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Wealth Management Research

Michael P. Ryan, CFA, Head WMR Americas, mike.ryan@ubs.com Stephen R. Freedman, CFA, Strategist, stephen.freedman@ubs.com

17 July 2009

Investment Strategy Guide

Leveraging the Investment Strategy Guide
This Education Note is a users guide for UBS Wealth Management Researchs Investment Strategy Guide (ISG) publication. It is intended as a manual for readers interested in better understanding the investment process used to determine the tactical asset allocation decisions and asset allocation models found in the ISG.
Contents The new Investment Strategy Guide Asset allocation within the investment process Overview of tactical asset allocation in the ISG Investment cases: tactical asset allocation decisionmaking process Appendix: Advanced topics in tactical asset allocation Page 1 2 3 4 9

The new Investment Strategy Guide

At the end of June, UBS Wealth Management Research relaunched its flagship publication, the Investment Strategy Guide (ISG). The report has been expanded to include new features aimed at better serving the needs of investors and their advisors. With the introduction of the new ISG, we thought readers would find the following companion report helpful in order to fully leverage the ISG. The ISG will continue to be published on a monthly basis, highlighting changes in our outlook and asset allocation models. However, an extended quarterly version of the report will provide a deeper dive into the financial market outlook for the quarter ahead. The new publication features an extended number of asset allocation models now available for seven investor risk profiles. It also includes a broader Focus article, commentary on political developments known as Washington Watch, a probabilistic analysis of market scenarios, and an expanded set of charts supporting investment cases. This report is a guide for readers of the ISG who wish to gain a deeper understanding of how the asset allocation models in the publication are generally derived. The first section of this report explains how asset allocation fits into a comprehensive investment process. After highlighting the difference between strategic asset allocation (SAA) and tactical asset allocation (TAA), this section describes how SAAs are typically derived. The second section of this report offers an overview of the concept of TAA, followed, in the third section, by a detailed explanation of the investment decision-making framework relied upon to determine individual tactical views. This framework consists of three pillars, namely valuation, cyclical analysis and timing. The section also covers the role of market scenario analysis and of thematic research in a TAA framework.
Source: UBS WMR

A guide the ISG

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimer and disclosures at the end of the document.

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In the appendix in section four, we provide a deeper examination of advanced topics in TAA. We start with an overview of the range of tactical views that are expressed in the ISG and their hierarchy, including the asset class level, the regional level and a US-specific layer. The procedure used to integrate all of these views into a single model portfolio is described as well. We then move on to describing the approach used to translate our tactical recommendations across each of the different risk profiles and SAAs. Finally, we expand on topics related to international investing. In particular, we distinguish between approaches that include or exclude views on foreign currency movements.

Fig. 1: Asset allocation in the broader investment context

Steps in a well-structured investment process

1. Asset allocation within the investment process

The ISG provides asset allocation guidance to investors.1 Asset allocation determines a portfolios composition by asset class, region and market segment. There is an extensive body of work in academic literature in this area, reflecting the importance of asset allocation in the investment decision-making process. For both institutional and individual investors, the appropriate mix of the different risk-bearing and risk-free asset classes plays a large role in determining whether a portfolio meets an investors goals for total return and risk. Indeed, individual security selection is often found to play a secondary role in well-diversified portfolios. As background, we find it important to highlight the role of asset allocation in a well-structured investment process. In general, an investment process can be divided into the following six steps (Fig. 1): Investor risk profiling: An assessment of an investors risk tolerance, time horizon and return objectives. Strategic asset allocation (SAA): SAA refers to the portfolio benchmark allocation across asset classes, regions, and financial market segments as deemed suitable for an investor with a specific risk profile and return objectives over the long term. The SAA is therefore based on long-term assumptions about financial market behavior, including asset class returns, volatilities and the degree to which the returns across these different assets are correlated. Tactical asset allocation (TAA): TAA represents an intentional deviation from SAA in an attempt to both take advantage of financial market opportunities as well as to avoid downside risks. Portfolio construction: Involves the choice of appropriate investment instruments including single securities, fund or manager solutions, and structured products. Portfolio implementation: Focuses on timeliness and efficiency in conducting the necessary transactions. Portfolio monitoring: Seeks to ensure that portfolios remain within desired risk / expected return parameters.

1. Investor Risk Profile

2. Strategic Asset Allocation

3. Tactical Asset Allocation

4. Portfolio Construction

5. Portfolio Implementation

6. Portfolio Monitoring

Source: UBS WMR

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From investor risk profile to SAA1:

The first step in the investment process is to determine the appropriate risk profile of the investor. Dimensions to be considered include the investors return objectives, investment time horizon and risk tolerance levels. The risk profile is usually determined through a questionnaire or a more comprehensive goal-based financial planning process. Advances in portfolio theory over the past two decades highlight how important these characteristics are in determining the asset allocation that is appropriate for a particular investor at a given point in time. The research stresses that no portfolio is optimal for all investors regardless of their circumstances. This means that any asset allocation must be tailored to fit an individual investor's risk profile. In a second step in this process, the investor's risk profile is mapped to an SAA. This represents the suitable allocation across asset classes, regions, and financial market segments for the investor based on longrun assumptions about risk and return. The SAA is often also called "benchmark allocation." 1 Typically, the SAA is well-diversified across asset classes, regions and market segments. The goal of diversification is to improve the portfolios risk versus return trade-off. That is, effective diversification tends to reduce the risk level of the portfolio for a given expected return, or it enables a higher expected return for a given level of portfolio risk. The development of the SAA starts with the estimation of a set of capital market assumptions, including expected returns, risk and correlations of returns across different asset classes. Based on these assumptions, combinations of the asset classes that provide the highest level of expected return for each level of expected risk are calculated. The procedure includes both mathematical optimization techniques as well as a qualitative overlay generating a practical version of the efficient frontier often used in finance theory. In a final step, these SAAs are then mapped onto each investor risk profile (see Figures 2 and 3). Note that the range of SAAs / benchmark allocations included in the ISG are derived not by WMR but by the UBS Investment Solutions department.1

Fig. 2: From investor risk profile to SAA1

Capital market assumptions and optimization as a link
Risk profile X Risk profile Y Risk profile Z

Investor Risk Profile Capital Market Assumptions

Standard deviations Correlations Expected returns

Optimization / Expert Judgment

Efficient frontier Practicality

Mapping process determines SAA for each risk profile

Expected return Efficient frontier Bonds Equity Cash

Risk

Strategic Asset Allocation

SAA Y SAA Z

SAA X

Source: UBS WMR

Fig. 3: A different strategic asset allocation for each investor risk profile1
Illustration

Expected return Efficient frontier Bonds Equity Cash

Risk

Source: UBS WMR

Fig. 4: Tactical asset allocation

Example of a tactical shift
Strategic Asset Allocation + Tactical Deviations = Current Allocation
Cash 2%

2. Overview of tactical asset allocation in the ISG

While a portfolios SAA corresponds to the risk / return properties that are deemed appropriate for an investor under longer-term assumptions about risk and returns, there is usually room to improve upon the SAA / benchmark allocation by introducing shorter-term tactical portfolio tilts. Indeed, the portfolio's composition dictated by its SAA may not be optimal at a specific point in time, given the information available about current financial market conditions. Deviating from the Strategic Asset Allocation to capture perceived market opportunities is typically referred to as tactical asset allocation (TAA). The purpose of tactical deviations from the benchmark is to tilt the allocation toward asset classes and markets that are expected to outperform the rest of the portfolio, while at the same time reducing exposure to those asset classes that are expected to underperform. In doing so, an investment manager tries to generate an excess return relative to the benchmark.

Strategic Asset Allocation

Cash 2%

Equities 52%

Fixed Income 46%

Fixed Income 38% Equities 60%

TAA shifts represent movement in relation to SAA

Example: Tactical Deviations Neutral Cash: +0% Underweight Bonds:-8% Overweight Equities: +8%

Source: UBS WMR

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The two bear markets experienced over the last decade have resulted in an atypical situation where for a protracted period of time riskier portfolios have tended to underperform more conservative portfolios. In other words, investors have not been compensated for taking risk. As we highlighted in our April 2009 publication Crisis: what it taught us. An investment framework for the future, this suggests severe limitations to following an investment approach based solely on SAA without employing these tactical portfolio tilts. Within the ISG, positive, zero or negative tactical deviations relative to the SAA / benchmark allocation are termed over-weight, neutral or underweight, respectively. The ISG provides both benchmark allocations and tactical deviations with specific numerical values across a full range of risk profiles. This is illustrated at the asset class level in Table 1 for a moderate risk profile. The tactical deviations are added to the benchmark allocation to obtain a current allocation. The latter represents the asset allocation at that point in time for an investor within the relevant risk profile. Tactical deviations are also communicated using qualitative ranges in order to provide a sense of the degree of conviction. Three types of overweights (strong overweight, overweight and moderate overweight) are distinguished as well as three corresponding types of underweights (strong underweight, underweight, moderate underweight) (see Table 2). The numerical values are in effect mapped onto this qualitative scale and are presented in bar chart form. Figure 5 illustrates this, using the allocation of equities across regions as an example. In the remainder of this report, we highlight the steps involved in developing asset allocation models that include tactical tilts for a full range of risk profiles. The process, depicted in Figure 6, starts with investment cases. These are research-based views on performance and relative performance of subsets of the overall financial markets. For instance, views will usually include tactical preferences between asset classes (equities, fixed income, etc.) or across regions within an asset class (US equities vs. non-US equities). Section 3 describes how investment cases are derived. In a second step, the views derived from the investment cases need to be integrated into an overall portfolio that includes the entirety of relevant asset classes, regions and segments. This is performed for a reference portfolio, usually a moderate risk portfolio. Finally, the tactical tilts derived for the reference portfolio are then translated onto the portfolios for all other risk profiles. The two latter steps are described in the Appendix in section 4.

