TheAdvisoryINVESTMENT OUTLOOK FROM BROWN ADVISORY

COVER STORY

BIG DATA 3D PRINTING

NEUROSCIENCE

OPPORTUNITY IN THE MIDDLE EAST

THE CLOUD REVOLUTION

INVESTING IN AFRICA

SUSTAINABILITY CYBERSECURITY

The Future is NOW Our recent Navigating Our World (NOW) conference illuminated many compelling trends that are likely to shape the path of societies and industries in the future. The key is knowing how to prudently capture these important but uncertain drivers in client portfolios.

Brown Advisory recently held the fourth biennial Navigating Our World (NOW) conference, in

which we gather with our clients to hear leading thinkers share their insights on the powerful trends that are rapidly reshaping our world. The speakers at our NOW conferences always offer up illuminating per-spectives on the future, and this year

was no exception. For example, Josh Wolfe, co-founder of seed-stage ven-ture firm Lux Capital, noted how quickly things morph from science fiction to reality. He pointed out that the disembodied voice of HAL 9000 from Stanley Kubrick’s 2001: A Space Odyssey was the fictional precursor to Siri, the friendly voice of today’s iPhones. MIT’s Andrew McAfee echoed the point, citing how

the driverless car was considered an impossibility by many just a handful of years ago and is now in beta testing at Google. The implication is clear: The seemingly unattainable ideas that we dream up today are likely to become reality sooner than we think. The world is changing exponentially.

NOW is special in that it allows us to take a step back—from our day-to-day work, the current fiscal year, and

CONTINUED ON PAGE 2

JUNE 2014

1 COVER STORYTHE FUTURE IS NOW

4 THE WILD FRONTIERASSET ALLOCATION

6 CONVERSATION WITH A SUSTAINABILITY SKEPTICPORTFOLIO MANAGER Q&A

8 DIVERGENT RETURNSEQUITY STRATEGY

10 MAKING YOUR MARKPHILANTHROPIC PLANNING

2 T H E A D V I S O R Y J U N E 2 0 1 4

COVER STORY

BY TIMOTHY HATHAWAY, CFA

Director of Equity Research

COVER STORY CONTINUED

even the current economic cycle—and explore various potential paths of innovation and progress in an attempt to understand where the world might be headed over the next five, 10 or 20 years.

But as much as NOW highlights potential breakthroughs, it also exposes the challenge that we face every day as investors. For any given company that we consider for one of our portfolios, we have to ascer-tain the value of its current business model as well as the promise of its future and uncertain innovation, and compare that valuation to the price of the company’s stock. Situations that are attractive from both a near-term and long-term perspective are some-what scarce even when markets are at trough levels. The challenge is even greater after the market’s 2013 run, in which the S&P 500 Index rose 32% and the Russell 2000® Index of small-cap stocks climbed more than 37%.

SEARCHING FOR OPPORTUNITYThis year’s NOW conference discussed a number of disruptive and truly excit-ing trends, but in many cases the current opportunity to capitalize on those trends in client portfolios is lim-ited. On one hand, it may be too early to invest in a particular field of innova-tion. For example, Dr. Peter Searson

of Johns Hopkins spoke about how the blood-brain barrier—the chemis-try and physiology that keep the brain relatively protected from variations in the bloodstream—is perhaps the big-gest obstacle to treating neurological conditions ranging from Alzheimer’s to migraine headaches. The research being conducted to find ways to break that barrier shows enormous long-term potential, but it still resides firmly in the realm of experimental science, and we are likely many years away from an investable opportunity in this area.

salesforce.com and Ultimate Software at what we believed to be reasonable valuations relative to their peers, but the point remains that investing is about more than just innovation and growth, it is also about price.

FINDING THE BARGAINHowever, in the middle space between too early and too expensive, we are finding companies that we believe offer both current value as well as attractive runways for future growth.

One example is Google, a com-pany that started in online search and quickly branched into every corner of the technology universe. For all of its advanced projects, Google is still pri-marily driven by online advertising, from which it collected $51 billion of its $56 billion in revenue in 2013. While its profit margins have declined slightly in recent years as it expanded into new markets, it still captured an extremely impressive 57% gross margin and a 22% net profit margin in 2013 thanks to its dominant position in the online-ad food chain. We believe there is more growth to come in this core business, as there is still a major dis-connect between the amount of time that consumers spend online and the percentage of advertising dollars that are allocated to the medium. Given its growth over time, we believe that Google currently trades at a discount to what we see as the intrinsic value of its current business, before even taking into account the potential of initiatives like Google Glass, driverless cars, Nest intelligent thermostats and its Project Ara modular smartphone effort. More importantly, we consider Google’s culture of innovation as a highly valu-able asset in and of itself. In our view, many investors do not fully appreci-ate the long-term potential of what Google can accomplish within the

AS MUCH AS NOW HIGHLIGHTS POTENTIAL BREAKTHROUGHS, IT ALSO EXPOSES THE CHALLENGE THAT WE FACE AS INVESTORS.”

