Asset management

Professional clients only

Alternative beta
Risk premia investing that is more targeted in nature than broad market beta.

1
Contents

Introduction 3

Building smarter value equity strategies 6

Minimum expected tail loss equity portfolios 11

Tactical tilts and multi asset class risk premia 14

Your global investment challenges answered 18

Contact 19

Contributing authors
Art Gresh
Adam Jokich
Andreas Razen
Patrick Zimmermann

UBS 2016. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

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Introduction

Smart beta, factor beta, strategic beta ... it goes by many

names; we prefer the term alternative beta. What it
generally refers to is risk premia investing that is more
targeted in nature than broad market beta. Its origins lie in
early quantitative investment approaches that seek to add
value using factor based models for identifying what are
now familiar return drivers, e.g. value, momentum, size
and quality to name a few. Although initial applications
have primarily been focused on equity markets, the
alternative beta concept can also be applied to other asset
classes such as fixed income and commodities.

One could argue then that alternative beta has been a feature of some
quantitatively managed investment strategies for quite some time. Where
alternative beta differs from its active, quantitatively managed counterparts,
is in its level of transparency. Put simply, this takes the form of simple rules-
based methods for portfolio construction or, in an analogy to traditional passive
investing, indexing by a means other than market capitalization. Indeed it is in
part the relative simplicity and transparency of the alternative beta approach
that has led to its adoption by an increasing number of investors.

However, as investors' interest in alternative beta strategies has grown, so have

their questions. Investors often find it challenging to choose between a growing
field of providers that purport to offer the same alternative beta exposures.
Methodologies differ across providers. Are these differences meaningful in
terms of capturing the beta exposure in question? Do process differences lead
to economically different outcomes? Perhaps even more fundamental are
questions regarding how alternative beta strategies can be used in practice.
How should alternative beta strategies be combined or packaged and how
might alternative beta vehicles be employed as instruments for factor beta
based allocation?

What follows is our attempt to explore these questions and present them
within the context of three examples. Each has been selected in response to
specific client queries. We do not contend that what we present is an exhaustive
treatment of the subject. Rather we hope it will be illustrative of our approach
to the topic and UBS Asset Management's contribution to the discussion.

The first paper focuses on what is perhaps the most well-known and
thoroughly studied factor, premium:value. Both practitioners and academics
have devoted considerable effort to:

In the case of the former, developing investment processes utilizing

valuation techniques, and

In the case of the latter, testing alternative rationales for the existence of
the value premium.

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 That said, it is the apparent persistence of the value premium across markets
and asset classes that has resulted in its emergence as one of the largest asset
categories in the alternative beta space. The research here examines the value
premium in the equity market, specifically focusing on how the premium is
measured and how the resulting indices are constructed.

Our research indicates that the methods typically employed by most index providers
can be improved upon with relatively modest effort. In particular, we find that
measuring value using customized metrics that reflect the specific industry / sector
dynamics and structure leads to superior results compared to techniques typically
employed by most alternative beta index providers where an almost identical list
of metrics is used for each and every sector. The fundamental insight here can
be simply stated by way of an example: Utility companies are very different to
Technology companies so why would we use the same metrics or ratios to measure
value in both of these sectors? A superior approach is to use our fundamental
understanding of these sectors to develop sector specific metrics that better
measure and capture the value premium.

Our second paper examines the factor risk premium that rivals, if not exceeds, value
in terms of asset flows and client interest low-risk. In particular, we focus on the
variant of the low-risk premium termed 'Minimum Volatility'. Minimum Volatility
investing has expanded dramatically in the years following the Financial Crisis
and while the desire on the part of investors to mitigate losses is understandable
given the searing experience of Autumn 2008, we question whether a Minimum
Volatility strategy is the best means of securing this objective.

A Minimum Volatility approach defines risk, as the name implies, in terms of

volatility. For a portfolio of stocks, this means that the portfolio's volatility is
determined by the underlying volatilities and correlations of the stocks held
in the portfolio. Unfortunately, volatility only adequately describes the risk an
investor faces under fairly restrictive assumptions. In the real world of markets, the
assumptions are nearly always violated:

Correlation only captures linear relationships

The co-movements of stocks are often non-linear, especially in times of

crisis. Volatility is only an adequate descriptor when returns are normally
distributed

Empirical evidence demonstrates that returns are more extreme than what
can be supported under the assumption of log normality, as the following
papers will highlight.

Finally, the nature of the volatility statistic makes it at best a partial solution to the
investor's problem of minimizing drawdown. Volatility is a symmetric measure.
A process that minimizes volatility not only reduces downside potential but also
reduces upside potential.

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In order to address investors' concern over loss mitigation, we propose
constructing a portfolio around a risk measure that better captures the non-
linearities and non-normality of the distribution of stock returns. The measure
we use is Expected Tail Loss (ETL). ETL allows us to estimate the features of
the distribution that cannot be adequately captured using volatility. The richer
measure of risk that ETL affords allows us to better target portfolio drawdown
risk. Additionally, ETL has the benefit of not explicitly compressing the exposure
to the upside of the distribution. Our simulation results show the ETL approach
achieving superior risk adjusted returns and lower drawdowns than those
achieved using Minimum Volatility.

