Market Insights and Outlooks from Senior Investors at Neuberger Berman

solving for 2012

Neuberger Berman
We are an independent, employee-controlled investment manager in service to our clients. We partner with institutions, advisors and individuals throughout the world to customize solutions that address their needs for income, growth and capital preservation. With more than 1,700 professionals focused exclusively on asset management, we are deeply grounded in original, fundamental research and offer an investment culture of independent thinking. Founded in 1939, Neuberger Berman today provides solutions across equities, fixed income and alternative investments.

A Look Ahead, With Humility

The past year has been nothing if not unpredictable for investors. Even the most ardent bears would have been unlikely to anticipate many of the unfolding events that caused markets to gyrate, sometimes spectacularly; meanwhile, many bulls were probably caught off-guard by the continued earnings health of blue and near-blue chip companies and the pockets of return strength that emerged in the face of turbulence and aura of global crisis. How then, can one seek to opine on the outlook for 2012? To begin with, one needs a dose of humility. Difficult as it once was to anticipate the ebb and flow of the capital markets, the task has become harder as countries have traded closer together, economies have intertwined and the array of investment strategies has escalated. Investment conclusions must emerge from disciplined researchyou cant be a fortune teller, but you can certainly assess conditions analytically and determine what you think may happen and what may work from an investment perspective. At Neuberger Berman, we have been actively observing and investing in the markets for more than 70 years, with a mission of working with clients to achieve their unique investment objectives. Rather than impose a house view on our portfolio managers, we provide them with resources and let them make the decisions. It is an approach that has seen great success over time. This leads to another guideline on investment outlooks: respect divergent views and understand, to paraphrase Roy Neuberger, our founder, that there is more than one way to skin a cat. With these ideas in mind, I present to you Solving for 2012, with opinions on the upcoming year from some of Neuberger Bermans most seasoned investors, and covering a range of topics including global equities, fixed income, alternatives and multi-asset strategies. Whether investing on your own behalf, or working to address other individual or institutional needs, I believe you will find this material to be useful in considering investment positioning and strategy in this turbulent time.

Sincerely,

Joseph V. Amato

President and Chief Investment Officer Neuberger Berman

Solving for 2012

Contents

Introduction l Joseph V. Amato, President and Chief Investment Officer .......................................i Strategic Perspectives Old Dogmas, New Dharmas l Alan H. Dorsey, CFA, Head of Investment Strategy and Risk; Juliana Hadas, CFA, Vice President ........................................................................................4 Multi-Asset Class Portfolios l Wai Lee, PhD, Chief Investment Officer and Director of Research Quantitative Investment Group ................................................................7 Asset Allocation View l Neuberger Berman Asset Allocation Committee .................................10 Global Equities Overview l Joseph V. Amato, President and Chief Investment Officer .........................................14 U.S. Equities l Leah Modigliani, Multi-Asset Class Strategist ....................................................15 2012 Election l Matthew L. Rubin, Director of Investment Strategy...........................................19 International l Benjamin Segal, CFA, Portfolio Manager and Head of Global Equity Team ...............20 Emerging Markets l Conrad A. Saldanha, CFA, Portfolio Manager Global Equity Team ...............22 Greater China l Frank Yao, Senior Portfolio Manager Greater China Equity Team .......................24 Global Fixed Income Overview l Brad Tank, Chief Investment Officer Fixed Income ...............................................28
Investment Grade Fixed Income ..........................................................................................29

U.S. Economy, Rates and Sectors l Andrew A. Johnson, Chief Investment Officer

High Yield Bonds and Bank Loans l Ann H. Benjamin, Chief Investment Officer Leveraged Asset Management ...........................................................................................31 Municipal Bonds l James L. Iselin, Head of Municipal Fixed Income .........................................32 Eurozone and Asia Fixed Income, Global Currency l Ugo Lancioni, Portfolio Manager
Global Fixed Income and Currency; Thanos Bardas, PhD, Portfolio Manager and Global Head of Sovereigns and Interest Rates .............................................................................................33

Emerging Market Debt l Bobby T. Pornrojnangkool, PhD, Portfolio Manager Emerging Market Debt .....................................................................................................34 Alternatives Private Equity l Anthony D. Tutrone, Global Head of Alternatives.............................................38 Fund of Hedge Funds l Eric Weinstein, Chief Investment Officer Fund of Hedge Funds.......................................................................................................43 About the Authors l ...................................................................................................48

STRATEGIC PERSPECTIVES

Old Dogmas, New Dharmas

alan H. dorsey, cFa, Head of Investment strategy and risk Juliana Hadas, cFa, vice president

The dogmas of the quiet past are inadequate to the stormy present.1 Abraham Lincoln made this statement in the midst of the social and political changes of his time. Granted, our troubles today (at least in the investment world) are small in comparison. Nevertheless, investors are faced with some difficult problems in conforming to the stormy present and its new laws of order (i.e., dharmas).
Here, we have identified some of the issues that investors, particularly institutional ones, have been voicing and related solutions that are being developed by investment managers. Hopefully, articulating these issues and potential answers will yield an illustrative roadmap for the year ahead. Improved TacTIcal asseT allocaTIon responsIveness Some investors find that their decision-making and approval process can be cumbersome, which may be especially detrimental in highly volatile markets, such as those experienced over the past few years. In this instance, investors in retrospect may find that they have made decisions later than they would have liked, made incorrect decisions, or made no tactical decisions at all, adhering to strategic asset class rebalancing regardless of the environment or its nature. Delegating some tactical repositioning authority to external partners can enable the institution to implement portfolio tilts more nimbly. Increasingly, investors are entering into multi-asset class strategic partnerships with investment managers. Such mandates consist of active asset class management and tactical asset allocation (TAA) systematic and discretionary overlays. Another approach to improving asset allocation responsiveness is to hire flexible mandate managers within a single asset class, such as equities, credit or commodities. Strategic asset allocation rarely provides beta moderation outside of TAA tilts. Giving some managers within single asset classes the ability to moderate their betas can help mitigate downside capture, which could enhance returns over time. volaTIlITy reducTIon and rIsk BalancIng Investors are looking for ways to reduce volatility and balance risk both across asset classes and within some of the riskier asset classes. One way to pursue this goal is to manage a strategic asset allocation more dynamically in response to market events. Risk-balanced asset allocation approaches can be effective strategies for doing this. In these approaches, the weights to each asset class are determined in such a way that each asset classs contribution to total portfolio risk is similar. Volatility, tail risk and liquidity all can be considered in determining portfolio risk.

1. Abraham Lincolns Second State of the Union Address (December 1, 1862).

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STRATEGIC PERSPECTIVES

A long-term view is complemented by a combination of shorter-term views from systematic models and mediumterm views from a multidisciplinary asset allocation committee. This melds the concepts of strategic and tactical asset allocation in a responsive and adaptive approach. (For example, see the display, which depicts a strategic asset allocation that is comprised of risk-weighted asset classes and is dynamic, changing over time depending on the volatility and correlations of the underlying asset classes.) The alternativerebalancing to a static strategic benchmarkis not unlike rebalancing to an arbitrary asset allocation. A risk-balanced approach can also be employed in single asset-class mandates. In equities, for example, lower-beta managers who are likely to hold more cash and fixed income and focus on more defensive sectors would get higher allocations than their higher-beta peers. In credit, the portfolio manager may toggle between credit risk and duration risk in different market environments.

lIquIdITy and TaIl rIsk managemenT In addition to seeking overall volatility reduction, investors are particularly attuned to mitigating the risk of extreme tail events, in terms of both asset class returns and liquidity. Options and swaps are one way to manage tail risks; however, they can be costly, particularly in todays high-volatility environment. Alternative ways to achieve tail risk mitigation include expanding or contracting liquidity based on rich or cheap risk premia, and allocating assets to managers who can hold cash and vary its amount dynamically based on market conditions. Long-only equity strategies with the flexibility to hold cash and fixed income instruments when the manager deems prudent have the potential to achieve results similar to other strategies that seek unconstrained global-equity exposure, such as long/short hedge funds, but with lower fees, higher liquidity and less tail risk than hedge funds that may use shorting and leverage. Different

hedge fund strategies have different sensitivity to equity illiquidity shocks, however. Strategies such as equity long/short, convertible arbitrage and event-driven have historically seen return deterioration during times of illiquidity shocks in the equity markets. On the other hand, strategies such as statistical arbitrage and macro have seen little to no return deterioration, and CTA (commodity trading advisor) strategies have actually seen their returns improve in such environments. Incorporating the latter in the portfolio can help mitigate tail and illiquidity risk. InFlaTIonary Hedge With sovereign debt levels growing across the globe and significant resistance to fiscal austerity coming from both politicians and the general populace, concern occurs about future inflation. While commodities and inflation-linked bonds offer a degree of hedging against inflation and currency depreciation, a risk is that their beta-to-inflation can turn negative when inflation reaches certain levels, and that performance of the asset classes will likely begin to diverge as significant changes emerge in inflation estimates. An equal duration-risked multi-asset portfolio can account for this by adjusting its monthly sensitivity to inflation. This approach to risk allocates to various assets in such a way that each contributes similarly to the sensitivity of the overall portfolio to changes in inflation. The strategy is flexible in that it can adjust to changing betas to inflation and changing forecasts for inflation. Numerous asset classes can be included, such as high yield bonds, inflation-linked bonds, commodities, leveraged loans, real estate investment trusts (REITs), and high-dividend

Ex AmPlE : RISk-BAl AncEd StRAtEGIc ASSEt AllocAtIon Percent age of S a m ple A lloc ation O ver Tim e 100% 90 80 70 60 50 40 30 20 10 0 1991 EM Equity EAFE 1995 1999 R2000 R1000 2003 TIPS Global Agg 2007 2011 U.S. Agg

Source: Neuberger Berman. For illustrative purposes only. The percentages reflect the dynamic asset class/index allocations of a hypothetical risk parity portfolio, rebalanced monthly. The information shown is hypothetical and is not representative of any investment product. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal.

Solving for 2012

equities in sectors such as materials and energy. lIaBIlITy rIsk managemenT Generally, lower interest rates have caused liabilities to rise, while risk asset prices have fallen. This has led to a decrease in many pension plans funded status. Plans that are considering removing liability hedges are considering whether now is the time to do so. One tactic is to make this decision in the context of a liabilitydriven investing (LDI) framework. While basic LDI strategies typically focus on investment-grade fixed income for liability matching, more advanced strategies also incorporate high yield bonds and high-dividendpaying stocks, such as utilities and

REITs. This LDI++ approach considers both liability hedging and return generation, and seeks to add value through sector research, issue selection and duration management, while controlling risk. ouTsourced alTernaTIves Investors are increasingly seeking non-discretionary help in their hedge fund and private equity fund selection, due diligence and portfolio construction. The rationale is based in wanting to create completion portfolios of underlying managers that are complementary to either direct fund commitments that the investor has made or broad fund of funds commitments that have been done. In other cases, funds of funds

can be employed to provide nondiscretionary assistance. Although limited in scope, such implementation can be a cost-effective solution for certain large investors who are looking for skills to complement their own internal investment processes. We hope we have provided insights into approaches that could prove useful in seeking to solve for issues that may concern our readers. And as our 16th President posited about his own situation, Determine that the thing can and shall be done, and then [together] we shall find the way.2

2. Abraham Lincolns speech in the House of Representatives (June 20, 1848). This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. Please see disclosures at the end of this publication, which are an important part of this article.

Neuberger Berman

STRATEGIC PERSPECTIVES

Multi-Asset Class Portfolios: Keeping Things Flexible

Wai lee, phd, chief Investment officer and director of research quantitative Investment group

After an extended period of market turbulence, macroeconomic dislocations and increased cross-asset class correlations, the investment community is increasingly looking past traditional onesize-fits-all asset allocation strategies to find solutions that may be effective in an increasingly variable environment. In our view, it makes sense to approach asset allocation flexibly, with the investors choices
depending on a variety of factors. Below, we provide a few ideas to consider as we move into 2012. TurBulenT landscape, neW quesTIons There is no doubt that the past few years have been challenging for investors. From increased market volatility to historical trend deviations to myriad macro-level events that have impacted market and asset price behavior in often extreme ways, investors have been left to question long-held assumptions underlying various asset allocation methodologies as well as their own approaches. The environment has shifted to one in which constructing multi-asset class portfolios that can deliver on investment objectives over a period of several years seems infinitely more complicated than just a few years ago. In fact, 2011 punctuated this perhaps most distinctly, as the third quarter of the year saw many markets post their worst quarter since early in the financial crisis, only to be followed by a month that was one of the best for certain equity markets since the 1970s. How should investors handle these extremes and how can they effectively build portfolios to weather such storms and changing conditions? As investors have asked such questions, this has highlighted many of the assumptions that led them to more traditional asset allocation methodologies in the first place. For institutions, for example, typical plan restrictions might prohibit the use of leverage or shorting of securities yet, at the same time, have a required return, which has led long-term allocations to relatively risky assets such as equities. Over time, the portfolio mix of 60% equities and 40% fixed income (or slight variations thereof) emerged as typical because it was thought to have a good chance of meeting the required return. This was despite the known concentration in equity risk resulting from the mismatch between equity and fixed income risks in such a portfolio. (Note that, in and of itself, equity can be interpreted as a leveraged investment, as the stock market includes companies that have issued debt as part of their financing.) Focus on alTernaTIve approacHes More recently, the investment communitys focus has shifted to developing alternative approaches to asset allocation and multi-asset class portfolios. As part of this, assumptions relating to leverage and shorting are being reevaluated, questions are being posed regarding the meaning of strategic and tactical with respect to asset allocation, and the role of forecasting returns and

Solving for 2012

assumptions about risk are all being reevaluated. Risk parity, for example, has moved into the spotlight. And while some of the buzz around this approach to asset allocation is likely just that, we do believe it serves an important role in certain portfolios. So, where will the dust settle in 2012 and how should investors think about asset allocation? Although it is common to define asset allocation in strict terms of strategic and tactical (with time horizons such as three to five years for strategic, or significantly less than this for tactical), we believe this one-sizefits-all approach actually fits very few investors objectives successfully. For instance, the process of rebalancing a

portfolio periodically back to a strategic 60/40 mix may require trading more frequently than a threeto five-year investment horizon. How this process is designed and whether these trades should be considered tactical are up for debate. We think it is more useful for investors to consider the degree of uncertainty associated with their particular time horizons, and to adjust their investment approach and diversify accordingly. To be sure, diversification is one of the most basic terms in investing, but its meaning and application are not always clear. Based on our extensive research, we believe that investors should diversify to the degree they are uncertain about something.

