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CIO WM Research 13 February 2014

Andrew Lee, CIO Head of Alternative Investments, UBS AG A closer look at alternative andrew.lee@ubs.com Dominic Schnider, analyst, UBS AG investments [email protected] Cesare Valeggia, analyst, UBS AG [email protected] • Investors who hold only cash and traditional asset classes in Stefan Brägger, strategist, UBS AG their investment portfolios are missing out on the return and [email protected] diversification potential of alternative investments. Table of contents • UBS's definition of alternative investments focuses on hedge funds and private market investments, including private equity, private Executive summary 1 debt and real assets. Definition of alternative investments 2 Benefits of alternative investments 3 • Alternative investments are key strategic components of a well- Alternative investments in a portfolio context 5 diversified portfolio as they have the potential to improve overall Implementation considerations 8 risk-adjusted returns and diversify sources of returns. Risks of alternative investments 9 • We advise clients to allocate 12-15% of their overall portfolio to hedge funds, depending on individual risk profile. For clients who can tolerate significant illiquidity, we recommend a 3-11% allocation to private markets investments. • Allocating to alternative investments requires a long-term investment horizon. Balanced exposure across alternative investment strategies should allow these allocations to perform across market cycles.

Executive summary Fig. 1: Alternative investments as part of a diversified portfolio Alternative investments are important tools that provide investors with We focus on hedge funds and private markets exposure well beyond long-only investments in traditional asset classes.

They allow investors to improve overall risk-adjusted portfolio returns s

t Liquidity n while diversifying sources of those returns by (i) expanding the investors’ e Bonds m t

toolkit with strategies and opportunities not available through traditional s

e Equities instruments; (ii) offering illiquidity premiums as compensation for the long- v n i term capital commitment; and (iii) providing actively managed exposure to e Hedge funds v i t

various asset classes and the potential to capture excess returns. a

n Private markets r e t l Commodities It is important to recognize that alternative investments comprise a A wide range of heterogeneous strategies, all with differing approaches, exposures, return drivers and risks. We focus on hedge funds and private Source: UBS markets that have different liquidity profiles and play different roles in a Liquid real estate investments form a part of equities, while illiquid real estate investments are a sub-category of private markets. portfolio context. Hedge funds cover a range of actively managed strategies providing exposure to equity, fixed income and other asset classes, which require moderate illiquidity and target up to equity-like returns with lower volatility. Private markets represent various illiquid strategies pursuing equity and debt investments in unlisted companies and assets (including real estate and real asset investments), by seeking additional risk-adjusted returns through active involvement, leverage and illiquidity.

This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 12. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication. Alternative investments

Investors need to be mindful of certain aspects of alternative investments, including the liquidity trade-off, higher fee levels, the level of transparency and the importance of manager selection. Decisions about how to implement these investments, such as the desired degree of involvement and the level of diversification, are also important. All of these factors should be carefully considered as they can impact the investor's portfolio exposure, expected returns and risk profile.

Overall, hedge funds and private markets should serve as important strategic components of a well-diversified portfolio. The ultimate decision on how to incorporate these investments and how much to allocate depends on investors' individual objectives, risk profile and tolerance for illiquidity in addition to the expected investment benefits to the portfolio. Definition of alternative investments Fig. 2: Overview of alternative investments Hedge funds and private markets consist of several What do we mean by “alternative investments”? This term is often used strategy buckets with each of the strategy buckets to refer to the diverse range of asset classes and investment strategies having their own sub strategies outside of the traditional investments of equities, fixed income and cash. The broadest definitions of the term often include commodities, real estate, Alternative investments hedge funds, private markets, and collectibles such as art and luxury assets.

