Capital Market Assumptions

Global Investment Solutions Capital Market Assumptions
February 2005
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February 2005
Capital Market Assumptions
Contents 1. Introduction 2. Risk Estimates 2.1 Assumptions 2.2 Historical Data 2.2.1 Historical Volatility as a Proxy for Future Risk 2.2.2 Degree of Freedom Problem 2.3 Consistency 2.4 Factor Approach 2.4.1 Two-Layer Approach 2.4.2 Multi-Layer Approach 2.5 Qualitative Judgment vs. Quantitative Inputs 2.6 About Alternative Assets 3. Returns 3.1 Introduction 3.2 Integration/Segmentation Approach 3.3 Illiquidity 3.3.1 Issue 3.3.2 Sharpe Ratio Approach 3.3.3 Improved Put Option Approach 3.3.4 Results 3.4 Return Summary References 2 2 2 3 3 3 3 4 4 5 7 7 9 9 9 9 9 10 10 10 11 12
2005 UBS Global Asset Management (Americas) Inc., a member of UBS AG - All rights reserved.
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1. Introduction One of the most important decisions investors need to make is determining their asset allocation. This sets the portfolio composition in terms of asset classes, such as US stocks, European stocks, US bonds, etc., for reasons of achieving the best risk-return ratio. Further, it includes both the long-term average or so-called "normal" allocation, and the size and duration of temporary deviations. First of all, we need to define the relevant investment universe. In their seminal article, Brinson, Diermeier and Schlarbaum formulate "admission" criteria to the universe of investable assets.1 The criteria are:
Analytical Adequate Control and Regulation Marketability and Liquidity Meaningful Impact Nonredundant Manageable Estimation Risk Legal Talent Availability
Emerging Mkt Equities 0.9%
US Equity 17.2%
Private Markets 0.2% Cash Equiv. 5.2% US Real Estate 5.7% High Yield Bonds 1.1%
All Other Equities 15.6%
Emerging Mkt Debt 2.1%
Dollar Bonds 27.8%
All Other Bonds 24.2%
That is, first we estimate the average risks and correlations. Thereafter, the returns are estimated as a function of the risk structure. On the other hand, as we do not live in an entirely efficient world, we must allow for return-generating factors other than risk and correlation. The two other main return-generating sources are the degree of segmentation and illiquidity. Segmentation states the extent to which a market's capital in- and outflows are hampered by legal and practical barriers; illiquidity describes lock-in periods for investors, constraining their investment flexibility. In a rational context, investors expect to be compensated for segmentation and illiquidity. It is the objective of this paper to explain how we estimate our long-term policy covariance matrix, which is an instrumental input for The long-term return estimates; and The construction of the normal allocation. In turn, we receive the derivation of the long-term average rates of return that are essential for the Construction of a normal allocation; and Valuation. 2. Risk Estimates 2.1 Assumptions We assume implicitly that risk is measured in terms of standard deviation. We are aware of the fact that risk is one word,4 but not one number. That is, risk has various facets such as return span, downside risk, kurtosis, skewness, changing states, etc. But as there is justification for these various measures in specific contexts, we do not think they are overly relevant in the classical top-down world of asset
Based on these criteria, e.g., it would not make sense to invest in a market that provides economic value, but has no viable legal system to protect ownership of this value. Brinson, Diermeier and Schlarbaum considered over 80 asset classes and subclasses for inclusion in their Multiple Markets Index (MMI). They describe the investable capital market as "primary wealth generating assets where sufficient markets have developed and legal hurdles do not prohibit meaningful investment by tax-exempt investors".2 This definition then led to the inclusion of five asset classes: equity, venture capital, fixed income, real estate, and cash; more recently, we added high yield bonds, emerging markets bonds, and emerging markets equity. Given the relevance of what has become a $800 billion industry, we should include hedge funds as well. But for reasons of double-counting assets, we exclude these from the universe.3 As of 2003, this implies the following investable capital market, as shown in the right-hand column. Once the universe is identified, both the derivation of the average long-term portfolioi.e., the policy or "normal" portfoliothe valuation of the individual markets require the long-term rates of return as an input. These in turn depend on their risks and correlations.
1 [2] Brinson, Diermeier and Schlarbaum (1986), p.17. 2 [2] Brinson, Diermeier and Schlarbaum (1986), p.17. 3 Theoretically, hedge funds are strategies rather than an asset class. That is, they are built on the basis of already existing asset classes. 4 Quote of Harry M. Kat, Q-group conference, Scottsdale, AZ, 2003.
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allocation. In the following sections, we describe our process for: Modeling the policy covariance matrix; Modeling the long-term sustainable returns; and Discussing the main issues in this process. 2.2 Historical Data 2.2.1 Historical Volatility as a Proxy for Future Risk In practice, there is usually a historical investigation at the beginning of every risk analysis. Too often, unfortunately, this simply means that the analyst in charge extends the past into the future without much further reflection. Hasty shortcuts like this are not necessarily justified, as it is easily possible, for instance, that some market provided a high average return at a low volatility over some examination period, while another market produced little or even a negative return at a high volatility. That is, the ex-post observation is not necessarily consistent with the according ex-ante expectation that ultimately determines pricing. Rather, observed volatility may turn out significantly different from expected risk. This does not mean that historical estimates per se are inappropriate proxies for future expectations. But instead of serving as a proxy in the first place, they should be considered as a starting point for a discussion. If we find no justification for a change going forward, it is fine to project the historical estimates into the future. 2.2.2 Degree of Freedom Problem The estimation of historical correlations requires the number of observations to be larger than the number of variables. Assume the simplest case to be where you observe two markets twice. Every market is represented by an axis in a plane, and the observations are marked by dots. Since a straight line is defined by two (different) dots, there is always a perfect regression line in the case of two observations and two markets only, hence, implyingtechnicallya perfect correlation. As a result, we estimate a correlation of 1, even if the markets are uncorrelated. Hence, there is no correlation information in two observations only. A more formal explanation is the observation that a straight line is a 1D subspace of a 2D plane. Hence, we need at least three observations.
