Legg Mason : How Can Investors Potentially Generate Income and Grow Their Assets?

Madelyn McHugh (212) 805-6039

mmchugh@leggmason.com

"Low Vol, High Div" Strategies are the New Black for Many Savvy Investors

What should spenders do, investors near or in retirement? They want income today and probably a little more growth for tomorrow, especially as they are living longer. What should younger savers do? They want to build assets more than ever due to concerns about social security benefits and traditional pension plans being a thing of the past for most. The key for investment managers and financial advisors is to keep both groups in the markets over the short term, while trying to limit their potential downside. Both groups are justly wary of big risks in the wake of the Financial Crisis.

What will happen when interest rates rise? How will investors prepare?

This creates the backdrop for a perennial problem facing U.S. investors: how can they generate income, while still continuing to harness opportunities to grow their hard-earned assets to meet their life goals and objectives?

QS Investors, a Legg Mason affiliate based in New York, has a strategy: "low vol, high div."

Low volatility and high dividend strategies are emerging as potentially attractive substitutes for the classic utility stocks of yore. They can offer relatively low risk positions that can be less exposed to U.S. equity market swings, yet seek to pay regular dividends to support income objectives.

"In this unpredictable climate, there are woefully few attractive, dependable, low-risk options for investors seeking solid income," observed QS Investors President James H. Norman. "Our parents' and grandparents' generations could steadily plow their savings into utility stocks. They were viewed as safe, typically paid regular dividends, and appreciated in value nicely with the market. Sadly, with deregulation of their industries, those popular options have become more treacherous making it important to find another path through a mine field. Yet investors still need income somewhere, without taking undue risks."

"We believe that high yield, managed volatility strategies can be a core holding of income-oriented portfolios," Mr. Norman said. "They can also receive meaningful allocations in conservative and aggressive portfolios with long investment horizons."

As Chief Investment Officer of QS Investors Rosemary Macedo notes, living longer with more years in our retirement amplifies the impact of our investment choices. And the safety net of social security shows signs of fraying, making the prudent person wary of reliance. Clearly, the stakes are higher than ever for both retirees and those who hope to retire one day.

To achieve high growth, investors must take on risk. But simply ratcheting up equity allocations exposes investors not just to more market volatility, but also to more panic risk - the instinctive reaction to flee the market after a large loss, right at the time investors should consider holding strong.

How to provide the growth investors need, generate income without precluding growth, and do so with enough relative stability to keep clients invested through down markets so that they participate in up markets?

The old strategy: the utility of utilities.

For decades, utility stocks were the standard answer to this perennial challenge. It was for good reason that advisors traditionally put 'widows and orphans' and other conservative investors' savings into utility stocks: they produced income plus modest real principal growth with the relative stability that came with regulated industries. These included electric, gas and water utilities, as well as telephones in the days of the AT&T monopoly.

Although US Government and AAA Corporate Bonds also offered income and nominal safety, the higher risk of utility stocks compared with bonds was deemed to be worth bearing, since bonds could not match utilities' principal growth potential and inflation management.

But utilities were not immune to the reality that industries and markets can experience significant disruption. In this case, de-regulation opened the door to changes that fundamentally altered the nature of utility stocks. Seeking a better return on investment, utility companies' management took advantage of deregulation by "diworsifying" into unrelated businesses; examples include Southern California Gas with Thrifty Drug Stores and Arizona Public Service with Mera Bank.

While not all diversification turned out badly, the utilities sector was no longer a pure play on a regulated industry, but rather a mix of the regulated (transmission) and the unregulated (generators), of the diversified and the not. This invited market speculation as some utilities pursued returns more aggressively, including, according to Fortune magazine, "America's Most Innovative Company", i.e., Enron.

The new strategy for investors: form follows function - defensive yield.

Nowadays, investors have to be more enterprising to get income plus growth with relative stability. The attributes investors liked in regulated utilities still exist, though not all utilities have these characteristics today, and not all stocks with these characteristics are utilities. We can

systematically seek out the stocks with lower volatility and higher dividend yield in any market sector, and with them build a broader, more diversified portfolio that explicitly focuses on the tried and true benefits of lower volatility and higher dividend stocks.

The combination of lower volatility and higher dividend yield can be far more powerful than either attribute alone, and produces a distinct investment strategy, much as blue and yellow produce the distinct color green. By combining these characteristics, we can mitigate or even avoid the pitfalls of each when used individually. For example, emphasizing high dividend yields effectively excludes any low volatility stocks that are fundamentally expensive.

Retirees should consider this kind of strategy, as they are living longer, are less likely to have a pension, and bond yields are at secular lows.

So should savers of any age, who can benefit from the higher total returns associated with higher yield stocks, as well as from the compounding benefits of lower volatility.

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As President of QS Investors, James Norman is responsible for assisting the CEO with all business, strategic and investment decisions. He is also Head of Equity and the Portfolio Management Strategy team. Before moving to Legg Mason with QS Investors, Mr. Norman was head of Deutsche Asset Management Quantitative Strategies Qualitative Alpha research. At Deutsche Asset Management, he also served as Global Head of Product Management, Senior Portfolio Specialist for Active US Equity and Asset Allocation, and as a senior management consultant from 1995 to 2010. Prior to joining Deutsche Asset Management, he spent five years as a senior casualty underwriter for CIGNA International. Mr. Norman earned an A.B. from Vassar College and an M.B.A. from New York University.

The Chief Investment Officer of QS Investors, Rosemary Macedo is responsible for all alpha research. Before joining Legg Mason with QS Investors, she was head of Active Quantitative Equity research at Deutsche Asset Management from 2008 to 2010. Prior to joining Deutsche Asset Management, Ms. Macedo spent two years as Executive Director of the Thomas J. Watson Fellowship Program. Prior to Watson, she spent 14 years with Bailard, Inc., where she managed Bailard's international equity mutual fund, landing it in the top overall rankings for Morningstar, Standard & Poor's and Lipper. She began her career in asset management at First Quadrant. Ms. Macedo earned a B.S. from California Institute of Technology, and a B.A. from Pomona College as part of a joint 3-2 program.

A wholly-owned, independently-managed affiliate of Legg Mason, Inc., QS Investors, LLC was formed in 1999 as the quantitative platform of a global asset manager. As an investment firm providing asset management and advisory services to a diverse array of institutional clients, QS Investors delivers disciplined, systematic solutions that address clients' complex challenges. The QS team has developed unique approaches to integrating quantitative and behavioral investment insights and dynamically weighting opportunities in response to changing economic and market

conditions. Risk identification, assessment and management are intrinsic to their process. Based in New York, QS Investors offers a broad spectrum of strategies to clients worldwide, including actively managed U.S. and global equities, liquid alternatives and customized solutions.

Legg Mason is a global asset management firm with $757 billion in assets under management as of July 31, 2016. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).

Fixed-income securities involve interest rate, credit, inflation, and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed-income securities falls. High yield bonds are subject to greater price volatility, illiquidity, and possibility of default. International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The views expressed are as of the date indicated, are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

©2016 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investors Services, LLC, and QS Investors, LLC are subsidiaries of Legg Mason, Inc.

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