Table 1: Asset allocation illustration

Moderate risk profile In percent Cash Bonds Equities
Source: UBS WMR

SAA / Benchmark allocation1 2.0 46.0 52.0

Tactical deviation +0.0 -8.0 +8.0

Current allocation 2.0 38.0 60.0

Table 2: Ranges for tactical deviations

Symbol +++ ++ + n
Source: UBS WMR

Description strong overweight vs. benchmark overweight vs. benchmark moderate overweight vs. benchmark neutral, i.e. on benchmark moderate underweight vs. benchmark underweight vs. benchmark strong underweight vs. benchmark

Fig. 5: Tactical asset allocation (illustration)

Deviations from SAA / benchmark allocation

US EM U UK Japan Other Develo ped Emerging M arkets

---

--

++

+++

Source: UBS WMR

Fig. 6: Steps in building TAA models

Investment Cases
for tactical building blocks E.g. Asset Classes, Regional, Equity Style

Integration
of tactical building blocks into moderate risk portfolio

Translation
of tactical tilts onto other risk profiles

3. Investment cases: TAA decisionmaking process

The methodology that we employ within the ISG to derive investment cases relies upon several beliefs about how financial markets work and accordingly is based on several decision-making variables or pillars (see Figure 7). The three main pillars used for investment cases are: Valuation analysis Cyclical analysis Timing In addition, once all investment cases are available, our TAA decisions UBS FS

Source: UBS WMR

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must be placed within a portfolio context to ensure appropriate risk management.

Fig. 7: TAA decision-making pillars

A disciplined approach for investment cases
Research

Valuation Analysis:
We assume there is a fair value toward which financial asset prices tend to revert over time. This fair value acts as an anchor for prices in the long run (over several years). Moreover, we believe there are reasonable ways to assess an assets fair value. One approach to assessing fair value for stocks and bonds is based on discounted cash flow (DCF) models. These models derive the value today (the discounted value) of the stream of future cash flows that the asset is expected to yield to investors. This requires modeling the path of projected cash flows and interest rates into the distant future. This is achieved by tying long-term assumptions about these value drivers with assumptions about the convergence path toward the long-term values. Value drivers include real interest rates, inflation, earnings growth, payout ratios and risk premiums. By comparing an assets estimated fair value with its current market price, one can form an opinion about whether an asset is overvalued (unattractive), undervalued (attractive) or fairly valued (see Figure 8). The magnitude of the misevaluation can then be compared across different asset classes, regions or segments to determine a relative ranking on the valuation scale. An alternative to DCF models is to compare observed yields or some sort of pricing multiple (price to earnings, price to book, etc.) across markets. Here again, the idea is that valuation relationships tend to revert back to historical norms. So, for instance, if the ratio of yields or price multiples between two segments (say large-cap stocks and smallcap stocks) is out of line with its historical average, and there is no good explanation for this deviation, one would expect this relationship to normalize and the undervalued (cheaper) segment to outperform over time. For example, when determining the relative attractiveness between stocks and bonds, one measure that is often considered is whats known as the equity risk premium. For valuation purposes it is defined as the yield difference between stocks and fixed income, whereby the earnings yield is used for stocks and compared to the real (inflationadjusted) bond yield (see Figure 9). In this example the equity risk premium is above its long-term average. This suggests that investors are being compensated better than average for the risk of investing in equities relative to bonds as an alternative. In other words, equities are attractively valued relative to bonds in this illustration. As a second example, lets consider the relative value between US value stocks and growth stocks using a price/earnings multiples-based valuation analysis. In Figure 10, we will rely on P/E ratios to this effect, specifically computing the ratio of P/E ratios and comparing it to its average value over time. On this metric, Growth stocks appear more attractive than Value stocks from a valuation perspective. Acknowledging the limitations of valuation multiples, one will typically not rely upon a single multiple but rather perform the same analysis across a range of different metrics. The valuation tools used for different portions of the financial markets can vary depending upon their characteristics. For currencies, UBS FS
Valuation Analysis

Cyclical Analysis

Timing

Portfolio Context Allocate active risk budget in proportion to opportunities

Views on the Take business cycle advantage of and their price-value impact on discrepancies asset returns
Investment Cases

Sentiment and fund flows

Source: UBS WMR

Fig. 8: Valuation analysis

Prices are assumed to converge to fair value over time

price Fair value in year 0 + Current value

Fair value in year 3

time
Source: UBS WMR

Fig. 9: Relative value between stocks and bonds: yield-based example

Equity Risk Premium (ERP): US earnings yield minus US real bond yield, in %
20 15 10 5 0 -5 60
Equities un-attractive vs. bonds Equities attractive vs. bonds

65

70

75

80

85

90

95

00

05

Equity risk premium

Average

Source: Reuters EcoWin, UBS WMR

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purchasing power parity models, which link long-term currency movements to inflation differences between the respective countries, are usually relied upon. For commodities, which do not yield cash flows and therefore are not suitable for DCF modeling, we compare market prices with estimates of the marginal costs of production. For corporate bonds, valuation analysis incorporates expectations about the likely defaults and credit losses and assesses whether corporate credit spreads compensate for these risks. However, regardless of the method of valuation employed, it is important to keep in mind that a convergence of market prices to their fair value should only be expected over several years, while in the short term other factors may have a much greater influence upon market prices. Over a typical cycle, there are phases during which asset prices can deviate from their fair value for significant periods of time. This arises because market prices are ultimately determined by the beliefs, expectations and fears of market participants about economic and financial fundamentals, as well as their views about other market participants. Therefore, it is crucial to complement valuation analysis with cyclical analysis and market timing analysis to determine when other factors are likely to drive market prices away from fair value (see Figure 11).

