Alternative Investments

The Trend Toward many people viewed foreign markets Incorporating Alternative Investments with a high degree of skepticism. Exotic Hedge Funds and Many individual and institutional investors and risky are two terms that come to have been introducing or increasing their mind. And yet, since that time, many Managed Futures allocations to “alternative” or non- astute investors have embraced traditional investments in their portfolios. international investing as a key element in a Portfolio Why? Because, in short, the poor market of building a diverse portfolio. In the performance of 2000 – 2002—the same way, investors today are intrigued weakest period for the stock market by the benefits that early adopters of UBS Financial Services is pleased since the 1970s—drove investors to seek alternative investments have been seeing to provide you with information investment strategies that were more since the 1990s—chief among them about alternative investments. independent of market movements. diversification. These investors want There are a few points we would They sought portfolio performance that insightful guidance on how best to like to raise with you at the outset. wouldn’t hinge on the traditional asset understand and evaluate the classes of stocks, bonds, and cash—and opportunities provided by alternative This article is for educational and this led them to alternative investments.1 investments, in both a general and a informational purposes only. It detailed sense, that accounts for their does not constitute investment Alternative investments—defined here as own investment goals and portfolio. advice. Among other things, it hedge funds, managed futures, private does not take into account your equity and real estate—can play an This brief introduction to alternative personal financial situation, or important role in creating a complete investments provides an overview of the your investment goals or strategies. portfolio solution. With their diverse role hedge funds and managed futures You should not construe any sources of return and relatively low can play in a portfolio. Since hedge information provided here to be correlation with traditional asset classes funds and managed futures share several an investment recommendation such as stocks and bonds, alternative similarities—both investment approaches for you to follow. You should investments have the potential to reduce are based primarily on tradable securities contact your Financial Advisor for risk and/or enhance returns when such as stocks, bonds, options and information or recommendations included in a diversified portfolio. futures—for our purposes here we are that may be useful specifically including managed futures within the to you. Alternative investments often are broader hedge fund category. We’ll misperceived, much as international include private equity and real estate investing was a generation ago when in subsequent pieces.

UBS is the world’s largest wealth manager 2 and is one of the largest participants in the alternative investments industry, managing and distributing more than $100 billion3 in client assets. Our global team has relationships with many of the world’s leading hedge fund, managed futures, private equity and real estate firms. We bring this elite talent to eligible individual and institutional investors.

1 Hedge Fund Research, Inc. (HFR) September 10, 2007, www.hedgefundresearch.com 2 Source: Scorpio Partnership, June 20, 2007, www.scorpiopartnership.com ab 3 Source: UBS. Figure as of June 30, 2007

1 Alternative Investments

We realize that our clients’ financial Hedge Fund Strategies Some of the more common sources goals and needs differ. You may be The alternative investments category of return are alpha generation, beta particularly focused on growing or has evolved rapidly over the past ten exposure, risk premium and leverage. maintaining family business interests, years and with it the number of funds, multi-generational planning or strategies and styles available to Alpha and Beta philanthropic funding. We’ve found that individual investors. The term “hedge Alpha is defined as the manager’s when individuals or families begin to fund” is often used as a catch-all phrase added value on a risk-adjusted basis. think about how their assets will benefit to imply that all funds are the same. An example is the extra return a portfolio future generations or worthy causes, A hedge fund is really the packaging, earns by superior stock selection after an important shift takes place: These or the investment structure. The key is comparing the beta of an appropriate investors begin to think and act more like to examine the underlying investment benchmark. Beta expresses the variance institutional investors than as individual strategy and the techniques that the between an investment’s return and its investors. The types of strategies that fund is pursuing. Some examples include benchmark. A stock with a “high beta” may be appropriate for a “lifecycle” funds that pursue event-driven strategies, has been more volatile than its portfolio—more stocks at a young age, such as investing in a company that benchmark index, while a stock with more bonds toward retirement—become has been or will be influenced by a a low beta has been less volatile than less so. Multi-generational investing merger or regulatory changes; global that benchmark. requires a total return approach that macro strategies that hinge on will surpass inflation, taxes and fees, fluctuating economic situations and Alpha and beta often are tossed around while preserving and growing wealth. currencies, such as currency trading. as “good” and “bad” indiscriminately. Alternative investments have the Even within one strategy—equity hedge We say “indiscriminately” because potential to achieve these goals. (long/short) —one hedge fund manager the roles of alpha and beta must be might employ “low net” exposure (more understood within the context of Whether one’s investment objective hedged) while another might favor one’s overall investment objective. is wealth preservation or capital long-biased exposure (closer to 100% Beta exposure is not necessarily bad; appreciation, there are many different net long). Hence the term “hedge fund” if markets trend higher over time, types of strategies within alternative is simply the start of a much more it is beneficial to have some beta investments from which to choose. detailed conversation. exposure in a portfolio. Our goal here is to provide valuable initial guidance on how these strategies Sources of Return can be introduced into a traditional Every strategy should be examined portfolio. We hope that this information and employed within the context of will prompt helpful conversations about its potential for return. Because hedge alternative investments between you funds generate returns that are less and your Financial Advisor. dependent upon market performance, it is important to understand the underlying return drivers for hedge fund strategies.

