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% the Anatomy of Bubbles and Busts— and the Opportunities They

% the Anatomy of Bubbles and Busts— and the Opportunities They

VI, NO. 1 | SUMMER 2008

> The Anatomy of Bubbles and Busts— and the Opportunities They Create

> Wealth Transfer Strategies: The Timely and the Timeless

> Using Research to Navigate a Dynamic

> Can Early Harvesting Reap Greater Gains?

> China: The Impact of Domestic Policy on the Future of Global Trade

Global Wealth Management PERMISSION TO REPRINT MATERIALS FROM THE BERNSTEIN JOURNAL With the exception of fair dealing for the purposes of research or private study, or criticism or review, no part of the Bernstein Journal may be reproduced, stored, or transmitted in any form or by any means without prior permission. To obtain permission to reprint any material from this or prior issues, please call 212.969.6724.

© Copyright July 2008, AllianceBernstein L.P. All rights reserved. This publication is for use only with the private client of Bernstein Global Wealth Management, a unit of AllianceBernstein L.P. Bernstein does not provide tax, legal, or advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions. Table of Contents

> The Anatomy of Bubbles and Busts— and the Opportunities They Create 1

> Wealth Transfer Strategies: The Timely and the Timeless 9

> Using Research to Navigate a Dynamic 15

> Can Early Tax Harvesting Reap Greater Gains? 21

> China: The Impact of Domestic Policy on the Future of Global Trade 28 The Anatomy of Bubbles and Busts—and the Opportunities They Create by Dianne Lob, Chairman—Private Client Investment Policy Group and Beata Kirr, Senior Portfolio Manager, Wealth Management Group

The root cause of asset bubbles is not too-lax but too-gullible human beings. Behavioral fi nance sheds light on the origins of bubbles—and points the way for to capitalize on the busts that invariably follow.

FOR CENTURIES, INVESTORS HAVE FALLEN > Investors rationalize the soaring prices prey to the lure of a heady rise in or by telling themselves that some unique or or houses, and these overzealous revolutionary aspect of the infl ated asset has buyers have suffered losses in the bust that has rendered the old economic rules obsolete. inevitably ensued (Display 1, following page). With each bubble/bust cycle comes investors’ > At last (though it’s always hard to predict refrain: “This time it’s different.” But while when), some failure—a scandal, an earnings the object of affection-then-disdain may vary, shock, or a sign of weakness in the support bubbles and busts exhibit a predictable pattern: for the boom—signals the old rules do in fact still apply, rattling investors and precipi- > A sharp rise in the price of stocks or some tating a crisis of confi dence. Prices start to other object of sparks the fall, gathering as investors’ panic of investors. contaminates even good investments.

> Hunger for the coveted investment fuels > Eventually the fears subside and “normal” borrowing, which fuels demand that drives market drivers reassert themselves, creating prices up further. With no end to the outperformance opportunities for those inves- increases apparently in sight, still more inves- tors who remained true to fact, not euphoria. tors are lured into the marketplace, thereby pushing up prices even higher. All the while, The US Housing Bubble fl ows freely, and often some fi nancial The US housing bubble and its painful unravel- innovation facilitates the leveraging process. ing are a vivid reminder that markets have a disturbing habit of becoming grossly overin- > As a bubble builds, valuations become more fl ated—and then collapsing, infl icting damage and more distorted; fundamental consider- on investors’ wealth. Home prices started to ations, such as realistic profi t potential, are rise in the late , as low interest rates disregarded amid the prevailing irrational and easy credit facilitated by fi nancial innova- exuberance. tions—notably, subprime mortgages pitched to

The specifi c securities identifi ed and described in this article do not represent all of the securities purchased, sold, or recommended for the strategy or the portfolio, and it should not be assumed that investments in the securities identifi ed were or will be profi table. Please note that the specifi c securities discussed here may no longer be held within the strategy or portfolio.

SUMMER 2008 | 1 Display 1 Bubbles are as old as investing itself, but no matter what the chosen asset is, the pattern of self-delusion persists

Bubbles Across the Centuries

Bubble When Coveted Asset Inspired Idea Telltale Warning 1630s Purple-streaked Foreign tulip fanciers would sustain Tulip bulbs cost fi ve times a worker’s Semper Augustus boom for Dutch speculators annual salary South Sea 1720 in South Sea Spain granted monopoly on all South Joint stock in rose tenfold Company American trade in one year Mississippi 1729 Stock in Monopoly on trade in “French Shares shot from 500 to 10,000 livres Mississippi Louisiana” on beaver pelts, gold, in a few months (and plunged as fast) Company , coinage Roaring Late 1920s “High-tech” Purportedly transformational “New Massive public participation—and Twenties stocks of the day Economics” revolving around auto and shares trading at dot-com-style P/E airplane stocks ratios (until market fell 90%) Nifty Fifty 1960s–70s Blue Chips like High-P/E, brand-name growth stocks Kodak soared to $148 at its peak, Kodak, Polaroid, were deemed so reliable as to be only to plunge 60% and Xerox “one-decision” purchases— forever Japan Late 1980s Any big Japanese Japan was said to be the unstoppable The Nikkei index hit 38,915 in stocks new global economic powerhouse ‘89—even today it is back only to around 13,000 Tech and Late 1990s Internet and The Internet and communications Internet start-ups with no actual Telecom telecom stocks revolution had supposedly transformed profi ts, just a business idea, traded the rules of economics, permitting for triple-digit multiples ( permanent rapid growth index would plunge 80%) Source: AllianceBernstein

borrowers with limited or bad credit history— 50 million homes with mortgages, as many made home ownership widely accessible. as 7.5 million could have seriously negative —that is, be worth signifi cantly less than In a classic pattern, the favorable environment the principal remaining on their mortgages—if drove increasing demand for homes, propelling the average house price were to fall 20% from home prices higher. The escalating prices the 2006 peak (Display 2). attracted speculators, causing still more Display 2 to fl ow into housing as buying and selling Many homes could soon be worth less than the became fervid. By 2005, buyers and lenders alike principal remaining on their mortgages reassured themselves that prices could only go up, and buyers used their houses’ values to fund Houses with Negative Equity ≥10% Depending on Price Declines* a spending spree. Credit standards eased further. (Millions) The June 13, 2005, cover of Time magazine, 10.0 which depicted a man hugging a house, bore the 7.5 line: “Home $weet Home.” 5.0 3.0 That may well have marked the housing 1.9 bubble’s psychological high point. Soon after, 1.1 investors became alarmed when overextended 0% (5)% (10)% (15)% (20)% (25)% subprime borrowers began falling seriously Depreciation behind on mortgage payments. By 2007, the *Estimates based on what would occur if the average house depreciated housing market entered an inevitable correc- up to 25% from the 2006 peak Source: , National Association of Realtors, and tion, which is still under way. Of the nation’s AllianceBernstein

2 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT The US housing bubble has had far-reaching Key Concepts ramifi cations for the global investing markets. > Asset bubbles and busts—such as today’s Subprime and other asset-backed had housing crisis—have occurred throughout been bundled into packages of securities and sold to fi nancial institutions globally. As history, in remarkably similar guise indications mounted that the underlying loans > Behavioral fi nance scientists have identifi ed were at risk, turmoil grew, and the market emotional traits of investors that ultimately lead for such securities evaporated. Holders— to bubbles and busts: among them, believing predominantly fi nancial institutions and other that rising markets will keep rising; irrationally leveraged investors—were forced to mark down their holdings, often accompanied by fearing even small losses; and preferring instant calls that prompted widespread selling gratifi cation to greater -term reward of other liquid securities, especially stocks. > Given human nature, cycles of bubbles and Stock markets around the globe have tumbled, busts are inevitable and stock prices of fi nancial institutions, at the heart of the maelstrom, have been hardest hit. > These cycles offer great opportunity for investing that’s driven by intensive research and With rising home values no longer available a disciplined process as the credit line for US consumers’ spending, fears of a US economic have grown, fanning the fl ames of investor anxiety. In a How Behavioral Finance Illuminates Bubbles sign of how pronounced the tidal wave of fear Why the investing markets are prone to such had become, as of the end of March 2008, cycles has been explained, in part, by experts investors were willing to accept a real (after- in the fi eld of behavioral fi nance—in which infl ation) of (2.38)% on two-year US investing, economics, and psychology intersect. Treasuries—in other words, they were willing Pioneered in the 1970s by Daniel Kahneman, to accept a negative investment return for the winner of the 2002 Nobel Prize in Economic safety of holding Treasuries. Sciences, and the late Amos Tversky, the study of how human beings make decisions when Although the resolution of the housing bubble faced with unknown outcomes has shed light has yet to occur, history may offer some hope on investor behavior. What compels inves- for the future: A study of modern tors to chase “hot” performers long after the bubbles reminds us that recovery does come opportunity has passed, or to steer clear of eventually (Display 3).

Display 3 Stock bubbles burst…and markets recover

Subsequent Percent Percent Change First Bubble Had to Own Peak Trough Change Year After Trough Nifty Fifty Kodak $148 (1972) $59 (1974) (60)% 75% Oil S&P Oil & Gas Index $51.23 (1980) $24.39 (1982) (52) 55 Japan Nikkei index 38,915 (1989) 14,309 (1992) (63) 45 Biotech Amex Biotech Index 257 (1992) 73 (1994) (71) 24 Technology Nasdaq 5,046 (2000) 1,114 (2002) (78) 72

Source: FactSet, Markit, and AllianceBernstein

SUMMER 2008 | 3 out-of-favor stocks despite their longer-term Display 4 promise, or to avoid risk even at the cost of a A loss hurts twice as much as a gain pleases reduction in yield or return? Loss Aversion

In all cases, the answer is predicated on human Pleasure emotion or, more precisely, on a set of deci- sion-making biases that kick in when risk is involved. Nevertheless, there’s a positive side Small to investors’ penchant for engaging in mass Pleasure psychological self-deception: It can create Loss Gain opportunities to profi t from emotion-driven Big Pain investors’ overreactions to good or bad news. While the fi eld of behavioral fi nance is rich with evidence of a wide array of such biases, here we focus on just a few of the critical ones Pain that come into play during boom/bust cycles. Source: AllianceBernstein

iled and they can’t get rid of it fast enough, Decision-Making Glitches which hastens the downward spiral of the Behavioral fi nance suggests that human beings investment’s price. are as poorly equipped to be investors as could be imagined: Our own wiring works against The bait for another thinking trap is “avail- our very success. For example, through exten- ability,” or people’s tendency to be infl uenced sive research, Kahneman and Tversky proved by what they hear most frequently. In today’s that we feel pain from loss more keenly than always connected world, headlines can become we feel pleasure from gain (Display 4). In stand-ins for “the truth,” and decision making fact, based on their studies, if you won $100 refl ects that. one day and lost it the next, you’d be twice as unhappy about your loss as you were happy The Cost of Emotions about your good fortune. Such extreme sen- sitivity to pain makes investors generally risk These biases are so very natural that fi ghting averse, and that trait becomes even more them seems unthinkable. Yet, such emotion- pronounced when bubbles burst. That’s a driven investing can be extremely detrimental, powerful headwind in investing, where greater as Display 5 illustrates. Over the past 20 years, return opportunities typically entail more risk. the average stock investor reaped an annualized return of about 4.5%, barely Another powerful bias that foils good decision outpacing infl ation, while the US stock market making is “anchoring.” When an investment grew at close to 12% annualized over the same has done especially well, investors become period. The marked discrepancy is a function of convinced that such performance will continue fl awed choices driven by these biases. Anchoring into the future, fueling frenetic demand that, and availability tend to cause investors to move for some period of time, becomes self-fulfi lling: out of an investment that may be lagging and Prices continue to rise. The same holds true on into one that has been prospering. But doing the bust side: When something has faltered, or so typically means they’ve missed most of the some bad news besets the investment, investors opportunity in the hot idea and forgone the become adamant that it is permanently imper- developing opportunity in the disappointment.