At the other end of the spectrum, several of our speakers and panels touched on the growth opportuni-ties in hot technology markets such as mobile and cloud computing, areas that do not lack for investable com-panies. The problem is that while we expect to see continued rapid growth in these spaces, many of these stocks—both pre- and post-IPO—are prohibitively expensive. (See Teddy Lamade’s article on page 8 for more on that topic.) We have been fortunate to be able to build positions in stocks like

T H E A D V I S O R Y J U N E 2 0 1 4 3

COVER STORY

search-engine ecosystem it has built. What’s more, we believe that the mar-ket completely overlooks the fact that Google is likely to continue pushing the innovation envelope in the years to come with initiatives that we do not even know about yet.

Stericycle is another company that offers a solid present-day business model and exciting long-term poten-tial. Through hard work and strategic acquisitions, it has attained a nearly unassailable position in the U.S. med-ical-waste management market. It has a dense network of collection routes that allow for highly efficient coverage of its customers, it owns a large per-centage of all the federally permitted medical incineration capacity in the

U.S., and it has specialized expertise in navigating the web of federal, state and local regulations governing medical waste. Because of all of this, it enjoys exceptionally high customer reten-tion rates—customers would need an extremely strong reason to switch from the recognized industry leader to another vendor, given all of the regu-latory risks that such a switch might entail. Stericycle’s business is tightly aligned with a variety of long-term societal trends, such as cost contain-ment in health care and the growing impact of environmental factors on businesses. In addition, its strong customer relationships have created a number of ancillary growth opportu-nities, such as a potentially lucrative

business offering remote cloud-based call centers and office management for doctors’ offices.

In the end, the basic principles of stock investing never change: Decisions boil down to whether we think a company’s likely future cash flows are worth more or less than the current share price. The NOW conferences remind us that the word “future” is a broad term, encompassing the more visible possibilities of today and the next few years, as well as the leaps of faith required to value a firm’s potential over much longer periods of time. We believe we can uncover truly compelling opportunities if we can keep one eye on the ground in front of us and the other on the horizon.

ANNE-MARIE SLAUGHTERCHARLIE COOKDALIA MOGAHED

VIVEK KUNDRA

ANDREW MCAFEEGLENN HUTCHINS

4 T H E A D V I S O R Y J U N E 2 0 1 4

ASSET ALLOCATION

Many investors with an appetite for growth are looking ahead to the next chapter of emerging

growth, in a set of aptly named “fron-tier markets” that span the entire globe from Argentina to Vietnam. Like the first wave of emerging markets in the 1980s and 1990s, this diverse set of economies is expected to grow far more rapidly than the rest of the world.

However, it’s unlikely to be a smooth journey. The early years of growth for “traditional” emerging markets in the 1980s and 1990s were marked by poor liquidity, extreme political events, cur-rency crises and numerous examples of heavy market losses, especially for foreign investors. We believe that the current scenario in frontier markets offers just as many investment risks, which is why we are not yet comfort-able recommending a broad allocation to these markets.

NEW BOUNDARIESThe list of 24 countries covered by the MSCI Frontier Markets Index is highly diverse; it includes Kuwait, Saudi Arabia and Jordan in the Middle East; Nigeria, Tunisia and Kenya in Africa; Vietnam, Pakistan and Bangladesh in Asia; and Kazakhstan, Romania and Slovenia in Eastern Europe. GDP grew at a 5.2% clip on average between 2003 and 2013 in these countries, well

The Wild FrontierEmerging markets have produced powerful growth over the past generation, and many investors are hoping that today’s frontier markets can duplicate that feat. But investors beware: developing economies can travel an extremely rocky road in their early years of growth.

ahead of the worldwide 3.9% average over that time.

Many of these countries have pow-erful demographic trends on their side. China’s population roughly doubled between the mid-1960s and today, greatly boosting its economic growth during that time. Several frontier markets project population growth similar to China’s in its high-growth period. Nigeria’s population, for example, has doubled since 1980 and is expected to grow another 176% between 2010 and 2050, according to the United Nations. Kenya is not far behind, with an expected 138% growth rate between 2010 and 2050.

