Passive Equity Approach

We manage our international passive portfolio to the Morgan Stanley Europe Australasia and Far East (the EAFE) GDP-weighted Index. We believe market-cap-weighted indexing may overweight or underweight certain markets. A GDP-weighted index has historically produced less volatility and equal returns relative to a market-capitalization index. Country allocations in a market-capitalization index have historically been more volatile than in a GDP-weighted index.

Our preference for a GDP-weighted index is based on several observations.

• The relative stock market capitalization of a particular country can become greater than its economic output when price-to-earnings multiples are much higher in one market compared to another. The result is a systematic overweighting or underweighting of the country. We saw this with Japan's high weight in the market-capitalization-weighted MSCI EAFE in the 1980's.
• Some countries have large economies as measured in GDP but relatively thin public stock markets. If a large portion of a country's equities are privately held, its stock market capitalization is much smaller than its relative economic production. We see this for example in Germany. It is an issue that has recently by addressed by MSCI in its index methodology.
• Market capitalization weights result in greater instability, turnover, and expenses. Market movements can result in more frequent rebalancing in a portfolio benchmarked to a capitalization-weighted index, which can prove to be expensive in the long run.

We manage our domestic passive portfolio to the S&P 500 Index.