4 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT Display 5 Display 6 The average investor’s results lag the market— Distinguishing a permanent problem from a temporary because of fl awed, emotional decision making setback is critical to

Annualized Returns 1988–2007 11.8% Long-Term Earnings Power Investment Controversy

4.5% Which? 3.0% Profits & Stock Price Decline Research S&P 500 Inflation Average Stock Conclusion Fund Investor “Value Trap” Past performance is no guarantee of future results. Source: Dalbar, Inc. Source: AllianceBernstein

Risk-aversion features here, too, as investors The emotional challenge, though, in value tend to shy away from stocks when times get investing is that the greatest buying opportuni- diffi cult, thus locking in losses and missing ties are created when negative sentiment is at its out on surges. most intense—the very time when buying into controversy seems entirely irrational.

From Destructive Bias to Advantaged Insight For example, think back to 1990, when big When faced with such faulty decision-making American were in a not-unfamiliar frameworks, can an investor come out ahead? : mired in a mortgage crisis, amid the The answer is yes, although what it takes to worst downturn in commercial since succeed does not always feel good. the 1930s. On top of that, banks were still coping with soured developing-country and Perhaps the greatest example is value-stock leveraged merger loans. As most investors saw investing. As Bernstein practices it, value it, the “troubled” big banks would go on hem- investing seeks out stocks that intensive orrhaging losses, and, what’s more, their research reveals are exceptionally inexpen- basic business model was becoming obsolete. sive versus their long-term earnings potential. People assumed a number of big banks would During booms, these are often stocks of collapse, along with many S&Ls. not associated with the fad of the moment; during busts, when widespread Our research uncovered a different picture: anxiety fuels high levels of risk aversion and We felt certain out-of-favor banks had the often indiscriminate avoidance of stocks, the profi t potential to more than cover their bad opportunity set for value investors widens. As loans and that industry plus Display 6 illustrates, the pertinent question for cost-cutting and fee-raising would in fact a value investor is: Is the stock price depressed spark an earnings boom. Convinced that because of some problem from which the loss-averse investors had vastly overreacted, company is unlikely to recover, or is it in fact we sought out beleaguered but basically sound a setback that ultimately will be corrected, banks, like Citicorp (whose total return was restoring the company’s long-term earnings down 52% in 1990); Chemical , (59)%; power—and its stock price?

SUMMER 2008 | 5 and Bank of Boston, (64)%. More stringent overhaul, IBM stock embarked on an impres- lending policies soon brought loan losses under sive recovery (Display 8). control, and merger synergies helped restore profi ts. Banks and bank stocks rebounded Display 8 dramatically (Display 7). From 1990 through Investors’ emotional overreaction to the computer maker’s travails created a value opportunity 1996, Citicorp rewarded investors with 338% in total return; Chemical, 321%; and Bank of IBM Stock Price Boston, 318%. Profits Recover $180 Display 7 Massive Restructuring, Layoffs, Cost-Cutting Bank stocks suffered in 1990 but ultimately Earnings 120 Plummet rebounded, outperforming the market New Management 60 Bank Stocks vs. S&P 500 199% 0 156% 92 93 94 95 96 97 Note: IBM went on to split two-for-one in May 1997, and again in May 1999. S&P Bank Source: FactSet and AllianceBernstein 500 Stocks (3)% (38)% Value investing thrives on controversy, which 1990 Cumulative Return invariably has an emotional component. 1990–1996 Although dominant in computer printers,

Past performance is no guarantee of future results. Hewlett-Packard in 2001 was subscale Source: Standard & Poor’s and AllianceBernstein in personal computers and hardware and services. By the end of 2002, the market valued In a fast-changing world, investor opinion often HP more like an appliance-maker than a high- veers rapidly from one extreme to another, as tech company. And when HP announced its behavioral fi nance has documented. A shining acquisition of Compaq in 2002, the merger star of high tech for decades, IBM fell on hard appeared merely to combine two weak PC times in the late 1980s, as demand for main- makers, thereby diluting the high-value printer frames shrank and its of the personal business. Compounding the investment con- computer market fell from 100% in 1981 to troversy was a formidable rival in Dell and a a mere 16% 10 years later. By 1993, IBM was high-profi le CEO at HP who served as a light- earning less than $1 a share, and its stock price ning rod for investor anxiety. Many doubted fell to $41 in August of that year, down from HP management could make the merger work, $100 in July 1992. and the stock continued to slide through 2002.

Nevertheless, under new management IBM However, our objective research persuaded began to reboot itself, although investors us that HP’s prospects were underrated. The remained skeptical. Our research indicated merger fundamentally improved the company’s the company’s strategy was sound and that competitive position in both personal comput- the stock was signifi cantly undervalued. IBM ers and enterprise hardware. Greater leverage revamped its product mix to increase revenues; over suppliers and a tougher negotiating sharply cut costs (expenses went from 43% of stance allowed HP to boost gross margins, sales in 1991 to 28% in 1996); and boosted and it decisively lowered operating costs by more than tenfold. When reducing head count. Operating earnings on investors fi nally began to catch on to the the PC business went from a loss of nearly

6 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT $1 billion in fi scal 2001 to a profi t of nearly signifi cantly outperformed the broad stock $800 million in fi scal 2007. The Dell threat market since its inception, after fees (Display abated, as that company’s was 10, bottom). replicated by Taiwanese assemblers. And HP Display 10 countered a competitive challenge to its printer business by introducing a low-cost unit capable Disciplined value investing involves a rational approach that has been successful over time of producing high-quality images. New man- agement in 2005 added momentum to HP’s US Strategic Value recovery (Display 9). But again, being able to Growth of $1 Million (after fees) Jan 1990–June 2007 spot the underlying opportunity when things Bernstein US Strategic Value: looked bleakest was key. $7.7 Mil. $8 Mil.

Display 9 7 The market was skeptical of HP’s merger with Compaq, 6 5 but our research foresaw that in time it would pay off S&P 500 4 $6.2 Mil. Hewlett-Packard Stock Price 3 $45 2 40 1 0 35 90 92 94 96 98 00 02 04 06 30 Announced Merger with Compaq 25 US Strategic Value Since Inception* vs. S&P Proxy 20 Battle Growth of $1 Million (after fees) Jan 1974–June 2008 15 New Management $71.4 Mil. 10 Appointed $39.6 Mil. 01 02 03 04 05 06 07

Source: Company reports and AllianceBernstein

Strategic Value S&P 500 Bernstein’s history as a value investor suggests Past performance is no guarantee of future results. See notes on that a disciplined process, driven by intensive performance, page 8. research, can effectively gauge the oppor- *January 1, 1974 Source: Standard & Poor’s and AllianceBernstein tunities created by controversy to generate long-term success. Over the period from 1990 Cycles of booms and busts seem to be unavoid- through June 2007, which saw the pronounced able features of investing, and the process of declines and recoveries referenced above, $1 equilibrium being restored—whether at the million invested in Bernstein’s US Strategic individual stock level or, as today, across a Value portfolio would have grown to $7.7 wide swath of the capital markets—is painful. million after fees, while a million dollars But the emotional biases that, in part, underlie invested in the S&P 500 would have amounted them can translate into unduly pronounced to $6.2 million (Display 10, top). And by mispricing. For those who rely on deep adhering to this discipline throughout our research as a guide, exploiting the discrepancies history, our US Strategic Value portfolio has can create signifi cant opportunity for gain. ■

SUMMER 2008 | 7 US Strategic Value (All Accounts) 1. General Notes: These monthly and quarterly performance fi gures are geo- metrically linked to calculate cumulative and/or annualized a. Performance Statistics Are Not Financial Statements— “time-weighted” rates of return for various time periods. There are various methods of compiling or reporting Closed accounts are included in the composite for each full performance statistics. The standards of performance quarter prior to their closing. measurement used in compiling these data are in accor- dance with the methods set forth below. Past performance d. Benchmark—The benchmark for the composite is the does not guarantee future results. A portfolio could suffer S&P 500 Index. The S&P 500 Index is widely regarded losses as well as achieve gains. as the standard for measuring large-cap US stock market performance. b. Composite Structure—Beginning in 1993, the Bernstein US Strategic Value (all accounts) composite (the “com- 2. Net-of-fee performance fi gures for the composite have posite”) includes only fee-paying private and institutional been calculated as follows: discretionary accounts not subject to signifi cant investment restrictions imposed by clients. From 1974 through 1992, a. Prior to 1983, management fees were not charged; the composite includes all private and institutional discre- instead, the accounts incurred transaction costs. tionary US Strategic Value accounts. b. From 1983 through 1992, the composite’s net-of-fee c. —Performance returns for each account return is the equal-weighted average of the actual after- are calculated monthly using trade-date accounting. fee returns of each account in the composite. From 1993 Performance results are reported on a total-return basis, forward, the composite’s net-of-fee return is the asset- which includes all income from and interest, weighted average of the actual after-fee returns of each and realized and unrealized gains or losses. Prior to July account in the composite. 1993, all fl ows were assumed to have occurred on the c. Net-of-fee returns for the past 10 years are as follows: last day of the month. From July 1993 through 2000, if an 1998: 10.1%; 1999: (0.2)%; 2000: 10.0%; 2001: 9.3%; account’s net monthly cash fl ows were equal to or exceeded 2002: (17.6)%; 2003: 32.0%; 2004: 13.5%; 2005: 8.6%; 10% of its beginning market value, the Modifi ed Dietz 2006: 20.1%; 2007: (1.2)%. Method was used to daily-weight the cash fl ows. When an account’s net monthly cash fl ows were less than 10% of its 3. Dispersion—Dispersion is calculated on the gross-of-fee beginning market value, the cash fl ows were assumed to annual returns of the accounts included in the composite have occurred on the last day of the month. Beginning in for all 12 months of the calendar year; it is the asset- 2001, all cash fl ows are daily-weighted using the Modifi ed weighted standard deviation of these returns. Dispersion of Dietz Method. Beginning in 1993, the monthly composite returns for the composite is as follows: 1998: 2.0%; 1999: returns are calculated by weighting each account’s monthly 2.0%; 2000: 1.6%; 2001: 1.7%; 2002: 1.6%; 2003: 1.4%; return by its beginning market value as a percent of the 2004: 1.2%; 2005: 1.1%; 2006: 0.8%; 2007: 1.1%. total composite’s beginning market value. Prior to 1993, the composite results are equal-weighted on a quarterly basis.

8 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT Wealth Transfer Strategies: The Timely and the Timeless by David Weinreb, Director—Wealth Management Group and Ted Mann, Analyst—Wealth Management Group

At least one silver lining has emerged from the recent dark clouds over fi nancial markets: Low interest rates and depressed asset valuations make it easier to escape gift and estate taxes. But be careful not to rush into long-term plans based on -term economic trends. Seemingly attractive market opportunities can be misleading, although any opportunity that triggers a review of your estate plan is useful.