Market 1
Regression Line
Observation 2
Observation 1 Market 2
In the case of three observed markets, this means that we need at least four observations, as three observations only are located in a plane, i.e., a 2D subspace of the 3D space. However, the degree of insufficiency could even be worse, if all dots lined up perfectly, in which case they would be located in a one-dimensional subspace. On the other hand, nothing prevents us from calculating pairwise correlations, but in case of insufficient observations, the resulting correlation matrix is of limited use, even if not immediately evident.5 As we may deal with many variables in practice, the degreeof-freedom problem often requires long data series. However, this may turn into another problem: Most likely, long data series cover various regimes. Time series of the required length may not be available. In order to get a data series of the required length, the analyst may be tempted to increase the frequency (weekly or even daily). Data of higher frequency are more sensitive to asynchronism. As a result, high-frequency data tend to produce lower correlation estimates. 2.3 Consistency Another important question is whether to set the correlation matrix directly or by some methodology. In the case of a small matrix, it is no challenge to set the correlations directly. But we should not underestimate the consistency problem. Assume the following correlation matrix:
Market 1 Market 1 Market 2 Market 3 1 -1 -1 Market 2 -1 1 -1 Market 3 -1 -1 1
5 In this case, a row of the matrix is a linear combination of other rows. Technically, this is revealed through the so-called eigenvalues of the matrix. For the theory of
eigenvalues, see [6] Hamilton, pp. 729-732.
7
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However, mutual correlations of -1 between all three markets are not possible. Namely, if market A and B are diametrical and market B and C are diametrical, then Market A and C are identical. Hence, the above matrix reflects an unfeasible correlation pattern. It is an inconsistent matrix. There are, thus, constraints. What may look like a real correlation matrix at first inspection is not necessarily feasible in reality. But while the above example is intuitive, there are less obvious border cases in practice. Are, for instance, mutual correlations of -0.51 feasible? No. Mutual correlations of -0.50, on the other hand, are feasible. While dealing with three markets means dealing with three relations only, we are able to set a consistent correlation structure without theory. But as the number of markets increases, the number of relations explodes at some point, and, hence, it becomes impossible to set a consistent matrix directly. For a large matrix, it may be still possible, if all correlations are fairly high and of similar size, but this does not apply to a market covariance matrix. Clearly, we need a methodology for setting a consistent matrix. 2.4 Factor Approach 2.4.1 Two-Layer Approach Our methodology separates the generation process into several manageable steps and ensures consistency. It is a socalled factor approach. In order to understand it, we offer the following example: Assume that the risks of the investable universe are driven by two factors only, global equity and global bonds. In this case, we start the modeling process with a 2 x 2 covariance matrix, F, between global equity and global bonds. Assuming a 14% risk for global equity and 4% for global bonds, and a correlation of 0.30 between them, this implies the following covariance matrix.
Global Equity Global Equity Global Bonds 0.0196 0.0017 Global Bonds 0.0017 0.0016
to a 100 basis point move of global equity, the corresponding position in the loadings matrix is 110%. In addition, every market has usually some risk that is not explained by the factors. It is called idiosyncratic or residual risk. Here is a hypothetical example consisting of five markets only:
Global Equity Market A Market B Market C Market D Market E 110% 105 90 0 0 Global Bonds 0% 0 0 103 99 Residual Risk 10.0% 8.0 7.0 1.2 0.9
Apparently, market A is an equity market, as it only loads on global equity. On the other hand, a zero sensitivity versus global bonds does not necessarily mean it is uncorrelated with global bonds. Rather, it only claims that global bonds is not one of A's drivers. Through the positive correlation between global equity and global bonds, market A is still positively correlated with global bonds, albeit very moderately. Ultimately, the market covariance, M, is calculated as follows:6 M = LFL' + diag (R2) (1) The first term captures the systematic risk contribution to the covariance matrix, and the second term the nonsystematic risk contribution. Further, as usual, risks are added geometrically. An invaluable advantage of the factor-approach is the fact that M is consistent as long as F is consistent, no matter how the sensitivities and residual risks are set. Namely, every market istechnicallyabsolutely free in terms of its responses to factor movements and its independent moves. On the other hand, consistency of F is no challenge, as it is a 2 x 2 matrix only. To sum up, we have presented so far a two-layer approach with the factors on the first layer and the markets to be modeled on the second layer.6
Layer 2: Markets Markets A, B, C, D and E
This is a factor covariance matrix, as it contains the driving factors only. Next, in order to derive the market covariance matrix, we need to know how the markets respond to factor movements. These responses are reflected by the socalled sensitivity or 'loadings' matrix, L. Essentially, L contains the betas of the modeled markets with regard to the factors. If market A moves by 110 basis points in response
Layer 1: Factors Global Equity Global Bonds
6 Diag (R2) means a squared matrix with R2 in the diagonal and zeros elsewhere. 7 The two-layer concept goes back to [5] Grinold and Kahn (1995) who employ it for stock modeling. For more detail, see p. 58f.
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2.4.2 Multi-Layer Approach In practice, a two-layer approach is not sufficient. Assume, for instance, you model various real estate sectors such as apartment, industry, office, and retail. These are highly mutually correlated, but they only have moderate correlations with all other markets. In order to differentiate them sufficiently from the other markets, we need to add substantial residual risk to them. On the other hand, much residual risk differentiates them among themselves. As a result, the mutual correlations between the real estate sectors turn out low. This is not what we want to achieve. In short, the challenge of modeling this particular constellation cannot be mastered by a two-layer approach. The point is that at one end of the spectrum there are very broad factors, and at the other end there is much fine-tuning. Ultimately, the world is driven by more than just two factors, but the perception of "factor" depends on the layer we are looking from. Two factors may be sufficient, but only for modeling the next level of granularity after global equity and global bonds, which is still very broad. Global equity is sufficient to model global sectors, but not individual stocks. Clearly, we cannot go all the way from the broadest aggregates to all the fine-tuning with one step only. Rather, we have to go through several layers.
This scheme allows modeling through as many layers as needed. The process resembles the organic growth of a tree from the very root all the way up to its leaves. Assigning aggregates to selected layers is trickier than it may seem at first inspection, as it leaves much room for interpretation, and, hence, requires judgment. On the other hand, there are clear constraints. As a national real estate market, for instance, is driven (to some extent) by its national stock market, it must be modeled on a consecutive layer. Actually, our covariance matrix is based on a six-layer approach, involving the following aggregates:
Layer 6 # of Aggregates Aggregates 66 National early stage venture capital markets National late stage venture capital markets National LBO markets National mezzanine markets National distressed debt markets U.S. hedge fund strategies U.S. private real estate sectors U.S. REITs sectors 22 National corporate bond markets National inflation protected bond markets National real estate markets Regional timber factors Regional farmland factors 4 82 National equity markets National bond markets National cash markets National currency markets 3 25 10 equity sectors Regional currency factors Country factors 2 13 Broad regional bond factors Broad equity sectors Global currency factors Global real estate factor Global timber factor Global farmland factor 1 5 Global equity factor Global bond factor Broad regional factors
Layer 6 Layer 5 Layer 4 Layer 3 Layer 2 Layer 1
Hence, while modeling European equity and US early-stage venture capital on the same layer does not seem appropriate from a practical perspective, this is not even feasible from a theoretical point of view. For these reasons we need to replace the two-layer approach by a multi-layer approach. Technically, it is straightforward: The covariance matrix, M, as derived on the basis of F, L and R, is considered the input matrix for generating the third layer. Then we define new matrices L and R that contain the sensitivities and residual risks of the next layer aggregates. Finally, we calculate equation (1) with the new set of input variables F, L, and R; as a new output, we get layer 3.
