Charles Brandes' First Quarter 2014 Commentary

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May 29, 2014
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Trading Value - Pursuit of Best Execution and Innovation

This edition of the Brandes Quarterly Commentary offers an inside look at our trading team, and how its commitment to efficient, positive change in the marketplace helps serve our clients' long-term interests. An important part of the firm's commitment to best execution is our investment in The IEX Group (

IEX, Financial), which we describe in detail below i .

More investors are now aware of the industry challenges created by high frequency trading, mostly due to the intense interest in the new book by best-selling author Michael Lewis, Flash Boys: A Wall Street Revolt .

The book outlines how one company—IEX—almost single-handedly combats what it calls a "rigged game" that has siphoned billions of dollars from the investing world. We are proud to be an inaugural supporter of IEX, as it reflects our interests in promoting a fair and transparent trading environment that we believe will benefit our clients and the industry. This commentary highlights:

• The "Electronification" of Markets and What We're Doing: Why it is now more complex to execute effective trading strategies and how Brandes has efficiently and pro-actively navigated the trading arena.

• Our Investment in IEX: Brandes took an early lead in supporting the formation of IEX, whose primary purpose is to address the challenges created by a fragmented and fast market. We consider trading a means to an end, and not an end in and of itself. While Brandes will always focus on value at the company level, best trading execution is a critical part of our investment process as well.

• Client Benefits: The Brandes commitment to best practices and innovations in technologies, processes and team development that help benefit our clients. A Fragmented and Fast Market Depicted in Exhibit 1 is our current, fragmented U.S. equity market, electronically connected via high-speed networks and computers. According to research, by the end of 2013 the U.S. stock market was comprised of 13 exchanges and 40+ additional venues for trading—referred to as Alternative Trading Systems (ATS), as well as "dark pools." 1

• For both parties—buyers and sellers—orders enter the market through a broker-dealer, which then places them in one of several algorithms (computer programs). The algorithms then slice large orders into smaller ones (called child orders).

• Another layer of computer programs, named Smart Order Routers (SOR), contains rules that are used to determine where to send the child orders, typically a myriad of venues (exchanges and dark pools).

• The SOR sends child orders back and forth until they are filled. This process increases the opportunity for what is referred to as "information leakage," where one's intention to trade can be inferred, and it can ultimately have a negative impact on the price.

In this environment, a new class of short-term oriented traders (or participants) also evolved, practicing what is commonly referred to as High Frequency Trading (HFT) 2 . While the term HFT is broad, many HFT strategies now have replaced the traditional role of the specialist and market makers 3 as liquidity providers, but without the same obligations.

As HFT gained influence and access, it wasn't long before buy-side traders witnessed its impact by patterns of "unexplained" changes on their screens. Usually, any of the buy-side's attempts to lift 4 the offer on certain stocks would result in frustration, as the displayed liquidity vanished and implicit costs increased. Not wanting to rely solely on their brokers, some buy-side firms have had to spend a considerable amount of resources to understand this new game and its rules to help protect their clients' orders.

Unraveling the Complexity

In order to effectively serve clients in this new environment, we believe that an investment manager's trading desk must master market structure—the regulatory, competitive and technological "plumbing" of stock markets.

Since the first day the firm took its trading capabilities in-house in 1991, the Brandes Trading Group has kept vigil to identify and understand industry trends, while simultaneously retooling, educating and training our personnel for the constantly changing and ever-complicated investment landscape.

Brandes and The IEX Group: Advocates of Change Today the time it takes to buy and sell stocks is measured not in minutes but in microseconds, 5 thanks to evolution in technology, high-speed networks and increasingly sophisticated trading algorithms. While this trend isn't necessarily bad for traditional investors in general, we believe it can be increasingly problematic over time. It wasn't long before we discovered that many of our peers shared our view, and eventually we pooled our resources to do something about it.