WHEN THE FEDERAL RESERVE SLASHED Nonetheless, given the recent upheaval in the interest rates early this year, a spate of head- markets and the decline in interest rates, many lines declared the time was right for certain individuals and their professional advisors are tax-minimization strategies. As the Wall Street being tempted to establish long-term GRATs Journal wrote: “Low interest rates and the in order to “lock in” a low rate. For a fresh slumping market make this the best time in at perspective on the effect of interest rates and least fi ve years to use so-called estate-freeze market conditions on wealth transfer, we con- strategies, which can help shield a fortune ducted new research on GRAT strategies. The from estate taxes, say wealth advisors.”1 results were eye-opening:

While it is true that low interest rates and a > Contrary to common wisdom, locking in slumping market may facilitate a few such a low on a long-term GRAT is strategies, trying to “time” estate planning almost certainly not the best choice among according to market conditions is shortsighted. GRAT strategies for transferring liquid Smart estate planning is timeless: You can assets. A series of rolling short-term GRATs shield wealth from gift and estate taxes in will most likely outperform a long-term any interest rate or market environment. For GRAT regardless of interest rates. example, as Bernstein research has shown, a series of “rolling” short-term grantor-retained > Further, a rolling GRAT strategy will most annuity trusts (GRATs) funded with publicly likely outperform a long-term GRAT regard- traded stocks is a simple and effective wealth less of the stock market environment at the transfer strategy, regardless of market condi- strategy’s inception. tions at its inception.2

1 “Market Slump Means Time Is Right for Strategies to Curtail Estate Taxes,” Wall Street Journal, April 1, 2008, page D4. 2 See Keeping It in the Family: Planning for Effi cient Wealth Transfer, Bernstein, May 2006.

Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.

SUMMER 2008 | 9 The Case for Wealth Transfer Today Display 2 When interest rates drop, you can expect to The hurdle rate set by the IRS is near an all-time low hear that “it’s a great time to GRAT,” because 7520 Rate a key rate set by the IRS, the so-called Section 7520 rate, is integral to the GRAT structure. 12% May 1989 11.6% 10 As shown in Display 1, a GRAT is a trust that Average 6.8% allows you to move a portion of the future 8 return on assets to benefi ciaries without paying gift tax or using your gift-tax exemption. You 6 make an irrevocable gift to the GRAT and 4 retain the right to receive an annuity payment from it each year during the trust’s term. 2 June 2008 3.8% Anything left in the GRAT at the end of its 89 91 93 95 97 99 01 03 05 07 08 term passes to your benefi ciaries. If you struc- Source: US Treasury Department ture the GRAT so that it is “zeroed-out”—in other words, so that the present value of the A low 7520 rate sets a lower “hurdle” for a annuity payments equals the value of the assets GRAT to succeed in transferring wealth. If the you transfer to the GRAT—then you have assets in the GRAT grow at a rate in excess made no gift under tax law. of the 7520 rate, all that excess growth (the “remainder” of your GRAT) will transfer to Display 1 your benefi ciaries free of gift tax. This is the A simple GRAT structure allure of locking in a low 7520 rate for a long

GRAT You (the Grantor) term—it should be easier to beat—but it may Contribution not be the wisest choice. For a more nuanced GRAT Personal Assets perspective, let’s take a look at an alternative GRAT strategy—rolling short-term GRATs. Annuity RemainderPayments Taxes In a rolling GRAT strategy (Display 3), you Government create a short-term GRAT (say, two years) and use each year’s annuity to create a new GRAT. Your Income Taxes on Beneficiaries All Trust Income You can keep doing this for as many years as you want, but for the sake of comparison,

Source: AllianceBernstein suppose you continue this process for 10 years. During this time you will have created nine Here’s why the 7520 rate matters: It is the two-year GRATs (the fi nal one expires at the interest rate for the present value calculation. end of year 10). The IRS publishes the 7520 rate monthly. In simple terms, it is set at a modest premium Previous Bernstein research has shown that a to prevailing intermediate-term interest rates. rolling short-term GRAT strategy will most As Display 2 shows, the 7520 rate is near its likely outperform a single, long-term GRAT historical low. for two main reasons:

10 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT Display 3 Key Concepts Rolling GRATs can lock in gains > The common wisdom that low interest rates Annuities Annuities Annuities Annuities recommend creation of a long-term grantor- retained annuity trust (GRAT) may cause individuals and wealth planners to overlook a

GRAT 1 GRAT 2 GRAT 3 GRAT 4 better GRAT strategy 2 Years 2 Years 2 Years 2 Years > Building on previous Bernstein research, new analysis and a study of historical data show

Your Beneficiaries that rolling short-term GRATs are more likely

Source: AllianceBernstein to transfer more wealth, free of gift tax, than a long-term GRAT, regardless of interest rates or First, it keeps more of the capital committed to the strategy. In a single long-term GRAT, market environment the capital declines each year, as the annuity > “Don’t try to time the market” is good advice in payments return assets in the GRAT to you, the investment management, and our new research grantor. By contrast, the rolling GRAT strategy indicates it is equally apt for estate planning maintains all of the original capital committed to the strategy in the GRATs.

Second, the shorter, two-year time horizon Just How Important Are Low 7520 Rates? minimizes the chance that good investment One might argue that in the example above, performance in one year will be offset by the 7520 rate was much higher than it is today: poor investment performance in another year. In 1998 it was 7.2%; in June of this year it Even if the compound return during a 10-year was 3.8%. Shouldn’t such a low rate provide period is poor, there may be good two-year a powerful tailwind to the long-term GRAT periods along the way that will successfully structure? Since no one can predict what the transfer wealth. markets will do in the future, we approached the question in two ways: 1) by forecast- As an example, consider the decade that just ing potential future market returns, using ended: 1998 through 2007. This dramatic Bernstein’s proprietary Wealth Forecasting period saw the rise of the tech stock bubble, the System,3 and 2) by looking at history—which in depths of the ensuing bear market, and a strong some periods (the 1940s and early 1950s) had recovery. From start to fi nish of this roller- interest rates even lower than today’s. coaster ride, stocks turned in a 5.9% annualized return. Yet, as Display 4, following page, shows, First, using our Wealth Forecasting System, we a 10-year GRAT funded with $5 million in 1998 modeled 10,000 future market environments would have failed to transfer any wealth. A series to show their effect on two GRAT strategies: of rolling two-year GRATs, however, would a single 10-year term GRAT versus a series of have succeeded in six of the 10 years, transfer- two-year rolling GRATs for 10 years. Next, we ring $3.4 million out of your estate free of gift looked at the GRATs beginning in low interest tax. This shows how the rolling GRAT strategy rate periods—defi ned as the lowest quartile of capitalizes on the of the stock market. 7520 rates modeled. The rolling GRAT strategy

3 See Notes on Wealth Forecasting Analysis, page 34.

SUMMER 2008 | 11 Display 4 structure that uses its fi rst annuity to create a 1998–2007: How rolling short-term GRATs capitalized nine-year GRAT, and its next annuity (plus the on volatility nine-year GRAT’s fi rst annuity) to create an

10-Year Term GRAT eight-year GRAT, and so on, keeping all the Initial Contribution: $5 Mil. money at work and ending with a two-year GRAT. Yet, as Display 5 shows, this strategy 40% 30 29% 29 will likely underperform the simple rolling 20 21 16 short-term GRAT strategy—both in terms of 10 11 5 5 success rate and the median amount transferred. 0 (10) Display 5 (20) (9) (12) Even with low interest rates, rolling short-term GRATs (30) (22) beat other GRAT strategies Initial Section 7520 Rate: 7.2% 10-Year Term 10-Year S&P Compound Return: 5.9% 10-Year GRAT with Annual Rolling Term Decreasing Term Short-Term Remainder: $0.0 GRAT* GRATs* GRATs

Two-Year Rolling GRATs Probability of Success 76% 96% >98% Initial Contribution: $5 Mil. Median Wealth S&P S&P Compound Transfer $3.6 Mil. $5.3 Mil. $7.4 Mil. 7520 Annual Two-Year Wealth Rate Return Forward Return Transferred All strategies are funded with $10 million, beginning in the lowest- quartile interest rate environments. All assets are invested in a globally 1998 7.2% 28.6% 24.8% $0 diversifi ed equity portfolio composed of 35% US value/35% US 1999 5.6 21.0 4.9 $1.65 Mil. growth/25% developed international/5% emerging markets stocks. Wealth to benefi ciaries is reinvested and adjusted for infl ation. See Notes 2000 7.4 (9.1) (10.5) $179,756 on Wealth Forecasting Analysis, page 34. 2001 6.8 (11.9) (17.1) $0 *The 10-year term GRAT in each case uses 20% increasing payouts to keep money at work, as do the nine-year through three-year term GRATs in the 2002 5.4 (22.1) 0.1 $0 decreasing term GRAT strategy. Rolling GRATs have constant annuities. 2003 4.2 28.7 19.4 $0 Source: AllianceBernstein 2004 4.2 10.9 7.8 $877,809 2005 4.6 4.9 10.2 $190,887 A Historical Analysis Drives the Case Home 2006 5.4 15.8 10.5 $176,527 While the simulated results were compelling, 2007 NA 5.5 NA $322,580 we were curious to see how the term GRAT Total Remainder: $3.4 Mil. and rolling GRAT strategies would have Term GRATs assume 20% increasing annuities, while rolling GRATs assume fared historically. We compared the results constant annuities. See Notes on Wealth Forecasting Analysis, page 34. Source: Standard & Poor’s, US Treasury Department, and AllianceBernstein of the two strategies—rolling short-term versus 10-year term—assuming they had been won handily, succeeding more than 98% of launched every month from May 1941 through the time, compared with a 10-year term GRAT April 1998, for 684 trials in all. We assumed success rate of only 76%. each GRAT began with $10 million invested in the S&P 500. And, since the 7520 rate has As noted above, one reason a rolling GRAT existed only since 1989, we created a proxy strategy will likely outperform a single long- for earlier periods based on the IRS methodol- term GRAT is that it keeps more of the capital ogy. This 57-year span covers a wide range of committed to the strategy at work. Accordingly, interest rates and stock market returns, with we also tested the benefi t of locking in a low the 7520 rate averaging 6.7%, but dipping as interest rate by modeling a 10-year GRAT low as 1.2%.

