volume vi no 1 summer 2008 · japan nikkei index 38,915 (1989) 14,309 (1992) (63) 45 biotech amex...

> 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 Bond Market

> Can Early Tax Harvesting Reap Greater Gains?

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

V O L U M E V I , N O. 1 | S U M M E R 2008

Global Wealth Management

© Copyright July 2008, AllianceBernstein L.P. All rights reserved.

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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.

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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 Bond Market 15

> Can Early Tax Harvesting Reap Greater Gains? 21

> China: The Impact of Domestic Policy on the Future of Global Trade 28

SUMMER 2008 | 1

FOR CENTURIES, INVESTORS HAVE FALLEN prey to the lure of a heady rise in stocks or commodities or houses, and these overzealous buyers have suffered losses in the bust that has inevitably ensued (Display 1, following page). With each bubble/bust cycle comes investors’ refrain: “This time it’s different.” But while the object of affection-then-disdain may vary, bubbles and busts exhibit a predictable pattern:

> A sharp rise in the price of stocks or some other object of speculation sparks the interest of investors.

> Hunger for the coveted investment fuels borrowing, which fuels demand that drives prices up further. With no end to the increases apparently in sight, still more inves-tors are lured into the marketplace, thereby pushing up prices even higher. All the while, capital fl ows freely, and often some fi nancial innovation facilitates the leveraging process.

> As a bubble builds, valuations become more and more distorted; fundamental consider-ations, such as realistic profi t potential, are disregarded amid the prevailing irrational exuberance.

> Investors rationalize the soaring prices by telling themselves that some unique or revolutionary aspect of the infl ated asset has rendered the old economic rules obsolete.

> At last (though it’s always hard to predict when), some failure—a scandal, an earnings shock, or a sign of weakness in the support for the boom—signals the old rules do in fact still apply, rattling investors and precipi-tating a crisis of confi dence. Prices start to fall, gathering momentum as investors’ panic contaminates even good investments.

> Eventually the fears subside and “normal” market drivers reassert themselves, creating outperformance opportunities for those inves-tors who remained true to fact, not euphoria.

The US Housing Bubble

The US housing bubble and its painful unravel-ing are a vivid reminder that markets have a disturbing habit of becoming grossly overin-fl ated—and then collapsing, infl icting damage on investors’ wealth. Home prices started to rise in the late 1990s, as low interest rates and easy credit facilitated by fi nancial innova-tions—notably, subprime mortgages pitched to

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 credit but too-gullible human beings. Behavioral fi nance sheds light on the origins of bubbles—and points the way for investors to capitalize on the busts that invariably follow.

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.

2 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT

borrowers with limited or bad credit history—made home ownership widely accessible.

In a classic pattern, the favorable environment drove increasing demand for homes, propelling home prices higher. The escalating prices attracted speculators, causing still more money to fl ow into housing as buying and selling became fervid. By 2005, buyers and lenders alike reassured themselves that prices could only go up, and buyers used their houses’ values to fund a spending spree. Credit standards eased further. The June 13, 2005, cover of Time magazine, which depicted a man hugging a house, bore the line: “Home $weet Home.”

That may well have marked the housing bubble’s psychological high point. Soon after, investors became alarmed when overextended subprime borrowers began falling seriously behind on mortgage payments. By 2007, the housing market entered an inevitable correc-tion, which is still under way. Of the nation’s

50 million homes with mortgages, as many as 7.5 million could have seriously negative equity—that is, be worth signifi cantly less than the principal remaining on their mortgages—if the average house price were to fall 20% from the 2006 peak (Display 2).

Display 1

Bubbles are as old as investing itself, but no matter what the chosen asset is, the pattern of investor self-delusion persists

Bubbles Across the Centuries

Bubble When Coveted Asset Inspired Idea Telltale Warning

Tulip Mania 1630s Purple-streaked Semper Augustus

Foreign tulip fanciers would sustain boom for Dutch speculators

Tulip bulbs cost fi ve times a worker’s annual salary

South Sea 1720 Stock in South Sea Company

Spain granted monopoly on all South American trade

Joint stock in company rose tenfold in one year

Mississippi 1729 Stock in Mississippi Company

Monopoly on trade in “French Louisiana” on beaver pelts, gold, taxes, coinage

Shares shot from 500 to 10,000 livres in a few months (and plunged as fast)

Roaring Twenties

Late 1920s “High-tech” stocks of the day

Purportedly transformational “New Economics” revolving around auto and airplane stocks

Massive public participation—and shares trading at dot-com-style P/E ratios (until market fell 90%)

Nifty Fifty 1960s–70s Blue Chips like Kodak, Polaroid, and Xerox

High-P/E, brand-name growth stocks were deemed so reliable as to be “one-decision” purchases—buy and hold forever

Kodak soared to $148 at its peak, only to plunge 60%

Japan Late 1980s Any big Japanese stocks

Japan was said to be the unstoppable new global economic powerhouse

The Nikkei index hit 38,915 in ‘89—even today it is back only to around 13,000

Tech and Telecom

Late 1990s Internet and telecom stocks

The Internet and communications revolution had supposedly transformed the rules of economics, permitting permanent rapid growth

Internet start-ups with no actual profi ts, just a business idea, traded for triple-digit multiples (Nasdaq index would plunge 80%)

Source: AllianceBernstein

Display 2

Many homes could soon be worth less than the principal remaining on their mortgages

Houses with Negative Equity ≥10% Depending on Price Declines*

(Millions)

0% (5)% (10)% (15)% (20)% (25)%

1.93.0

5.0

7.5

10.0

1.1

Depreciation

*Estimates based on what would occur if the average house depreciated up to 25% from the 2006 peak Source: Federal Reserve, National Association of Realtors, and AllianceBernstein

SUMMER 2008 | 3

The US housing bubble has had far-reaching ramifi cations for the global investing markets. Subprime and other asset-backed loans had been bundled into packages of securities and sold to fi nancial institutions globally. As indications mounted that the underlying loans were at risk, turmoil grew, and the market for such securities evaporated. Holders—predominantly fi nancial institutions and other leveraged investors—were forced to mark down their holdings, often accompanied by margin calls that prompted widespread selling of other liquid securities, especially stocks. Stock markets around the globe have tumbled, and stock prices of fi nancial institutions, at the heart of the maelstrom, have been hardest hit.

With rising home values no longer available as the credit line for US consumers’ spending, fears of a US economic recession have grown, fanning the fl ames of investor anxiety. In a sign of how pronounced the tidal wave of fear had become, as of the end of March 2008, investors were willing to accept a real (after-infl ation) yield of (2.38)% on two-year US Treasuries—in other words, they were willing to accept a negative investment return for the safety of holding Treasuries.

Although the resolution of the housing bubble has yet to occur, history may offer some hope for the future: A study of modern stock market bubbles reminds us that recovery does come eventually (Display 3).

How Behavioral Finance Illuminates Bubbles

Why the investing markets are prone to such cycles has been explained, in part, by experts in the fi eld of behavioral fi nance—in which investing, economics, and psychology intersect. Pioneered in the 1970s by Daniel Kahneman, winner of the 2002 Nobel Prize in Economic Sciences, and the late Amos Tversky, the study of how human beings make decisions when faced with unknown outcomes has shed light on investor behavior. What compels inves-tors to chase “hot” performers long after the opportunity has passed, or to steer clear of

Display 3

Stock bubbles burst…and markets recover

Bubble Had to Own Peak Subsequent Trough

PercentChange

Percent Change First 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

Key Concepts

> Asset bubbles and busts—such as today’s housing crisis—have occurred throughout history, in remarkably similar guise

> Behavioral fi nance scientists have identifi ed emotional traits of investors that ultimately lead to bubbles and busts: among them, believing that rising markets will keep rising; irrationally fearing even small losses; and preferring instant gratifi cation to greater long-term reward

> Given human nature, cycles of bubbles and busts are inevitable

> These cycles offer great opportunity for value investing that’s driven by intensive research and a disciplined process


out-of-favor stocks despite their longer-term promise, or to avoid risk even at the cost of a reduction in yield or return?

In all cases, the answer is predicated on human 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 to investors’ penchant for engaging in mass psychological self-deception: It can create opportunities to profi t from emotion-driven 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 that come into play during boom/bust cycles.

Decision-Making Glitches

Behavioral fi nance suggests that human beings are as poorly equipped to be investors as could be imagined: Our own wiring works against our very success. For example, through exten-sive research, Kahneman and Tversky proved that we feel pain from loss more keenly than we feel pleasure from gain (Display 4). In fact, based on their studies, if you won $100 one day and lost it the next, you’d be twice as unhappy about your loss as you were happy about your good fortune. Such extreme sen-sitivity to pain makes investors generally risk averse, and that trait becomes even more pronounced when bubbles burst. That’s a powerful headwind in investing, where greater return opportunities typically entail more risk.

Another powerful bias that foils good decision making is “anchoring.” When an investment has done especially well, investors become convinced that such performance will continue into the future, fueling frenetic demand that, for some period of time, becomes self-fulfi lling: Prices continue to rise. The same holds true on the bust side: When something has faltered, or some bad news besets the investment, investors become adamant that it is permanently imper-

iled and they can’t get rid of it fast enough, which hastens the downward spiral of the investment’s price.

The bait for another thinking trap is “avail-ability,” or people’s tendency to be infl uenced by what they hear most frequently. In today’s always connected world, headlines can become stand-ins for “the truth,” and decision making refl ects that.

The Cost of Emotions

These biases are so very natural that fi ghting them seems unthinkable. Yet, such emotion-driven investing can be extremely detrimental, as Display 5 illustrates. Over the past 20 years, the average stock mutual fund investor reaped an annualized return of about 4.5%, barely outpacing infl ation, while the US stock market grew at close to 12% annualized over the same period. The marked discrepancy is a function of fl awed choices driven by these biases. Anchoring and availability tend to cause investors to move out of an investment that may be lagging and into one that has been prospering. But doing so typically means they’ve missed most of the opportunity in the hot idea and forgone the developing opportunity in the disappointment.

Display 4

A loss hurts twice as much as a gain pleases

Loss Gain

Pleasure

Loss Aversion

Pain

Big Pain

Small Pleasure


SUMMER 2008 | 5

Risk-aversion features here, too, as investors tend to shy away from stocks when times get diffi cult, thus locking in losses and missing out on surges.

From Destructive Bias to Advantaged Insight

When faced with such faulty decision-making frameworks, can an investor come out ahead? The answer is yes, although what it takes to succeed does not always feel good.