Fig. 10: Relative value between US value and growth stocks: multiples-based example
Ratio of P/E on value relative to P/E on growth stocks

2 1.5 1 0.5 Value attractive 0 95 97 99 01 03 05 07 09 Ratio of P/E (US Value vs. Growth) Average
Source: Bloomberg, UBS WMR

Growth attractive

Fig. 11: Cyclical and market timing analysis

In the short term, prices may drift away from fair value

Cyclical analysis:
The second pillar of tactical asset allocation (TAA) decision-making framework, involves relying on a thorough analysis of business cycle conditions and drawing implications for the performance and relative performance of financial markets. The key ingredient is an ability to forecast the business cycle. This matters because, as new phases of the business cycle unfold, market participants tend to update their expectations for key economic variables such as inflation, interest rates or earnings. The resulting economic surprises tend to affect financial markets sometimes sharply as the news is incorporated into asset prices. Moreover, longer-term trends in financial market behavior are often related to liquidity conditions and changes in investors' attitude towards risk. As a result, one tends to find some broad regularities in the relative performance of asset classes depending on the phase of the business cycle. Figure 12 illustrates under what combinations of economic growth and inflation particular asset classes tend to perform best. The cyclical analysis approach involves three steps: The first step is to identify the current phase of the business cycle as well as its likely future evolution. Second, similar historical circumstances are analyzed to determine the typical asset price performance during those phases. For instance, the analysis of market bottoms in Figure 13 suggests that the stock market tends to reach its low a couple of months before the trough in business confidence (ISM). When conducting such analyses, it is important to stress parallels and possible salient differences between the considered historical episodes and current circumstances. The third step is to determine whether ones economic forecasts are already broadly shared among other market participants. This can be achieved by comparing these forecasts with consensus forecasts. To the extent that one has a strong conviction in a UBS FS

price

Short-term trend time

Source: UBS WMR

Fig. 12: Cyclical analysis

Typical asset performance across the business cycles
Inflation

Rate hikes overheating stagflation Cash Commodities Stocks Time

Growth vs trend Bonds Rate cuts reflation recovery

Source: UBS WMR

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scenario that is not yet anticipated by others, one may be more inclined to invest based on this view of the economic cycle. At UBS Wealth Management Research, the reliance on cyclical analysis for investment decision making is one important reason why we devote considerable effort to forecasting economic trends and cycles. Based on a global team of economists, and relying on an array of econometric models and expert judgment, economic and financial market forecasts are key factors we consider when approaching TAA.

Fig. 13: Cyclical analysis example

Economic indicators average behavior near market bottom since 1970
160 150 60 140 130 120 55 65

50

Market timing analysis:

Analyzing market behavior is especially important during extreme situations. Unusual events can cause sharp shifts in the perceptions of risk, and markets often tend to overreact to such news. This offers opportunities for disciplined investors as risk perceptions usually tend to revert back to their longer-term mean over time. Thus, understanding when extreme caution or extreme enthusiasm among market participants is unwarranted is key to navigating through volatile times. To this end, WMR analyzes various investor sentiment indicators. Such indicators can also serve as useful timing signals under more normal times when used in combination with other types of analysis. For example, Figure 14 illustrates the sentiment of individual investors based on a weekly survey. This indicator is usually considered a contrarian indicator. A strong net bullish sentiment suggests that the stock market is overbought and may be up for a correction, while a strong bearish reading suggests that pessimism is at extremes and that any improvement in the news flow could lead to a sentiment reversal. Interestingly, the reading in early March 2009 was at an extremely bearish level when the market had reached a cyclical low and subsequently rebounded by about 40% during the following three months. A variety of similar indicators are often monitored by analysts, including the VIX volatility index or the put/call ratio. What is important to keep in mind is that: a) using such indicators is more an art than a science; b) the reliability of such indicators must be back-tested using historical data; c) their reliability can change over time; and d) timing indicators should be used in conjunction with valuation and cyclical analysis rather than in isolation.

110 45 100 90 -24 -20 -16 -12 S&P 500 -8 -4 0 4 8 12 16 20 24 28 32 36 Trailling real earnings ISM (right scale) 40

Source: Bloomberg, Datastream, UBS WMR S&P 500 is indexed to 100 at the market low (t=0) and averaged out for all the bear markets since 1970. Horizontal axis represents months before and after the market bottom

Fig. 14: Market timing analysis example

Individual investor sentiment as a contrarian indicator

80 60 40 20 0 -20 -40 -60 90

Individual investors bullish

Individual investors bearish 92 94 96 98 00 02 Net bullish sentiment 04 06 08 Average

Source: Bloomberg, AAII, UBS WMR

Scorecard approach to combining investment case pillars:

Once the three individual decision-making pillars have been analyzed, we rely on a scorecard approach to come to a conclusion (see Figure 15). Valuation, cyclical and timing factors are each attributed a score between -3 (very unattractive) and +3 (very attractive). While it can be tempting to attach a fixed set of weights to these scores, we choose not to as we believe there is no theoretically sound fixed weighting scheme. We believe that the weights attached to the individual scores can vary over time depending on market circumstances. However, we typically attach more significance to both the valuation and cyclical score than the timing score.