The third paper is an example of how an investor might use alternative beta
strategies as building blocks in a multi-asset portfolio. Where our previous
discussion has focused exclusively on equities, this piece of research introduces
additional sources of alternative beta from fixed income, foreign exchange
and commodities. The alternative beta elements form the core of the portfolio
in much the same way as conventional market capitalization indexed passive
strategies often form the components in a traditional asset allocation strategy.
Construction of the core portfolio is governed by a modified risk parity
approach where the marginal contribution of each factor's risk component
is equalized subject to a risk budget constraint at the asset class level (e.g.,
50% fixed income, 40% equity and 10% commodities).The paper then goes
on to explore ways that the core portfolio can be improved by a series of
enhancements. The most relevant of these enhancements in terms of alternative
beta premia is the introduction of macroeconomic tilts. The tilts imposed are
a function of the macroeconomic cycle and take the form of deviations from
the core risk parity portfolio aligned with that cycle. As an example, while in
the recessionary phase of the cycle the portfolio would tilt toward Minimum
Volatility and equity yield factor premium.

The work presented here is just one of many potential alternative beta
applications in the multi-asset context. For those interested in learning more, we
encourage you to read the individual papers. We hope you find them useful in
framing your own questions, and answers, on the appropriate use of alternative
beta strategies in your portfolio or that of your clients.

Art Gresh
Managing Director
UBS Asset Management

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Building smarter value equity strategies
Introduction and overview
Value investing is perhaps the most well-established
of investment principles. Its core tenet implies that
investors can earn superior returns by preferring cheap
assets over expensive ones. It is the basis of modern
security analysis in which analysts attempt to discern the
value of a security by assessing that security's underlying
fundamentals. For decades this has been the process
which has guided traditional active management.
In recent years, investors have begun to explore
systematic approaches to capture what has come to
be termed 'the value premium'. In an effort to harvest
the observable value premium in the market, nearly
all large index vendors have devoted resources to the
development and marketing of value indices. In general
these indices are of two broad types. The first utilizes
the concept of fundamental weighting which derives
constituent weights from the underlying company
fundamentals. The rationale behind fundamental
weighting is that over the long term, weighting the
universe by fundamental measures, rather than prices,
will guard against market bubbles and crashes as
deviations between fair price and fundamental value
can be long-lived. These types of strategies employ
a combination of sales, operating cash flow, uses of
cash, and book value to determine the weight of the
company in the index. By construction, fundamental
indexing has historically exhibited a tilt towards value
versus its capitalization weighted universe.
The second method directly incorporates price level
valuation ratios for the security selection and index
construction process. In practice, this approach is
typically implemented by first computing a composite
value score for each company using valuation metrics
such as price to earnings and price to book value.
The index constituents and their respective weights
are then determined largely by a security's market
capitalization and value score. A value tilt is a natural
by-product of the relative value metrics employed in
the security selection and index construction process.
The primary objectives of these indices are to maintain
a significant exposure to value, while also aligning
closely with its capitalization weighted index. To
achieve both objectives, constraints may be imposed
when constructing the index, such as target holding
counts and sector neutrality relative to its capitalization
weighted index (i.e. zero active sector bets).
6
A feature common to both the fundamental and price-
relative indexing approaches is each methodology's
almost uniform application of the same fundamental
ratios / value metrics across all sectors and industries.
Aside from Financials, most indices are naively
constructed using the same valuation metrics across all
industries, and fail to recognize the heterogeneity in
industry dynamics and return drivers across industries.
Introducing industry specific metrics
Given the above, a natural extension of current practice
is the introduction of industry specific valuation metrics,
ones that better reflect the idiosyncrasy of each industry
structure. Consider Financials, a sector that contains
industries with differing market cycle dynamics. For
example, the revenue stream and capital requirements
of Real Estate companies are significantly different to
those of Insurance companies.
Going a bit deeper, let us examine the construction
methodology of the value score used by MSCI in the
construction of their MSCI Enhanced Value suite. These
indices use an equally weighted average of the forward
Price to Earnings (P/E), Enterprise Value (EV) to Cash
Flow from Operations (CFO), and Price to Book Value
(P/B) in the computation of the composite value score,
with the exception of the Financials sector. Within the
Financials sector, companies are measured based on
forward Price to Earnings (P/E) and Price to Book (P/B).
While all three components have been shown to exploit
different aspects of a company's value, these signals
should not be applied uniformly across the market. For
example, the P/B ratio tends to work well when firms
have large amounts of fixed assets on their balance
sheet, however, the efficacy of this ratio will suffer
when companies have large, intangible assets (e.g.
brand names, patents).
These observations lead to the question: How well
does the MSCI Enhanced Value methodology identify
over or undervalued companies, using the three
aforementioned factors uniformly across all sectors?
Figure 1
MSCI Financials Valuation Signal
Monthly returns for the top 25% of companies (most attractive) in the MSCI World Index
based on their valuation score, versus the bottom 25% of companies (least attractive) in
the MSCI World Index. The valuation scores are calculated using the same methodology
used to constructed the MSCI World Enhanced Value Index, which is an equally weighted
average of the forward Price to Earnings (P/E) and Price to Book Value (P/B) value.
160
140
120
100
80
60
40
20
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Top 25% Wealth relative Bottom 25%
Source: UBS Asset Management. For details of computation see footnote 1 on page 10.
See disclosures for important information regarding simulated results.
Figure 1 presents the results of a simple back-test where
we attempt to answer this question. Using the MSCI
Enhanced Value methodology, and the MSCI World
Index as our universe, we create two equally weighted
portfolios based on their assigned value score, one of
the top quartile (under-valued), and one of the bottom
quartile (over-valued), and plot their respective returns
over time. With approximately 1,600 companies in the
MSCI World Index, selecting the top quartile provides
adequate breadth within each sector, and is well aligned
with the MSCI World Enhanced Value Index target
of 400 companies. We also plot the wealth relative
line (i.e., the difference in return between the top
and bottom 25% of companies, based on their value
score). Examining the results we see little difference in
the performance of the top and bottom 25% of the
distribution.
These results suggest an industry specific mapping may
be merited. Our approach draws upon the knowledge
of our global fundamental analysts. We use their
understanding of the industry dynamics to identify the
appropriate metrics for each industry in the Financials
sector. The Financials sector is comprised of industries
with significantly different business models and thus,
each should be valued using valuation metrics that are
specific to that industry. Like MSCI, we believe Price
to Book (P/B) and Forward Earnings Yield (E/P) have
persistently proved to add value across the Financials
sector and broader global equity markets. The two
aforementioned factors provide a base for valuing Banks
and Insurance companies. Specifically, Price to Book is
a critical measure in assessing the value of a company
within these industries. Given much of their value is
derived from capital markets, they are required to mark-
to-market their assets and liabilities on the balance
sheet, which gives investors an accurate assessment of
shareholders' equity at fair value.
However, within the Diversified Financials and Real
Estate industry, Price to Book (P/B) proves to be of less
importance. Unlike Banks and Insurers, the assets and
liabilities for Real Estate companies are not liquid, and
prices are not readily available in the capital markets;
this requires investors to carefully scrutinize Price to
Book ratios across companies as the book values may be
distorted.
Further, much of the Real Estate industry, specifically
REITs, are heavily regulated and forced to distribute a
large portion of earnings to shareholders. As a result,
the current dividend yield and sustainability of the
dividend policy are critical in assessing the value of REITs.
Monitoring the ongoing operating cash flow through its
reported Funds from Operation (FFO) is a more accurate
measure of a REIT's sustainable profitability than the
standard Cash Flow from Operations (CFO). Specifically,
the latter often includes many one-time items, such as
gains / losses from the sale of property and reported
changes in the equity positions of unconsolidated
entities. The NAREIT definition of FFO strips out these
non-recurring and / or non-cash line items, allowing
investors to better ascertain the ongoing cash earnings
from the real estate business. Additionally, given the
capital intensive nature of the Real Estate industry, we
believe EBITDA Yield gives a clearer reflection of the
business operations when compared to Earnings Yield,
as it is irrespective of the financing and depreciation /
amortization decisions.
Lastly, as mentioned above, dividend policy is critically
important in valuing companies in the Real Estate
industry, but total yield, which includes net share
buybacks, is more suitable for Banks and Insurance
companies, given their preference and history of share
buybacks.
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With these customized industry specific valuation
measures we repeat the analysis we presented above.
The results of this exercise are presented in Figure 2.
Inspecting the results we now see better separation
Figure 2
UBS Financial Valuation Signal
Monthly time series of returns for the top and bottom 25% of the sorted Financials sector
based on UBS scoring methodology customized for the Financials sector. Portfolios are
indexed to 100 as of December 31 2007 and tracked through to April 30, 2016.