Perhaps the greatest example is value-stock investing. As Bernstein practices it, value investing seeks out stocks that intensive research reveals are exceptionally inexpen-sive versus their long-term earnings potential. During booms, these are often stocks of companies not associated with the fad of the moment; during busts, when widespread anxiety fuels high levels of risk aversion and often indiscriminate avoidance of stocks, the opportunity set for value investors widens. As Display 6 illustrates, the pertinent question for a value investor is: Is the stock price depressed because of some problem from which the company is unlikely to recover, or is it in fact a setback that ultimately will be corrected, restoring the company’s long-term earnings power—and its stock price?

The emotional challenge, though, in value investing is that the greatest buying opportuni-ties are created when negative sentiment is at its most intense—the very time when buying into controversy seems entirely irrational.

For example, think back to 1990, when big American banks were in a not-unfamiliar position: mired in a mortgage crisis, amid the worst downturn in commercial real estate since the 1930s. On top of that, banks were still coping with soured developing-country and leveraged merger loans. As most investors saw it, the “troubled” big banks would go on hem-orrhaging loan losses, and, what’s more, their basic business model was becoming obsolete. People assumed a number of big banks would collapse, along with many S&Ls.

Our research uncovered a different picture: We felt certain out-of-favor banks had the profi t potential to more than cover their bad loans and that industry consolidation plus cost-cutting and fee-raising would in fact spark an earnings boom. Convinced that loss-averse investors had vastly overreacted, we sought out beleaguered but basically sound banks, like Citicorp (whose total return was down 52% in 1990); Chemical Bank, (59)%;

Display 5

The average investor’s results lag the market— because of fl awed, emotional decision making

Annualized Returns1988–2007

11.8%

3.0%

S&P 500 Inflation Average StockFund Investor

4.5%

Past performance is no guarantee of future results.Source: Dalbar, Inc.

Display 6

Distinguishing a permanent problem from a temporary setback is critical to value investing

ResearchConclusion

Profits & Stock Price Decline

InvestmentControversy

Which?

“Value Trap”

Long-TermEarnings Power



and Bank of Boston, (64)%. More stringent lending policies soon brought loan losses under control, and merger synergies helped restore profi ts. Banks and bank stocks rebounded dramatically (Display 7). From 1990 through 1996, Citicorp rewarded investors with 338% in total return; Chemical, 321%; and Bank of Boston, 318%.

In a fast-changing world, investor opinion often veers rapidly from one extreme to another, as behavioral fi nance has documented. A shining star of high tech for decades, IBM fell on hard times in the late 1980s, as demand for main-frames shrank and its share of the personal computer market fell from 100% in 1981 to a mere 16% 10 years later. By 1993, IBM was earning less than $1 a share, and its stock price fell to $41 in August of that year, down from $100 in July 1992.

Nevertheless, under new management IBM began to reboot itself, although investors remained skeptical. Our research indicated the company’s strategy was sound and that the stock was signifi cantly undervalued. IBM revamped its product mix to increase revenues; sharply cut costs (expenses went from 43% of sales in 1991 to 28% in 1996); and boosted earnings per share more than tenfold. When investors fi nally began to catch on to the

overhaul, IBM stock embarked on an impres-sive recovery (Display 8).

Value investing thrives on controversy, which invariably has an emotional component. Although dominant in computer printers, Hewlett-Packard in 2001 was subscale in personal computers and hardware and services. By the end of 2002, the market valued HP more like an appliance-maker than a high-tech company. And when HP announced its acquisition of Compaq in 2002, the merger appeared merely to combine two weak PC makers, thereby diluting the high-value printer business. Compounding the investment con-troversy was a formidable rival in Dell and a high-profi le CEO at HP who served as a light-ning rod for investor anxiety. Many doubted HP management could make the merger work, and the stock continued to slide through 2002.

However, our objective research persuaded us that HP’s prospects were underrated. The merger fundamentally improved the company’s competitive position in both personal comput-ers and enterprise hardware. Greater leverage over suppliers and a tougher negotiating stance allowed HP to boost gross margins, and it decisively lowered operating costs by reducing head count. Operating earnings on the PC business went from a loss of nearly

Display 7

Bank stocks suffered in 1990 but ultimately rebounded, outperforming the market

Bank Stocks vs. S&P 500

S&P500

BankStocks

(3)%(38)%

156%

199%

Cumulative Return1990–1996

1990

Past performance is no guarantee of future results.Source: Standard & Poor’s and AllianceBernstein

Display 8

Investors’ emotional overreaction to the computer maker’s travails created a value opportunity

IBM Stock Price

0

60

120

$180

979695949392

EarningsPlummet

Massive Restructuring,Layoffs, Cost-Cutting

ProfitsRecover

NewManagement

Note: IBM went on to split two-for-one in May 1997, and again in May 1999.Source: FactSet and AllianceBernstein

SUMMER 2008 | 7

$1 billion in fi scal 2001 to a profi t of nearly $800 million in fi scal 2007. The Dell threat abated, as that company’s supply chain was replicated by Taiwanese assemblers. And HP countered a competitive challenge to its printer business by introducing a low-cost unit capable of producing high-quality images. New man-agement in 2005 added momentum to HP’s recovery (Display 9). But again, being able to spot the underlying opportunity when things looked bleakest was key.

Bernstein’s history as a value investor suggests that a disciplined process, driven by intensive research, can effectively gauge the oppor-tunities created by controversy to generate long-term success. Over the period from 1990 through June 2007, which saw the pronounced declines and recoveries referenced above, $1 million invested in Bernstein’s US Strategic Value portfolio would have grown to $7.7 million after fees, while a million dollars invested in the S&P 500 would have amounted to $6.2 million (Display 10, top). And by adhering to this discipline throughout our history, our US Strategic Value portfolio has

signifi cantly outperformed the broad stock market since its inception, after fees (Display 10, bottom).

Cycles of booms and busts seem to be unavoid-able features of investing, and the process of equilibrium being restored—whether at the individual stock level or, as today, across a wide swath of the capital markets—is painful. But the emotional biases that, in part, underlie them can translate into unduly pronounced security mispricing. For those who rely on deep research as a guide, exploiting the discrepancies can create signifi cant opportunity for gain. ■

Display 9

The market was skeptical of HP’s merger with Compaq, but our research foresaw that in time it would pay off

Hewlett-Packard Stock Price

10

15

20

25

30

35

40

$45

07060504030201

Announced Mergerwith Compaq

ProxyBattle

New ManagementAppointed

Source: Company reports and AllianceBernstein

Display 10

Disciplined value investing involves a rational approach that has been successful over time

0

1

2

3

4

5

6

7

$8 Mil.

060402009896949290

US Strategic ValueGrowth of $1 Million (after fees)

Jan 1990–June 2007Bernstein US

Strategic Value:$7.7 Mil.

S&P 500$6.2 Mil.

US Strategic Value Since Inception* vs. S&P Growth of $1 Million (after fees)

Jan 1974–June 2008

$71.4 Mil.

$39.6 Mil.

Strategic Value S&P 500

Past performance is no guarantee of future results. See notes on performance, page 8. *January 1, 1974Source: Standard & Poor’s and AllianceBernstein


US Strategic Value (All Accounts)

1. General Notes:

a. Performance Statistics Are Not Financial Statements—There are various methods of compiling or reporting performance statistics. The standards of performance measurement used in compiling these data are in accor-dance with the methods set forth below. Past performance does not guarantee future results. A portfolio could suffer losses as well as achieve gains.

b. Composite Structure—Beginning in 1993, the Bernstein US Strategic Value (all accounts) composite (the “com-posite”) includes only fee-paying private and institutional discretionary accounts not subject to signifi cant investment restrictions imposed by clients. From 1974 through 1992, the composite includes all private and institutional discre-tionary US Strategic Value accounts.

c. Rate of Return—Performance returns for each account are calculated monthly using trade-date accounting. Performance results are reported on a total-return basis, which includes all income from dividends and interest, and realized and unrealized gains or losses. Prior to July 1993, all cash fl ows were assumed to have occurred on the last day of the month. From July 1993 through 2000, if an account’s net monthly cash fl ows were equal to or exceeded 10% of its beginning market value, the Modifi ed Dietz 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 beginning market value, the cash fl ows were assumed to have occurred on the last day of the month. Beginning in 2001, all cash fl ows are daily-weighted using the Modifi ed Dietz Method. Beginning in 1993, the monthly composite returns are calculated by weighting each account’s monthly return by its beginning market value as a percent of the total composite’s beginning market value. Prior to 1993, the composite results are equal-weighted on a quarterly basis.

These monthly and quarterly performance fi gures are geo-metrically linked to calculate cumulative and/or annualized “time-weighted” rates of return for various time periods. Closed accounts are included in the composite for each full quarter prior to their closing.

d. Benchmark—The benchmark for the composite is the S&P 500 Index. The S&P 500 Index is widely regarded as the standard for measuring large-cap US stock market performance.

2. Net-of-fee performance fi gures for the composite have been calculated as follows:

a. Prior to 1983, management fees were not charged; instead, the accounts incurred transaction costs.

b. From 1983 through 1992, the composite’s net-of-fee return is the equal-weighted average of the actual after-fee returns of each account in the composite. From 1993 forward, the composite’s net-of-fee return is the asset-weighted average of the actual after-fee returns of each account in the composite.

c. Net-of-fee returns for the past 10 years are as follows: 1998: 10.1%; 1999: (0.2)%; 2000: 10.0%; 2001: 9.3%; 2002: (17.6)%; 2003: 32.0%; 2004: 13.5%; 2005: 8.6%; 2006: 20.1%; 2007: (1.2)%.

3. Dispersion—Dispersion is calculated on the gross-of-fee annual returns of the accounts included in the composite for all 12 months of the calendar year; it is the asset-weighted standard deviation of these returns. Dispersion of returns for the composite is as follows: 1998: 2.0%; 1999: 2.0%; 2000: 1.6%; 2001: 1.7%; 2002: 1.6%; 2003: 1.4%; 2004: 1.2%; 2005: 1.1%; 2006: 0.8%; 2007: 1.1%.