Fig. 15: Scorecard example for global equities

Scores can range from -3 (very unattractive) to +3 (very attractive)

Valuation Cyclical Factors Timing

Source: UBS WMR

Score +1 +1 -1

Portfolio context:
After a set of tactical views has been derived for the asset classes and markets in a portfolio, it must be translated into actual tactical deviations from benchmark portfolio weights. One important decision is to determine the size of the tactical UBS FS Investment Strategy Guide 7

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deviations. This, in turn, will influence the possible extent of performance differences between the portfolio and its benchmark. The key consideration is the total tracking error of a portfolio at a point in time. Tracking error (also called active risk) measures the volatility of excess returns vs. the benchmark generated by the managers tactical decisions. Understandably, larger tactical deviations are associated with a larger tracking error. Typically, the overall tracking error should be contained within a predetermined budget for active risk-taking that is established when setting up a TAA process. Another consideration is the allocation of the tracking error across various subsets of the TAA decision. This is illustrated in Figure 16 with a hypothetical example. Subsets may include, for instance, the choices between equity markets within the equity portion of the portfolio, the choices within bond markets, or the choice across asset classes. Determining the appropriate allocation of tracking error across TAA decision subsets is essential to risk management in a portfolio context. The allocation of tracking error across investment decisions must be monitored and should be based on the conviction level underlying each decision and on the expected reward for taking a particular position. It may also be advisable to adjust the total level of tracking error as a function of the overall level of conviction that one has in the tactical views. There are times when tactical opportunities may be limited, which would warrant taking a lower tracking error. At other times opportunities may be more significant, for instance following market dislocations, and tracking error can be scaled up. Tracking error may also be adjusted when the assessed probability of some significant event rises. For instance, if it can be concluded that the likelihood of a geopolitical crisis that would lead to a spike in risk aversion has already been fully discounted into market prices, it may be wise to reduce the tracking error from an overweight position on some risky assets. Within UBS Wealth Management Research, TAA recommendations are only set after a thorough tracking-error analysis.

Fig. 16: Allocation of active risk (hypothetical)

Tracking error contributions, in basis points
140 120 100 80 60 40 20 0 25 Bond Market Selection Equity Market Selection Asset Class Selection Total 52 121 44

Source: UBS WMR

Fig. 17: Thematic research underlying TAA

Examples:
Demographic trends

Growth Expectations Risk premiums Real interest rate Inflation premium Valuation Cyclical analysis TAA

Emerging Market Convergence

Return of big government

Source: UBS WMR

Fig. 18: Market scenarios to guide TAA

High Growth

Base case: moderate recovery 55%

V-shaped recovery 15%

Thematic research as an input into TAA:

In addition to valuation and cyclical assessments, our asset allocation process also integrates the work we do in identifying longer-term themes and trends. These trends include subjects ranging from demographic drivers, to developments across the global economy, to changing regulatory and tax schemes, to efforts to mitigate climate change, to innovations within the financial markets themselves. We typically highlight these themes and trends through our Research Focus and Strategic Call series of reports. These insights help to guide our TAA decisions by influencing expectations about the drivers of financial market performance: growth rates, real interest rates, inflation expectations, and risk premiums. These in turn affect the inputs into valuation models. In addition, such considerations can affect cyclical analysis especially to the extent that these trends are not fully understood by the marketplace and that market expectations are only expected to gradually incorporate this information over time (see Figure 17).

Low Growth

Deflation / Depression
Negative Growth

Stagflation 20%

10%
Negative Inflation Low Inflation

High Inflation

Source: UBS WMR

Market scenario analysis as an input into TAA:

Another factor in our investment decision making process is the incorporation of a scenario-based overlay upon our tactical view. The future is far from certain, irrespective of the amount of resources UBS FS Investment Strategy Guide 8

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devoted to forecasting. As a result, any TAA is bounded by the skills of the individual decision makers and the robustness of the investment research process utilized, with studies suggesting that the prospects for consistently outperforming strategic benchmarks are limited. However, the potential to enhance portfolio returns can still be improved by incorporating a scenario-based overlay on the SAA. While timing markets is a challenge even to the most skilled managers, setting a medium- to longer-term tactical tilt based upon an assessment of the likely macro scenario can both reduce timing risks and enhance return prospects. This is not meant to suggest that a single or even narrow asset allocation process is the preferred approach. However, it does indicate that a higher weighting to certain asset classes can be appropriate based upon the scenario forecast. We believe it is important not only to determine a base-case scenario but also to identify alternative scenarios and monitor how their likelihood is evolving. Alternative scenarios can become base-case scenarios at some point and having considered them ahead of time is an important element of contingency planning. Even if an alternative scenario never materializes, changes in the likelihood that financial market participants attach to these potential outcomes may drive market prices. It is therefore important to assess whether financial markets are overestimating or underestimating the probabilities of certain scenarios. Similarly, perceived changes in the ranking of probabilities attached to alternative scenarios can affect financial market dynamics, since markets often focus on a base scenarios and the main alternative scenario. The ISG therefore includes a probabilistic analysis of the main macroeconomic scenarios and allows the reader to track how our assessment of these scenarios is evolving over time (see Figure 18).

