JULY 2016

BREXIT: Roadblock or Speed Bump En Route to a 20,000 Dow?

Seth J. MastersChief Investment Officer Bernstein Private Wealth Management

2

Market sentiment was very pessimistic four years ago. Despite a significant bounceback from the bottom of the 2008/2009 credit crunch, some prominent investors were arguing that the world had entered a “new normal” in which stocks would struggle to rise. By contrast, we made the case that the Dow was likely to reach 20,000 by 2022. Though many observers thought we were far too bullish, the US stock market has exceeded our median forecast since then (Display 1).

In the wake of the UK’s vote to leave the European Union (Brexit), sentiment has once again plunged. Clearly, there is now more uncertainty about the economic outlook for the UK: As politicians negotiate new rules, companies will hesitate to invest and consumers may be less willing to spend. This could lead to slower growth or a recession in the UK and possibly Europe.

Thus, we think now is a good time to revisit our forecasts from four years ago and reflect on how events since then affect the outlook today. Although we expect US stock returns over the next five years to be much lower than in the past 20 years, we continue to expect a 20,000 Dow, with spikes in volatility along the way.

Indeed, we think the more important questions are: How many times will the Dow trade through 20,000? and What can investors do to achieve their goals when risk is rising and the return outlook is modest?

DISPLAY 1: THE DOW IS AHEAD OF OUR “BULLISH” 20,000 FORECAST

Actual DJIA Levels

20,000

Median Forecast

Forecast Range

Very Good Markets

Very Poor Markets

2012 20222013 2014 2015 2016 2017 2018 2019 2020 2021

0

20,000

10,000

30,000

40,000

Actual Dow Jones Industrial Average (DJIA) levels through June 30, 2016. Forecast ranges for DJIA from 90th to 10th percentile levels, based on Bernstein Capital Markets Engine projections as of March 31, 2012. See Notes on the Bernstein Capital Markets Engine on the back cover. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: Dow Jones and AB

BREXIT: Roadblock or Speed Bump En Route to a 20,000 Dow? 3

THE PATH WE’VE TRAVELEDWhen we published “The Case for the 20,000 Dow”1 in July 2012, the stock market had already recovered sharply from its deep drop in the credit crisis of 2008 and early 2009.

Over the previous three years, robust earnings growth had powered the 16.4% annualized return of the S&P 500 Index (a broader and more representative benchmark than the Dow). The left-hand bar in Display 2 shows that earnings per share (EPS)had grown at an 18.7% annualized rate, as fiscal and mone-tary stimulus helped the US economy return from recession to growth—and aggressive corporate cost cutting dramatically boosted margins on rising revenues.

But investors traumatized by the credit crisis and the subsequent sovereign-bond crisis in Europe appeared unwilling to acknowl-edge the vast improvement in corporate earnings and corporate balance sheets, or to believe these healthy developments could last: The price that investors were willing to pay for each dollar of US corporate earnings declined more than 4% annually in the same period.

In contrast, during the two years after June 2012, earnings growth slowed in line with our forecast to a still-healthy 7% annualized rate, and market sentiment changed dramatically—from gloomy to ebullient. The ballooning price investors were willing to pay for each dollar of earnings added 11.8% to annu-alized returns. Add in dividend yields, and the S&P 500 returned nearly 21% in the two years after our supposedly bullish forecast of annualized returns in the 7% range over 10 years.

Indeed, we thought market valuations had expanded too much, given the limited earnings growth we expected. In July 2014, we wrote in “‘The Case for the 20,000 Dow’ Revisited”2 that low ex-pected earnings growth and dividends were likely to drive be-low-average annualized returns of 6.8% over the following five years. (See “The Nature of Forecasting” on page 4.)

Since then, events have played out more or less as we thought likely. Over the two years through June 2016, the S&P 500 re-turned 5.7%, somewhat below our median five-year forecast from July 2014. EPS growth was mildly negative in this peri-od, depressed by the crash in energy-related earnings and US dollar strength; valuations continued to expand modestly. Dividend yield accounted for less than half of the S&P 500’s 5.7% annualized return.