SUMMER 2008 | 9

WHEN THE FEDERAL RESERVE SLASHED interest rates early this year, a spate of head-lines declared the time was right for certain tax-minimization strategies. As the Wall Street Journal wrote: “Low interest rates and the slumping market make this the best time in at least fi ve years to use so-called estate-freeze strategies, which can help shield a fortune from estate taxes, say wealth advisors.”1

While it is true that low interest rates and a slumping market may facilitate a few such strategies, trying to “time” estate planning according to market conditions is shortsighted. Smart estate planning is timeless: You can shield wealth from gift and estate taxes in any interest rate or market environment. For example, as Bernstein research has shown, a series of “rolling” short-term grantor-retained annuity trusts (GRATs) funded with publicly traded stocks is a simple and effective wealth transfer strategy, regardless of market condi-tions at its inception.2

Nonetheless, given the recent upheaval in the markets and the decline in interest rates, many individuals and their professional advisors are being tempted to establish long-term GRATs in order to “lock in” a low rate. For a fresh perspective on the effect of interest rates and market conditions on wealth transfer, we con-ducted new research on GRAT strategies. The results were eye-opening:

> Contrary to common wisdom, locking in a low interest rate on a long-term GRAT is almost certainly not the best choice among GRAT strategies for transferring liquid assets. A series of rolling short-term GRATs will most likely outperform a long-term GRAT regardless of interest rates.

> Further, a rolling GRAT strategy will most likely outperform a long-term GRAT regard-less of the stock market environment at the strategy’s inception.

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 short-term economic trends. Seemingly attractive market opportunities can be misleading, although any opportunity that triggers a review of your estate plan is useful.

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.



The Case for Wealth Transfer Today

When interest rates drop, you can expect to hear that “it’s a great time to GRAT,” because a key rate set by the IRS, the so-called Section 7520 rate, is integral to the GRAT structure.

As shown in Display 1, a GRAT is a trust that allows you to move a portion of the future return on assets to benefi ciaries without paying gift tax or using your gift-tax exemption. You make an irrevocable gift to the GRAT and retain the right to receive an annuity payment from it each year during the trust’s term. Anything left in the GRAT at the end of its term passes to your benefi ciaries. If you struc-ture the GRAT so that it is “zeroed-out”—in other words, so that the present value of the annuity payments equals the value of the assets you transfer to the GRAT—then you have made no gift under tax law.

Here’s why the 7520 rate matters: It is the interest rate for the present value calculation. The IRS publishes the 7520 rate monthly. In simple terms, it is set at a modest premium to prevailing intermediate-term interest rates. As Display 2 shows, the 7520 rate is near its historical low.

A low 7520 rate sets a lower “hurdle” for a GRAT to succeed in transferring wealth. If the assets in the GRAT grow at a rate in excess of the 7520 rate, all that excess growth (the “remainder” of your GRAT) will transfer to your benefi ciaries free of gift tax. This is the allure of locking in a low 7520 rate for a long term—it should be easier to beat—but it may not be the wisest choice. For a more nuanced perspective, let’s take a look at an alternative GRAT strategy—rolling short-term GRATs.

In a rolling GRAT strategy (Display 3), you create a short-term GRAT (say, two years) and use each year’s annuity to create a new GRAT. You can keep doing this for as many years as you want, but for the sake of comparison, suppose you continue this process for 10 years. During this time you will have created nine two-year GRATs (the fi nal one expires at the end of year 10).

Previous Bernstein research has shown that a rolling short-term GRAT strategy will most likely outperform a single, long-term GRAT for two main reasons:

Display 1

A simple GRAT structure

GRAT Personal Assets

You (the Grantor)

YourBeneficiaries

Remainder Taxes

AnnuityPayments

GRATContribution

Income Taxes onAll Trust Income

Government


Display 2

The hurdle rate set by the IRS is near an all-time low

2

4

6

8

10

12%

0807050301999795939189

7520 Rate

May 1989 11.6%

Average 6.8%

June 2008 3.8%

Source: US Treasury Department

SUMMER 2008 | 11

First, it keeps more of the capital committed to the strategy. In a single long-term GRAT, the capital declines each year, as the annuity payments return assets in the GRAT to you, the grantor. By contrast, the rolling GRAT strategy maintains all of the original capital committed to the strategy in the GRATs.

Second, the shorter, two-year time horizon minimizes the chance that good investment performance in one year will be offset by poor investment performance in another year. Even if the compound return during a 10-year period is poor, there may be good two-year periods along the way that will successfully transfer wealth.

As an example, consider the decade that just ended: 1998 through 2007. This dramatic period saw the rise of the tech stock bubble, the depths of the ensuing bear market, and a strong recovery. From start to fi nish of this roller-coaster ride, stocks turned in a 5.9% annualized return. Yet, as Display 4, following page, shows, a 10-year GRAT funded with $5 million in 1998 would have failed to transfer any wealth. A series of rolling two-year GRATs, however, would have succeeded in six of the 10 years, transfer-ring $3.4 million out of your estate free of gift tax. This shows how the rolling GRAT strategy capitalizes on the volatility of the stock market.

Just How Important Are Low 7520 Rates?

One might argue that in the example above, the 7520 rate was much higher than it is today: In 1998 it was 7.2%; in June of this year it was 3.8%. Shouldn’t such a low rate provide a powerful tailwind to the long-term GRAT structure? Since no one can predict what the markets will do in the future, we approached the question in two ways: 1) by forecast-ing potential future market returns, using Bernstein’s proprietary Wealth Forecasting System,3 and 2) by looking at history—which in some periods (the 1940s and early 1950s) had interest rates even lower than today’s.

First, using our Wealth Forecasting System, we modeled 10,000 future market environments to show their effect on two GRAT strategies: a single 10-year term GRAT versus a series of two-year rolling GRATs for 10 years. Next, we looked at the GRATs beginning in low interest rate periods—defi ned as the lowest quartile of 7520 rates modeled. The rolling GRAT strategy

Key Concepts

> The common wisdom that low interest rates recommend creation of a long-term grantor- retained annuity trust (GRAT) may cause individuals and wealth planners to overlook a better GRAT strategy

> Building on previous Bernstein research, new analysis and a study of historical data show that rolling short-term GRATs are more likely to transfer more wealth, free of gift tax, than a long-term GRAT, regardless of interest rates or market environment

> “Don’t try to time the market” is good advice in investment management, and our new research indicates it is equally apt for estate planning

Display 3

Rolling GRATs can lock in gains

GRAT 12 Years

GRAT 22 Years

GRAT 32 Years

GRAT 42 Years

Annuities Annuities

Your Beneficiaries

Annuities Annuities


3 See Notes on Wealth Forecasting Analysis, page 34.


won handily, succeeding more than 98% of the time, compared with a 10-year term GRAT success rate of only 76%.

As noted above, one reason a rolling GRAT strategy will likely outperform a single long-term GRAT is that it keeps more of the capital committed to the strategy at work. Accordingly, we also tested the benefi t of locking in a low interest rate by modeling a 10-year GRAT

structure that uses its fi rst annuity to create a nine-year GRAT, and its next annuity (plus the nine-year GRAT’s fi rst annuity) to create an eight-year GRAT, and so on, keeping all the money at work and ending with a two-year GRAT. Yet, as Display 5 shows, this strategy will likely underperform the simple rolling short-term GRAT strategy—both in terms of success rate and the median amount transferred.

A Historical Analysis Drives the Case Home

While the simulated results were compelling, we were curious to see how the term GRAT and rolling GRAT strategies would have fared historically. We compared the results of the two strategies—rolling short-term versus 10-year term—assuming they had been launched every month from May 1941 through April 1998, for 684 trials in all. We assumed each GRAT began with $10 million invested in the S&P 500. And, since the 7520 rate has existed only since 1989, we created a proxy for earlier periods based on the IRS methodol-ogy. This 57-year span covers a wide range of interest rates and stock market returns, with the 7520 rate averaging 6.7%, but dipping as low as 1.2%.

Display 5

Even with low interest rates, rolling short-term GRATs beat other GRAT strategies

10-Year Term GRAT*

10-Year Term GRAT with Annual Decreasing Term GRATs*

Rolling Short-Term GRATs

Probability of Success 76% 96% >98%

Median Wealth Transfer $3.6 Mil. $5.3 Mil. $7.4 Mil.

All strategies are funded with $10 million, beginning in the lowest-quartile interest rate environments. All assets are invested in a globally diversifi ed equity portfolio composed of 35% US value/35% US growth/25% developed international/5% emerging markets stocks. Wealth to benefi ciaries is reinvested and adjusted for infl ation. See Notes on Wealth Forecasting Analysis, page 34. *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 decreasing term GRAT strategy. Rolling GRATs have constant annuities. Source: AllianceBernstein

Display 4

1998–2007: How rolling short-term GRATs capitalized on volatility

(30)(20)(10)

010203040%

29%21

(9)

29

115

16

5

10-Year Term GRATInitial Contribution: $5 Mil.

(12)(22)

Initial Section 7520 Rate: 7.2%

10-Year S&P Compound Return: 5.9%

Remainder: $0.0

Two-Year Rolling GRATsInitial Contribution: $5 Mil.

7520 Rate

S&P Annual Return

S&P Compound Two-YearForward Return

Wealth Transferred

1998 7.2% 28.6% 24.8% $0

1999 5.6 21.0 4.9 $1.65 Mil.

2000 7.4 (9.1) (10.5) $179,756

2001 6.8 (11.9) (17.1) $0

2002 5.4 (22.1) 0.1 $0

2003 4.2 28.7 19.4 $0

2004 4.2 10.9 7.8 $877,809

2005 4.6 4.9 10.2 $190,887

2006 5.4 15.8 10.5 $176,527

2007 NA 5.5 NA $322,580

Total Remainder: $3.4 Mil.

Term GRATs assume 20% increasing annuities, while rolling GRATs assume constant annuities. See Notes on Wealth Forecasting Analysis, page 34.Source: Standard & Poor’s, US Treasury Department, and AllianceBernstein

SUMMER 2008 | 13

The results were striking: The rolling short-term GRAT strategy beat the 10-year term GRAT in every period, and succeeded 100% of the time at transferring wealth to the next gen-eration, while the long-term GRAT succeeded only 80% of the time, as Display 6 shows.

Not only was the rate of success higher, but the amount of wealth transferred was much greater. Even when the 10-year term GRATs succeeded, the rolling GRAT strategy transferred nearly twice as much wealth: a median transfer of $11.0 million compared with $6.1 million.

We also compared shorter-term GRATs, because a 10-year term might not fi t every individual’s needs. The results were compa-rable: Running the same historical analysis using four-year term GRATs versus four years of rolling two-year GRATs, the rolling strategy succeeded 98% of the time, compared with 79% for the term GRATs. And out of 684 trials, the four-year GRAT transferred more wealth than the rolling strategy only 18 times, or in just 2.6% of the trials.

