The Stampede to Safety

A Tragedy of the Commons

By Gerry Paul Chief Investment Officer, US Value Equities

In This Paper Our research found that much of the recent rise in market volatility was actually coming from the very strategies used to manage itbecause they amplify market behavior and reduce the benefits of diversification. These forces will shift with changing perceptions of risk. But they are probably here to stay, suggesting that market volatility is likely to continue swinging between extreme highs and lows in the future. We discuss the implications of these new market dynamics and the various paths investors can take in response.

The Stampede to Safety

If it feels as though the world is more volatile today, thats because it is. Price swings in global stock markets have grown increasingly violent since the crash of October 1987, reaching new highs in the aftermath of the 2008 collapse (Display). Indeed, as the market has lurched with greater frequency from periods of unprecedented placidity to periods of unprecedented upheaval, the volatility of volatility itself has soared.

Surprisingly, at the heart of the markets recent manic behavior is investors heightened intolerance for risk and their collective actions to escape it. Surely, much of this risk aversion is in reaction to the global financial crisis and lingering economic uncertainties, which have challenged almost everyones perspective of risk. Anxiety triggered by bad experiences is typically cyclical and should fade once good times return. Other causes are more structural in nature and, hence, are likely

to be longer lasting. 1

The Pension Protection Act of 2006, for example, changed US pension accounting rules, essentially reducing the ability to smooth asset returns and making funding requirements much more sensitive to the current market values of pension assets.

Chief executives hate to be surprised by capital calls for their pension plans, so managing the year-to-year gap between pension assets and liabilities has taken on more importanceand so have capital preservation and return predictability. Another recent structural change was the 2005 implementation of C3 Phase II, a set of regulatory standards that significantly raised capital requirements on unhedged variable annuities portfolios, making those products less profitable. In response, the $1 trillion US variable annuity business has significantly increased the hedging of its portfolios, principally through the use of long-dated put options. Again, safety of returns became paramount. More recently, the newly proposed Basel III Accord for international bank capital adequacy and risk-weighting of assets will most certainly curb demand for risky assets among financial institutions.

As risk tolerance was waning, the financial-services industry was diligently crafting new financial tools and technologies, many of which, as it turned out, have made it easier and less costly for investors to express these new risk preferences. Most notably, over the past decade, weve seen the rapid proliferation of index-based futures, exchange-traded funds (ETFs) and program trading (particularly high-frequency trading).

Investor distaste for risk has become so strong that it has eclipsed even the desire to make money. A recent survey of pension officers in the US, Canada, the Netherlands and the UKwhich account for the lions share of global pension assets and have recently undergone significant pension regulatory changesshows just how risk-sensitive institutional investors have become. In 2007, 28% of respondents said that their top priority was the absolute return of the plan, while 23% said 2

that the funding level of the planthat is, the relationship between the size of the liability and the assetswas their primary focus. By 2009, however, a mere 15% of respondents said that absolute returns were the top priority, while 42% identified funding status as their chief concern (Display 2).

This survey reflects recent changes in attitudes about risk, but the exodus from risk has been going on for some time. Equity allocations, the most volatile component of plan portfolios, have borne the brunt of this transformation. The outflows have been massive. In the US, for instance, corporate plans have been liquidating their equity accounts since late 2003, with net outflows reaching an equivalent of nearly 8% of total plan assets in 2009 (Display 3). State and local planswhich have less onerous funding regulations and are more underfundedhave done the same, though to a far lesser extent. Were seeing similar shifts among plans in other countries.

The Cost of Playing It Safe

3

All this would be understandable, except for one basic fact: risk generally has a traveling companionreturn. While institutions have been plowing money into fixed-income instruments at rock-bottom yields and siphoning funds from stocks offering greater (yet more volatile) return potential, they have not tempered their long-term return expectations. The gap between yields on low-risk bonds and long-term return assumptions remains very wide worldwideabout five percentage points in the US and four percentage points in the UK and Canada (Display 4). This puts institutional investors in a quandary: they want to play it safe, but they also know that doing so wont get them where they need to go.