Alternative investments (AI), as we define the term, focus specifically on Hedge funds Private markets hedge funds and private market investments, including private equity, private debt and real assets. We address them separately due to their relative illiquidity, complexity of strategies and underlying investments, and Equity hedge Private equity greater reliance on third-party manager skill and execution to achieve expected performance. We exclude direct commodities and listed real Event driven Private debt estate investments as they can be accessed directly through highly liquid instruments providing exposure to these asset classes. Private markets Relative value Real assets do include illiquid real estate and real assets, such as farmland and infrastructure, as these investments are longer duration and are generally Macro/trading accessed through similar structures as other private markets. The strategies we include in alternative investments are widely heterogeneous and provide Source: UBS exposure to a broad set of underlying investments and assets, but they generally share some common characteristics, including attractive risk-adjusted return profiles, potentially lower correlations to traditional risk assets, and some degree of illiquidity premium. Fig 3: Alternative investments in context Alternative investments increase the opportunity set Hedge funds are actively managed investment vehicles with flexible man- through active investment management and illiq- dates enabling managers to invest opportunistically both long and short uidity across asset classes using a range of strategies and instruments to achieve attractive risk-adjusted returns. To allow managers to match liquidity of their funds with the time required to execute their strategies, these vehicles have reduced liquidity with typically quarterly redemption at best, though certain strategies are also available through more liquid structures. The hedge fund universe can be broadly divided into four strategy styles: equity hedge, event driven, relative value, and macro/trading. Each category is made up of various sub-strategies with differing approaches, exposures and return drivers. Although hedge funds share some common objectives such as a focus on controlling downside risk and targeting asymmetric returns, they are widely heterogeneous and provide investors with access to dif- Source: UBS fering approaches, asset class focus, exposure levels, use of leverage, and risk-adjusted return profiles.

Private markets investments comprise a wide range of illiquid strategies targeting longer-term equity and debt investments in unlisted companies and assets. Investors commit capital to these strategies through actively managed vehicles that typically invest over several years and require lockups of up to 10 years or more as fund managers need a longer time to

UBS CIO WM Research 13 February 2014 2 Alternative investments

realize intrinsic or potential value from the underlying assets. Historically, such investments have been associated primarily with private equity, but the illiquid universe has expanded to include private debt and real asset strategies (incl. real estate) as well. As with hedge funds, these three broad categories comprise several sub-strategies targeting differing assets, exposures, degrees of strategic and operational involvement, and return drivers. Benefits of alternative investments Table 1: Hedge funds have delivered attractive risk adjusted returns by managing volatility Despite greater illiquidity, higher fees and relatively increased com- Risk adjusted returns have moderated over time, plexity versus traditional investments, alternative investments, viewed in but remain attractive compared to traditional asset aggregate, are important tools for investors seeking to maximize expected classes HF Hedge HF Equity HF Macro- HF Event World World returns for a given level of risk. Exposure to return drivers other than market Hedge funds Relative funds hedge trading driven equities bonds performance is a key differentiator that has enabled hedge funds and value private markets to generate better risk-adjusted returns historically than 10 years, monthly returns traditional asset classes, even after fees. Investors who can accept some Avg. return 6.0% 5.7% 4.8% 6.5% 7.3% 9.6% 4.9% level of illiquidity on a portion of their assets can improve their overall port- Volatility 6.4% 8.7% 5.0% 4.9% 6.6% 16.6% 4.3% folio by incorporating alternatives. We address the specific merits of hedge Sharpe ratio 0.69 -0.05 0.47 0.65 0.98 0.48 0.99 funds and private markets individually given that they enhance portfolios Sortino ratio 0.85 -0.05 0.58 1.34 0.79 0.58 1.61 in different ways. 20 years, monthly returns

Avg. return 9.0% 10.4% 8.0% 8.4% 10.2% 8.1% 6.2%

Hedge funds Volatility 7.0% 9.2% 6.7% 4.3% 6.7% 15.8% 4.8%

Hedge funds provide actively managed exposure to various asset classes, Sharpe ratio 0.86 0.80 0.75 1.27 1.07 0.32 1.16 with a focus on downside protection. Investors who are willing to accept Sortino ratio 1.15 1.15 1.39 0.92 1.18 0.42 1.84 moderate illiquidity on a portion of their assets gain access to benefits, Source: Bloomberg, UBS including: Values are based on arithmetic returns • Expanded toolkit. Hedge funds have access to a broader range of Hedge fund indices are based on the HFRI product family World equities are based on the MSCI TR index investment strategies and instruments, allowing them to invest across World bonds are based on the Barclays Eurodollar AA+ 5-7 years TR index traditional asset classes and capitalize on market inefficiencies in ways Risk free rate is based on 1-month US Treasuries that long-only managers cannot. This provides investors with alternate ways to gain exposure to asset classes they are familiar with, while diversifying sources of returns. • Focus on downside protection and asymmetric returns. Hedge funds generally focus on protecting against significant capital losses by targeting asymmetric returns, or returns skewed to the upside. As a result, hedge funds tend to protect against drawdowns in adverse market conditions better than traditional long-only investments, sup- porting attractive long-term compounded returns and lowering overall volatility. • Reduced market dependence and potential for excess returns. Many hedge fund strategies seek to generate returns through drivers other than just traditional beta, which can reduce performance dependence on market movements. Furthermore, hedge funds are run with an active investment and risk management approach by managers who seek to generate excess returns through skill and investment acumen. These additional sources of returns differentiate hedge funds from traditional assets.