In other words, if you had perfect forecasting ability, there would be no need to diversify at allyou could simply invest in the assets that would do well and avoid the others. On the other hand, where you do not have perfect forecasting ability or you have conditionssuch as extended time horizonsthat make you less certain about your expectations, then it makes sense to adopt an approach that does not rely so heavily on these forecasts as inputs. In the context of asset allocation, this is what we believe separates tactical from strategic asset allocation decisions and is a guide that we believe investors should consider utilizing more extensively. Although there is

FInAncIAl cRISIS ShockEd coRREl AtIonS Rolling Two -Year Correlation of Stoc k Market and Cu rre nc y Retu rn s W it hin a Give n Region 100% LTCM 80 60 40 20 0 -20 -40 -60 -80 -100 1986 1988 1990 1992 U.S. Japan Source: Bloomberg, Neuberger Berman Quantitative Investment Group. 1994 1996 1998 Europe U.K. 2000 2002 Australia Canada 2004 2006 2008 2010 2011

Global Financial Crisis

Switzerland

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STRATEGIC PERSPECTIVES

a high degree of uncertainty in forecasting far into the future, our research has shown that, over longer investment horizons, riskadjusted rewards of risky assets are more comparable to one another than they are in the shorter term. Given that insight, we believe a portfolio constructed using a riskbalanced approachor one that selects assets based on their expected contribution to the portfolios risk, rather than one that is constructed based on return forecastsmay be more robust over time. Moreover, if investors are able to relax certain guidelines, such as those around the use of leverage, a leveraged risk parity portfolio with equal contributions to risk from all assets may be able to generate returns on par with traditional 60/40 type portfolios, but at a lower volatility and with less tail risk. With the compounding effect in the

investors favor, lower risk over time could mean higher returns. Given the uncertainties we face going into 2012, such an approach may make even more sense to consider. For similar reasons, we believe that shorter-term tactical asset allocation also remains essential to achieving investment success. Such an approach factors in shorter-term return forecasts, including analysis of market trends and interrelationships among asset prices. In the period since the financial crisis of the late 2000s, we have witnessed some of the most dramatic shifts in these relationships in over a decade. For example, both within and across asset categories including stocks, bonds and currencies, correlations are at historically extreme levels. Our research has shown that, increasingly, investor risk appetitewhether in a risk on or a risk off periodis driving these

correlations. As such, we believe the success of a shorter-term asset allocation approach is determined in part by the ability to assess, and effectively manage, these interrelationships. lookIng aHead Putting it all together and looking ahead to 2012, we believe that investors will remain highly focused on asset allocation. Whether one believes that it accounts for a small or large part of long-term portfolio return, in our view asset allocation should not be dictated by passive, possibly antiquated, assumptions. Factors ranging from the time horizon, to both short-term and long-term asset price and market behavior, to, of course, the investors own ability to assess and manage all of these dynamics will be important considerations for multi-asset class allocation in 2012 and beyond.

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. Please see disclosures at the end of this publication, which are an important part of this article.

Solving for 2012

Asset Allocation View: Positioning Portfolios for the Coming Year

neuberger Berman asset allocation committee

Asset allocation is a crucial part of the investment process that has become ever more relevant as investors have sought to limit risk in volatile markets, in part by exploring new approaches to diversification and broadening asset class exposures. At Neuberger Berman, our Asset Allocation Committee is a group of senior strategists and portfolio managers from across investment disciplines who meet on a regular
basis to consider the outlooks for a range of asset classes. For 2012, we generally favor equities, although we see a number of potential value opportunities in fixed income and other areas as well. Below, we present some of our key viewpoints. Within equities, the committee favors U.S. large capitalization stocks over small-cap, developed international and emerging market equities, due to what we consider solid earnings growth, attractive valuations and abundant liquidity. Given the expectation for continued market turbulence, we are also favoring income-oriented securities such as high-dividend-paying equities, which tend to dampen portfolio volatility in times of economic distress. Among fixed income securities, we prefer credit sectors (like corporate bonds) relative to government issues. However, we see strong valuation opportunities for asset-backed and commercial mortgage-backed securities following expanding spreads this past summer. The committee has an overweight viewpoint on U.S. high yield fixed income securities, based on what we believe to be attractive valuations from both a spread and yield perspective. While European debt-market worries are influencing high yield prices, we believe the default rate for U.S. high yield bond issuers should remain low, thanks to robust corporate balance sheets and cash flows. Even in the face of a more significant economic slowdown, stronger cash flows at companies should adequately cover coupon payments. In the alternative asset classes, the committee favors an overweight to lower volatility and macro hedge funds, while noting potential longterm opportunities in commodities. volaTIlITy presenTs opporTunITIes hedge funds may be unique in todays landscape in that both their short- and long-term prospects may benefit from, rather than be disrupted by, macro-related volatility. In the class of macro-driven funds, the expected backdrop of market turmoil actually creates opportunities in both directional and geographic bets among global equities, bonds, currencies and commodities. Lowervolatility hedge funds may be an attractive option in volatile markets for their low correlation to equity and credit beta. commodities are an area for which the short-term outlook could differ significantly from longer-term prospects. The performance of most commodities is tied to the strength of the global economy. Considering the wide anticipation of a moderate pullback in economic growth in both

10

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STRATEGIC PERSPECTIVES

emerging and developed economies, this should mean lower demand growth for commodities, at least in the short term. Additionally, developing economies are fighting against domestic inflation, which could cut into commodity demand as well. Over the longer term, however, a broader pullback in economic growth would likely tame some of that inflation and

allow policymakers to ease up on the brakeswhich could, in turn, provide a boost to commodity performance. conclusIon In summary, the committee holds a relatively favorable view on the prospects for equities relative to other asset classes, based largely on the

sound fundamental condition and reasonable market valuations of many companies. Overall, the investment environment will likely continue to be affected by ongoing risk relating to the global economy, sovereign debt and geopolitics, reinforcing the merits of broadly diversified portfolios.

mARkEt VIEwS BASEd on 1-YEAR REtURn oUtlook FoR EAch ASSEt cl ASS ASSET CL ASS

Below-Normal Return Outlook

Long-Term (10-Yr.+) Annual Return Outlook

Above-Normal Return Outlook

Fixed Income Investment Grade Fixed Income U.S. TIPS High Yield Corporates Developed International Fixed Income Emerging Market Fixed Income Equity U.S. All Cap Core U.S. Large Cap U.S. Small Cap Master Limited Partnerships Developed International Equities Emerging Market Equities Public Real Estate Real and Alternative Assets Commodities Lower Volatility Hedge Funds Macro Hedge Funds Private Equity

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. The views expressed herein are generally those of Neuberger Bermans Asset Allocation Committee which comprises nine professionals across multiple disciplines, including equity and fixed income strategists and portfolio managers. The Asset Allocation Committee reviews and sets long-term asset allocation models, establishes preferred near-term tactical asset class allocations and, upon request, reviews asset allocations for large diversified mandates and makes client-specific asset allocation recommendations. The views and recommendations of the Asset Allocation Committee may not reflect the views of the firm as a whole, and Neuberger Berman advisors and portfolio managers may recommend or take contrary positions to the views and recommendation of the Asset Allocation Committee. The Asset Allocation Committee views do not constitute a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. This material may include estimates, outlooks, projections and other forward-looking statements. Due to a variety of factors, actual events may differ significantly from those presented. Please see disclosures at the end of this publication, which are an important part of this article. Solving for 2012 11

GLOBAL EQUITIES

Overview: Beneath the Surface, Opportunities Await

Joseph v. amato, president and chief Investment officer

Over the past year, the most commonly used words in relation to the markets were probably macro,

volatility and contagion. The least uttered? Id say fundamentals, as in what differentiates individual
companies at any given time. Clearly, the big picture was front and center in 2011, as investors grappled with an array of unanticipated, significant events often simultaneously. Whether the Arab Spring,
the Japan earthquake, the U.S. Treasury downgrade or the ongoing drama in Europe, these factors coalesced to heighten market turbulence and reinforce the notion that markets are truly interconnected as never before. Looking ahead to 2012, we see little sign that such issues are abating. European nations, despite ongoing dialogue, continue to struggle to achieve a credible solution to the debt crisis. The region, in our opinion, requires concrete steps toward fiscal consolidation followed by meaningful intervention by the European Central Bank. The political process has been taking much longer than markets demand. While this is understandable, given the complexities of the political process, financial markets may yet force the political leadership to move more quickly. In the U.S., Congress has postponed hard decisions about budget cuts until after the November elections. This will likely result in important policy initiatives going into suspended animation. The world is also watching closely as to whether China can successfully achieve a soft landing for its influential economy. In short, it seems like heightened volatility, tight correlations and near-term focus on high-level investment choicessuch as asset class, region and sector will continue to predominate in the short term. Despite this, as evident in our outlook pieces on the U.S., Europe, Emerging and China equities, we believe there are exceptional opportunities for bottom-up investors. For example, if you look past the general gloom in Europe, you find that there are numerous high-quality companies domiciled there with broad global exposure that are providing strong earnings at reasonable multiples. Elsewhere, despite a difficult 2011, emerging markets continue to provide secular advantages over developed counterparts. Economic growth is much faster, governments and individuals carry less debt, and demographics are favorable, as young and growing populations raise their living standards and increase consumption. Among stocks, the sell-off of 2011 has provided ample opportunities for bargain hunters. As for the U.S., individual companies are actually doing better than the sluggish economy would suggest. Many continue to generate healthy earnings and boast cash-rich balance sheets, low financing costs and limited wage pressures. Overall,

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GLOBAL EQUITIES

they seem well-positioned to ride out a downturn and perform well should the economy maintain modest growth (our expectation) or surprise on the upside. In all likelihood, 2012 is going to be another eventful year. But if, like us,

you think of current volatility and pessimism as opening and not just shutting doors, then you may also see this as a good time to capitalize on the attractive opportunities that await, especially given that many stocks have seen lower valuations in the wake of undifferentiated market

turbulence. In our view, the key in this environment is to exert patience and maintain investment discipline, while waiting out the structural, big-picture issues that continue to heighten anxiety around the world.

This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. This material may include estimates, outlooks, projections and other forward-looking statements. Due to a variety of factors, actual events may differ significantly from those presented. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Please see disclosures at the end of this publication, which are an important part of this article.

U.S. Equities: In the Back Seat Now, Fundamentals Should Eventually Drive Results
leah modigliani, multi-asset class strategist

Uncertainty abounds as we enter 2012for equities and fixed income, in the U.S. and globally. It could be another trying year. We expect a barrage of macro issues, including questions about the ongoing European sovereign debt crisis, whether China can avoid a hard landing, the health of the U.S. economy and the November elections, to continue to shape investor sentiment. Against this backdrop, strong corporate fundamentals, which are usually a forceful driver of equity returns, continue to take a back seat to daily headlines and the periods of heightened volatility that often follow. While investors could be in for a bumpy ride, we are generally positive on the prospects for the U.S. equity market and the eventual return of fundamentalsdriven performance. 2011: rIsk aversIon surged as THe year progressed The U.S. equity market, which began the year with much promise, was

soon hampered by a confluence of events that resulted in a significant flight to quality and, at times, indiscriminate selling. The shift from robust risk appetite (risk on) to risk aversion (risk off) began in the late spring. After a period of resiliency in the wake of the uprisings in the Middle East and the devastating earthquake in Japan, investor sentiment started to sour. Data pointed to moderating economic growth, and fears of Greece defaulting on its debt obligations again took center stage. Risk aversion gained momentum in the third quarter due largely to the downgrade of U.S. Treasuries by Standard & Poors. Mixed economic data, fears of contagion from the European sovereign debt crisis, and growing expectations for a double-dip recession compounded investor concerns. At times, investors were willing to park their money in Treasuries earning minimal returns as they took shelter in the rising storm. Despite a strong rally for stocks in October, inves-

tor goodwill soon faded with new concerns in Europe, including fears about Italian debt and a surge in the countrys borrowing costs. Political gridlock in Washington also came to a head as the debt-reduction super committee failed to reach a compromise to meet budgetary targets by the agreed-upon deadline. economy, FronT and cenTer As we look ahead to 2012, the economy, as usual, will be central to the health of the stock market. Unfortunately, economic data have been less than conclusive in gauging a clear course for recovery. Consumer and business spending, manufacturing activity and other metrics have fluctuated from month to month, leading to shifting expectations by turn from expansion to contraction and back again. However, two constants remain: elevated unemploymentrecently at nearly 9%and weakness in the housing market, which has had little momentum after

Solving for 2012

15

wIll REBoUnd In mARkEt Vol AtIlIt Y contInUE In 2012? N u m ber of Trading Day s w it h I ntraday Sw ing s A bove 3 % for S & P 50 0 80 70 60 50 40 30 20 10 0 00 01 02 03 04 05 06 07 08 09 10 11*

policy is likely to remain accommodative. This monetary stimulus may be particularly important given that U.S. budgetary pressures and political gridlock suggest that meaningful fiscal stimulus is unlikely to be put into place in the coming year. european deBT saga conTInues With unprecedented connectivity among businesses across global markets, U.S. economic health will depend in part on whats happening elsewherewhether in Berlin, Hong Kong or Tehran, for that matter. At this point, sovereign debtin the U.S., but particularly in Europecontinues to have an enormous impact (at least psychologically) on business and consumer confidence as well as market performance. As we write this report, the European situation continues to shift rapidly. A late October agreement by European Union members to reduce Greeces debt by 50% and substantially increase the European Financial Stability Facility (EFSF), designed to support euro-area member states, was initially viewed by investors as a significant step in quelling the escalating crisis. However, it soon became clear that the various players remain at loggerheads on how to deal effectively with major issues of implementation, timing and funding. Indebted nations bridle under pressure to implement austerity measures and reduce expenditures while core countries (Germany and France) have shown reluctance to bear the brunt of potential bailouts, and the European Central Bank seems cautious about taking on a larger role in quelling the crisis.

Source: FactSet. *As of November 30,2011.

dramatic declines in volume and pricing. These factors, combined with worries about global macro developments, have in turn negatively impacted confidence and consumption. Still, we think the U.S. economy has enough momentum to avoid a double-dip recession in 2012, and grow at a positive, even if subpar, pace. Among the factors that could potentially support growth are the sizable cash holdings of many companies that have been hesitant to deploy capital in an uncertain environment. If confidence improves, the increased use of this cash could augment GDPas could a positive change in spending by consumers, who have been relatively conservative in their spending over the past several years.

