Fall 2011

ExchangeUBS invites preeminent thinkers to discuss the day’s most critical investment issues

Performing at the speed of stall

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Publication details

Publisher UBS Financial Services Inc.1285 Avenue of the Americas, 13th Floor New York, NY 10019

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

This report was published on 1 November 2011.

Editor in ChiefKatie Klingensmith

Authors (in alphabetical order)Rich BernsteinMichael CrookMohamed El-ErianStephen FreedmanAlex FriedmanKiran GaneshKatie KlingensmithGeorge MagnusRick RiederMike Ryan

EditorMarcy Tolkoff

Desktop Publishing George StilabowerCognizant Group – Basavaraj Gudihal,Srinivas Addugula and Virender Negi

Project ManagementPaul LeemingMark Kanter

Contents01 Letter from Mike Ryan

02 Point of View

The great deleveraging

UBS Chief Investment Strategist Mike Ryan frames the discussion and introduces the themes and topics as presented by our guest

commentators.

05 Dialogue

Katie Klingensmith, Economic and Policy Analyst,

UBS Wealth Management Research, moderates a discussion with:

Mohamed El-Erian, CEO and co-CIO, PIMCO; and

George Magnus, Senior Economic Advisor, UBS Investment Bank

11 Perspectives

11 Avoid another “lost decade” by Rich Bernstein, CEO, Richard Bernstein Advisors LLC

16 Managing fi xed income in a low interest rate environment by Rick Rieder, CIO – Fixed Income and Fundamental

Portfolios, BlackRock

20 The hunt for alpha: alternative investments by Alex Friedman, CIO, UBS Wealth Management

and Swiss Bank

23 Portfolio strategies for a low-growth, low-yield environment by Stephen Freedman, Head of Investment Strategy, UBS Wealth Management Research, and Michael Crook, Head of Portfolio Advisory Group,

UBS Wealth Management Solutions

27 Contributor Bios

29 Notes and Disclaimer

Hammerhead stall turnA plane performs a hammerhead or “stall turn” aerobatic maneuver. The name is not entirely accurate; while airspeed may be close to zero at the peak of the maneuver, the air-plane never actually stalls.

Dear readers,

The current economic recovery process has been likened by some to an airplane that has encountered diffi culty gaining suffi cient airspeed and is therefore at risk of “stall-ing.” The metaphor fi rst was employed by Federal Reserve offi cials to describe the subtrend recovery but since has been taken up by others to depict the general state of the world. While the symbolic imagery is powerful, it does not completely capture the nuances – or for that matter the potential – of the investment environment at present. Slower than normal growth will admittedly pose daunting challenges, but opportunities will no doubt emerge as markets overreact to periodic recession fears and busi-nesses learn to adapt to more modest growth prospects. So just as experienced pilots must learn to make aircra perform in moments of risk and uncertainty – even “at the speed of stall” – so too must investors learn to posi-tion portfolios to thrive in the current low-growth world.

We are therefore fortunate to have access to some of the most thoughtful and well-respected investment profes-sionals in our industry to help us sort through these new economic and market dynamics. By bringing together some contrasting views, we hope to help investors challenge existing assumptions about the limits of what they can do within their portfolios – especially during the current environment.

We begin our tour of this new reality with Dialogue, a discussion with Mohamed El-Erian, CEO and co-CIO of PIMCO, and George Magnus, Senior Economic Advisor for UBS, facilitated by Katie Klingensmith of WMR. These two thought leaders walk through some of the reasons for low growth in the future – high government debt, overlever-aged households and consumers, and a real estate market that remains a major drag on consumers. We then shi

Chief Investment Strategist, Head of UBS Wealth Management Research – Americas

Letter from Mike Ryan

gears, and in the Perspectives section of the report, we look to prominent professional investors for successful portfolio strategies. We have asked fi ve experts for their views on equity markets, fi xed income and alternative investments, as well as on how these various asset classes might best fi t together in a portfolio.

We hope the following discussions help frame these complicated times in which we live, and that the diff erent vantage points provide informative approaches to invest-ing. We also encourage you to contact your Financial Advisor to discuss this report and how it may impact your investment strategy.

Thank you for allowing us to share these insights with you.

Mike Ryan, CFAChief Investment Strategist

Katherine KlingensmithEconomic and Policy Analyst, WMR

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The current recovery has proven broadly disappointing by almost every conventional metric or historical bench-mark. Given the depth of the contraction suff ered during the 2008-09 recession, the ensuing economic recovery process would typically be expected to be a fairly robust one. But the current business cycle is proving to be anything but typical. The US economy has expanded at a moderate 2.4% annual pace in the nine quarters since the recession offi cially ended. Taking into account that deeper recessions tend to be followed by stronger recoveries, the current recovery has so far only delivered 1.1% growth per percentage point of real GDP loss during the last re-cession. This is meager compared with the average 4.7% growth per percentage point of real GDP loss during all prior post-war recessions over a comparable nine-quarter period into the recovery (see Fig. 1). Job creation has also lagged behind past cycles, with the unemployment rate having declined only 1% since the economy troughed back in the fourth quarter of 2009. Concerns over a possi-ble “double-dip” recession have surfaced repeatedly amid

a series of shocks ranging from the eurozone fi scal crisis and a surge in oil prices to supply chain disruptions caused by the Japanese earthquake and a downgrade of the US sovereign debt rating. Such events usually amount to little more than glancing blows in normal times. But given the fragile and shallow nature of the current recovery, they’ve instead represented debilitating “body shots” that have very nearly brought the economy to a standstill.

What is it about this recovery process that diff ers so radi-cally from prior periods? To fully appreciate what sets the current period apart from prior recoveries, it’s essential to fi rst understand the nature of the most recent recession. Almost all of the economic contractions in the post-war era have been a fairly standard function of the business cycle. First, supply temporarily exceeds demand, forcing businesses to cut back on production. This, in turn, triggers employment losses, which naturally prompts additional declines in demand. This “vicious cycle” continues until the point where the supply/demand imbalance is fi nally

P O I N T O F V I E W

The great deleveragingI can get no remedy against this consumption of the purse: borrowing only lingers and lingers it out, but the disease is incurable. William Shakespeare (1564-1616)

By Mike Ryan, CFA, Chief Investment Strategist, Head of UBS Wealth Management Research – Americas

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corrected. The economy then bounces back fairly sharply, as pent-up demand within the consumer sector prompts a renewed surge in economic activity. In short, the “vicious cycle” gradually gives way to a “virtuous cycle.”

But the 2008-09 recession wasn’t caused by too many goods stuck on merchant’s shelves – it was instead the result of too much debt having accumulated on consumer balance sheets. As Fig. 2 illustrates, consumer indebted-ness reached record levels relative to both GDP and dis-posable income by 2008. The catalysts behind this historic borrowing binge were manifold: surfeit of global savings; collapse in lending standards; stagnant real income growth; generationally low interest rates; rapid expansions in fi nancial engineering; and the proliferation of debt securitization. Eventually, this credit bubble was bound to burst – and it did. But this debt problem and associated deleveraging wasn’t limited to the consumer sector alone. The collapse in lending standards and freewheeling credit practices saddled banks with a heavy burden of potential bad loans – especially subprime mortgage assets. With most banks having leveraged up their own balance sheets in an eff ort to squeeze greater profi ts from a narrower capital base, the rapid rise in defaults pushed many fi nan-cial institutions to the very brink of insolvency.

Governments around the globe therefore were forced to play an expanded role on several fronts simultaneously. As a fi rst step, those fi nancial institutions considered “sys-temically important” (i.e., “too big to fail”) were bailed out in order to prevent the fi nancial crisis from spreading further. This entailed massive forced capital injections

such as the TARP program in the US, as well as a partial nationalization of the banking system in Western Europe. Meanwhile, the collapse in demand resulting from the bursting of the credit bubble not only triggered increases in automatic stabilizers such as unemployment benefi ts, but also prompted elected offi cials to cobble together massive “stimulus packages” intended to fi ll the void le by the private sector. This combination of measures resulted in the largest budget defi cits in US history, and pushed the level of overall indebtedness to levels not seen since World War II (see Fig. 3).

Keep in mind that balance sheet problems tend to become more challenging as they work their way “up the food chain.” That is, high levels of government indebtedness pose a bigger potential threat to both the real economy and fi nancial markets than either bank or consumer balance sheet stresses alone. There has been a great deal of work done in recent years on the implica-tions of the fi nancial crisis and associated government debt burdens for longer-term growth prospects. Perhaps the most infl uential of these studies has been the work of economists Ken Rogoff and Carmen Reinhardt. What they found is that when the ratio of government debt to GDP exceeds 90%, median real growth rates tend to be about 1% lower than normal. A simultaneous deleverag-ing within both the private and public sectors therefore represents a pretty signifi cant structural headwind for the economy that is likely to unfold over a number of years. The problems confronting consumers, policymakers and businessmen this time around aren’t just cyclical – they are structural. This suggests an extended period of sub-par

A simultaneous deleveraging within both the private and public sectors represents a pretty signifi cant structural headwind for the economy that is likely to unfold over a number of years.