Hedge funds are differentiated from traditional investments as they generate returns from multiple sources: traditional beta due to market exposure, non-traditional beta due to exposure to other risk factors, and alpha or excess returns due to manager skill. These factors have enabled hedge funds overall to generate risk-adjusted returns of 9.6% annually with 7.1% volatility over the past 20 years, and 6.0% annually with 6.4% volatility over the past 10 years. These returns, which are net of management fees of up to 2% and incentive fees of up to 20%, compare favorably to traditional asset classes on a risk-adjusted return basis.

We expect hedge funds to generate a similar risk-return profile over the next five years, with returns of 4-6% annually and volatility of 5-7%. Within

UBS CIO WM Research 13 February 2014 3 Alternative investments

a portfolio context, a balanced allocation to hedge fund strategies should improve overall risk-adjusted returns while diversifying return drivers and providing the benefits described above. In our view, these benefits more than compensate investors for the incremental illiquidity tradeoff.

Private markets Table 2: Private markets have delivered higher Private market investments can add differentiated sources of returns to risk-adjusted returns complement traditional asset classes in portfolios. These investments are Private equity and private real estate (proxy for attractive as they provide investors, who can tolerate significant illiquidity private market) investments World and complexity, with benefits, including: Private DM ex US US real DJ Small EM US PE EM PE equities markets PE estate Cap equities • Expanded opportunity set. Private markets allow investors to gain (ex US) exposure to private companies and assets, as well as investment 10 years, quarterly returns themes and strategies that are unavailable through traditional liquid Avg. return 13.6% 14.1% 12.4% 6.7% 10.9% 10.6% 14.0% securities. Examples include corporate turnaround situations, unlisted Volatility 16.8% 10.3% 13.5% 9.0% 20.6% 21.1% 25.7% firms, and direct lending. Sharpe ratio 0.71 1.21 0.80 0.57 0.45 0.43 0.48 • Differentiated return drivers. As a result of the expanded oppor- 20 years, quarterly returns tunity set and other strategies and levers that fund managers use to Avg. return 15.1% 14.9% 7.2% 7.9% 7.8% 10.4% 7.6%

generate returns, private market strategies have the potential for lower Volatility 14.3% 11.0% 11.8% 6.5% 18.9% 19.3% 27.6%

correlations with traditional assets. This is not necessarily true for all Sharpe ratio 0.85 1.09 0.36 0.75 0.33 0.38 0.17 strategies, however. Source: Cambridge Associates, NCREIF, Dow Jones, UBS • Higher risk-adjusted returns. Private markets have historically gen- Start and end date: 3Q 1993 to 2Q 2013 and based on quarterly observations. Return data is based on arithmetic returns erated higher risk-adjusted returns than traditional assets, in part due Private equity indices based on Cambridge Associates data World ex US and EM equities are based on MSCI TR indices. US real estate is to an illiquidity premium which we estimate at 2-4% a year to com- based on NCREIF pensate for long-term capital commitments. Risk free rates = US 1-month Treasuries Note: Performance data for private markets are mainly available for private • Active manager involvement. Private market managers generally equity strategies and cover around 70-80% of the fund investment universe. Cambridge Associates is a widely-used provider of private market performance pursue active strategic and operational change in order to realize the data. The data is free of charge, making it easy for investors worldwide to intrinsic or potential value of the underlying portfolio company or compare performance figures; the sample size is large especially in emerging markets; and the data goes back over 20 years. Other data providers are Preqin asset. This is a significant point of differentiation compared to long- and ThomsonOne, which focus on the US and European markets, and are more useful in analyzing different strategies by vintage years. only managers. Note: Volatility is likely somewhat understated as private market returns are only reported on a quarterly basis, and fund managers tend not to change • Benefit from information asymmetry and short-term uncer- portfolio companies' valuations substantially unless there are significant events tainty. The long duration of private market capital allows managers to or changes in the company's performance. capitalize on asset mispricings that may result from short-term uncer- tainty. This dynamic can lead to outsized returns over longer time horizons.

Private market returns are differentiated from traditional investments as they generate returns from multiple sources: traditional beta due to market exposure, an illiquidity premium to compensate for the long-term capital commitment, and alpha or excess returns due to manager skill. These factors have enabled private markets overall to generate returns of 8-14% annually, with 11-15% volatility over the past 20 years. Volatility may not fully represent the risks involved given the smoothing effect of private market returns, resulting from industry-standard reporting and valuation approaches for private assets.