Brandes is one of the initial investors in a company called The IEX Group, the first Alternative Trading System (ATS) funded exclusively by a group of mutual funds, hedge funds, family offices and individuals. An ATS is an electronic trading venue that matches buyers and sellers of securities. In our initial talks with IEX, its innovative and potentially industry-changing model became clear, so we stepped up along with other institutional investors to help IEX get started.

Our finding IEX, as the company was sketching out a business plan two years ago, was no coincidence or accident. It was the result of our trading desk proactively seeking out the best and the brightest that the industry can offer to ensure our clients' experience is world class. We've known the core team behind IEX for years, dating back to when its members worked for the Royal Bank of Canada and had proved themselves a talented and reliable resource for the Brandes trading desk.

How does IEX help? IEX seeks to provide a more balanced marketplace via a simplified market structure design and its own proprietary, cutting-edge technology. With its fair-access platform available to any qualified broker-dealer, IEX aims to neutralize predatory high-speed strategies.

IEX Technology

IEX's patent-pending Anti-Colocation Architecture (IEX POP) separates its matching engine (where IEX buys and sells are matched) and Access Layer (where brokers connect to the IEX platform) by 350 microseconds. IEX's smart order router captures nearly 99% of displayed liquidity. These two features, which are unique to IEX, can benefit orders in two ways: a) Prevent Slow Market Arbitrage – The IEX POP creates a critical latency buffer, slowing down the HFT, and which allows IEX to accurately price trades in relation to the most up-to-date National Best Bid and Offer (NBBO).

6 b) Prevent Electronic Front-Running – When routing orders, the IEX POP ensures they arrive at all designated locations before predatory strategies have a chance to pick up a signal at IEX and race the order to other markets. What would otherwise result in "fading liquidity" has been largely eliminated by the IEX routing methodology.

Requiring no changes to our existing trading systems, Brandes traders can direct a portion of orders to rest in the IEX pool and leverage IEX's proprietary routing technology. Combined with other IEX features, the ultimate result is increased control of our orders, reduction of information leakage and less opportunity for electronic front-running 7 and other forms of unnecessary intermediation. Therefore, as liquidity congregates in one location, there is less need to slice orders, creating an opportunity to improve the quality of each trade execution. This ultimately should be reflected in the price our clients receive over the long term. Our decision to support IEX is a logical extension of our commitment to promote and protect the long- term interests of our clients, as well as our constant vigilance to improve industry best practices, fairness and transparency.

Brad Katsuyama, President and CEO of The IEX Group, comments on Brandes' support of IEX: "This has been a five-year journey in learning about market structure and although I have been thrown into the spotlight recently, there have been many people at IEX, brokers, and buy-side firms who have contributed to our discoveries. Among the firms we work with, Brandes is one of the most thoughtful and passionate supporters of market-structure reform. The firm was an early user of the THOR trading platform at Royal Bank of Canada and was also an early adopter of using IEX. Most importantly, the Brandes team decided to be part of our buy- side investor consortium, without which IEX would not exist. Thanks to managers like Brandes, the market structure is changing to benefit not only their own clients, but investors worldwide."

Striving for Excellence in Execution: Four Tenets of an Effective Trading Enterprise

IEX is a high-profile example of how we advocate and pursue industry improvements that we believe are right and in our clients' interests. However, it's just one aspect of a bigger picture for the Brandes Trading Team— framed by four basic principles:

• Vehement advocacy of market and regulatory changes that aims to benefit long-term owners of capital.

• Constant improvement through early adoption and constructive analysis of new trends, technology and pre- and post-trade data.

• Smart, effective and adaptive team culture, through encouragement, education and incentives toward seeking new client-centric disciplines and innovations.

• Wide global presence and responsiveness, with 24/5 trade monitoring in markets around the world. We monitor the global markets from Sunday evening when Asian markets open to Friday afternoon when markets in the Americas close.

Vehement Advocacy ...

