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November 2015 Monthly Performance Report Smarter Money Active Cash (SMAC) Strategy

• Smarter Money Active Cash’s (SMAC) total returns after fees rose in the month of November (up to +0.1% depending on unit class)---with even greater strength in December to-date---while its net weighted-average interest rate (ie, running yield) across SMAC’s 42 deposits and investment-grade floating-rate notes (FRNs) remained stable at a robust +3.4% as at 30 November (depending on the unit class) after all fund fees. SMAC’s running yield is above its official benchmark of the RBA cash rate + 1% pa (or 3% in total) and many alternative strategies. The chart below shows the running yields available from different asset-classes, including the leading 1, 3, 6, 9 and 12 month term deposit rates, SMAC, Smarter Money Higher Income, and the Australian equities market (note different investments carry different risks and past performance is not a guide to future returns). SMAC, which offers daily application/redemption rights on a t+3 basis, is designed to carry very low interest rate duration (historically always less than 3 months) and credit (historically in the "A" band) risk that should outperform conventional “duration-rich” fixed-income strategies when long-term interest rates start to normalise. With the US Federal Reserve hiking rates to 0.5% in December for the first time since 2006, duration exposed products may struggle in 2016.

• Despite experiencing the most challenging 12 months since its inception 4 years ago, with “two standard deviation” shocks hitting Australian and global equities, Australian government bonds, corporate bonds and hybrids in June, August and September, SMAC has delivered a year-on-year gross (net) return over the 12 months to 30 November of 3.17% (2.53%) and 3.08% (2.41%) for institutional (assisted) unitholders, respectively. This has been superior to the AusBond Bank Bill Index (+2.37%), the average retail term deposit rate (+2.36%), the average short-term fixed-interest fund in Morningstar's universe (+2.18%) and in line with, or slightly better, than the performance of the AusBond Floating Rate Note Index (+2.51%) and a composite of the Bank Bill and FRN indices (+2.44%) that reflects SMAC’s portfolio weights to cash and FRNs.

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• In November SMAC's asset-allocation was broadly stable with 79.3% of its portfolio invested across 38 different (mainly bank-issued) Australian FRNs and the remaining 20.7% allocated across 6 deposits. The weighted-average credit rating across SMAC’s deposits and FRNs was in the “A” band in November, which is consistent with its mandate. Accounting for both its holdings of deposits and FRNs, SMAC’s portfolio is diversified across 14 APRA-regulated Authorised Deposit-Taking Institutions (ADIs).

• SMAC has beaten its official benchmark of the RBA cash rate plus 1% pa in 79% of the 46 months since its inception in February 2012 with low annual return volatility (or variability) of 0.50% pa (measured daily and then annualised). Over the 12 months to 30 November 2015, SMAC’s return volatility has been slightly lower at 0.46% pa as portfolio diversification has improved. SMAC’s “Sharpe Ratio”, which measures risk-

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adjusted returns, has been a strong 4.0 times since inception (the specific calculation is SMAC’s net return less the RBA cash rate, which is then divided by the SMAC’s return volatility).

• Since its inception 3 years and 9 months ago, SMAC has outperformed competing solutions, including, amongst others: leading at-call and term deposit rates; BetaShares’ ASX-listed cash ETF (which invests in at-call accounts and 90 day TDs); competing peer short-term funds tracked by Morningstar; an index of bank bills and investment-grade FRNs that replicates SMAC’s portfolio weights to these asset-classes; and the AusBond FRN Index (see below noting that different products can carry very different levels of risk). SMAC is also rated by Morningstar (4 stars), Mercer, Lonsec, Atchison Consulting and Australia Ratings and listed on 13 different platforms.

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• SMAC’s portfolio has been constructed such that it has little-to-no “interest rate duration” risk (or “modified duration”), which was just 1.3 months as at 30 November 2015. It achieves this by not assuming fixed-rate (as opposed to floating-rate) exposures that lock in interest rates for multi-year periods and which can subject investors to capital losses when rates climb. The chart below highlights the inherently higher risk of fixed-rate bonds, which have had 5.4 times the volatility of a portfolio of Aussie FRNs over the last 15 years notwithstanding that both these markets have similar underlying credit ratings. This is almost exclusively an artefact of the uncertainty introduced by interest rate risk. As at 30 November SMAC’s cash-flow duration across all assets was 1,030 days (spread duration was 2.5 years).