To fill the gap, plans have been flocking to alternatives strategies, including hedge funds and less liquid private equity, direct real estate and venture capital funds. The category represented about 11% of overall institutional assets under management (AUM) in 2009, but received more than one-third of all newly invested dollars in the first half of 2010 (Display 5). Actively managed equities lost. They made up about 35% of institutional AUM but just over 20% of incremental dollars placed (Display 5).

The allure of hedge funds, in particular, stems from their promise to deliver equity-like returns with much lower volatilityand, 4

in many cases, to preserve capital in down markets. To be fair, hedge funds encompass a wide variety of strategies, some of which have considerable market exposure. But the vast majority offer lower volatility.

Hedge funds tend to invest in volatile asset classes, such as equities and commodities, but remove some of the risk via offsetting trades or trading algorithms designed to limit vola-tility. In the alchemy of hedge funds, managers transform base metals (volatile assets) into gold (high-returning, low-volatility assets). In essence, they create synthetic low volatility assets.

You Can Run

Practitioners achieve this alchemy in a variety of ways. Though there are thousands of hedge funds, each following its own unique approach, almost all of them use one or both of two broad strategies for eliminating unwanted volatility from portfolios: Sell it to someone else. In other words, hedge it. Hedge fund managers identify characteristics of an investment they like and those they dislike, usually based on some proprietary insight; they then take additional positions that offset or hedge the undesirable characteristics while keeping (or amplifying with leverage) the desired exposures. Outrun it. Hedge funds can also sell the asset when it looks as if it is becoming excessively riskythat is, unusually volatile or unpredictablebefore the rest of the market catches on. Staying one step ahead of the crowd requires keeping a close watch on the direction of prices over short time horizonsessentially using measures of price momentumto detect subtle shifts in behavior.

but You Cannot Hide

But neither of these approaches neutralizes the unwanted risk in a systemic way; they merely shift it to other market participants. In the process, these strategies actually end up adding to the risks they were meant to eliminate. Thus, the mass desire to control volatility without sacrificing returns becomes self-defeating.

To fully grasp how this happens, we must first understand the forces that drive market risk. Asset-class risk comes from two simple factors: 1) volatility, or variability of price movements of all the individual securities that make up the asset class; and 2) correlation, or the degree to which individual securities within the asset class track each other. All else being equal, increases in the volatility of individual securities will raise the volatility of the asset class as a whole. Higher correlation among individual securities will increase the volatility of the asset class by reducing the beneficial effects of diversification. As the chief enabling tools for reducing market risk, these two strategieshedging and price momentumare fueling 5

self-reinforcing feedback loops that are amplifying stock-price volatility and correlation and, hence, overall market risk.

Hedging Feedback Loops

Lets first look at the impact of hedging on market behavior. One of the first things to know is that hedging against unwanted risks, one by one, in a portfolio full of individually selected stocks is a Herculean effort. Second, many risks that alternatives managers seek to hedge are more universal in nature than the specific company and industry risks they typically want to emphasize. For instance, they may want exposure to the risks common to all stocks by virtue that they are stocks. inherent to stocks with low valuations but not want the risk

Most risks that hedge fund managers hedge are big-picture market movers such as the business cycle, interest rates, politics and regulation. This macro focus has intensified recently, as macro strategies are increasingly being used to boost return as well as control risk. Macro hedge funds (which we define to include global macro, managed futures and multistrategy categories) have risen from 10% of total hedge fund assets in 2001 to nearly 40% today (Display 6).

This macro trend, coupled with the institutional shift from active to passive strategies, is having a profound effect on market behavior and risk. Thats because macro strategies employ index-based products such as futures and some broad-index ETFs, which essentially yoke the returns of individual securities more tightly together than would otherwise be the case. With an ETF, the managers main task is to keep the portfolio as close as possible to the index it tracks, regardless of

individual company fundamentals or price. A trade in an S&P 500 Index futures contract does not result directly in transactions in the underlying stocks the way an ETF does, but the dealer or counterparty to the trade often places simultaneous orders for many of the 500 underlying securities in an effort to shed risk. 6

Growth in index futures and ETF trading has been explosive. Futures volumes in the US have soared from about 30% of cash equity trading 10 years ago to about 86% today. ETFs, which were virtually unknown a decade ago, now constitute nearly 60% of US equity volumes (Display 7); broad-based index ETFs currently account for about 60% of that activity. Together, these two instruments currently transact nearly 1.5 times the volume of the equity market.