Fig. 1: Recent recovery has been subpar

Source: Bloomberg, UBS WMR, as of 31 October

Cumulative real GDP per percentage point of peak-to-trough loss in preceding recession, indexed

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Postwar recessions (average)2008/09 recession

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Fig. 2: Early-to-middle innings of consumer deleveraging cycle

Source: Thomson Reuters and UBS WMR

Ratio of US household financial liabilities to disposable income, in %

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growth that could well extend through the fi rst half of this decade.

So what will this all mean for investors and how should they position investment portfolios for this more challeng-ing macroeconomic environment? To help sort through these issues, we have assembled a panel of distinguished investment professionals and thought leaders from both within our own organization as well as from several of our key strategic partners. In the following pages, we present the fruits of this collective exercise – summarized briefl y as follows:

• Dialogue features a discussion with Mohamed El-Erian, CEO and co-CIO of PIMCO, and George Magnus, our own senior economic advisor here at UBS. While Mohamed is widely credited with having coined the term “new normal” to describe the current low-growth, low-return world, George was equally prescient in identifying the “Minsky Moment” that precipitated the entire credit crisis. Katie Klingensmith of Wealth Management Research has posed a series of questions to both Mohammed and George to get their views on longer-term growth prospects.

• Rich Bernstein, CEO of Richard Bernstein Advisors, off ers his take on how equity investors should position for this slow growth environment. As is so o en the case, Rich off ers a thoughtful and decidedly non-con-sensus view on where the best opportunities are likely to be found. While so many continue to focus their at-tention and eff orts on the developing world, Rich fi nds both better value and lower risk in developed markets. Although we may not agree with all of Rich’s conclu-sions about the emerging markets, we fi nd his perspec-tive on equity investing insightful and his take on the performance prospects for the US fairly compelling.

• Rick Rieder, CIO of fi xed income at BlackRock, explores the dilemma that most bond investors currently face in a low-growth, low-rate world. Rick cautions against simply extending duration, and instead makes a persuasive argument for investing in higher quality “spread product.” He argues that structural shi s in demographics will not only help keep rates contained, but will also drive demand for yield-generating assets of all kinds.

• Alex Friedman, CIO of UBS Wealth Management & Swiss Bank, narrows in on one of the themes highlight-ed in our last chapter – alternative investments – and explores it a bit further. Alex argues that the promise of higher returns without a commensurate increase in portfolio risk still holds true for alternative investments despite the current uncertain political environment. But he also suggests that the Yale endowment approach, with its focus on diversifi cation, access to quality man-agers and leverage of its liquidity fl exibility, is critical.

• UBS investment strategists Michael Crook and Stephen Freedman argue that structurally lower growth and interest rates will pose signifi cant challenges for investors overall in achieving long-term return objec-tives. However, they off er some practical guidance on how investors can begin to meet these challenges including: 1) increasing allocations to alternative investments; 2) selectively reaching for yield; and 3) understanding how to fi nd investment growth when economic growth is scarce.

As you can see from this brief overview, our report will sometimes present you with opposing views on particular issues. We fi nd that a diversity of viewpoints ultimately enriches the conversation. As for how it all applies to your particular long-term investment strategy, that can only be determined through a thoughtful discussion between you and your Financial Advisor. We hope you will consider the perspectives presented herein as fodder for a deeper conversation.

Fig. 3: Largest budget deficits in recent US history

Source: Bloomberg, Budget of the United States Government and UBS WMR

US Federal budget deficit / surplus as a % of nominal GDP (chart inverted)

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Klingensmith: George, You have written extensively on what you call a “Minsky Moment.” Can you tell us what this means in context of the fi nancial crisis?

Hyman Minsky, who died in 1996 in his late 70s, was an American economist in the Keynesian tradition. His principal academic legacy was the fi nancial instability hypothesis, where he ex-plained why fi nancial instability and systemic crises are endemic to capitalism, and how we can at least try to mitigate this fl aw. A Minsky Moment, then, refers to the point where the fi nancial system breaks down, requiring urgent and extraordinary policy measures to stabilize the system and the economy.

When subprime lending and housing were still buried at the back of newspapers in 2006, I began to wonder whether this was the last of Minsky’s three stages of leverage – or what he called Ponzi fi nance, that is, where borrowers have to incur debt to service their liabilities and repay them, and where lenders trust the system will be stable by pronouncing that the underlying asset prices will keep rising. It quickly became apparent that subprime was the large tip of an even larger iceberg, and so I wrote a research note for UBS clients in March 2007, called “Have we arrived at a Minsky Moment?” A dozen or so research notes later, we did unfortunately.

Klingensmith: Mohamed, PIMCO famously coined the term, “New Normal” in 2009. Can you describe what you mean by this and how it has played out since then?

When we developed the concept of the New Normal, it was our attempt to signal to our own people, as well as more broadly, that the global economy a er the fi nancial crisis would not reset in a simple manner. We realized this was much more than a cyclical moment and also a time of fundamental structural and secular shi s. We portrayed it as a bumpy journey to a new destination.

We expected the New Normal to involve unusually sluggish growth in advanced economies, persistently high unemployment, recurrent balance sheet issues and regulatory changes. And for the world as a whole, we anticipated an acceleration in the multi-decade convergence between advanced economies and the systemically important ones in the emerging world.

Mohamed El-Erian, CEO and co-CIO of PIMCO, and George Magnus,

UBS Senior Economic Advisor, recently sat down with UBS Economic

and Policy Analyst Katie Klingensmith to lay the foundation for our

discussion on investing in a low-growth, low-yield environment.

El-Erian

Dialogue

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This global macroeconomic scenario has played out largely as we expected, with one important exception: we underestimated the extent to which policymakers would appeal to unconvention-al cyclical monetary policies, in reaction to a New Normal – for example, the Federal Reserve’s quantitative easing program, QE2, which only temporarily restarted economic growth. We also did not anticipate the degree of political dysfunction, both here in the U.S. and in Europe, which has eff ectively stymied progress on structural reform.

Klingensmith: Real U.S. GDP growth was at about 1.5% over the last 10 years, and global growth was at 2.5%. These numbers are pretty unspectacular, although they clearly have been brought down substantially by the sharp declines following the fi nancial crisis. What do you expect will be the growth trends in the U.S. and the rest of the developed world over the next few years, and even the next decade?

I think it’s indisputable that trend growth in the West has been torpedoed by the fi nancial crisis and by its economic a ermath. We have lost our previous growth drivers, that is, hous-ing, fi nancial services and credit. We haven’t got viable replacements yet. We are failing in job creation and income formation, and have a mountain of private and public debt to pay off or restructure. I think for the time being, trend growth in Europe may be around 1% or a little less, and possibly 1.5-2% in the U.S., where the population at least is continuing to grow.

PIMCO’s economic forums, which we hold quarterly, are designed to help us formulate and refi ne our global macro outlook. We use this outlook to map out expected economic and market scenarios based on key variables, which we are constantly monitoring and evaluating. So through the early part of 2011, our baseline scenario posited the continuation of a bumpy journey to a New Normal – characterized by lower growth in developed economies, sustained high unemployment, the shi ing of growth drivers to emerging markets and fatter tails driven by the potential for market accidents or policymaker missteps.

We have since qualifi ed our baseline growth projections for the next 12 to 18 months to emphasize the multi-speed growth and balance sheet dynamics, as well as asymmetrical balance of risks to the global outlook. While emerging economies will continue to expand, albeit at a somewhat slower pace, many developed countries will struggle just to stay fl at overall. We have forecasted only zero to half a percent growth in the U.S., or the risk of a “stall speed” that speaks to the many structural impediments that need to be removed in order for us to be competitive: the housing and labor markets, credit, infrastructure, public fi nances and so on.

The situation is much more uncertain for the eurozone, with the region almost certainly moving into recession over the cyclical horizon. Japan will be the fastest-growing country in the indus-trial world, refl ecting the bounce-back from the terrible, triple calamities.

In addition to structural aspects, balance sheets are at the heart of the issue. Both the U.S. and Europe are grappling with a consequential set of unhealthy balance sheets, as households and governments delever in the a ermath of the fi nancial crisis. On the plus side, healthy balance sheets do exist, among certain emerging economies and among multinational companies that are sitting on very substantial amounts of cash. The problem right now is that with policymakers seemingly unable to act and provide suffi cient clarity and direction, these healthy balance sheets simply aren’t engaging – they’re not hiring, they’re not investing.

We have forecasted only zero to half-a-percent growth in the U.S., or the risk of a “stall speed” that speaks to the many structural impediments that need to be removed in order for us to be competitive.

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Klingensmith: Europe’s debt crisis continues to unsettle fi nancial markets. What steps must the ECB and other regulators take to help the region regain its footing and reassure the markets?

Europe is grappling with the challenge of trying to bring 17 governments to a unifi ed resolu-tion to help stabilize both its ailing members with sovereign debt issues and a fragile banking system, and counter insuffi cient growth. For investors, the situation is like being in the backseat of a car that’s being driven on a bumpy road by policymakers who are driving rather erratically, arguing instead of keeping their eyes on the road and not telling you where you’re going. So the markets have been moving from one uncertainty to the next, with a bit of good news in between.