An All-Market Strategy

What about the stock market environment? One might argue that if the stocks in a GRAT were poised for an upsurge (even though no one can predict future performance), a

long-term GRAT might outperform rolling short-term GRATs. But as Display 7 shows, rolling GRATs outperformed term GRATs by wide margins, no matter what the stock market had done in the year prior to the strategies’ inceptions. This refl ects the fact that historically, stocks have tended to rise over any 10-year period, with market downturns being relatively short in duration.

In summary, our research provided an over-whelming case against trying to “time” your wealth transfer strategy with GRATs. Regardless of interest rates or the current market environment, a strategy of rolling short-term GRATs funded with publicly traded stocks appears very likely to provide better results than a single, longer-term GRAT.

When Timing Does Pay Off

A few wealth transfer strategies will benefi t from low interest rates. For example, our research showed that charitable lead annuity trusts (CLATs) should perform better when launched in low interest rate environments. CLATs resemble GRATs, with the main dif-ference being that the annuities go to charity,

Display 6

1941–1998: Rolling short-term GRATs beat long-term GRATs

Rolling GRATs 10-Year Term GRATs

Frequency of Success 100% 80%

Median Wealth Transfer $11.0 Mil. $6.1 Mil.

All strategies are funded with $10 million and invested in a portfolio representative of the S&P 500. Wealth to beneficiaries is reinvested and adjusted for inflation. See Notes on Wealth Forecasting Analysis, page 34.Term GRATs assume 20% increasing annuities, while rolling GRATs assume constant annuities.Source: AllianceBernstein

Display 7

1941–1998: Rolling GRATs beat term GRATs in both bull and bear markets

S&P 500 Trailing 12-Month Return

10-Year Term GRAT Median Remainder

Rolling Short-Term GRAT Median Remainder

Lowest (38.9)%Quartile to 2.3%

$6.6 Mil. $11.0 Mil.

Second 2.5%Quartile to 14.4%

$6.5 $11.4

Third 14.4%Quartile to 26.1%

$4.3 $10.4

Highest 26.2%Quartile to 61.2%

$5.6 $10.9

All strategies are funded with $10 million and invested in a portfolio representative of the S&P 500. Wealth to beneficiaries is reinvested and adjusted for inflation. See Notes on Wealth Forecasting Analysis, page 34.Term GRATs assume 20% increasing annuities, while rolling GRATs assume constant annuities.Source: AllianceBernstein


rather than back to the donor. As a result, a rolling short-term structure is impossible because each year’s annuity goes to charity and is out of your hands. This favors a longer-term structure, so that the assets have plenty of time to grow. Consequently, CLATs are typically created with long terms—10 to 20 years.

We used our Wealth Forecasting System to model hypothetical 20-year CLATs funded with a $10 million initial contribution. We compared how CLATs would fare if started in a low interest rate environment (defi ned as the lowest quartile of interest rate scenarios) versus high interest rates (the top quartile). Display 8 shows the results: CLATs perform much better with a low 7520 rate.

If a CLAT strategy suits your estate planning goals, today’s market conditions are ideal.

However, CLATs are not right for everyone, or every situation. First, success is by no means guaranteed. Even in the low interest rate scenarios, only 88% of the CLATs in our simulation had money left at the end of their term. So if your primary goal is to pass money on to the next generation, better wealth transfer vehicles exist. Further, if your primary goal is giving to charity, there may be better ways to do so.

It’s Always a Good Time for Estate Planning

One of the well-worn maxims of investment management is that it doesn’t pay to time the market. This wisdom applies to wealth transfer strategies as well. While a few specialized strategies, such as CLATs, may benefi t from low interest rates, it is better to start early with a comprehensive estate plan designed to weather any market environment, rather than waiting for the market to turn your way.

The reasons are simple: First, as our research above shows, a rolling short-term GRAT strategy can effectively transfer wealth regard-less of interest rates or market environment. Second, by trying to time the market you run the risk of using up your “time capital,” that is, the amount of time you have to transfer wealth during your lifetime. In other words, for every year you procrastinate, you lose the ability to transfer assets and have them grow outside of your estate, and you increase the risk that upon your death you will leave an overly large estate for the government to tax.

If, however, the current market environ-ment induces you to “use lemons to make lemonade,” today is as good a time as any to consider estate planning. Just be sure to consult your tax advisor and use a thoughtful approach grounded in research, rather than relying on common wisdom. ■

Display 8

CLATs benefi t from a low hurdle rate

$5.2 Mil.

Low Rates

Probability of passing wealth to beneficiaries

20-Year CLATMedian Wealth Transfer

High Rates

0.0

1.0

2.0

3.0

4.0

5.0

$6.0

$1.5 Mil.

88% 59%

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 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 growth/25% developed international/5% emerging markets stocks), 30% taxable bonds, and 10% REITs. See Notes on Wealth Forecasting Analysis, page 34.Source: AllianceBernstein

SUMMER 2008 | 15

IN BERNSTEIN’S VIEW, BONDS ARE AN essential complement to stocks in an inves-tor’s overall portfolio. They provide income, and they stabilize the total portfolio against stocks’ volatility. In addition, a bond portfolio can generate incremental return when actively managed using a sound research framework. The investing landscape of the past 12 months provides the backdrop for a compelling narra-tive of how active bond management can add value across all three strategic imperatives.

Setting the Stage: The Hunt for Yield

For several years prior to the summer of 2007, the stock and bond markets were unusually calm. With risk seemingly absent, many municipal bond managers were grabbing yield anywhere they could fi nd it, purchasing both very long-term and lower-rated bonds. As a result, the shape of the municipal yield curve had become fl atter than it had been in decades: With so many eager buyers, long bonds offered little additional yield versus short-term bonds of the same credit quality. Plus, the additional yield for riskier bonds fell to historically low levels.

But the reign of calm came to an abrupt end in July of last year, as the effects of the subprime crisis paralyzed the global markets.

Municipal bonds were not immune to the contagion: Buyers rushed to purchase safer (that is, higher credit-quality and shorter maturity) bonds, causing prices to rise in response to demand. And in its efforts to quell the subprime crisis, the US Federal Reserve aggressively cut interest rates several times, helping to further lift bond prices. As prices and yields are inversely correlated, by the end of March 2008, the yield curve had gone from fl at to steep: Yields on short-term bonds had fallen, while yields on riskier longer-term bonds had risen (Display 1). Managers holding

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.

Display 1

The shift from great calm to extreme fear caused the municipal yield curve to steepen dramatically

AAA Municipal Yield Curves

March 31, 2007

March 31, 2008

1.5

2.5

3.5

4.5

5.5%

30-Year20-Year6-Year1-Year

Estimates for AAA-rated insured municipal bondsSource: Municipal Market Data Corp. and AllianceBernstein


the lower-rated or longer-term bonds saw their prices plummet. The dramatic change in the yield curve and the increased demand for high-quality bonds refl ected the switch in investor sentiment from greed to fear.

The Calm Before the Storm

Back in the spring of 2007, it was clear that market risk was absent from many investors’ minds—they weren’t demanding much more yield for holding long bonds. We determined that the modest additional yield being offered by long-term bonds was not suffi cient compen-sation for the mounting risk that these bonds’ prices could fall; when income and price return were both considered, our calculations indicated our investors would be best served if we concentrated holdings in the intermedi-ate-maturity range, resulting in a four-year duration overall (Display 2).

Our analysis of credit quality revealed a similar story. By March 2007, credit spreads had become extremely compressed, meaning the premium being offered to take on the extra

Display 2

In early 2007 we concentrated the maturity structure of our portfolios

Our Maturity Selection

1

2

3

4

5%

2%10%

88%

25-Year1-Year 6-Year 20-Year

Duration Target(4.1 Years)

As of March 31, 2007Source: Municipal Market Data Corp. and AllianceBernstein

Bonds in BriefBonds can present a complex landscape for inves-tors, as their returns are influenced by so many factors. Here, we recap the key drivers that affect bonds’ performance.

Interest rates: When interest rates rise, the prices of bonds that are outstanding fall, as the income they generate will be less than that from a new bond issued at the higher interest rate. The bond’s price needs to fall as a way of compensating buyers for its lower income versus the new bond.

Duration: A measure of how much a bond’s price will change for every 1% change in the interest rate. Expressed in years and mathematically computed, the longer a bond’s duration, the greater its price change will be when interest rates change.

Yield: There are several measures of “yield” in bonds. We’ll focus for simplicity on “yield-to-maturity”: This is the internal rate of return of

the bond investment, assuming the bond is held until maturity and that income is reinvested at a constant rate.

Credit quality: Third-party agencies rate the creditworthiness of each bond; bonds with higher credit quality are deemed safer in terms of the issuer’s ability to make its interest payments and return the full value of the bond to the buyer upon the bond’s maturity. Bond prices move up or down in line with credit-rating changes up or down.

Maturity: The length of time until a bond matures and the issuer pays back the face value of the bond. Long maturity bonds, typically those with maturi-ties of 10 or more years, are riskier than bonds with lesser maturities in that their price moves are greater, owing to interest rate changes or credit downgrades. As compensation for this added risk, long bonds typically offer higher yields than bonds with shorter maturities. ■

SUMMER 2008 | 17

risk of lower-quality BBB bonds versus the highest-quality AAA bonds was almost non-existent. In fact, an increase of only 0.08 in the yield of BBB bonds translated into a drop in prices that more than offset the benefi t of higher income over one year.

With virtually no incentive to move down in credit quality, we chose to hold primarily very high-credit-quality bonds in our portfolio. The only BBB bonds we bought were those that our credit team determined were likely to be upgraded by the rating agencies or were stable and scheduled to mature soon.

We didn’t make these portfolio decisions in response to a premonition about the subprime crisis: We made them based on our ongoing 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 our deep conviction about how to design the portfolio to ensure it played its three roles well: income, stability, and incremental return.

The Market Awakens to Risk

In July 2007, the scope of the subprime mortgage crisis began to sink in. As investors became increasingly aware of the potential risks, both the yield curve and credit spreads began moving. The markets convulsed as nervous investors sold risky assets and bought the safest investments they could fi nd. US Treasuries were the prime benefi ciary of inves-tors’ fl ight to safety, especially short-term bonds, whose yields fell signifi cantly more than those of long bonds.