between the top 25% of most attractive companies 160

(under-valued) and the bottom 25% of least attractive
companies (over-valued). Figure 3 presents further 140
evidence of this improvement. Here we plot the
histograms of the monthly return spreads (Top 25% 120
- Bottom 25%) using both the methodology used in
100
constructing the MSCI World Enhanced Value Index
and UBS Asset Management approaches. It is clear that 80
the UBS AM histogram has shifted rightward relative
to that of the MSCI. This indicates that a greater return 60
differential between the top and bottom quartile is
40
captured using industry specific valuation metrics. A
99% confidence t-test for mean equality confirms the 20
average UBS return spread is greater than the return 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
spread using the MSCI Enhanced Value methodology. Top 25% Wealth relative Bottom 25%

Source: UBS Asset Management. See disclosures for important information regarding
simulated results.

Figure 3
Return Spreads for Financial Signals
Distribution of monthly return spreads between the top and bottom 25% of the sorted
sector. Returns are from December 31, 2007 April 30, 2016
Number of months
50

40

30

20

10

0
-10 -8 -6 -4 -2 0 2 4 6 8 10

UBS MSCI Return spread between top and bottom portfolios in %

Source: UBS Asset Management

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Next, we extend the industry specific approach across
all MSCI GICS Sectors in the MSCI World Index to
create a well-diversified portfolio of the top 25% (most
attractive based on valuations) and bottom 25% (least
attractive based on valuations) of companies in each
Figure 4
Return Spreads for the well-diversified portfolios using MSCI World
Enhanced Index methodology and UBS AM methodology
Distribution of monthly return spreads between the most attractive (top 25% under-
valued) and least attractive (bottom 25% over-valued) well-diversified portfolios. Returns
are from December 31, 2007 April 30, 2016.

sector, using both, the methodology employed by the Number of months

MSCI Enhanced Value suite and the UBS AM approach. 35
The sector specific and well-diversified portfolio results
30
of this exercise are presented in Table 1. We see that for
most sectors, and in the well-diversified portfolio, using 25
industry specific valuation metrics improves the top
minus bottom return spreads. 20

Figures 4 and 5 tell the same story for the well-diversified 15

portfolio we observed in the Financials sector. It is evident 10
that using valuation factors uniformly across all sectors, as
employed by the MSCI Enhanced Value suite, does not do 5
an adequate job in distinguishing the difference between
over and undervalued companies across all sectors. In 0
-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6
contrast, using industry specific valuation factors provides
a clearer distinction between the top and bottom UBS MSCI Return spread between top and bottom portfolios in %
quartiles, thus better capturing the value premium. As
Source: UBS Asset Management
shown in figure 5, the spread distribution between
the most attractive and least attractive well-diversified
portfolios are persistently greater using the UBS AM
approach relative to the methodology employed by the
MSCI Enhanced Value suite; the results are confirmed to
be statistically significant using a t-test for mean equality.
It is apparent that using industry specific valuation factors
is the superior methodology across many of the MSCI
GICS sectors, as shown in Table 1 on the following page.