We expect a similar risk-return profile over the next five years for a diversified private market portfolio. Private market returns of 11-13%, or 4-6% a year above the returns of a diversified equity portfolio, should come with an annual volatility of 10-15%. Within an overall portfolio context, an allocation to private market strategies should improve overall risk-adjusted returns and provide access to attractive themes and opportunities not oth- erwise available through traditional listed assets. In our view, these benefits more than compensate investors for the significant illiquidity required by private markets.

UBS CIO WM Research 13 February 2014 4 Alternative investments

Fig. 4: Portfolio considerations when allocating Alternative investments in a portfolio to alternative investments context Alternative investments can be allocated to individual asset classes, or treated as a standalone allo- We have outlined above many of the attributes that make alternative invest- cation ments valuable strategic components of well-diversified portfolios. Some 60% key considerations of incorporating these investments into portfolios are outlined below. 50%

40% Approaches to incorporating alternative investments 30% Institutional allocators have different approaches to visualizing alternative investments into portfolios. One approach is to group alternative invest- 20% ments with traditional assets based on the underlying asset class. For 10% AI AI example, directional long-short equity strategies would be included in the AI 0% equity allocation. This approach can be beneficial as it allows an investor Equities Bonds Liquidity Equities Bonds Liquidity Alternative investments to assess together all investments with exposure to a particular asset class. Integrated approach Standalone approach There are advantages to improving one's understanding of the underlying asset class through exposure in alternative investments. However, there Source: UBS are significant limitations on how effectively this can be accomplished in practice. Alternative investment funds' positioning and exposures are Fig. 5: Volatility adjusted return profiles when dynamic and disclosure often lags. Correctly allocating many strategies to adding different HF and PE combinations to specific asset classes is challenging due to funds' flexibility to invest across portfolio of bonds and equities asset classes, the complexity of adjusting for gross and net exposure, the X-axis shows the percentage of HF & PE exposure in impact of drawdown structures, and constantly changing positioning. the portfolio; y-axis shows annual returns divided by volatility; values are based on quarterly returns from We believe alternative investments are best approached as standalone cat- 3Q 1993 - 2Q 2013 egories in a portfolio from an asset allocation perspective. Hedge funds and 1.4 private markets generate a substantial portion of returns from non-tradi- 1.3 tional factors, illiquidity premiums and manager alpha. Such attributes dis- tinguish alternative investments from traditional long-only investments and 1.2 warrant approaching these strategies independently. 1.1

We therefore use a portfolio framework with separate hedge fund 1.0 and private market allocations, while incorporating elements of the first 0.9 approach - considering the market (beta) exposure of alternative investments. By maintaining a dynamic understanding of the underlying asset 0.8 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% class exposures in the alternative investment allocations, we can estimate Adding HF exposure to an equity/bond portfolio Adding HF & PE exposure (equally weighted) to an equity/bond portfolio the incremental contributions to traditional risk exposures. In certain cases, Adding PE exposure to an equity/bond portfolio the impact is obvious. Strategies such as long/short equity, long/short credit Source: UBS, Bloomberg Time series based on quarterly observations, arithmetic returns and private equity provide clear exposure to specific asset classes and as Equity/Bond portfolio is equally weighted: MSCI World TR index and Barclays such can be grouped with the relevant asset class exposure. However, as Eurodollar AA+ 5-7 years TR index Private equity index: Generic index based on Cambridge Associates data discussed above, assessing the true nature of underlying exposures is not (Weights: US 50%, DM ex US 30% and EM 20%), always straightforward. Hedge fund index: HFRI fund weighted index

Setting portfolio weights for hedge funds and private markets An investor's risk-return objectives, investment horizon, preference for active risk exposure, and capacity to hold illiquid assets are key considerations when determining portfolio allocations to hedge funds and private markets. Traditional mean-variance optimization is not appropriate for determining the optimal allocation for either hedge funds or private markets, as AI risk factors beyond simple volatility are difficult to quantify. We therefore use a combined qualitative and quantitative approach to determine the optimal weighting of alternative investments in a portfolio.