• Another indication of SMAC’s low interest rate duration risk is the fact that its monthly returns have historically had a very low 2.4% (14.6%) correlation to Australian fixed-rate bonds (Australian equities), which implies that it could provide conventional fixed-income and equities portfolios with diversification gains. As one would expect, SMAC’s correlation with Australian FRN returns is very high. This should prove increasingly relevant as long-term interest rates normalise. In the first chart below SMAC’s analysts highlight the performance of the Australian floating-rate versus fixed-rate bond universes during a rising rate climate between 2002 and 2007 when the cash rate gradually lifted from 4.75% to 6.75%. Understanding where normalised interest rates lie is also important because convergence back to these levels could cause problems, as fixed-rate fund manager returns in both April and June showed (they suffered two standard deviation losses as noted in the table above). If the 3 year Australian government bond yield gravitates back to a more normal level equivalent to, say, (conservative) real GDP growth of 2.0% plus 2.5% inflation (or 4.5% in total), or its average level of around 6% in the notably “low-inflation” period since 1990, it would inflict circa -7.4% to -11.2% losses on holders of these assets, which are often assumed to be "defensive" (see second chart below).

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SMI Research Briefs:

• Strong US core inflation: SMI has long had a non-consensus view that core inflation in the US would rise above the Fed's 2% target on the back of a declining jobless rate (currently only 5.0%). In December the US Bureau of Labor Statistics reported that US core inflation (ex energy and food) rose to 2% year-on-year (also 2% on a 6 month annualised basis), which is up from a low of 1.6% in December 2014. The chart (see below) indicates US core inflation will shortly rise to its highest level since 2012 with the current 2% print the highest since February 2013. We believe this is a crucial dynamic for asset-allocation with the inflation data likely to eventually trigger a major repricing of long-term interest rate risk that favours avoiding interest rate duration or equities beta. We are forecasting that the US jobless rate will fall towards 4.0% and possibly lower with the Fed hell-bent on driving the jobless rate below its estimate of the "non-accelerating inflation rate of unemployment" (NAIRU), which is 4.9%. We think US inflation is potentially the single most important economic variable for financial markets globally.

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• Problems with the Fed's forecasts post the December hike: The key to our medium-term belief that markets will be forced to fight the Fed is found in its forecasts. The Fed projects that the US jobless rate, which has declined from 10% to 5%, will not fall below 4.7% over the next three years. We think that lacks credibility. Based on current job creation, we could see a US jobless rate with a 3-handle in front of it within 18 months. In December the Fed also reiterated that its estimate of the NAIRU---which is the "full employment" level below which you get inflation---is between 4.8% and 5%. So we are there already. A related flaw in the Fed's forecasts concerns inflation. The Fed predicts that core inflation will never breach 2% between now and 2018, which is heroic. There are two main measures of US inflation: the Bureau of Labor Statistics' core inflation index that removes energy and food prices and the Bureau of Economic Analysis's core personal consumption expenditure (PCE) benchmark that excises similar things. While core PCE inflation, which is the Fed's preferred proxy, has been well-behaved and is around 1.3% (below the Fed's 2% target), the Bureau of Labor Statistics measure has, as noted above, risen to 2% over the last year. This is the biggest divergence between the two inflation trackers---which are normally well-correlated---in over 15 years. Since the Bureau of Labor Statistics index leads the PCE proxy, the latter should start increasing. And while markets are fretting about falling oil prices, there are many more oil consumers than producers, which means this should be a long-term positive for growth and inflation.

• RBA Governor on bank capital: In his annual interview with the AFR, Governor Stevens made some interesting remarks on bank capital: "Certainly, the problem of not enough capital---that's being addressed [SMI: note, not past tense as in the banks are "done"]. The problem of the quality of capital---that's in the process of being addressed [SMI: again, emphasising this is ongoing]...The response here has been for the Murray Inquiry to say that we would like to position the Australian banks definitely in the top quartile by capital. There's a lot of debate about whether they're there, or not quite there, but anyway they're going to have some more capital to try to be sure they're there [SMI: there is more capital raising to be done].” Some banks are pushing the line they are done and dusted on capital raising, although we believe they have another ~100-200bps of common equity Tier 1 (CET1) to raise after the 2016 risk-weight changes, which is broadly consistent with the views of NAB and CBA's credit analysts. NAB forecasts ~$10bn of new Tier 1 in the next year and up to ~$30bn of Tier 1 in the next few years. See CBA's comments below. This will be very credit positive for major bank debt securities and also reduce the volume of debt they need to issue (given the increase in equity funding). On TLAC, the Governor emphasised APRA's "hasten slowly" point. Our own view is that there is a very real possibility that the major banks' senior unsecured bonds will be modified in a statutory fashion to make them TLAC eligible and that there is support amongst the majors for pursuing this in one way or another given the rest of the world have already done so (specifically, the US, Canada, UK, New Zealand, and Europe). Note that APRA says it can already de facto bail-in senior bonds under the Banking Act, and the main thing necessary to make them TLAC eligible will be making derivative contracts senior in ranking. Here the Governor remarked:

"Well, I think there's going to be a TLAC [total loss-absorbing capacity] standard, so-called, for globally-systemic banks. There isn't one for domestically-systemic banks (D-SIBs) at this point, and we certainly wouldn't be the first country to push for there to be one, but it would be a bit surprising if

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people don't turn their mind to that at some stage...So I think that's probably the lay of the land over the next five years or so. As I say, there's no specific D-SIB framework here for TLAC, but on past form people will at least think about it, and we will have to give thought to such issues ourselves in Australia, and everyone can see that, really, can't they? It would have to be done in a way that's tailored to, cognisant of, the unique features of our system, but, you know, that's true with all regulations."

• How expensive will senior bail-in be? This begs the question of whether it will be expensive to make Aussie senior bank debt TLAC eligible. Most banks agree that the German precedent, wherein they subordinated their senior bonds in accordance with the FSB TLAC terms sheet, is a very good one, albeit conservative insofar as the German laws are retrospective and any Australian changes may be prospective like the Canadian approach. Our analysis implies that that the German bail-in proposal has widened senior Deutsche Bank spreads by about ~10bps on a worst-case assessment. Refer to the chart enclosed below. Specifically: we use two senior and liquid DB FRNs as benchmarks---a 2019 and 2021 issue of EUR2.1bn and EUR1.5bn in size each; we quantify the change in spreads around the 2 key events---the 10 March German parliamentary proposal to bail-in senior and the 2 September ECB announcement that German senior may not be repo-eligible; adding up the spread widening after these two events gives us a circa 7bps to 11bps total move. As one can see from the chart, the real driver of spreads was the Greek crisis in June---as with Australian credit, spreads have not recovered their tights since. If you assume the spread widening during the Greek crisis was actually due to German bail-in concerns, then and only then do you get a ~33bps widening. However, as another benchmark, we provide the Euro iTraxx Senior Index, and you can see that the June spike in spreads was exclusively a Greek event. If we agree that the German precedent is a good one for Australian senior, then objectively we are talking about a modest increase in funding costs in the order of ~10bps.

• Australian senior versus subordinated bond spreads: Banks have noted of late that Australian Basel 3 Tier 2 spreads seem particularly wide relative to senior unsecured bonds. There has also been commentary that the ratio of Aussie Tier 2 spreads relative to senior is unusually high compared to some key peer banks around the world. As a very preliminary first-pass at objectively addressing this question, we examined the ratio of Tier 2 to senior unsecured spreads for Australia's four major banks, Wells Fargo (US), and Royal Bank of Scotland (UK) on a like-for-like basis. Specifically, we only look at securities issued in the same currencies using the CAST function in Bloomberg and then curve-adjust senior spreads on a simple linear basis to maturity-match Tier 2 equivalents. Notwithstanding that Australia's major banks (AA-) have higher issuer credit ratings than Wells (A+) and RBS (BBB-), and superior CET1 and Tier 1 capital ratios, we find that the ratio of major bank Tier 2 to senior unsecured spreads was extremely high at an average of 2.75 times across 5 different Tier 2 securities. This contrasts with an average 1.25 times Tier 2 to senior unsecured ratio for Wells Fargo (5 issues) and an average 1.28 times ratio for RBS (4 securities). Full details are provided in the tables below. It's also worthwhile mentioning that the major banks' Tier 2 also typically pays higher absolute spreads despite the fact that they are being issued by theoretically lower risk entities. One hypothesis is that Australian institutional investors have underestimated (or not understood) the "loss-absorbing"

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characteristics of their senior unsecured bonds (ie, they assumed they were basically risk-free), which APRA says are (1) subordinated to deposits and (2) can be "economically bailed-in" during an insolvency event via APRA's asset transfer powers under the Banking Act. At the same time, we suspect institutions have over-estimated the probabilities of default that would trigger a non-viability event in a Tier 2 security (given non-viability is defined as de facto insolvency by APRA and insolvency is the key trigger for the possibility of loss-absorbency on senior unsecured bonds, the probability of being bailed-in under senior and Tier 2 is actually somewhat similar subject to the magnitude of the bank's losses and the recapitalisation it requires).

