I give us some credit (pretty generous of me, no?!) for recognizing this trend and creating
liquid alternatives that allow investors to get access to these alternative betas at fees that correspond to the fact that these are good long-term strategies, but (at this
point) not magical proprietary alpha. I think the market has been very receptive to that. But I don’t think it’s a magic formula. If you create alternatives that really
hedge (remember the average hedge fund is too net long, in our view), charges less, and is honest and transparent about what it does and how often it’s expected to
excel, I think the world beats a path to your door. We’ve gotten lucky to hit on this formula early but it’s not something only we can do.

Volatility has been exceptionally low again in 2017. Do you think this will continue, and how do you think a sustained lower volatility
environment will affect various investment strategies in your world?

I really don’t know whether the current low volatility environment will continue. Predicting market volatility is hard (other than the trivial short-term prediction
that when low your best guess next week is “still low,” though that’s only a guess, of course), and predicting market direction is much harder. This means market
timing is also very difficult, and we’ve written about this. I know I’m a broken record but both things lead us back to why we believe so strongly in diversification.
Our liquid alternative strategies tend to be designed to have low correlation to traditional markets, so the performance should not be driven by the level of
volatility, where we are in the cycle, or whether equity markets are up or down, but rather by how the non-directional underlying investment themes perform.
In other words, we seek to make or lose money (well, we don’t ever seek to lose money but we know it will happen occasionally!) in both up and down markets.
Over the intermediate and longer term, we expect our liquid alternative long-short strategies to be largely independent of, and resilient to, the level of volatility as
well as bull and bear markets. So, I know this is a bit of a cop-out, but I think the opposite — acting like we have a really strong short-term opinion and “because
volatility is low this is really likely to happen” — is just not AQR.

We continue to see the term “smart beta” used more frequently. How do you define smart beta and how should clients think about
allocation to smart beta versus more active strategies?

Though some confusion continues regarding the subject, the term “smart beta” (including “Fundamental Indexing”) is just a new way to describe some
well-known and well-tested investment ideas. Smart Beta is mostly re-packaged, re-branded quantitative management. The distinctions some make to try
to differentiate it seem like sophistry to me. It takes well-established, quantitative investing styles, or factors (like value), and implements them in a simple,
transparent manner often, though not always, at lower fees than what we’ve seen in the past. All that is pretty good — I don’t mean to disparage any part of it
except the idea that it’s new or very different. In this way, you can think of an investment style, or smart beta strategy, as simply trying to identify what might be
considered the “good parts” of active investing. That certainly sounds like a worthwhile repackaging, and it’s not surprising that style investing or Smart Beta has
received great attention.
I actually fought the term “smart beta” for a while on the grounds that I didn’t think it was really new stuff, it’s not “beta,” and even though I may agree it’s smart,
“smart” as a title seems arrogant. I lost. Language is a democratic process and the term won. If I didn’t start using it I’d just be an old bitter man nobody understood.
So, I’ve decided to use it (perhaps under some protest) and be an old bitter man that people do understand! So, while it’s still not new, the term is here to stay.

* The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This material
is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.
The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Diversification does
not eliminate the risk of experiencing investment losses. Past performance is not a guarantee of future performance.
** “Hedge Funds: The (Somewhat Tepid) Defense,” Cliff’s Perspective, AQR Capital Management, October 24, 2014 (www.aqr.com/cliffs-perspective/hedge-funds-the-somewhat-tepid-
defense, accessed on May 23, 2017).

CIO REPORTS • The Monthly Letter 8

 When assessing your portfolio in light of our current guidance, consider the tactical positioning around asset allocation in reference to your
own individual risk tolerance, time horizon, objectives and liquidity needs. Certain investments may not be appropriate, given your specific
circumstances and investment plan. Certain security types, like hedged strategies and private equity investments, are subject to eligibility
and suitability criteria. Your financial advisor can help you customize your portfolio in light of your specific circumstances.