There are three things that policymakers need to be doing. First, they need to stabilize the sovereign debt and bank issues. Movement has been made on this front, which is positive but not yet suffi cient. Second, they need a new, sustainable plan for stabilizing Greece, including growth promotion and not just endless austerity. And third, they need to communicate their vision for the eurozone going forward to help wring out some of that uncertainty.

Klingensmith: There seems to be an emerging consensus that growth potential among advanced economies has declined. George, you have discussed a “crisis of capitalism.” Can you tell us what you mean and how this could aff ect our economic future?

I think we have a crisis of capitalism for two reasons. First, the fi nancial crisis has exposed deep fl aws in the way our economic system works, and especially our failure, given existing policies, to grow employment and income. And second, it also exposed some critical weaknesses that existed before but were ignored, such as rising income inequality, and a 20-year long stagna-tion in real wages and salaries. For many years, credit availability and creation obscured these problems, but now that the credit function in our economies has broken down, they have leapt into sharp focus. Put simply, we have extremes of inequality, over-production, unemployment and under-employment. These are classic recurring problems in capitalism.

Klingensmith: How does the U.S. compare to other advanced economies?

Personally, I am quite hopeful for the U.S. by comparison. It has better demographics and universities, big markets, helpful geography, a more fl exible economic system and a strong com-petitive and innovative culture that is deeply engrained. Over time, I think these qualities may be the reason why RIP in the case of America may stand for Renewal in Progress, rather than Rest in Peace. But this isn’t to deny that there are very big problems ahead in macroeconomic management, the labor market, the secondary school system and above all in the functionality of the political system.

Klingensmith: What about emerging markets: Do they face the same constraints? George, you write about convergence between the East and the West: How do you expect this to play out?

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I’m a big believer in the Great Convergence. It’s what has happened mostly in human develop-ment over thousands of years. It just so happens that the last 250 years were an aberration! But the reconvergence process pre-dates the fi nancial crisis, and we should expect emerging market growth to outpace that of the West for a while yet. Poorer countries grow faster, by and large, and provided we don’t put sand into the gears of globalization, their natural advantages in population and labor force growth will be topped by further educational, trade and technological advances.

I expect to see more and more companies headquartered in emerging markets making it into the Fortune 500. I also expect to see foreign direct investment by emerging markets, especially China, to rise, and think the Asian middle class and consumption stories will not only drive East-West trade growth, but intra-emerging trade too.

Let’s leave aside some of the problems emerging markets will face in the next two to three years from higher infl ation — and in China’s case, the decent chances of an investment and property bust — as I assume these will be uncomfortable but ultimately manageable. And yet I don’t wear rose-tinted spectacles. One problem all emerging countries face – other than the already proven success stories of South Korea, Taiwan, Singapore and Hong Kong – is to avoid getting stuck in a middle-income trap, that is, at around $10,000-$13,000 of per capita income. For many this has proven to be a so-called BRIC Wall. This was the fate of the former USSR, Venezuela, Argentina and a few other South American economies. Mexico and Malaysia may be in danger of succumbing to this problem. Poland may not. The biggest challenge of all will be for China, which should, on current form, reach the top end of this per capita income band by 2020. The key to moving up into the high income league is top quality institutions – including legal institutions – in which China is sorely lacking.

I’m not saying China can’t jump over the Wall, but I don’t think it can do so with the political status quo. Something substantial is going to have to change.

Klingensmith: George, you have written about the importance of deleveraging a er the fi nancial crisis. Can you explain this concept for our readers as well as how you expect it to play out?

Deleveraging is the process whereby households, banks and governments – not so much listed companies – will sooner or later reduce the burden of indebtedness accumulated before or since the fi nancial crisis. It takes a long time, but normal patterns of lending and spending, which drive economic growth, cannot really resume until the deleveraging is much further along. In other words, the debt ratios, like debt to GDP or income, must fall a lot further. The biggest problem we have is that the debt burdens are large, compounded by the onset of aging societ-ies, and spread throughout the Western world. We have not had a concerted deleveraging like this since 1945.

Klingensmith: What role does economic policy play in the deleveraging process?

Absolutely crucial question. It plays a vital role – and politicians have myopically embraced gov-ernment deleveraging, or defi cit reduction – as the key to economic renewal. This is a dangerous delusion. You simply cannot have the government and households and banks deleveraging simultaneously unless you want to end up in a depression, which is where some European countries have ended up already. For some governments, there is little choice now, but large

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Politicians have myopically embraced government deleveraging, or defi cit reduction, as the key to economic renewal. This is a dangerous delusion.

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economies like the U.S., Germany and the U.K. have considerable scope to tread so ly when it comes to defi cit reduction for a while, and have options to restructure tax and spending com-mitments so as to focus like a laser beam on job creation. You have to have a growth agenda. That way, you can allow the private sector to recover fi nancially and economically, higher tax revenues will then ease the defi cit reduction plan, and harsher political decisions on spending and tax reform can come into their own over time.

Klingensmith: It seems logical that with such threats looming, risk aversion is likely to stay high and it may be more diffi cult for investors to fi nd attractive and stable yields. What do you think has changed about market dynamics?

Market turbulence has become increasingly pronounced, as we have seen a series of unthink-ables become reality, e.g., Standard & Poor’s credit downgrade of the U.S. and other countries, U.S. politicians fl irting with a technical debt default, a likely Greek default, etc.

The S&P 500, a widely followed index for the largest stock market in the world, declined 14.3% in the third quarter, its worst showing since the fourth quarter of 2008. Since then, it has rebounded strongly.

It’s important to recognize that the volatility we’ve been experiencing since the summer is not just noise. It’s a signal about major structural changes. With markets in the unusual and uncom-fortable position of being wholly dependent on policymakers and politicians, company analysis, no matter how good, pales in comparison to the importance of getting policy calls right. This indicates a fundamental shi in typical market dynamics, suggesting both prudence and pa-tience on the part of investors.

Well the main things that have changed are fi rst, we now live in what is likely to be a protracted period of very low interest rates, punctured here and there by elevated risk premiums in coun-tries like those in southern Europe where there is major credit risk. And second, risk premiums in equity markets are higher because of macroeconomic risk, even though listed companies have so far managed to sustain high levels of earnings. In major emerging markets, investors will fi nd lower levels of sovereign credit risk, and what we might call more typical macroeconomic risks. And remember that in emerging markets, returns to equity should be sustained at higher levels because of the underlying demographic and economic trends. But in Western markets, a lot of global and well-known companies off er attractive dividend yields which have already drawn a lot of investors into the space.

Klingensmith: What do you expect to happen with yields on sovereign debt, as well as corporate debt, going forward?

Sovereign yields have bifurcated either side of a solvency line, and at the current time, of course, countries like Italy and Spain are sitting on the line. It doesn’t mean that sovereigns can’t trade places, but I would say that the U.S., U.K., Germany and some smaller northern European countries will probably remain where they are, and Ireland has moved in the right direction, but the rest have much to prove. Corporate debt yields can’t help but refl ect those on the sovereign to a signifi cant extent, and should be more cyclically sensitive. But I don’t see why we should expect to see any major backup in yields, unless of course credit risk reemerges in any future economic contraction.

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Klingensmith: Will there be other sources of growth and yield outside of the U.S.? Do you recommend seeking growth, incremental yield or some alternative strategy?

The one thing we can take from the crisis is that for the time being growth in the U.S. and other developed markets will lag a long way behind that in emerging markets. Some of the latter’s growth is what we might call “alpha,” that is homegrown phenomena like a bulge in the work-ing age population, improving economic and corporate governance, higher technological and educational achievement levels, and high savings and investment. This is what playing ”catch-up” is all about. There is still quite a lot of “beta,” that is dependence on the demand from the West, but the alpha is set to stay. If you don’t like investing in emerging markets directly, there are other ways of getting the exposure, for example, in the so and industrial commodity markets, in emerging market currencies and by buying the equity of Western companies whose fortunes are closely correlated to emerging market growth. I’m not saying now is necessarily the time to buy – that depends on one’s sense of valuation and what’s priced. But from a strategic investment perspective, I think this should work.

Klingensmith: How is PIMCO investing in this environment?

PIMCO manages the full range of asset classes, and we are very cautiously positioned across the capital structure – focusing on the return of capital fi rst and foremost.

In terms of bonds, we’re investing in countries with relatively healthy balance sheets, such as Australia, Canada, Mexico and Brazil, as well as global credits of the strongest companies. On the equity side, we are looking to multinationals that are attractively valued and that, impor-tantly, off er high dividends as cushions.

Investors also shouldn’t underestimate the optionality value of cash in an uncertain world. It’s an eff ective defense, of course, but it can also be an important off ensive tool. At some point, market volatility will provide attractive entry points, allowing you to go in and buy companies very cheaply.

Klingensmith: What are the implications of the New Normal for investors? How would you recommend private investors shi their strategies given a tempered outcome of lower growth and lower returns?