Even if the U.S. falls back into recessionwhich we see as the less likely scenariowe think it would probably be relatively shallow, due to what we consider to be a lack of excesses in the economy. In the housing sector, for example, construction starts, residential sales and home prices all declined dramatically for several years, and appear to have little room to fall further from todays depressed levels. Corporations, having cut costs during the depths of the economic crisis, are operating leanly, aided by healthy balance sheets and inexpensive financing. We believe default rates on company debt are likely to come in below average next year. Indeed, given modest inflation numbers and fears about the economy, the Federal Reserves monetary

coRPoRAtE BAl AncE ShEEtS REmAIn hEAlthY Perce nt age of A sset s in C ash : S & P 50 0 Co m p a nies ( e x Fina ncials ) 10% 8

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Source: FactSet, through September 30, 2011.

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GLOBAL EQUITIES

France and Germany have called for reworking the European Union (EU) as a whole and amending European treaties to include centralized oversight of national budgets and automatic sanctions against countries in violation of new stricter rules, at least for the 17 eurozone countries. But the U.K. has so far vetoed the proposed EU-wide agreement, and some European voters are voicing complaints as well. Meanwhile, the prolonged inability to come up with a decisive fix to its debt woes appears to threaten the credit ratings of even core eurozone countries. All told, the ongoing uncertainty and hobbled banking system will likely impact economic activity in the near termsomething that new European Central Bank President Mario Draghi acknowledged in noting the potential for a mild European recession by the end of 2011. oTHer Issues: cHInese Hard landIng Beyond the maneuverings in Europe, we are keeping a close eye on developments in China, which have significant implications for global growth and the equity markets in 2012. Much has been written about whether China has the ability to orchestrate a soft landing for its economy by ending a two-year tightening cycle that has included numerous interest rate increases and higher bank reserve requirements. Indeed, the countrys economy has decelerated somewhat, from 10.4% GDP growth in 2010, to around 9.2% for 2011. If the Chinese governments measures to cool the property market and tame inflation turn out to have

been too heavy-handedespecially with economic pressures mounting in the developed worldthe resulting slowdown could substantially impact global business activity. From our perspective, although Chinas economic expansion is likely to further moderate in 2012, we dont believe the country will experience anything too severe. Chinas inflation rate now appears to be at, or near, a peak while its property market has shown signs of cooling. As a result, we think that Chinese policymakers have the flexibility to stop or potentially reverse course on their tightening measures in pursuit of the elusive soft landing. elecTIon grIdlock? Finally, one issue that is a bit harder to handicap is the potential impact of election politics in 2012, when the U.S. will choose its President and both the House and Senate have the potential to change hands. (See 2012 Election on page 19.) Despite extensive wrangling, little progress has been made toward reducing the federal budget deficit and level of federal debt, which has now reached a staggering $15 trillion. Moreover,

should the economy soften, as noted, it seems unlikely that there would be agreement on any major stimulus. Indeed, given the political gamesmanship displayed during the debt ceiling crisis and with the failure of the Congressional super committee to reach budgetary compromise, we think that the run-up to the election will only intensify current polarization and extend gridlock. This, in turn, could influence Standard & Poors and other rating agencies as they consider a potential further downgrade of U.S. Treasuries, as well as the willingness of businesses to make major investments in equipment or hiring in an uncertain environment. Although there may be some movement on tax reform, it seems that the most important policy initiatives will probably have to wait until after November. WHaTs aHead For sTocks Many of the key issues facing the worlds governments and economies will likely take time to play out. As such, we think that the short-term movements of the U.S. equity market in 2012 will continue to hinge on

UncERtAInt Y, mAcRo FocUS hEIGhtEnEd coRREl AtIon AmonG StockS S & P 50 0 I nd u str y Grou ps : 30 - day Rolling Correlation 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 2004 2005 2006 2007 2008 2009 2010 2011

Source: FactSet, through November 30, 2011.

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signs of improvements and/or setbacks in these key issues, as well as the outcome of economic data along the way. This, in turn, could lead to additional periods of heightened market volatility and a continuation of the risk-on/risk-off investor mentality that characterized 2011. Similarly, with macro issues dominating the markets, we expect that higher-thanaverage correlations among asset classes and among individual securities will continue, making it more challenging for investors to build meaningfully diversified portfolios. Ultimately, where the market ends up on December 31, 2012 will, in our view, depend on whether cumulative progress is made on key fronts, such as Europes debt crisis, Chinas economic path, or U.S. business and consumer confidence. From a fundamental perspective, we believe U.S. stocks are a good value. Low interest rates are extremely supportive and valuations are attractive from

a historical perspective, with the S&P 500 Index trading at a forward price/earnings ratio of roughly 10.9, versus 15.0 over the past 10 years.1 Despite challenging economic conditions, corporate profits generally remain solid. Companies within the S&P 500, for example, are expected to generate earnings per share of $107 in 2012, up from a projected $97 in 2011. As mentioned, corporate balance sheets are generally cashrich, which could provide something of a cushion if the economy stumbles. Using some of this cash for shareholder-friendly activities, such as increased dividends and share buybacks, would likely lend support to the stock market, as would an increase in mergers-and-acquisitions activity. That being said, corporate guidance for 2012 has been vague or noncommittal, given the macroeconomic headwinds; so investors currently lack the clear visibility to increase their confidence from current levels.

Taking into account both the macro issues and underlying fundamentals, we recognize the likelihood of continued near-term market volatility, but we also think that U.S. equities are generally attractive at these levels and have attractive upside potential for long-term investors. Near term, should the economy surprise on the upside, we could see investors begin to rotate from defensive to early cyclical stocks (while, of course, a downturn could have the opposite effect). Regardless, we are encouraged by corporations resiliency since the credit crisis and feel that many businesses are well-positioned to capitalize on opportunities for growth that we expect to materialize once a more stable global framework and a better economic backdrop begin to emerge.

1. Source: FactSet, as of November 25, 2011. This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. This material may include estimates, outlooks, projections and other forward-looking statements. Due to a variety of factors, actual events may differ significantly from those presented. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Investing in the stocks of even the largest companies involves all the risks of stock market investing, including the risk that they may lose value due to overall market or economic conditions. Small- and mid-capitalization stocks are more vulnerable to financial risks and other risks than stocks of larger companies. They also trade less frequently and in lower volume than larger company stocks, so their market prices tend to be more volatile. Please see disclosures at the end of this publication, which are an important part of this article.

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2012 Election: An Exercise in Austerity

matthew l. rubin, director of Investment strategy

Politicians have long recognized the relationship between voter approval and the state of the financial markets and economy. This is most evident in U.S. presidential election years, when campaign promises and stimulus packages become the norm and tend to benefit stocks. In 2012, however, things could be a bit different. Historically, presidential cycles and U.S. stock markets have exhibited some recurring trends, with equity market returns tending to be stronger in the third and fourth years of presidential administrations, as incumbents have pumped stimulus into the economy in hopes of furthering their reelection chances. Since 1926, the S&P 500 total return has averaged 8.2%, 9.0%, 19.4% and 11.0% in years 1, 2, 3 and 4, respectively, of each presidential term. Under President Obama, however, equity returns have been front-loaded, with the S&P 500 returning 26.5% and 15.1% in his first (2009) and
oBAmA And thE Stock mARkEt S & P 50 0 Tot al Retu rn by Preside ntial Year 30% 25 20 15 10 5 0 Year 1

second (2010) years as President, and only 1.1% year-to-date as of November 30, 2011. To be fair, the market environment throughout Obamas tenure to date has been tumultuous early gains reflect the rebound from the depths of the March 2009 market lows, while more recently the European debt crisis and economic fears have had a dampening market impact. an ausTerITy elecTIon Looking toward 2012, we do not expect major stimulus measures to be enacted by the federal government, as has often been the case in an election year. Fears over debt levels and the vast political divide in Congress have simply changed the debate. Instead of proposing tax cuts and spending increases, politicians are generally contemplating tax increases and spending cuts. All things being equal, such austerity measures will likely be a drag on economic growth.

As some will observe, the economy is not the stock market and the stock market is not the economy. We agree, but the 2012 elections are particularly uncertain, with the President appearing to be hanging on by a thread and the major political parties defending slim margins in the House and Senate. Moreover, tax reform, health care regulation, international trade and many other issues are still up in the air and may not be decided until after November 6. This will likely prompt businesses and individuals to take a cautious approach until greater clarity emerges. As a result, we anticipate the elections to have a dampening effect on both the economy and stock market in 2012if we do happen to reach the 11.0% average S&P 500 return for year 4 of the election cycle, I highly doubt it would be a result of government largesse.

Year 2 Historical Average

Year 3 Obama

Year 4

Source: FactSet. Year 3 Obama data through November 30, 2011. This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. The views expressed herein are generally those of Neuberger Bermans Investment Strategy Group (ISG), which analyzes market and economic indicators to develop asset allocation strategies. ISG consists of five investment professionals who consult regularly with portfolio managers and investment officers across the firm. This material may include estimates, outlooks, projections and other forward-looking statements. Due to a variety of factors, actual events may differ significantly from those presented. Any views or opinions expressed may not reflect those of the firm as a whole. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. Please see disclosures at the end of this publication, which are an important part of this article.

Developed International Markets: Looking Beyond the Eurozone

Benjamin segal, cFa, portfolio manager and Head of global equity Team

With so much uncertainty in the past years global equity markets, courtesy of the eurozone sovereign debt crisis, investors may wonder how much appeal an international equity allocation holdsespecially as the crisis and related concerns remain an ongoing risk. In our opinion, plenty. We think a global perspective, along with a bottom-up, qualityand valuations-focused investment approach, can continue to uncover attractive long-term opportunities for both appreciation and diversification, and help mitigate many of the risks associated with a tougher macroeconomic backdrop. From a regional perspective, we think its critically important for investors to differentiate between sources of opportunity and sources of anxiety in the developed international arena. The weak performance of the MSCI EAFE Index in 2011 was clearly driven by the eurozone, with its news of downgrades, potential defaults and bailout-related political concerns. The eurozone continues to garner attention, as the debt accumulated by the weaker GIIPS economies1 strains stronger nations such as Germany, and taxes the capabilities of the European Financial Stability Facility and commitment of its member states. Additionally, austerity programs and higher taxes aimed at reducing large deficits, while necessary for the longer term, will likely continue to impede growth and weaken consumer and business sentiment in the near term. This

suggests that serious challenges remain as the region works toward economic stability. While the U.K. is not part of the eurozone, the outlook there seems fairly unappealing for many of the same reasons. The U.K. has high levels of consumer and government debt, as well as large government deficits. Attempts to cut government spending have met with significant resistance and have acted as a drag on an already slowing economy. This contrasts with other non-eurozone countries like Switzerland and the Nordic region that offer more economic and fiscal stability. On the other side of the globe, Japan struggles with an aging demographic profile, high public debt levels, and an export sector exposed to an appreciating yen and slowing global economylikely a recipe for continued anemic growth going forward. Elsewhere in Asia, and more broadly in emerging markets,

new middle class consumers and corporations offer opportunity for growth and investment. navIgaTIng Weaker markeTs With most mature economies seeking to reduce fiscal deficits, we believe economic growth in the developed world is likely to remain weak. As a result, inflation should stay subdued, and interest rates can remain at low levels. We believe that spending will remain weak, and therefore see little appeal in companies that rely on a buoyant consumer in Europe or Japansuch as auto manufacturers and more appeal in companies with a more defensive customer profile. We also believe that prospects for multinational businesses with established operations in North America and Emerging Markets are more attractive than those with operations focused on Europe or Japan. A number of Europebased companies have many decades

EURozonE lIkElY to lAG, whIlE Em ShoUld lEAd GloBAl GRowth % Year- over-Year Econo mic Grow t h projections 2010 Eurozone United Kingdom United States Canada Japan Emerging Markets World Output Source: IMF World Economic Outlook, September 2011. 1.8 1.4 3 3.2 4 7.3 5.1 2011 1.6 1.1 1.5 2.1 -0.5 6.4 4 2012 1.1 1.6 1.8 1.9 2.3 6.1 4

1. Greece, Italy, Ireland, Portugal and Spain.

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GLOBAL EQUITIES

of experience operating in emerging markets, offer strong corporate governance and transparency, and trade at attractive valuation levels today. Within Europe and Japan, we believe defensive sectors like health care and consumer staples hold appeal. We also find certain segments of the consumer discretionary sectors attractivesuch as cable TV and satellite broadcastingwhere many companies maintain a recurring stream of revenue that tends to be insensitive to the economic backdrop. We also view parts of the information technology and industrial sectors in the same light, as many companies in these areas derive most of their profits from maintenance or service revenue. Even in mature markets, we believe that telecommunications spending will continue to rise, as consumers adopt more data-intensive devices and applications. Within this area, we believe that cellular operators and equipment suppliers are likely to benefit from greater volumes and capital spending.

In contrast, we are generally pessimistic about the financial sector, as we believe that the developed world is in a prolonged period of deleveraging. Credit markets globally remain vulnerable to policy in Europe, which represents an area of potential risk that it seems prudent to avoid. IdenTIFyIng areas oF sTrengTH In Europe, once one steps outside the markets at the center of the debt issue, we believe there are attractive investment opportunities. Countries such as Norway and Switzerland are good examples. Norway has retained its own currency, has limited public debt, and maintains significant oil reserves. Switzerland has also retained its currency and is home to several world-class global health care and consumer staples companies that operate in a variety of developed and emerging markets. Similarly, while we expect the U.K. economy to remain lackluster, there are solid companies in Britain that appear well-positioned with global brands and operations.

From our perspective, a well-rounded approach to international equity investing should also consider nonEAFE index exposure. The Canadian economy fared well through the global financial crisis of 2007-09, and is home to some of the worlds leading energy, precious metals and agricultural commodities companies. Emerging markets include many companies that are relatively insensitive to policy changes in their home markets and offer a strong strategic position in global markets. Overall, we believe that international markets offer compelling valuations and select areas for secular growth. While there are countries and sectors to avoid, we think there are also world-class opportunities for longterm investors willing to look beyond the headlines.