1Seth J. Masters, “The Case for the 20,000 Dow,” Bernstein Private Wealth Management (July 2012)2Seth J. Masters, “‘The Case for the 20,000 Dow’ Revisited,” Bernstein Private Wealth Management (July 2014)

DISPLAY 2: WE EXPECT US STOCK RETURNS WILL BE MODEST

Composition of S&P 500 Returns (Percent)

Earnings Growth Valuation Change

Dividends

2.22.2

5.7

(1.5)

20.9

5.918.7

16.4

2.0

(4.3)

2.0

7.0

11.8

June 2009–June 2012

July 2012 –June 2014

2016–2020Median Forecast*

July 2014–June 2016

4.9 3.6

As of June 30, 2016Historical returns decomposed into dividends, earnings growth, and price-to-earn-ings (P/E) valuation expansion. Columns may not sum due to rounding. *Forecast returns based on Bernstein Capital Markets Engine projections as of March 31, 2016.Neither past nor forecast performance is a promise of future results. Source: Bloomberg, Standard & Poor’s, and AB

4

What’s next? Our Capital Markets Engine won’t be updated until late July, but we expect that despite the post-Brexit mar-ket moves, our forecasts will be little changed. We continue to expect about 6% annualized returns through 2020.

US STOCK MARKET VALUATIONSThe S&P 500’s valuation has varied widely over time, relative to 10-year Treasury yields. In general, stock valuations have been higher when bond yields were low, and lower when bond yields were high. You can see this in Display 3, where most of the purple diamonds fall fairly close to the curved trend line.

There are good fundamental reasons for this relationship. Low bond yields tend to reduce companies’ borrowing costs, drive up the present value of future earnings and dividends, and make bonds less appealing as an alternative to stocks. High bond yields, by contrast, drive up companies’ borrowing costs, re-duce the present value of their future earnings and dividends, and make bonds more appealing relative to stocks. So it makes sense for the market price/earnings (or P/E) ratio to be higher when interest rates are low.

But the period since 2008 has been anomalous. In the first few years after the credit crisis, bond yields plunged as central banks sought to support the financial system and provide econom-ic stimulus. Nonetheless, the market P/E ratio (represented by the green squares in Display 3) stayed far below the trend line. Investors just weren’t willing to pay much for future earnings at a time when the future still looked bleak.

Since June 2012, as the global financial system, the econo-my, and corporate earnings improved, stock market valuations rose somewhat more—but remained extraordinarily low relative to bond yields. The S&P 500 was trading at about 19.4 times earnings on June 30, 2016, suggesting that investors were dis-counting bond yields more than three times current levels, as shown by the intersection of the horizontal line and the trend line in Display 3.

Stock market valuations have remained extraordinarily low relative to bond yields.

Precise economic and market predictions are almost always proven wrong. So, why bother making fore-casts? Although it’s hard to predict exactly what will happen in the future, we’ve found that starting condi-tions at a given point in time provide some guidance about what’s likely to happen next.

For example, when we first published “The Case for the 20,000 Dow,” we showed that stocks out-performed bonds dramatically after every 10-year period since 1901 in which stocks had materially trailed bonds. That was one reason we concluded that stocks were likely to continue to do well.

We didn’t stop there. We also projected 10,000 paths for the economy and asset-class returns, based on the initial conditions of key variables, including economic growth, inflation, interest rates, and asset prices. Those 10,000 paths gave us useful data about the likely range of outcomes.

Our call that the Dow was likely to reach 20,000 in 10 years was just our median forecast: Half the potential outcomes were higher, half lower. For investors who seek greater than 50/50 odds of success, estimated market returns in hostile environments will be more important than the median estimate.

In this paper, we take a similar approach: We look at the path the markets have traveled to date in order to project the likely range of the potential future paths ahead.

THE NATURE OF FORECASTING

BREXIT: Roadblock or Speed Bump En Route to a 20,000 Dow? 5

That makes sense: Investors were pricing stocks as if bond yields were going to rise. The Federal Reserve has stressed its intent to normalize its policy gradually in the years ahead, given con-tinued economic growth, low unemployment, and rising wages. Indeed, the Fed stopped its bond-buying program two years ago and began raising short-term interest rates in December 2015.