In the fi rst quarter of 2008, a new series of shocks emanating from the subprime crisis hit the municipal bond market head-on. Bond insurers had long been a part of the munici-pal bond market landscape. By guaranteeing timely interest and principal payments from a bond whose underlying credit rating may have been only A or BBB, they assured the bond’s higher AAA rating. For this insurance to have value, the investors counted on insurers remaining AAA rated. But insurers ran into problems when they expanded beyond the municipal bond market to subprime debt and that debt went sour. Suddenly the insurers were being downgraded—along with many of the bonds they’d insured (Display 3, following page).

Key Concepts

> Fallout from the subprime crisis caused signifi cant dislocations in the municipal bond market over the last year

> As risk entered the market, the shape of the yield curve changed dramatically—moving from fl at to normal

> Thanks to the high average credit quality of our portfolios’ holdings and their concentration around a four-year duration, our portfolios outperformed

> As the market shifted, we took advantage of opportunities to increase yield by adding high-yielding auction-rate securities and lower-rated but solid bonds


By March 2008, due to the subprime crisis and exacerbated by the downgrading of bond insurers, the difference in yield offered by high-quality investment-grade municipal bonds versus those of lower quality had widened sharply (Display 4).

Assessing Insured Bonds’ Risks

Insured bonds are structured assets with two parts—the insurance and the underlying credit of the issuer. In evaluating an insured bond for inclusion in a portfolio, Bernstein has always used our credit research to separately evaluate the insurer and the underlying bond.

In 2007, our analysis indicated that buying insured bonds whose underlying issuer was poorly rated didn’t offer enough of a yield benefi t versus those where the underlying issuer was highly rated, so we bought bonds of municipalities with solid underlying credit; insurance was not a material part of the instru-ment. As a result, the underlying credit rating of our insured holdings averaged a very high AA-/A+. When the bond-insurer storm hit, we knew that even if the insurance were completely stripped away, the value of our insured-bond holdings would not change materially. Thus, the downgrades did not signifi cantly affect our portfolios. We further insulated our portfolios from exposure to any single insurer by virtue of strict portfolio construction guidelines that assured our portfolios were well diversifi ed by bond insurer.

Where Risk Does Bring Reward

Unusual dislocations in the municipal bond market continued through the fi rst quarter of 2008, including problems in auction-rate securities, troubles with variable-rate demand notes, and margin calls on leveraged municipal portfolios. Again, navigating these develop-ments required intensive analysis, which uncovered some real opportunities.

Display 3

Bond insurers’ ratings have declined

Ratings of Bond Insurers*

Mar 07 Outlook Mar 08 Outlook

Ambac AAA stable AA negative

FGIC AAA stable BB negative

FSA AAA stable AAA stable

MBIA AAA stable AAA negative

XLCA AAA stable BB negative

*As of March 2007, all three rating agencies gave the same ratings. March 2008 data (as of March 31) refl ect the lowest rating assigned by one of the three rating agencies.Source: Fitch Ratings, Moody’s Investor Services, and Standard & Poor’s

Display 4

The subprime crisis caused municipal bond credit spreads to widen sharply

Yield Advantage of BBB Debt over AAA Debt

0.0

0.5

1.0

1.5%

06030097949188

From June 30, 2007, to March 31, 2008,spreads widened by 69 basis points

Through March 31, 2008; 10-year municipal securitiesSource: Municipal Market Data Corp.

SUMMER 2008 | 19

Consider the municipal auction-rate market. Historically, these securities have been viewed as near-cash equivalents with interest rates that reset at some predetermined frequency, usually seven, 28, or 35 days, when an auction is held. Investors in these securities place bids indicating how much they want to buy and the yield they require. Once all the bids are in, the auction agent fi lls the lowest-rate bids fi rst, then the next highest, and so on, until all the bids are fi lled. The rate at which the last bid is fi lled is called the clearing rate, and all the bidders receive that rate until the next auction. If there are insuffi cient bids for all the securities up for auction, the auction “fails” and the holders retain all the bonds at a maximum interest rate specifi ed in each bond’s indenture—the written agreement between a bond issuer and bond-holders—until the next auction. Each bond indenture is different, and the maximum rate is based either on a formula typically tied to some short-term index (which results in a relatively low maximum rate) or on a specifi c fi xed rate, which is usually quite high, 12% or 15%.

Capital-constrained investment banks aban-doned the municipal auction-rate market in mid-February of 2008, causing these auctions to fail at record levels. As a result, tax-exempt yields on these securities were as high as 15%. We carefully evaluated the underlying credit quality of each issuer and the terms of each issue’s auction, seeking to determine whether the yields were a function of true risk or of undue risk aversion.

Based on our analysis, we determined that those securities with high fi xed maximum rates were attractive, while those with formula-based rates were not. When many of the auction-rate securities we fi rst bought failed, they did so at very high rates, such as 15%. And, because

their rates could jump to 15%, these securities attracted new investors, signifi cantly reducing the risk of future failed auctions. Thus, we took advantage of the risk aversion of money market investors to add high-yielding auction-rate secu-rities to our portfolios.

A second opportunity was in bonds with lower credit quality. Having avoided the negative impact of the downgrades in bond quality on our portfolios, we worked to exploit the downgrades to our advantage. With spreads on investment-grade municipals having widened sharply since July 2007, signifi cant extra yield was available for going down in credit quality from AAA to BBB. Plus, the number of bonds being insured had fallen from 50% of new issuance over the last few years to only 25%—so the supply of lower-rated bonds on the market was greater. Many of these bonds were quite solid, and we took advantage of this singular opportunity to earn extra yield in our portfolios. A comparison of our buys in the fi rst quarter of 2008 versus 2007 shows a signifi cant increase—more than double—in bonds with credit ratings of less than AAA (Display 5).

Display 5

We found opportunities in downgraded bonds

Ratings Distributions of Buys

2007 Q1

A3%

BBB & Other6%

BBB & Other5%

2008 Q1

AAA72%

AA46%

AA19%

AAA33%

A16%



The Power of Active Bond Management

This period of extreme volatility in the usually earthbound municipal bond market provides a useful lens for examining how our research and the application of our long-term invest-ing paradigm work to protect and build client portfolios. In this fast-moving environment, returns on our intermediate-duration munici-pal bond portfolios were among the best in their peer groups for the one-year period ending March 31, 2008 (Display 6).

Bernstein commits substantial resources to active bond management: tracking the con-stantly shifting mix of risk and opportunity in the marketplace; assessing and monitoring the soundness of every bond we buy; and securing the best prices for the bonds we buy and sell. At the core of our operation is an established Bernstein strength: rigorous research. Our goal as active bond managers is to use research to identify values in the marketplace created by changes in price.

The advantages of active management are clear: It took only six months to move from one of the fl attest yield curves in history to one with a normal shape and for credit spreads to move from an all-time low to more attractive levels. Thus, our concentrated maturity struc-ture and high-credit-quality stance paid off. By optimizing our portfolios to avoid the pitfalls of this environment while taking advantage of its opportunities, we were able to create value for our clients. ■

Display 6

Our active management delivered in a turbulent time

One-Year Returns* Bernstein Municipals vs. Peer Groups†

4.31

1.95

4.46

Diversified California New York

0

1

2

3

4

5% 4.69%

2.60

Bernstein Lipper Average

2.83

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

SUMMER 2008 | 21

WHEN ASKED WHAT THE STOCK MARKET would do, J.P. Morgan famously asserted, “It will fl uctuate.” The same is true of tax rates, and, as with the markets, their fl uctuations can have a sizable impact on individual wealth.

Timing the Taxman

Throughout history, both the level of the capital gains tax rate and expected increases in rates have infl uenced investor behavior. Specifi cally, investors tend to defer more gains during periods of higher taxes and become more willing to harvest gains in low-rate regimes. Investors have also been tempted to realize embedded gains in anticipation of higher tax rates, refl ecting their desire to get a jump on any expected tax increases. For example, investors realized unusually large gains in the last quarter of 1986, in advance of a scheduled tax rate increase of eight percentage points (from 20% to 28%) on January 1, 1987, as a result of the Tax Reform Act of 1986 (Display 1).

The increase in capital gains rates in 1987 must have seemed like a locomotive coming down the line: Many investors simply leapt off the tracks to avoid it. Under current tax law, the long-term capital gains tax rate increases fi ve percentage

points, from 15% to 20%, in January 2011. But there’s widespread belief that the rate increase could be higher and that it could come as early as mid-2009, after the next president takes offi ce and a new Congress convenes. The question this raises is: Should investors acceler-ate their harvesting of embedded capital gains before higher rates become a reality?

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?


Display 1

Tax rates and gains realizations: A contrary relationship

Realized Capital Gains as Percent of GDP vs. Tax Rate on Long-Term Capital Gains

1960–2011*

Tax Reform Actof 1969

Tax Reform Actof 1986Capital Gains

Tax Rate

Cap

ital

Gai

ns

Tax

Rat

e

Cap

ital

Gai

ns

Rea

lizat

ion

s

Capital GainsRealized, % of GDP

0

1

2

3

4

5

6

7

8

2010200019901980197019600

5

10

15

20

25

30

35

40

45(%) (%)

*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.Source: Department of the Treasury—Offi ce of Tax Analysis and AllianceBernstein


A Taxing Matter: No Easy Answers

At fi rst blush, realizing taxable gains in the face of higher future tax rates may seem like the obvious thing to do. But trying to sidestep any presumed or even scheduled shift in tax rates before a comprehensive assessment of all the investment variables involved could prove both untimely and imprudent. After all, the benefi t of deferring taxes is well established—when we defer taking gains, money that would otherwise have gone to the government instead can continue to grow, leading to greater future wealth. And, of course, the investment objec-tive is to maximize the likelihood of better after-tax returns, not simply to minimize taxes.

To complicate matters further, there’s another important (and often overlooked) factor in examining the value of skirting any prospec-tive rate increase: the very real possibility that tax rates at the end of an investor’s expected holding period may be very different from the rate expected in the near term. In our 1986 example, rates fell a decade later by as much as they rose, and then dropped another fi ve per-centage points a few years after that. In fact, rates have varied considerably over the years: The maximum tax rate on long-term capital gains has ranged from a high of almost 40% in 1978 to the current, historic low of 15%.

Given that tax rates have fl uctuated and likely will continue to do so over the coming years, there may be real danger in focusing myopi-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 gains rates have, on occasion, been enforced retroactively, so that almost any strategy of anticipating a change may have an outcome other than the one expected.