Though it is difficult to prove a direct connection, the rapid proliferation of these index-based products has coincided with a huge upsurge in intra-stock correlations, which measures how closely stocks in an index move in unison. Over the past three years, intra-stock correlation for the S&P 500 has soared as high as 65% (Display 8); it has peaked at more than 40% for the MSCI World Index. Correlation for both indices remains well above long-term averages.

Certainly, some of the flare-up in correlations would have occurred even without the rise in futures and ETF volumes as investors reacted to the financial crisis. Normally, there is a very strong and linear relationship between volatility and correlation: As volatility rises, so do correlations, and vice versa. It is not clear whether rising correlation is driving todays higher market volatility or if rising volatility is driving investor fear and, thus, correlations. But we do know that what weve 7

been observing lately is outside the bounds of historical relationships.

This is evident in the recent spike in excess correlation (Display 9). By comparing the historical statistical relationship between volatility and correlation with current observations, we can predict how much correlation we should expect given the level of market volatility were experiencing. Excess correlation is the amount above that prediction.

What were seeing today is that correlation has risen much more than market volatility can explain, indicating that other drivers are at work. In our view, a significant degree of the recent increased market risk is coming from internal, self-perpetuating feedback loops propelled by the actions of individual market participants in response to shifting attitudes about risk.

In the case of hedging, the feedback loop works as follows: Investors grow more risk-averse in reaction to the financial crisis and structural changes, driving the desire to reduce volatility, which in turn spurs the use of macro-hedging strategies employing index futures and ETFs. Increased use of these products causes correlations among individual securities to rise, which increases market volatility and makes investors even more risk-averse. And the cycle continues (Display 10).

Momentum Feedback Loop

Now lets look at the second way that alternatives managers create synthetic low volatility: outrunning risk. For this approach to work, the manager must rely on short-term price movements to identify and act on changes in risk before they become more broadly acknowledged. The key point to remember about these strategies is that they rely on the directionnot the levelof prices. In that way, they are essentially designed to followindeed, accentuatetrends.

Display 11 sheds light on why momentum-based approaches are appealing. Historically, strategies relying on high-momentum stocks have been significantly more effective over short holding periods than those based on attractively valued stocks, though that advantage vanishes as the holding period lengthens.

This explains the current positioning of hedge fund portfolios, which are generally much more focused on price momentum than their traditional long-only counterparts, and are currently short longer-horizon, steadier value exposure. Over the past four quarters ended June 2010, for example, the typical US hedge funds exposure to stocks with high momentum relative to the S&P 500 was three to 10 times larger than that of the typical institutional long-only equity fund (Display 12). Meanwhile, hedge funds had two to three times the short exposure to stocks trading at low valuations.

The reliance on momentum as a hedging and investment tool is important because hedge funds are often the marginal buyers and sellers of stocks. Though hedge funds controlled about 3% of US equity assets in 2009, they were responsible for about 30% of trading volume, for a volume-to-asset ratio of 10:1.

The focus on momentum also influences hedge fund exposures in other subtler, but meaningful, ways. For example, hedge funds employ, almost universally, Value at Risk (VaR) models to help manage risk. These models look at historical distributions of and correlations among asset returns to calculate a probability distribution of these returns over various time periods. Hedge fund managers use this distribution to help understand how much money they could possibly lose in a given period. Managers often have limits, either self-imposed or from superiors, as to how large forecast losses can be. Further, these VaR models are increasingly adaptive in their approach to predictingthat is, the models pay the most attention to what happened recently and place the least weight on longer-term data.