CHIEF INVESTMENT
ASSET CLASS OFFICE VIEW COMMENTS
Negative Neutral Positive
Maintaining our overweight to global equities versus fixed income based on expectations for higher
Global Equities nominal growth and improving corporate profits.
Positive based on higher nominal growth, improving sales and earnings growth for S&P 500 companies,
despite extended valuations. Favor cyclical sectors such as consumer discretionary, financials, energy,
U.S. Large Cap select industrials and factors like dividend growth, high quality. Prefer Value over Growth based on
improving earnings and higher exposure to financials and energy.
U.S. Mid & Lowering small cap conviction to slight overweight due to rising fiscal policy uncertainty, especially concerning
Small Cap tax reform, and investor complacency.
Positive on Japan on fiscal and monetary stimulus, weaker yen and potential for improving domestic
International
demand. Increasingly positive on Europe on improving growth outlook, earnings growth and receding
Developed political risk.
Moderately positive given attractive valuations, improving economic activity, rising commodity prices.
Emerging
Republican sweep and prospect for rising interest rates and U.S. dollar, anti-trade measures have reduced our
Markets earlier conviction. Longer-term, reform-oriented countries and consumer spending exposures are preferred.
Bonds provide portfolio diversification, income and stability, but low rates skew downside risk. Slightly
Global Fixed Income short duration is warranted balancing expectations of higher short-term rates in the U.S. and inflation
with overwhelming demand for fixed income globally.
Current valuations stretched. Rate risk is more balanced, but still tilted toward the upside. Some
U.S. Treasuries allocation for liquidity and safety is advised. Fed will continue to raise short rates and longer rates will
be impacted by impending fiscal stimulus and balance sheet reductions.
Longer-term muni valuations have improved, although we believe munis will continue to provide value,
U.S. Municipals based on mostly stable or strengthening credit fundamentals and the increasing likelihood that tax
reform will not severely reduce the value of the municipal bond tax exemption.
Although accommodative global central bank monetary policies could begin to tighten, we remain
U.S. Investment modestly overweight investment grade (IG) credit, predicated on a gradually improving economic
Grade backdrop, modest carry relative to Treasurys & Agencies, in addition to continued technical tailwinds
particularly from institutional investors. Overweight positioning remains biased towards U.S. banks.
Valuations are rich. Expect a high degree of volatility. Prefer actively-managed solutions that are
U.S. High Yield higher in credit quality. Fundamentals remain soft. Allocation to floating rate, secured bank loan
strategies is advised.
Higher rates have extended durations in mortgage-backed securities. Volatility should continue to
weigh on the market, and spreads may rise as the market anticipates the Fed balance sheet unwind.
U.S. Collateralized Cap rates in commercial mortgage-backed securities have become less appealing. Select opportunities
exist in properly structured CMBS and asset-backed securities.
Yields continue to be low. Despite valuations, we see spreads grinding tighter for the next few months
Non-U.S. Corporates thanks to favorable tailwinds.
Compressed yields and risk premiums around the globe compared to the U.S., combined with
Non-U.S. Sovereigns potentially higher volatility in non-U.S. markets, present unfavorable risk/reward conditions for non-U.S.
fixed income, justifying an underweight position.
Emerging Economic growth is likely to outpace that in developed nations, but the market has rallied and spreads have
Market Debt narrowed. For non-US$ bonds, a rising US$ is a risk.
Select Alternative Investments help broaden the investment toolkit to diversify traditional stock and
Alternatives*
bond portfolios.
We currently emphasize hedge fund strategies that have low to moderate levels of market exposure
Hedged Strategies and those managers that can generate a large portion of their return from asset selection and/or
market timing.
Private Equity We see potential opportunities in special situations/opportunistic and private credit strategies.

Real Estate We prefer opportunistic and value sectors.

Medium-/long-term potential upside on stabilizing oil prices; near-term opportunities in energy
Commodities
equities /credits.
Stronger domestic growth and a less dovish Federal Reserve policy (relative to the monetary policies
U.S. Dollar of other Developed Market central banks) support a stronger dollar going forward.
Cash We have a small cash position awaiting deployment when opportunities arise.

* Many products that pursue Alternative Investment strategies, specifically Private Equity and Hedge Funds, are available only to pre-qualified clients.