Finally, if your expected holding period is forever (or at least until death parts you from your investment, assuming the law still allows a step-up in basis), the question whether to harvest or defer is moot—capital gains taxes are not an issue. But the situation is more com-plicated if you anticipate selling the position in the future, either as part of your natural turnover or to raise cash for a particular need. To help investors take a more clearheaded, objective view of this diffi cult and emotional topic, let’s explore the drivers that determine whether or not accelerating gains ahead of an anticipated tax increase makes sense.

To Harvest Early or Defer Gains: A Framework

At the most basic level, the decision to tax-trade ahead of an expected increase in rates hinges on the interplay of two key variables: the inves-tor’s expected horizon, or holding period before liquidating the portfolio, and the expected increase in tax rates (Display 2).1 Generally speaking, the shorter the investment horizon, the more valuable it is to harvest gains in the lower-rate regime—the benefi ts of deferral are offset by larger future taxes paid under the higher-rate regime. And, of course, the higher the future tax rate, the more incentive there is to capitalize on the current lower rate.

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.

Display 2

Harvest or defer? The decision hinges on two key factors

Defer Harvest Early

Longer

Lower

Shorter

Higher

Investment Horizon

Future Tax Rate


SUMMER 2008 | 23

To bring this framework to life and illus-trate the trade-offs at a very simplistic level, imagine an investor, Earl E. Gaines, who has a $1 million portfolio of diversifi ed equities with a cost basis of $500,000. Let’s say he plans on selling the portfolio a year from now, and expects it to earn 8% during that period. Convinced that rates will increase in the fol-lowing year from 15% to 20%, Earl wants to look at two scenarios. In the fi rst, he sells his entire portfolio now, pays taxes at the current 15% capital gains rate, reinvests the proceeds in an identical equity portfolio, and then cashes that out a year hence, paying tax again, but now at the prevailing 20% long-term capital gains rate. In the second scenario, Earl simply holds on to his current portfolio and liquidates the entirety a year later, paying all of the capital gains taxes once, at the going 20% rate. Display 3 shows how the two portfolios fare over that period, the capital gains taxes they incurred, and their fi nal wealth values.

The “deferral” strategy shows higher pretax growth (ending at $1,080,000), as the original sum, undiminished by any up-front tax hit, continues to compound for an additional year. But it also has the highest tax bill: The larger total gain (of $580,000) was all taxed at the higher 20% rate. The “harvest” strategy saves on taxes, but reinvests less princi-pal: It ends the year with a pretax value of $999,000. However, the initial embedded gain (of $500,000) was taxed at the lower 15% rate, while only the following year’s gain (of $74,000) was taxed at the higher 20% rate, for a combined capital gains tax of 16%. In this case, harvesting early (at the end of one year) provides an advantage of about 2% in overall wealth versus the deferral scenario.

Key Concepts

> Shifting capital gains tax rates have infl uenced investor behavior in the past

> Capital gains taxes are scheduled to rise from 15% to 20% in 2011, but many think that the increase could be even greater, and come sooner

> For holders of diversifi ed equity portfolios, an increase in rates to 20% would not present a particularly strong case to actively tax-trade ahead of the policy change; but an increase in rates to 28% may suggest a clearer rationale to take action

> For investors holding concentrated stock positions, any rise in capital gains rates increases the appeal of harvesting embedded gains in a lower-rate regime and diversifying the proceeds into a lower-risk portfolio

Display 3

The harvest or defer trade-off: Greater growth or lower taxes?

Harvest Strategy Deferral Strategy

Initial Value $1 Mil. $1 Mil.

Cost Basis $500,000 $500,000

Tax Rate 15% N/A

Tax on Gain $75,000

Proceeds $925,000

Tax Rate Next Year 20% 20%

Value Next Year $999,000 $1.08 Mil.

Gain Next Year $74,000 $80,000

Tax on Next Year’s Gain $14,800 $116,000*

Combined Tax Rate 16% 20%

Total Taxes $89,800 $116,000

Liquidation Proceeds $984,200 $964,000

Advantage 2.1%

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


Looking for Breakeven

But our example extends out only one year. What if Earl had a longer investment horizon, as most investors typically do? A more practi-cal way of framing the decision, therefore, is to examine what we call the “break-even” horizon, the expected holding period that would result in the same wealth outcome whether one defers the tax hit for some time or realizes gains, pays tax at today’s rate, and then reinvests the proceeds before realizing a gain at the end of the investment horizon.

Display 4 shows the break-even horizon for the same portfolio calculated with two differ-ent future tax scenarios in mind: a moderate increase in the capital gains tax rate from 15% to 20% in one analysis, and a more aggressive move from 15% to 28% in the other. The area below the zero line indicates those outcomes where the deferral strategy is optimal; above the line the harvest strategy wins out. You can see that at a 20% future capital gains rate, the advantage of harvesting versus deferring over a one-year horizon is Earl’s 2%, as detailed in the example above. But that modest advan-tage declines over time and turns negative at about year seven, as the benefi ts of tax deferral win out.

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 increase in wealth over this horizon is less than 1%. For investors with longer holding periods, deferring appears to make sense.

However, when we look at a potential increase in rates from 15% to 28%, the story changes dramatically: Here the benefi t of harvesting

early is more than 6% at year one, and while that advantage too declines over time, there is no liquidation horizon within which the port-folio’s growth can overcome the drag of the higher future tax.2

From the Possible to the Probable

But the analysis is still too simplistic, as we’ve considered only a scenario in which the future return was assured. We haven’t yet taken account of the uncertainty surrounding the level and path of future returns, and the success of early harvesting depends critically on the return environment over the course of

Display 4

Time and taxes: Break-even time horizons for different rate scenarios

Sell and Repurchase Strategy Results in Higher Average Wealth

Hold Strategy Results in Higher Average Wealth

Median Increase in Post-Liquidation WealthSell vs. Hold (%)

(1)

(2)

0

1

2

3

4

5

6

7%

15131197531

28% Future Tax Rate

20% Future Tax Rate

Break-Even Liquidation Horizon

Liquidation Horizon (Yrs.)

28% Rate 20% Rate

The initial position is a $1 million diversifi ed equity portfolio (35% US value/35% US growth/25% developed international/5% emerging 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 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 assumes future capital losses are used to offset outside gains. See Notes on Wealth Forecasting Analysis, page 34.Source: AllianceBernstein

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.

SUMMER 2008 | 25

the holding period. If future markets are better than average, then tax deferral has higher value. Should future markets be disappointing, then harvesting early becomes more attractive.

Of course, we cannot divine the future. But to help our clients make thoughtful decisions based on a realistic assessment of potential future outcomes, we’ve developed a quan-titative capital markets model. Our Wealth Forecasting System3 takes the known facts—our clients’ assets, income needs, risk toler-ance, tax brackets, and time horizon—and runs various investment scenarios through our model to project 10,000 possible return paths. With it, we can analyze the impact of changes in tax rates across the spectrum of possible future capital market outcomes, thus helping clients make informed decisions regarding the probability that accelerating gains realizations will result in greater wealth.

In Display 5 you can see that should the capital gains rate stay constant at 15%, accel-erating gains will typically be a poor decision, although there still would be scenarios—that is, when markets are particularly hostile—in which the client is better off. But if rates increase to 20%, the appeal of harvesting embedded gains early rises, and the likelihood of being better off remains above 50% for investors with a horizon of up to seven years (our break-even holding period).

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 that realizing gains early is in his best interest, he will not want to take action if rates rise to 20% (given there is only a 60% probability of success). However, the same investor can be very comfortable he is making the right decision if rates are scheduled to rise to 28%, in which case the probability of success is high

across all investment horizons, and the mag-nitude of success, in terms of greater after-tax wealth, is higher too.

But considering the inherent uncertainty as to what tax rates will be at the end of the pro-spective holding period (itself not known with certainty), as well as whether tax rates will in fact be higher next year (who knows what Congress will approve?), one should be cautious when contemplating harvesting gains as part of a strategy of “front-running” the rate increase.

The Perils of the Concentrated Position

There is one situation, however, in which a prospective shift in capital gains tax rates has powerful relevance to the “harvest or defer” decision: concentrated positions of low-cost-basis stock. In this case, in addition to taking advan-tage of a lower tax rate on your sale, you also reinvest the proceeds in a lower-risk portfolio.

3 See Notes on Wealth Forecasting Analysis, page 34.

Display 5

Gauging the likelihood of a successful early harvest

Probability That Harvesting Early Delivers Higher Post-Liquidation Wealth (%)


0

25

50

75

100%

151413121110987654321

28% Tax Rate 20% Tax Rate 15% Tax Rate

The initial position is a $1 million diversifi ed equity portfolio (35% US value/35% US growth/25% developed international/5% emerging 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 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 assumes future capital losses are used to offset outside gains. See Notes on Wealth Forecasting Analysis, page 34.Source: AllianceBernstein


While the allure of building massive wealth by concentrating your portfolio in one or several holdings is great, the likelihood of achieving returns superior to the markets’ is low, and the volatility one can expect to encounter is high. This higher volatility has a real cost. Our research has shown that historically, a typical single stock has compounded at a growth rate almost three percentage points below that of the S&P 500. And for single stocks with the highest volatility, the results were even worse, compounding at a rate of only half that of the market.4 In fact, if we look at a similar liqui-dation analysis but without any change in tax rates, simply exchanging a single stock position for a diversifi ed portfolio of global equities, the median wealth outcome is superior over every time period (Display 6).

When we add the future capital gains rate increases into the mix, the “harvest or defer” decision is easier: In all of our prospective tax regimes (a static 15% rate, as well as increases to 20% and 28%), the benefi ts of harvesting and diversifying the concentrated position, in the median case, appear signifi cant: With an increase in rates to 28%, the magnitude of the benefi t of harvesting early amounts to about 18% in the fi rst year (Display 7). And, unlike a diversifi ed portfolio, for which the advantage of front-running the tax increase declines over time, with a single stock portfolio the advan-tage of selling and diversifying never sets on this particular horizon, rising to over 30% in year 15.