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. Investing in foreign securities involves greater risks than investing in securities of U.S. issuers, including currency fluctuations, interest rates, potential political instability, restrictions on foreign investors, less regulation and less market liquidity. Investing in emerging market countries involves risks in addition to those generally associated with investing in developed foreign countries. Securities of issuers in emerging market countries may be more volatile and less liquid than securities of issuers in foreign countries with more developed economies or markets. Please see disclosures at the end of this publication, which are an important part of this article.

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Emerging Markets: Real Growth in a Weakening Global Economy

conrad a. saldanha, cFa, portfolio manager global equity Team

After sharp losses stemming from extreme risk aversion during 2011, we believe emerging markets (EM) equities may be poised for a reboundfirst for larger-capitalization stocks and then smaller-cap issues. In our view, fundamentals remain strong and, after the sell-off, valuations have become compelling. Perhaps most importantly, compared with the headwind that we expect developed market companies to experience, EM companies are currently benefiting from real secular growth. While risks remain, including domestic inflation and ongoing global economic pressures, we believe that EM companies focused on meeting domestic demand have attractive return potential in the year ahead.

sell-oFF In 2011 Was IndIscrImInaTe As 2011 began, loose monetary policy in the developed markets helped push commodities and energy prices higher. This caused EM central bankers to focus on taming inflation. The need for vigilance was particularly pertinent in high-growth economies such as China, India and Brazil, and policymakers embarked on monetary tightening programs in an effort to limit the risk of their economies overheating. While this made sense economically, the policy caused EM investors to worry about slowing growth. In the second half of the year, the European sovereign debt crisis intensified. This, along with signs of slowing growth across the major developed economies, and a potential hard landing for the Chinese economy, led markets to a period of massive risk aversion.

Given the risk-aversion sentiment, although fundamentals generally remained strong, investors sold off EM equities. This risk-off trade began in the third quarter, with the MSCI Emerging Market Index declining 22.5%, the worst performance since the fourth quarter of 2008. Now, with valuations at attractive levels, and relatively superior economic growth rates, we view this as an attractive time for investors with a longer-term view to reconsider emerging markets. secular groWTH and THe domesTIc advanTage From our perspective, the secular advantages emerging markets enjoy over developed markets have only increased, driving and sustaining their longer-term growth trajectories. Gross domestic product (GDP) growth is highin fact, some research suggests

EmERGInG mARkEtS : UnPARAllElEd GRow th At A low PRIcE Forward Price/Earnings* 35 30 25 20 15 10 5 0 3/06 9/06 3/07 9/07 3/08 9/08 3/09 9/09 3/10 9/10 3/11 9/11 11/11 5 0 15 10 25% 20 Forward EPS Growth Rates

3/06 9/06 3/07 9/07 3/08 9/08 3/09 9/09 3/10 9/10 3/11 9/11 11/11 MSCI World

MSCI Emerging Markets Sources: MSCI, FactSet, RIMES. Data as of November 30, 2011. * Based on one-year estimates. Based on 3-5 year earnings-per-share growth rates.

1. Source: Morgan StanleyGlobal Economics, August 2011. 22 Neuberger Berman

GLOBAL EQUITIES

that up to 80% of global GDP growth will be generated from the emerging markets in 2012.1 In addition, emerging markets countries tend to have strong balance sheets versus the overly indebted developed market countries. Longer term, we believe one of the most important secular drivers for EM economies is their demographic profile: Young and growing populations are rapidly increasing their standards of living and consumption habits, driving growth for many domestically focused consumer staples, consumer discretionary and health care companies. These countries also have to spend on local infrastructure that will benefit local growth, improving efficiency and raising capacity. A new positive shift weve seen is taking place within emerging markets export sectors, which have traditionally been aimed at developed markets. In light of a slow global economy, intra-emerging markets trade has been the key growth driver for the export sector, and has resulted in more exports remaining in EM. Clearly, companies with the brand, distribution and exposure to other growing economies appear, at this point, better positioned than those relying on developed markets for their growth. In terms of market capitalization, we see the most compelling valuations in small- and mid-cap stocks, as they underperformed for much of 2011

when investment fund flows migrated out of EM. With a longer-term view, we think they offer an attractive risk/ reward profile as, in general, they are well-positioned to benefit from the domestic growth. Issues remaIn BuT are relaTIve The types of issues we see in emerging markets can be categorized either as exogenous (such as effects of the global economic slowdown, EM investor behavior and liquidity issues) or internal (inflation or sub-optimal growth). While any of these could impact equity market performance, we take comfort in the idea that strong secular growth stories with solid company and economic fundamentals should hold investment appeal, particularly in light of the challenges facing developed equity markets. Regarding inflation, while emerging markets companies continued to see strong growth in 2011, higher raw material and input costs as well as higher wages created some margin pressure. We think these effects will start to taper off; and, from an earnings growth standpoint, we continue to feel more comfortable with the domestically oriented sectors. To maintain growth in a slowing global economy, many countries are either already cutting rates or nearing the end of tightening cycles. In cases where inflation has remained

fairly sticky, as in China and India, policymakers appear to want to see evidence that inflation has abated before making definitive moves. On the other hand, in Turkey, Indonesia and Brazil, rate cuts are already underway. For Brazil, specifically, high rates had strengthened the real, which has hurt export sectors. A surprise rate cut last summer was aimed at removing some of the upward currency pressure. The fact remains, however, that there is structural inflation in emerging markets, with wages increasing considerablywhich, in part, also fuels strong domestic demand. To help increase productivity and offset wage pressures, investments in capacity will be needed. A general lack of capacity is an ongoing problem hampering overall growth, but it provides another secular investment theme focused on industrial and materials companies. cauTIous opTImIsm As we look to the year ahead, we are cautiously optimistic. When the market returns to focusing on the fundamentals, we think domestically driven emerging markets companies could be a real growth story for 2012.

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. Investing in foreign securities involves greater risks than investing in securities of U.S. issuers, including currency fluctuations, interest rates, potential political instability, restrictions on foreign investors, less regulation and less market liquidity. Investing in emerging market countries involves risks in addition to those generally associated with investing in developed foreign countries. Securities of issuers in emerging market countries may be more volatile and less liquid than securities of issuers in foreign countries with more developed economies or markets. Please see disclosures at the end of this publication, which are an important part of this article.

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Greater China: Challenges, Select Opportunities

Frank yao, senior portfolio manager greater china equity Team

In recent years, China has achieved generally stable and rapid economic growth, averaging 10% gross domestic product (GDP) growth in the last 31 years, and 9.4% in the first three quarters of 2011.1 As we look to 2012, however, the sluggish world economy and market volatility may pose significant challenges for investors. Does the Greater China region continue to provide opportunities? In our view, the answer is yes, especially in view of 2011 market declines; although selectivity, as always, will be important in this relatively volatile segment of the worlds capital markets. groWTH remaIns sTrong, valuaTIons compellIng Projected growth rates for China, albeit lower than those seen recently, remain strong. The Chinese government has targeted GDP growth of approximately 7% for the next five years,2 and we anticipate Chinese GDP growth rates of 8.5% and 8% over the next three and five years, respectively. If GDP growth rates for other economies remain in line with consensus estimates, these figures would be among the highest in Asia and about two times that of U.S. and Europe combined. Chinese per capita GDP and private consumption are much lower than those of other major economies. This reflects the vast gap in living standards between China and developed economies and, we believe, supports the case
1. 2. 3. 4. 5. 6. 7. 8. 24

for continued strong growth. Also important, bargain-hunting opportunities have emerged following the recent market corrections, with valuations near 2008 lows despite what we consider to be very strong earnings potential. For example, the trailing 12-month price/earnings ratio for the MSCI China Index was 8.4 as of September 30, 2011.3 This is despite projected 2012 earnings-per-share growth in the low teens for MSCI China and mid-teens for the China A-shares market. underWeIgHTed In gloBal IndIces In our view, Greater Chinas weighting in global indices does not properly reflect its size, importance and influence in relation to global markets. Mainland China is the worlds largest emerging market and Greater China4 (including Hong Kong and Taiwan) is the second-largest equity market in terms of market capitalization. However, the MSCI global indices only include a subset of the Greater China markets and do not reflect the entire opportunity set. The MSCI World Index contains only Hong Kong companies listed in Hong Kong, which represents just 1.3% of the index total.5 Meanwhile, China is captured in the MSCI Emerging Markets (EM) Index only as mainland Chinese companies listed in Hong Kong, and comprises 17.3% of

the index (see display) 6 versus 15.3% for Brazil. In fact, Greater China has a market capitalization of over three times that of Brazil, but the market is under-represented by global indices because only a portion of it is captured. In our view, this misalignment underscores the magnitudeand, therefore, the opportunity setof the potential investment universe within the Greater China equity markets (see display on page 25). sHIFT ToWard domesTIc consumpTIon Historically, GDP growth in China has been driven by government investment. Today, although still the worlds largest exporter, the country is becoming less dependent on fixed asset investment and foreign trade for growth, reflected by its standing as the worlds second-largest importer. In the first three quarters of 2011, growth of imports outpaced that of exports, up 26.7% versus 22.7%, respectively.7 Another key metric is retail sales, which we consider an important indicator of domestic consumption. Retail sales rose 17.7% yearover-year in September 2011 and 17% in the first three quarters of 2011.8 We believe these shifts in Chinas growth model will contribute to the sustainability of its long-term expansion.

National Bureau of Statistics of China. Outlines for the 12th Five-Year Plan on National Economic and Social Development, March 2011. Bloomberg, as of September 30, 2011. Greater China includes companies incorporated, organized under the laws of, or that have a principal office in, the Peoples Republic of China, Hong Kong SAR, Macau SAR or Taiwan. It also includes companies that derive a majority of their revenue or profits or that have a majority of their assets in mainland China or Taiwan. Barclays Capital, as of August 31, 2011. Greater China represents Hong Kong companies listed in Hong Kong, which is in the MSCI World Index. Barclays Capital, as of August 31, 2011. China represents Mainland China companies listed in Hong Kong, which is in the MSCI Emerging Markets Index. Chinas Foreign Trade to Top $3 trillion This Year: Official, China Daily, October 29, 2011. Total Retail Sales of Consumer Goods in September 2011, National Bureau of Statistics, China.

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GLOBAL EQUITIES

chInA IndEx wEIGhtInGS UndERwEIGht mAjoR mARkEt Grow t h , Market C apit aliz ation of L argest Em erging Eq uit y M arket s GDP Real Rate (% as of July 2011) 12% Brazil China1 Mainland China 17.64% 15.32% India Indonisia Russia 6 Brazil 4 Malaysia South Korea Taiwan 0 0 Mexico 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 Market Capital ($ in billions as of September 30, 2011) Source: Bloomberg and CIA World Fact Book, as of September 30, 2011. Size of circle represents size of market capitalization. Mainland China includes A and B shares only. 2.83% Source: Barclays Capital, as of August 31, 2011. 1. China represents Mainland China companies listed in Hong Kong, which is in the MSCI Emerging Markets Index. 2. Others include Chile, Colombia, Czech Republic, Egypt, Hungary. Malaysia, Mexico, Morocco, Peru, the Philippines, Poland, Thailand, Turkey. 7.89% 6.74% 14.38% 6.95% India 10.99% 17.25% Korea Russia South Africa Taiwan Others2 MSCI Em erging M arket s I nde x Con stitue nt s

10

Turkey

InFlaTIon concerns aBaTe Throughout 2011, the Chinese government grappled with balancing slowing growth and the potential for high inflation. Since September 2010, the Peoples Bank of China (the countrys central bank) has been active in its tightening policyraising benchmark interest rates five times and increasing the reserve requirement ratio for major banks to a record 21.5% from 17% last year.9 However, of late, policymakers have eased these measures due to potential concerns over social unrest and slowing growth. Overall inflation (as represented by the Consumer Price Index) peaked in July 2011 at 6.5% and has gradually decreased, easing to 6.2% in August

2011 and dipping slightly below 6.1% in September 2011.10 We expect inflation of approximately 5% for the last quarter of 2011. Compared with the countrys savings rate of approximately 3.5%, the real savings rate (after inflation) is still negative. While we believe it remains too early to confirm that inflation has abated, we feel that the easing to date is a positive indicator. amId sloWIng, look To IndusTry leaders Looking ahead to 2012, Chinas economic prospects will likely be affected by slower projected growth in the U.S. and Europe. However, we think a healthy job market supported by rising wages reinforces the potential for select opportunities in sectors driven

by economic growth and consumption, such as consumer discretionary and consumer staples. Within these sectors, we are more optimistic about companies that are leading players in their respective industries, with high top- and bottom-line visibility, stable and recurring operating cash flows, and robust distribution channels. More broadly, although short-term uncertainties persist, we believe the Greater China equity markets are at compelling valuations and seem likely to rebound during the coming year. In our view, taking a bottomup approach using on the ground research will be the best way to try to limit the potential pitfalls and capitalize on the opportunities in the region.

9. Corporate Yield Gap Shrinks as China Curbs Ease, Bloomberg, October 30, 2011. 10. National Bureau of Statistics of China. This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. Please see disclosures at the end of this publication, which are an important part of this article. Solving for 2012 25

GLOBAL FIxED INCOME

Overview: Despite Uncertain Economy, A Generally Positive Outlook

Brad Tank, chief Investment officer Fixed Income

The economic picture is clouded with an unusual number of macro issues that could potentially undermine global growth in 2012. However, should some of these issues be resolved or even become less negative, the result could be an upside surprise for the global economy, given the current
level of pessimism. Overall, despite a host of macro uncertainties, we are generally positive about the various sectors of the global fixed income market. a look Back The first quarter of 2011 and much of the remainder of the year were a study in contrasts for the fixed income market. When the year began, there were expectations for a strengthening global economy and inflationary concerns. In the first quarter, despite many geopolitical issues, the ongoing European sovereign debt crisis and the devastating natural disasters in Japan, most spread sectors outperformed equal-duration Treasuries and U.S. Treasury yields moved higher across the curve. However, beginning in late spring, global growth moderated and investor risk appetite was replaced with risk aversion. The risk off trade gained momentum in the third quarter of the year due in part to a lack of U.S. fiscal discipline resulting in Standard & Poors Treasury rating downgrade, disappointing economic data that triggered expectations for a double-dip recession, and fears of contagion from the European sovereign debt crisis. At one point in September, the yield on the 10-year Treasury fell to levels not seen since the 1940s. At this point, it appears that many spread sectors may generate positive returns in 2011, but lag equal duration Treasuries. gloBal economIc uncerTaInTy Against such an uncertain backdrop, the following is our base case for 2012, albeit with several caveats given the unfolding situation in Europe, evolving fiscal and monetary policies around the globe and questions regarding Chinas ability to orchestrate a soft landing for its economy. What is crystal clear is the fact that the global recovery has lost some momentum. Leading indicators across the globe point to a slowdown that is broad-based. Whats more, consumer spendingthe true driver of an economic expansionremains weak as households deleverage and repair their balance sheets. These headwinds, coupled with a growing push for fiscal consolidation and sovereign debt reduction, lead us to believe that global growth will remain below trend in the short to medium term. In the midst of elevated levels of risk aversion and deteriorating macroeconomic fundamentals, we feel that exceptional stimulative measures are likely to remain in place for longer than previously anticipated. We also feel that interest rates around the globe should remain relatively low. This is a potential recipe for solid results from many sectors in the global fixed income market. Given spread widening that occurred during recent flights to quality, we now find many spread sectors to be attractively valued.