The market P/E ratio seems to reflect considerable uncer-tainty about corporate earnings. The EPS of the S&P 500 has declined from the all-time high it reached in October 2014, mostly due to the huge losses incurred by energy-

related firms and the rise in the US dollar versus most other currencies. Excluding energy-related firms, however, the market EPS was still close to its peak. More than seven years after the current economic, earnings, and market recovery

began, many investors are worried there’s a downturn ahead—and that Brexit could be the trigger.

US STOCK MARKET FUNDAMENTALSOur forecasts recognize the need to consider a wide range of outcomes, given the uncertainty about future developments. (See “The Nature of Forecasting” on page 4.)

We expect US earnings growth to be modest over the next five years. Profit margins are already high and are unlikely to grow much. Thus, earnings will likely grow mainly as a function of cor-porate sales, which we forecast will expand at a 3.5% to 4% rate; margin compression would lead to slightly slower earnings growth (Display 4, next page). On the other hand, US corporate balance sheets remain strong, on average, which gives many companies the potential to boost EPS growth by buying back stock with excess cash.

And that includes paths where things go dreadfully wrong, either due to a nasty recession or to stagflation. In those scenarios, corporate productivity and margins would decline, driving down earnings growth to as low as (5.7)% annually. What might trigger some of the negative scenarios?

DISPLAY 3: STOCK MARKET P/E ALREADY DISCOUNTS HIGHER INTEREST RATES

1970—June 2016

June 30, 2016

50

0

40

30

20

10

0 2 4 6 8 10 12 14 16

10-Year US Treasury Yield (%)

S&P

500

P/E

(x)*

2008–May 2012

June 2012–June 2016

1970–2007

Historical analysis does not guarantee future results. *P/E is one-year trailing.Trend line is for 1970–2007.Source: Federal Reserve Board, Haver Analytics, Standard & Poor’s, and AB

Low stock-market valuations may reflect uncertainty about

corporate earnings growth.

6

THE FUNDAMENTAL RISKSIn our view, Brexit is almost certain to weigh on near-term eco-nomic growth for the UK, but given the uncertainty of how Brexit will unfold, it’s hard to gauge the magnitude of the hit to the UK economy. If the UK economy weakens, the Bank of England could cut interest rates later this year; it could even implement another round of quantitative easing, if things get really bad.

Brexit also creates uncertainty for Europe at a time when most European economies are already weak. But we don’t think Brexit will be a Lehman-like event, leading to a global financial crisis and recession. Brexit is primarily a political—not a financial—shock. Ultimately, market turbulence is likely to subside. But it could give central banks another nudge toward easier monetary policy and help keep global interest rates lower for longer.

The direct impact of Brexit on the US economy and corporate profits is likely to be small, in our view. Financial-market volatility

spiked after the UK vote as investors rushed to safe havens, but in the immediate aftermath of the Brexit vote, US stocks in gen-eral have shown greater resilience to Brexit concerns than UK and European stocks. We are guardedly optimistic that this will continue to be the case.

It’s also hard to predict who will win the US presidential election in November, or how the market will respond. Historically, there’s been no correlation between presidential popularity and market returns: The results have been all over the map.

Another risk is that a continued economic slowdown in China will drag down global growth. In our analysis, China appears likely to succeed in rebalancing its economy.3 While manufacturing, the longtime driver of China’s growth, is now stagnating, over half of China’s economy is now driven by consumers and growing at about 10% a year. Chinese policymakers have the capacity to stimulate their economy, if necessary. Hence, we think China can likely maintain 5% to 6% growth for some time, a lower but more sustainable pace.

The divergence in global central bank policy after years of large-ly coordinated policy also creates risk (Display 5). The Federal Reserve began raising US interest rates in December 2015 in response to good economic growth and low jobless rates. In contrast, the European Central Bank has cut rates to below zero to avert deflation; the Bank of Japan has done the same to end a deflation problem that has persisted for nearly two decades.