12 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT Display 6 Display 7 1941–1998: Rolling short-term GRATs beat 1941–1998: Rolling GRATs beat term GRATs in both bull long-term GRATs and bear markets

10-Year Term 10-Year Rolling Short- Rolling GRATs GRATs Term GRAT Term GRAT S&P 500 Trailing 12-Month Median Median Frequency of Return Remainder Remainder Success 100% 80% Lowest (38.9)% $6.6 Mil. $11.0 Mil. Median Wealth Quartile to 2.3% Transfer $11.0 Mil. $6.1 Mil. Second 2.5% $6.5 $11.4 All strategies are funded with $10 million and invested in a portfolio Quartile to 14.4% representative of the S&P 500. Wealth to beneficiaries is reinvested and adjusted for . See Notes on Wealth Forecasting Analysis, page 34. Third 14.4% $4.3 $10.4 Term GRATs assume 20% increasing annuities, while rolling GRATs Quartile to 26.1% assume constant annuities. Highest 26.2% $5.6 $10.9 Source: AllianceBernstein Quartile to 61.2%

All strategies are funded with $10 million and invested in a portfolio The results were striking: The rolling short- representative of the S&P 500. Wealth to beneficiaries is reinvested and term GRAT strategy beat the 10-year term adjusted for inflation. See Notes on Wealth Forecasting Analysis, page 34. Term GRATs assume 20% increasing annuities, while rolling GRATs GRAT in every period, and succeeded 100% of assume constant annuities. the time at transferring wealth to the next gen- Source: AllianceBernstein eration, while the long-term GRAT succeeded only 80% of the time, as Display 6 shows. long-term GRAT might outperform rolling short-term GRATs. But as Display 7 shows, Not only was the rate of success higher, but the rolling GRATs outperformed term GRATs amount of wealth transferred was much greater. by wide margins, no matter what the stock Even when the 10-year term GRATs succeeded, market had done in the year prior to the the rolling GRAT strategy transferred nearly strategies’ inceptions. This refl ects the fact that twice as much wealth: a median transfer of historically, stocks have tended to rise over any $11.0 million compared with $6.1 million. 10-year period, with market downturns being relatively short in duration. We also compared shorter-term GRATs, because a 10-year term might not fi t every In summary, our research provided an over- individual’s needs. The results were compa- whelming case against trying to “time” rable: Running the same historical analysis your wealth transfer strategy with GRATs. using four-year term GRATs versus four years Regardless of interest rates or the current of rolling two-year GRATs, the rolling strategy market environment, a strategy of rolling short- succeeded 98% of the time, compared with term GRATs funded with publicly traded stocks 79% for the term GRATs. And out of 684 appears very likely to provide better results than trials, the four-year GRAT transferred more a single, longer-term GRAT. wealth than the rolling strategy only 18 times, or in just 2.6% of the trials. When Timing Does Pay Off A few wealth transfer strategies will benefi t An All-Market Strategy from low interest rates. For example, our What about the stock market environment? research showed that charitable lead annuity One might argue that if the stocks in a GRAT trusts (CLATs) should perform better when were poised for an upsurge (even though launched in low interest rate environments. no one can predict future performance), a CLATs resemble GRATs, with the main dif- ference being that the annuities go to charity,

SUMMER 2008 | 13 rather than back to the donor. As a result, However, CLATs are not right for everyone, a rolling short-term structure is impossible or every situation. First, success is by no because each year’s annuity goes to charity and means guaranteed. Even in the low interest is out of your hands. This favors a longer-term rate scenarios, only 88% of the CLATs in structure, so that the assets have plenty of time our simulation had money left at the end of to grow. Consequently, CLATs are typically their term. So if your primary goal is to pass created with long terms—10 to 20 years. money on to the next generation, better wealth transfer vehicles exist. Further, if your primary We used our Wealth Forecasting System to goal is giving to charity, there may be better model hypothetical 20-year CLATs funded ways to do so. with a $10 million initial contribution. We compared how CLATs would fare if started in It’s Always a Good Time for Estate Planning a low interest rate environment (defi ned as the lowest quartile of interest rate scenarios) versus One of the well-worn maxims of investment high interest rates (the top quartile). Display 8 management is that it doesn’t pay to time the shows the results: CLATs perform much better market. This wisdom applies to wealth transfer with a low 7520 rate. strategies as well. While a few specialized strategies, such as CLATs, may benefi t from Display 8 low interest rates, it is better to start early CLATs benefi t from a low hurdle rate with a comprehensive estate plan designed to weather any market environment, rather than 20-Year CLAT Median Wealth Transfer waiting for the market to turn your way. $6.0 $5.2 Mil. The reasons are simple: First, as our research 5.0 above shows, a rolling short-term GRAT 4.0 strategy can effectively transfer wealth regard- 3.0 less of interest rates or market environment.

2.0 Second, by trying to time the market you run $1.5 Mil. the risk of using up your “time capital,” that 1.0 is, the amount of time you have to transfer 0.0 wealth during your lifetime. In other words, Low Rates High Rates for every year you procrastinate, you lose the Probability of ability to transfer assets and have them grow passing wealth to beneficiaries 88% 59% outside of your estate, and you increase the risk that upon your death you will leave an Low rates are defi ned as the bottom quartile of potential interest rate scenarios; high rates defi ned as the top quartile. Wealth to benefi ciaries is overly large estate for the government to tax. adjusted for infl ation. CLAT strategies are funded with $10 million, with assets invested in a diversifi ed portfolio composed of 60% equities (35% US value/ 35% US If, however, the current market environ- growth/25% developed international/5% emerging markets stocks), 30% taxable bonds, and 10% REITs. See Notes on Wealth Forecasting Analysis, ment induces you to “use lemons to make page 34. lemonade,” today is as good a time as any Source: AllianceBernstein to consider estate planning. Just be sure to consult your tax advisor and use a thoughtful If a CLAT strategy suits your estate planning approach grounded in research, rather than goals, today’s market conditions are ideal. relying on common wisdom. ■

14 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT Using Research to Navigate a Dynamic Bond Market by Guy Davidson, Director—Municipal Investments

Amid the unusual developments in the bond market during the past year, an actively managed bond portfolio guided by rigorous research and a disciplined investment process avoided the pitfalls of a greedy market while taking advantage of its opportunities—earning signifi cant premiums along the way.

IN BERNSTEIN’S VIEW, BONDS ARE AN Display 1 essential complement to stocks in an inves- The shift from great calm to extreme fear caused the tor’s overall portfolio. They provide income, municipal to steepen dramatically and they stabilize the total portfolio against stocks’ volatility. In addition, a bond portfolio AAA Municipal Yield Curves can generate incremental return when actively 5.5% managed using a sound research framework. March 31, 2008 The investing landscape of the past 12 months 4.5 provides the backdrop for a compelling narra- 3.5 March 31, 2007 tive of how active bond management can add value across all three strategic imperatives. 2.5

1.5 Setting the Stage: The Hunt for Yield 1-Year 6-Year 20-Year 30-Year

For several years prior to the summer of 2007, Estimates for AAA-rated insured municipal bonds the stock and bond markets were unusually Source: Municipal Corp. and AllianceBernstein calm. With risk seemingly absent, many Municipal bonds were not immune to the managers were grabbing yield contagion: Buyers rushed to purchase safer anywhere they could fi nd it, purchasing both (that is, higher credit-quality and shorter very long-term and lower-rated bonds. As a maturity) bonds, causing prices to rise in result, the shape of the municipal yield curve response to demand. And in its efforts to quell had become fl atter than it had been in decades: the subprime crisis, the US Federal Reserve With so many eager buyers, long bonds offered aggressively cut interest rates several times, little additional yield versus short-term bonds of helping to further lift bond prices. As prices the same credit quality. Plus, the additional yield and yields are inversely correlated, by the for riskier bonds fell to historically low levels. end of March 2008, the yield curve had gone from fl at to steep: Yields on short-term bonds But the reign of calm came to an abrupt end in had fallen, while yields on riskier longer-term July of last year, as the effects of the subprime bonds had risen (Display 1). Managers holding crisis paralyzed the global markets.

SUMMER 2008 | 15 the lower-rated or longer-term bonds saw their Display 2 prices plummet. The dramatic change in the In early 2007 we concentrated the maturity structure of yield curve and the increased demand for high- our portfolios quality bonds refl ected the switch in investor Our Maturity Selection sentiment from greed to fear. 5%

88% 2% The Calm Before the Storm 4 10% Back in the spring of 2007, it was clear that 3 market risk was absent from many investors’ minds—they weren’t demanding much more 2 Duration Target yield for holding long bonds. We determined (4.1 Years) that the modest additional yield being offered 1 by long-term bonds was not suffi cient compen- 1-Year 6-Year 20-Year 25-Year sation for the mounting risk that these bonds’ As of March 31, 2007 prices could fall; when income and price Source: Municipal Market Data Corp. and AllianceBernstein return were both considered, our calculations indicated our investors would be best served Our analysis of credit quality revealed a if we concentrated holdings in the intermedi- similar story. By March 2007, credit spreads ate-maturity range, resulting in a four-year had become extremely compressed, meaning duration overall (Display 2). the premium being offered to take on the extra

Bonds in Brief the bond investment, assuming the bond is held Bonds can present a complex landscape for inves- until maturity and that income is reinvested at a tors, as their returns are influenced by so many constant rate. factors. Here, we recap the key drivers that affect Credit quality: Third-party agencies rate the bonds’ performance. creditworthiness of each bond; bonds with higher Interest rates: When interest rates rise, the prices credit quality are deemed safer in terms of the of bonds that are outstanding fall, as the income issuer’s ability to make its interest payments and they generate will be less than that from a new return the full value of the bond to the buyer upon bond issued at the higher interest rate. The bond’s the bond’s maturity. Bond prices move up or down price needs to fall as a way of compensating in line with credit-rating changes up or down. buyers for its lower income versus the new bond. Maturity: The length of time until a bond matures Duration: A measure of how much a bond’s price and the issuer pays back the face value of the bond. will change for every 1% change in the interest Long maturity bonds, typically those with maturi- rate. Expressed in years and mathematically ties of 10 or more years, are riskier than bonds computed, the longer a bond’s duration, the greater with lesser maturities in that their price moves are its price change will be when interest rates change. greater, owing to interest rate changes or credit Yield: There are several measures of “yield” in downgrades. As compensation for this added risk, bonds. We’ll focus for simplicity on “yield-to- long bonds typically offer higher yields than bonds maturity”: This is the internal rate of return of with shorter maturities. ■

16 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT risk of lower-quality BBB bonds versus the Key Concepts highest-quality AAA bonds was almost non- > Fallout from the subprime crisis caused existent. In fact, an increase of only 0.08 in signifi cant dislocations in the municipal bond the yield of BBB bonds translated into a drop in prices that more than offset the benefi t of market over the last year higher income over one year. > As risk entered the market, the shape of the yield curve changed dramatically—moving from With virtually no incentive to move down in fl at to normal credit quality, we chose to hold primarily very high-credit-quality bonds in our portfolio. The > Thanks to the high average credit quality of only BBB bonds we bought were those that our portfolios’ holdings and their concentration our credit team determined were likely to be around a four-year duration, our portfolios upgraded by the rating agencies or were stable outperformed and scheduled to mature soon. > As the market shifted, we took advantage of We didn’t make these portfolio decisions in opportunities to increase yield by adding high- response to a premonition about the subprime yielding auction-rate securities and lower-rated crisis: We made them based on our ongoing but solid bonds research and disciplined approach to invest- ing. An intensive assessment of the after-tax total expected return (including yield and likely price movements) versus the risks led to In the fi rst quarter of 2008, a new series of our deep conviction about how to design the shocks emanating from the subprime crisis portfolio to ensure it played its three roles well: hit the municipal bond market head-on. Bond income, stability, and incremental return. insurers had long been a part of the munici- pal bond market landscape. By guaranteeing timely interest and principal payments from a The Market Awakens to Risk bond whose underlying may have In July 2007, the scope of the subprime been only A or BBB, they assured the bond’s mortgage crisis began to sink in. As investors higher AAA rating. For this to became increasingly aware of the potential have value, the investors counted on insurers risks, both the yield curve and credit spreads remaining AAA rated. But insurers ran into began moving. The markets convulsed as problems when they expanded beyond the nervous investors sold risky assets and bought municipal bond market to subprime and the safest investments they could fi nd. US that debt went sour. Suddenly the insurers Treasuries were the prime benefi ciary of inves- were being downgraded—along with many tors’ fl ight to safety, especially short-term of the bonds they’d insured (Display 3, bonds, whose yields fell signifi cantly more following page). than those of long bonds.