Figure 5
Well-diversified portfolio
Monthly time series of well-diversified portfolios. Well-diversified portfolios are created by aggregating the top and bottom 25% of companies in each MSCI GICS sector based on valuation
using the UBS AM and MSCI Enhanced Value Index methodology. Portfolios are indexed to 100 as of 31 Dec 2007and extend until April 30, 2016

MSCI Enhanced Value Index methodology UBS AM methodology

180 180

160 160

140 140

120 120

100 100

80 80

60 60

40 40
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Top 25% Wealth relative Bottom 25% Top 25% Wealth relative Bottom 25%

Source: UBS Asset Management

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Conclusion
This study examines some potential limitations of off-
the-shelf / one-size-fits-all products that seek to capture
the value premium. Careful consideration should be
placed on metrics used to measure value and the
process of signal construction. It is imperative to realize
that for strategies attempting to take advantage of the
value premium, the input signals need to be defined in
a manner that will segment the market effectively as
no portfolio construction technique will compensate
for inefficient underlying signals. The value premium
still exists, but as the market evolves, smarter signal
construction is necessary in order to capture it.

Table 1
Return Spreads Summary
Annualized returns comparing the methodology used by the MSCI World Enhanced Value Index and UBS AM. Returns are an equal weight of the top 25% (most attractive based on
valuation) and bottom 25% (least attractive based on valuation) of companies in each sector. The well-diversified portfolio is an equally weighted sector portfolio. The returns are from
December 31, 2007 to April 30, 2016.

Asset MSCI UBS Difference in

MSCI MSCI Annualized UBS UBS Annualized Average Spreads1
Top 25% Bottom 25% Difference Top 25% Bottom 25% Difference (UBS-MSCI)
Consumer Discretionary 6.3 8.4 -1.3 5.2 7.5 -1.6 -0.3
Consumer Staples 8.2 6.8 1.3 11.6 6.2 4.9 3.6***
Energy -2.1 -5.8 3.6 -0.3 -6.5 6.3 2.7***
Financials -1.7 1.0 -1.1 0.2 -2.1 3.4 4.5***
Industrials 14.3 11.1 2.2 15.2 12.2 2.2 0.1***
Health Care 4.6 2.2 2.8 5.8 1.3 5.0 2.1
Information Technology 5.5 5.3 0.1 5.6 4.6 0.9 0.8
Materials -1.3 3.7 -3.7 1.5 -0.5 1.8 5.5***
Telecommunications 7.8 6.2 0.8 7.4 6.7 -0.3 -1.1
Utilities 2.9 1.1 1.4 3.5 -1.6 5.0 3.6***

Well-Diversified Portfolio 5.0 4.4 1.1 6.1 3.2 3.2 2.1***

1 Significance level based on P-value from T-Test with hypothesis of UBS mean spread > MSCI mean spread without assumption of equal variance
* Significant at 10% level, ** Significant at 5% level, *** Significant at 1% level
2 Methodology shown in Figure 6 and Figure 7
Past performance, whether simulated or actual, is not a reliable indicator of future results.
Source: MSCI, UBS Asset Management, 31 Dec 2005 31 Dec 2014 (Returns in USD)
See disclosures for important information regarding simulated results.

1
S imulation is based on a subset of equity constituents in the MSCI World index, in USD, gross of fees and transaction costs. Simulated portfolio was rebalanced monthly. The dividend
criteria used for stock selection is net of non-reclaimable withholding tax dividend yields from a Luxembourg domiciles perspective, but returns are based on total returns. Simulation is
hypothetical and does not represent a live track record or actual returns realized by any investor. Past performance, whether simulated or actual, is not a guarantee for future performance.
See disclosures for additional information.