Also, frontier economies today aren’t following incremental develop-ment paths—they often “leapfrog” into fully modernized financial struc-tures, technologies and transportation networks. For example, in Africa, vast portions of the population are unbanked or underbanked, but the widespread mass adoption of mobile phones has sparked a $61 billion “mobile money” market in Africa, according to Gartner Research. Today more than 55 million Africans access basic banking, credit and insurance solutions over standard analog cell phones—and that may just be a beach-head for further growth, given the more than 780 million mobile phone subscriptions in Africa, according to the 2013 Ericsson Mobility Report.

BY TAYLOR GRAFF, CFA

Asset Allocation Analyst

THE OTHER SHOEAgainst this rosy backdrop, what could go wrong? The answer is plenty, at least during these early years of development.

We should note that frontier mar-kets are still just a tiny sliver of the global equity market. According to Bloomberg, the market capitalization (aggregate market value) of the global investable equity universe sits in the vicinity of $60 trillion. On April 30 of this year, the entirety of the MSCI Frontier Markets Index had a free-float market cap of $198 billion, a figure not quite as large as Verizon’s.

This is important because the small size of these markets, compared with the potential flows of foreign invest-ment in and out of them, can have a dramatic effect on liquidity. A sizable percentage of shares in these markets is locked up in the hands of govern-ment and other elite stakeholders. Only 65% of Kuwait’s and 39% of Vietnam’s stock markets are consid-ered “free floating.” Morocco’s market is composed of approximately $36 billion of public equities, but only $2 billion floats freely. In many of these countries, access can also be a problem for foreign investors, as many stock transactions are conducted privately between two parties via handshake deals at a local bank.

In the event that conditions deterio-rate in one of these markets, foreign

T H E A D V I S O R Y J U N E 2 0 1 4 5

ASSET ALLOCATION

investors may find themselves in a liquidity squeeze or unable to sell. During the 1990s, a series of crises (devaluation of the Mexican peso in 1994, the Southeast Asian currency crisis in 1997 and the Russian debt crisis in 1998) destabilized govern-ments and currencies, and in response some nations took the step of block-ing foreign investors from selling their stakes in emerging-market companies. Largely due to these crises, the MSCI Emerging Markets Index lost 40% of its value between December 1993 and December 1998, while the MSCI World Index of developed-market stocks more than doubled during that period. It did not matter that emerg-ing economies grew more quickly during this timeframe. Political and monetary instability ruled the day, and many of the countries caught up in those crises, such as Mexico, Brazil, Russia and the Philippines, had more mature economies and financial sys-tems than most frontier markets do today (see table to the right).

Instability still poses a big risk today. Argentina has proven extremely vulnerable on the monetary front. As noted in the table above, U.S.-dollar-based investors in the MSCI Argentina Index have twice lost more than 70% of their money in the past six years alone. Devaluation has hurt investors there during bull markets as well. From March 2011 to March 2014, the MSCI Argentina Index pro-duced a powerful 52% return in local terms, but that actually would have been a 23% loss for U.S. investors due to the Argentine peso’s 51% decline vs. the dollar over that timeframe.

Nigeria and Tunisia are just two of many examples of countries with political stability issues. Nigeria has a long history of military coups, most

but we already have some exposure to these markets simply through the wide range of global firms in our portfolios that do business in frontier economies. Additionally, our emerg-ing-market managers are building toeholds in frontier markets. Examples in Somerset Capital’s portfolio include Cia Cervecerias Unidas (a Chilean brewer selling into Argentina), OTP Bank (a Hungarian bank with opera-tions in Bulgaria, Serbia and Croatia), and Pou Chen (a Taiwanese footwear firm with meaningful business in Vietnam). We believe that this indirect frontier-market exposure offers us real opportunities for growth with limited vulnerability to sovereign issues. But as time goes on, we fully expect that many of these countries will mature as their emerging-market predecessors did before them, and provide more fer-tile ground for public investors.

recently in 1993 by a junta that stayed in power until 1998. A democratic gov-ernment was established in 1998, but the country is plagued by an increas-ingly violent divide between Islamic and Christian factions that represents a tangible threat to political order. The stock market of Tunisia, another fron-tier market, hit an all-time high in late 2010, and just months later Tunisia’s government was toppled, its market collapsed, and investors seeking to sell Tunisian investments confronted a severe liquidity challenge.

These threats are a particular prob-lem for investors who focus on the deep, fundamental, company-specific research that we believe to be the hall-mark of the best managers. Even the best businesses can be swamped by a political or economic catastrophe.

We are not yet comfortable with a direct allocation in frontier markets,

Peak to TroughThe following examples show the staggering losses that U.S.-based investors experienced from a combination of stock declines and currency devaluation in emerging markets in the 1990s and early 2000s—and much more recently in frontier markets like Argentina (in bold).