As we confront a reality in which some old patterns no longer hold, investors need to create multi-step strategies that will allow them to be benefi ciaries of change rather than victims of it. One of the fi rst challenges an investor or an advisor faces is trying to evaluate why the world is behaving the way it is. You have to ask yourself why unthinkable things are happening. Finding the answers requires intellectual agility that lets you look at global issues with a fresh lens. You also should try to have a forward-looking view on the world that will allow you to map out your destination without relying on old conventions. Next, you need to remember that as global markets continue to realign, traditional risk classifi cations are morphing. These shi s require a fl exible mindset about allocation, one that thinks in terms of risk factors rather than asset classes and that exploits the broadest possible opportunity set. And fi nally, with volatility an inescapable feature of the New Normal, you have to pay attention to the “fat tails,” and actively manage a portfolio of hedges that can help add value when the worst happens.

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If investors were reading this report in 2001 instead of 2011, they would probably be expecting to read about “the new economy,” and the appropriate time to revisit technology shares a er their underperformance subse-quent to the March 2000 peak. Perhaps more important, readers at that time would have had little if any interest in many of the investment themes that outperformed during the subsequent decade. Themes like emerging markets, gold, commodities, energy, REITs and Treasuries were not on investors’ radar screens.

Investors tend to look backward and extrapolate trends, and then are o en disappointed when the past trend didn’t continue into the future. The so-called “lost

decade” in stocks wasn’t really a lost decade at all. Certainly, US stocks performed poorly from 2000 to 2010, but there were many opportunities in equity markets around the world, and in non-technology sectors within the US Investors at the beginning of the decade simply had no interest in these investments.

Investors may be setting themselves up for another lost decade in equities. Much as investors looked backward 10 years ago, and determined that technology was the place to invest, today’s investors sound similarly backward-looking when discussing emerging markets, commodities or gold.

P E R S P E C T I V E S

Avoid another “lost decade”In keeping with the assumption that growth will remain low, depressing yields, Rich Bernstein of Bernstein Advisors off ers his take on equity portfolios. He urges investors to embrace equities (especially US) and thereby avoid another “lost decade.” Contrary to many observers, the author sees a bubble forming in emerging markets and thinks that valuations argue strongly for overweighting US stocks.

By Rich Bernstein, CEO, Richard Bernstein Advisors LLC

12

Presently, investors are concerned that the global econ-omy is entering a period of sustained subpar growth. While that might be true, investors’ fears regarding the developed markets are well-voiced, widely understood and largely based on extrapolation of recent trends. However, we feel that the primary investment risk to a slow-growth environment is not the developed markets as many believe, but rather the emerging markets. Emerging market equities are quite expensive, and their valuations do not allow for disappointment. Thus, our investment strategy for a slow-growth environment focuses largely on US assets, which we feel have adequately discounted such an economic scenario, and might be ripe for out-performance should the economy perform better than is currently anticipated.

Case in point, most investors are totally unaware that US stocks have signifi cantly outperformed stocks of the BRIC countries (Brazil, Russia, India and China) for almost four years. As Fig. 1 below points out, the S&P 500 has out-performed the MSCI BRIC index by nearly 20 percentage points from December 2007 through September 2011.

Investors were unaware of the changing economic and fi -nancial backdrop in the early 2000s that caused a change in stock market leadership away from technology shares. It appears as though they are similarly unaware of the changes that are under way with respect to the US and the emerging markets.

Our analyses suggest that US assets may be particularly at-tractive throughout the current decade for three reasons: valuation, sentiment and the coming defl ation of emerg-ing market credit bubbles.

ValuationIt appears as though relative valuations between US and emerging market stocks are totally opposite of what they were a er the emerging market crises in 1997 and 1998, when investors felt that emerging market stocks were too risky. Meanwhile the US was in the earlier stages of the technology bubble.

At year-end 1998, the free cash fl ow yield of the MSCI Emerging Markets Index was 7.2% versus only 3.4% in the US (see Fig. 2). Those attractive free cash fl ow yields in 1998 were one of the many indicators that suggested longer-term investors should look at equities outside the US

Today, however, the picture is quite opposite. The US’ free cash fl ow yield is currently 7.7%, whereas the free cash fl ow yield of the emerging markets is only 2.8%. According to Bloomberg, current free cash fl ow yields in China and India are actually negative.

Valuation is rarely a good short-term market timing tool, but it is generally a reliable long-term indicator of an investment’s attractiveness. The fact that today’s valuation of the US stock market is substantially more conserva-tive than that of the emerging markets is, to us, a very

Fig. 1: Total Returns: S&P 500 vs. BRICs

Source: Richard Bernstein Advisors LLC, MSCI, Bloomberg

12/31/07 through 9/30/11

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Fig. 2: Free Cash Flow Yields: 1998 vs. Today

Source: Richard Bernstein Advisors LLC, Bloomberg

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important investment consideration, and certainly goes against accepted wisdom regarding the attractiveness of emerging market equities. SentimentWhen investments are popular, the valuations of those investments tend to be higher. As in any economic mar-kets, buyers pay more for something they feel they have to own. The valuation discussion above demonstrates that investors feel they need to own emerging market equities, but don’t attach the same level of necessity to owning US equities. By our reckoning, investors’ bearish views of the US are not only refl ected in valuations, but also in a broad range of sentiment indicators.

There are many short-term investor sentiment indicators, but our work suggests that most provide no investment information at all. We prefer to focus on long-term, struc-tural sentiment indicators.

Gold has become a popular investment, but few investors in gold consider its valuation. Fig. 3 portrays the real (i.e., infl ation-adjusted) spot price of gold. It went completely unnoticed by most investors that gold recently reached its 1980 peak real price. It is important that gold reached such overvalued levels. However, it is more important to realize that fi nancial assets began a secular 20-year bull market a er the 1980s peak valuation. Although the near term remains quite murky, we feel that gold’s extreme valuation is a bullish long-term signal for stocks.

Defl ating emerging market credit bubblesEveryone knows that emerging market economic growth has been stronger than that of the developed markets. However, few people ask why this has occurred. It appears as though what started as a normal economic phenome-non has morphed into signifi cant credit bubbles that now dominate some of the major emerging market economies.Contrary to current popular belief, “printing money” does not cause infl ation. Rather, monetary theory says that printing money and using it to create credit causes infl ation. Monetary theory suggests that abnormal infl a-tion only occurs when it is accompanied by abnormal credit creation. The recent housing bubble would be a good example. There was abnormal credit creation in the mortgage market, and the result was abnormal infl ation (although many preferred to call it appreciation) in home prices. Some economists have forecasted that US infl ation would get out of control, but that has not happened to any great degree largely because credit growth in the US has been quite moribund since 2008’s fi nancial crisis.Money and credit growth has been very rapid, however, in the major emerging markets. In fact, the BRIC countries have some of the fastest rates of money growth in the world and the accompanying fastest rates of infl ation. Fig. 4 shows the relationship between countries’ money growth and infl ation rates. The BRICs rank high in both categories. Growth in the major emerging markets has been fueled by signifi cant credit bubbles. Like all credit bubbles, we ex-pect these credit bubbles to slowly defl ate. The US’ bubble is largely defl ated, but still has a way to go. Europe’s may be in the earlier phases of defl ating. The emerging market credit bubbles have yet to begin to defl ate, but history strongly indicates that investors should not be lured into a sense of false security.

As these unanticipated bubbles defl ate, we think investors will begin to rotate back into US assets, which will also support the US dollar. Much as investors are not generally aware that the S&P 500 has been outperforming BRIC stocks for almost four years, investors seem equally un-aware that the US dollar troughed more than three and a half years ago (the DXY Index’s low was in April of 2008).

This is particularly important with respect to non-US income streams. Investors searching for higher-yielding assets have invested in emerging market

Fig. 3: Real Gold Price

Source: Richard Bernstein Advisors LLC, Bloomberg

10/31/1975 through 10/12/2011

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We feel that the primary investment risk to a slow-growth environment is not the developed markets as many believe, but rather the emerging markets.

/ continues on pg. 15

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Fig. 4: Global Growth in Money Supply* vs. Inflation Rate

Source: Richard Bernstein Advisors LLC, The Economist, Bloomberg*Money Supply defined as M2 (or M3, if M2 not available, or IMF Currency Issued by Monetary Authority in National Currency, for EMU countries).

Latest available as of 9/30/2011

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local currency bond funds and globally exposed dividend-paying stocks. We caution against blindly following such strategies if the US dollar does appreciate. The yields in local currencies might be attractive, but the translation to US dollars could easily negate those yield advantages if the US dollar were to appreciate.

We have long believed that compounding dividend income is a cornerstone of building long-term wealth. Thus, we continue to believe that longer-term investors should have core positions in dividend-yielding stocks, but we think that investors must be careful to assess the sources of earnings and cash fl ow growth. We generally prefer domestic US dividend-paying stocks to multina-tional dividend-paying stocks.

Correlation defi nes diversifi cationInvestors seem to have confused the number of asset classes held in a portfolio with diversifi cation. Diversifi cation is determined by the correlation among assets, not by the number of assets. Today, the correla-tions among most major asset classes are signifi cantly positive, which suggests that investors may be underdiver-sifi ed. We have pointed out for more than fi ve years that there is only one major asset class that provides diversifi ca-tion: US Treasuries. Despite the fact that investors’ cost of capital is basically 0% (i.e., the Fed has set the “risk-free” rate at 0%), investors still perceive Treasuries to be overly risky. Traditional risky assets are now widely held, but Treasuries are strongly disliked by most investors.