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Hedge funds Table 3: Expected returns and volatility for We use an index-based approach to determine the level of allocation to hedge funds and traditional assets hedge funds in the portfolio. There is no clean standardized data tracking Time horizon 5 years, in USD Ex-Ante Sharpe the performance of the overall hedge fund universe or individual strategies. Asset class Expected returns Expected volatility Ratio Instead, the industry relies on a few databases that aggregate self-reported data by funds to construct "benchmark" indices. These indices all carry Risk free rate 1.7% n.a. n.a. potential biases, including survivorship bias, backfill bias and selection bias. High grade bonds 2.6% 2.5% 0.4 Equities 7-8% 15-17% 0.3-0.5

For our work, we use the HFRX and HFRI indices from Hedge Fund Research, Alternative invest. Inc. The advantage of the HFRX is that the index is in theory "investable". Hedge funds 4-6% 5-7% 0.4-1.0 However, this comes with restrictions for hedge fund managers such as higher transparency and separate account requirements, and as a result the Source: UBS index contains a limited number of constituents, few of which might be Hedge fund index: HFRI fund weighted composite index Equities: Proprietary portfolio of country weighted MSCI TR indices based considered top institutional quality managers. In contrast, one advantage of High grade bonds: Barclays Eurodollar AA+ 5-7 years TR index the HFRI is that the index comprises a much larger number of constituents Risk free rates: US treasuries across a range of strategies. However, it includes funds that are closed to new investment and are therefore not investable. We use both indices in our analysis, focusing on the HFRX as it is more conservative and repre- sents performance that is theoretically available to a potential investor, but viewing HFRI as more indicative of performance that should be achievable by large institutional investors such as UBS, and its clients by extension.

We perform quantitative analysis using these datasets to assess historical Table 4: Core SAA including hedge funds relationships to selected risk factors and calculate return and risk expecta- Asset allocation weights for hedge funds range from tions using our capital markets assumptions. We derive expected returns 12% to 15% for the next five years of 4-6% a year, with a volatility of 5-7%. Fixed Asset class Income Yield Balanced Growth Equities income These long-term return and risk estimates serve as inputs to the overall Liquidity 5% 5% 5% 5% 5% 5% SAA portfolio construction process. The process is based on a quantitative Bonds 95% 73% 55% 38% 21% 5% approach using different risk factor expectations derived across multiple Equities 0% 10% 25% 42% 62% 90% business cycles, which provides stability to the model. Due to AI-specific Alternative invest. risk factors that are difficult to quantify and integrate in a mean variance Hedge funds 0% 12% 15% 15% 12% 0% approach, we also consider other risk measures such as diversification coef- Total 100% 100% 100% 100% 100% 100% ficients, Value at Risk, and drawdown analysis, which we integrate quanti- tatively into the allocation decision. Using this combined quantitative/qual- Source: UBS itative approach, we arrive at recommended allocations of 12-15% to hedge funds in the core SAAs, depending on the investor's risk profile. These allocations presume hedge fund exposure that is reasonably balanced across strategies.

Hedge funds are not necessarily consistent with the objectives of all investor risk profiles. Investors seeking current yield should not look to hedge funds as they do not generate distributable cash flow (no allocation in "Fixed Income" risk profile), and investors targeting higher returns who have a tolerance for volatility should replace hedge funds with an equity allocation ("Equity" risk profile).

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Private markets Table 5: Expected returns and volatility for The UBS WM core SAAs do not include private markets due to the inherent private equity and traditional assets illiquidity of these investments. We have constructed an alternate set of Time horizon 5 years, in USD Ex-ante Sharpe “SAAs including private markets” only for use by clients who are able to Asset class Expected returns Expected volatility ratio take a longer-term investment view and tolerate significant illiquidity in some of their assets. By allocating to longer-lockup investments, investors Risk free rate 1.7% n.a. n.a. capture illiquidity premiums while expanding their universe to include High grade bonds 2.6% 2.5% 0.4 assets, strategies and themes unavailable elsewhere in their portfolios. As Equities 7-8% 15-17% 0.3-0.5 with hedge funds, the recommended weights presume a private market Alternative invest. allocation that is relatively balanced across strategies as well as vintages, to Hedge funds 4-6% 5-7% 0.4-1.0 minimize dependence on timing or any single return driver. Private markets 11-13% 10-15% 0.6-1.2