Will the move to negative interest rates help or hurt those re-gional economies and markets, and the world as a whole? Will investors believe they can succeed? If confidence in central banks erodes, there could be deflation—or inflation.

3Stuart Rae and Anthony Chan, “Disruptive Reforms: China’s Risks and Opportunities,” Bernstein Private Wealth Management (April 2016)

DISPLAY 4: WE EXPECT MODEST EARNINGS GROWTH IN THE MEDIAN CASE

Forecast S&P 500 Earnings GrowthNext Five Years’ Range

Very Good Conditions

Median

Very Poor Conditions

13.9%

(5.7)%

0%

3.6%

As of March 31, 2016Very good conditions are the 10th percentile forecast; very poor conditions are the 90th percentile forecast. Forecasts derived from Bernstein Capital Markets Engine forecasts of return on equity and book growth. See Notes on the Bernstein Capital Markets Engine on the back cover. Forecasts are not a guarantee of future results or a range of future results. Source: AB

Uncertainty about Brexit, China, and interest rates weighs on the

stock market, but housing data could provide a positive surprise.

BREXIT: Roadblock or Speed Bump En Route to a 20,000 Dow? 7

These risks are widely discussed today, and therefore likely reflected in market prices. The next market move is more likely to be driven by a big surprise—something people didn’t expect. Indeed, the market sell-off in response to Brexit was huge pre-cisely because it was unexpected.

But the next surprise could be positive. For example, we are beginning to see signs of a pickup in US household formation (Display 6), which could prolong the growth phase of this eco-nomic cycle by boosting consumer spending. This development could boost sales and earnings for homebuilders and manufac-turers of consumer durable goods.

As always, we forecast a wide range of possible outcomes. If everything goes perfectly, economic growth will be strong but inflation moderate, and companies will maintain balance-sheet discipline, resisting the temptation to overinvest. Such a Goldilocks scenario—while hard to imagine right now—could lead to revenue, productivity, and margin expansion, and drive earnings growth higher.

But how would the market react to this type of positive sur-prise? It’s possible that investor sentiment could improve in response to the prospect of prolonged growth, driving up market prices and valuations. But the stock market could also fall on expectations of more rapid interest rate hikes by the Fed. In other words, the outcomes of surprises are uncertain.

The only thing we can predict with confidence is that there are plenty of potential triggers for increased volatility in the months and years ahead.

DISPLAY 5: MARKETS EXPECT CENTRAL BANK POLICY DIVERGENCE TO WIDEN

Market-Implied Policy Rate Forecasts*

US

Japan

Europe

Rat

e (%

)

(0.6)

(0.4)

(0.2)

0.0

0.2

0.4

0.6

12/31/2015 1-Year 2-Year

As of June 29, 2016*Based on the cash yield of currency forwardsPast performance does not guarantee future results. There is no guarantee that any estimates or forecasts will be realized.Source: Bloomberg and AB

DISPLAY 6: A RECOVERY IN HOUSEHOLD FORMATION COULD SPUR CONSUMER SPENDING

(1.6)

(1.1)

(0.6)

(0.1)

0.4

0.9

1.4

1.9

2.4

95 97 99 01 03 05 07 09 11 13 15

Household FormationYear-on-Year Change in Total Occupied Housing Units

Mill

ions

Through December 31, 2015 Historical analysis does not necessarily predict future results. Source: Bloomberg, US Census Bureau, and AB

The next surprise could be positive. A pickup in US household formation could

prolong economic growth.

8

WHAT WE NOW EXPECTFour years ago, we predicted that in the median case the Dow would reach 20,000 in 10 years. Since then, the economy and markets have done a bit better than our median forecast. We’ve rerun our forecasts based on today’s conditions, and now we ex-pect the Dow to reach 20,000 by 2019 in the median case. This

forecast implies that stock indexes will rise relatively slowly from current levels, because earnings growth is likely to be modest and valuations are now full.

Note, too, that the range around our forecast has shifted. We now see less downside risk than we did in 2012, and similar

upside potential (Display 7 ). While there could be a bear market, there has been sufficient fundamental improvement since 2012 that the downside scenarios appear less dire.