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

Display 6

Exchanging a single stock for a diversifi ed portfolio

0

5

10

15

20

25%

Median Wealth AdvantageDiversified Stock Portfolio vs. Single Stock (%)

Liquidation Horizon (Yrs.)151413121110987654321

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-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 35% US value/35% US growth/25% developed international/5% emerg-ing markets, and the portfolio’s results refl ect post-liquidation proceeds and 15.25% annual gains realizations; the analysis assumes future capital losses are used to offset outside gains. See Notes on Wealth Forecasting Analysis, page 34.Source: AllianceBernstein

Display 7

A magnitude of difference: Harvesting a single stock versus diversifi ed portfolios

0

10

20

30%

151413121110987654321

Median Increase in Post-Liquidation WealthSell vs. Hold (%)


28% Tax Rate 20% Tax Rate 15% Tax Rate


SUMMER 2008 | 27

But once again, looking only at scenarios in which the future returns are known with certainty is not enough. We must consider the full spectrum of portfolio outcomes to judge the likelihood of any strategy’s success. When harvesting gains and diversifying the single stock position, we found that the prob-ability of success remains above 50% across the entire 15-year time frame of our analysis, and does so in both of our prospective rate regimes (Display 8). Yet even here, of course, the questions of how much to sell—and how quickly—are matters that must be tailored to each investor’s risk tolerance, spending needs, and overall fi nancial profi le.

Decision Time?

The moral of the story: Tax rates change over time—and they change often and fairly unpre-dictably. For investors whose expected holding period is not forever, it’s a diffi cult decision whether to forgo tax deferral in favor of locking in today’s low tax rate. For holders of sub-stantial single stock positions, the appeal of harvesting gains on those stocks now and diver-sifying their portfolio is high, in terms of both the magnitude and the probability of success, regardless of the level of any future tax rate. But for investors who already hold diversifi ed port-folios, the decision is less clear: It will depend both on the investor’s time horizon and the size of the anticipated change in tax rates. At a future capital gains rate of 20%, the magnitude of the benefi t from harvesting early is modest, and the probability of success declines quickly

with time. But in the event that a 28% rate looms, there is a higher probability of success in accelerating gains, and a superior average wealth outcome, and this may bias some toward taking preemptive action.

Regardless of the future tax regime, our Wealth Forecasting System can help clients quantify the likelihood and magnitude of success of different investment strategies so that they can make the most informed decision. ■

Display 8

Positively probable: Tax-trading out of a single stock

Probability That a Diversified Portfolio Will Deliver Higher Post-Liquidation Wealth (%)


0

20

40

60

80%

151413121110987654321

28% Tax Rate 20% Tax Rate



OVER THE PAST DECADE, CHINA’S

rapid industrialization has had a profound impact on world trade. In its drive to supply the world, China has helped push down the price of fi nished goods, while its enormous appetite for raw materials has helped push up and sustain the prices of energy and com-modities. This double threat—economists call it “downstream defl ation” combined with “upstream infl ation”—has squeezed the operating margins of foreign manufacturers, forcing many of them to either relocate or out-source production to China in order to remain competitive. It has also helped build profi ts for corporations and others that have invested in China. Will the next 10 years be anything like the past 10 years? Is China likely to continue its current economic strategy?

When It Started: Deng Xiaoping’s Economic Reforms

When Deng Xiaoping launched China’s Open Door Policy in 1979, his aim was simple: to raise China’s standard of living in the after-math of the Cultural Revolution by making the economy more attractive to foreign inves-tors. Deng probably never dreamt that in little more than two decades it would help make his country the factory to the world.

Foreign companies saw Deng’s economic reforms as an opportunity to profi t from a consumer market that was not only totally

new to them, but also huge—China’s popula-tion crossed the one billion threshold during the 1980s—and growing fast. China appeared to be an El Dorado, a golden opportunity for massively expanding their global sales. According to popular lore, shoe manufacturers aimed to sell an additional two billion shoes simply by selling one pair to each person in China.

In reality, the policy played out very differ-ently from what anyone had anticipated. While Deng’s reforms opened the economy to foreign capital, they also liberated China’s homegrown capitalist talent. Chinese-made home appli-ances and other electronic products—likely to be followed in the not-too-distant future by Chinese cars—are building market share not only in the developed world but, increas-ingly, in developing markets as well. And today China’s textile and garment exports are the targets of a protectionist backlash within the US and European markets.

Statistics illustrate the scale of China’s impact. In 1997, Chinese fi nished-goods exports averaged about US$10 billion a month. In 2007, the fi gure was close to US$80 billion—an eightfold increase. Imports of raw materials have grown nearly sevenfold during the same period, from US$3 billion a month to US$20 billion (Display 1).

China: The Impact of Domestic Policy on the

Future of Global Trade

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.

SUMMER 2008 | 29

High Consumption, Low Prices

For everyone—from the consumers and com-modity producers benefi ting from China’s emergence to the foreign manufacturing fi rms without access to its production base—the critical question is: How sustainable is China’s business model? In our view, China’s economic fundamentals are such that, in the absence of external pressure to change, its current business model will be maintained.

China’s model, in essence, consists of high energy and commodity consumption and low-priced goods. For example, today the country consumes about 25% of global commodi-ties (such as steel, copper, and iron ore), but accounts for only about 6% of global nominal GDP, as shown in Display 2, following page. In the absence of exogenous shocks, there appear to be few incentives for China to consume energy and commodities more effi ciently and increase production value-added more quickly. If China continues on this path, its impact on the world economy could become even more dramatic over the next 10 to 20 years.

Indeed, China has powerful incentives to maintain its current model, as we shall see. The main risk, in our view, is a potential economic backlash that could even escalate to a trade war between China and major Western economies.

The Long March to Urbanization

After thousands of years as a predominantly agrarian society, China is rapidly becoming more urbanized. The combination of low agrarian wages and the lure of better-paying jobs in the cities is causing a massive redistri-bution of China’s population of 1.3 billion. From 1996 to 2006, 122 million rural inhabitants—an average of 11 million a year—moved to the cities. Indeed, no other country in history has witnessed migration from the country to the city on such a scale.

But the rural population still accounts for 55% of the total—a far higher proportion than in such neighboring countries as South Korea, Taiwan, and Japan, where less than 10% live on the land. This relative imbalance is unlikely to change soon: Even if the country’s rural exodus were to accelerate to 15 million a year, 40% of the people would remain on the land in 2020 (Display 3, following page).

The urban migration has led to great income disparities between farm and city families. The average household income in the indus-trialized east is three times that of the more rural west—and the gap is widening, further

Display 1

Exports of fi nished goods and imports of commodities have risen together

0

20

40

60

80

95 96 97 98 99 00 01 02 03 04 05 06 07 08

(US$

Bill

ion

s)

Finished-GoodsExports

Raw-MaterialsImports

China’s Foreign Trade: 1995–2007

Source: CEIC Data and AllianceBernstein

Key Concepts

> China is experiencing a massive population migration from rural areas to urban centers with higher-paying jobs

> China will continue to push down the prices of fi nished goods while sustaining the high prices of energy and commodities

> Despite the threat of a protectionist backlash from the rest of the world, China is likely to continue to expand its industrial capacity

> We expect the decline in world prices and manufacturers’ operating margins to persist for another decade at least


encouraging the urban migration. China’s leaders must create enough jobs in urban areas to absorb this continuing infl ux—or risk social and political instability. In the next 10 years, in fact, China needs to create 69 million new jobs just to support its working-age population. Therefore, China must—and will—expand its industrial capacity rapidly at all costs.

China Lags the World in Energy Efficiency

China’s expansion will doubtless keep its appetite for energy and commodities enormous. Its energy consumption has accelerated sharply, with its share of world consumption jumping to about 15.5%, far higher than Japan’s and close to that of the European Union (Display 4). Unfortunately, China isn’t using the energy it consumes very effi ciently. Although the country made solid energy-effi ciency improvements

Display 3

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

Net Change in Rural Population

(15)

(10)

(5)

0

5

10

15

79 82 85 88 91 94 97 00 03 06

Mill

ion

Per

son

s

Share of Total Population

50 55 60 65 70 75 80 85 90 95 00 05 10 15 20

Rural Population

Open Door Policy

Urban Population

0

10

20

30

40

50

60

70

80

% S

har

e

90

100

Source: CEIC Data and AllianceBernstein

Display 2

China consumes roughly one-fourth of global commodities… …yet produces only 6% of global GDP

Share of World Nominal GDP

3.8%

2000

4.2%

2001

4.4%

2002

4.5%

2003

4.7%

2004

5.1%

2005

5.5%

2006

5.9%

2007F

Share of Global Consumption

Aluminum Copper Zinc IronOre

CrudeSteel

Nickel StainlessSteel

2001 2004 2006E

0

510

15

20

25

30

35

40%

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

SUMMER 2008 | 31

during the 1990s, the investment boom has eroded them. According to our estimates, China brought up the rear in terms of world energy effi ciency in 2006, being 3.5 times less effi cient than the US. Even if it managed to improve effi ciency dramatically, it would still rank near the bottom.

Corporate Strategy: Expansion, Not Profit, Is the Key

The sharp increase in investment and indus-trial growth in China highlights the country’s unique perspective on corporate profi tability: Growing the business and increasing market share are the highest priorities; profi ts come second. This stands in marked contrast to a market economy, where fi scal prudence eventually dictates that business lending to companies with low profi ts be scaled back. However, China’s business model is unlikely to change for one simple reason: Its future under that model is promising. China’s potential for industrial development is enormous. In fact, the recent surge in wages and land prices in a few highly developed eastern regions is sending just the right market signals to Chinese fac-tories: to maintain their competitive edge by starting to relocate to lower-cost regions, where the labor supply is abundant and the vast rural countryside underdeveloped.

Why Banks Won’t Pull the Plug

Thus far, China’s government-controlled banks have supported the expansion of low-profi t companies, with no apparent attempt to scale back expansion in favor of profi ts. Beyond a certain threshold, of course, this low-margin bubble may burst. But a fully market-oriented banking system has yet to be developed in China, and Chinese state banks—which account for about 70% of banking system assets—remain heavily infl uenced by govern-ment directives.

If the bank loan market were to run into trouble, China’s leadership would face a tough choice between righting banks’ balance sheets and preserving or creating jobs. On the whole, we think that job creation and social stability would take precedence and that any shortfall on banks’ balance sheets would be remedied by an injection of public funds. The pressure to create 69 million new jobs in the next 10 years will remain intense, and the incentive to reduce production capacity in labor-intensive indus-tries will be small.

Policy Choices and the Protectionist Backlash

The main threat to China’s ability to maintain its high-growth, low-margin business model is the potential for a protectionist backlash by other countries. The US and other Organisation for Economic Co-operation and Development countries have seen their jobs and manufacturing plants move to China—and they’ve seen their domestic markets fl ooded with cheaper-priced Chinese goods. As China’s industrial revolution continues, this situation will likely become more pronounced. If China maintains its current policy, it risks a trade war, a deceleration of the globalization process, and a decline in world trade, all of which could pose a serious threat to China’s export-led economy.