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GLOBAL FIxED INCOME

U.S. Economy, Rates and Sectors

andrew a. Johnson, chief Investment officer Investment grade Fixed Income

We expect U.S. growth to remain modest, but generally positive, as the economy adjusts to tighter fiscal conditions. Easy monetary conditions, ample liquidity and stronger balance sheets for both consumers and corporations (higher savings rate for the former and significant amounts of cash and extended debt maturities for the latter) should, in our view, provide an improved environment for consumer spending and, thus, U.S. growth. We think unemployment will remain elevated but begin to drift lower. Overall, in our opinion, GDP growth will most likely be between 1.5% and 2.5% in 2012. InTeresT raTes and InFlaTIon We have a fairly negative outlook for Treasuries given recent valuation levels. The outright level of rates, a multidecade low, reflects a substantial

amount of risk/uncertainty premiums associated with the European situation, expectations for a U.S. recession and potential for a deflationary environment. Given low Treasury yields, any material change in sentiment and/ or positive surprises in economic data will, in our view, result in negative absolute returns for the asset class in 2012. We expect the trading range for the 10-year U.S. Treasury to be between 2% and 3% for 2012 and for the five-year Treasury to fluctuate between 0.9% and 1.6%, given the Feds commitment to keeping the Federal Funds rate anchored in a historically low range between zero and 0.25% until mid-2013. The longer end of the curve (30-year maturities) has the potential to be more volatile and could trade between 3.0% and 4.4% in 2012. We believe headline inflation will moderate from 4%, while core CPI should remain relatively steady

given the large positive gap between headline and core CPI. InvesTmenT grade credIT While the near-term outlook for the credit market is cloudy, we feel the intermediate- to longer-term picture remains bright. Near term, a number of macro factors could overshadow generally strong fundamentals which typically drive the performance of the credit market. These factors include concerns about contagion from the European sovereign debt crisis and fears of a recession in the U.S. While the situation in Europe remains fluid, it is our belief that a resolution will eventually occur. We also feel that the U.S. will skirt a double-dip recession. When some of the uncertainties regarding the macro headwinds lift, investor sentiment could improve, providing a tailwind for the credit

PRIcInG In A REcESSIon, InVEStmEnt-GRAdE cREdIt APPEARS At tRActIVE Spread to Treasury (bps) 800 700 600 500 400 300 200 100 0 1925 Corporate Malfeasance 2001 Recession S&L Crisis 8081 Recession 9091 Recession Credit Crisis

1935

1945

1955

1965

1975

1985

1995

2005

U.S. Recession

BBBs (to Treasury)

AAA/AA (to Treasury)

Source: Morgan Stanley, Moodys, the Yield Book, Federal Reserve. Data through October 31, 2011.

Solving for 2012

29

market. Further supporting the credit market is the fundamental backdrop. Overall, corporate balance sheets are generally strong, with record amounts of cash on their books. In addition, unlike the 2008 credit crisis, U.S. banks have recapitalized, there is ample liquidity, default rates are extremely low and we expect to see more upgrades than downgrades. Furthermore, corporations continue to enjoy exceptionally low borrowing costs and, given the low interest rate environment, we believe demand for the asset class will again be robust. Given this outlook, we expect to see investment-grade bond spreads tighten in 2012. resIdenTIal morTgage-Backed securITIes We are generally positive regarding the agency mortgage-backed securities (MBS) market in 2012. Valuations are fairly attractive from a historical perspective and fundamentals are

encouraging overall. In our view, prepayment risks are muted, given the high percentage of mortgages that remain under water due to the prolonged downturn in the housing market. Agency MBS are also a relatively high-quality spread sector, which could prove advantageous during periods when there are heightened concerns over credit risk. Also supporting the agency MBS market, in our opinion, is the Federal Reserves initiative to reinvest coupons and principal payments from its holdings of agency debt and agency mortgage-backed securities into agency MBS. The main risk to our outlook comes in the form of unexpected regulatory actions. In particular, prepayment risks would increase if the federal government is successful in introducing measures to help homeowners who have negative equity refinance their mortgages. In our view, the prospects for the nonagency residential mortgage-backed securities (RMBS) market are also

encouraging. A number of technical factors, including the Federal Reserve Bank of New Yorks attempts to sell its stake in Maiden Lane II LLC in the open market, caused non-agency RMBS spreads to widen during the spring of 2011. The downturn in this sector resumed as the general shunning of credit risk continued through the summer and fall. As a result, we feel that non-agency RMBS lossadjusted yields havent been this attractive since mid-2009. Fundamentals in this market are also generally benign, as we do not expect to see significant further deterioration in the housing market. In addition, we could see further progress between regulators and mortgage originators/ servicing companies regarding the servicing and foreclosure process. This could positively impact the foreclosure timeline, which, we believe, would be beneficial for the overall RMBS market.

REAl RAtES dRoP In PoSt-REcESSIon EnVIRonmEnt 10 -Year Treasu r y and Fed Fu nd s Historic al Real Rate 6% 5 4 3 2 1 0 -1 -2 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Fed Funds Real Rate Source: Yield Book; data through October 31, 2011.

10-Year Treasury Real Rate

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GLOBAL FIxED INCOME

asseT-Backed securITIes We generally do not find asset-backed securities (ABS) to offer compelling valuations, as their spreads have largely moved back to their pre-credit crisis levels. Additionally, regulatory uncertainty, especially in terms of how the DoddFrank Act treats securitization going forward, could negatively impact ABS. In particular, the use of securitization by financial companies has become less attractive and has resulted in less liquidity in the secondary market. commercIal morTgageBacked securITIes The risk-off trade caused most spread sectors to perform poorly as 2011 progressed, and commercial mortgage-backed securities (CMBS) were no exception. This has presented what we consider some compel-

ling spreads at the top of the capital structure tranches in the CMBS market. Loss severities on liquidated loans have also not been as bad as was feared a year ago, as commercial property pricesespecially in major metropolitan marketshave often held up better than anticipated. Potentially undermining our generally positive outlook are regulatory uncertainties related to the securitization of commercial mortgages. We also saw that the CMBS market was highly susceptible to spread-widening during recent periods of heightened risk aversion. Given the unsettled macro environment, we acknowledge that a resumption of the risk-off trade could negatively impact the CMBS market in 2012, but we believe that this would be temporary, as yield spreads are very attractive for such relatively high-quality assets.

Treasury InFlaTIonproTecTed securITIes As we approach the conclusion of 2011, Treasury Inflation-Protected Securities (TIPS) seem likely to have generated a strong absolute return for the year, but underperformed Treasuries. For 2012, we expect TIPS to deliver positive excess returns as break-even inflation is expected to firm. It is our belief that headline inflation data will remain volatile in 2012 and that the Federal Reserves accommodative monetary policy will increase long-term inflation risk premiums.

High Yield Bonds and Bank Loans

ann H. Benjamin, chief Investment officer leveraged asset management

Given the underlying fundamentals and current spread levels, we have a positive outlook for the high yield/ bank loan market in 2012. From a fundamental perspective, despite moderating economic growth, corporate profits have generally been solid and leverage levels are manageable. Furthermore, in our view, the large amount of cash sitting idle on corporate balance sheets provides something of a cushion if economic growth weakens further. We also feel that implied default levels may be overstated. In our view, default rates will not materially increase in the next several years, even if the U.S. slips back into a recession. The usual catalysts for defaults have significantly dissipated, as bond and loan maturities have been extended,

bank covenant packages have been lightened and the average coupon is not a significant cash flow hurdle for most issuers. More specifically, we
dEFAUlt RAtES REmAIn modERAtE Hig h Y ield Bond a nd L o a n De fault Rates 14% 12 10 8 6 4 2 0 98 99 00 01 02 03 04 05

anticipate a default rate of roughly 2% in 2012, versus a historical average of approximately 4%.

06

07

08

09

10 11E 12E 13E

High Yield Bonds Loans Source: J.P. Morgan. Data shown above is illustrative only and is represented by the J.P. Morgan universe of high yield bonds and the J.P. Morgan universe of institutional leveraged loans. Actual default rates may differ from the estimated default rates shown above.

Solving for 2012

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We also feel that the technical backdrop is supportive. From a new supply perspective, by and large, we feel that issuers will be opportunisticnot forcedborrowers, as they will tap the market when rates are favorable. To a great extent, we expect new issuance to be driven by refinancing to extend maturities at attractive rates. We are also positive in terms of investor demand. In particular, when some of the clouds surrounding the economy and the crisis in Europe lift, we

expect to see generally solid demand, especially in light of the Federal Reserves vow to keep short-term rates on hold until at least mid-2013. Of course, the high yield/bank loan market is not immune to macro issues such as those that impacted the financial markets at times in recent months. That being said, our base case is for the U.S. to skirt a recession. In a low/no growth environment, we feel that investors will generally be

compensated for the risks associated with the high yield/bank loan market by receiving a healthy coupon. Again, even in a double-dip environment, we do not expect to see substantial spread-widening or increased defaults given solid underlying fundamentals. Best case, should economic growth be somewhat better than is currently anticipated, we could see spreads narrow from current levels, which would further boost high yield/bank loan returns in 2012.

Municipal Bonds
James l. Iselin, Head of municipal Fixed Income

While certain economic and credit challenges remain, overall, we have a positive outlook for the municipal market in 2012. The municipal yield curve remains steep from a historical perspective and, in our view, supply should remain fairly muted in 2012. In addition, we believe that municipal bonds are attractively valued versus their U.S. Treasury counterparts. We also expect investor demand to remain solid given what we feel will be a slow growth/low interest rate environment. While we do not anticipate a doubledip scenario, further economic softening or higher-than-expected inflation could impact the municipal market in 2012. Should the economy stumble, tax revenues would decline and put additional strains on municipalities that are still repairing their budgets following the lengthy recession. In terms of inflation, we expect it to be relatively benign. That being said, given the Federal Reserves accommodative policies and the potential for a third round of quantitative easing, higher inflation and, by extension, higher rates cannot be ruled out.

Other wild cards that warrant attention are headline risks and the political environment in Washington, DC. While its now clear that draconian predictions for massive municipal defaults in 2011 were significantly overblown, we expect to see sporadic defaults in 2012 and more downgrades than upgrades. How these events are portrayed in the news media could impact investor sentiment. Were also keeping a watchful

eye on legislative proposals being discussed in Washington. Although we do not place a high probability of a change in the tax-exempt status of municipal bonds, we dont think the potential for some adjustments can be dismissed out of hand. Based on technical factors and attractive valuations, we believe that the municipal market can produce positive returns in 2012, albeit not as robust as those in 2011. That being

mUnIcIPAl SUPPlY hAS BEEn mUtEd, SUPPoRtInG PRIcES L ong -Ter m M u nicip al Bond S ales 2010 ver su s 2011 (In Billions) $50 45 40 35 30 25 20 15 10 5 0 Jan.

Feb.

Mar.

Apr.

May 2010

Jun.

Jul.

Aug.

Sept.

Oct.

Nov.

2011

Source: The Bond Buyer.

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GLOBAL FIxED INCOME

said, based on the macro uncertainties that exist, we feel that having a thorough understanding of individual

municipal credits is imperative. This is especially true given the pressure on the federal government to reduce

spending and the subsequent trickledown impact on funding for state and local municipalities.

Eurozone and Asia Fixed Income, Global Currency

ugo lancioni, portfolio manager global Fixed Income and currency Thanos Bardas, phd, portfolio manager and global Head of sovereigns and Interest rates

As 2011 progressed, core European growth slowed markedly, and we expect this to continue in 2012. Exacerbating the bleak global economic outlook has been the outbreak of contagion as large, systemically important markets such as Italy, Spain and, most recently, France have faced stern questions from investors regarding their solvency. Although plans have been tentatively set to expand the European Financial Stability Facility and recapitalize banks, questions remain about the actual implementation and timing. We expect the European Central Bank to continue its monetary easing cycle and extend the liquidity accommodation in 2012 in an attempt to combat a return to recession and continued tensions surrounding the European debt crisis. Moreover, we expect moderately higher yields in core Europe, particularly Germany, as the core is slated to bear most of the costs of bailing out smaller peripheral countries. The main risk to this forecast is politics, as coordinating 17 parliaments to carry out the plan to save the European Union is a daunting task and competing interests further complicate the process. A lack of a credible solution would give rise to disorderly defaults and an intensification of the flight-toquality trade in 2012. Japans economic growth was sluggish in 2011, with a significant contraction in the first half of the year

due to the devastating earthquake in March. While we expect a modest recovery in 2012 given continued easing of supply constraints and reconstruction efforts, downside risks to growth have increased considerably. Declining global growth will present a major challenge to Japans exporters, as demand has continued to fall amid widespread fiscal austerity, along with a deleveraging of household balance sheets. Compounding the loss of momentum in the global recovery is the sustained appreciation of the yen. While we believe that global yields are likely to rise modestly in 2012, the Japanese bond market has generally proven to be less volatile than its G10 counterparts and absolute yields have remained low. However, the major risk associated with owning Japanese government bonds in 2012 revolves around the countrys precariously high levels of debt. With a debt/GDP ratio of well over 200%, ratings pressure will likely persist in 2012. Additionally, Japans fractious political profile presents a significant risk-to-debt consolidation, as evidenced by the rapid turnover in its parliament and the lack of a credible plan to reduce the countrys debt burden. Nonetheless, we expect the Bank of Japan to remain on hold throughout 2012. Furthermore, our base case scenario remains that the interest rate environment will remain low, although credit concerns increase the risks to this forecast.