Still, it’s not an easy environment for investors. Volatility is likely to be higher, so the Dow will likely wiggle up and down through 20,000 a number of times in the years ahead.

Longer-term returns on high-quality bonds are generally in line with starting yields. That suggests that investors are likely to receive just 1.8% annualized returns from municipal bonds, far below the historical average (Display 8). And our median fore-cast for global stock returns is 6.5% annualized, below the 7% average for global stock returns over the past 20 years.

As a result, we think an investor with a moderate allocation is likely to garner annualized returns in the 4.5% to 5% range, be-fore inflation and taxes. To obtain the nearly 6% historical aver-age return of the past 20 years, a moderate investor would have to take a lot more risk, adopting a growth allocation.

DISPLAY 7: IN OUR MEDIAN FORECAST, THE DOW REACHES 20,000 IN 2019

Very Good Markets

Very Poor Markets

Actual DJIA Levels

20,000

2012 20222013 2014 2015 2016 2017 2018 2019 2020 2021

March 2012

March 2016

Overlap

Forecast Range

— March 2012

— March 2016

Median Forecast

Actual Dow Jones Industrial Average (DJIA) levels through June 30, 2016. Forecast ranges for DJIA from 90th to 10th percentile levels, based on Bernstein Capital Markets Engine projections as of March 31, 2012, and March 31, 2016. See Notes on the Bernstein Capital Markets Engine on the back cover. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: Dow Jones and AB

We now forecast lower stock returns and a narrower range of potential outcomes.

BREXIT: Roadblock or Speed Bump En Route to a 20,000 Dow? 9

Similarly, an investor with a conservative allocation is likely to garner returns only slightly above 3%. To obtain the nearly 5% annualized average returns for a conservative allocation over the past 20 years, investors would have to step up to a moderate allocation, with considerably greater risk.

Increasing portfolio risk might be tolerable if market volatility were to remain at the unusually subdued levels that prevailed for much of 2012 through 2014. But ever since the Fed stopped buying bonds in late 2014, volatility has generally been closer to average, and it has spiked far higher on several occasions (Display 9). We expect more of the same for some time to come.

So, we see Brexit as more of a speed bump than a roadblock for the Dow and other market benchmarks. While a sustained market drop is not our central case, we think it’s quite likely that the Dow could repeatedly trade through 20,000 before estab-lishing a sustained trend above it.

PLANNING FOR CHALLENGING MARKETS Few investors relish the prospect of lower returns with more volatility. But smart planning takes uncertainty into account and lets you budget and trade off different forms of risk. For long-term investors, two risks are particularly important: the risk of a big market plunge (investment risk), and the risk of failing to meet your objectives (depletion risk).

Investment risk is the probability of a short-term drop in port-folio value. For most investors, a 20% peak-to-trough loss can be hard to tolerate. Investment risk is higher for portfolios with more exposure to return-seeking assets, such as stocks, and lower for portfolios with more exposure to risk-mitigating investments, such as investment-grade bonds (Display 10, next page).

DISPLAY 8: WE EXPECT RETURNS TO BE LOWER THAN IN THE PAST 20 YEARS

Historical and Forecast Annualized Index Returns (Percent)

3.6

4.9

5.96.5

7.0Return Gap

20-Year HistoricalIndex Return*

Median IndexReturn Projection:

Next Five Years†1.8

3.2

4.85.7

6.5

100%Bonds

Conservative Moderate Growth 100%Global Stocks

*20-year historical index returns calculated from April 1, 1996, through March 31, 2016. Equities are represented by a 70% allocation to the S&P 500, 25% to the MSCI EAFE, and 5% to the MSCI Emerging Markets. Bonds are represented by the Lipper Short/Intermediate Municipal Bond Fund Average.†Forecast projected pretax five-year compound annual growth rate models stocks as 70% US diversified, 25% developed international, and 5% emerging-market stocks, and bonds as intermediate-term diversified municipal bonds. Reflects Bernstein’s estimates and the capital-market conditions as of March 31, 2016. Based on Bernstein’s estimates of the range of returns for the applicable capital markets over the period analyzed. See Notes on the Bernstein Wealth Forecasting System on the back cover.Conservative allocation defined as 30% global stocks and 70% municipal bonds; moderate, as 60% stocks and 40% bonds; growth, as 80% stocks and 20% bonds. Neither past performance nor forecasts guarantee future results or a range of future results. There is no guarantee that any estimates or forecasts will be realized.Source: Lipper, Morgan Stanley Capital International (MSCI), Standard & Poor’s, and AB