2 Alternative Investments

Risk Premium Some strategies, such as directional Risk premium can be defined as the ones including equity hedge, can be amount of return earned by bearing viewed as managing market exposure risk that others may seek to avoid. (beta) plus security selection (alpha). For instance, high-yield bonds pay a Many non-directional strategies, such as higher rate of interest to investors to fixed-income arbitrage, earn their returns compensate for the risk their lower by exploiting a spread (risk premium) credit ratings carry. Option sellers earn based on duration or credit rating and premiums when they provide other magnifying this spread with leverage. market participants with puts or calls for hedging or speculating purposes. Risk Factors The most common risk factors for Leverage alternative strategies include the direction Leverage—using financial instruments or of the stock market and its volatility, borrowed capital—is often used to interest rates and credit spreads. By increase the potential return of an examining the sources of return for a investment. A simple example is buying strategy, specific variables or risk factors securities on margin to benefit from an can be identified as having a tendency to expected increase in the price of a stock. influence the returns of these strategies. As long as the gains from price returns Evaluating risk factors is an important exceed the cost of borrowing, the trade step in building a portfolio. is profitable. Other forms of leverage include options, futures or swaps that The sources of return and risk across have embedded leverage because of the alternative strategies are based on relatively small initial capital required to the components of the strategy hold these positions. These types of employed and the style of the manager. trades can be used to increase returns Evaluating these strategies requires both or provide downside protection and can a qualitative and quantitative approach. magnify all of the return drivers present Before looking at specific risk statistics in hedge funds and managed futures. that may be helpful to compare investments, it is important to have an in-depth knowledge of the strategy and the manager’s style.

3 Alternative Investments

Pursuing Asymmetric Return In short, many investors place a high • Supplying risk management/ Opportunities: The Goal value on consistent, positive returns that “selling insurance” to other market of Alternative Investments minimize participation in down markets. participants (risk premium strategies) Long-only asset classes/strategies tend Alternative investments may help a to be (generally) symmetric; that is, the portfolio accomplish that outcome on • Specialized techniques—short potential to earn returns has a direct a more regular basis. selling, options, leverage, less relationship to the amount of risk taken. efficient markets (distressed debt, There is an opportunity for large gains– Hedge funds and managed futures have convertible arbitrage) but also the potential for large losses. been used to improve asymmetric As many clients express their investment outcomes by employing some of the • Structured products, another financial objectives in absolute terms, alternative following methods: innovation, are created based on strategies can be added to a portfolio to hedge funds and managed futures produce more asymmetric return profiles • Strategies that are designed to forego strategies to target asymmetric results that target the positive side of the return some portion of the upside return in distribution with greater frequency. exchange for less participation in the downside (managing long/short exposures, seeking absolute returns)