SUMMER 2008 | 17 Display 3 Assessing Insured Bonds’ Risks Bond insurers’ ratings have declined Insured bonds are structured assets with two parts—the insurance and the underlying credit Ratings of Bond Insurers* of the issuer. In evaluating an insured bond for Mar 07 Outlook Mar 08 Outlook inclusion in a portfolio, Bernstein has always Ambac AAA stable AA negative used our credit research to separately evaluate FGIC AAA stable BB negative the insurer and the underlying bond. FSA AAA stable AAA stable MBIA AAA stable AAA negative In 2007, our analysis indicated that buying XLCA AAA stable BB negative insured bonds whose underlying issuer was *As of March 2007, all three rating agencies gave the same ratings. March poorly rated didn’t offer enough of a yield 2008 data (as of March 31) refl ect the lowest rating assigned by one of the three rating agencies. benefi t versus those where the underlying Source: Fitch Ratings, Moody’s Investor Services, and Standard & Poor’s issuer was highly rated, so we bought bonds of municipalities with solid underlying credit; By March 2008, due to the subprime crisis insurance was not a material part of the instru- and exacerbated by the downgrading of bond ment. As a result, the underlying credit rating insurers, the difference in yield offered by of our insured holdings averaged a very high high-quality investment-grade municipal bonds AA-/A+. When the bond-insurer storm hit, we versus those of lower quality had widened knew that even if the insurance were completely sharply (Display 4). stripped away, the value of our insured-bond holdings would not change materially. Thus, Display 4 the downgrades did not signifi cantly affect our The subprime crisis caused municipal bond credit portfolios. We further insulated our portfolios spreads to widen sharply from exposure to any single insurer by virtue Yield Advantage of BBB Debt over AAA Debt of strict portfolio construction guidelines that assured our portfolios were well diversifi ed by 1.5% From June 30, 2007, to March 31, 2008, bond insurer. spreads widened by 69 basis points

1.0 Where Risk Does Bring Reward

0.5 Unusual dislocations in the municipal bond market continued through the fi rst quarter

0.0 of 2008, including problems in auction-rate securities, troubles with variable-rate demand 88 91 94 97 00 03 06 notes, and margin calls on leveraged municipal Through March 31, 2008; 10-year municipal securities portfolios. Again, navigating these develop- Source: Municipal Market Data Corp. ments required intensive analysis, which uncovered some real opportunities.

18 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT Consider the municipal auction-rate market. their rates could jump to 15%, these securities Historically, these securities have been viewed attracted new investors, signifi cantly reducing as near-cash equivalents with interest rates the risk of future failed auctions. Thus, we took that reset at some predetermined frequency, advantage of the risk aversion of usually seven, 28, or 35 days, when an auction investors to add high-yielding auction-rate secu- is held. Investors in these securities place bids rities to our portfolios. indicating how much they want to buy and the yield they require. Once all the bids are in, the A second opportunity was in bonds with lower auction agent fi lls the lowest-rate bids fi rst, then credit quality. Having avoided the negative the next highest, and so on, until all the bids impact of the downgrades in bond quality are fi lled. The rate at which the last bid is fi lled on our portfolios, we worked to exploit the is called the rate, and all the bidders downgrades to our advantage. With spreads on receive that rate until the next auction. If there investment-grade municipals having widened are insuffi cient bids for all the securities up for sharply since July 2007, signifi cant extra auction, the auction “fails” and the holders yield was available for going down in credit retain all the bonds at a maximum interest rate quality from AAA to BBB. Plus, the number specifi ed in each bond’s indenture—the written of bonds being insured had fallen from 50% agreement between a bond issuer and bond- of new issuance over the last few years to only holders—until the next auction. Each bond 25%—so the supply of lower-rated bonds on indenture is different, and the maximum rate is the market was greater. Many of these bonds based either on a formula typically tied to some were quite solid, and we took advantage of short-term index (which results in a relatively this singular opportunity to earn extra yield low maximum rate) or on a specifi c fi xed rate, in our portfolios. A comparison of our buys which is usually quite high, 12% or 15%. in the fi rst quarter of 2008 versus 2007 shows a signifi cant increase—more than double—in Capital-constrained investment banks aban- bonds with credit ratings of less than AAA doned the municipal auction-rate market in (Display 5). mid-February of 2008, causing these auctions to fail at record levels. As a result, tax-exempt Display 5 yields on these securities were as high as 15%. We found opportunities in downgraded bonds We carefully evaluated the underlying credit Ratings Distributions of Buys quality of each issuer and the terms of each 2007 Q1 2008 Q1 issue’s auction, seeking to determine whether BBB & Other the yields were a function of true risk or of A 6% undue risk aversion. 3% BBB & Other A 5% 16% AA AA Based on our analysis, we determined that 19% 46% AAA AAA those securities with high fi xed maximum rates 72% 33% were attractive, while those with formula-based rates were not. When many of the auction-rate Source: AllianceBernstein securities we fi rst bought failed, they did so at very high rates, such as 15%. And, because

SUMMER 2008 | 19 The Power of Active Bond Management Bernstein commits substantial resources to This period of extreme volatility in the usually active bond management: tracking the con- earthbound municipal bond market provides stantly shifting mix of risk and opportunity in a useful lens for examining how our research the marketplace; assessing and monitoring the and the application of our long-term invest- soundness of every bond we buy; and securing ing paradigm work to protect and build client the best prices for the bonds we buy and sell. portfolios. In this fast-moving environment, At the core of our operation is an established returns on our intermediate-duration munici- Bernstein strength: rigorous research. Our goal pal bond portfolios were among the best in as active bond managers is to use research to their peer groups for the one-year period identify values in the marketplace created by ending March 31, 2008 (Display 6). changes in price.

Display 6 The advantages of active management are Our active management delivered in a turbulent time clear: It took only six months to move from One-Year Returns* one of the fl attest yield curves in history to one Bernstein Municipals vs. Peer Groups† with a normal shape and for credit spreads to move from an all-time low to more attractive 5% 4.69% 4.31 4.46 levels. Thus, our concentrated maturity struc- 4 ture and high-credit-quality stance paid off. By 3 2.83 2.60 optimizing our portfolios to avoid the pitfalls 2 1.95 of this environment while taking advantage of its opportunities, we were able to create value 1 for our clients. ■ 0 Diversified California

Bernstein Lipper Average

Past performance is no guarantee of future results. *Through March 31, 2008 †Bernstein Intermediate portfolios versus their Lipper peer group averages Source: Lipper and AllianceBernstein

20 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT Can Early Tax Harvesting Reap Greater Gains? by Greg Singer, Director of Research—Wealth Management Group and Vincent Childers, Research Analyst—Wealth Management Group

Capital gains taxes are scheduled to rise from 15% to 20% in 2011, but many think that the increase could be greater and could come two years sooner, when the next president takes offi ce and a new Congress convenes. Should a prospective change in tax policy infl uence your investment strategy?

WHEN ASKED WHAT THE STOCK MARKET Display 1 would do, J.P. Morgan famously asserted, “It Tax rates and gains realizations: A contrary will fl uctuate.” The same is true of tax rates, relationship and, as with the markets, their fl uctuations can Realized Capital Gains as Percent of GDP vs. have a sizable impact on individual wealth. Tax Rate on Long-Term Capital Gains 1960–2011*

(%) Tax Reform Act (%) Timing the Taxman of 1986 8 Capital Gains 45 Throughout history, both the level of the capital 7 Tax Rate 40 gains tax rate and expected increases in rates 6 35 30 have infl uenced investor behavior. Specifi cally, 5 25 investors tend to defer more gains during 4 20 periods of higher taxes and become more 3 15 willing to harvest gains in low-rate regimes. 2 Capital Gains 10 Investors have also been tempted to realize 1 Tax Reform Act Rate Capital Gains Tax Capital Gains Realizations 5 of 1969 Realized, % of GDP embedded gains in anticipation of higher tax 0 0 rates, refl ecting their desire to get a jump on any 1960 1970 1980 1990 2000 2010 expected tax increases. For example, investors *Realized gains as % of GDP in 2006 and 2007 refl ect Bernstein estimates; the capital gains tax rate from 2008–2011 refl ects the current schedule. realized unusually large gains in the last quarter Source: Department of the Treasury—Offi ce of Tax Analysis and of 1986, in advance of a scheduled tax rate AllianceBernstein increase of eight percentage points (from 20% to 28%) on January 1, 1987, as a result of the points, from 15% to 20%, in January 2011. Tax Reform Act of 1986 (Display 1). But there’s widespread belief that the rate increase could be higher and that it could come The increase in capital gains rates in 1987 must as early as mid-2009, after the next president have seemed like a locomotive coming down the takes offi ce and a new Congress convenes. The line: Many investors simply leapt off the tracks question this raises is: Should investors acceler- to avoid it. Under current tax law, the long-term ate their harvesting of embedded capital gains capital gains tax rate increases fi ve percentage before higher rates become a reality?

Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.

SUMMER 2008 | 21 A Taxing Matter: No Easy Answers Finally, if your expected holding period is At fi rst blush, realizing taxable gains in the forever (or at least until death parts you from face of higher future tax rates may seem like your investment, assuming the law still allows the obvious thing to do. But trying to sidestep a step-up in basis), the question whether to any presumed or even scheduled shift in tax harvest or defer is moot—capital gains taxes rates before a comprehensive assessment of all are not an issue. But the situation is more com- the investment variables involved could prove plicated if you anticipate selling the position both untimely and imprudent. After all, the in the future, either as part of your natural benefi t of deferring taxes is well established— turnover or to raise cash for a particular need. when we defer taking gains, money that would To help investors take a more clearheaded, otherwise have gone to the government instead objective view of this diffi cult and emotional can continue to grow, leading to greater future topic, let’s explore the drivers that determine wealth. And, of course, the investment objec- whether or not accelerating gains ahead of an tive is to maximize the likelihood of better anticipated tax increase makes sense. after-tax returns, not simply to minimize taxes.

To Harvest Early or Defer Gains: A Framework To complicate matters further, there’s another important (and often overlooked) factor in At the most basic level, the decision to tax-trade examining the value of skirting any prospec- ahead of an expected increase in rates hinges on tive rate increase: the very real possibility that the interplay of two key variables: the inves- tax rates at the end of an investor’s expected tor’s expected horizon, or holding period before holding period may be very different from the liquidating the portfolio, and the expected 1 rate expected in the near term. In our 1986 increase in tax rates (Display 2). Generally example, rates fell a decade later by as much as speaking, the shorter the investment horizon, they rose, and then dropped another fi ve per- the more valuable it is to harvest gains in the centage points a few years after that. In fact, lower-rate regime—the benefi ts of deferral are rates have varied considerably over the years: offset by larger future taxes paid under the The maximum tax rate on long-term capital higher-rate regime. And, of course, the higher gains has ranged from a high of almost 40% in the future tax rate, the more incentive there is to 1978 to the current, historic low of 15%. capitalize on the current lower rate.