Again, the resulting covariance matrix is on a market level. The risks and betas on the market level are revealed in the return table in section 3. Ultimately, through aggregation, we get the covariance matrix on an asset class level, as shown on page 5.8
8 The covariance matrix on a market level has a dimension greater than 200 x 200, and is, hence, too large to be presented in this paper.
Risk
GIM (Hedged)
GSMI
BVG *)
CAPS **)
US Equity
US Bonds
ex-US Equity (Hedged)
ex-US Bonds (Hedged)
Emerging Markets Equity
Emerging Markets Bonds
US High Yield Bonds
US Private Equity
UK Private Equity
US REITS
US Real Estate
US Timber
US Farmland
US Hedge Funds
ex-US Real Estate
GIM (Hedged) 0.91 0.92 0.67 0.84 0.66 0.82 0.61 0.65 0.45 0.57 0.79 0.64 0.47 0.43 0.35 0.26 0.24 0.39 0.49 0.47 0.68 0.30 0.16 0.37 0.23 0.29 0.28 0.29 0.19 0.30 0.06 0.24 0.03 0.19 0.10 0.14 0.26 0.27 0.16 0.27 0.20 0.19 0.05 0.21 0.16 0.35 0.38 0.25 0.35 0.22 0.31 0.09 0.29 0.19 0.21 0.17 0.14 0.18 0.36 0.44 0.26 0.34 0.27 0.30 0.16 0.28 0.20 0.23 0.45 0.52 0.33 0.46 0.17 0.40 0.08 0.34 0.19 0.24 0.43 0.33 0.33 0.25 0.26 0.28 0.74 0.73 0.88 0.62 0.17 0.78 0.19 0.54 0.25 0.33 0.60 0.85 0.89 0.60 0.87 0.31 0.75 0.16 0.63 0.35 0.45 1.00 0.60 1.00 0.32 0.24 0.25 0.16 0.19 0.51 0.53 0.53 0.35 0.48 0.47 0.41 0.33 0.37 0.30 1.00 0.45 0.33 0.41 0.41 0.26 0.35 0.45 0.30 0.27 0.31 1.00 0.30 0.35 0.25 0.19 0.24 0.43 0.32 1.00 0.85 0.19 0.15 0.14 0.29 0.71 0.71 0.58 0.65 0.28 0.68 0.15 1.00 0.31 0.37 0.63 0.54 0.34 0.32 0.30 0.22 0.17 0.73 0.27 1.00 0.15 0.27 0.33 0.16 0.19 0.08 0.16 0.28 0.20 0.23 0.33 0.24 0.85 1.00 0.17 0.14 0.10 0.28 0.86 0.86 0.79 0.79 0.20 1.00 0.27 0.68 0.30 0.41 0.75 0.78 0.40 0.30 0.41 0.41 0.21 0.30 1.00 0.20 0.73 0.28 0.45 0.47 0.31 0.17 0.17 0.27 0.22 0.31 0.09 0.29 0.19 0.21 0.33 0.25 0.19 0.17 1.00 0.14 0.10 0.12 0.93 0.93 0.64 1.00 0.30 0.79 0.17 0.65 0.35 0.48 0.87 0.62 0.46 0.34 0.35 0.81 0.78 1.00 0.64 0.21 0.79 0.22 0.58 0.26 0.35 0.60 0.88 0.33 0.26 0.25 0.16 0.27 0.20 0.19 0.05 0.21 0.16 0.17 0.25 0.16 0.15 0.14 0.14 1.00 0.08 0.08 0.99 1.00 0.78 0.93 0.41 0.86 0.30 0.71 0.41 0.53 0.89 0.73 0.52 0.44 0.38 0.27 1.00 0.99 0.81 0.93 0.41 0.86 0.32 0.71 0.41 0.53 0.85 0.74 0.45 0.36 0.35 0.26 0.28 0.29 0.19 0.30 0.06 0.24 0.03 0.19 0.10 0.14 0.26 0.19 0.14 0.10 0.10 0.08 1.00 0.09
6.44%
1.00
0.91
0.92
0.67
0.84
0.66
0.82
0.61
0.65
0.45
0.57
0.79
0.64
0.47
0.43
0.35
0.26
0.24
0.39 0.49 0.47 0.68 0.30 0.16 0.37 0.23 0.29 0.14 0.18 0.28 0.51 0.29 0.28 0.12 0.08 0.09 1.00
6.67% 7.41% 7.81% 7.56% 8.13% 5.78% 8.08% 5.60% 10.00% 7.09% 6.63% 15.04% 14.71% 7.01% 6.67% 8.23% 7.67% 7.04% 7.25%
GSMI
10.41%
BVG *)
10.20%
CAPS **)
14.41%
US Equity
15.00%
US Bonds
5.68%
ex-US Equity (Hedged)
13.89%
Market Covariance Matrix Aggregated to Asset Classes The risks and betas on the market level are revealed in the return table in section 3. This table is the result of aggregating the market covariance matrix.
ex-US Bonds (Hedged)
4.77%
Emerging Markets Equity
21.91%
Emerging Markets Bonds
12.00%
US High Yield Bonds
9.00%
US Private Equity
26.12%
UK Private Equity
28.91%
US REITS
12.16%
US Real Estate
9.99%
US Timber
13.70%
US Farmland
13.50%
US Hedge Funds
5.67%
ex-US Real Estate
12.67%
* Risk from CHF perspective: 6.1%
** Risk from GBP perspective: 12.2%
Return
Capital Market Assumptions February 2005
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2.5 Qualitative Judgment vs. Quantitative Inputs Although sounding fairly mechanical, our modeling process is just the framework that ensures a consistent covariance matrix. Consistency, however, only means free of internal contradictions, but not necessarily accuracy. In the end, setting concrete numbers is a decision. Numbers must be deliberated. In spite of implying objectiveness and precision, numbers are based on judgment, no matter whether explicit or implicit. Consider, for instance, rolling volatility estimates of the S&P 500 Index, based on monthly or quarterly returns: Rolling 3-Year Volatility of the S&P 500
30%
Consider the following analogy: A bat is flying through a dark tunnel. While it is in the tunnel, you cannot see it.