non-u.s. credIT Overseas, the European sovereign debt crisis has directly impacted much of the credit universe. Specifically, banking credits are likely to be directly impacted by expected haircuts to peripheral debt, recapitalization of large parts of the banking system, and the potential for losses on lower parts of their capital structure. We believe that industrial and utility credits in Europe will also be volatile as the debt crisis progresses. However, in our view, this could be an area of opportunity to capitalize on attractive valuations. Given the fluid nature of the situation in Europe, we feel that security selection in Europe is even more vital as opportunity exists, but tail risk is real. currency markeTs It is our base case that the G10 currencies will trade in a relatively narrow range in 2012. Against such a backdrop, we believe investors will be best served to exploit opportunities in the currency markets through tactical exposures and active rotation. Major central banks have been active in both the bond and currency markets in 2011, with the objective to safeguard the stability of the financial system and, in some cases, with the clear objective to limit excessive currency appreciation. This is likely to continue, especially if currency strength begins threatening

Solving for 2012

33

already-modest economic growth. Deterioration of competitiveness in the global trade markets could affect monetary policy decisions and, in some cases, trigger direct central bank intervention. Such actions were taken by a number of countries over the last year, sometimes with limited or no success (for example, in Japan). Fiscal consolidation and debt reduction is a matter of urgency in Europe as markets are not prepared to wait any longer and European policymakers have been forced to act. Fiscal tightening is a painful process and its effect on the economy is likely to continue to have a negative impact on European assets and on the currency in the short term. A weaker euro would be welcomed by the Europeans, as it would somewhat offset growth-choking austerity measures. However, the need for fiscal consolidation is not only a European

story, but something that touches most of the major economies. In our view, fiscal consolidation will continue to be a major theme in 2012 and its impact on currencies is likely to be more pronounced at times of lower global growth expectations. During 2012, Australia, New Zealand and Sweden, all of which are highly exposed to commodities and cycles in global growth, are likely to continue to be significantly impacted by swings in sentiment and investor confidence. We would seek to avoid overweight exposures to the commodity currency bloc, especially with the Australian dollar and the New Zealand dollar close to record highs. Those currencies are still significantly overvalued from a purchasing power parity perspective, and their countries have most recently suffered from a gradual deterioration in consumer and business confidence. In Australia, the

non-mining sectors are suffering. In our view, further appreciation would have to be backed by stronger-thanexpected global growth. We remain modestly bearish on the Swiss franc. Despite the Swiss National Banks setting a floor at 1.20 in the euro/ franc exchange rate, we think the franc remains unattractive, given its significant appreciation in recent years. A risk to our view is represented by the currency reserve diversification process, which remains an important structural driver of currencies in the long run. While it was once felt that the euro would be a beneficiary of such a shift, given the troubles in the eurozone, the ultimate beneficiaries could be other liquid currencies, including the commodity-based bloc.

Emerging Market Debt

Bobby T. pornrojnangkool, phd, portfolio manager emerging market debt

We have a generally positive outlook for emerging market external debt in 2012. Supporting the asset class, in our view, are strong fundamentals. Continued growth in emerging market economies should help keep their balance sheets generally strong and debt service ratios fairly low. Emerging market investment flows also remain encouraging. Despite periodic flights to quality, investor demand for emerging market external debt has generally been robust in recent years. We anticipate this trend continuing given the incremental yields offered by emerging market debt versus the low yields in the developed world. It

is also our belief that new supply will remain manageable given investors appetite for the asset class. On the policy front, emerging market policymakers also have some flexibility. Given higher interest rates and lower fiscal constraints, we feel that emerging market policymakers have the ability and wherewithal to react to external shocks that could negatively impact their growth trajectories in 2012. In addition, we have a positive view on oil prices in 2012, given continued tightness in the supply situation. This would also be beneficial for the revenues generated by emerg-

ing market oil exporters. Against this backdrop, the default picture looks rather benign for emerging market countries as a whole in 2012. Finally, while certain macro risks remain, we feel they are already largely priced into the market. Recent data from China are less supportive of a hard landing scenario, whereas recent U.S. data suggest subpar growth but not outright recession in 2012. Eurozone sovereign risk will remain a key issue, but a meltdown scenario like that of 2008 is, in our opinion, quite remote.

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Global Fixed Income: Conclusion

The past year demonstrated, once again, how conventional wisdom regarding the global economy and financial markets can quickly be proven wrong. This was evident in the third quarter, when it was thought that U.S. Treasury yields could not possibly go any lower, only to have 10-year yields fall to levels not seen in more than 60 years. But market volatility often breeds opportunity for disciplined investors who are able to tune out the daily noise and maintain a longerterm focus. While the magnitude of todays macro issues cannot be discounted, it appears to us that the prospects for the economy and spread sectors are generally positive. That being said, it would be nave to think that there will not be periods of heightened volatility and perhaps even some sleepless nights for investors in 2012. Overall, we are encouraged by the underlying fundamentals in many spread sectors, and expect these very fundamentals to ultimately drive performance when some of the macro issues subside.

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. Please see disclosures at the end of this publication, which are an important part of this article.

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ALTERNATIVES

Private Equity: Amid Public Market Turbulence, Private Landscape Looks Robust
anthony d. Tutrone, global Head of alternatives

In currently volatile markets and uncertain economic conditions, we believe that private equity investing provides substantial advantages. With the ability to invest based on fundamentals and without regard to daily market price fluctuations, private equity managers can adopt a long-term view towards their portfolio investments. Given limited visibility on near-term business prospects, private
equity firms have the ability to implement long-term value-creating operational and strategic initiatives without the pressures of quarterly earnings targets. Although the credit markets are not as robust as in early 2011, private equity managers currently have access to credit to finance transactions, albeit with higher pricing, lower absolute leverage levels and tighter covenant packages. Moreover, receptive initial public offering markets and cash-rich strategic acquirers should provide attractive exit alternatives for both leveraged buyout and venture-backed portfolio companies in the year ahead. BuyouTs: opporTunIsTIc, more gloBal The first half of 2011 was characterized by improved sentiment for global GDP growth, robust credit markets and an increased number of completed buyout transactions. Since then, as global macroeconomic conditions have become more uncertain, credit market conditions have weakened. However,
38 Neuberger Berman

credit is still available for buyouts, but with higher pricing, lower leverage multiples and tighter covenant packages than earlier in 2011. Within the credit markets for small and middle market companies, dedicated buy-and-hold lenders will

likely remain active. For larger companies, we expect credit market conditions to be dictated by the volatility of flows into high-yield debt funds as the attractiveness of absolute yield alternates with overall risk aversion in driving investor behavior.

dESPItE Vol AtIlIt Y, REcEnt BUYoUt VolUmE hAS BEEn StABlE N u m ber of U. S . Leveraged Bu you t Tra n s ac tion s a nd Tot al Sou rces by Q uar ter 1 (In Billions) $180 160 140 120 100 80 60 40 20 0
1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3

(Number of Deals) 90 80 70 60 50 40 30 20 10 0

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Number of Deals

Capital Invested

Source: S&P Q3 2011 Leveraged Buyout Quarterly Review. 1. Leveraged buyout volume includes the total sources (loans, secured debt, unsecured debt, sub debt, and equity) involved in leverage buyouts.

ALTERNATIVES

In our view, U.S. and European buyouts will be able to take advantage of the volatility in the public equity and debt markets to complete attractive opportunistic transactions. Buyout activity will continue to become more global, with an increased emphasis on more rapidly growing emerging economies such as China, Brazil and India. Although few private equity firms currently possess the relationships and knowledge of local market idiosyncrasies, substantial resources and fundraising activities are focused on these markets. We expect private equity managers to continue to implement operational improvements at portfolio companies; in the absence of organic growth opportunities, there will likely be an increased emphasis on achieving growth via add-on acquisitions. We favor small and mid-market buyouts where there is generally more opportunity for improvement initiatives and where growth is easier to achieve. New buyouts are likely to be concentrated among industries less influenced by the larger economy including health care, business services and software. Given that many private equity funds are capital-constrained and that multi-sponsor club deals have fallen out of favor, they will increasingly seek co-investors to help finance new deals and follow-on financings for existing portfolio companies. We also anticipate elevated levels of public-to-private LBOs, as private equity firms seek to take advantage of seemingly attractive valuations in the public equity markets. During 2011, public equity markets were generally receptive to private equity-backed IPOs, including Kinder Morgan, Nielsen Holdings and

moRE SEllERS AddInG to VolUmE Secondar y M arket Size (In Billions) $30 25 20 15 10 5 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E

Secondary Supply Brought to Market Source: Secondary market advisor research.

Closed Secondary Transaction Volume

hospital operator HCA. A backlog of private-equity IPOs remains and, during 2012, we expect underwriters to take advantage of periods of public market stability to bring new IPOs to market. Cash-rich strategic acquirers seeking growth should provide an attractive exit avenue for portfolio companies as well. secondarIes: record supply, lImITed dry poWder 2011 is expected to be a record year in the secondary market, with approximately $25 billion of transaction volume, largely driven from selling by public pension plans and financial institutions. Pricing continued to pick up from 2010 levels in the first half of 2011 as quarterly net asset value increases and improved exit activity allowed secondary buyers to price assets more competitively, although public market volatility in the third quarter led to more attractive repricing of portfolios with significant public exposure. During 2012, we expect the strong growth to continue, due to a variety

of factors. With a record $1.9 trillion of private equity commitments raised between 2005 and 2011, the secondary market is anticipating high levels of deal flow for the foreseeable future. The secondary market has witnessed a rapid expansion in the universe of sellers. Secondary flow from traditional sellers, including banks, insurance companies and high net worth individuals has been supplemented by increasing activity among nontraditional sellers, including public pensions, endowments, publicly listed private equity funds and hedge funds. Given the size of private equity portfolios held by public pensions and endowments, continued selling by these groups is expected to drive secondary volume. Additionally, investors are increasingly looking to manage their private equity portfolios just as they do their public equity and debt portfolios; and as investment objectives and asset allocations change over time and the teams managing these portfolios turn over, the secondary market is regularly accessed as a portfolio management tool.

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The changing regulatory environment, both in the United States and internationally, has led to a significant sell-off of private equity assets by financial institutions. In response to the Volcker Rule, many of the major U.S. banks, including Citibank and Bank of America, have sold portions of their private equity holdings. The trend has been mirrored globally with sales by the Royal Bank of Scotland, Deutsche Bank and Lloyds, among others. Despite increased selling, banks continue to be massive holders of private equity and are expected to be a significant source of supply for the foreseeable future. With regard to transaction volume, record levels in 2010 outpaced secondary fundraising, resulting in a reduction of capital available for investment by secondary funds. Transaction volume in 2011 is on pace to drive a further reduction in dry powder. The transaction volume estimates are understated, accounting for publicly reported transactions but not the large number of privately negotiated secondary deals. Overall, transaction volumes in excess of $50

VEntURE InVEStmEntS ARE ShowInG RESURGEncE Deal Flow a nd Eq uit y I nvested in Ve ntu re - B ac ked Co m p a nies (In Billions) $35 30 25 20 15 10 5 0 2003 2004 2005 2006 2007 2008 2009 2010 LTM Q3 2011 (Number of Deals) 3,500 3,000 2,500 2,000 1,500 1,000 500 0

Amount Invested

Number of Deals

Source: Dow Jones VentureSource. LTM Q3 2011 was calculated using VentureSource.

billion over the last two years has outstripped the approximately $30 billion of secondary funds raised over the same period, creating a favorable investment environment for disciplined secondary investors. The secondary market has historically benefited during times of high market volatility as many investors seek to quickly monetize their private equity holdings and move into liquid assets. This increase in volume,

coupled with the motivated nature of many sellers and the market premium placed on liquidity during periods of volatility, should create attractive secondary investment opportunities moving forward. venTure capITal: m&a looks sTrong, Ipos Face uncerTaInTy Despite lower fundraising levels than in 2009 and 2010, investments by U.S. venture capital firms were on course in 2011 to return to the recent highs of 200608, with an annualized rate through the first three quarters of $31 billion, or 30% higher than the recent low seen in 2009. Increased capital flows have directly impacted valuations, with a meaningful increase seen in both the earliest and latest rounds of venture financing. At the seed stage, this is being caused by an increased interest among angel and super-angel investors. Relative to institutional venture capital firms, these investors typically provide better terms

REcoRd tRAnSActIonS oUtPAcInG FUndRAISInG C apit al Co m mit ted to Secondar y Fu nd s (In Billions) $50 44.5 40 30 20 10 0

22.0 13.0 35.5 25.0 19.5 30.0

2010 Secondary Secondary 2011 Est. Est. 2011E Beginning Transaction Capital Beginning Secondary Secondary Ending Dry Powder Volume Raised Dry Powder Transaction Capital Dry Powder Volume Raised

Source: Secondary market advisor research.

40

Neuberger Berman

ALTERNATIVES

and more attractive valuations to start-ups. Their strong support of early-stage companies could create an opportunity for institutional investors in B and C rounds of financing as the super angels may not have the reserves and resources needed to protect these positions. Also, more capital is once again being focused on the later stages of company development as difficult exit markets force all but the most successful and mature companies to fund their companies in private markets for longer periods of time. Notably, the one stage of financing that has not seen an increase in valuation levels is the round subsequent to seed funding (first institutional round or early stage). The supply of capital focused on this area has not increased significantly in recent years, yet the supply of companies in need of financing is increasing, leading, in our opinion, to attractive opportunities in this area. Looking at the exit market for venture capital, 2011 began on a positive note, with differentiated companies such as LinkedIn (8.2 years from founding to IPO) and Fusion IO (5.5 years to IPO) completing successful public offerings. In the wake of last summers turbulence, the public market for new issues dried up and the second half of 2011 saw a dearth of IPOs. It is still unclear whether the IPO of Groupon (3.9 years to IPO) will reopen this window for other companies. Of course, the exit market for the vast majority of venture-backed companies continues to be mergers and acquisitions, and there, trends remain strong. Throughout 2011, a combination of a search for growth and increasingly sizable cash balances has led to large technology companies such as Google, Microsoft and Oracle

aggressively acquiring companies that will allow them to enter new markets and improve their products positioning in the ongoing shift to mobile and cloud computing. In this area, the median age of companies acquired remains at approximately 5.5 years. In the growth equity markets, the outlook is similar to that which we described in last years outlook report. The dearth of bank financing amid uncertain global economic conditions is unchanged, providing continued opportunity to private equity investors. In these difficult times, we believe that the importance of guidance from experienced professional investors and operational value-add means that growth equity is likely to remain a highly attractive source of financing to small- and medium-sized enterprises for the foreseeable future. dIsTressed: TurBulence adds To opporTunITy In our opinion, market conditions for distressed investors should be favorable in 2012 against a backdrop of high volatility, challenged economic growth, political instability and the ongoing crisis in Europe.