Fig. 19: From tactical building blocks to integrated tactical views

Source: UBS WMR

Fig. 20: From tactical building blocks to integrated tactical views

Tactical deviations from benchmark, in % (example)

Integrated tactical views

4. Appendix 1: Advanced topics in TAA

Integration: Combining tactical building blocks into an integrated view:
Once our investment cases have been laid out and tactical preferences have been determined, the next step is to integrate these views into an overall portfolio. Tactical views are structured as a hierarchy of building blocks (see Figure 19). We start with a top-level layer with broad asset classes, where tactical preferences between global equities, global fixed income, cash and commodities are expressed. In a second layer, global equities and global fixed income are then subdivided into regional blocks. At this level, preferences are expressed among US equities, non-US developed equities and emerging market equities. A similar process takes place on the fixed income side. Finally, in a third step, US equities are subdivided into different market segments. While there are different ways to slice up the US equity market, we break it down largely according to both size and style (i.e., Large Cap Value, Large Cap Growth, Mid Cap, Small Cap and REITs).

Large Cap Value Large Cap Growth Mid Cap Small Cap REITs Non-US dev. Eq. EM Eq. US Fixed Income Non-US Fixed Income Cash Commodities -5 -4 -3 -2 -1 +0 +1 +2 +3 +4 +5

Source: UBS WMR

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To help visualize how this process works, these tactical deviations are shown one building block at a time in Figure 20. It is important to note that each of the building blocks is self-contained, i.e. the tactical deviations across all the segments of a building block (overweights and underweights) all add up to 0. The key question, then, is how to go from tactical deviations structured in these building blocks to an integrated set of tactical weightings for all segments in the portfolio as shown in the bottom of Figure 20. In Figure 21, this process is illustrated by focusing on the step in which the tactical deviations between regional equity markets are combined with the tactical deviation on global equities at the asset class level. In essence, a segment such as US equities will receive a tactical deviation that combines the tactical deviation on US equities vs. other regional equity markets within the equity building block and a pro rata portion of the tactical deviation on world equities at the asset class level. A similar formula-based computation is applied to all markets. In a final step these formula-driven weights are then rounded to the nearest 0.5% point increment.

Fig. 21: Integrating asset class and regional tactical views (illustration) For this illustration, we will assume that global equities are held with a 4% overweight relative to the benchmark. Moreover, within global equities, there is a 2% overweight to US equities, offset by a 1% underweight in non-US developed equities and emerging market equities each. In order to determine the tactical deviations that will apply to these three regional blocks in a portfolio consisting of stocks, bonds, cash and commodities, the 4% overweight attached to global equities must be allocated across the three regions. This is done proportionally according to the market capitalization of each region.
Equity (Global) Fixed Income (Global) Cash Commodities Tactical +4% -2% -2% 0% Tactical Market Incl. cap Equity asset share only class 100% 0% 4% 40% 2% +3.6% = +2% +40% x (+4%) 50% -1% +1.0% = -1% +50% x (+4%) 10% -1% -0.6% = -1% +10% x (+4%)

Translation of tactical views across SAAs and risk profiles:

Once the tactical building blocks are available and have been integrated for a particular investor risk profile / SAA1, the last step is to determine how to translate these tactical views onto the remaining risk profiles (see Figure 22). There are different approaches that can be adopted to achieve this, each with their own pros and cons. The path taken in the ISG seeks to translate the tactical views in a way that takes the characteristics of the respective risk profiles and SAAs / benchmark allocations1 into account. Specifically, the approach starts from the tactical building blocks and prior to integrating them into the overall portfolios, scales these tactical deviations while applying the following considerations: At the asset class level, relative to a moderate risk profile, tactical deviations are scaled up for riskier profiles, and scaled down for more conservative profiles (see Figure 23). In other words, the tracking error at the asset class level increases for riskier portfolios. The reasoning behind this is to prevent the overall market risk of conservative portfolios from shifting into that of a higher risk profile because of tactical overweights on risky assets (e.g., equities or commodities). Within equities and bonds tactical deviations are scaled by the importance of the asset class in the overall portfolio. This means that between two portfolios, tactical deviations within the fixed income module will be greater for the portfolio that incorporates a larger share of fixed income. Similarly, the tactical tilts within the equity module will be higher for the portfolio that has a larger share of equity. With these altered building blocks in hand, the same integration procedure described in Section 4 is applied to each risk profile.