We think the issue is that investors have thought of Treasuries too narrowly. They base investment consider-ations purely on Treasuries’ coupons, and ignore the total return potential. Oddly enough, Treasuries have become even better diversifi ers within a global equity portfolio because the coupon decreased, and their total return potential has increased (as the coupon decreases, the duration or interest rate sensitivity increases). We continue to believe that Treasuries should be part of any well-diversifi ed portfolio.

The US ain’t so badInvestors seem unduly pessimistic about the prospect for investing in US and developed market assets, and unduly optimistic about the prospects for returns in the emerging markets. We think investors should ignore the rosy stories about emerging market economies, and concentrate more on the overvaluation and slow profi ts growth of emerging market equities.

Everything people said about “the new economy” 11 years ago has come true, but the investor who bought NASDAQ at that time would have seen his investment depreciate by about 50%. The stories of the emerging market economies might indeed come true. That doesn’t mean that emerging market investors will necessarily reap high returns.

A er all, the S&P 500 has already outperformed the BRICs for nearly four years. Something appears to be changing. Don’t structure portfolios for yet another lost decade.

We continue to believe that longer-term investors should have core positions in dividend-yielding stocks, but we think that investors must be careful to assess the sources of earnings and cash fl ow growth.

16

For the past three decades, fi xed income investors have benefi ted from the secular decline in interest rates and corresponding rally in fi nancial asset values (see Fig. 1). Since the onset of the credit crisis and the severe reces-sion which followed in its wake, interest rates have been pushed even lower, driven by the extraordinarily accom-modative policies of the Federal Reserve and expectations for these policies to continue for an extended period. While accommodative monetary policy has set the stage for higher rates of growth and infl ation at some point, this dynamic has evidently been pushed further off into the future. Economic growth, infl ation and interest rates remain constrained by structural headwinds and height-ened market volatility.

As we long argued would be the case, since the Fed’s QE2 program ended on June 30, fi nancial markets have exhibited considerably higher levels of volatility and in many fi xed income sectors, signifi cantly reduced liquid-ity. This dynamic of low growth should persist for quite some time as the global economy remains mired in an ongoing cycle of disequilibrium, where the systemic need for developed market deleveraging results in defl ationary pressures that are in turn combated by increasingly ac-commodative monetary policies. Added to this destructive global dynamic are the increasing intensifi cation of the

P E R S P E C T I V E S

Managing fi xed income in a low interest rate environment Fixed income is an important part of any portfolio, especially for those living off of their savings. However, with interest rates very low, not only are returns poor, but the chance that bonds lose value when interest rates go up is of major concern. Rick Rieder of BlackRock sheds some light on how to manage these risks, and he encourages investors to consider adding some credit risk instead of just being exposed to duration risk.

By Rick Rieder, Chief Investment Offi cer – Fixed Income and Fundamental Portfolios, Head of Corporate Credit and Multi-Sector and Mortgage Groups, BlackRock

sovereign debt crisis in Europe and the rising likelihood of a secondary recession both there and in the United States. With fi xed income markets relegated to a low interest rate environment and volatility likely to persist, the next decade of fi xed income investing will be vastly diff erent from the last 30 years, requiring investors to reassess their investment strategy.

While the effi cacy of unconventional Fed policy is the subject of great debate, there is little doubt that there is

Fig. 1: 10-year treasury constant maturity rate

Source: US Treasury

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still ample room for incremental policy tweaks in order to meet its two formal mandates of price stability and full employment. The critical questions are whether this accommodation will be suffi cient in degree and its time horizon long enough to allow policy to serve as a bridge to needed structural change?

In the meantime, investors are exposed to an increasingly volatile environment driven by monetary policy deci-sions that inject liquidity into the global markets. During periods in which global liquidity (the sum of the change in global foreign exchange reserves and Fed Treasury hold-ings) grew by 1% or more, this was consistent with VIX

readings below 20, near the index’s long-term average. Furthermore, over the past year, when the accu-mulation of offi cial liquidity slowed, the volatility of the VIX index spiked, causing markets to become highly illiquid (see Fig. 2). That dynamic has been particularly pronounced since the conclusion of QE2, as we supposed would be the case, calling for monetary policy to remain highly accommodative. Ultimately, fi nancial market volatility and illiquidity need to be addressed in the short run as they present a meaningful challenge to consumer and business confi dence and add

to le -tail risk potential, factors that could dramatically impair the recovery. As it stands, recent economic data have confi rmed the fundamental fragility of the economic recovery since the labor market and housing sector still sit at deeply depressed levels. With fi scal policy shi ing to a program of austerity, economic data need to be closely monitored to determine if the private sector can indeed refl ate the economy in the absence of government support. Adding to the complexity of an already diffi cult economic environment, European sovereign debt risks continue to escalate, as policymakers appear to be running well behind the curve, and seem to be employing delaying tactics, while the fi nancial markets have responded in punishing fashion in each case. The ECB’s policy toolbox has heretofore focused on liquidity provision, but it has been rather short on details regarding solvency and reform solutions. At each point when peripheral spreads widened versus German Bunds, policymakers stepped in with liquidity, but what is needed is structural reform, with liquidity serving as a bridge. While recent policy action from European leaders to expand the capacity of the EFSF has reduced le -side tail risk, volatility will likely continue as the details of the plan are formalized. The question before the eurozone, however, continues to be whether the political will exists to make the required changes to solve the crisis more defi nitively, or if a further deepening of the crisis will be required to induce key countries to act (see Fig. 3).

Fig. 2: Monetary stimulus has muted volatility

Source: Bloomberg

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We have come to a point where volatility and illiquidity in fi xed income and equity markets threaten to undermine gains made in investor, consumer and business confi dence since the depths of the fi nancial crisis.

18

We have come to a point where volatility and illiquidity in fi xed income and equity markets threaten to undermine gains made in investor, consumer and business confi -dence since the depths of the fi nancial crisis. Given this dynamic coupled with an extended period of low interest rates, advisors need to reconsider how to generate yield and total return in fi xed income portfolios. The current level of interest rates does not provide investors with the appropriate compensation for the amount of duration risk they are assuming. Incorporating a greater allocation to credit product should help a portfolio adapt to transitions in the economy and interest rate backdrop. In particular, investors should consider holding some exposure to non-government spread sectors of the market, including investment grade or high-yield corporate debt, fl oating rate bank loans, commercial mortgage-backed securities and non-agency mortgage-backed securities.

In the near term, investors would be well advised to move higher in quality within their allocation to spread sectors in order to protect their portfolio if growth should slow. As a result of illiquidity and policy lags, we think some fundamentally sound regions of spread sector markets have been punished disproportionately and will present good opportunities, particularly when liquidity returns. That said, investors should add to risk assets slowly and with caution, as volatile markets may remain with us for some time. Overall, the increasing complexity and diversity of the fi xed income markets demand a multi-sector, active approach to managing credit exposure.

Looking further out, the correct balance between dura-tion risk and credit risk can provide attractive fi xed income returns while providing a cushion against market volatility (see Fig. 3). For example, during 2010, a year character-ized by a slow growth economy supported by two rounds of highly accommodative monetary policy, fi xed income investors were best served by extending duration and maintaining an overweight to spread sectors. This year, however, while economic data remain weak, supportive government policies have rolled off and sovereign risks in Europe continue to escalate. The much lower levels of in-terest rates and the volatility of risk assets mean investors are best served by dynamically managing both interest rate and credit risk.

With interest rates at their lows, advisors should encour-age clients to reduce their duration risk (interest rate sensitivity) or invest with managers who have the fl exibility to rapidly and signifi cantly adjust duration. Investors solely positioned in a traditional core bond portfolio tied to the Barclays Capital Aggregate benchmark will fi nd them-selves heavily overweight duration risk at a time when risks will have shi ed to outweigh the rewards (see Fig. 4). A core allocation to an unconstrained bond fund that can be fl exible in managing the fund’s interest rate risk and credit risk would help enhance the overall success of a client’s fi xed income portfolio over the long run. Outside of that core position, advisors can help clients add tacti-cal satellite positions in order to increase the portfolio’s diversifi cation and income potential.

Fig. 3: 10-year sovereign debt spreads (over German Bunds)

Source: Bloomberg

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Spread vol 25% Rate vol 75%

Fig. 4: Core bond portfolios have concentrated interest rate risk

Barclay’s Aggregate Bond Index

Source: BlackRock

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Casting off narrow benchmark constraints allows a fi xed income investor to maintain a more advantageous mix of interest rate risk and credit risk, as well as to capitalize on the most compelling opportunities around the globe and across all fi xed income sectors. When investing in a diversifi ed, unconstrained portfolio, the portfolio manager

also is equipped to rapidly and eff ectively manage key fi xed income risks. The manager assumes investment positions with greater conviction by using a broader range of tools to seek returns in a low-growth environment that will remain challenging for quite some time.