Display 2 Given that tax rates have fl uctuated and likely Harvest or defer? The decision hinges on two will continue to do so over the coming years, key factors there may be real danger in focusing myopi- Defer Harvest Early cally on the next rate regime, which, if history is any guide, is not likely to persist for long. Even more dismaying, changes in capital Longer Investment Horizon Shorter gains rates have, on occasion, been enforced retroactively, so that almost any strategy of anticipating a change may have an outcome Higher other than the one expected. Lower Future Tax Rate

Source: AllianceBernstein

1 This leaves out the important question of existing cost basis. Realizing gains on a lower-cost-basis holding means a larger tax upon liquidation, so a higher future tax rate might appear to incline investors to accelerate their gains realizations. But ultimately, while cost basis will magnify the difference in wealth between a strategy of harvesting or deferring, it does not signifi cantly impact the likelihood that a harvesting strategy is preferable.

22 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT To bring this framework to life and illus- Key Concepts trate the trade-offs at a very simplistic level, > Shifting capital gains tax rates have infl uenced imagine an investor, Earl E. Gaines, who has investor behavior in the past a $1 million portfolio of diversifi ed equities with a cost basis of $500,000. Let’s say he > Capital gains taxes are scheduled to rise from plans on selling the portfolio a year from now, 15% to 20% in 2011, but many think that the and expects it to earn 8% during that period. increase could be even greater, and come sooner Convinced that rates will increase in the fol- lowing year from 15% to 20%, Earl wants to > For holders of diversifi ed equity portfolios, an look at two scenarios. In the fi rst, he sells his increase in rates to 20% would not present a entire portfolio now, pays taxes at the current particularly strong case to actively tax-trade 15% capital gains rate, reinvests the proceeds ahead of the policy change; but an increase in in an identical equity portfolio, and then rates to 28% may suggest a clearer rationale to cashes that out a year hence, paying tax again, take action but now at the prevailing 20% long-term capital gains rate. In the second scenario, Earl > For investors holding concentrated stock simply holds on to his current portfolio and positions, any rise in capital gains rates increases liquidates the entirety a year later, paying all of the appeal of harvesting embedded gains in a the capital gains taxes once, at the going 20% lower-rate regime and diversifying the proceeds rate. Display 3 shows how the two portfolios into a lower-risk portfolio fare over that period, the capital gains taxes they incurred, and their fi nal wealth values.

Display 3 The “deferral” strategy shows higher pretax The harvest or defer trade-off: growth (ending at $1,080,000), as the original Greater growth or lower taxes? sum, undiminished by any up-front tax hit, continues to compound for an additional Harvest Strategy Deferral Strategy year. But it also has the highest tax bill: The Initial Value $1 Mil. $1 Mil. larger total gain (of $580,000) was all taxed Cost Basis $500,000 $500,000 at the higher 20% rate. The “harvest” strategy Tax Rate 15% N/A saves on taxes, but reinvests less princi- Tax on Gain $75,000 pal: It ends the year with a pretax value of Proceeds $925,000 $999,000. However, the initial embedded gain Tax Rate Next Year 20% 20% (of $500,000) was taxed at the lower 15% Value Next Year $999,000 $1.08 Mil. rate, while only the following year’s gain (of Gain Next Year $74,000 $80,000 $74,000) was taxed at the higher 20% rate, for Tax on Next a combined capital gains tax of 16%. In this Year’s Gain $14,800 $116,000* case, harvesting early (at the end of one year) Combined provides an advantage of about 2% in overall Tax Rate 16% 20% wealth versus the deferral scenario. Total Taxes $89,800 $116,000 Liquidation Proceeds $984,200 $964,000 Advantage 2.1%

*Includes tax on the embedded gain of $500,000 Source: AllianceBernstein

SUMMER 2008 | 23 Looking for Breakeven Display 4 But our example extends out only one year. Time and taxes: Break-even time horizons for different What if Earl had a longer investment horizon, rate scenarios as most investors typically do? A more practi- Median Increase in Post-Liquidation Wealth cal way of framing the decision, therefore, is to Sell vs. Hold (%) examine what we call the “break-even” horizon, 7% the expected holding period that would result 6 28% Future Tax Rate in the same wealth outcome whether one defers 5 Sell and the tax hit for some time or realizes gains, 4 Repurchase Strategy Results pays tax at today’s rate, and then reinvests the 3 in Higher proceeds before realizing a gain at the end of 2 20% Future Tax Rate Average Wealth 1 Break-Even the investment horizon. Liquidation 0 Horizon (1) Hold Strategy Display 4 shows the break-even horizon for Results in Higher the same portfolio calculated with two differ- (2) Average Wealth ent future tax scenarios in mind: a moderate 1 3 5 7 9 11 13 15 increase in the capital gains tax rate from 15% Liquidation Horizon (Yrs.) to 20% in one analysis, and a more aggressive 28% Rate 20% Rate move from 15% to 28% in the other. The area The initial position is a $1 million diversifi ed equity portfolio (35% US below the zero line indicates those outcomes value/35% US growth/25% developed international/5% emerging markets) with an existing cost basis of $500,000. The current tax rate on where the deferral strategy is optimal; above capital gains is 15% and either 20% or 28% in all future years, while the the line the harvest strategy wins out. You can ordinary income tax rate is 39.6% in all years. The analysis refl ects post- liquidation proceeds and 15.25% annual gains realizations and assumes see that at a 20% future capital gains rate, the future capital losses are used to offset outside gains. See Notes on Wealth advantage of harvesting versus deferring over Forecasting Analysis, page 34. Source: AllianceBernstein a one-year horizon is Earl’s 2%, as detailed in the example above. But that modest advan- early is more than 6% at year one, and while tage declines over time and turns negative at that advantage too declines over time, there is about year seven, as the benefi ts of tax deferral no liquidation horizon within which the port- win out. folio’s growth can overcome the drag of the higher future tax.2 For investors with a liquidation horizon of less than seven years, there is some benefi t to har- vesting early, though it is modest. The average From the Possible to the Probable increase in wealth over this horizon is less than But the analysis is still too simplistic, as 1%. For investors with longer holding periods, we’ve considered only a scenario in which deferring appears to make sense. the future return was assured. We haven’t yet taken account of the uncertainty surrounding However, when we look at a potential increase the level and path of future returns, and the in rates from 15% to 28%, the story changes success of early harvesting depends critically dramatically: Here the benefi t of harvesting on the return environment over the course of

2 The break-even horizon for a diversifi ed portfolio actually depends not only on portfolio performance and the liquidation horizon but also on what percentage of the portfolio’s embedded capital gains are realized annually—what we refer to as the gains realiza- tion rate. The gains realization rate is often proxied by the more common metric of portfolio turnover—although, strictly speaking, effi ciently tax-managed portfolios can endure higher turnover without excessive gains realizations. High rates of gains realization, which typically characterize a less tax-effi cient portfolio, will extend the break-even horizon, and in extreme cases can overcome any advantage to tax deferral over any time horizon. For example, an investor with a gains realization rate approaching 100% (he pays taxes on all of his gains every year) leaves no opportunity for the compounding benefi t of tax deferral to work to his advantage, and as such is almost always better off realizing embedded gains at today’s lower rate than at “tomorrow’s” higher rate.

24 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT the holding period. If future markets are better Display 5 than average, then tax deferral has higher Gauging the likelihood of a successful early harvest value. Should future markets be disappointing, Probability That Harvesting Early Delivers then harvesting early becomes more attractive. Higher Post-Liquidation Wealth (%)

100% Of course, we cannot divine the future. But to help our clients make thoughtful decisions 75 based on a realistic assessment of potential future outcomes, we’ve developed a quan- 50 titative capital markets model. Our Wealth Forecasting System3 takes the known facts— 25 our clients’ assets, income needs, risk toler- 0 ance, tax brackets, and time horizon—and 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 runs various investment scenarios through our Liquidation Horizon (Yrs.) model to project 10,000 possible return paths. 28% Tax Rate 20% Tax Rate 15% Tax Rate With it, we can analyze the impact of changes The initial position is a $1 million diversifi ed equity portfolio (35% US in tax rates across the spectrum of possible value/35% US growth/25% developed international/5% emerging future outcomes, thus helping markets) with an existing cost basis of $500,000. The current tax rate on capital gains is 15% and either 20% or 28% in all future years, while clients make informed decisions regarding the the ordinary income tax rate is 39.6% in all years. The analysis refl ects post-liquidation proceeds and 15.25% annual gains realizations and probability that accelerating gains realizations assumes future capital losses are used to offset outside gains. See Notes will result in greater wealth. on Wealth Forecasting Analysis, page 34. Source: AllianceBernstein In Display 5 you can see that should the across all investment horizons, and the mag- capital gains rate stay constant at 15%, accel- nitude of success, in terms of greater after-tax erating gains will typically be a poor decision, wealth, is higher too. although there still would be scenarios—that is, when markets are particularly hostile— But considering the inherent uncertainty as to in which the client is better off. But if rates what tax rates will be at the end of the pro- increase to 20%, the appeal of harvesting spective holding period (itself not known with embedded gains early rises, and the likelihood certainty), as well as whether tax rates will of being better off remains above 50% for in fact be higher next year (who knows what investors with a horizon of up to seven years Congress will approve?), one should be cautious (our break-even holding period). when contemplating harvesting gains as part of a strategy of “front-running” the rate increase. But is a 50/50 shot at success enough entice- ment to take gains early? If an investor with a fi ve-year horizon wants to be 75% certain The Perils of the Concentrated Position that realizing gains early is in his best interest, There is one situation, however, in which a he will not want to take action if rates rise to prospective shift in capital gains tax rates has 20% (given there is only a 60% probability powerful relevance to the “harvest or defer” of success). However, the same investor can decision: concentrated positions of low-cost-basis be very comfortable he is making the right stock. In this case, in addition to taking advan- decision if rates are scheduled to rise to 28%, tage of a lower tax rate on your sale, you also in which case the probability of success is high reinvest the proceeds in a lower-risk portfolio.

3 See Notes on Wealth Forecasting Analysis, page 34.

SUMMER 2008 | 25 While the allure of building massive wealth by When we add the future capital gains rate concentrating your portfolio in one or several increases into the mix, the “harvest or defer” holdings is great, the likelihood of achieving decision is easier: In all of our prospective tax returns superior to the markets’ is low, and regimes (a static 15% rate, as well as increases the volatility one can expect to encounter is to 20% and 28%), the benefi ts of harvesting high. This higher volatility has a real cost. Our and diversifying the concentrated position, in research has shown that historically, a typical the median case, appear signifi cant: With an single stock has compounded at a growth rate increase in rates to 28%, the magnitude of the almost three percentage points below that of benefi t of harvesting early amounts to about the S&P 500. And for single stocks with the 18% in the fi rst year (Display 7). And, unlike highest volatility, the results were even worse, a diversifi ed portfolio, for which the advantage compounding at a rate of only half that of the of front-running the tax increase declines over market.4 In fact, if we look at a similar liqui- time, with a single stock portfolio the advan- dation analysis but without any change in tax tage of selling and diversifying never sets on rates, simply exchanging a single stock position this particular horizon, rising to over 30% in for a diversifi ed portfolio of global equities, the year 15. median wealth outcome is superior over every Display 7 time period (Display 6). A magnitude of difference: Harvesting a single stock

Display 6 versus diversifi ed portfolios

Exchanging a single stock for a diversifi ed portfolio Median Increase in Post-Liquidation Wealth Sell vs. Hold (%) Median Wealth Advantage Diversified Stock Portfolio vs. Single Stock (%) 30% 25%

20 20

15 10 10

5 0

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Liquidation Horizon (Yrs.) Liquidation Horizon (Yrs.) 28% Tax Rate 20% Tax Rate 15% Tax Rate The initial position is a $1 million single stock position with 30% volatility and 1.0 to US equities; the analysis assumes a zero cost basis, a cur- The initial position is a $1 million single stock position with 30% volatility rent tax rate of 15% on capital gains and 15% in all future years, and an and 1.0 beta to US equities; the analysis assumes a zero cost basis, a cur- ordinary income tax rate of 39.6% in all years. The portfolio’s allocation is rent tax rate of 15% on capital gains and 15% in all future years, and an 35% US value/35% US growth/25% developed international/5% emerg- ordinary income tax rate of 39.6% in all years. The portfolio’s allocation is ing markets, and the portfolio’s results refl ect post-liquidation proceeds 35% US value/35% US growth/25% developed international/5% emerg- and 15.25% annual gains realizations; the analysis assumes future capital ing markets, and the portfolio’s results refl ect post-liquidation proceeds losses are used to offset outside gains. See Notes on Wealth Forecasting and 15.25% annual gains realizations; the analysis assumes future capital Analysis, page 34. losses are used to offset outside gains. See Notes on Wealth Forecasting Source: AllianceBernstein Analysis, page 34. Source: AllianceBernstein

4 See our comprehensive research study on single stock positions, The Enviable Dilemma: Concentrated Stock—Hold, Sell, or ?