Equity US Equity Non-US dev. EM

With US equities accounting for 40% of global stock market capitalization, 40% of the 4% overweight on global equities is allocated to the US. This is in addition to the 2% overweight to US equities from the regional tactical view, resulting in an overweight toward US equities of 3.6%.
Source: UBS WMR

Fig. 22: Translation of tactical views

Large Cap Value Large Cap Growth Mid Cap Small Cap REITs Non-US dev. Eq. EM Eq. US Fixed Income Non-US Fixed Income Cash Commodities -5 -4 -3 -2 -1 +0 +1 +2 +3 +4 +5

Return

Risk
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Currency considerations in TAA:

In the context of an international portfolio, foreign exchange markets add another level of complexity when setting a TAA. Most individual investors are exposed to currency movements when they invest outside of their home country. For instance, a US investor purchasing UK shares may reap returns if the UK stock market performs, but will lose performance if the British pound depreciates sufficiently against the US dollar. They are therefore exposed to the risk of both the foreign investment and the foreign currency. Institutional investors, on the other hand, are often able to hedge the currency exposure of their foreign investments by using instruments such as forward or futures contracts. By doing so, they eliminate their foreign currency exposure, while remaining exposed to the risk of the foreign investment. The returns they can achieve abroad reflect the returns in the foreign market adjusted for hedging costs (see Figure 25). In the ISG, WMR provides TAA on an unhedged basis for a US dollarbased investor. These allocations are relevant for investors who do not hedge their foreign currency exposure and who therefore bear foreign currency risk when investing internationally. These allocations thus reflect WMRs views on both the underlying foreign markets (bonds, equities, etc.) and the associated currencies. When considering the investment cases in the ISG relating to regional equity and regional fixed income allocations, one distinction must be kept in mind. While in principle currency movements matter for internationally oriented US investors regardless of whether they invest in stocks or bonds, in practice currency considerations are much more important for bonds investors. Figure 26 illustrates the relative performance in US dollars of investments in the US fixed income market and in the global ex-US fixed income market. The non-US returns are provided with currency hedging and without hedging. It is apparent that the largest source of performance variation arises in the case without hedging. This suggests that currency movements dominate the relative performance of US and non-US bond markets hedged for currency movements. Accordingly, our tactical views on US vs. non-US fixed income are guided predominantly by our view on the US dollar vs. the currencies of the main foreign bond markets. In contrast, for internationally oriented US equity investors the importance of currency movements and differences in local stock market returns is much more balanced. Figure 27 even shows that since 1995, the difference in performance between US and non-US equity has been driven to a greater extent by regional equity market factors than currency considerations. Accordingly, the regional equity analysis in the ISG takes both regional equity factors and currency aspects into account.

Source: UBS WMR

Fig. 23: Across asset classes

Tracking error budget for tactical deviations rises for riskier profiles
Conservative Risk Profile Equity Fixed Income Cash Commodities
-8 -6 -4 -2 +0 +2 +4 +6 +8 -8 -6 -4 -2 +0 +2 +4 +6 +8
-8 -6 -4 -2 +0 +2 +4 +6 +8

Moderate Risk Profile

Aggressive Risk Profile

Source: UBS WMR

Fig. 24: Within asset classes

Tracking error budget for tactical deviations is proportional to share of asset class in portfolio
Conservative Risk Profile US Equity Non-US dev. EM
+0+1+2+3+ -4 -3 -2 -1 +0 +1 +2 +3 +4 -4 -3 -2 -1 +0+1+2 +3+4 -4 -3 -2 -1 +0+1+2+3 +

Moderate Risk Profile

Aggressive Risk Profile

Fixed US Income Non-US

-4 -3 -2 -1 +0+1 +2+3+4

-4 -3 -2 -1 +0+1+2+3+4 -4 -3-2 -1 +0+1+2+3+4

Source: UBS WMR

Fig. 25: Dealing with foreign currency exposure

Hedged vs. unhedged TAA
Type of TAA Embedded views View on foreign market View on foreign currency Risk exposure

No

Unhedged TAA

Market & currency risk

Foreign currency hedging? Hedged TAA

Yes

View on foreign market Currency hedging costs

Market risk

Source: UBS WMR

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5. Conclusion
This report has laid out the processes and methodology underlying the strategic and tactical asset allocation models in the ISG. We believe that today more than ever, following a well-structured and disciplined investment process is key to investment success. Asset allocation is a critical element in this process and should be at the heart of discussions between individual investors and their financial advisors. We believe that the ISG is a valuable source of guidance in this area.