Asymmetric Returns Hedge Funds target positive returns that occur with greater frequency and attempt to mitigate losses. (Jan 1990 to Aug 2007)

Annualized Return Maximum Drawdown

16.6%

14.3%

11.8% 10.7% 9.9%

7.1%

HFRI Hedge HFRI HFRI HFRI Funds Relative Event Equity S&P Lehman of Funds Value Driven Hedge 500 Aggregate

HFRI HFRI HFRI HFRI S&P Lehman -6.6% -5.2% Hedge Relative Event Equity 500 Aggregate Funds Value Driven Hedge -10.8% -10.3% of Funds -13.1%

-44.7%

Source: Hedge Fund Research, Inc. and Barclay Hedge, August 2007. Indices are unmanaged and not available for direct investing. Past performance is not indicative of future results.

4 Alternative Investments

A Different Approach to The Compounding Effect Putting It All Together to Portfolio Strategy The compounding effect—the cumulative Build a Portfolio Many of the traditional asset classes impact of consistent, positive returns— It would seem to follow that building may rely on very long-term historical is a powerful force. However, one year portfolios with components that have studies to calibrate relative return and of significant losses requires many years higher (historic) returns, lower (historic) risk relationships. of positive returns just to get back to standard deviations and less correlation prior asset values. The chart illustrates with traditional assets would produce When adding alternative investments, how recovering from a significant loss portfolios with superior characteristics. we suggest an approach that is based can be a difficult and lengthy process, One might think this approach would on the “characteristics” of the particular even if a portfolio grows at a 10% mechanically create portfolios that have strategy. There are several dimensions to annual rate of return. reasonably good returns with lower risk. “characteristics” including equity market While this approach seems logical and sensitivity, interest rate sensitivity, credit There are compelling reasons to focus straightforward, it is incomplete. For one quality, net long or short exposure, on downside risk when evaluating thing, it can lead to allocations based liquidity risk, risk premium strategies alternative investments: exclusively on “low volatility” strategies and others. which may eliminate the benefits of • The recent historic period (1990 – diversifying among strategies. In addition, the guidance that we present) has presented us with several provide relies more heavily on downside challenging environments from a risk A better approach is to construct a risk-based analysis—attempting to avoid perspective to evaluate the inherent portfolio that balances a client’s risk losses—rather than forecasting returns. vulnerabilities of these strategies. profile and investment objectives. The events of 1997, 1998 and 2000 – Risk profiles should be defined by Why focus on downside risk? Even 2002 serve as good proxies for risk. the investors’ sensitivity to drawdowns one double-digit losing year can and downside volatility. The appropriate significantly compromise the ability • Relative returns, especially in short-term mix of alternative strategies can be to achieve a financial goal in a periods, are somewhat random. While determined that will be consistent reasonable time horizon. Drawdowns— many alternative investments have with these downside risk parameters. an investment’s peak-to-trough declines historically generated positive returns The investment objectives—whether in value—are the largest hindrance to in most calendar years, it is highly absolute or relative to a benchmark— the benefits of compounding. uncertain how these strategies may can be incorporated into strategy compare to traditional asset classes. level allocations based on degrees of market sensitivity (beta), market • Forecasting returns of asset classes or exposures (leverage) and the specific set individual strategies is a difficult task of investments that can deliver the for any time horizon. proper characteristics to the portfolio.

Recovering From a Loss May Be Difficult % Appreciation Years Required to % Loss Required to Break Even Break Even at 10% Annual Return 20% 25.0% 2 years, 4 months