So if market volatility starts to rise, VaR models will predict that it will rise further still, increasing the range of predicted losses. In response, hedge fund managers will rein in exposures (i.e., acceptable ranges. hedge more) to bring forecast losses within

Coupled with their disproportionate share of volume, hedge funds dependence on price momentumand momentum in the volatility of marketshas created a second risk-amplifying feedback loop: Concern about rising risk prompts the desire to sell ahead of near-term increases in volatility, which increases the reliance on price momentum. Acting on these trends magnifies price swings as hedge funds, which are punching above their weight, push down the price of a stock that is 10

already declining. This registers in the market as increased volatility. And the cycle continues (Display 13).

A Tragedy of the Commons

Efforts to manage risk today have taken on elements of the classic tragedy of the commons, which occurs when many individuals, each acting independently and rationally, end up damaging or depleting an important common resource. In this case, efforts to shed risk through hedging and momentum strategies have merely ended up dumping risk back into the equity markets.

The desire to control risk is perfectly rational. Efforts to do it through hedge fund managers offering high return and low volatility are also perfectly rational. Further, hedge funds and their managers are all working very hard and arein many cases, successfullydelivering on the promise of more efficient return streams.

We are also not saying that investors should necessarily consider the actions of others when making their investment decisions. Doing so could make matters even worse. To refrain from trying to control volatility in portfolios simply because to do so raises the residual volatility for everyone else merely ensures that you, too, will suffer from that heightened risk. But keep in mind that the risk-transmitting feedback loops currently wreaking havoc are reversible. Though it may be difficult to imagine now, tranquility will eventually return to the capital markets, only to eventually be followed by another period of extreme volatility. But neither environment will reflect the true, underlying level of economic risk.

What to Do?
So how can investors deal with this situation? Perhaps the most important thing to recognize is that the assumptions on which asset allocation is predicated will themselves change. A better understanding of what drives these assumptions could lead investors down several paths.

11

First, just as the recent rush to safety has changed the risk landscape, it has also altered the reward proposition. Today, that means that investors may want to reconsider the opportunity in equitiesnot because they are any less risky but because

their return potential is looking particularly compelling. As investors have grown increasingly unwilling to take on equity exposure, our research suggests that the expected reward for taking that risk has risen significantly.

For instance, the free-cash-flow yield of global stocks is more than five times the yield on 10-year government bonds (Display 14), a spread that is exceptionally wide by historical standards. Meanwhile, corporate balance sheets are as strong as theyve ever been, offering the potential for substantial upside as managements begin to unlock the value of their enormous cash hoards via stock repurchases, dividends and acquisitions. Taken altogether, equities look very attractive. Second, we believe that investors should expect active strategies to be rewarding, but volatile, in their delivery of premiums. This means resisting the temptation to fire active managers after periods of poor performance. Why do we believe this? Because intra-stock correlationsthe very metric we highlighted as being elevated by hedging behavioralso influence the ability of active managers to add value relative to benchmarks.

As we see in Display 15, manager alpha (the blue bars) ebbs and flows, with lengthy periods of outperformance and underperformance. Many factors affect manager alpha. There is a meaningful negative statistical relationship between correlation (green line) and relative returns. Another, even more significant, factor is return dispersion (blue line), or the degree of difference among stock returns, which is unusually low today for many of the same reasons that correlations are so high.

12

The combination of these two factors has made it especially difficult for active managers to deliver a premium because investors are not distinguishing among stocks based on fundamentalsin other words, they are treating good companies and bad companies as if they were all equally risky. But companies operating in the real economy have been showing greater, not narrower, divergence in earnings strength. In the US, disparity in company earnings growth now stands at an all-time high (Display 16). This disconnect is creating opportunity.

Correlations will rise and fall with shifting perceptions of market risk and, in turn, hedging behavior. So, once risk appetite returnsand we are confident that it willwe expect the risk-transmitting feedback loops to reverse course and for correlations to return to more normal levels.

We firmly believe that fundamentals, not fear, will ultimately drive stock performance. That hasnt been the case lately; but at 13

some point, it will surely matter again. In the meantime, active managers can take advantage of the opportunity created by high correlations to become more concentrated in companies with the characteristics that they prize the mostand that should pave the way for stronger active returns as investors pay more attention to these differences.