Tunnel Tunnel
But the fact that you cannot see it, does not mean that it does not move up and down on its flight through the tunnel.
20%
10%
Monthly Data
Quarterly Data
0% Dec-72
Dec-77
Dec-82
Dec-87
Dec-92
Dec-97
Dec-02
Source: Standard & Poors
Now, if we conclude that historical estimates are a reasonable proxy for future expectations, who tells us in the end what frequency and observation span we should use? Again, historical estimates are an accurate starting point for a discussion, but accepting them as a forward-looking expectation is a decision. It cannot be delegated and requires qualitative judgment. A good example of qualitative judgment is the correlation between US equity and US bonds. Based on data between the mid 1970s and 1998, we estimate a correlation of more than 0.40. But since inflation is one common factor of stock and bond returns, and we may not feel that inflation shocks similar to the 1970s will happen again in the medium term, we think a realistic forward looking correlation will be smaller than 0.40. We set it to 0.30. 2.6 About Alternative Assets The perception of alternatives is quite often that they not only yield high returns and low risk, but that they also hardly correlate with traditional asset classes. This perception is due to the fact that the according data show little volatility and correlation. The reason is that alternative assets are not traded on stock exchanges, and continuously observable market data are thus not available.
The time in the tunnel corresponds to the illiquidity span of the alternative asset. The price at which the asset would be traded goes up and down. You just cannot see it, because it is not traded. The point of time when the asset becomes liquid corresponds to the end of the tunnel. Then you see the true price, as you can see the bat's true position. In the context of venture capital, for instance, the end of the tunnel can be the IPO. The reason for the inaccuracy of data for alternative assets is the fact that they are appraisal-based, which is tricky, as appraisals tend to be overly smooth. Indices for real estate, private equity and natural resources were created for measuring return rather than risk. Once alternative investments are involved in risk estimates, the consequences of historical estimates are intensified. For alternatives, the main issue is not whether the past is a good indicator for the future; rather, the problem is that the past is not even correctly recorded. As an illustration, between 1981 and 2004, we calculate volatilities of 16.3% for the S&P 500 and 15.0% for venture capital. Meanwhile, the average annual returns for the same period are 12.8% and 15.8%, respectively.
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Such numbers suggest a free lunch for venture capital: More return for less risk. Hence, we should not trust them, and we need to find other approaches for estimating the risks and correlations of alternative investments. In order to triangulate the "true" risks, we apply several heuristic approaches. The following documents one of them: The S&P 500 provided the following quarterly returns between 1981 and 2004, wherein the crash of 1987 stands out: Quarterly S&P 500 Returns between 1981 and 2004
30% 20% 10% 0% -10%
Overall, only 17 negative quarters are reported, and we estimate an annual volatility of 15% and a correlation with the S&P 500 of 0.41. As rational investors are compensated for taking more risk, the risk of the better-performing venture asset class should be greater. Specifically, the fourth quarter return of 1987 demonstrates how the strongly lagged appraisals reduce volatility. We would expect the opposite, i.e., substantially higher venture capital returns as a compensation for the burden of higher risk. The idea of this heuristic approach is to rescale the reported venture capital return data such that their dispersion is increased, but the mean is unchanged. The point is that the larger the rescaling, the larger the number of negative quarterly returns. The next figure shows the same returns but rescaled by a factor of 2. Quarterly US Venture Capital Returns between 1981 and 2004 Rescaled
30%
-20%
20%
-30% Mar-81 Mar-84 Mar-87 Mar-90 Mar-93 Mar-96 Mar-99 Mar-02
10% 0% -10%
Source: Standard & Poors
We count 26 negative quarters. On the other hand, based on Venture Economics data, the index-based quarterly venture capital returns over the same period are considerably smoother. Venture capital also seems unaffected by the crash, according to a reported return of -0.2% in the fourth quarter of 1987: Quarterly US Venture Capital Returns between 1981 and 2004
30% 20% 10%
-20% -30% Mar-81
Mar-84
Mar-87
Mar-90
Mar-93
Mar-96
Mar-99
Mar-02
Source: Venture Economics
The data series manipulated like this provides 38 negative quarters. Overall, we find:
Rescaling Factor S&P 500 1.0 1.0 Venture Capital 1.5 2.0 2.5 3.0 Shortfalls 26 17 33 38 42 44 Risk 16.3% 15.0% 22.5% 30.1% 37.6% 45.1%
0% -10% -20% -30% Mar-81 Mar-84 Mar-87 Mar-90 Mar-93 Mar-96 Mar-99 Mar-02
Source: Venture Economics
This experiment suggests that venture capital's risk is probably a multiple of index-based volatility estimates, given that venture capital is subject to more shortfalls than the S&P 500. In the end, we propose risks of 43% for early-stage venture capital, 34% for late-stage venture capital, 29% for LBOs, 20.5% for distressed debt, and 18% for mezzanine investments.
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The key is to model the risks of alternative investments as if they were liquidthat is, through their exposure. This means that the price of alternatives moves in the same manner as does the price of constantly traded assets. The fact that an investor needs to hold on with the exposure to the risks of alternative assets means that he faces a wider price distribution once the asset can be liquidated (i.e., at the end of the "tunnel"). The wider distribution is the result of compounded instantaneous risks. In a rational world, we expect this to be compensated. 3. Returns 3.1 Introduction As mentioned previously, returns must be estimated after the risks and correlations, as returns depend on them. Our main approach for return modeling is the integration/segmentation approach. Further, in the case of alternative assets, we need to compensate illiquidity. As the literature does not provide ready-to-go approaches, we derive two proprietary approaches, which can be combined with the integration/segmentation approach. 3.2 Integration/Segmentation Approach9 A cornerstone in finance, and generally accepted as an equilibrium model, the Capital Asset Pricing Model (CAPM) is usually the approach of choice for estimating risk premia. It claims that every asset is rewarded by a risk premium proportional to its beta versus the entire market plus a risk-free return, that is:
These barriers are not necessarily erected by law; rather, they may reflect investor preference. Such restrictions on capital in- and outflows tend to create markets that are dominated by local investors, and, in the most extreme case, i.e., if a market is completely segmented, its own risk becomes its compensation reference, because there are no substitution opportunities. That means that the market's absolute rather than systematic risk is compensated:
Ri =
i M
(R M R f ) + R f
11
(3)
Of course, complete segmentation is as fictitious as perfect integration. Therefore, in practice, it is important to estimate a market's degree of integration. The according return is considered a weighted average of perfect integration and absolute segmentation. That is:
R i,weighted = w int R i,int + w segR i,seg

where the two weights sum up to 100%.