CIO REPORTS • The Monthly Letter 9

Appendix
Index Definitions
The Bloomberg U.S. Economic Surprise Index shows the degree to which economic
analysts under- or over-estimate the trends in the business cycle. The surprise element
is defined as the percentage (or percentage point) difference between analyst forecasts
and the published value of economic data releases. The analyst forecasts are surveyed
by Bloomberg.
Commercial and industrial loans include loans for commercial and industrial
purposes to sole proprietorships, partnerships, corporations, and other business
enterprises, whether secured (other than by real estate) or unsecured, single-payment,
or installment. Loans to individuals for commercial, industrial, and professional
purposes, but not for investment or personal expenditure purposes, also are included.
Commercial and industrial loans reported on the Call Report exclude the following:
loans secured by real estate; loans to financial institutions; loans to finance agricultural
production and other loans to farmers; loans to individuals for household, family, and
other personal expenditures; as well as other miscellaneous loan categories.
The Conference Board Consumer Confidence Index (CCI) is a barometer of the
health of the U.S. economy from the perspective of the consumer. The index is based
on consumers’ perceptions of current business and employment conditions, as well as
their expectations for six months hence regarding business conditions, employment
and income. The index and its related series are among the earliest sets of economic
indicators available each month and are closely watched as leading indicators for the
U.S. economy.
The Consumer Price Index (CPI) is a measure of the average change over time in the
prices paid by urban consumers for a market basket of consumer goods and services.
U.S. CPI Urban Consumers is an index that measures the movements of prices paid
by consumers for a market basket of consumer goods and services. The yearly (or
monthly) growth rates represent the inflation rate.
Eurostat Industrial Production measures year-over-year growth of Eurozone
industrial activity excluding construction and is working day adjusted. Industrial
production measures the output of industrial establishments in the following
industries: mining and quarrying, manufacturing and public utilities (electricity, gas and
water supply). Production is based on the volume of the output.
The Institute of Supply Management (ISM) Manufacturing Index is based on
surveys of more than 300 manufacturing firms by the Institute of Supply Management
(ISM). The index monitors employment, production inventories, new orders and
supplier deliveries.
The Institute of Supply Management (ISM) Non-Manufacturing Index is a
composite index of four indicators with equal weights: Business Activity, New Orders,
Employment and Supplier Deliveries. An index reading above 50% indicates an
expansion and below 50% indicates a decline in the non-manufacturing economy,
whereas per Supplier Deliveries Index, above 50% indicates slower deliveries and below
50% indicates faster deliveries.
The MSCI AC Asia Pacific Index captures large and mid cap representation across 5
Developed Markets countries and 8 Emerging Markets countries in the Asia Pacific
region. With 1,023 constituents, the index covers approximately 85% of the free float-
adjusted market capitalization in each country.
The MSCI Europe TR USD Index captures large and mid cap representation across
15 Developed Markets (DM) countries in Europe. With 446 constituents, the index
covers approximately 85% of the free float-adjusted market capitalization across the
European Developed Markets equity universe.
The MSCI Japan Index is designed to measure the performance of the large- and
mid-cap segments of the Japanese market. With 318 constituents, the index covers
approximately 85% of the free float-adjusted market capitalization in Japan.
The MSCI Korea Index is designed to measure the performance of the large and mid
cap segments of the South Korean market. With 107 constituents, the index covers
about 85% of the Korean equity universe.
CIO REPORTS • The Monthly Letter
The MSCI Taiwan Index is designed to measure the performance of the large and
mid cap segments of the Taiwan market. With88 constituents, the index covers
approximately 85% of the free float-adjusted market capitalization in Taiwan.
The MSCI USA Index is designed to measure the performance of the large and
mid cap segments of the U.S. market. With 636 constituents, the index covers
approximately 85% of the free float-adjusted market capitalization in the U.S.
Markit Eurozone Manufacturing Purchasing Managers Index (PMI) tracks
sentiment among purchasing managers at manufacturing firms. An overall sentiment
index is generally calculated from the results of queries on production, orders,
inventories, employment, prices, etc.
The National Homebuilders’ Association Housing Index tracks sentiment among
participants in the housing industry.
The one-year breakeven rate measures market expectations of the inflation rate in
one year.
The Purchasing Managers’ Service Index tracks sentiment among purchasing
managers at manufacturing, construction and/or services firms. An overall sentiment
index is generally calculated from the results of queries on production, orders,
inventories, employment, prices, etc.
The Russell 1000® Growth Total Return Index measures the performance of the
large-cap growth segment of the U.S. equity universe. It includes those Russell 1000
companies with higher price-to-book ratios and higher forecasted growth values.
The Russell 1000® Value Total Return Index measures the performance of the
large-cap value segment of the U.S. equity universe. It includes those Russell 1000
companies with lower price-to-book ratios and lower forecasted growth values.
The Russell 3000 Growth Index is a market capitalization weighted index based
on the Russell 3000 index. It includes companies that display signs of above-average
growth. The index is used to provide a gauge of the performance of growth stocks in
the U.S.
The Russell 3000 Value Index is a market-capitalization weighted equity index
maintained by the Russell Investment Group and based on the Russell 3000 Index,
which measures how U.S. stocks in the equity value segment perform. Included in the
Russell 3000 Value Index are stocks from the Russell 3000 Index with lower price-to-
book ratios and lower expected growth rates.
The S&P 500 Index is a market-capitalization weighted index that measures the
market value of 500 large U.S. companies having common stock listed on the NYSE or
NASDAQ. The S&P 500 index components and weightings are determined by S&P Dow
Jones Indices.
The S&P Small Cap 600® Index measures the small-cap segment of the U.S. equity
market. The index is designed to track companies that meet specific inclusion criteria
to ensure that they are liquid and financially viable.
The STOXX Europe 600 Index is derived from the STOXX Europe Total Market
Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number
of 600 components, the STOXX Europe 600 Index represents large, mid and small
capitalization companies across 17 countries of the European region: Austria, Belgium,
Czech Republic, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the
Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.
The University of Michigan Consumer Sentiment Index is a summarization
of consumer attitudes and expectations, in order to determine the changes in
consumers’ willingness to buy and to predict their subsequent discretionary
expenditures. This Index is comprised of measures of attitudes toward personal
finances, general business conditions, and market conditions or prices. Components
of the Index of Consumer Sentiment are included in the Leading Indicator Composite
Index. Unit: Index (Q1 1966=100).
U.S. Personal Consumption Expenditures measured in nominal dollars (also referred
to as consumption) tracks consumer expenditures on goods and services. This concept
is not adjusted for inflation.
10
 CHIEF INVESTMENT OFFICE
Christopher Hyzy
Chief Investment Officer
Bank of America Global Wealth & Investment Management