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Minimum expected tail loss equity portfolios
Introduction
The wealth eroding losses experienced in the Financial
Crisis of 2008 have driven interest in low risk equity
strategies. These include minimum volatility, inverse
variance weighted, equal weighted, maximum
diversification and equal risk contribution. The most
popular, by far, has been minimum volatility portfolio
construction. As the name suggests, minimum volatility
strategies seek to reduce the volatility of expected
returns thereby decreasing expected losses but also
limiting upside exposure.
Minimum volatility investing has some support in
academic literature: studies have shown it to be
consistent with the behavioral notion of loss aversion
bias, where investors strongly prefer loss avoidance to
acquiring gains see Tversky and Kahneman 19911. This
note takes a closer look at minimum volatility investing
and considers an alternative we find more appealing.
A closer look at Minimum Volatility
Minimum volatility portfolio construction has its
origins in Modern Portfolio Theory (MPT) which holds
that under fairly restrictive assumptions, investors'
preferences can be described using two statistical
variables: expected return (mean) and risk (variance). It's
important to note that the minimum volatility portfolio
is not simply a collection of stocks with the lowest
individual volatilities; rather, it is the outcome of a mean-
variance optimization that exploits the opportunities for
cross stock diversification, where the required inputs
are individual stock volatility and cross stock correlation
estimates. However, the conditions where the mean-
variance framework adequately captures the full
dimensionality of risk facing the investor are rarely met
in practice.
Let's investigate this proposition further by looking
at the co-movement of stocks. In a mean-variance
world this co-movement is sufficiently measured by
cross stock correlation. Correlation is, of course, a
linear measure of association. Observation, however,
suggests the co-movement of stocks can be non-linear
/ unstable at times. Consider that the diversification
effect is dependent on robust correlation estimates,
which are typically estimated using historical data.
1
Tversky & Kahneman (1991) "Loss Aversion in Riskless Choice: A Reference-Dependent Model" The Quarterly Journal of Economics
2
Xiong, J. (2010) "Nailing Downside Risk" Journal of Risk Management
Then consider the case where most of the estimation
window corresponds to a relatively calm state of the
market. This leads to issues during market turmoil when
correlations are known to increase drastically; just when
diversification is urgently needed. Under this minimum
volatility methodology, the correlation estimates do not
accurately reflect the relationships between assets in this
high risk environment and are ill-equipped to provide
diversification during extreme conditions.
Further, the mean-variance framework upon which
minimum volatility is based, assumes that stock returns
are normally distributed. If this assumption were to hold
then a plot of the histogram of stock returns would be
bell shaped and symmetric with thin tails. But, in fact,
this is not what we observe. As an illustrative example,
Xiong (2010)2 points out that observations drawn for a
normal distribution with the same standard deviation for
the S&P 500 (measured from January 1926 April 2009)
predict a return of -15.5% to occur just over once in 83
years. In point of fact, the S&P 500 suffered a monthly
loss of greater magnitude in at least 10 instances during
the same measurement interval.
Finally, and perhaps most importantly, volatility has
some properties that may make it a less desirable
measure of risk from an investor's perspective. Recall,
volatility is a statistic that describes how observations
are dispersed around the average value. Its symmetrical
nature means that values below and above the average
both contribute equally. Minimizing the volatility of a
portfolio limits negative portfolio returns as desired;
however, minimizing volatility will also decrease positive
returns. A preferable low risk strategy would lower
the magnitude of losses but preserve the ability of
the portfolio to recover quickly. After a 20% portfolio
drawdown, a 25% gain is required to climb out of the
trough as a result of the lower asset base. The portfolio
constructed to minimize volatility limits downside
exposure but it also restricts upside potential.
With the caveats cited above in mind, we now examine
another approach, one which attempts to address the
apparent pitfalls and limitations of minimum volatility
portfolio constructions.
11
Introducing Expected Tail Loss
We propose a risk measure for use in portfolio
construction that does not face the issues and
limitations of minimizing volatility described above.
The ideal measure would neither require symmetry nor
assume normality and should be robust during market
downswings in an attempt to prevent drawdown.
Expected Tail Loss (ETL), which is an extension of the
commonly used Value at Risk (VaR) statistic, fits these
requirements. Recall, VaR is a threshold statistic defined
as the minimum amount of portfolio loss at a specified
probability and horizon. For example, a particular
portfolio might have a 5% VaR value of USD1 million.
This means that 5% of the time the portfolio will lose
USD1 million or more in a specified time horizon, say
over a month. VaR does not, however, tell the investor
how much on average they can expect to lose when
losses exceed USD1 million. This is the information that
the ETL statistic can relate.
ETL is also a threshold statistic that has as its basis
VaR. ETL is defined as the expected amount of
portfolio loss at a specified probability level. Instead
of using VaR and knowing that the portfolio will lose
at least USD1million 5% of the time, using the ETL
measure will tell us that we expect to lose on average
USD1.2million 5% of the time. Figure 1 shows this
graphically using a histogram of portfolio returns. The
VaR value, represented by the dotted line, is the return
Figure 1
Calculating VaR and ETL: Value at Risk represents the minimum amount
of loss that will happen x% of the time. Expect Tail Loss represents the
expected amount of loss that will happen x% of the time.
35
Count VaR
30
25
20
15
10
5 ETL
0
-10% -9% -8% -7% -6% -5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6%
Monthly return
Source: UBS Asset Management
12
value when 5% of the distribution is to the left. The ETL
value is the expectation or average of the distribution
to the left of the VaR. One note about semantics, in the
example we used the cash value of the loss, but this
can also be expressed in return space, which we did for
Figure 1 and continue to do for the rest of the note.
ETL is calculated by averaging the losses that are beyond
a certain threshold of a portfolio return distribution.
There are many ways to create the distribution, but
the simplest is to use the empirical portfolio returns.
The minimum ETL portfolio optimization finds the
combination of portfolio weights that result in the lowest
ETL value (by summing the weighted individual asset
return distributions). Minimum ETL portfolio construction
uses every past return to capture co-movement of assets
and does not suffer from the issues associated with a
correlation estimate based upon a return distribution
assumption. Upside reduction due to symmetry also does
not exist for ETL because the statistic focusses purely on
the loss side of the distribution. Additionally, assumptions
of normality are not needed with ETL; the optimization
process uses every observation of the asset return data
within the specified historical window to model the left
side fatter tail in the distribution. Most importantly the
concept of ETL is in line with the investor's true objective,
reducing portfolio loss and not just portfolio uncertainty.
In simulations it yields more attractive risk adjusted
returns and lower drawdowns than its minimum volatility
counterpart.
ETL versus Minimum Volatility:
Comparative backtest simulations
There is a considerable body of research demonstrating
the advantages of using ETL in the asset allocation
space. In contrast, applications to stock only portfolios
have been limited due to computational burdens.
However, improvements in computer processing power
and advancements in mathematical programming
techniques have made large scale problems
computationally feasible.
We compare the ETL and minimum volatility approaches
over the period January 2000 December 2014. For
the minimum volatility portfolio we select the MSCI
USA Minimum Volatility Index. The ETL portfolio is
constructed using the same universe of MSCI USA
Index constituents that MSCI uses in constructing
their minimum volatility index. In order to improve
comparability we impose the same constraints on the
ETL portfolio optimization as those imposed by MSCI
in constructing their minimum volatility index. The ETL
portfolio is minimized at a 10% threshold.
The minimum ETL simulation results in Figure 2 and
Table 1 include estimated transaction costs. The
ETL portfolio is preferable to minimum volatility and
the capitalization weighted benchmark, not only in
annualized returns but also across other performance
metrics; it has lower maximum drawdown, lower ETL,
and even lower realized volatility, leading to a portfolio
with greater annualized risk-adjusted returns. It closely
matches the performance of the MSCI Minimum
Volatility during the down months and outperforms
during the up months leading to greater wealth
accumulation.
Conclusion
When adding a low risk strategy to an investor's
portfolio it is important that the strategy captures the
investor's actual risk objective: wealth preservation.
Minimizing volatility lowers uncertainty about portfolio
outcomes, but for many reasons is not designed to
reduce long term losses. ETL addresses the shortcomings
of minimum volatility by not assuming symmetry
and focusing on the loss side of the portfolio return
distribution. After creating an ETL backtest simulation
with similar constraints to the MSCI USA Minimum
Volatility index, the outcome and resulting portfolio
characteristics are encouraging. Certainly investors
should consider an ETL approach as an option when
evaluating low risk investment alternatives.