SOURCE: BLOOMBERG. PERFORMANCE IS MEASURED BY EACH COUNTRY’S RESPECTIVE MSCI INDEX.

Country Date RangePercentage of

Investment Lost(Stock Market + Currency)

Mexico 2/7/1994 3/8/1995 -74.9%

Russia 1/2/1998 10/2/1998 -94.3%

Philippines 1/31/1997 12/18/2002 -88.5%

Indonesia 2/26/1997 9/18/1998 -93.8%

Brazil 3/20/1998 10/15/2002 -78.7%

Malaysia 3/2/2000 6/7/2002 -88.0%

Argentina 6/30/2008 3/9/2009 -76.4%

Argentina 1/19/2011 11/16/2012 -72.1%

CONVERSATION SUSTAINABILITY SKEPTIC

WITHA

6 T H E A D V I S O R Y J U N E 2 0 1 4

Portfolio managers Karina Funk and David Powell view a company’s sustainability strategy as a potential driver of the outperformance of its stock. Not everybody buys it. Here they respond to the most common questions they get from skeptics.

We hold ourselves to the same standard as any insti-

tutional investor or consultant does—we seek to max-

imize returns and outperform our peers on a risk-ad-

justed basis.

This question is an understandable one, given the his-

tory of socially responsible investing (SRI). Starting back

in the 1970s (and much earlier for faith-based investors),

many SRI strategies focused entirely on reflecting the

What is your ultimate goal with your strategy? Are you trying to maximize returns, or are you trying to support some political or social or environmental viewpoint?

By limiting yourself to the “green” stocks, aren’t you inevitably limiting your performance?

BY KARINA FUNK, CFA

AND DAVID POWELL, CFA

Co-Portfolio Managers, Large-Cap Sustainable Growth Strategy

values or beliefs of their investors, using a series of sim-

ple screens to avoid tobacco companies or oil companies

or any number of industries or business practices that

might be deemed undesirable.

You can debate the performance implications of this

approach, and academics have done so for decades. In

fact, a commonly cited argument is that because socially

screened strategies only “fish” in a certain part of the

market, by definition they limit their ability to outper-

form. Regardless of how SRI may affect performance, its

primary goal is to reflect an investor’s values, both in per-

sonal terms and in terms of where that investor wants to

see society direct its capital. Those are certainly admira-

ble motives, but they have little to do with performance.

Our approach is quite different and focused entirely

on opportunity and risk assessment. We look for stocks

that we believe have attractive upside and limited down-

side, a core tenet of all of Brown Advisory’s equity strate-

gies. We simply use a sustainability lens to identify driv-

T H E A D V I S O R Y J U N E 2 0 1 4 7

SUSTAINABLE INVESTING

Our focus is on identifying companies whose EBA is

having tangible impact on business results in the form

of revenue growth, cost reduction, customer loyalty

or other drivers of shareholder value. For example,

BorgWarner (one of our current holdings) is a well-man-

aged auto supplier, but if it had not focused over time as

heavily as it has on fuel efficiency and emission reduc-

tion, it would have likely grown in line with the broader in-

dustry. Instead, its growth has outpaced the auto indus-

try and many of its peers by a healthy margin—thanks, in

our view, to its EBA.To date, we have found the majority of our ideas in the

consumer, industrials, materials and technology sec-

tors. But we do not fill out the sector wedges in a pie

chart in order to align with our benchmark—the willing-

ness to differ from our benchmark is an essential aspect

of Brown Advisory’s equity investing philosophy. Rather,

our portfolio is the result of bottom-up, fundamental re-

search to identify stocks that we like on a case-by-case

basis. We have not found many persuasive, EBA-driven

growth stories in the energy or financial sectors, while

we see more and more consumer, industrial and technol-

ogy companies recognizing the growth potential of EBA-

driven strategies. Our sector allocation compared to the

market is a secondary concern—our primary goal as

growth managers is to seek growth, and our EBA-driven

process, in our view, gives us an excellent opportunity to

achieve our growth objective.

What kind of “green” hurdle does a company have to get over in order to be eligible for your portfolio?

Given that sustainability impacts different sectors of the economy, does this mean that your portfolio gets heavily skewed toward or away from certain industries?

What if you find a terrific growth stock that has no meaningful “EBA driver”? Would you still buy it?

ers of opportunity and risk that may not be as obvious to

traditional investors. The term we use for these drivers—

environmental business advantages, or EBA—conveys

our belief that sustainability strategies can and do pro-

duce tangible business results. Our portfolio companies

are often more a part of the “solution” than the “prob-

lem” when it comes to things like energy efficiency or

healthy food, which is great, but that’s not why we invest

in them. The reason we invest is because their strategies

are driving revenue, profit or market share.