We promote sweeping regulatory improvements designed to protect long-term investors. For example, Joe Scafidi, Brandes Director of Trading, participated in two fact-finding meetings on Capitol Hill. U.S. lawmakers and the SEC are proposing elimination of the maker-taker pricing model, a fee structure adopted by the U.S. exchanges in the 1990s amid the rise in electronic trading. Our contribution to this effort is geared toward promoting good public policy, which could benefit many industry participants.

Constant Improvement ...

We use technology and decipher pre- and post-trade data in all aspects of our trading to seek to constantly improve trade results and help maximize the alpha of our investment team decisions.

Smart, Effective and Adaptive Team Culture ...

In this era of electronic trading, it is important to note that for every trade, the decision on which algorithm to choose, the optimal entry and exit points, the appropriate level of participation and other criteria to a successful trade— must ultimately come from a human trader . Our traders have an average of 15 years with the firm, 19 with the industry.

Moreover, members of the Brandes Trading Desk are in a state of constant learning, with direct access to senior market structure specialists on the sell-side and the exchanges. Leveraging our relationships, we are able to obtain in-depth knowledge on the topics most relevant and impactful to our firm and our clients.

Wide Global Presence ...

The Brandes trading desk is staffed 24 hours a day to ensure continuous market coverage and enable traders to take advantage of market liquidity during local exchange hours anywhere in the world. The firm has trading relationships with many global and regional broker-dealer firms, providing Brandes with diversified trading coverage, competitive pricing, and local market experience with the securities it trades.

Committed to Best Possible Execution

Investment performance, asset allocation and monitoring remain key considerations for investors looking to grow and protect their hard-earned assets over time, and rightly so. We understand every basis point saved reduces implicit costs in execution and over time compounds the savings in our clients' accounts year after year.

It's sometimes easy to forget that the process and timing of trades, in an era of fast-moving markets, can also add tremendous value to client portfolios. Sound fundamental investment research and portfolio management remain the core of investment management, but we recognize that having the right team in trading ensures that work isn't unduly impacted during the implementation process.

At Brandes, we are proud of what we believe are best-in-class trading capabilities. Alongside our investment teams, our trading staff works round-the-clock to ensure we deliver our best possible execution on your behalf.

As always, we appreciate your business and the trust you place in us. Thank you.

The recommended reading has been prepared by independent sources which are not affiliated with Brandes Investment Partners. These materials are recommended for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. No investment strategy can assure a profit or protect against loss.

The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Portfolio holdings and allocations are subject to change at any time and should not be considered a recommendation to buy or sell particular securities. Strategies discussed herein are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. Indices are unmanaged and are not available for direct investment. Market conditions may impact performance. The performance results presented were achieved in particular market conditions which may not be repeated. Moreover, the current market volatility and uncertain regulatory environment may have a negative impact on future performance. International investing is subject to certain risks such as currency fluctuation and social and political changes which may result in greater share price volatility; such risks are increased when investing in emerging markets. Additional risks associated with emerging markets investing include smaller-sized markets, liquidity risks, and less established legal, political, social and business systems to support securities markets. Emerging markets investments can experience substantial price volatility in the short term and should be considered long-term investments. Investments in small and medium capitalization companies tend to have limited liquidity and greater price volatility than large capitalization companies.

The foregoing reflects the thoughts and opinions of Brandes Investment Partners ® exclusively and is subject to change without notice. Brandes Investment Partners ® is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada.

End Notes

i Brandes has a non-controlling interest on The IEX Group ("IEX"), with no seat on the board of directors. Our ownership of IEX and our discretion to route orders to IEX may create a conflict of interest, in that we may have an incentive to route more orders to IEX. The purpose of the investment was not revenue generation, but to support the formation of a trading venue that is aligned with the interest of long-term investors. The firm mitigates potential conflicts in this area by adhering to the best execution policy and procedures. We have implemented transaction cost analysis procedures designed to monitor our efforts to seek to obtain best execution.

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