Figure 2 Table 1
ETL vs MSCI Minimum Volatility: 14 year backtest for the Minimum Factor Tilts in Economic Regimes
ETL strategy, compared to the MSCI USA Index and MSCI Minimum
Asset Minimum MSCI Minimum
Volatility Index.
ETL USA Volatility
Cumulative returns (%)
Annualized Returns 7.1% 3.9% 6.6%
200
Annualized Volatility 11.1% 15.4% 11.8%

150 Risk Adjusted Return 0.64 0.26 0.56

Maximum Drawdown -36.3% -50.8% -41.0%

100 Value at Risk 95% -5.0% -7.9% -5.1%

Expected Tail Loss 95% -7.4% -9.9% -8.0%

50 Source: UBS Asset Management
See disclosures for important information regarding simulated results.

-50
2000 2002 2004 2006 2008 2010 2012 2014
Minimum ETL MSCI USA Minimum Volatility

Source: UBS Asset Management.

See disclosures for important information regarding simulated results.

13
Tactical tilts and multi asset class risk premia

Introduction allocations to assets with low risk and low correlation,

Factor-based investing has received growing attention
in recent years. In parallel there has been increased
interest in the portfolio construction technique known
as risk-parity. In the risk-parity approach the portfolio
is constructed so that all holdings have an equal
contribution to total portfolio risk. The approach is most
frequently applied to asset allocation questions. In the
examples which follow we will begin our analysis by
doing the same but using factor-premia as our building
blocks rather than conventional asset classes. We will
then introduce departures from strict risk-parity in the
form of tactical tilts and examine the impact of these
changes on portfolio performance.
Risk parity applied to risk premia
We begin with a multi asset-class investment universe.
Equities are traded via instruments replicating the MSCI
equity factor premia. We also include sources of risk-
premia from the fixed income, foreign exchange and
commodity markets. In total there are 13 instruments:
Equity: MSCI minimum volatility, momentum,
quality, risk-weighted, value-weighted and high
dividend yield (starting in 1989)
Fixed Income: US 7-10 year government bonds, US
investment grade, US high yield (starting in 1989)
Alternative Beta: Commodity carry, FX carry, short
rates volatility strategy and equity volatility strategy
(starting between 1994 and 2003)
and elevated leverage. To mitigate this issue, we constrain
the allocations so that 40% of the risk budget is allocated
to equities, 50% to fixed income and 10% to alternative
beta.
In Figure 1 we plot the cumulative returns (e.g.
log wealth) of the risk-premia portfolio versus the
benchmark, which we assume to be 50% MSCI World
and 50% World Global Bond Index (WGBI). Returns are
in excess of cash (i.e. US 3 month Libor).
We notice that despite the lower volatility of the risk
parity portfolio, both benchmark and risk-parity portfolios
have close to identical final wealth. The first source of
risk reduction comes from holding a diversified universe
of risk factors rather than the benchmark. The second,
somewhat trivial, is that the benchmark allocates 50% to
fixed income expressed in terms of percentage weights,
whereas the risk parity portfolio allocates 50% in terms
of risk. Given the lower volatility of fixed income and
its performance during the back-test period, some
outperformance relative to benchmark mechanically
comes from the overweight to bonds. Given the 40% risk
allocation to equities, the portfolio exhibits, as expected,
a substantial drawdown in 2008 (-22.1%). Second, part
of the risk reduction seems to relate to the avoidance of
the bear market following the Dot Com bubble, reflecting
the fact that the equity risk factors may have underlying
sector over or under exposures.

The commodity carry strategy seeks to profit from the Figure 1

observation that commodities in backwardation tend Cumulative Returns and Ratio of Risk Premia to Benchmark Wealth
to have a positive return expectation. For simplicity, we 1.0
have used as a proxy the Morgan Stanley Roll Select
index that goes long a basket of commodities that 0.8
are in backwardation and goes short the DJUBS (Dow
Jones UBS) index. The FX carry strategy goes long (conv. 0.6
short) currencies with the highest (conv. lowest) short
term interest rates. Finally, the interest rate and equity 0.4
strategies1 seek to benefit from shifts in volatilities by
investing in short dated straddles. All alternative beta 0.2
strategies used in this paper are easily accessible.
-0.0
To construct the 'core' of the portfolio, we equalize the
marginal contribution to risk of each of the 13 assets, -0.2
under constraints. For computation of the covariance 1989 1994 1999 2004 2009 2014
matrix we consider a rolling 5 year period 2. The Benchmark Core risk parity
portfolio is rebalanced monthly and targets an ex-ante
5% volatility level. Risk-parity is notorious for its large Source: UBS Asset Management:
See disclosures for important information regarding simulated results.