Mary Ann Bartels Karin Kimbrough Niladri Mukherjee

Head of Merrill Lynch Wealth Head of Investment Strategy Director of Portfolio Strategy,
Management Portfolio Strategy Merrill Lynch Wealth Management Private Banking & Investment Group (PBIG)
and International

Nicholas Giorgi Tony Golden Emmanuel D. Hatzakis Marci McGregor Rodrigo C. Serrano John Veit
Vice President Director Director Director Vice President Director

This material was prepared by the Global Wealth & Investment Management Chief Investment Office (GWIM CIO) and is not a publication of BofA Merrill Lynch Global Research.
The views expressed are those of the GWIM CIO only and are subject to change. This information should not be construed as investment advice. It is presented for information
purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular
retail financial product or service that may be available.
This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client’s investment
objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any
related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to
change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global
Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives,
financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized.
Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.
Alternative Investments such as derivatives, hedge funds, private equity funds, and funds of funds can result in higher return potential but also higher loss potential. Changes
in economic conditions or other circumstances may adversely affect your investments. Before you invest in Alternative Investments, you should consider your overall financial
situation, how much money you have to invest, your need for liquidity, and your tolerance for risk.
Investments have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies
or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investments in high-yield bonds may be subject to
greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Income from investing in municipal bonds is generally exempt from federal and state
taxes for residents of the issuing state. While the interest income is tax exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal
alternative minimum tax (AMT). Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic
or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification
and sector concentration. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values,
changes in interest rates, and risk related to renting properties, such as rental defaults. There are special risks associated with an investment in commodities, including market price fluctuations,
regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.
No investment program is risk-free, and a systematic investing plan does not ensure a profit or protect against a loss in declining markets. Any investment plan should be subject to periodic
review for changes in your individual circumstances, including changes in market conditions and your financial ability to continue purchases.
Reference to indices, or other measures of relative market performance over a specified period of time (each, an “index”) are provided for illustrative purposes only, do not represent
a benchmark or proxy for the return or volatility of any particular product, portfolio, security holding, or Alternative Investment. Investors cannot invest directly in indices. Indices are
unmanaged. The figures for the index reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenses which would reduce returns. Merrill Lynch does not
guarantee the accuracy of the index returns and does not recommend any investment or other decision based on the results presented.
MLPF&S is a registered broker-dealer, Member SIPC and wholly owned subsidiary of BofA Corp.
© 2017 Bank of America Corporation . All rights reserved. AR3QWMG9