Realistic Expectations for Alternatives

Finally, in an environment where the assumptions driving asset-allocation decisions may be unstable, its important to set realistic expectations for the benefits of allocations into alternatives programs. Several adjustments may need to be made. First, widely cited databases show that even median hedge fund managers have significantly outperformed equities. However, it is important to know that these data do not represent a consistent group of assets that are selected and monitored over a long time horizonand they are not independently verifiable. For hedge funds, only 14 years of reliable index data are available, based on self-reported monthly data and covering the early stages of the industrys development. That said, hedge fund results were still impressive, even after adjusting for survivorship biases (in which the poor results of now-defunct firms are excluded from performance data) and other related issues (Display 17).

Second, in moving from stocks to hedge funds, investors are

substantially replacing market risk (beta) with

manager-selection risk (alpha). In Display 18, we have isolated the return sources for actively managed long-only equity portfolios into the beta, or market-driven component, and the alpha, or stock-selection components. We have done the same for hedge funds on average and then for the largest categories of hedge funds.

14

What is striking is the stark differences in risk allocation between long portfolios and hedge funds. The former sources almost 90% of return from beta, while hedge funds derive, on average, about 40% from beta and nearly 60% from security selection. Some categories, such as global macro funds, are almost 90% driven by manager decisions.

This raises two critical issues for investors: First, since beta is more homogenous than alpha, the dispersion of manager returns in a hedge fund universe will be much wider. The choice of manager matters even more and should be considered carefully. Second, to the extent that high correlations among securities undermine the alpha capabilities of long-only managers, they may also affect security selection among hedge funds. This means that hedge fund returns from security selection may be lumpier and less predictable going forward.

When considering both risk and return, hedge funds are not as clearly superior to other asset classes once we account for manager-selection risk. We modeled hedge fund returns incorporating the additional risk that comes from hedge fund selection using Monte Carlo techniques. After reviewing 10,000 possible return paths drawn from our Capital Markets Engine, we find that on average, hedge funds lie on the efficient frontier of risk and return somewhere between bonds and stocks, but not clearly better or worse in return per unit of risk (Display 19).

15

But hedge funds can play a modest yet major role in portfolios because they are diversifying to traditional assets. Depending on an investors risk appetite and need for return and liquidity, an allocation as high as 25% may be warranted. The diversification that hedge funds provide comes from their source of returnalphaand its weak statistical relationship to the drivers of return in traditional stock and bond portfolios.

The case for the inclusion of alternatives in an asset allocation is built on historical asset returns and the observed relationships among the drivers of those returns. Though the history of hedge fund returns is short by investment standards, market conditions have changed in ways that require us to think carefully about whether the historical behavior of hedge funds and other asset classes will be predictive of future relationships.

As plans have rushed to fund alternatives, can the promise of hedge funds be realized? Probably not, at least not to the extent many may expect. We modeled the effect that this displaced riskthat is, the tragedy of the commonscan have on a portfolio that is following the popular script:of shifting assets from equities to alternatives. Our hypothetical portfolio starts with an asset allocation of 60%/30%/10% to stocks, bonds and hedge funds, respectively (Display 20). This portfolio has a Sharpe ratio of 0.38 based on our estimates of return, risk and correlation among these respective asset classes. To control risk, without sacrificing too much return, our hypothetical investor decides to shift 15% of capital out of stocks and into hedge funds, ending with a 45%/30%/25% mix.

16

This reallocation looks very sensible. Return declines a little, but risk declines even more, owing to the less volatile nature of hedge funds and their low correlation with other assets. The portfolios Sharpe ratio improves to 0.40, a substantial increase in the return efficiency of the portfolio.

But this hypothetical investor is not acting alone. Other investors are looking at the same data and pursuing the same goal: lower risk and better returns. Not surprisingly, many are coming to the same conclusion: to shift part of their equity allocations into alternatives. The result, of course, will be higher equity volatility in times of stress, since hedging doesnt neutralize risk in the financial system but merely shifts it to someone else.

If the collective shift from equities to alternatives raises the volatility of equities by just about 1%from a long-term forecast of 15.5% to 16.5%the new portfolios Sharpe ratio falls from 0.40 back to 0.38. Viewed collectively, investors are right back where they started. As Lewis Carrolls Red Queen noted, It takes all the running you can do to keep in the same place.