(4)
Both approaches require the global price of risk as an input. Singer and Terhaar12 have spent a considerable amount of time for estimating it. While they recommend a price of 0.30% return per 1% of (compensated) risk, we adopted 0.25%. A few years later, Goodall, Manzini, and Rose13 revisited this issue on the basis of different macro models and recommended a price of 0.28% return per 1% risk, which was never approved. However, given the large error margins of macro models, this is not significantly different from what we have in place. While we set a degree of segmentation as low as 20% for developed equity and bond markets, we think it is relatively high for less developed and alternative markets. As of now, the most extreme degree of segmentation is set to 60% for Latin American timber. Probably more important than the absolute values of the degrees of segmentation, however, are their relative values. According misrankings would most likely cause serious policy misallocations. 3.3 Illiquidity 3.3.1 Issue The integration/segmentation approach characterizes liquid assets fairly well, but for alternative investments, we need to model illiquidity compensation as well. There are different perceptions about illiquidity. Illiquidity as relevant to our case does not mean that assets can only be traded at the cost of significant bid-ask spreads. Rather, it applies to
Ri = i,M (RM R f ) + R f
(2)
Based on the criteria of Brinson, Diermeier and Schlarbaum,10 we define the Global Investable Market (GIM). In contrast to a common US-biased global balanced portfolio, GIM has less exposure to US assets (particularly US equity). On the other hand, GIM contains alternative assets, which are mainly, but not exclusively, represented by US real estate. The CAPM, however, assumes perfect markets, and is thus not an appropriate representation of the real world. While the US equity market approaches a state of high integration, it does not meet it perfectly. Barriers to international capital flows have come down, but they still exist to some extent, and many asset markets are still significantly segmented by national borders.
9 This approach is documented at length in [7] Singer and Karnosky (1993). 10 [2] Brinson, Diermeier and Schlarbaum (1986), p.17.
11 Where i indicates an individual market and M the entire market. Rf is the risk-free rate of return 12 [8] Singer and Terhaar (1997), pp. 44-52. 13 [4] Goodall, Manzini, and Rose (1999), pp. 4-10.
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assets that cannot be traded at all for quite some time, as they are completely locked up. Traditional finance does not provide answers with regard to illiquidity compensation: The CAPM assumes perfect markets and, hence, ignores the "real world issue" of illiquidity. Hence, we derive two proprietary methods.14 3.3.2 Sharpe Ratio Approach The key point of this approach is the fact that a one-period Sharpe Ratio is an inappropriate measure of the compensation for risk when assets cannot be liquidated after one period. Consequently, the liquidity premium should be derived in the context of an asset's time horizon, and it can be shown that its multiperiod Sharpe Ratio (MPSR)that is, the asset's multi-period wealth in excess of the wealth generated by the risk-free investment (i.e., compounded return over compounded cash return)is a nonlinear function of time. Sharpe Ratio
1.20
Sharpe Ratio
1.20
0.80 SR1 0.40 SR2
0.00 0 5 10 15 20 25 30 35 40 45 50 Illiquidity Horizon (Years)
3.3.3 Improved Put Option Approach Considering the value of a risky asset with all dividends reinvested, the difference between the asset's expected value and median value increases with an increasing horizon. We call the difference the holding effect; it applies to both liquid and illiquid assets. The Put Option Approach15 claims that free insurance of the expected value versus the median valuei.e., the average portion gained through holdingis a fair compensation for the commitment to stay exposed to this asymmetric return pattern.16 In contrast to the Sharpe Ratio Approach, the Put Option Approach only relates to the asset's own risk and return properties. 3.3.4 Results
SR1
0.80
SR2
0.40
0.00 0 5 10 15 20 25 30 35 40 45 50 Illiquidity Horizon (Years)
Investing in liquid assets, the investor has the option of frequent rebalancing. On the other hand, with illiquid investments, the investor is "locked in," and, as a consequence, instantaneous rebalancing between the traded-asset market portfolio and the alternative assets is not possible. We think there is no incentive to invest in the illiquid alternative investments unless the MPSR - the risk-adjusted wealth - for its horizon is as high as the MPSR for the reference market, which is the entire market. In the above graphs, SR1 is the MPSR of the reference portfolio, and SR2 is the MPSR of the alternative asset in the case. While in the first graph, SR2 is not adjusted for illiquidity, it is adjusted in the second graph. Overall, through an increase in the liquidity premium, SR2 is lifted. We lift it such that the resulting total return of the illiquid asset equals the total return of the reference market for the given lock-up span (in our example about 5 years).
While the risk estimates are determined by the underlying covariance structure and the capitalization weights, the determination of the illiquidity horizon is more challenging. For venture capital, for instance, the illiquidity span in a duration-sense is much shorter, as not all capital is invested at the very beginning and the investment starts to generate cash flows after a few years. Based on both approaches, we find that the larger the risk and illiquidity horizon, the larger the return and the steeper the return function. Ultimately, both can be translated into our standard framework of integration/segmentation for liquid assets, in that we calculate them with both total and systematic risk and take the weighted mean. While illiquidity compensation turns out to be substantial for assets with long illiquidity spans at high risk, low-risk assets only get moderate liquidity premia, no matter how long the lock-up period. Venture capital clearly gets the highest compensation due to its high risk, combined with a significant lock-up time. Further, the low illiquidity premia for real estate and timber are due to low total and systematic risk.
14 These are documented at length in [9] Staub and Diermeier (2003). 15 The Put Option Approach is our response to other put option approaches that arein our opiniontoo generous or not generous enough, depending on the length of
the lock-up.
16 "Commitment to stay exposed" is just a more technical definition of investing in an illiquid asset.