No, there has to be an EBA driver to a company’s growth

to attract our interest. Of course, EBA is not always pres-

ent in an easy-to-measure form. The bottom line for us is

a company’s management team. When a company’s man-

agers are thoughtful about sustainability, we believe that

often represents a competitive advantage in and of itself—

those managers are likely casting a wide net when they

think about risk, and that may position them more favor-

ably both now and in the future. So, for example, informa-

tion-storage leader EMC (a former holding in our portfolio)

identified weather-related disasters in Southeast Asia as a

meaningful risk to its supply chain, and in response it built

redundant suppliers into its system. When heavy flooding

in Thailand temporarily swamped that country’s electron-

ics firms, many global semiconductor firms saw interrup-

tions in supplies while EMC was in much better shape.

Do you buy companies just because they are “green”?

No. We look for companies with strong fundamentals,

compelling EBA, and attractive valuation—all three must

be present for us to invest. If all a company has going for

it is its good intentions about the environment, it will not

find a place in our portfolio. Take solar panel manufactur-

ers as an example. The concept of renewable energy is

obviously attractive from an environmental perspective.

But panel manufacturers essentially sell a commodity

today, and they offer little in the way of competitive dif-

ferentiation. Their businesses are highly capital inten-

sive, their industry is highly cyclical, and they are all sub-

ject to a patchwork of regulations that vary from country

to country and state to state. Situations like that are not

attractive to us.

8 T H E A D V I S O R Y J U N E 2 0 1 4

EQUITY STRATEGY

Divergent ReturnsThis year we have seen a major separation in performance between small and large stocks, as well as growth and value styles. With the proper perspective, such periods of divergence are as much an opportunity as they are a reason for concern. BY TEDDY LAMADE

Portfolio Manager

During the years after the 2008-09 financial cri-sis, investors learned to live with particularly long

and heavy bouts of market volatility, driven largely by their own emotional responses to high levels of uncertainty. Because many investors were trading on emotion and not fundamentals during this period, U.S. stocks tended to move in lockstep with each other—when the recovery seemed likely to falter, stocks of all stripes swooned, and when the outlook looked rosier, equities across the board rose.

A casual look at the S&P 500 Index’s return of 2% through the end of May might suggest a relatively indifferent start to 2014 on the part of investors. But under the surface, the market has taken off in all directions: Large-cap value U.S. stocks returned 4% while their small-cap growth counterparts fell 7% as noted in the graphic to the right. In fact, the CBOE S&P 500 Implied Correlation Index—which measures the correlations of the com-ponents of the S&P 500 Index with each other—hit an all-time peak of 90 in September 2011, but since then has gradually faded to its current range between 55 and 60.

Periods of divergence like this can be unnerving—after all, how can one reconcile these positive and negative performances simultaneously? But to us, this market represents opportu-nity—both as a realization of some

of the scenarios that drove our tac-tical asset-allocation decisions last year, and as a resetting of prices in certain segments where we are now able to build positions in what we see as great companies at what we see as attractive prices.

WHAT GOES UP…A large driver of this year’s big market variance has been a market correction in areas that were high flyers in 2013 such as biotechnology and cloud com-puting. The NASDAQ Biotech and Internet indices each raced to a 66% return last year. Several 2014 exam-ples provide a sense of the exuberance in the market. Facebook purchased mobile-messaging firm WhatsApp in February for $19 billion, a price tag

Break PointAfter years of performing in relative harmony, the four major segments of the U.S. stock market have split apart from each other so far in 2014.

SOURCE: FACTSET

-8% -6 -4Year-To-Date Index Return As of 05/31/14

-2 0 2 4 6%

Large-Cap Value

Russell 1000® Value Index

3.86%

Small-Cap Value

Russell 2000® Value Index

-2.76%

Large-Cap Growth

Russell 1000® Growth Index

2.01%

Small-Cap Growth

Russell 2000® Growth Index

-6.61%

of $40 per subscriber (each of whom pays WhatsApp $1 per year). In April, online home-sharing platform Airbnb closed a round of financing that valued the company at $10 billion. Without a single square foot of its own real estate, Airbnb is now in the same ballpark with Marriott’s $17 billion valuation as of late May. Finally, car-ride service firm Uber received funding in early June at a $18 billion valuation, greater than that of either Hertz or Avis. These firms may in fact earn their current valuations over time, but in the near term, valuation levels such as these are rarely sustainable for extended periods. This proved itself out starting in March when the high-growth, high-valuation segments of the market fell subject to the laws of

10.47% DIFFERENCE IN RETURNS

T H E A D V I S O R Y J U N E 2 0 1 4 9

EQUITY STRATEGY

gravity. The NASDAQ Biotech and Internet indices fell by 13% and 14% respectively between March 1 and May 20, and the Russell Microcap® Index dropped 10%—all contribut-ing to the general decline of small caps.