1
Respectively proxied by the Deutsche Bank Impact Dollar Rates 3M and Goldman Sachs Volatility Carry strategy.
2
Note that the data for alternative beta starts late, their weights are equal to 0 up to 5 years after the data become available.

14
In Table 1 we provide the summary statistics of the risk
premia portfolio and the benchmark3. The risk parity
portfolio generates a higher risk-adjusted performance
over the entire sample, with less volatility due to
diversification across factors.
Table 1
Summary Statistics
Benchmark
Sharpe 3yrs 1.51
5 yrs 1.32
10 yrs 0.61
since 1989 0.47
Avg Return (%, ann.) 3.76
Std Deviation (%, ann.) 7.91
Max Drawdown (%) -29.17
Skewness -0.66
Kurtosis 4.70
Source: UBS Asset Management
See disclosures for important information regarding simulated results.
Introducing tactical tilts:
The macroeconomic cycle and momentum
There is considerable evidence that asset returns or risk-
premia are not constant through time, nor are correlations
static. For instance, bear markets are characterized by high
correlation across risky asset classes and a flight to quality.
Observations like these have given rise to numerous studies
on conditional asset allocation, whereby the composition
of a portfolio depends upon the 'state' of the economy,
or underlying risk regimes. It is beyond the purpose of
this note to present a survey of these studies, but a few
preliminary observations are necessary.
Generally, the time series predictability of these
approaches has been found to be low but consistent with
expectations, given the inherent difficulty of the task.
However, in recent research Neely et al (2012)4 note that
macroeconomic and technical indicators both tend to
capture counter-cyclical information, but at different points
of the cycle: Technical indicators tend to detect the typical
decline in the equity risk premium near business cycle
peaks while macroeconomic variables more readily pick up
the typical rise in the equity risk premium later in recessions
near cyclical troughs. This observation leads us to consider
an approach that combines macro and technical based
indicators.
The tactical tilts we propose are comprised of two
components:
A momentum strategy, including both cross-sectional
and time series momentum, with a signal constructed
over the previous 3, 6, 9 and 12 months with more
emphasis on the longer time windows for stability
A macro based strategy that applies fixed tilts to
Risk Premia each asset based upon the state of the economy
1.48
1.58 Including momentum enables the capture of shifts that
are typically not detected by fundamental variables,
0.66
as well as identifying time-varying risk-aversion. In
0.67 constructing the macroeconomic trading rule we use only
3.69 one indicator, the OECD composite leading indicator (CLI),
5.52 and classify the regime or state of the economy based
-22.11
upon two dimensions: (1) its 3-month rate of change and
(2) its level.
-1.13
6.95 Regime classification is done out of sample, using the
latest available release each month. This indicator may
be viewed as a base-case indicator given that there is a
2-month lag in the release of the latest data. Depending
upon whether the economy is growing (e.g. positive
3-month change), and whether it is above average (e.g.
level above 100), the regime is classified as being in
recession, recovery, expansion or slowdown.
In order to address concerns over 'noise regime shifts'
and its attendant portfolio turnover, we impose a 'no-
change' band so that unless the indicator has crossed
the 40% or 60% percentile (computed over past
observations) we classify the current regime as being
identical to the one the previous month. Figure 2 provides
a graphical representation of how we classify regimes.5
During recessions, portfolio tilts are conservative. We
overweight US government bonds and reduce allocation
to high yield and investment grade. In equities, we increase
the allocation to minimum volatility and quality while
reducing momentum and the allocation to alternative beta.
During recoveries, we tilt the portfolio in a more aggressive
direction. Previous research suggests that tilts tend to be
more successful in recessionary environments and that
it may be difficult to distinguish between recoveries and
expansion, or between slowdown and recessions. We
simplify and assume less confidence for slowdown regimes
(e.g. tilts are half than during recessions), and are identical
during recoveries and expansions. This leaves us with three
regime-dependent allocations.

3 We assume it to be 50% MSCI World and 50% WGBI. Returns are annualized and in excess of cash (i.e. US 3 month Libor).
4
Neely, C.J., Rapach, D.E., Tu, J., Zhou, G, (2012), "Forecasting the Equity Risk Premium: The Role of Technical Indicators", Working paper, Federal Reserve Bank of St. Louis.
5
Note that the graph, for ease of representation, is based upon the latest release whereas in the practice each data point pertains to its release date at the time.

15
Figure 2
Regime Classification
0.3
Strength Negative Strength Positive
Momentum Positive Momentum Positive
Momentum: Pace of change

Recovery Expansion
Mar-13 Sep-13 Dec-10
0.1
Dec-12 Dec-13
Jun-13 Jan-15
Mar-12 Dec-14 Mar-14
Nov-14 Mar-11
Dec-11 Sep-14 Jun-14
Sep-12
-0.1 Jun-12
Recession Sep-11 Slowdown
Jun-11
Strength Negative Strength Positive
Momentum Negative Momentum Negative
-0.3
99 100 101
Strength: Relative to trend-growth

Shaded light brown area represents a momentum crossover zone

Source: OECD, UBS Asset Management

Table 2 summarizes these portfolio tilts. On average, we Combining risk parity with tactical shifts
have one portfolio tilt a year. The magnitude of the tilts is and momentum
small and the realized volatility of the resulting portfolio The final portfolio is a combination of three
below our target of 5%. In what follows we rescale the components: the risk-premia portfolio, the momentum
weights obtained to reach a target volatility of 5%. strategy and the tactical macro tilts.