10
February 2005
However, real estate and natural resource investments are mainly driven by diversification purposes and their capability to hedge against inflation rather than for boosting return. 3.4 Return Summary A high segmentation premium is due to the combination of a high risk and a low degree of integration. Hence, emerging markets equity and venture capital provide by far the highest compensation for segmentation. The most outstanding return numbers are probably the returns for early-stage venture capital. However, note that 'early-stage' is a relatively short period with anonetheless long lock-up and a very high risk; therefore, the high illiquidity compensation. Hedge funds do not seem to achieve particularly high risk and illiquidity premia. The reason is that we model, consequently, on a passive basis in order to put everything on an equal footing; and we do not expect hedge funds to provide a significant illiquidity compensation as their lock-up is short. Finally, both the risk premium and illiquidity premium for real estate are moderate, since real estate's risk and correlation are moderate. Again, the prime motivation to invest in real estate is diversification. Note, never compare absolute asset returns per se. You should always put returns in relation to their beta and lockup, since the 'competitiveness' of returns is clearly a relative issue. Conclusion In a first step, we identified the investable capital market. This universe forms the market aggregate from which we derive long-term rates of return for each asset class, consistent with their risks relative to, and correlations with, the global market. We model risks on the basis of both historical observation and qualitative assessment. We employ a multi-layer approach which starts with very broad aggregates and transitions to increasingly detailed markets. This approach reduces complexity as much as possible and ensures consistency of the matrix. In fact, the factor approach is a nice reconciliation between a quantitative method and qualitative input. The resulting correlation matrix reflects our general beliefs: There are no negative correlations, as markets are considered (to some extent) investment substitutes; in fact, a 0.40 correlation of any market with the entire market is at the lower end of what can be expected. Balanced portfolios are highly correlated with equity markets and also show considerable correlation with bond markets. The lower correlations
of markets such as REITs, natural resources and farmland with the overall market are a result of higher idiosyncratic risk in these markets. Further, alternative assets have various specific characteristics: Real estate, e.g., is a low-risk / lowcorrelation market. On the other hand, private equity is a high-risk / high-correlation market. Since selected global capital markets may not be entirely efficient, our approach also allows for return-generating factors other than risk and correlation: the degree of market segmentation, i.e. the extent to which a markets capital inand outflows are hampered by legal and practical barriers; and illiquidity, which describes the constraint to investor flexibility imposed by lock-in periods. It turns out that markets with higher risk receive more compensation for the same degree of segmentation through the direct impact of total risk. Apart from an already significant compensation for segmentation, private equity is substantially compensated for illiquidity due to a relatively long lock-up period combined with a high level of risk. On the other hand, real estate only gets a moderate compensation for illiquidity. However, real estate provides further diversification and return in the form of yield. Our long-term global market covariance matrix is not only used in estimating long-term returns; it is also critical for setting appropriate asset allocation policies, and for deriving discount rates for use in cash flow-driven valuation models. In practice, these estimates of asset class and market returns and risks are reviewed and revised regularly, to ensure accurate inputs for our valuation models.
11
February 2005
Markets of the UBS Global Asset Management Covariance Matrix

Lock-up time 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Integrated Segmented Risk Risk Premia Premia 2.73% 2.98 2.74 2.68 2.67 2.93 3.04 3.43 2.98 2.70 2.95 3.02 3.00 2.76 2.68 2.58 2.93 2.81 2.89 2.87 2.76 2.68 3.33 3.15 3.21 4.08 4.06 2.99 3.35 3.00 3.31 2.95 4.00 3.70 4.18 3.39 3.00 3.53 1.08 0.99 0.87 1.03 0.74 0.83 0.71 1.01 1.17 0.62 0.90 5.00% 5.63 4.38 4.00 4.63 4.51 6.26 7.51 5.00 8.01 4.63 6.26 5.00 4.13 6.01 6.76 5.50 6.26 5.51 6.26 4.63 4.00 3.94 3.75 3.80 9.01 8.01 8.51 8.51 8.51 8.51 7.01 7.51 9.51 8.51 8.51 8.51 5.33 2.00 1.80 1.80 1.80 1.80 1.80 1.50 1.80 1.80 1.12 1.60 Risk Premia 3.18% 3.51 3.07 2.94 3.06 3.24 3.68 4.24 3.39 3.76 3.29 3.67 3.40 3.03 3.35 3.41 3.45 3.50 3.41 3.55 3.13 2.95 3.45 3.27 3.33 5.80 5.44 5.48 4.90 5.48 4.87 4.17 5.05 6.02 5.26 4.41 4.93 4.16 1.27 1.16 1.06 1.18 0.96 1.03 0.87 1.17 1.30 0.72 1.04 Liquitidy Premia 0.00% 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Total Return 8.03% 8.37 7.91 7.78 7.91 8.10 8.56 9.14 8.25 8.64 8.14 8.54 8.26 7.87 8.20 8.27 8.31 8.36 8.27 8.41 7.98 7.79 8.31 8.13 8.19 10.78 10.40 10.43 9.83 10.44 9.80 9.06 9.99 11.01 10.21 9.32 9.86 9.06 6.03 5.91 5.81 5.94 5.70 5.77 5.61 5.92 6.06 5.45 5.78