PROACTIVE STEPS

Market corrections are rarely a cause for celebration, but we see this reca-libration as a healthy development. Fortunately, we had worked during the second half of 2013 to position client portfolios for this sort of correc-tion. We are still finding opportunities to invest in companies we have had on our radar for some time that are now available at attractive prices.

As we entered the second half of 2013, our asset allocation and client teams worked extensively to exam-ine the state of equity markets and to discuss options for rebalancing portfolios. As of mid-year, growth stocks were on a tear while economi-cally sensitive value stocks had lagged the overall market, and bonds were in the middle of a rare year of nega-tive returns. For smaller, high-growth companies, we saw meaningful head-winds; the price/earnings ratio of the Russell 2000® Growth Index jumped to 26x in September 2013 from 16x a year earlier, while price-to-sales and price-to-cash-flow ratios increased similarly. We were also concerned that the hottest stocks were the most spec-ulative names—within the Russell 2000® Growth Index, companies below $250 million in market cap advanced by 57% in 2013, those with no profits returned more than 50%, and stocks priced under $5 per share returned more than 60%. For cycli-cal value stocks we saw the opposite: Many firms had produced healthy earnings growth for several years but

still traded at valuations well below their defensive counterparts. Finally, we also saw healthier prospects in core fixed income. For all the fears about the possibility of rising rates, such an environment would let us reinvest and rebuild bond allocations that we had reduced considerably in the low-yield-ing years after the financial crisis. So starting in the middle of the year, we trimmed small-cap growth allocations and redeployed assets into larger, cycli-cal-value stocks and core fixed income.

As it happens, these decisions worked out relatively well. Bonds have recovered some of their losses this year and the Russell 1000® Value Index is slightly positive for the year, while smaller high-growth stocks have declined considerably as noted. We would emphasize that our timing is rarely perfect or even close to it when repositioning tactically. The key is staying watchful for points when asset

U-Turn The stocks that drove the market to new heights in 2013 have reversed course in the past few months.

classes or sectors diverge from the mean, and not getting too caught up in exactly when they will revert back.

We still see opportunity to take advantage of this recent market reversal. Unlike what we saw in the Internet bubble of 2000-02, plenty of companies caught up in this correc-tion are producing healthy earnings and what we see as durable top-line growth. For example, we recently added Pegasystems, a small-cap cloud-based software firm, to our All-Cap strategy, which seeks to give our clients broad equity exposure in a concentrated and tax-sensitive strategy. Our research analysts have viewed Pegasystems favorably for years, but only this recent sell-off provided us with an entry point that we considered attractive. That is just one example of how we try to take advantage of a fast-moving and divergent market.

SOURCE: FACTSET. ALL RETURNS ARE CUMULATIVE.

COMPARATIVE INDEX RETURNS

100%

80

60

40

20

0

-20

12/31/12 — 2/28/14

76.8%

63.4%

43.0%

-14.5% -10.2%-13.2%

2/28/14 — 5/21/14

NA

SD

AQ

Bio

tech

NA

SD

AQ

In

tern

et

Ru

ssel

l M

icro

cap

1 0 T H E A D V I S O R Y J U N E 2 0 1 4

PHILANTHROPIC PLANNING

Making Your MarkIn establishing your philanthropic legacy, the choice of how you pursue that legacy—specifically, the vehicles and the legal structures you use—is one of the most important choices you can make.

During my time at Brown Advisory, I have seen our clients do wonderful things with their wealth, and being

a small part of that is one of the most rewarding aspects of my job. We work with entrepreneurs who have created businesses that employ thousands of people and make products that benefit countless others; nonprofit organiza-tions that work tirelessly to serve those in need; and private clients who make the selfless decision to dedicate con-siderable portions of their wealth to charitable and philanthropic activities.

For our clients seeking to forge a phil-anthropic legacy, we often guide them through a wide array of topics, from developing their specific philanthropic mission, to identifying organizations aligned with that mission that they can support, to determining the right legal and financial structures that can help them maximize the impact of their efforts.