• S&P reiterates major bank credit ratings and flags “upside scenario” involving increases to their stand-alone credit profiles (SACPs): In December S&P highlighted for the fourth time in 2015 that it could potentially upgrade the major banks' SACPs from "a" to "a+". S&P outlined a scenario where senor ratings are unchanged due to a loss of one notch (currently they get two notches) of government support but major bank sub debt gets upgraded from “BBB+” to "A-" as a result of the SACP uplift. S&P is also forecasting rising CET1 ratios for the major banks and says that the major banks' risk-adjusted capital ratios (RACs) will be in the "upper end" of the range for banks with an SACP of "a". Quotes as follows:

“A one-notch improvement affecting CBA's SACP (to 'a+', from 'a') would not cause a positive revision to the issuer credit ratings, all other rating factors remaining equal. This is because support would decrease to one notch because CBA is a "highly systemically important" bank domiciled in a country we view as "highly supportive" of institutions that are core to the national economy. A SACP factor that may have a positive bearing on CBA's SACP is if CBA achieved and sustained a RAC ratio in excess of 10%. We assess that on a forward-looking basis CBA's capital and earnings will sit at the upper end of our range for an "adequate" category (a RAC ratio range of 7% to 10%). In our view, the overall level of capital for Australian banks is rising, mainly due to the Financial System Inquiry's

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(FSI) recommendations and regulatory developments taking place. We observe that the FSI expects Australian banks to capitalize at an 'unquestionably strong' level relative to global peers.”

• CBA credit analysts forecast major banks will raise another $30bn to $32bn of CET1: CBA's chief credit strategist Scott Rundell and head of fixed-income strategy Adam Donaldson have published a detailed new report that: (1) reiterates their forecasts for substantial CET1 raisings by the major banks to meet a new normal of a minimum 10% CET1 ratio; (2) estimates the current CET1 shortfall across the major banks is still $30-32bn (Quote: "Capitalisation [is] likely to be a source of credit strength for banks as they build toward meeting APRA’s expected ‘unquestionably strong’ capital requirements. The ultimate target has yet to be determined, but market speculation centres around CET1 levels of around 10.0-10.5%. Given current global comps, that would put the majors at the bottom of the top quartile...We estimate a current pro-forma shortfall of $30-32bn across the sector, which should be manageable, but likely remain a drag on equity performance."); (3) forecasts that the major banks will lose one notch of government support on their credit ratings, but be uplifted one notch on their SACPs (Quote: "A key risk here is around the loss of implied government support as the resolution framework is developed – our base case is a loss of one notch from this, leaving one notch of uplift still in place. Countering this ‘downgrade’, we expect banks will continue to accumulate capital in order to meet regulatory requirements, which will warrant a one notch upgrade."); (4) argues the major banks will not issue large amounts of Tier 2 debt to satisfy TLAC and instead meet any shortfall with bail-in-able senior (Quote: “With the release of the FSB’s TLAC eligibility requirements, we remain comfortable with expectations of only modest tier 2 growth and as such do not have material concerns holding them, especially those issued by strong D-SIB’s such as the majors...We consider it unlikely Tier 2 will materially exceed its current ‘proportionate’ position in bank capital stacks. While Tier 2 capital is TLAC eligible, we think it unlikely the majors will utilise Tier 2 to meet any TLAC requirements to be imposed upon them. Alternative forms of capital are considered a more economic option if they can be proven viable (i.e. Tier 3 bonds as discussed here)”).