30% 42.9% 3 years, 9 months

40% 66.7% 5 years, 5 months

50% 100.0% 7 years, 3 months

5 Alternative Investments

When incorporating alternative investor begins with an asset allocation benefits of hedge funds and managed investments into traditional portfolios, consisting of 60% equities and 40% futures. They offer greater opportunities it is important to combine an in-depth bonds. To diversify some of the risk in to achieve investment objectives through knowledge of the strategy with a traditional assets, the investor carves out combinations of risk reduction and/or broad range of statistics to capture 10% from equities and 5% from fixed return enhancement. At the same its characteristics, both sources of income to place 15% in alternative time, these strategies present some return and risk factors. A strategy that investments. The 15% can be divided interesting challenges when included may appear too risky as a stand-alone into three equal portions in relative in a diversified portfolio. investment may offer valuable value, event-driven and equity hedge diversification benefits in a portfolio. fund strategies. This example provides If portfolio construction relied exclusively This approach is similar to what you diversification within hedge fund on annualized return, standard deviation should find in a diversified hedge strategies and adds a mix of non- and correlation, the task would be fund-of-funds. Our purpose here is to directional and directional characteristics relatively simple to calculate and easy outline a methodology for investors to the portfolio. The resulting allocation to implement. Relying solely on a few who prefer a more targeted or is 50% equities, 35% fixed income and historical data points as the basis for personalized approach. 15% alternative investments. an investment allocation understates the importance of the task. Moreover, Another consideration is the proper The Barbell investor begins with a because markets and investment combination of strategies that is portfolio of 100% municipal bonds. opportunities change over time, you constructed to pursue a specific financial While municipal bonds can generate and your Financial Advisor will want to objective. This objective should lead to tax-free income with low risk of review and adjust your portfolio together well–defined characteristics contained principal if held to maturity, they do not periodically to reflect those changes. within a strategy, the style of the participate in rising equity markets. manager and the necessary level of In this case, the alternative investments Consequently, forging an alternative diversification among these components considered should be much more investment strategy that meets to produce the desired portfolio. directional with an opportunity to your specific requirements is a complex capture higher returns such as equity scenario. That’s why our Financial It may be easier to understand some of long/short, distressed, managed futures Advisors rely on our extensive team these concepts by including hypothetical and global macro. This investor may of product specialists and alternative examples. We understand that all choose to allocate 20% to a combination investments consultants in order to bring investors have different objectives and of these strategies. While the all of UBS’ many capabilities to bear in preferences. This is not an attempt to components of this portfolio may be creating your personalized strategy. provide a specific recommendation; at opposite ends of the spectrum, the rather, it is solely for illustrative purposes. total portfolio may have the potential This professionally orchestrated team Consider two investors, both of whom to achieve attractive absolute returns approach can be especially productive have a moderate risk profile with a on a consistent basis. for more complex financial situations, strong desire to earn consistent absolute resulting in new opportunities for returns. One investor we will label as In Conclusion diversification which attempts to “Diversified” and the other will be There are many compelling reasons capture upside potential while known as “Barbell.” The Diversified investors should explore the potential minimizing downside risk.

A note on the presentation of hypothetical examples. This presentation does not reflect the actual investment experience of any investor. Among other things, any rates of return or investment results presented or suggested here do not reflect the deduction of any management fees, or other fees or expenses that an investor would pay. In addition, while “Barbells” and other hypothetical examples may have been tested and examined over a period of several years, and while aggregate overall returns or investment results may have been positive over an extended period of time, please note that there may have been times during that period when performance was negative and/or risk increased. To the degree that any rates of return are presented or suggested, please note that past performance is not necessarily indicative of future results.