In Figure 3, we plot the cumulative returns of the three

Table 2 components and the balanced benchmark. All three
Factor Tilts in Economic Regimes components are rescaled in order to achieve an ex-ante
Asset Recovery Expansion Slowdown Recession rolling 5% target volatility, with no leverage constraint
Minimum Volatility -8% -8% 2% 5%
imposed. The momentum strategy tends to outperform
during crisis (and volatile) times. It was profitable in
Momentum 10% 10% -5% -10% 2008, in line with the performance of Commodity
Quality -6% -6% 5% 10% Trading Advisors (CTAs), and flat in the following two
years, consistent with the fact that medium to long term
Risk Weighted 4% 4% -3% -5%
trend followers took a longer time to rebuild positions
Value Weighted 4% 4% -3% -5% in risky assets. The macro tilts tend to outperform in
High Dividend Yield 4% 4% 3% 5% recessionary environments, an observation highlighted
in earlier research, and underperform in quieter
US 7-10 yr bonds -9% -9% 14% 28%
economic regimes. Because of their counter-cyclical
US Investment Grade 6% 6% -3% -5% properties at different points of the business cycle, both
US High Yield -13% -13% -4% -9%
complement the risk parity strategy well.

Commodity Carry 2% 2% 0% 0%

FX Carry 2% 2% -3% -7%

Interest Rate Vol 2% 2% -1% -3%

Equity Vol 2% 2% -2% -4%

Sum 0% 0% 0% 0%
Source: UBS Asset Management
See disclosures for important information regarding simulated results.

16
Figure 3 Table 3
Cumulative Returns of the Strategy Components Summary statistics
140 Risk Macro Mom- Comb-
Premia Tilts entum ination
120
Sharpe 3 yrs 1.50 -0.17 1.23 1.47
100
5 yrs 1.53 0.10 0.86 1.46
80
10 yrs 0.86 0.46 1.33 1.18
60
since 1989 0.72 0.37 0.92 0.88
40
Avg Return (%) 4.24 2.09 5.21 3.36
20
Std Deviation (%) 5.86 5.73 5.63 3.84
0
Max Drawdown (%) -18.35 -17.95 -9.76 -5.40
-20
1989 1994 1999 2004 2009 2014 Skewness -0.33 0.64 0.06 0.16
Benchmark Risk parity Macro tilts Momentum
Kurtosis 5.07 6.20 6.44 4.64
Source: UBS Asset Management Source: UBS Asset Management
See disclosures for important information regarding simulated results. See disclosures for important information regarding simulated results.

We form an aggregate portfolio by assigning 50% of
the weight to the risk-parity portfolio, 25% to macro
tilts strategy and 25% to momentum strategy. We
constrain portfolio weights to be positive and gross
leverage not to exceed 1. Because of these controls
and the low correlation of the three components, the
realized volatility of the portfolio falls just under 4%.
In Table 3 we provide the summary statistics for three
components and their combination in the final portfolio.
Cumulative returns are shown in Figure 4.
Figure 4
Cumulative Returns of Aggregate Portfolio
1.0
0.8
The strategy exhibits flat returns in 2008 as losses in the
core portfolio were offset by the gains in momentum
and macro-based strategies. Momentum and risk-
parity strategies achieve the highest risk-adjusted
performance over the whole sample. As expected
from a low-turnover strategy, the performance of the
macroeconomic strategy is much weaker, especially in
the last five years given that most of this time period
was spent in recovery, a regime where tactical tilts tend
to underperform. However this component has a 0%
correlation with risk-parity and 30% with momentum,
hence contributing to diversification. The combination
exhibits a more stable risk-return profile through the
entire sample and positive skewness5. Fat tails, as
measured by kurtosis, are less pronounced. Finally, the
ratio of maximum drawdown to standard deviation is
more favorable.

0.6 We hope this note proves useful in two ways: First as

a practical illustration of how factor risk-premia can be
0.4 used in asset allocation, and second as example of how
the conventional risk-parity approach can be enhanced
0.2 by incorporating the momentum and macro-based
strategies that lend diversification by adding value at
-0.0 different points in the market cycle.

-0.2
1989 1994 1999 2004 2009 2014
Benchmark Combination

Source: UBS Asset Management 5 Please note that Sharpe ratio and other statistics for the risk premia portfolio slightly
See disclosures for important information regarding simulated results. differ from those in Table 1 because the portfolios in Table 3 have been rescaled to
achieve an out of sample target volatility of 5%.

17
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simulated results prepared by UBS Asset Management. The simulated results are presented for illustrative purposes only. Simulated results are developed with the benefit of hindsight and
have inherent limitations. The analysis contained herein is based on historical analyses and numerous assumptions. Different assumptions could result in materially different results. The
simulated results do not represent actual trading using client assets and are not based on the results of any actual strategy managed by UBS Asset Management. Investors should not take
the example herein as an indication, assurance, estimate or forecast of future results. Actual results may differ materially from the simulated results shown. Simulated results may not reflect
the impact that material economic and market factors might have had on UBS Asset Management decision making if actual client assets were managed during the time periods portrayed.
No representation is being made that any strategy will achieve results similar to the simulated performance shown in this commentary. The simulated performance is presented gross of
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