• APRA announces big win for regional banks: In December APRA announced “two important changes” to the accreditation process by which “standardised” banks, which include all Australian banks except the four majors and Macquarie, can become “advanced” or “internal ratings-based” (IRB) banks in a major competitive win for the likes of Bank of Queensland, Bendigo & Adelaide Bank, Suncorp Metway, and ME Bank. Whereas IRB banks get to use their own internal models to estimate how much regulatory capital (and thus leverage) they hold against residential, business, and retail loans, standardised banks have regulatory capital for each asset class determined by much tougher APRA rules. Since this approach was introduced in 2008 an enormous gap has emerged between the capital the quasi “self-regulating” IRB banks hold against loans compared with the standardised banks. The “risk-weightings” standardised banks are forced to apply to their residential mortgages have, for example, been about 2.7 times higher than those used by IRB banks. This means the major banks have been allowed to hold less than half the capital and more than twice the leverage of competitors when lending against housing, which has been a key driver of their superior 15%

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plus returns on equity with smaller rivals struggling to get into double-digit territory. In December APRA announced it was dropping the previous condition that standardised banks seeking IRB approval “meet accreditation requirements for all such portfolios before models can be used for regulatory capital purposes”. Instead, APRA will now allow “staged accreditation”, which “provides the capacity for [a bank] to use accredited IRB models for regulatory capital purposes for some credit portfolios ahead of others”. Banks could be approved for their home loan portfolios first and business and retail loans later. APRA also announced it is “decoupling operational risk modelling from IRB accreditation” in a move that will pave the way for the likes of Bank of Queensland, Bendigo & Adelaide Bank, Suncorp Metway and ME Bank to seek IRB status. The changes will allow non-major banks to materially reduce home loan risk-weights from around 40% currently to the 25% plus levels the major banks will have to target by July 2016 and slash their business and retail loan risk-weights from 100% currently to the 50% to 60% levels the majors use. This will significantly boost returns on equity and/or enable smaller banks to undercut the majors on interest rates and win market share.

• SMAC’s portfolio management team expects reasonable global economic growth—driven by the US—to eventually feed-back into a “surprising” resurgence in wage inflation in the US. Given the very strong correlation between US long rates and global rates, this could trigger a steepening of the yield curve that pushes otherwise dear equity, bond and house prices back towards more credible equilibrium values. If this perspective proves accurate, asset-allocation should be biased towards market-neutral equities alpha, cash, and FRNs as other investments, like long-only equities, fixed-rate bonds, and residential property, realise capital losses as net present values are adjusted downwards (given higher risk-free rates). We note that conventional asset-allocation within domestic portfolios tends to favour correlated Australian and global equities (including private equity and property equity) and has only modest holdings of cash and floating-rate debt. The chart below shows that the typical Australian super fund has around 77% of its capital tied up in equities risk despite the rapid ageing of the domestic population. If one examines the long-term relationship between the ASX/S&P 200 and the S&P 500 indices, the correlations look low at around 18%. (While the monthly correlation is a much higher 54%, one should where possible use daily as opposed to monthly returns to minimise statistical biases associated with low-frequency sampling.) The problem is that during the Chinese equities crash in August the correlation between Aussie and US equities spiked three times higher than its long-run average. Theoretical diversification that was meant to protect you faded. Many investors learned this lesson in the global financial crisis, when supposedly uncorrelated assets like listed equities, infrastructure, hedge funds and private equity suffered simultaneous losses.

• Under its mandate, SMAC is not permitted to use any leverage, not allowed to invest in related party securities, and has never used derivatives. A summary of prohibited investments include:

x. No leverage

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x. No sub-investment grade bonds

x. No unrated bonds

x. No foreign-issued bonds

x. No fixed-rate bonds with maturities > 12 months

x. No equities

x. No convertible preference shares

x. No related-party investments

x. No direct loans

• SMAC is available on the ASX’s new managed fund platform, called “mFund” (code: SMF01), which allows you to buy/sell units in SMAC via a stockbroker, or online broking account from the likes of Bell Direct or CMC, without dealing with new application forms. SMAC distributes interest quarterly, offers online account access and daily (t+3) investment and withdrawal rights, including BPAY and direct debit facilities. It is accessible on numerous platforms, which you can view here. You can apply to invest in SMAC online here and read the full PDS here.

Disclaimer: Past performance does not assure future returns. Returns are shown after all trust fees. All investments carry risks, including that the value of investments may vary, future returns may differ from past returns, and that your capital is not guaranteed. To understand SMAC’s risks better, please refer to the detailed Product Disclosure Statement. A fund is not a bank deposit and your capital is not guaranteed. This information has been prepared by Smarter Money Investments Pty Ltd. It is general information only and is not intended to provide you with financial advice.