Source: UBS In contrast to traditional asset classes, there is no standardized benchmark Private equity index: Generic index based on Cambridge Associates data measuring performance of private market strategies. Investors accustomed (Weights: US 50%, DM ex US 30% and EM 20%), Equities: Proprietary portfolio of country weighted MSCI indices TR based to passive investing in listed market indices need to understand that this High grade bonds: Barclays Eurodollar AA+ 5-7 years TR index is not possible for private markets. To track overall performance, the Risk free rates: US treasuries Smoothing of returns tends to understate the volatility of the underlying invest- industry relies on various databases provided by reputable independent ments, which needs to be considered when assessing the volatility of illiquid research firms such as Cambridge Associates, Preqin or ThomsonOne. investments like private equity These databases compile return data that is self-reported by fund managers in order to construct “benchmark” indices to track the performance Table 6: Strategic asset allocation including of private market investments. These indices carry potential biases like sur- private markets vivorship bias and selection bias, among others, and primarily focus on Only for investors who can tolerate illiquidity risks. private equity strategies. Historical data is scarce for other private market Asset allocation weights for private equity/debt strategies within private debt and real assets, and what is available gen- range from 3 to 9% erally dates back only a few years. Fixed Asset class Income Yield Balanced Growth Equities income We expect a diversified private market portfolio to generate annual returns Liquidity 5% 5% 5% 5% 5% 5% of 11-13% over the next five years, or 4-6% per annum above the returns Bonds 95% 70% 50% 33% 16% 5% of a diversified public equity market portfolio, with 10-15% volatility, which Equities 0% 10% 22% 38% 56% 81% is in line with realized historical volatility. These expected returns are based Alternative invest. on our long-term CIO capital market assumptions for equity returns, the Hedge funds 0% 12% 15% 15% 12% 0% risk free rate and an illiquidity premium of 2-4%. Private equity/debt 0% 0% 3% 4% 6% 9% An even more heterogeneous return profile offers private debt investments Real assets/estate 0% 3% 5% 5% 5% 0% with annual returns of 5-10% for senior secured loans, 10-15% for unse- Total 100% 100% 100% 100% 100% 100% cured, subordinated debt instruments, and more than 15% for directly Source: UBS originated small/mid-cap direct lending strategies. Traditional real asset strategies focusing on defensive, cash-flow generative assets, such as core real estate or brownfield infrastructure, trend to generate annual returns of 5-10%. That said, more opportunistic real asset strategies have comparable risk-return profiles to private equity.

We apply a combined quantitative/qualitative approach in deriving an allocation to private markets. After considering the risk-return profile of private markets overall and assessing areas within traditional asset classes with similar risk-return and drivers, we also make adjustments to ensure prudent diversification and liquidity. For clients who can tolerate illiquidity in a portion of their assets, we recommend allocations of 3-11% to a private market portfolio that is generally balanced by strategy, geography and vintage. CIO WM is in the process of creating an "endowment style SAA" specifically for clients who are interested in significantly higher (40-80%) allocations to alternative investments, in particular private markets.

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Strategic perspective is required for alternative investments Fig. 6: Liquidity profile for alternative invest- We remind investors of the need to take a strategic longer-term perspective ments and traditional assets when allocating to alternative investments. Knowing the benefits of alter- As alternative investments are less liquid, they are native investments to the overall portfolio, investors need to decide upfront optimally approached in an SAA context how much illiquidity they can tolerate, whether they want to allocate to both hedge funds and private markets and what long-term allocation they are comfortable with. Once these strategic allocations have been set, we Private markets m

advise against altering the weights significantly over time unless investors' u i m

e HFs circumstances change materially. r HFs unregulated p regulated y t i d i u

The underlying hedge fund strategies are already actively managed from q i Traditional l l an investment and risk perspective, so our view is that "managing the I assets managers" on an overly tactical basis is ineffective. However, we do rec- Degree of illiquidity (redemption w indow ) ommend constantly evaluating the appropriateness of strategy weightings Daily Monthly Quarterly Years and implementing periodic strategy shifts within the hedge fund allocation to capitalize on changing opportunities in the economic and financial land- Source: UBS scape.