6 Alternative Investments

Glossary: General Terms With ever-increasing financial innovations, offsetting short positions in an attempt Alpha stock indices, bond markets and to achieve a net market exposure as A measure of performance on a risk- currencies have become the dominant close to zero as possible. adjusted basis. Alpha incorporates the tradable “commodities” through financial volatility of an investment and compares futures, forwards and options. In current Convertible Arbitrage its risk-adjusted performance to a investing parlance, managed futures is Builds a portfolio of convertible benchmark index. The excess return of generally considered to be a hedge fund securities and hedges company risk by the investment relative to the benchmark strategy, but sometimes the structures/ shorting equities, debt securities, index is the investment’s alpha. products investors use to access these or using derivatives. strategies may be reviewed by different Beta regulatory bodies.4 Fixed Income Arbitrage A measure of the volatility, or systematic Seeks to profit by investing in the pricing risk, of an investment compared to a Maximum Drawdown inefficiencies that occur among related benchmark index. A beta of 1.0 indicates A measure that can be used to evaluate fixed income securities. that the investment will move with the risk. Maximum drawdown measures the benchmark index. A beta of less than peak-to-trough decline in an investment’s Merger Arbitrage 1.0 indicates less volatility while a beta net asset value over a period of negative Invests long and short in event-driven of more than 1.0 indicates more volatility. performance. It is simply the largest situations such as leveraged buyouts, percentage decline in net asset value mergers and hostile takeovers. Correlation that has occurred since inception of an A statistical measure of the investment. Monthly data are used to Distressed interdependence of two or more random calculate this statistic. Invests in or sells short securities of variables. Fundamentally, the value companies undergoing or expected indicates how much of a change in one Standard Deviation to undergo a significant change such variable corresponds to a change in A measure of dispersion of a set of as bankruptcy, reorganization, another. A correlation of 1.0 indicates a data from its mean. The standard or recapitalization. significant relationship between variables. deviation indicates how much an investment has performed (more or less Special Situations Hedge Fund volatile) from its mean return over time. Invests in or sells short companies A commingled pool of assets that may Typically calculated from monthly data involved in spin-offs, smaller or use specialized techniques—short selling, and annualized (multiplied by the square lesser–known companies or companies options and leverage—that are not root of 12, or 3.46). with other unique characteristics. readily available in traditional investment structures. In addition to a management Volatility Equity Long/Short fee, these funds may also charge an A statistical measure of the tendency Invests in a core holding or long equities incentive fee, or pay managers a of a market or a security to rise or fall and sells short stocks and/or stock percentage of the profits. Regulatory sharply within a set period of time. options and index options in an effort limits generally restrict investment in Volatility is typically calculated by using to reduce market exposure and risk. hedge funds to high net-worth investors. annualized standard deviation of the price or return. A measure of the relative Managed Futures Managed Futures volatility of a stock to the market is its Trades long and short positions in Managed futures programs trace their beta. A highly volatile market or security futures, forwards and options contracts beginnings to the trading of physical means that prices have large swings in on currencies, stock and bond indices goods such as agricultural products and very short periods of time. and physical commodities. metals for the purpose of producer and commercial hedging. The instrument Hedge Fund and Managed Global Macro traded was labeled a “commodity” Futures Strategies Attempts to profit from anticipated (whether futures, forwards or options) Equity Market Neutral price movements in stock markets, as were the exchanges where the trading Invests in long equity positions and an interest rates, foreign exchange and took place. approximately equal dollar amount of physical commodities.

4 Managed futures programs, generally, are not reviewed by the SEC (Securities and Exchange Commission), but by the CFTC (Commodity Futures Trading Commission) and NFA (National Futures Association).

7 Alternative Investments

Risk Considerations tax information to investors. They are There are risks associated with investing subject to investment management fees in alternative investments. and performance-based allocations and other fees and expenses, all of which You should be aware of the following will reduce profits. There is no secondary as you learn more about alternative market for the interests of the Funds, investment opportunities (“Funds”). and none is expected to develop. There are risks associated with investing Interests of the Funds are not deposits in a Fund. An investment in a Fund is or obligations of, or guaranteed or speculative, and you may lose some or endorsed by, any bank or other insured all of your investment. This is not an depository institution, and are not offer to purchase or sell the interests federally insured by the Federal Deposit of any Fund. Insurance Corporation, the Federal Reserve Board, or any other Alternative investment Funds are not governmental agency. mutual funds and are not subject to the same regulatory requirements as Finally, you must meet certain mutual funds. Alternative investment eligibility requirements in order Funds may engage in leveraging and to invest in the Funds. These other speculative investment practices requirements generally require that that may increase the risk of investment you satisfy certain criteria concerning loss. They are illiquid; they are not your net worth, your annual income, required to provide periodic pricing the amount you have invested with or valuation information to investors; UBS and/or the amount of investable they may involve complex tax strategies; assets that you own. and there may be delays in distributing

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