This, Too, Shall Pass

Weve always assumed that risk was largely imposed on the capital markets from outside forces. But as we looked more closely at the possible causes of the recent extreme ups and downs in market volatility, we found that much of it was coming from self-perpetuating influences from inside the financial markets in reaction to shifting perceptions of risk.

In their quest for safety and predictability, investors are making choices that, in aggregate, have turned the equity markets more volatile, making their return objectives that much harder to attain and the peace of mind they seek even more elusive. But, as we noted earlier, these feedback loops can also spin in the opposite direction. At some point, many of the 17

macroeconomic uncertainties inflaming investor fears today will be resolved or not loom so large. As investor confidence is restored, the amplifying powers of hedging and momentum strategies will then fuel a virtuous cycle in which risk-taking will once again be rewarded. So, while we expect the equity markets to become less volatile as the economic recovery strengthens and risk appetites return, the heightened influence of these internal forces is likely to keep the volatility of market volatility elevated going forward. We are just beginning to understand the full investment implications of these new market dynamics, and we will all have to learn how to adapt.

Notes 18

For each hedge-fund category, we determined the market factors (from those given below) that drive that categorys index returns. Using the selected market factors, we then analyzed each individual hedge funds returns based on the category to determine what portion of return is attributable to these market factors (beta). Then we aggregated the betas of the individual hedge funds to determine the beta of each category and for the average hedge fund. We deem any return not attributable to beta to be alpha. The market factors are: MSCI World Index excess return; global large-cap equity size factor return; global large-cap equity momentum factor return; global large-cap equity book-price factor return; global large-cap equity leverage factor return; MSCI Emerging Market Index equity return; Russell 3000 Index return; CBOE Volatility Index (VIX); change in VIX; change in CBOE S&P 500 BuyWrite Index; 10-year US Treasury yield over three-month US T-bill return; Barclays Capital US Aggregate Index option-adjusted-spread change; emerging-market debt return; high-yield debt return; high-yield option-adjusted-spread change; mortgage-backed securities option-adjusted spread; Convertible Bond Index return; currency carry; major partners USD Index change; GSCI Commodity Index return.

Disclosures and Important Information

Disclosure on Security Examples
References to specific securities are presented to illustrate the application of our investment philosophy only and are not to be considered recommendations by AllianceBernstein. The specific securities identified and described in this presentation do not represent all the securities purchased, sold or recommended for the portfolio, and it should not be assumed that investments in the securities identified were or will be profitable. Upon request, we will furnish a listing of all investments made during the prior one-year period. Past performance is not a guide to future performance.

Additional Information
The value of investments and the income from them can fall as well as rise, and you may not get back the original amount invested. The value of nondomestic securities may be subject to exchange-rate fluctuations. 19

The views and opinions expressed in this presentation are based on AllianceBernsteins internal forecasts and should not be relied upon as an indication of future market performance or any guarantee of return from an investment in any AllianceBernstein services. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

Notes and Disclosures

Notes on Sources of Asset-Class and Manager Data

Unless otherwise specified, throughout this document we use MSCI World Index data for historical data on equities; the Barclays Capital Global Aggregate Bond Index for bonds; and three-month US Treasury bills, rolled, for T-bills. For historical manager data, we use the Lipper TASS database, as adjusted by AllianceBernstein to reduce biases, to represent hedge funds; Cambridge Associates databases to represent venture capital and private equity; and the NCREIF/Townsend database to represent real estate funds. We use Mercer databases to represent traditional, long-only equity and fixed-income managers. In our projections, hedge funds are well diversified; illiquid alternatives are well-diversified portfolios of private equity, venture capital and opportunistic real estate investments.