Within the private market allocation, investors will have to make regular commitments to maintain a roughly static portfolio weighting over time, as distributions from existing private market investments are not automat- ically re-invested. Investors should ensure that their overall allocation stays balanced by geography, strategy and vintage, and should use a thematic approach to identify the most attractive opportunities in the market at any given time for reinvestment and new investment of capital. Implementation considerations Fig. 7: Overview of alternative investments from an implementation perspective Executing the actual fund investments to implement these allocations is a FoHF refers to multi-manager fund-of-hedge-fund critical part of the investment process for alternatives. Portfolio construction structures and manager/vehicle selection can significantly impact expected return and risk of the allocations. Investors have to make strategic decisions about Alternative investments whether to take a broadly diversified or deliberately targeted approach, Hedge funds Private markets whether to self-direct management or outsource to a third party, and their liquidity preference in hedge funds. Self-directed Inst. managed Direct Indirect ) ) d d Investors need to decide whether they have the time and resources to take ) ) Self-directed Inst. managed r e e r d d t t e e e e e e a a F t t l F g l l l g a a a g H a g u u H l l n an active role in managing their alternatives allocations. Active involvement n n o n g g o u u i i a F a F e e s t g S g - S s r r d e e n o s M d M n n r r n c e e ( ( s s / n i u u u / e s ( ( in hedge fund portfolio management, even with the assistance of advisors, f r e e s u m t i e t t a e f i t r i a r a s n r r d a f a e e a d a n o v d m m n p m i requires time and effort for strategy selection, manager selection, and i o n t n r a r d e c i s P o - P n S e e c m o v u S e s n F C monitoring of performance, exposures and positioning. The advantage i of this approach is that it allows for greater customization and control. Investors who do not want to take an active role can outsource portfolio Source: UBS Inst. managed = institutionally managed management to third parties, either delegating to an advisor who can Regulated refers to UCITS hedge funds (Undertakings for Collective Investment manage the allocation within agreed-upon guidelines, or simply investing in Transferable Securities), and unregulated refers to offshore hedge funds in a multi-manager/fund-of-fund solution. In both cases, professional managers actively research, select and execute fund investments on investors’ behalf in return for an additional fee.

A related decision for investors is whether to take a diversified or targeted strategy approach. The recommended allocations for both hedge funds and private markets presume balanced exposure across the different strategies; disproportionate weightings are only advised in order to target specific exposure or return drivers. Investors who delegate management to third party managers tend to want a diversified approach as this best fulfills the role of hedge funds and private markets in a portfolio context. However, investors can choose a more imbalanced approach if their objective is to target specific exposures or return drivers, or if they aim to use alternatives less in a portfolio context and more to replace certain traditional asset class exposures.

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Investors increasingly also have a choice of vehicles to obtain their hedge fund exposure. The full range of hedge fund strategies is available through direct investments in offshore vehicles, which are unregulated, tend to have high minimum investment levels, and typically provide quarterly liquidity at best. Private banks offer feeder fund vehicles, which reduce minimum investment levels in return for upfront placement and monitoring fees. Finally, hedge fund strategies with highly liquid underlying investments are increasingly available via regulated UCITS structures which provide greater liquidity. Not all strategies are suitable for this format, but UCITS may be the most effective way to achieve hedge fund exposure in certain jurisdictions. Risks of alternative investments Fig. 8: Risk factors to consider when investing in hedge funds and private markets Investors allocating to alternative investments should consider the addi- Illiquidity risks should receive special attention when tional risks associated with these investments, including illiquidity, exposure investing in alternative investments to leverage, operational risks, and lower levels of transparency. Under- standing and managing these additional risks is vital. Proper oversight and Alternative investments stringent due diligence processes help to mitigate, though not eliminate, Hedge funds Private markets some of these risks. Forced sale by investor of his illiquid Longer redemption terms of certain Illiquidity. Illiquidity fund investments in the secondary • Investors in private markets investments must be prepared investments and greater illiquidity of risks: market at a significant discount to net the securities they are invested in to accept significant illiquidity. These investments require long-term asset value capital commitments to allow managers to match liquidity of their Financial gearing on a corporate level fund with the expected time required to realize value from the under- Leverage Greater loss potential and the (balance sheet) amplifies the volatility risks: introduction margin call risks of equity returns and can lead to loss lying investments. Investors must expect to access this capital in the of investment near term, or be prepared to accept a potentially significant discount to Losses arising from executing Operational Errors related to policies, procedures inadequate or faulty strategies on fair value if they choose to seek liquidity in the secondary market. The risks: and safety checks at the manager level corporate level and external events illiquidity risk for hedge fund investors relates to liquidity mismatch of the fund compared to the underlying investments, particularly in non- Blind pool as investors have limited Insufficient disclosure masking fraud, idea upfront about investments to be Black box: equity-focused strategies. Adverse market conditions can cause liq- leverage and style drifts among others made; limited disclosures and only periodic uidity to dry up for periods of time, leading to wide bid-ask spreads and An economic or financial market potentially large mark-to-market losses. Investors in offshore vehicles Systemic Remain susceptible to complete collapse affecting the real economy risks: market failure have only periodic liquidity and no ability to force realizations, and and the underlying portfolio firms can therefore be subject to these losses and managers’ ability to gate or sidepocket. (Gating is when a hedge fund restricts investor with- Source: UBS drawals from the fund. Sidepocketing is when a hedge fund segre- Regulated refers to UCITS hedge funds (Undertakings for Collective Investment in Transferable Securities), and unregulated refers to offshore hedge funds, gates illiquid, difficult-to-value assets into a separate vehicle in which Others refers to separate mandate, secondaries and co-investments existing investors have stakes, but future investors do not participate.) • Leverage. Private markets and hedge fund managers generally have the ability to use leverage at the asset or fund level. This can increase returns but also impacts the risk profile of the investment. In a private market context, the use of leverage in a buyout transaction subjects the portfolio company to the risk of lender action if debt covenants are breached; in a hedge fund context, a fund could face margin calls if the value of the collateral falls sharply. In certain cases, the lack of leverage availability or affordability could hurt strategies like buyouts. Monitoring the use of leverage and the impact on risk-return profile requires time, effort and resources that many individual investors do not have. • Operational risks. Due to the complexity of the strategies, instruments and structures used by private market and hedge fund managers, there are significant risks related to inadequate or flawed con- trols over people, processes, systems, and other operational aspects relating to investment management, portfolio management and risk management. Often, operational risks are defined as those risks beyond market, credit and liquidity risks. These risks cannot be eliminated, but can be mitigated to an extent through proper due diligence and a focus on investing with more established firms that have pro-