26 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT But once again, looking only at scenarios Display 8 in which the future returns are known with Positively probable: Tax-trading out of a single stock certainty is not enough. We must consider Probability That a Diversified Portfolio Will Deliver the full spectrum of portfolio outcomes to Higher Post-Liquidation Wealth (%) judge the likelihood of any strategy’s success. 80% When harvesting gains and diversifying the single stock position, we found that the prob- 60 ability of success remains above 50% across the entire 15-year time frame of our analysis, 40 and does so in both of our prospective rate 20 regimes (Display 8). Yet even here, of course, the questions of how much to sell—and how 0 quickly—are matters that must be tailored to 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 each investor’s risk tolerance, spending needs, Liquidation Horizon (Yrs.) and overall fi nancial profi le. 28% Tax Rate 20% Tax Rate

The initial position is a $1 million single stock position with 30% volatility and 1.0 beta to US equities; the analysis assumes a zero cost basis, a cur- Decision Time? rent tax rate of 15% on capital gains and 15% in all future years, and an ordinary income tax rate of 39.6% in all years. The portfolio’s allocation is The moral of the story: Tax rates change over 35% US value/35% US growth/25% developed international/5% emerg- ing markets, and the portfolio’s results refl ect post-liquidation proceeds time—and they change often and fairly unpre- and 15.25% annual gains realizations; the analysis assumes future capital dictably. For investors whose expected holding losses are used to offset outside gains. See Notes on Wealth Forecasting Analysis, page 34. period is not forever, it’s a diffi cult decision Source: AllianceBernstein whether to forgo tax deferral in favor of locking in today’s low tax rate. For holders of sub- with time. But in the event that a 28% rate stantial single stock positions, the appeal of looms, there is a higher probability of success harvesting gains on those stocks now and diver- in accelerating gains, and a superior average sifying their portfolio is high, in terms of both wealth outcome, and this may bias some toward the magnitude and the probability of success, taking preemptive action. regardless of the level of any future tax rate. But for investors who already hold diversifi ed port- Regardless of the future tax regime, our folios, the decision is less clear: It will depend Wealth Forecasting System can help clients both on the investor’s time horizon and the quantify the likelihood and magnitude of size of the anticipated change in tax rates. At a success of different investment strategies future capital gains rate of 20%, the magnitude so that they can make the most informed of the benefi t from harvesting early is modest, decision. ■ and the probability of success declines quickly

SUMMER 2008 | 27 China: The Impact of Domestic Policy on the Future of Global Tr ade by Anthony Chan, Asian Sovereign Strategist—Global Economic Research

In its push for industrial expansion, China has released a fl ood of cheap manufactured goods— and challenged the world economic order.

OVER THE PAST DECADE, CHINA’S new to them, but also huge—China’s popula- rapid industrialization has had a profound tion crossed the one billion threshold during impact on world trade. In its drive to supply the 1980s—and growing fast. China appeared the world, China has helped push down the to be an El Dorado, a golden opportunity price of fi nished goods, while its enormous for massively expanding their global sales. appetite for raw materials has helped push According to popular lore, shoe manufacturers up and sustain the prices of energy and com- aimed to sell an additional two billion modities. This double threat—economists shoes simply by selling one pair to each call it “downstream defl ation” combined person in China. with “upstream infl ation”—has squeezed the operating margins of foreign manufacturers, In reality, the policy played out very differ- forcing many of them to either relocate or out- ently from what anyone had anticipated. While source production to China in order to remain Deng’s reforms opened the economy to foreign competitive. It has also helped build profi ts for capital, they also liberated China’s homegrown and others that have invested in capitalist talent. Chinese-made home appli- China. Will the next 10 years be anything like ances and other electronic products—likely the past 10 years? Is China likely to continue to be followed in the not-too-distant future its current economic strategy? by Chinese cars—are building market share not only in the developed world but, increas- ingly, in developing markets as well. And today When It Started: Deng Xiaoping’s Economic Reforms China’s textile and garment exports are the When Deng Xiaoping launched China’s Open targets of a protectionist backlash within the Door Policy in 1979, his aim was simple: to US and European markets. raise China’s standard of living in the after- math of the Cultural Revolution by making Statistics illustrate the scale of China’s impact. the economy more attractive to foreign inves- In 1997, Chinese fi nished-goods exports tors. Deng probably never dreamt that in little averaged about US$10 billion a month. In more than two decades it would help make his 2007, the fi gure was close to US$80 billion— country the factory to the world. an eightfold increase. Imports of raw materials have grown nearly sevenfold during the same Foreign companies saw Deng’s economic period, from US$3 billion a month to US$20 reforms as an opportunity to profi t from a billion (Display 1). consumer market that was not only totally

28 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT Display 1 Key Concepts Exports of fi nished goods and imports of commodities have risen together > China is experiencing a massive population migration from rural areas to urban centers with China’s Foreign Trade: 1995–2007 higher-paying jobs 80 Finished-Goods > China will continue to push down the prices of 60 Exports fi nished goods while sustaining the high prices of 40 energy and commodities

(US$ Billions) 20 > Despite the threat of a protectionist backlash

Raw-Materials from the rest of the world, China is likely to 0 Imports continue to expand its industrial capacity 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Source: CEIC Data and AllianceBernstein > We expect the decline in world prices and manufacturers’ operating margins to persist for High Consumption, Low Prices another decade at least For everyone—from the consumers and com- modity producers benefi ting from China’s emergence to the foreign manufacturing fi rms The Long March to Urbanization without access to its production base—the After thousands of years as a predominantly critical question is: How sustainable is China’s agrarian society, China is rapidly becoming business model? In our view, China’s economic more urbanized. The combination of low fundamentals are such that, in the absence agrarian wages and the lure of better-paying of external pressure to change, its current jobs in the cities is causing a massive redistri- business model will be maintained. bution of China’s population of 1.3 billion. From 1996 to 2006, 122 million rural China’s model, in essence, consists of high inhabitants—an average of 11 million a year— energy and consumption and low- moved to the cities. Indeed, no other country priced goods. For example, today the country in history has witnessed migration from the consumes about 25% of global commodi- country to the city on such a scale. ties (such as steel, copper, and iron ore), but accounts for only about 6% of global nominal But the rural population still accounts for 55% GDP, as shown in Display 2, following page. In of the total—a far higher proportion than in the absence of exogenous shocks, there appear such neighboring countries as South Korea, to be few incentives for China to consume Taiwan, and Japan, where less than 10% live energy and commodities more effi ciently and on the land. This relative imbalance is unlikely increase production value-added more quickly. to change soon: Even if the country’s rural If China continues on this path, its impact on exodus were to accelerate to 15 million a year, the world economy could become even more 40% of the people would remain on the land dramatic over the next 10 to 20 years. in 2020 (Display 3, following page). Indeed, China has powerful incentives to The urban migration has led to great income maintain its current model, as we shall see. disparities between farm and city families. The main risk, in our view, is a potential The average household income in the indus- economic backlash that could even escalate trialized east is three times that of the more to a trade war between China and major rural west—and the gap is widening, further Western economies.

SUMMER 2008 | 29 Display 2 China consumes roughly one-fourth of global commodities… …yet produces only 6% of global GDP

Share of Global Consumption Share of World Nominal GDP 40% 5.9% 5.5% 35 5.1% 4.7% 30 4.4% 4.5% 4.2% 25 3.8% 20 15 10 5 0 Aluminum Copper Zinc Iron Crude Nickel Stainless 2000 2001 2002 2003 2004 2005 2006 2007F Ore Steel Steel 2001 2004 2006E

Source: Deutsche Bank Global Commodity Research, International Monetary Fund (IMF), and AllianceBernstein

Display 3 Although rural migration is unprecedented… . …40% of the population will still be rural in 12 years

Net Change in Rural Population Share of Total Population 15 100 90 10 80 70 Rural Population 5 60 0 50 40 % Share (5) 30 Million Persons 20 Urban Population (10) 10 (15) 0 Open Door Policy 79 82 85 88 91 94 97 00 03 06 50 55 60 65 70 75 80 85 90 95 00 05 10 15 20

Source: CEIC Data and AllianceBernstein encouraging the urban migration. China’s China Lags the World in Energy Efficiency leaders must create enough jobs in urban China’s expansion will doubtless keep its areas to absorb this continuing infl ux—or appetite for energy and commodities enormous. risk social and political instability. In the next Its energy consumption has accelerated sharply, 10 years, in fact, China needs to create 69 with its share of world consumption jumping million new jobs just to support its working- to about 15.5%, far higher than Japan’s and age population. Therefore, China must—and close to that of the (Display 4). will—expand its industrial capacity rapidly at Unfortunately, China isn’t using the energy it all costs. consumes very effi ciently. Although the country made solid energy-effi ciency improvements

30 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT during the 1990s, the investment boom has Why Banks Won’t Pull the Plug eroded them. According to our estimates, China Thus far, China’s government-controlled banks brought up the rear in terms of world energy have supported the expansion of low-profi t effi ciency in 2006, being 3.5 times less effi cient companies, with no apparent attempt to scale than the US. Even if it managed to improve back expansion in favor of profi ts. Beyond a effi ciency dramatically, it would still rank near certain threshold, of course, this low-margin the bottom. bubble may burst. But a fully market-oriented banking system has yet to be developed in Display 4 China, and Chinese state banks—which China consumes almost as much energy as the European Union account for about 70% of banking system assets—remain heavily infl uenced by govern- Percent Share of World Consumption ment directives. 30% US 25 If the bank loan market were to run into

20 trouble, China’s leadership would face a tough European Union choice between righting banks’ balance sheets 15 China and preserving or creating jobs. On the whole, 10 we think that job creation and social stability Japan 5 would take precedence and that any shortfall 0 on banks’ balance sheets would be remedied 79 82 85 88 91 94 97 00 03 06 by an injection of public funds. The pressure to Source: BP Statistical Review of World Energy 2006, CEIC Data, create 69 million new jobs in the next 10 years and AllianceBernstein will remain intense, and the incentive to reduce production capacity in labor-intensive indus- Corporate Strategy: Expansion, Not , Is the Key tries will be small. The sharp increase in investment and indus- trial growth in China highlights the country’s unique perspective on corporate profi tability: Policy Choices and the Protectionist Backlash Growing the business and increasing market The main threat to China’s ability to maintain share are the highest priorities; profi ts come its high-growth, low-margin business model second. This stands in marked contrast to is the potential for a protectionist backlash a , where fi scal prudence by other countries. The US and other eventually dictates that business lending to Organisation for Economic Co-operation and companies with low profi ts be scaled back. Development countries have seen their jobs However, China’s business model is unlikely to and manufacturing plants move to China— change for one simple reason: Its future under and they’ve seen their domestic markets that model is promising. China’s potential for fl ooded with cheaper-priced Chinese goods. industrial development is enormous. In fact, As China’s continues, this the recent surge in wages and land prices in a situation will likely become more pronounced. few highly developed eastern regions is sending If China maintains its current policy, it risks a just the right market signals to Chinese fac- trade war, a deceleration of the tories: to maintain their competitive edge by process, and a decline in world trade, all of starting to relocate to lower-cost regions, which could pose a serious threat to China’s where the labor supply is abundant and the export-led economy. vast rural countryside underdeveloped.