We think there are key long-term, structural supports for fi xed income assets that will provide an important source of technical demand in the years ahead, miti-gating the disruptive rise in rates envisioned by some.

A key pillar of this structural demand for yielding assets is demographic change. While it is well known that the “Baby Boom” generation now beginning to enter retirement will require stability and income from their investment portfolios (which will ultimately bolster demand for yielding assets), we think the implications on the landscape of asset purchases in the years ahead is largely underappreciated. We are now at the beginning of a 12-year period that refl ects dramatic spikes in the annual birth rate 65 years ago. As these individuals near retirement age, they will require a signifi cant asset reallocation not only in any personal accounts, but also in institutional accounts run on their behalf (such as pension funds) toward fi xed income assets. Moreover, this demand technically is not merely theoretical; a comparable dynamic existed in the United Kingdom, but with roughly a fi ve-year lead, and the result has been impressive. From 2000 to 2010, pension assets in the UK have shot up more than 80% (compared to a 50% rise in the U.S. and a 44% jump in Japan over the same period) to $2.28 trillion, as institutions prepared for the demographic shi and bolstered portfolios buff eted from a decade of market shocks. One of the eff ects this change has had on the UK bond market is to eff ectively support a bid for long-dated government bonds, allowing the government to term out its debt so as to improve

the maturity profi le overall. Additionally, over this same decade, the average percentage of assets in UK pension funds that were devoted to a fi xed income allocation rose markedly from 15% in 2000 to 35% in 2010 (mostly at the expense of equities), again underscoring the need for yield in the context of an aging population. In the years to come, we think this dynamic may begin to exhibit itself to a greater extent in the U.S. as well.

The institutional bid for fi xed income assets in the US is likely to remain strong and increase over time, while simultaneously supply will remain constrained. For example, in the period ahead, we estimate that the demand for interest rate and credit spread duration from insurance companies and pension funds alone likely will outpace available supply, keeping prices sup-ported and yields relatively stable.

Structural shift in demographics keeping interest rates contained

Fig. 5: US live births and estimated retirement date (65 years)

Source: US Census Bureau, Center for Disease Control and Prevention,Office of National Statistics, Credit Suisse Demographics Research

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In today’s low-yield environment, a growing number of individual investors are turning to non-traditional ap-proaches, such as hedge funds, private equity, real estate and infrastructure in an attempt to fi nd more attractive re-turns than what seems likely from traditional asset classes. Theoretically, alternative assets off er relatively low cor-relation to traditional assets, a wider range of investment opportunities and greater fl exibility in a volatile market. Increasing allocations to this asset class provide an investor with the potential to enhance portfolio performance with-out adding to the overall risk of a portfolio (see Fig. 1). In this context, the rapid growth of the asset class over the past two decades is understandable. However, since 2008 a number of the most prominent alternative assets have been buff eted by crises. So does the promise of higher returns without a commensurate increase in portfolio risk still hold true?

Hedge funds: struggling in political marketsHedge funds employ various trading strategies, including long-short, special situations, distressed debt and global macro, without investment constraints that are imposed on traditional long-only investments. These strategies, when used by skilled managers, can theoretically produce steady, predictable returns by mitigating market risks regardless of the direction of the markets.

Hedge funds grew in repute with consistently positive returns over the 1990s and early 2000s, and assets under

P E R S P E C T I V E S

The hunt for alpha:

Alternative investmentsWhile once a novelty, alternative investments have become more accessible to many individuals. Such investments include hedge funds, private equity, real estate and infrastructure investing. While the last few years have seen widespread stress in the sector, Alex Friedman, the Chief Investment Offi cer of UBS AG, suggests that when chosen wisely they still are attractive in a long-term portfolio.

By Alex Friedman, CIO, UBS Wealth Management and Swiss Bank

management soared from $39 billion in 1990 to close to $2 trillion by 2008. The industry experienced just 8 quarters of negative performance in the 10 years before Lehman collapsed. But the investing climate over this period was largely a “rising tide” environment in which what appeared to be alpha (excess return) proved to be beta (market return), and usually levered beta. The 2008 fi nancial crisis revealed that the returns were indeed not uncorrelated to the broader market and a combination of volatile markets and frozen credit conditions led to mass liquidations, with close to 2,500 funds failing in 2008-09.

Although the hedge fund industry as a whole has more than recovered the assets under management lost since 2008, funds of funds in particular have struggled as their advantages (e.g., manager vetting, manager selection and diversifi cation) have been largely outweighed by a more onerous fee structure and reputational issues.

In 2011, a number of hedge funds have been caught off -guard by markets that have been driven more o en than not by unpredictable political dynamics, rather than eco-nomic fundamentals. The HFRI Fund Weighted Composite Index has dropped 6% in the fi rst three quarters of 2011. Market correlation is at multi-year highs due to a combination of the sovereign crisis and growing investor appetite for passive investing. This has made it particularly challenging for managers focused on bottom-up funda-mentals as the core of their investing strategy.

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Private equity: deal activity slowsDespite a very long investment horizon and large pools of committed capital, private equity has also been aff ected by recent market volatility. The traditional merry-go-round of acquiring a company, raising debt, transforming the business and exiting at a higher price through an IPO or private sale has slowed amid market dislocations. For now, private equity investors are likely to see reduced distribu-tions due to the near-closure of the IPO market and a desire among corporations to continue to accumulate cash, rather than execute M&A. Approximately half of the exits that are taking place today are secondary buy-outs (i.e., sales to other private equity fi rms), o en leaving fund investors with nothing but a reshuffl ed portfolio. Furthermore, investors may see downward NAV adjust-ments as portfolios are revalued to match reduced public market valuations.

Deal fl ow remains signifi cantly below peak, hovering around $50 billion per quarter, compared to over $250 billion at the peak in Q2 2007. With the recent volatility sending the price of leveraged loans down 5% in the past three months, leveraged buyout activity is likely to remain muted. This has le fi rms sitting on over $900 billion of unspent capital, which may be worrisome for returns, given the competitive market dynamics of the industry and the possibility that fi rms will overpay for deals. However, there is an argument that all this uninvested capital is actually well-positioned to take advantage of current market dislocations that may off er attractive long-run opportunities (see Fig. 2) for managers skilled enough

to spot assets trading below potential valuation and/or for distressed-focused funds. Hard assets: growing in prominenceAs investors debate whether hedge funds off er alpha or levered beta, and private equity remains heavily unin-vested, hard alternative assets are growing in prominence, especially because quantitative easing and high levels of government debt are undermining confi dence in fi at cur-rencies. Gold’s rise has been well-documented, but, other, more unusual, assets have also benefi ted from the trend: the Liv-ex Fine Wine 100 Index has almost doubled in the past fi ve years and demand for art remains high.

Investment in infrastructure funds is also drawing inter-est from a number of prominent sovereign wealth funds looking to diversify equity and bond investments into infrastructure projects. The high barriers to entry and the monopoly-like characteristics of typical infrastructure assets mean that their performance may be relatively insensitive to the economy over the short-to-medium term. Infrastructure is also generally considered low-risk given the essential services provided, stable regulation and contracted revenues. On the negative side, valuations have periodically increased, commensurate with investor demand. Additionally, direct investment in infrastructure is tricky for individual investors to execute, and listed infrastructure companies usually are very exposed to government spending, which may be undesirable in an era of austerity.

Fig. 2: Difficult markets can provide opportunities for private equity

Source: Thomson One, UBS WMR (European funds raised between 1999 and 2004)

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Equally weightedbond/equity portfolio

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Addition of alternative asset classes to portfolio

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In the long run, there is empirical evidence that increasing portfolio allocations to alternatives can be an important ingredient for outperformance.

22

Opportunities for those with longer horizonsIn the long run, there is empirical evidence that increasing portfolio allocations to alternatives can be an important ingredient for outperformance. Alternative investments have long been incorporated into endowment portfolios at universities and foundations. Among the most prominent exponents of an alternatives strategy is the endowment fund at Yale, which currently has about 80% of its portfo-lio invested in a combination of private equity, real estate, hedge funds and natural resources, and just 20% in tra-ditional stocks and bonds (see Fig. 3). The so-called “Yale Model” has served the endowment well, returning 10.1% per annum for the 10 years to June 2011, surpassing the returns for both global equities (3.9%) and bonds (5.1%).

While a signifi cant allocation to alternatives may be logical for large endowments, for many individual inves-tors it is diffi cult, and o en undesirable, to follow this model for the following reasons: hedge funds and private equity usually request minimum investment sizes; the fee structures can be onerous, particularly for fund of funds; and most importantly, the asset class is highly illiquid and lock-ups frequently span years rather than months. Indeed, Yale CIO David Swensen suggests that, aside from real estate, most alternatives may not be appropriate for an individual investor’s portfolio.

Conclusion: manager selection and liquidity are key issuesIndividual investors can learn from the Yale endowment approach with its focus on diversifi cation, access to quality

managers and leverage of its liquidity fl exibility. In man-ager selection, investors should ensure that alternative investments off er true diversifi cation and are not merely providing public equity exposure in disguise, a particular danger with hedge funds and private equity. It is impor-tant to look past the “headline” of a manager’s strategy into both the underlying positions and the leverage employed, in order to determine how to mix and match alternative products among themselves as well as tradi-tional holdings.