Once a client commits to a philan-thropic path, we most often consider either donor-advised funds or private foundations as structures for their philanthropic activities. Each of these structures offers pros and cons from a financial perspective. Just as importantly, each represents a dis-tinct approach to philanthropy, with donor-advised funds offering a greater amount of external support and coor-dination, and a private foundation

offering a greater amount of control and flexibility.

THE DONOR-ADVISED FUND OPTIONFor those who are dedicated to a spe-cific cause or set of causes, but are not capable of or interested in taking on a heavy operational or organizational burden, donor-advised funds (DAFs) are often an excellent option. They have gained traction over time, and the DAF sector has grown well beyond its pre-crisis peak: The National Philanthropic Trust reports that DAFs held more than $45 billion in assets at the end of 2012 (a 42% increase over 2007 levels) and produced $8.6 billion in grant activity (a 37% increase over 2007 levels).

The three primary benefits of DAFs for donors are simplicity of adminis-tration, high limits on deductibility of contributions, and low required minimums to establish the DAF. When you create a DAF, it is admin-istered by a public charity that takes care of most day-to-day operational issues for you and your family. This lets you engage your current fam-ily members and future generations in the exercise of a philanthropic vision, without administrative head-aches. You also benefit from the high deductibility limits on donations to public charities. You can deduct up to 30% of your adjusted gross income (AGI) for contributions of long-term

appreciated assets, and up to 50% of AGI for cash and equivalents.

However, it is important to note that from a legal standpoint, your contribution to a DAF is an actual donation: You relinquish control and ownership over those assets. In reality, you will always have some say regard-ing how those funds are used and distributed. The charities that oversee these funds generally want to help their donors accomplish their phil-anthropic objectives and often give donors some level of discretion over contributed assets.

Additionally, DAFs can be attrac-tive when you are not ready to make specific charitable decisions but none-theless face a current-year financial event, be it a taxable gain that you wish to offset, or even a required dis-tribution from a private foundation. In these instances, you can direct funds into a DAF and receive the accompanying tax benefits, but still give yourself time to make decisions about how to disburse those funds.

THE PRIVATE FOUNDATION OPTIONPrivate foundations are appropriate for clients who know exactly what they want to accomplish with their chari-table funds and who want to play an active role in putting those funds to work. These structures allow donors to retain control over the manage-ment, distribution and use of their

BY BRIGID PETERSON

Strategic Advisor

T H E A D V I S O R Y J U N E 2 0 1 4 1 1

PHILANTHROPIC PLANNING

contributed assets, so donors will be able to choose the specific causes and organizations they wish to support and can modify their priorities over time if they wish to do so. Of course, with this control comes responsibil-ity. The financial and organizational burdens associated with creating and managing a private foundation can be sizable.

There are two types of private foundations, operating and non-oper-ating. Private operating foundations (“POFs”) conduct their own tax-exempt activities and programs, such as a community center or an edu-cational program. Because of these “charitable activities,” they are treated

similarly to public charities, and dona-tions to POFs benefit from the same high deductibility limits as DAFs. Few clients are looking for that level of day-to-day activity, so they often choose a non-operating private foundation (simply termed “private foundations”). These foundations are primarily grant-making organizations, established to carry out the charitable intent of their founders. Private foundations are viewed as distinct from public chari-ties, and therefore deductibility limits on contributions to them are lower—20% of adjusted gross income for contributions of long-term appreciated assets and 30% of AGI for contribu-tions of cash and equivalents.

Private foundations have to pay a variety of operating costs, they need to file annual disclosures and tax returns, and they have to distribute 5% of foundation assets every year. Additionally, the various rules regard-ing prohibited transactions for private foundations are complicated, so ongo-ing advice of counsel on these matters may be necessary. Still, clients who wish to commit substantial assets to charitable activities often prefer these structures, particularly when they want to ensure control over the dispo-sition of those assets.

Whether you use a DAF or a private foundation for your charitable strate-gies, there are a variety of exceptions and nuances regarding the taxable treatment of contributions and distri-butions. For example, a donation of stock would be treated quite differently depending on your holding period: If it is a long-term holding of more than a year, you can take the full, fair-mar-ket value of that property (subject to AGI limitations) as a charitable deduc-tion, but if it is a short-term holding, you can only take your cost basis (i.e., the amount you paid for it) as a deduc-tion. It is essential to seek advice from qualified tax advisors when consider-ing these sorts of charitable strategies, and we often work closely with our clients’ attorneys and accountants to develop well-rounded plans that con-sider a comprehensive range of factors.

In the end, all of this work serves one goal: identifying our clients’ objectives and helping them make a difference. Your goals, your tax situation and your inclination to stay involved in charita-ble activity on a day-to-day basis will determine whether a private founda-tion or a DAF is the best choice. Both options, however, offer you ample opportunity to establish and maintain a philanthropic legacy.