SUMMER 2008 | 31 To confront this threat, China could decide Korea, and Taiwan, the correlation between to bow to external pressure and “revalue” per capita GDP and consumption to GDP its —the renminbi—more quickly, tends to be high and positive—that is, the strengthening it versus other . In more people earn, the more they tend to spend theory, if this were to happen rapidly, it would (Display 5, top). The correlation between increase China’s purchasing power overseas, consumption-to-GDP ratios and rates thereby encouraging domestic consumption, tends to be inverse—that is, the more people decreasing a massive balance-of-trade surplus, spend, the less they tend to save (Display 5, and boosting GDP. A stronger currency would bottom). The high consumption-to-GDP ratio also encourage Chinese manufacturers to start (70%) in the US, for example, is the result not focusing on producing higher-quality, high-end only of its superior income per capita, but also goods, and would help enlarge its growing its extremely low savings rate (about 13.5%). services sector. Display 5 China’s consumption is constrained by its low Obstacles to Revaluation per capita income… Although speeding up the pace of currency Per Capita GDP vs. Consumption/GDP Ratio revaluation and turning itself into a consump- 2006 50,000 tion-driven economy makes sense for China in US theory, a number of huge obstacles remain— 40,000 UK making this course of action unlikely. While Japan Germany China’s nominal GDP (estimated at US$3.3 30,000 Singapore France trillion in 2007 prices) ranks among the Hong Kong South Korea world’s highest, the country’s per capita GDP 20,000 Taiwan remains among the lowest—about US$2,500

Per Capita GDP US$ 10,000 at current prices. This is 17 times lower than China Thailand Indonesia Philippines Malaysia the per capita GDP of the US, 14 times lower 0 Vietnam than that of Germany and Japan, and six to 35 40 45 50 55 60 65 70 75 seven times lower than that of South Korea Consumption-to-GDP Ratios (%) and Taiwan. Even if a currency revaluation …and exceptionally high savings rate made the renminbi twice as valuable in relation to the US dollar, the Chinese consumer’s Gross Savings Rates vs. Consumption/GDP Ratio purchasing power would still remain small. 2006 Further, not only are the Chinese low wage 55 Singapore earners, they are low spenders. China’s con- 50 Malaysia sumption-to-GDP ratio, which was about 36% 45 China 40 in 2006, is low by international standards. South Korea 35 Hong Kong 30 Vietnam Low income and high savings are seen in few Thailand India Japan Indonesia other countries, and the fact that they coincide 25 France Taiwan Philippines in China helps explain the country’s low 20 15 Germany consumption-to-GDP ratio. In industrialized UK US 10 countries such as the US, Germany, France,

Gross Domestic Savings Rates (% of GDP) 35 40 45 50 55 60 65 70 75 and Japan, as well as in certain advanced Consumption-to-GDP Ratios (%) Asian economies like Hong Kong, South Source: Asian Development Bank, CEIC Data, IMF, and AllianceBernstein

32 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT In order to boost consumption, China needs to to create a consumer class large enough for both lower the savings rate and boost income. multinationals to seek to target. This would be The real challenge will be to lower the savings an important driver for the expansion of the rate while accepting the harsh reality that services sector, although such growth would raising the income-per-capita levels of China’s probably be concentrated in the major cities, huge population will take several years. not evenly distributed nationwide.

A stronger Chinese currency would also make The development of the country’s interior will China’s goods more expensive in foreign increase. Some domestic Chinese companies markets, which would pose a huge threat to the are already leading the production shift inland, country’s low-profi t manufacturing . and a small but growing number of foreign While the price of the energy and commodities fi rms are following them. In our view, China’s that these businesses import from abroad would industrial sector will become more diverse drop, that would not be enough to make up the as a result: The developing hinterland will difference. On balance, we think it unlikely that become the focus of the country’s low-margin, China will opt for aggressive revaluation of the volume-oriented manufacturing base, allowing renminbi. Instead, we expect it to continue to production capabilities in the industrialized pursue its high energy/consumption, low-margin east—where skilled labor and quality infra- business development model, even at the risk of structure and logistics are readily available—to retaliatory action from other countries. be upgraded.

The transformation will resemble that of Our Outlook: Japan and Southeast Asia during the 1980s. China Will Continue to Push Down Prices It will also have similar consequences. For China’s role as factory to the world is unlikely example, whereas China’s growth as a global to diminish—in fact, it will become more pro- production center over the past two decades nounced as the country’s economy develops, has been achieved entirely through borrowed and its far-reaching effects on the world technology, the emergence of higher-margin economy will become more entrenched. China businesses will serve as a catalyst for research will continue to push up energy prices—and and development as well as for original push down prices across a wider range of product design, and the quality and sophisti- manufactured goods. As a result of the model’s cation of the goods it exports will rise. China success, however, a number of developments is ramping up its production capacity, and we will arise. For example, the push now being expect the decline in world prices and manu- seen across the industrial base toward the facturers’ operating margins will persist for manufacture of higher-margin goods is likely another decade at least. ■ to raise China’s per capita income, helping

SUMMER 2008 | 33 Notes on Wealth Forecasting Analysis The Bernstein Wealth Forecasting AnalysisSM (WFA) are represented by the S&P/Barra Value Index, with an is designed to assist investors in making a range of key assumed 20-year compounding rate of 8.2%, based on decisions, including setting their long-term allocation of simulations with capital market conditions as of December fi nancial assets. The WFA consists of a four-step process: 31, 2007; US growth stocks by the S&P/Barra Growth (1) Client Profi le Input: the client’s asset allocation, income, Index (compounding rate of 8.1%); developed international expenses, cash withdrawals, tax rate, risk-tolerance goals, stocks by the Morgan Stanley Capital International (MSCI) and other factors; (2) Client Scenarios: in effect, questions EAFE Index of major markets in Europe, Australasia, and the client would like our guidance on, which may touch the Far East, with countries weighted by market capitaliza- on issues such as which vehicles are best for intergenera- tion and currency positions unhedged (compounding rate tional and philanthropic giving, what his/her cash-fl ow of 8.0%); emerging markets stocks by the MSCI Emerging stream is likely to be, whether his/her portfolio can beat Markets Index (compounding rate of 6.6%); taxable infl ation long-term, when to retire, and how different bonds by diversifi ed securities with seven-year maturi- asset allocations might impact his/her long-term security; ties (compounding rate of 5.4%); real estate investment (3) The Capital Markets Engine: our proprietary model, trusts (REITs) by the NAREIT Index (compounding rate which uses our research and historical data to create a vast of 5.3%); a single stock with a beta of 1.0, volatility of range of market returns, taking into account the linkages 30%, and a yield of 0% (compounding rate of within and among the capital markets (not Bernstein 5.3%); and infl ation by the Consumer Price Index (com- portfolios), as well as their unpredictability; and (4) A pounding rate of 2.5%). Expected market returns on bonds Probability Distribution of Outcomes: based on the assets are derived taking into account yield and other criteria. invested pursuant to the stated asset allocation, 90% of the An important assumption is that stocks will, over time, estimated returns and asset values the client could expect outperform long-term bonds by a reasonable amount, to experience, represented within a range established by although this is by no means a certainty. Moreover, actual the 5th and 95th percentiles of probability. However, future results may not be consonant with Bernstein’s esti- outcomes outside this range are expected to occur 10% of mates of the range of market returns, as these returns are the time; thus, the range does not establish the boundar- subject to a variety of economic, market, and other vari- ies for all outcomes. Further, we often focus on the 10th, ables. Accordingly, this analysis should not be construed 50th, and 90th percentiles to represent the upside, median, as a promise of actual future results, the actual range of and downside cases. Asset-class projections used in this future results, or the actual probability that these results publication are derived from the following: US value stocks will be realized.

34 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT Global Wealth Management

Bernstein was founded in 1967 to manage investments for individuals and families and is dedicated solely to investment research and management. Today, as a unit of AllianceBernstein L.P., we oversee some $99 billion* in private capital. Research is the basis of our ability to prudently manage the assets under our care; it is also the foundation of the full array of investment products, both global and local, that we offer.

OUR CLIENT-CENTERED MISSION • To have more knowledge and to use knowledge better than any other investment fi rm in the world • To use and share knowledge to help our clients achieve investment success and long-term security • To place our clients’ fi rst and foremost

Research Excellence Broad Array of Services We believe that superior research is the ultimate source We offer value, growth, and style-blended stock port- of superior investment returns and requires both folios across the global markets, real estate investment knowing more and using knowledge better. Knowing trusts, hedge funds, and taxable and tax-exempt fixed more—having an information advantage over other income portfolios—all actively managed. market participants—requires doing deep fundamental and economic research on a truly global scale. Using Wealth Management Planning knowledge better means identifying and exploiting Because we recognize that private clients of very pricing anomalies that can provide incremental return substantial means have complex needs, we’ve created and employing portfolio-construction techniques to a team of people with expertise in a wide range of manage risk and return efficiently. disciplines to counsel clients on sophisticated financial planning. Our wealth management professionals have With those goals in mind, we’ve built one of the largest experience in areas such as estate planning, intergen- and broadest research footprints in the business: more erational wealth transfer, philanthropy, alternative than 300 analysts operating in 12 countries and , liquidity events, and investment strategies covering thousands of securities in capital markets for corporate executives. Working together with our around the world. Our research effort is organized clients’ other professional advisors and aided by a into separate groups dedicated to growth equities, quantitative state-of-the-art wealth forecasting tool, value equities, and , reflecting the unique we stress-test multiple solutions to complex investment needs of each investment approach. problems to help clients identify the strategies best suited to them financially and emotionally. Disciplined Investment Processes We leverage our research with systematic portfolio Client Service and Communications management. Because our top investment management We recognize that client needs are varied. Our invest- professionals determine the policies and make the ment professionals seek to provide clients with the decisions that underlie all our investment strategies, investment approach that is best for them, and they each client, regardless of account size, gets the very best pride themselves on personalized and timely service. our firm has to offer. These strategies and decisions are Further, our content-rich communications explain the then further customized in relation to each account’s research basis for our portfolio decisions, our analysis tax status and the client’s goals and circumstances. of recent market developments, and our market outlook, as well as other research findings.

*As of June 30, 2008 Global Wealth Management

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