When reviewing manager selections, the old adage that the past does not guarantee the future is worth highlight-ing because many of the best regarded managers made their names before the 2008 crisis, in a diff erent macro investing environment than exists today. Investors should be careful to focus on investment philosophies that seem logical in today’s economic environment. And it is important to remember that much of the alpha provided by alternatives can probably be more correctly attributed to a liquidity premium, given that lock-up periods o en span multiple years. Investors need to assess whether this kind of premium is worth the illiquidity and whether it is really practical given their individual situations. One of the painful lessons of 2008 centered on this point; when liquid portfolios shrink, the illiquid part in turn represents a larger proportion of the overall pie and can destabilize an asset allocation plan. Furthermore, illiquid alternative investments have capital calls and if an investor has less liquidity than expected at the time of such a call, it may force more selling of depressed liquid positions which in turn further unbalances asset allocation.

The environment for investing in alternatives has changed since the 2008 crisis, just as it has for other asset classes. An investor should not expect to fi nd alpha just by exposure to investments in the alternative realm. However, provided alternative investments are made with a proper understanding of the investment manager, liquidity and other specifi c risks, this asset class can off er the possibility of improved returns in the context of a broader portfolio. In today’s low-yield environment, sophisticated investors would be well served to educate themselves thoroughly about this asset class.

Fig. 3: Yale endowment fiscal 2012 asset allocation

Source: Yale

Allocation to asset classes, in% of total portfolio

Private equity

Real estate

Absolute return

Foreign equity

Bonds and cash

Natural resources

Domestic equity

34%9%

4%

17%

20%

9%

7%

Hard alternative assets are growing in prominence, especially because quantitative easing and high levels of government debt are undermining confi dence in fi at currencies.

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P E R S P E C T I V E S

Portfolio strategies for a low-growth, low-yield environmentAgainst the backdrop of multiple market and investment views, our own UBS Wealth Management Research and Portfolio Advisory colleagues weigh in on how the diff erent proposals fi t in a portfolio. Stephen Freedman and Michael Crook suggest strategies of increasing allocations to alternative investments, carefully seeking yield-enhancement strategies and fi nding growth opportunities even when economic activity is lackluster.

By Stephen Freedman, PhD, CFA, Head of Investment Strategy, UBS Wealth Management Research, and Michael Crook, CAIA, Head of Portfolio Advisory Group, UBS Wealth Management Solutions

Structurally lower economic growth and interest rates present multiple challenges for investors. Below-trend economic growth is likely to result in lower investment returns across traditional asset classes. In such an environ-ment, investors become less likely to achieve long-term portfolio return objectives. One current ramifi cation of low economic growth and low interest rates also presents a challenge for income-focused investors.

The portfolio problemThe risk-free interest rate (RFR), typically approximated as a yield on short-term U.S. Treasury security, is the rate of return that an investor can achieve without any risk of fi nancial loss. Accordingly, compensation for accepting investment risk is measured as a spread to the risk-free rate available in the market at any particular time.

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unpalatable for many investors. Other investors feel the same way about dramatically reducing investment portfo-lio goals. As such, we believe the following portfolio ac-tions are likely to help investors off set some of the impact from low economic growth and low interest rates.

Closing the gapWe recommend the following actions for investors seek-ing opportunities in the current environment.

1. Include portfolio allocations to alternative strategiesAlternative strategies play a dual role in the current envi-ronment. First, to the extent that profi tability in alternative strategies is driven by market factors other than economic growth, a low-growth environment increases their relative attractiveness within a portfolio. Second, many low volatil-ity strategies can serve an important role for conservative and moderately conservative investors seeking to diversify fi xed income portfolios.

Given that economic growth ultimately drives investment returns in most traditional markets in the intermediate- to-long run, lower global economic growth prospects generally result in relatively modest return expectations for most asset classes; this applies especially for equity, fi xed income and commodity markets. However, utilizing investment strategies that add non-economic growth-related return drivers (betas) to portfolios can provide a counterbalance to the economic growth headwind which investors currently face.

As was convincingly argued by Mohamed El-Erian and George Magnus in their respective interviews, we be-lieve we are likely in the midst of an extended period of unusually low interest rates – driven by accommodative monetary policy and modest economic growth (see Fig. 1). In fact, the market’s implied expectation for short-term interest rates, based on the Treasury yield curve, is for the 6-month Treasury bill to average slightly less than 2% over the next 7 years.

The implication of a low interest rate environment, simply put, is lower average portfolio returns across the board. To see why, consider the following. Academic research has found that the U.S. historical equity risk premium (i.e., the rate of return that an investor receives for taking equity market risk) has averaged about 5% since WWII. Assuming the equity risk premium remains constant over long periods of time, an investor could expect to receive a total equity return of 10% during the periods where the RFR averages 5% and a total equity return of 6% during periods where the RFR averages 1%.

The impact on investors can be signifi cant. The probability that an investor would be able to distribute 4% annually from a moderate portfolio in perpetuity, without reducing the nominal value of the portfolio, declines from 95% to 75% as the expected risk-free rate declines from 4% to 2%.

Investors are therefore faced with a diffi cult choice as expected returns decline. Strategically targeting higher portfolio risk, the most straightforward response, is

Fig. 1: Interest rates at historical low

Source: Federal Reserve, UBS WMR

3-Month Treasury Bill Yield, in %

2

0

6

14

12

10

8

16

18

4

20052000199519901985198019751970 2010196519601955

Fig. 2: Fund of funds volatility has been reasonably low

Source: Bloomberg, UBS WMR

Annualized Volatility, in %

0

12

8

16

BC HYBond Index

BC Gov.Bond Index

BCCredit Index

BCAggregateBond Index

HFRI Fund ofFunds Composite

Index

S&P 500

4

The implication of a low interest rate environment, simply put, is lower average portfolio returns across the board.

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For instance, volatility, market trends and corporate activ-ity are primary return drivers in relative value, managed futures and event-driven strategies, respectively. More generally, as Alex Friedman stresses in his section, alterna-tive strategies also typically earn a liquidity premium. With the exception of corporate activity, changes in economic growth typically have little eff ect on these factors and a low-growth environment can therefore enhance the tacti-cal appeal of such strategies. We believe most investors should initiate these investments through a diversifi ed allocation in alternative strategies, including relative value, event-driven, managed futures, global macro and equity long-short.

In addition to providing a way to reduce portfolio expo-sure to growth-related return drivers, alternative strategies are also well suited to help relatively conservative, typically fi xed income-oriented investors to incrementally diversify out of fi xed income exposure without materially alter-ing their risk budget. From a portfolio perspective, many multi-strategy hedge funds of funds are designed to pro-vide low-volatility exposure to alternative strategies. The realized volatility of the HFRI Fund Weighted Composite Index over the last 10 years has been about 5.5% per year – well within the range of U.S. bond market volatility dur-ing the same period (see Fig. 2). Alternative strategies also provide important diversifi cation benefi ts for portfolios that consist mainly of fi xed income and equities, and we currently recommend that conservative and moderately

conservative investors hold 9% and 11%, respectively, to alternative strategies.

2. Reach for yield, but beware carry trade cyclesIn an environment where yields remain structurally low, many investors will periodically be tempted to seek ad-ditional sources of yield as emphasized by Rick Rieder in his section. This usually means accepting some additional source of risk such as credit risk or interest rate risk – in exchange for a yield pickup. From a tactical perspective, such an approach can be profi table for some time but typically experiences performance reversals. Currently, we see relative value in the credit-sensitive portions of the fi xed income markets.

In its most extreme form, o en adopted by institutional investors, a strategy of reaching for higher yield involves investing in high-yielding securities while borrowing at a lower yield. Such a strategy is called a carry trade. As carry trades gain momentum and become widespread, prices of higher-yielding securities will be bid up (their yields bid down). However, such phases typically go too far, push-ing asset values into overvalued territory. Eventually, such trades are unwound, o en rather abruptly resulting in losses for investors that remained exposed to the underly-ing asset classes. Examples of such carry trades in recent history include the corporate credit bubble in the mid-to-late 2000s as well as the currency carry trade that was prevalent from 2003 to 2008 (see Fig. 3).

Fig. 3: Carry strategies go through cycles

Note: Credit Suisse FX Rolling Optimised Carry Index of Major 10 currencies, unfunded.Index tracks the performance of an optimised portfolio that is long high-yielding currenciesand short low-yielding ones. Source: Credit Suisse, BarCap, Bloomberg, UBS WMR

Credit Suisse FX Carry Index and US HY Corporate total return index

400

800

1200

1000

1400

600

80

160

240

200

280

120

2011200920072005200320011999

US High Yield corporates, total return (LHS)

FX Carry Trade Index (RHS)

Fig. 4: Growth premiums currently low

Source: IBES, Datastream, UBS WMR

PEG ratio: Price-Earnings divided by 5-year forward growth

US growth

US

EM

Non-US dev.