Technical factors positively influencing the market for distress managers include volatile flows into and out of funds focusing on high-yielding assets and selling pressure from banks and other financial institutions that are increasingly reluctant to maintain positions in distressed securities due to both regulatory and fundamental considerations. Although significant progress has been made in refinancing and extending maturities, the pending maturity wall remains substantial. While the highest levels of maturities are in the 20142017 time period, distressed managers are likely to establish positions in companies facing pending refinancing risks and potential covenant defaults. Due primarily to their more limited access to public credit markets, small and mid-size credits are experiencing higher default rates than larger credits. While default rates have steadily declined since 2009 and are likely to remain at reasonable levels in the near term due to improved cash flow coverage ratios and recent maturity extensions, increased market turmoil and a new wave of impending maturities beginning in 2013 could

REFInAncInG oVERhAnG REmAInS SUBStAntIAl N on - I nvest m e nt Grade M atu rities by Year (In Billions) $400 350 300 250 200 150 100 50 0 2012 2013 2014 2015 2016 2017 2018 2019

Source: Credit Suisse, as of October 31, 2011.

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41

cause default rates to pick up in the long term. Many companies will not be able to achieve sufficient growth to overcome their leverage levels; and managers with the ability to navigate complex restructurings in and out of court will possess a distinct advantage. Real estate markets, both residential and commercial, remain stressed and continue to weigh heavily on banks throughout the U.S. For example, troubled commercial construction loans and mortgages accounted for over 65% of the problem loans for the 11 banks that failed in October 2011, and nonperforming residential mortgages were the next biggest cause of distress for these institutions.

The European debt crisis has also created new opportunities, although few firms have established track records investing in European distressed debt. For the reasons discussed above, we believe that there are ample opportunities among multiple asset classes in the current distress cycle. We also expect the current cycle to be prolonged, given weak economic conditions and the large volume of historical debt issuance reaching maturity in the near future. conclusIon Over the past year, despite generally strong corporate earnings, modestly positive growth, and individual company success stories, macroeco-

nomic and policy uncertainty has slowed global growth and caused high levels of volatility in the public equity markets. Although private equity is affected over the long term by public market results, the current environment favors the advantages of private investors who can invest based on underlying business fundamentals without regard to market noise. Moreover, these advantages have the potential to translate not only into return opportunities, but uncorrelated returnswhich, at a time when asset prices move in lock-step fashion, are becoming increasingly valuable.

This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. This material may include estimates, outlooks, projections and other forward-looking statements. Due to a variety of factors, actual events may differ significantly from those presented. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Please see disclosures at the end of this publication, which are an important part of this article.

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ALTERNATIVES

Fund of Hedge Funds: The Opportunity Among Emerging Managers

eric Weinstein, chief Investment officer Fund of Hedge Funds

2011 witnessed significant return dispersion across hedge fund strategies during a year dominated by macro-influenced risk-on/risk-off market moves. We believe the volatility which characterized markets in 2011 will result in significant opportunities across a range of strategies in 2012. Perhaps most intriguing is the universe of newer hedge funds with smaller asset bases, known as
emerging managers. We discuss their prospects, as well as those of other key groups, below. Our team defines emerging managers as those with less than a three-year track record and below $500 million in assets under management. Historically, these managers have posted better returns than their more established peers, something we expect to continue moving forward. In 2011, demand for capital from emerging hedge fund managers continued to outweigh supply. In the first nine months of the year, $70.7 billion was invested in hedge funds, with 89.6% of inflows going to hedge funds with over $500 million in assets.1 As we have previously published, it is our view that the emerging manager space remains underfunded as there is a large supply of managers competing for small amounts of capital. Since 2008, the pipeline for new launches has been trending upward and remains robust. There were 578 new hedge fund launches from January through the second quarter of 20111 into an already saturated market. Contributing to this trend is an exodus of traders from banks, which have been forced by the Volcker Rule to significantly reduce their proprietary trading. Additionally, many hedge funds are below their high water marks or remain far below peak assets. This has led to large funds having difficulty compensating top portfolio managers, further encouraging new independent launches. The high number of emerging managers, diversified across strategies and all looking for capital, has created a significant opportunity in this space. Not only do early-stage investors now have a substantially larger investment universe, but they are also able to leverage their negotiation power to further enhance potential returns. By providing emerging managers with much-needed early funding, investors have the potential to negotiate for more favorable liquidity terms, transparency, corporate governance and fee arrangements. The emerging manager universe has seen particular pressure on the traditional 2/20 hedge fund fee structure. Negotiated fee structures typically include reduced management and incentive fees or a claw-back of the performance fee in the event a manager fails to achieve a targeted return. In our view, this can have a significant impact on performance over a five-year time horizon. sTrucTural advanTages Emerging funds often have structural advantages in the markets in which they trade. A smaller asset base

1. HFR Global Hedge Fund Industry Report Third Quarter 2011.

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43

allows them to invest full position sizes without hitting liquidity constraints or causing a market impact that could lead to greater trading costs. Along these lines, lower assets mean smaller investment ticket sizes, which allow mangers to take advantage of market inefficiencies that may be too small for larger funds. Smaller position sizes also draw less market attention and lower the possibility of position crowding or short squeezes. In addition, a smaller asset base allows managers to allocate to only their best ideas, resulting in higher conviction portfolios. Larger hedge funds, in contrast, have limited capacity and, in some cases, have grown so large that they may be forced to invest in ideas outside of their core expertise. In our view, this style drift has led to many large multistrategy funds becoming unattractive investment propositions. moTIvaTed To succeed For a number of reasons, newly launched hedge fund managers have a strong incentive to succeed. A short track record and smaller client base mean that emerging managers need to generate strong performance in order to strengthen their reputation and to raise assets. Furthermore, many principals have most of their net worth invested in their funds and have the most to gain should their fund succeed in generating performance fees (and often, the most to lose if they fail). Larger hedge fund managers, in contrast, may be more focused on building a business that is able to accommodate their large asset pool and are able to depend more on management fees and less

on performance fees. In our view, this increased manager motivation has contributed to the outperformance of emerging managers on a risk-adjusted basis compared to their emerged counterparts, something that has been achieved with less correlation and beta to major market indicesreflecting their diversification benefits. In our view, another important advantage of emerging managers is improved portfolio transparency and position-level disclosure, allowing for more effective monitoring. It is true that they have fewer resources for operations, requiring thorough due diligence by potential investors, but we believe this worry has become less significant. Todays emerging managers are more likely to have a stronger operational and risk infrastructure than five years ago because the technology needed to set up a

business and establish an infrastructure is more accessible. Indeed, new launches are often likely to implement current industry best practices. ImporTance oF due dIlIgence While we believe there are clear advantages to investing in emerging managers in 2012, we would also highlight the importance of manager selection given return dispersion among these managers. In addition, we would not suggest that a hedge fund portfolio only invest in emerging managers; rather, we believe that the optimal hedge fund allocation will include a diverse group of lessestablished managers, as well as larger and older funds, in order to maximize a portfolios risk/return profile and diversification.

nEwER mAnAGERS hAVE oUtPERFoRmEd moRE EStABlIShEd PEERS A n n u alized Retu rn a nd St a ndard Dev iation ( Ja n u ar y 20 02J ul y 2011) 10% 9 8 7 6 5 4 3 2 1 0 Emerging Managers Emerged Managers Return HFRX Global

Standard Deviation

Source: Neuberger Berman, HFRX Global Index. Includes the track records of 288 investments made by NB Alternative Investment Management LLC since January 2002. As a fund reached its 37th month of performance or exceeded the $500 million threshold, it moved out of the emerging manager group and became a part of the emerged manager composite. The track records of each investment are equally weighted.

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ALTERNATIVES

l ARGER hEdGE FUndS domInAtE ASSEt FlowS Distribu tion of Net A sset Flow s by AU M Year-to - Date T hroug h Q3 2011 (In Millions) $50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 <$100 mm $100 $250 $500 mm $1 bn $250 mm $500 mm $1 bn $5 bn >$5 bn

...BUt SmAllER FUndS ARE moRE PlEntIFUl Perce nt age of Tot al N u m ber of Hedge Fu nd s by A sset Size 4.7% 11.3% 7.4% 52.5% <$100 mm $100 $250 mm

$250 $500 mm $500mm $1 bn $1 5 bn

8.7%

15.5%

>$5 bn

Source: HFR Global Hedge Fund Industry Report Third Quarter 2011.

Other Hedge Fund Segments

dIsTressed sTraTegIes: spoTlIgHT on mIddle markeT and europe In 2012, we believe the default rate for large-cap companies is likely to remain low given the extension of the wall of debt maturities for this group. As a result, we believe that the best opportunities in distressed investing are likely to be found in the middle-market space, defined as companies with a market capitalization below $1 billion. Here, the default rate remains elevated compared to pre-2008 and substantial maturities are due from 2012 to 2015. While the capital markets have generally been open to larger companies to refinance their bond and bank debt, it remains a challenge for more modest-sized companies to raise new debt. From an investor perspective, such smaller opportunities are often overlooked by hedge funds that need to put large amounts of capital to work. As a result, funds with a lower asset base (such as emerging managers, noted

above) are often most effective in this context. In terms of geography, many European banks are selling non-core assets in an attempt to meet their regulatory capital requirements, which we believe creates attractive buying opportunities for distressed managers. Europes less-developed high yield market will likely experience higher default rates as the capital available for refinancing becomes less plentiful. Banks and collateralized loan obligations, which had been the primary engine financing high yield corporate issuers on the continent, are no longer in a position to provide a source of financing for these companies. In connection with new solvency rules, many observers have predicted that banks will be forced to sell non-performing assets in order to raise their capital ratios. Although this anticipated deluge of distressed debt has yet to fully materialize, there have been privately negotiated sales between banks in the U.K., Portugal, Germany and Spain in which hedge funds have participated. Should such activity pick up, we would expect

distressed hedge funds to be active consumers of the securities that emerge from these transactions. Unlike the middle-market opportunity noted above, in this instance, funds with larger asset levels would have a competitive advantage, given their ability to take on large pieces of the portfolios, in addition to the resources they can bring to bear in the sourcing and evaluation of these large pools of assets. Finally, we also expect managers to find opportunities in other, more idiosyncratic events, where recent market declines have provided attractive entry points, as well as in some postreorganization equities, which have historically traded at large discounts to peers following their emergence from bankruptcy. sTrucTured credIT: aFTer selloFF, compellIng values Technical pressures in 2011 have, in our opinion, resulted in an attractive opportunity set for hedge funds investing in non-agency residential mortgage-backed securities. Strong returns for the asset class in 2009 and
Solving for 2012 45

2010 were followed by sharp reversals in the second and third quarters of 2011. Prices are now off as much as 20-30%2 compared with February 2011 highs, due largely to a deluge of supply hitting the market this summer when the Federal Reserve attempted to sell its Maiden Lane II portfolio. The sell-off was exacerbated by rumors of further inventory from broker-dealers and fears regarding potential sales by European banks attempting to meet their increased capital requirements by shrinking their balance sheets. Supply pressures coincided with a slowdown in demand driven by concerns over the U.S. economy coupled with continued fears surrounding the eurozone. Looking beyond these technical issues, however, we see no real changes to the modestly improving fundamentals that existed in 2010. Loss severities have remained relatively stable, prepayments have remained low, and 60+ day delinquency rates are falling. House prices do remain significantly depressed, with no real clarity regarding their potential recovery. However, hedge funds that invest in non-agency residential mortgage-backed securities are generally assuming a 10-20% decline in house pricesa substantial cushion beyond common projections. With price declines, yields have increased by as much as 650 basis points to levels where the market considers them attractive compared with other credit instruments. Furthermore, hedge fund managers ability to hedge in this space has improved. In addition to using the ABx and Primex indices (with some managers developing customized baskets of the underlying tranches),

managers will also hedge prepayment risks and interest rate sensitivity. As always, they can focus on portfolio construction to benefit from the different cash flow characteristics of various bonds in the non-agency space. In our opinion, these factors put managers in a strong position to weather any broader market volatility going into 2012. evenT-drIven sTraTegIes: more acTIvITy In 2012? Large cash positions on company balance sheets should, in our view, lead to an increase in corporate activity in 2012, although the level of activity could be held back should macro concerns continue to result in significant market volatility. In particular, we believe the outlook for risk arbitrage is strong, with merger spreads at wide levels relative to historical norms following market weakness and uncertainty that was present for much of 2011. For Europe, in particular, the exit of proprietary trading desks since 2008 continues to provide attractive opportunities for experienced hedge funds due to reduced competition. Although markets and the economic outlook remain uncertain, we believe managers who focus on short- to mid-term catalysts and who have the ability to actively manage their net exposure are wellpositioned to take advantage of these opportunities. uncorrelaTed sTraTegIes: BeneFITs aT TurBulenT TIme We define uncorrelated strategies as those that demonstrate zero or negative beta to the broader equity markets as well as to other hedge

funds. This bucket includes (but is not limited to) short-term commodity trading advisors (CTAs), commodities arbitrage, statistical arbitrage, fixed income arbitrage and global macro. In 2012, we expect these funds to continue to provide a source of uncorrelated returns, particularly in the face of macro uncertainty, thereby warranting a role in a diversified fund of funds portfolio. For example, short-term CTAs, which pursue a mix of momentum strategies with shorter holding periods (intraday to weeks) and mean-reversion trading, have a long volatility profile and, we therefore believe, are likely to perform well in periods of high market volatility. asIan managers: under-coverage In groWIng markeTs While strategies such as equity long-short and long-biased credit continue to dominate the Asian hedge fund universe, event-driven, distressed and arbitrage strategies are becoming more common. Asian equities markets have grown from $10.7 trillion in mid-2006 to $12.8 trillion as of the third quarter of 2011.3 Although more companies are being listed on public exchanges, the growth of sell-side coverage continues to lag the growth of the market. As a result, we believe there are many uncovered or under-covered companies that could provide opportunities for Asian hedge fund managers looking to exploit mispricings. The ability to short securities has also increased over the last few years, assisting those managers who may utilize a single-stock shorting strategy. As China, South Korea and Taiwan have become more liquid, stock borrowing has increased dramatically, while India

2. Barclays, Housing and Residential Credit Outlook, October 2011. 3. Source: Bloomberg.

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ALTERNATIVES

is moving closer to implementing a liquid stock borrowing system. In our opinion, initial public offerings (IPOs) and other capital market activities present another important source of trading opportunities in Asia. Priced IPOs have rebounded in terms of volume and deal count since the financial crisis, outpacing both Europe and the U.S. in 2011, with a robust pipeline set for 2012. We believe there are clear opportunities in Asia, including larger upside potential, as valuations across multiple assets have been lower than those in the U.S. and Europe, resulting in more extreme price dislocations. In addition, the

market is experiencing long-term secular growth, fueled by the expansion of regional economies and the need to raise capital and develop more sophisticated, robust financial markets. Moreover, there continue to be fewer players in the space, making it easier for hedge fund managers to exploit these opportunities. conclusIon Overall, ongoing economic and market uncertainty suggest the likelihood of continued price volatility in 2012. Although turbulence can often prove challenging for long-only managers, it tends to benefit many hedge fund

managers with the ability to go long or short, or to capitalize in mispricing of assets, whether in relative or absolute terms. Looking within the overall hedge fund universe, we believe the nimble capabilities and motivation of emerging players make them especially compelling and an important element in an overall hedge fund allocation.