1. Purpose and Description of Wealth Forecasting System

Bernsteins Wealth Forecasting SystemSM is designed to assist investors in making long-term investment decisions regarding their allocation of investments among categories of financial assets. Our planning tool consists of a four-step

process: (1) Client Profile Input: the clients asset allocation, income, expenses, cash withdrawals, tax rate, risk-tolerance level, goals and other factors; (2) Client Scenarios: in effect, questions the client would like our guidance on, which may touch on issues such as when to retire, what his/her cash-flow stream is likely to be, whether his/her portfolio can beat inflation long term and how different asset allocations might affect 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, takes into 20

account the linkages within and among the capital markets, 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 ranges of returns and asset values the client could expect to experience are represented within the range established by the 5th and 95th percentiles on box and whiskers graphs. However, outcomes outside this range are expected to occur 10% of the time; thus, the range does not establish the boundaries for all outcomes. 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 bonds by a reasonable amount, although this is in no way a certainty. Moreover, actual future results may not meet Bernsteins estimates of the range of market returns, as these results are subject to a variety of economic, market and other variables. Accordingly, the 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.

2. Rebalancing
Another important planning assumption is how the asset allocation varies over time. We attempt to model how the portfolio would actually be managed. Cash flows and cash generated from portfolio turnover are used to maintain the selected asset allocation between cash, bonds, stocks, hedge funds and illiquid alternative investments over the period of the analysis. Where this is not sufficient, an optimization program is run to trade off the mismatch between the actual allocation and targets against the cost of trading to rebalance. The illiquid alternative investments are not sold to rebalance; thus, the allocation to these investments can be greater than their target, even substantially so. When the level of committed plus invested capital drops below the target allocation, additional commitment to these investments is made. In general, the portfolio allocation will be maintained reasonably close to its target.

3. Expenses and Spending Plans (Withdrawals)

All results are generally shown after applicable taxes and after anticipated withdrawals and/or additions, unless otherwise noted. Liquidations may result in realized gains or losses, which will have capital-gains tax implications.

4. Modeled Asset Classes

The assets or indices below were used in this analysis to represent the various model classes.

21

5. Volatility
Volatility is a measure of dispersion of expected returns around the average. The greater the volatility, the more likely it is that returns in any one period will be substantially above or below the expected result. The volatility for each asset class used in this analysis is listed in the Capital-Markets Projections section below. In general, two-thirds of the returns will be within one standard deviation. For example, assuming that stocks are expected to return 8.0% on a compounded basis and the volatility of returns on stocks is 17.0%, in any one year it is likely that two-thirds of the projected returns will be between 8.9% and 28.8%. With intermediate government bonds, if the expected compound return is assumed to be 5.0% and the volatility is assumed to be 6.0%, two-thirds of the outcomes will typically be between 1.1% and 11.5%. Bernsteins forecast of volatility is based on historical data and incorporates Bernsteins judgment that the volatility of fixed-income assets is different for different time periods.

6. Technical Assumptions
Bernsteins Wealth Forecasting System is based on a number of technical assumptions regarding the future behavior of financial markets. AllianceBernsteins Capital Markets Engine is the module responsible for creating simulations of returns in the capital markets. These simulations are based on inputs that assume that market conditions are in equilibrium. Projections for individual clients will be based on Capital Markets Engine forecasts that will be based on initial conditions at that time. A description of these technical assumptions is available on request.

7. Tax Implications
Before making any asset-allocation decisions, an investor should review with his/her tax advisor the tax liabilities incurred by the different investment alternatives presented herein, including any capital gains that would be incurred as a result of liquidating all or part of his/her portfolio, retirement-plan distributions, investments in municipal or taxable bonds, etc. 22

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.

8. Tax Rates
Bernsteins Wealth Forecasting System has used the following US tax rates for this analysis: The federal income-tax rate represents Bernsteins estimate of either the top marginal tax bracket or an average rate calculated based upon the marginal-rate schedule. The federal capital-gains tax rate is represented by the lesser of the top marginal income-tax bracket or the current cap on capital gains for an individual or corporation, as applicable. Federal tax rates are blended with applicable state tax rates by including, among other things, federal deductions for state income and capital-gains taxes. The state tax rate generally represents Bernsteins estimate of the top marginal rate, if applicable.

9. Capital-Markets Projections

10. Projected Correlations

23

AllianceBernstein L.P. 1345 Avenue of the Americas New York, NY 10105 212.969.1000

Note to All Readers: The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investors personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates.

24