Fig. 26: International fixed income driven largely by currency movements

Total return indices in USD, index 1990=100
450 400 350 300 250 200 150 100 50 0 90 92 US FI 94 96 98 00 02 Non-US FI currency unhedged 04 06 08 Non-US FI hedged

Source: Bloomberg, UBS WMR

Fig. 27: International equity driven more by local equity markets than currencies
Total return indices in USD, index 1990=100
450 400 350 300 250 200 150 100 50 0 95 97 99 01 03 05 US Equity Non-US Equity US dollar Non-US Equity local currency 07 09

Source: Bloomberg, UBS WMR

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Appendix 2
1. Sources of benchmark allocations and investor risk profiles: Benchmark allocations represent the longer-term allocation of assets that is deemed suitable for a particular investor. As the time of the publication of this report, the majority of the benchmark allocations expressed in the ISG have been developed by UBS Investment Solutions, a business sector within UBS Wealth Management Americas that develops research-based traditional investments (e.g., managed accounts and mutual fund options) and alternative strategies (e.g., hedge funds, private equity, and real estate) offered to UBS clients. The benchmark allocations are provided for illustrative purposes. They were designed by UBS Investment Solutions for hypothetical US investors with a total return objective under seven different Investor Risk Profiles ranging from very conservative, to very aggressive. In general, bench-mark allocations will differ among investors according to their individual circumstances, risk tolerance, return objectives and time horizon. Therefore, the benchmark allocations in this publication may not be suitable for all investors or investment goals and should not be used as the sole basis of any investment decision. As always, please consult your UBS Financial Advisor to see how these weightings should be applied or modified according to your individual profile and investment goals. Also, see the most recent issue of the Investment Strategy Guide for a current description of the source of benchmark allocations. Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are currently only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time UBS AG and other companies in the UBS group (or employees thereof) may have a long or short position, or deal as principal or agent, in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connected with an issuer. Some investments may not be readily realisable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realisation you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein. This document may not be reproduced or copies circulated without prior authority of UBS or a subsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document to third parties for any reason. UBS will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report is for distribution only under such circumstances as may be permitted by applicable law.
Australia: Distributed by UBS Wealth Management Australia Ltd (Holder of Australian Financial Services Licence No. 231127), Chifley Tower, 2 Chifley Square, Sydney, New South Wales, NSW 2000. Bahamas: This publication is distributed to private clients of UBS (Bahamas) Ltd and is not intended for distribution to persons designated as a Bahamian citizen or resident under the Bahamas Exchange Control Regulations. Canada: In Canada, this publication is distributed to clients of UBS Wealth Management Canada by UBS Investment Management Canada Inc.. Dubai: Research is issued by UBS AG Dubai Branch within the DIFC, is intended for professional clients only and is not for onward distribution within the United Arab Emirates. France: This publication is distributed to clients of UBS (France) SA, 69, boulevard Haussmann F-75008 Paris, R.C.S. Paris B 421 255 670, a duly authorized bank under the terms of the Code Montaire et Financier, regulated by French banking and financial authorities as the Banque de France and the Autorit des Marchs Financiers. Germany: The issuer under German Law is UBS Deutschland AG, Stephanstrasse 14-16, 60313 Frankfurt am Main. UBS Deutschland AG is authorized and regulated by the Bundesanstalt fr Finanzdienstleistungsaufsicht. Hong Kong: This publication is distributed to clients of UBS AG Hong Kong Branch by UBS AG Hong Kong Branch, a licensed bank under the Hong Kong Banking Ordinance and a registered institution under the Securities and Futures Ordinance. Indonesia: This research or publication is not intended and not prepared for purposes of public offering of securities under the Indonesian Capital Market Law and its implementing regulations. Securities mentioned in this material have not been, and will not be, registered under the Indonesian Capital Market Law and regulations. Italy: This publication is distributed to the clients of UBS (Italia) S.p.A., via del vecchio politecnico 3 - Milano, an Italian bank duly authorized by Bank of Italy to the provision of financial services and supervised by Consob and Bank of Italy. Jersey: UBS AG, Jersey Branch is regulated by the Jersey Financial Services Commission to carry on investment business and trust company business under the Financial Services (Jersey) Law 1998 (as amended) and to carry on banking business under the Banking Business (Jersey) Law 1991 (as amended). Luxembourg/Austria: This publication is not intended to constitute a public offer under Luxembourg/Austrian law, but might be made available for information purposes to clients of UBS (Luxembourg) S.A./UBS (Luxembourg) S.A. Niederlassung sterreich, a regulated bank under the supervision of the Commission de Surveillance du Secteur Financier (CSSF), to which this publication has not been submitted for approval. Singapore: This material is distributed to clients of UBS AG Singapore Branch by UBS AG Singapore Branch, an exempt financial adviser under the Singapore Financial Advisers Act (Cap. 110) and a wholesale bank licensed under the Singapore Banking Act (Cap. 19), regulated by the Monetary Authority of Singapore. Spain: This publication is distributed to clients of UBS Bank, S.A. by UBS Bank, S.A., a bank registered with the Bank of Spain. UAE: This research report is not intended to constitute an offer, sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE). The contents of this report have not been and will not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities, the Emirates Securities and Commodities Authority, the Dubai Financial Market, the Abu Dhabi Securities market or any other UAE exchange. UK: Approved by UBS AG, authorised and regulated in the UK by the Financial Services Authority. A member of the London Stock Exchange. This publication is distributed to private clients of UBS London in the UK. Where products or services are provided from outside the UK they will not be covered by the UK regulatory regime or the Financial Services Compensation Scheme. USA: Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate. Version as per July 2009. UBS 2009. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

Endnotes

Disclaimer

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