Integration Equity Australia Equity Austria Equity Belgium Equity Canada Equity Denmark Equity Germany Equity Greece Equity Finland Equity France Equity Hong Kong Equity Ireland Equity Italy Equity Japan Equity Netherlands Equity New Zealand Equity Norway Equity Portugal Equity Singapore Equity Spain Equity Sweden Equity Switzerland Equity UK Equity US (Wilshire 5000) Equity US (S&P 500) Equity US (MSCI) Equity Brazil Equity Chile Equity China Equity Hungary Equity India Equity Korea Equity Malaysia Equity Mexico Equity Russia Equity South Africa Equity Taiwan Equity Thailand Equity Emerging Markets 10y Treasury Australia 10y Treasury Canada 10y Treasury Denmark 10y Treasury EMU 10y Treasury Japan 10y Treasury Sweden 10y Treasury Switzerland 10y Treasury UK 10y Treasury US Bonds Australia Bonds Canada 80% 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 65 65 55 70 55 70 70 70 60 75 80 65 65 80 80 80 80 80 80 80 80 80 80 80
Risk 20.0% 22.5 17.5 16.0 18.5 18.0 25.0 30.0 20.0 32.0 18.5 25.0 20.0 16.5 24.0 27.0 22.0 25.0 22.0 25.0 18.5 16.0 15.7 15.0 15.2 36.0 32.0 34.0 34.0 34.0 34.0 28.0 30.0 38.0 34.0 34.0 34.0 21.3 8.0 7.2 7.2 7.2 7.2 7.2 6.0 7.2 7.2 4.5 6.4
Beta 1.69 1.85 1.70 1.66 1.66 1.82 1.89 2.12 1.85 1.67 1.83 1.88 1.86 1.71 1.66 1.60 1.82 1.74 1.79 1.78 1.71 1.66 2.06 1.96 1.99 2.53 2.52 1.86 2.08 1.86 2.06 1.83 2.48 2.30 2.59 2.10 1.86 2.19 0.67 0.62 0.54 0.64 0.46 0.52 0.44 0.62 0.73 0.38 0.56
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Markets of the UBS Global Asset Management Covariance Matrix (Continued)

Lock-up time Integrated Segmented Risk Risk Premia Premia Risk Premia Liquitidy Premia Total Return
Integration
Risk
Beta
Bonds Denmark Bonds EMU Bonds Japan Bonds Sweden Bonds Switzerland Bonds Switz. SBI Dom Bonds Switz. SBI For Bonds Switz. SBI Dom 3-5y Bonds Switz. SBI D/For 1-3y Bonds UK Bonds USA Bonds USA (SBBIG) Corporate Bonds Australia Corporate Bonds Canada Corporate Bonds EMU Corporate Bonds Japan Corporate Bonds Switz. Corporate Bonds UK Corporate Bonds USA Convertible Bonds Euro High Yield Bonds US RRB Canada ILG UK Tips US Bonds Emerging Markets Cash Australia Cash Canada Cash Denmark Cash Euro Cash Hong Kong Cash Japan Cash New Zealand Cash Norway Cash Singapore Cash Sweden Cash Switzerland Cash UK Cash US Cash Brazil Cash Chile Cash China Cash Czechia Cash Hungary Cash India Cash Indonesia Cash Korea Cash Malaysia Cash Mexico Cash Philippines Cash Poland Cash Russia
80% 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 80 70 80 80 80 65 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0.25 0 0 0 0.08 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
4.8% 5.6 5.2 4.4 6.1 4.5 3.4 3.2 2.0 7.3 5.7 5.1 3.5 5.3 4.6 4.2 3.0 7.3 5.6 9.6 9.0 6.7 5.2 4.8 12.0 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
0.37 0.51 0.34 0.32 0.45 0.34 0.26 0.24 0.15 0.64 0.58 0.53 0.33 0.50 0.46 0.26 0.24 0.70 0.60 1.09 0.80 0.25 0.19 0.19 0.85 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
0.59% 0.82 0.55 0.51 0.73 0.54 0.41 0.38 0.24 1.02 0.94 0.86 0.54 0.81 0.74 0.41 0.39 1.14 0.97 1.76 1.29 0.40 0.30 0.31 1.36 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
1.20% 1.41 1.31 1.09 1.52 1.13 0.86 0.80 0.50 1.82 1.42 1.28 0.87 1.33 1.16 1.05 0.74 1.84 1.40 2.40 2.25 1.67 1.30 1.20 3.00 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.13
0.71% 0.93 0.70 0.63 0.89 0.66 0.50 0.47 0.29 1.18 1.03 0.94 0.60 0.92 0.83 0.54 0.46 1.28 1.06 1.88 1.58 0.65 0.50 0.49 1.94 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
0.00% 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.40 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
5.45% 5.68 5.43 5.36 5.63 5.39 5.23 5.19 5.00 5.94 5.78 5.69 5.33 5.66 5.57 5.27 5.19 6.04 5.81 6.67 6.63 5.38 5.22 5.21 7.09 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70 4.70
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February 2005

Lock-up time 0 0 0 4 4 4 4 4 4 4 4 4 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 2 1 2 2 2 2 1 1 2 2 2 2 Integrated Segmented Risk Risk Premia Premia 0.00% 0.00 0.00 7.08 6.73 6.74 7.09 7.14 7.08 6.06 6.75 6.29 6.43 6.00 5.96 6.37 5.54 6.38 5.22 5.80 5.37 4.87 4.41 4.77 3.97 4.14 4.14 4.25 4.12 5.18 1.76 1.52 1.65 1.30 1.57 1.35 1.44 1.76 2.38 3.03 1.50 1.42 1.48 1.19 1.26 1.13 1.15 0.76 1.09 1.21 1.10 0.13% 0.13 0.13 13.01 12.51 12.51 13.01 12.01 13.01 12.01 11.26 10.76 10.51 10.01 10.01 10.51 9.51 10.51 9.51 9.01 8.51 8.51 9.01 9.01 10.01 8.51 9.51 8.51 7.51 7.26 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.50 5.13 4.00 4.00 4.00 3.38 3.88 3.13 2.50 2.32 2.70 2.90 2.89 Risk Premia 0.00% 0.00 0.00 9.45 9.04 9.05 9.46 9.09 9.45 8.44 8.55 8.08 8.06 7.60 7.58 8.03 7.13 8.03 6.93 7.08 6.62 6.33 6.25 6.46 6.39 5.89 6.29 5.95 5.48 6.01 2.76 2.61 2.69 2.48 2.64 2.51 2.57 2.76 3.23 3.87 2.25 2.45 2.49 2.06 2.31 1.73 1.56 1.23 1.57 1.71 1.64 Liquitidy Premia 0.00% 0.00 0.00 12.84 10.96 10.97 12.85 9.96 12.85 9.23 8.14 7.01 4.82 4.26 4.25 4.79 3.74 4.79 3.62 3.56 3.11 3.18 3.33 3.45 3.94 2.93 3.59 2.96 2.38 2.65 0.72 0.69 0.70 0.66 0.69 0.66 0.68 0.72 0.89 1.08 0.47 0.58 0.58 0.44 0.53 0.32 0.27 0.21 0.29 0.32 0.31 Total Return 4.70% 4.70 4.70 29.31 26.68 26.70 29.33 25.60 29.32 24.02 22.90 21.09 18.59 17.46 17.42 18.52 16.36 18.53 16.01 16.10 15.11 14.86 14.95 15.32 15.78 14.11 15.28 14.22 13.07 13.94 8.36 8.17 8.27 8.00 8.21 8.04 8.11 8.36 9.04 9.93 7.56 7.88 7.93 7.33 7.69 6.85 6.62 6.21 6.65 6.84 6.75