DISPLAY 9: WE EXPECT VOLATILITY TO BE HIGHER THAN IN RECENT YEARS

CBOE Volatility Index (VIX)

10

20

30

40

Jul 2012 Jan 2013 Jul 2013 Jan 2014 Jul 2014 Jan 2015 Jul 2015 Jan 2016

19.8 Average Since 1990

As of and through June 30, 2016 Past performance does not guarantee future results.Source: Bloomberg, Chicago Board Options Exchange (CBOE), and AB

10

Depletion risk is the risk of running out of money because port-folio growth and income don’t offset withdrawals. For example, the old rule of thumb was that retirees could spend 5% a year from their portfolio for the rest of their lives without significant depletion risk. But low expected returns and increased longev-ity have made the 5% rule a recipe for failure. Even just 3.3% withdrawals can be too much in today’s low-return environment.

If you’re spending 3.3% a year, adjusted for inflation, from an all-bond portfolio, you face a nearly 50% chance of spending down your portfolio in 30 years (Display 10, right side). Even if you add enough stocks to have a conservative allocation, there’s a 20% chance that spending 3.3% a year would deplete the portfolio

in 30 years. Reducing depletion risk to a more acceptable 10% level requires taking on at least a moderate allocation.

If you’re spending more than 3.3% each year, adjusted for in-flation, from your portfolio, you will probably have to take even more investment risk to limit depletion risk.

Similarly, trusts that are required to distribute 5% of their prin-cipal each year may end up spending from principal because investment returns are inadequate; this could reduce the life of the trust, or the amount likely to be available for remainder ben-eficiaries. Taking more investment risk could reduce depletion risk but lead to greater swings in portfolio value than the trustee or trust beneficiary has historically been willing to endure.

DISPLAY 10: CHOOSE THE RIGHT RETURN/RISK TRADE-OFF FOR YOU

Investment Risk*Peak-to-Trough Loss of 20%

Depletion Risk†Assuming 3.3% Real Spending

100% Global Stocks

Growth

Moderate

Conservative

100% Bonds

10%

9%

10%

20%

46%

92%

65%

34%

2%

<2%

As of March 31, 2016100% bond portfolio is all nominal bonds. Conservative portfolio is 24% stocks/56% nominal bonds/14% inflation-sensitive bonds/6% diversified hedge funds. Moderate portfolio is 50% stocks/32.5% nominal bonds/2.5% inflation-sensitive bonds/15% diversifiers (real assets and hedge funds). Growth portfolio is 65% stocks/15% nominal bonds/20% diversifiers (real assets and hedge funds). Stocks modeled as 21% US diversified, 21% US value, 21% US growth, 7% US small- and mid-cap, 22.5% developed international, and 7.5% emerging-market stocks. Nominal bonds modeled as intermediate-term diversified municipals. Inflation-sensitive bonds modeled as intermediate-term inflation municipals.*Investment risk is the probability of a peak-to-trough decline in pretax, pre-cash-f low cumulative returns of 20% over the next 30 years. Because the Wealth Forecasting System uses annual capital-market returns, the probability of peak-to-trough losses measured on a more frequent basis (such as daily or monthly) may be understated. The probabilities depicted above include an upward adjustment intended to account for the incidence of peak-to-trough losses that do not last an exact number of years. †Depletion risk is the probability of running out of money for a 65-year-old couple spending $100,000 a year (inflation-adjusted) from a $3 million portfolio; assumes 6.5% state tax.Based on Bernstein’s estimates of the range of returns for the applicable capital markets over the periods analyzed. See Notes on the Bernstein Wealth Forecasting System on the back cover. Data do not represent past performance and are not a promise of actual future results or a range of future results. Source: AB

BREXIT: Roadblock or Speed Bump En Route to a 20,000 Dow? 11

WHAT YOU CAN DOThere are three key things that can mitigate depletion risk with-out creating more investment risk than you can tolerate.