Display 4

China consumes almost as much energy as the European Union

0

5

10

15

20

25

30%

06030097949188858279

Percent Share of World Consumption

US

European Union

Japan

China

Source: BP Statistical Review of World Energy 2006, CEIC Data, and AllianceBernstein


To confront this threat, China could decide to bow to external pressure and “revalue” its currency—the renminbi—more quickly, strengthening it versus other currencies. In theory, if this were to happen rapidly, it would increase China’s purchasing power overseas, thereby encouraging domestic consumption, decreasing a massive balance-of-trade surplus, and boosting GDP. A stronger currency would also encourage Chinese manufacturers to start focusing on producing higher-quality, high-end goods, and would help enlarge its growing services sector.

Obstacles to Revaluation

Although speeding up the pace of currency revaluation and turning itself into a consump-tion-driven economy makes sense for China in theory, a number of huge obstacles remain—making this course of action unlikely. While China’s nominal GDP (estimated at US$3.3 trillion in 2007 prices) ranks among the world’s highest, the country’s per capita GDP remains among the lowest—about US$2,500 at current prices. This is 17 times lower than the per capita GDP of the US, 14 times lower than that of Germany and Japan, and six to seven times lower than that of South Korea and Taiwan. Even if a currency revaluation made the renminbi twice as valuable in relation to the US dollar, the Chinese consumer’s purchasing power would still remain small. Further, not only are the Chinese low wage earners, they are low spenders. China’s con-sumption-to-GDP ratio, which was about 36% in 2006, is low by international standards.

Low income and high savings are seen in few other countries, and the fact that they coincide in China helps explain the country’s low consumption-to-GDP ratio. In industrialized countries such as the US, Germany, France, and Japan, as well as in certain advanced Asian economies like Hong Kong, South

Korea, and Taiwan, the correlation between per capita GDP and consumption to GDP tends to be high and positive—that is, the more people earn, the more they tend to spend (Display 5, top). The correlation between consumption-to-GDP ratios and savings rates tends to be inverse—that is, the more people spend, the less they tend to save (Display 5, bottom). The high consumption-to-GDP ratio (70%) in the US, for example, is the result not only of its superior income per capita, but also its extremely low savings rate (about 13.5%).

Display 5

China’s consumption is constrained by its low per capita income…

0

10,000

20,000

30,000

40,000

50,000

35 40 45 50 55 60 65 70 75

China

Singapore

Consumption-to-GDP Ratios (%)

Thailand

US

UK

GermanyJapan

France

Hong Kong

Taiwan

South Korea

Philippines

IndiaIndonesia

Vietnam

Per

Cap

ita

GD

P U

S$

Malaysia

Per Capita GDP vs. Consumption/GDP Ratio2006

…and exceptionally high savings rate

10

15

20

25

30

35

40

45

50

55

35 40 45 50 55 60 65 70 75

China

Singapore

Malaysia

Hong Kong

France

Japan

VietnamIndia

Indonesia

Philippines

USUK

Taiwan

Germany

Consumption-to-GDP Ratios (%)

Gro

ss D

om

esti

c Sa

vin

gs

Rat

es (

% o

f G

DP)

Gross Savings Rates vs. Consumption/GDP Ratio2006

Thailand

South Korea

Source: Asian Development Bank, CEIC Data, IMF, and AllianceBernstein

SUMMER 2008 | 33

In order to boost consumption, China needs to both lower the savings rate and boost income. The real challenge will be to lower the savings rate while accepting the harsh reality that raising the income-per-capita levels of China’s huge population will take several years.

A stronger Chinese currency would also make China’s goods more expensive in foreign markets, which would pose a huge threat to the country’s low-profi t manufacturing businesses. While the price of the energy and commodities that these businesses import from abroad would drop, that would not be enough to make up the difference. On balance, we think it unlikely that China will opt for aggressive revaluation of the renminbi. Instead, we expect it to continue to pursue its high energy/consumption, low-margin business development model, even at the risk of retaliatory action from other countries.

Our Outlook: China Will Continue to Push Down Prices

China’s role as factory to the world is unlikely to diminish—in fact, it will become more pro-nounced as the country’s economy develops, and its far-reaching effects on the world economy will become more entrenched. China will continue to push up energy prices—and push down prices across a wider range of manufactured goods. As a result of the model’s success, however, a number of developments will arise. For example, the push now being seen across the industrial base toward the manufacture of higher-margin goods is likely to raise China’s per capita income, helping

to create a consumer class large enough for multinationals to seek to target. This would be an important driver for the expansion of the services sector, although such growth would probably be concentrated in the major cities, not evenly distributed nationwide.

The development of the country’s interior will increase. Some domestic Chinese companies are already leading the production shift inland, and a small but growing number of foreign fi rms are following them. In our view, China’s industrial sector will become more diverse as a result: The developing hinterland will become the focus of the country’s low-margin, volume-oriented manufacturing base, allowing production capabilities in the industrialized east—where skilled labor and quality infra-structure and logistics are readily available—to be upgraded.

The transformation will resemble that of Japan and Southeast Asia during the 1980s. It will also have similar consequences. For example, whereas China’s growth as a global production center over the past two decades has been achieved entirely through borrowed technology, the emergence of higher-margin businesses will serve as a catalyst for research and development as well as for original product design, and the quality and sophisti-cation of the goods it exports will rise. China is ramping up its production capacity, and we expect the decline in world prices and manu-facturers’ operating margins will persist for another decade at least. ■


Notes on Wealth Forecasting Analysis

The Bernstein Wealth Forecasting AnalysisSM (WFA) is designed to assist investors in making a range of key decisions, including setting their long-term allocation of fi nancial assets. The WFA consists of a four-step process: (1) Client Profi le Input: the client’s asset allocation, income, expenses, cash withdrawals, tax rate, risk-tolerance goals, and other factors; (2) Client Scenarios: in effect, questions the client would like our guidance on, which may touch on issues such as which vehicles are best for intergenera-tional and philanthropic giving, what his/her cash-fl ow stream is likely to be, whether his/her portfolio can beat infl ation long-term, when to retire, and how different asset allocations might impact his/her long-term security; (3) The Capital Markets Engine: our proprietary model, which uses our research and historical data to create a vast range of market returns, taking into account the linkages within and among the capital markets (not Bernstein portfolios), as well as their unpredictability; and (4) A Probability Distribution of Outcomes: based on the assets invested pursuant to the stated asset allocation, 90% of the estimated returns and asset values the client could expect to experience, represented within a range established by the 5th and 95th percentiles of probability. However, outcomes outside this range are expected to occur 10% of the time; thus, the range does not establish the boundar-ies for all outcomes. Further, we often focus on the 10th, 50th, and 90th percentiles to represent the upside, median, and downside cases. Asset-class projections used in this publication are derived from the following: US value stocks

are represented by the S&P/Barra Value Index, with an assumed 20-year compounding rate of 8.2%, based on simulations with capital market conditions as of December 31, 2007; US growth stocks by the S&P/Barra Growth Index (compounding rate of 8.1%); developed international stocks by the Morgan Stanley Capital International (MSCI) EAFE Index of major markets in Europe, Australasia, and the Far East, with countries weighted by market capitaliza-tion and currency positions unhedged (compounding rate of 8.0%); emerging markets stocks by the MSCI Emerging Markets Index (compounding rate of 6.6%); taxable bonds by diversifi ed securities with seven-year maturi-ties (compounding rate of 5.4%); real estate investment trusts (REITs) by the NAREIT Index (compounding rate of 5.3%); a single stock with a beta of 1.0, volatility of 30%, and a dividend yield of 0% (compounding rate of 5.3%); and infl ation by the Consumer Price Index (com-pounding rate of 2.5%). Expected market returns on bonds are derived taking into account yield and other criteria. An important assumption is that stocks will, over time, outperform long-term bonds by a reasonable amount, although this is by no means a certainty. Moreover, actual future results may not be consonant with Bernstein’s esti-mates of the range of market returns, as these returns are subject to a variety of economic, market, and other vari-ables. Accordingly, this analysis should not be construed as a promise of actual future results, the actual range of future results, or the actual probability that these results will be realized.


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’ interests fi rst and foremost

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.

Research ExcellenceWe believe that superior research is the ultimate source of superior investment returns and requires both knowing more and using knowledge better. Knowing more—having an information advantage over other market participants—requires doing deep fundamental and economic research on a truly global scale. Using knowledge better means identifying and exploiting pricing anomalies that can provide incremental return and employing portfolio-construction techniques to manage risk and return efficiently.

With those goals in mind, we’ve built one of the largest and broadest research footprints in the business: more than 300 analysts operating in 12 countries and covering thousands of securities in capital markets around the world. Our research effort is organized into separate groups dedicated to growth equities, value equities, and fixed income, reflecting the unique needs of each investment approach.

Disciplined Investment ProcessesWe leverage our research with systematic portfolio management. Because our top investment management professionals determine the policies and make the decisions that underlie all our investment strategies, each client, regardless of account size, gets the very best our firm has to offer. These strategies and decisions are then further customized in relation to each account’s tax status and the client’s goals and circumstances.

Broad Array of ServicesWe offer value, growth, and style-blended stock port-folios across the global markets, real estate investment trusts, hedge funds, and taxable and tax-exempt fixed income portfolios—all actively managed.

Wealth Management Planning Because we recognize that private clients of very substantial means have complex needs, we’ve created a team of people with expertise in a wide range of disciplines to counsel clients on sophisticated financial planning. Our wealth management professionals have experience in areas such as estate planning, intergen-erational wealth transfer, philanthropy, alternative asset classes, liquidity events, and investment strategies for corporate executives. Working together with our clients’ other professional advisors and aided by a quantitative state-of-the-art wealth forecasting tool, we stress-test multiple solutions to complex investment problems to help clients identify the strategies best suited to them financially and emotionally.

Client Service and CommunicationsWe recognize that client needs are varied. Our invest-ment professionals seek to provide clients with the investment approach that is best for them, and they pride themselves on personalized and timely service. Further, our content-rich communications explain the research basis for our portfolio decisions, our analysis of recent market developments, and our market outlook, as well as other research findings.

*As of June 30, 2008

BER–5293–0708 www.bernstein.com


volume vi no 1 summer 2008 · japan nikkei index 38,915 (1989) 14,309 (1992) (63) 45 biotech amex...

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