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. Please see disclosures at the end of this publication, which are an important part of this article.

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47

About the Authors

JosepH v. amaTo | president, chief Investment officer
Joseph V. Amato is president of Neuberger Berman Group LLC and chief investment officer, as well as a member of the firms Board of Directors and its Audit Committee. He joined the firm in 1994 and has 27 years of industry experience. Joe received his Bachelor of Science from Georgetown University.

THanos Bardas, phd | managing director, portfolio manager

Thanos Bardas, managing director, serves as a portfolio co-manager on multiple fixed income strategies. He is also a member of the fixed income investment team setting overall portfolio strategy and serves on specialty investment grade teams. Thanos joined the firm in 1998 and has 14 years of industry experience. He graduated with honors from the Aristotle University, Greece, and earned his MS from the University of Crete, Greece. Thanos also earned a PhD in Theoretical Physics from State University of New York at Stony Brook.

ann H. BenJamIn | managing director, chief Investment officer leveraged asset management
Ann H. Benjamin, managing director, is the chief investment officer for Leveraged Asset Management and portfolio co-manager for high yield portfolios and blended credit strategies. She serves on the firms Partnership Committee. Ann joined the firm in 1997 and has 31 years of industry experience. She earned a BA from Chatham College and a Masters degree in Finance from Carnegie Mellon University.

alan H. dorsey, cFa | managing director, Head of Investment strategy and risk
Alan H. Dorsey, managing director, is head of Investment Strategy and Risk and chairman of Neuberger Bermans Investment Risk Committee. Alan serves as an advisor to the firms institutional clients and provides investment strategies tailored to the institutional marketplace. He joined the firm in 2006 and has 27 years of industry experience. Alan holds a BA in Economics from Wesleyan University and is a Chartered Financial Analyst.

JulIana Hadas, cFa | vice president

Juliana Hadas, vice president, is a member of the Investment Strategy and Risk Group, for which she conducts research and advises clients on investment strategies. Juliana joined the firm in 2005 and has 10 years of industry experience. She earned a BSE in Economics, summa cum laude, from the University of Pennsylvania, the Wharton School and an MBA with distinction from Harvard Business School. She also holds the Chartered Financial Analyst designation.

James l. IselIn | managing director, Head of municipal Fixed Income

James L. Iselin, managing director, is head of the Municipal Fixed Income team and a senior portfolio manager. Jamie joined the firm in 2006 and has 18 years of industry experience. He holds a BA in Philosophy from Denison University.

andreW a. JoHnson | chief Investment officer Investment grade Fixed Income

Andrew A. Johnson, managing director, is chief investment officer and global head of Investment Grade Fixed Income and lead portfolio manager for multiple active and custom bond portfolios. He is also a member of Neuberger Bermans Fixed Income LLCs Board of Directors. Andy joined the firm in 1989 and has 22 years of industry experience. He earned BS and MS degrees in Electrical Engineering at the Illinois Institute of Technology and his MBA from the University of Chicago.

ugo lancIonI | managing director, portfolio manager

Ugo Lancioni, managing director, is a currency portfolio manager and heads the Currency team responsible for discretionary Fx strategies. Ugo is responsible for the currency overlay and the day-to-day management of the firms global fixed income portfolios. He joined the firm in 2007 and has 15 years of industry experience. Ugo received a Masters Degree in Economics from the University La Sapienza in Rome.

WaI lee, phd | managing director, chief Investment officer quantitative Investment group
Wai Lee, managing director, is the chief investment officer and director of research for the Quantitative Investment Group with overall responsibility for the quantitative investment function. He is a member of the firms Investment Risk and Asset Allocation committees. Wai joined the firm in 2004 and has 18 years of industry experience. He earned a BS with honors in Mechanical Engineering from the University of Hong Kong and holds MBA and PhD degrees in Finance from Drexel University.

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Neuberger Berman

leaH modIglIanI | senior vice president, multi-asset class strategist

Leah Modigliani, senior vice president, is a multi-asset class strategist on the Investment Strategy and Risk team. In this role, she works with the firms largest institutional clients on asset allocation and investment strategy, often creating customized investment approaches designed to solve specific client needs. Leah is a member of the firms Investment Risk and Asset Allocation committees. She joined the firm in May 2011 and has 15 years of industry experience. Leah earned a BS with high honors in Economics from Oberlin College and an MBA from Harvard Business School.

BoBBy T. pornroJnangkool, phd | senior vice president, portfolio manager

Bobby T. Pornrojnangkool, senior vice president, is a portfolio manager for all asset allocation portfolios. He also directs research, development and implementation efforts for asset allocation. Bobby joined the firm in 2005 and has 10 years of industry experience. He earned a BA with honors in Business from Chulalongkorn University, Thailand, an MS in Finance from the University of Wisconsin at Madison, and he holds a PhD in Financial Economics from Columbia Business School.

maTTHeW l. ruBIn | senior vice president, director of Investment strategy

Matthew Rubin, senior vice president, is the director of investment strategy at Neuberger Berman as well as the chief investment officer of the Neuberger Berman Trust Company. He is also the chair of Neuberger Bermans Asset Allocation Committee and a member of the firms Retirement Services Committee. Matt joined Neuberger Berman in 2007 and has 17 years of industry experience. He graduated summa cum laude with a BA from the State University of New York at Stony Brook.

conrad a. saldanHa, cFa | managing director, portfolio manager

Conrad A. Saldanha, managing director, is a portfolio manager for Neuberger Bermans Global Equity team and is responsible for emerging market equities. He has 18 years of industry experience and joined the firm in 2008. Conrad earned a B.Com from St. xaviers College, Calcutta, and an MBA from Virginia Polytechnic Institute. He also holds the Chartered Financial Analyst designation.

BenJamIn segal, cFa | managing director, Head of global equity Team

Benjamin Segal, managing director, is a portfolio manager and head of Neuberger Bermans Global Equity team. He joined the firm in 1998 and has 20 years of industry experience. Benjamin earned a BA from Jesus College, Cambridge University, an MA from the University of Pennsylvania, and an MBA from the University of Pennsylvania, the Wharton School. He is also a Chartered Financial Analyst.

Brad Tank | managing director, chief Investment officer Fixed Income

Brad Tank, managing director, is chief investment officer and global head of Fixed Income. He is also a member of the firms Senior Management Committee and Asset Allocation Committee. Brad joined the firm in 2002 and has 32 years of industry experience. He earned a BBA and an MBA from the University of Wisconsin.

anTHony d. TuTrone | managing director, global Head of alternatives

Anthony D. Tutrone, managing director, is the global head of Neuberger Bermans Alternatives group, which includes the private equity fund-of-funds, secondary and direct investment businesses and fund of hedge funds business. He is also a member of Neuberger Bermans Operating and Partnership committees as well as the Private Equity Investment and Valuations committees. Tony joined the firm in 2002 and has 25 years of industry experience. He earned a BA in Economics from Columbia University and an MBA from Harvard Business School.

erIc WeInsTeIn | managing director, chief Investment officer Fund of Hedge Funds
Eric Weinstein, managing director, is the chief investment officer for Neuberger Bermans Fund of Hedge Funds team. He joined the firm in 2002 and has 24 years of industry experience. Eric earned a BA from Brandeis University and an MBA from the University of Pennsylvania, the Wharton School.

yulIn (Frank) yao | managing director, senior portfolio manager

Yulin (Frank) Yao, managing director, is vice chairman Asia and a senior portfolio manager for the China-based Greater China Equity team. He joined the firm in 2008 and has 18 years of industry experience. Frank received a BS at Fudan University, an MS at Georgia Institute of Technology and an MBA in Finance from the Stern School of Business at New York University, where he was honored as a Stern Scholar. Frank also conducted a PhD study in engineering at Columbia University.

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49

This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. This material may include estimates, outlooks, projections and other forward-looking statements. Due to a variety of factors, actual events may differ significantly from those presented. Indexes are unmanaged and are not available for direct investment. Unless otherwise indicated, returns shown reflect reinvestment of dividends and distributions. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. A bonds value may fluctuate based on interest rates, market conditions, credit quality and other factors. You may have a gain or loss if you sell your bonds prior to maturity. Of course, bonds are subject to the credit risk of the issuer. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the investors state of residence. High-yield bonds, also known as junk bonds, are considered speculative and carry a greater risk of default than investment-grade bonds. Their market value tends to be more volatile than investment-grade bonds and may fluctuate based on interest rates, market conditions, credit quality, political events, currency devaluation and other factors. High Yield Bonds are not suitable for all investors and the risks of these bonds should be weighed against the potential rewards. Neither Neuberger Berman nor its employees provide tax or legal advice. You should contact a tax advisor regarding the suitability of tax-exempt investments in your portfolio. Government Bonds and Treasury Bills are backed by the full faith and credit of the United States Government as to the timely payment of principal and interest. Investing in the stocks of even the largest companies involves all the risks of stock market investing, including the risk that they may lose value due to overall market or economic conditions. Small- and mid-capitalization stocks are more vulnerable to financial risks and other risks than stocks of larger companies. They also trade less frequently and in lower volume than larger company stocks, so their market prices tend to be more volatile. The properties held by REITs could fall in value for a variety of reasons, such as declines in rental income, poor property management, environmental liabilities, uninsured damage, increased competition, or changes in real estate tax laws. There is also a risk that REIT stock prices overall will decline over short or even long periods because of rising interest rates. Investing in foreign securities involves greater risks than investing in securities of U.S. issuers, including currency fluctuations, interest rates, potential political instability, restrictions on foreign investors, less regulation and less market liquidity. Investing in emerging market countries involves risks in addition to those generally associated with investing in developed foreign countries. Securities of issuers in emerging market countries may be more volatile and less liquid than securities of issuers in foreign countries with more developed economies or markets. The sale or purchase of commodities is usually carried out through futures contracts or options on futures, which involve significant risks, such as volatility in price, high leverage and illiquidity. This document is issued for use in Europe and the Middle East by Neuberger Berman Europe Limited which is authorised and regulated by the UK Financial Services Authority (FSA) and is registered in England and Wales, Lansdowne House, 57 Berkeley Square, London, W1J 6ER. Neuberger Berman is a registered trademark. This document is being made available in Asia by Neuberger Berman Asia Limited (NBAL), a Hong Kong incorporated investment firm licensed and regulated by the Hong Kong Securities and Futures Commission (SFC) to carry on Types 1, 4 and 9 regulated activities, as defined under the Securities and Futures Ordinance of Hong Kong (Cap.571) (the SFO). This document, and the information contained in it, is being made available in Australia by Neuberger Berman Australia Pty Ltd (CAN 146 033 801), holder of Australian Financial Services Licence No. 391401 (NB Australia), to a person defined as a wholesale client under section 761G of the Corporations Act 2001 (Cth) and applicable regulations, and other such persons to whom disclosure would not be required under chapter 6D and Part 7.9 of the Corporations Act 2001 (Cth) (Wholesale Investor), for informational and discussion purposes only. This document is intended only for the Wholesale Investor to which it has been provided, is strictly confidential and may not be reproduced or redistributed in whole or in part nor may its contents be disclosed to any other person (other than such Wholesale Investors agents or advisers) under any circumstances without the prior written consent of NB Australia. This document, and the information contained herein, is not, and does not constitute, directly or indirectly, a public or retail offer to buy or sell, or a public or retail solicitation of an offer to buy or sell, any fund, units or shares of any fund, security or other instrument (Securities), or to participate in any investment strategy. The Wholesale Investor who receives this document should not consider it as a recommendation to purchase any Securities mentioned in it. To the extent that information in this document constitutes financial product advice, it is general financial product advice only, and provided only by NB Australia to Wholesale Investors. This document does not take into account the Wholesale Investors investment objectives, financial situation and particular needs (including financial and tax issues) as an investor. Any Securities mentioned in this document will only be available to a Wholesale Investor to whom the provision of a disclosure document prepared in accordance with Australian law is not required. The Wholesale Investor to which this document is provided should not rely on the information contained in this document in making any future investment decision. This document has been issued for use in Japan and Korea by Neuberger Berman Japan Limited, which is authorized and regulated by the Financial Services Agency of Japan and the Financial Services Commission of Republic of Korea, respectively. Please visit https://www.nb.com/Japan/risk.html for additional disclosure items required under the Financial Instruments and Exchange Act of Japan. The Neuberger Berman name and logo are registered service marks of Neuberger Berman Group LLC. Neuberger Berman LLC is a Registered Investment Advisor and BrokerDealer. Member FINRA/SIPC. 2011 Neuberger Berman LLC. All rights reserved.

Stepping Ahead in 2012

We are investors. We take seriously the responsibility our clients place in us to provide portfolio solutions that meet their specific needs. Whether investing for institutions and their constituents, or alongside advisors and their clients or investing directly for private individuals, Neuberger Berman is singularly focused. We are long on independent, original thinking and short on top-down house views. This is the passionate investment culture that we hope is conveyed in this set of forward-looking essays. We encourage you to learn more about Neuberger Berman, how we think, how we approach the marketplace and how we can work together. Please call us at 877.628.2583 or visit www.nb.com.

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