Comparison of Donor-Advised Funds and Private Foundations

Donor-Advised Funds Private (Non-Operating) Foundations

Initial set-up Agreement with sponsoring charity

Establish corporation or trust

Exempt status Falls under sponsoring charity’s exemption

Must file own application for exemption

Annual costs Typically a flat fee, which can vary from 0.25% to 2.00% of assets

Annual legal, accounting and administrative costs

Minimum contribution

Can start with as little as $5,000 to $10,000 Typically $1-2 million

AGI deduction limitations (for federal tax purposes)

Cash & equivalents - 50%; Long-term appreciated assets - 30%

Cash & equivalents – 30%; Long-term appreciated assets – 20%

Annual required distributions

None 5% of asset value

Annual taxes None 2% on investment income

Annual tax filings

None (included in the sponsoring charity’s filings)

Form 990-PF, any appli-cable state filings

SOURCE: INTERNAL REVENUE SERVICE AS OF MARCH 31, 2014.

OFFICE LOCATIONS

BALTIMORE

(410) 537-5400(800) 645-3923

BOSTON

(617) 717-6370

WASHINGTON

(240) 200-3300(866) 838-6400

CHAPEL HILL, NC

(919) 913-3800

LONDON

+44 203-301-8130

WILMINGTON, DE

(302) 351-7600

brownadvisory.combrownadvisory@brownadvisory.com

NEW YORK

(212) 871-8550

The views expressed are those of the authors and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients or other clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients and is for informational purposes only. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication.

The S&P 500 Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe, and con-sists of approximately 2,000 U.S. companies representing approximately 10% of the investable U.S. equity market. The Russell 2000® Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000 Index companies with higher price-to-value ratios and higher forecasted growth values. The Russell 2000® Value Index measures the performance of the small-cap value segment of the U.S. equity universe. It includes those Russell 2000 Index companies with lower price-to-value ratios and lower forecasted growth values. The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 Index companies with higher price-to-value ratios and higher forecasted growth values. The Russell 1000® Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 Index companies with lower price-to-value ratios and lower forecasted growth values. The Russell Microcap® Index measures the performance of the microcap segment of the U.S. equity universe and consists of approximately 2,000 U.S. companies representing approximately 3% of the investable U.S. equity market. All Russell indices mentioned above are trademarks/service marks of the Frank Russell Company. Russell® is a trademark of the Frank Russell Company. The MSCI Emerging Markets Index measures equity market performance in global emerging markets. It is a float-adjusted market capitalization index that consists of indices in 23 emerging economies. The MSCI Frontier Markets Index measures equity market performance of 24 frontier-market countries (generally defined as countries in an earlier development stage than countries classified as emerging markets). It is a float-adjusted market capitalization index that covers approximately 99% of the frontier-market universe. The MSCI World Index measures large and mid-cap equity market performance across 23 developed markets, covering approximately 85% of the free float-adjusted market capitalization in each country. The MSCI Mexico Index, MSCI Brazil Index, MSCI Malaysia Index, MSCI Philippines Index, MSCI Indonesia Index, MSCI Russia Index and MSCI Argentina Index are all designed to measure the equity market performance of large- and mid-cap equities in their respective countries. The NASDAQ Biotechnology Index includes securities of Nasdaq-listed companies that are classified according to the Industry Classification Benchmark as either Biotechnology or Pharmaceuticals and that also meet other liquidity and solvency criteria. The NASDAQ Internet Index is a modified market capitalization-weighted index designed to track the performance of the largest and most liquid U.S.-listed companies engaged in Internet-related businesses. The CBOE S&P 500 Implied Correlation Index is a market-based estimate of the average correlation of the stocks that make up the S&P 500 Index. One cannot invest directly in an index.

Circular 230 Compliance Statement: Regulations contained in IRS Circular 230 regulate written communications from us concerning tax matters. In compliance with those regulations, we must inform you that 1. Nothing contained in this document is intended to be used, and nothing may be used or relied upon by any taxpayer for the purpose of avoiding penalties that may be imposed on such taxpayer under the Internal Revenue Code of 1986, as amended; 2. No written statement in this document may be used by any person or persons to support the promotion, marketing or recom-mendation of any federal tax transaction(s) or matter(s) contained herein; and 3. Any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor with respect to any federal tax transaction or matter contained in this document.

Terms and definitions: Price-Earnings Ratio (P/E Ratio), Price-to-Sales and Price-to-Cash Flow are ratios of the price per share of a company’s stock compared to its per-share earnings, sales and cash flow, respectively.