Diversify more widely. For the sake of simplicity, we focused the asset-allocation discussion above (under the subhead “Planning for Challenging Markets”) on the risk and return trade-offs for various combinations of global stocks and municipal bonds. But our research suggests that broadening your strate-gic asset allocation to include other diversifying asset classes, such as real assets and some types of alternatives, can reduce portfolio risk somewhat, or allow you to seek somewhat higher returns without increasing your portfolio risk profile.

Manage risk actively. Market risk and return potential vary over time, so the risk and return potential in your portfolio are likely to rise and fall. If unmanaged, the near-term trade-off may become far less attractive than you expected when you estab-lished your strategic asset mix.

Bernstein’s Dynamic Asset Allocation (DAA) service weighs the ever-changing levels of market return potential and risk in a dis-ciplined process aimed at keeping your overall portfolio volatility within, or close to, your comfort zone: the portfolio volatility you thought you could accept when you set your asset allocation.

By keeping investors within or close to their comfort zone, DAA has given many Bernstein clients the confidence to stick with their strategic asset allocation in tough times—rather than sell-ing at market bottoms and missing the subsequent recovery. Since its inception in April 2010, DAA has successfully mitigated risk without taking from long-term returns.

Invest actively. The historical and projected returns we’ve shown so far were all based on market indexes. While index

investing has its virtues, by definition it can’t add to index return. When expected long-term returns from market indexes are low, as they are now, the additional potential returns from active man-agement become far more beneficial.

Of course, there’s no guarantee that active managers will out-perform the indexes, and active management does entail higher fees. Indeed, since 2009, investors have shifted nearly $900 billion in capital from active to passive index investing, because broad stock-market indexes, such as the S&P 500, have outper-formed a large majority of active managers, while the introduc-tion and proliferation of low-cost exchange-traded funds (ETFs) have increased the cost advantage of index investing.

Index investing in general will likely remain cheap (though not all ETFs are equally cost-efficient), but it’s not likely to retain its performance leadership, in our view. The strong returns with low volatility that prevailed for much of the last few years were both highly unusual and ideal for passive investing.4 By contrast, peri-ods of low returns and high volatility, which we expect, have his-torically rewarded research-driven active managers.

And while many investors think index investing is safer, that too is not necessarily true. Indeed, index investing requires taking in-creasingly large exposures to whatever has become most popu-lar—and therefore, possibly, overpriced. Disciplined, active man-agement can avoid undue concentration in high-priced stocks, sectors, countries, or other traits, such as yield or stability.

If you’re concerned your portfolio doesn’t offer the return you need or the risk you can tolerate, call your Bernstein Advisor. It may be time to revisit your strategic asset mix, assess whether to add or eliminate DAA, and refine your particular combination of active and, perhaps, passive investment services to meet your particular requirements.

4David Barnard, “The Case for Integrated, Active Wealth Management,” Bernstein Private Wealth Management (June 2016)

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NOTES ON THE BERNSTEIN CAPITAL MARKETS ENGINEThe Bernstein Capital Markets Engine is a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings, and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

NOTES ON THE BERNSTEIN WEALTH FORECASTING SYSTEMThe Bernstein Wealth Forecasting SystemSM seeks to help investors make prudent decisions by estimating the long-term results of potential strategies. It uses the Bernstein Capital Markets Engine to simulate 10,000 plausible paths of return for various combinations of portfolios. For taxable accounts, it takes the investor’s tax rate into consideration. Additional information on Bernstein’s Wealth Forecasting System is available upon request.

INFORMATION ABOUT MORGAN STANLEY CAPITAL INTERNATIONAL (MSCI)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 indexes or any securities or financial products. This paper has not been approved, reviewed, or produced by MSCI.

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