EMU

US value

UK

1.00.80.60.40.20.0 1.2

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For investors, the existence of carry trade cycles suggests some benefi t from market timing. While this can be achieved generally speaking by relying on comprehensive market research, the key ingredient of such an analy-sis involves gauging whether valuations have become exceedingly expensive. Turning back to the two examples above, in 2007, when carry trades peaked both the corpo-rate credit market (low credit spreads) and high-yielding currency markets (such as the Australian and New Zealand dollar) were at very expensive levels. Whether valuations are established by comparing asset prices to fundamental-ly derived measures of fair value or by comparing yields to their historic values, such analysis can help reduce expo-sure to higher-yielding market segments prior to possible reversals of carry trades.

3. Buy growth when growth is scarceDuring a multi-year period of substandard growth, we would expect a premium to be refl ected in segments of the global fi nancial markets that can deliver superior growth outcomes. Internationally speaking, emerging market (EM) equities fall into this category, given the structurally superior economic and earnings growth po-tential in the underlying economies. Domestically, growth stocks rather than value stocks are those that should be best positioned to deliver greater structural growth potential. The information technology and consumer eq-uity sectors – both cyclicals and non-cyclicals – are those commanding the greater growth-oriented characteristics. Finally, private equity investment vehicles can o en be viewed as following a growth strategy, as they seek to identify unlisted companies with strong growth prospects in need of fi nancing.

Currently, we believe that most growth-oriented invest-ments are not fully refl ecting the structural growth advantage they off er. This is illustrated in Fig. 4, which depicts the current Price-Earnings to long-term growth ratio (PEG ratio) for various equity markets. As a higher earnings growth trend justifi es a higher Price-Earning ratio, the PEG ratio is eff ectively a valuation metric that corrects for diff erent growth trends. Growth stocks have a lower PEG than value stocks at the moment, and EM equities appear cheaper than developed markets on this metric. In other words, the growth premium embedded in these market valuations is not high enough. This suggests

tactical opportunities within growth-oriented parts of the global stock market, namely EM equities as well as domestic growth stocks.

It is noteworthy that our conclusions regarding EM con-trast with Rich Bernstein’s, which are based on a com-parison of free cash fl ow yields. We believe, as George Magnus argues in his interview, that EM economies are in the process of economic convergence, whereby their GDP per capita levels are catching up with those of developed economies. leading to a protracted period of superior economic growth. While when translated into earnings growth the EM growth advantage is less spectacular, our PEG ratio analysis indicates that this advantage is currently not refl ected in market pricing.

However, it is worth stressing that growth-oriented strategies will not necessarily work continuously during low-growth phases. If such market segments become in demand for protracted time periods, they will eventu-ally grow expensive. The tech bubble of the late 90s is a reminder that one can pay too much for growth. So while a tactical opportunity currently exists, investors need to keep valuations in mind, along the same lines as our discussion of carry strategies above.

Wealth Management Research runs two stock lists that incorporate such considerations. The Q-GARP (quality growth at a reasonable price) is a growth stock list with a valuation overlay. The Dividend Ruler stock list includes stocks that off er attractive and stable dividend growth prospects, which is aligned with Rich Bernstein’s dividend compounding strategy, but adds the sustainable growth perspective as well.

Growth-oriented strategies will not necessarily work continuously during low-growth phases.

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ContributorsIn alphabetical order

Rich BernsteinRBARich is CEO of Richard Bernstein Advisors LLC. Prior to RBA, he served as the Chief Investment Strategist at Merrill Lynch, where he joined in 1988, and he held positions at E.F. Hutton and Chase Econometrics/IDC. Among other awards, he’s been voted to Institutional Investor’s “All-America Research Team” 18 times and has written two books. He serves as a trustee and sits on the Investment Committees for the endowments of the Alfred P. Sloan Foundation and Hamilton College. Rich holds a BA in economics from Hamilton College and an MBA in fi nance from NYU.

Michael Crook, CAIA UBS As Head of Investment Strategy, Michael advises on global invest-ment strategy, asset allocation and portfolio construction. Before join-ing UBS in 2010, he was a Senior Investment Strategist at Barclays and Lehman Brothers, where he man-aged discretionary portfolios. He has authored over 100 articles on asset allocation and investment strategy and is a frequent media commentator. A Chartered Alternative Investment Analyst, Michael earned a BS and MA in economics at the University of Georgia and NYU, respectively.

Mohamed El-Erian, PhD PIMCO Mohamed A. El-Erian is CEO and co-CIO of PIMCO. He re-joined PIMCO at the end of 2007 a er serving for two years as president and CEO of Harvard Management Company. He fi rst joined PIMCO in 1999 and was a senior member of the company’s portfolio management and investment strategy group. Before coming to PIMCO, Dr. El-Erian was a managing director at Salomon Smith Barney/Citigroup in London and before that spent 15 years at the International Monetary Fund in Washington, D.C. Dr. El-Erian has pub-lished widely on international econom-ic and fi nance topics. His book “When Markets Collide” was a New York Times and Wall Street Journal best-seller and also won multiple awards. He was named to Foreign Policy’s list of “Top 100 Global Thinkers” for 2009 and 2010 and has also served on several boards and committees. He holds a master’s degree and doctorate in economics from Oxford University and received his undergraduate degree from Cambridge University.

Stephen Freedman, PhD, CFAUBSSince joining UBS in 1998, Stephen has served as an economist and public policy analyst in a range of positions. Since 2004, he has been an Investment Strategist within Wealth

Management Research, and in 2007 he transferred from Switzerland to the Americas team as Global Investment Strategist. He has been featured in many media outlets, including PBS and Reuters TV, and has been quoted in Investment News and The Wall Street Journal, among others. He earned a PhD in fi nancial economics from the University of St. Gallen in Switzerland, following a master’s degree in eco-nomics and business administration from the same institution.

Alex FriedmanUBSIn his role as Chief Investment Offi cer of UBS Wealth Management, Alex oversees the investment policy and strategy for approximately $900 billion in assets. He is the former CFO of the Bill & Melinda Gates Foundation and a member of the foundation’s manage-ment committee. Additional roles have included managing a private investment vehicle, Asymmetry, serving as a senior advisor to Lazard, and serving as senior advisor to the board of directors of Actis, a global private equity fi rm. He served as a White House Fellow in the Clinton Administration and is represent-ed on multiple boards of trustees. He holds a JD from Columbia Law School, an MBA from Columbia Business School, and a BA from Princeton.

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Katie Klingensmith UBS Katie is currently a member of the UBS Wealth Management Research macroeconomics team posted in San Francisco, contributing to foreign ex-change and economic policy research, as well as representing global research views to clients on the West Coast. She has worked in Zurich for the foreign exchange research group of UBS WMR, at the US Treasury Department as an international economist and at the Federal Reserve Board on liquidity risk and payment system policy issues. She holds a master’s in public policy from Harvard University’s Kennedy School and an undergraduate degree in his-tory, public policy and Latin American studies from Swarthmore College.

George Magnus UBSGeorge is the Senior Economic Advisor at UBS Investment Bank. Previously, he had served as the Chief Economist with eff ect from the merger of UBS and Swiss Bank Corporation (SBC). He also has had roles at S.G. Warburg, Chase Securities, Bank of America, Lloyds Bank International, the UK Government’s Central Offi ce of Information, and he has taught at Westminster University and the University of Illinois. His 2008 book “The Age of Aging” was published by John Wiley in Asia, Europe and North

America. He received an MSc econom-ics from the School of Oriental and African Studies and did postgraduate research at the University of Illinois.

Rick Rieder BlackRockAt BlackRock, Rick serves as the CIO of Fixed Income and Fundamental Portfolios as well as the head of its Corporate Credit and Multi-Sector and Mortgage Groups. Before join-ing BlackRock in 2009, he was the founder, president and CEO of R3 Capital Partners, a multi-strategy credit hedge fund with $1.5 billion in assets under management. From 1987 to 2008 he was with Lehman Brothers, and has also served as Vice Chairman of the Borrowing Committee of the US Treasury. Additionally, he is a member of the Board of Trustees and Investment and Finance Committee for both Emory University and Emory’s Goizueta Business School. He earned a BBA in business from Emory and an MBA from the University of Pennsylvania.

Mike Ryan, CFA UBS Mike is Chief Investment Strategist (CIS) for Wealth Management Americas, Head of Wealth Management Research Americas and Chairman of the WMA Investment

Committee. As CIS, Mike is respon-sible for bringing together market and investment insights from multiple sources and positioning them so as to optimize impact for UBS clients. As Head of Wealth Management Research Americas, Mike directs teams of invest-ment strategists and analysts dedicated exclusively to serving the investment needs of individual investors. Mike appears regularly on CNN, CNBC, PBS, TV Tokyo and Bloomberg Television. He is frequently quoted in The Wall Street Journal, Dow Jones News Services, Reuters, Financial Times, Nikkei News and Bloomberg. He holds an MBA in fi nance from the University of Rochester’s William E. Simon Graduate School of Business Administration and a BA in political science/economics from Rochester as well.

AppendixDisclaimer The views of third party, non-UBS personnel expressed in this report do not necessarily refl ect the views of UBS or any of its business areas, including Wealth

Management Research. This publication is for your information only and is not intended as an off er, or a solicitation of an off er, to buy or sell any investment

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