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cesses, policies and procedures in place that support a culture of risk awareness. • Black box considerations. Alternative investments tend to provide only limited disclosure on underlying investments, and only period- ically. Although this dynamic is often necessary to allow managers the time and flexibility to execute certain strategies effectively, it may also help to hide fraud, mask style drift, obfuscate true exposures and the abnormal use of leverage, and understate general market and investment risks. These risks cannot be eliminated, but can be mitigated through regular exposure and performance monitoring by knowledgeable professionals. • Systemic risks. Few, if any, investments are immune to systemic risks and complete market failure. Alternative investments are vul- nerable to the same shocks of financial system collapse or liquidity crunch as other risk assets, even if active risk management and a focus on downside protection might mitigate the performance impact. Awareness of exposures, prudent diversification across strategies and reasonable limits on the illiquid weightings in a portfolio can also help to limit overall impact.

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Appendix

Selected definitions

 Alpha: the premium an investment portfolio earns above a certain benchmark (such as the Standard & Poor's 500). A positive alpha indicates that the investor earned a premium over that index. In terms of stocks; a positive alpha is viewed as a stock being undervalued in relation to other stocks with similar systematic risk. In terms of portfolios; a description of the extraordinary reward obtained from the portfolio. The better the management of the portfolio, the more positive the alpha.  Beta: the measurement of a dependent variable's (i.e. stock price) volatility relative to an independent variable (i.e. an index). Beta is the percent change in the price of the dependent variable given a 1% change in the independent variable. This reveals if the dependent variable moves in step with the independent variable; where a beta of 1 indicates perfect alignment. Beta is a measure of risk; the higher the beta, the higher the risk.  Correlation: the degree to which the fluctuations of one variable are similar to those of another.  Drawdown: the peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted as the percentage between the peak and the trough.  Gate: a restriction imposed by hedge funds to limit investor withdrawals from the fund during a redemption period.  Side Pocket: a type of account used in hedge funds to separate illiquid assets from other more liquid investments. Once an investment enters a side pocket account, only the present participants in the hedge fund will be entitled to a share of it. Future investors will not receive a share of the proceeds in the event the asset's returns get realized.  UCITS: Undertakings For The Collective Investment Of Transferable Securities - a public limited company that coordinates the distribution and management of unit trusts amongst countries within the European Union.  Volatility: the relative rate at which the price of a security moves up and down, found by calculating the annualized standard deviation of daily change in price.  Survivorship bias: tendency for historical returns to be overestimated as a result of databases removing track records of funds which liquidate and close; typically liquidating funds are underperformers rather than outperformers.  Backfill bias: tendency for historical returns to be overestimated as a result of databases instantly including historical performance of managers once they begin disclosing results; typically only managers that are outperforming would do so.  Selection bias: tendency for historical returns to be overestimated as a result of the self-reporting nature of databases; typically only funds that have generated outperformance would voluntarily report returns while underperformers would not do so.

Source: Bloomberg, UBS

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Appendix

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