Integration Cash South Africa Cash Taiwan Cash Thailand Venture Early Benelux Venture Early France Venture Early Germany Venture Early Italy Venture Early Scandinavia Venture Early Spain Venture Early Switzerland Venture Early UK Venture Early US Venture Late Benelux Venture Late France Venture Late Germany Venture Late Italy Venture Late Scandinavia Venture Late Spain Venture Late Switzerland Venture Late UK Venture Late US LBO Benelux LBO France LBO Germany LBO Italy LBO Scandinavia LBO Spain LBO Switzerland LBO UK LBO US Mezzanine Benelux Mezzanine France Mezzanine Germany Mezzanine Italy Mezzanine Scandinavia Mezzanine Spain Mezzanine Switzerland Mezzanine UK Mezzanine US Distressed Debt US Real Estate Australia Real Estate France Real Estate Germany Real Estate Netherlands Real Estate Switzerland Real Estate UK Real Estate US Real Estate US Apartment Real Estate US Industrial Real Estate US Office Real Estate US Retail 100% 100 100 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 60 70 60 60 60 60 70 70 70 70 70 70
Risk 0.5% 0.5 0.5 52.0 50.0 50.0 52.0 48.0 52.0 48.0 45.0 43.0 42.0 40.0 40.0 42.0 38.0 42.0 38.0 36.0 34.0 34.0 36.0 36.0 40.0 34.0 38.0 34.0 30.0 29.0 17.0 17.0 17.0 17.0 17.0 17.0 17.0 17.0 18.0 20.5 16.0 16.0 16.0 13.5 15.5 12.5 10.0 9.3 10.8 11.6 11.5
Beta 0.00 0.00 0.00 4.39 4.17 4.18 4.39 4.43 4.39 3.76 4.19 3.90 3.99 3.72 3.70 3.95 3.43 3.96 3.24 3.60 3.33 3.02 2.74 2.96 2.46 2.57 2.57 2.64 2.56 3.22 1.09 0.94 1.02 0.81 0.97 0.84 0.89 1.09 1.48 1.88 0.93 0.88 0.92 0.74 0.78 0.70 0.72 0.47 0.67 0.75 0.68
14
February 2005

Lock-up time 0 0.25 0.25 0.25 0.25 6 7 6 6 7 7 7 6 4 4 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Integrated Segmented Risk Risk Premia Premia 0.74% 1.25 1.39 1.51 1.42 1.23 0.77 1.14 0.88 1.29 1.16 1.25 1.07 0.82 1.09 0.26 0.26 -0.13 0.23 1.06 0.75 2.22 0.00 0.19 -1.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2.22% 3.31 3.42 3.80 3.75 7.26 4.00 6.01 5.00 5.51 3.63 4.25 6.25 3.38 4.50 2.75 2.75 2.75 2.75 3.50 2.75 5.76 5.00 5.75 5.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Risk Premia 1.04% 1.66 1.79 1.97 1.88 4.85 2.38 4.06 3.36 3.40 2.39 2.75 4.18 2.10 2.80 1.01 1.26 0.59 1.24 2.04 1.35 3.28 1.50 2.97 0.80 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Liquitidy Premia 0.16% 0.29 0.32 0.36 0.34 3.80 0.86 2.32 1.51 1.81 0.74 1.02 2.56 0.53 0.89 0.19 0.24 0.35 0.24 0.40 0.24 0.78 0.41 0.86 1.89 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Total Return 5.96% 6.75 6.92 7.15 7.04 13.95 8.12 11.48 9.85 10.22 8.00 8.68 11.87 7.46 8.59 5.96 6.27 5.68 6.25 7.26 6.36 8.98 6.70 8.74 7.54 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Integration Reits US Unleveraged 80% Reits US Apartment 80 Reits US Industrial 80 Reits US Office 80 Reits US Retail 80 Timber Argentina 40 Timber Australia 50 Timber Brazil 40 Timber Chile 40 Timber New Zealand 50 Timber US South 50 Timber US West 50 Timber Uruguay 40 Farmland US Row Crop 50 Farmland US Perm. Crop 50 HF US Market-Neutral 70 HF US Convertible Arbitrage 60 HF US Fixed-Inc. Arbitrage 75 HF US Merger-Arbitrage 60 HF US Distressed Securities 60 HF US Fund Of Funds 70 HF US Long/Short 70 HF US Macro 70 HF US Emerging Markets 50 HF US Short Sellers 70 Currency Australia 100 Currency Canada 100 Currency Denmark 100 Currency Euro 100 Currency Hong Kong 100 Currency Japan 100 Currency New Zealand 100 Currency Norway 100 Currency Singapore 100 Currency Sweden 100 Currency Switzerland 100 Currency UK 100 Currency US 100 Currency Brazil 100 Currency Chile 100 Currency China 100 Currency Czechia 100 Currency Hungary 100 Currency India 100 Currency Indonesia 100 Currency Korea 100 Currency Malaysia 100 Currency Mexico 100 Currency Philippines 100 Currency Poland 100 Currency Russia 100 Currency South Africa 100 Currency Taiwan 100 Currency Thailand 100 HF = Hedge Funds
Risk 8.9% 13.2 13.7 15.2 15.0 29.0 16.0 24.0 20.0 22.0 14.5 17.0 25.0 13.5 18.0 11.0 11.0 11.0 11.0 14.0 11.0 23.0 20.0 23.0 20.0 10.0 5.2 10.7 10.5 10.0 10.5 11.6 10.5 6.1 11.0 11.2 9.1 0.0 20.0 15.3 10.0 11.2 11.2 10.0 15.4 10.5 10.5 10.0 10.5 11.2 15.2 15.5 10.5 10.5
Beta 0.46 0.78 0.86 0.94 0.88 0.76 0.47 0.71 0.55 0.80 0.72 0.78 0.66 0.51 0.67 0.16 0.16 -0.08 0.14 0.66 0.46 1.38 0.00 0.12 -0.62 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
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February 2005
References [1] Brinson, G.P., L.R. Hood and G.L. Beebower. "Determinants of Portfolio Performance." Financial Analysts Journal, July/August 1986, pp. 39-44. [2] Brinson, Gary P., Jeffrey J. Diermeier and Gary G. Schlarbaum: "A Composite Portfolio Benchmark for Pension Plans." Financial Analysts Journal, March-April 1986, pp. 15-23. [3] Brinson, Gary P., Brian D. Singer and Gilbert L. Beebower. "Determinants of Portfolio Performance II: An Update." Financial Analysts Journal, May-June 1991, pp. 40-48. [4] Goodall, Thilo, Antonio Manzini, and Thomas Rose. "Risk Premium Project." Working Paper, UBS Global Asset Management, 1999. [5] Grinold, Richard C. and Ronald Kahn. "Active Portfolio Management." Probus Publications, Chicago, 1995. [6] Hamilton, James D. "Time Series Analysis." Princeton University Press, 1994. [7] Singer, Brian D. and Denis S. Karnosky. "Equilibrium Risk Premia Estimates." Working Paper, Brinson Partners, 1993. [8] Singer, Brian D. and Kevin Terhaar. "Economic Foundations of Capital Market Returns." Research Foundation of the Institute of Chartered Financial Analysts, 1997. [9] Staub, Renato and Jeffrey J. Diermeier. "Segmentation, Illiquidity, and Returns." Journal of Investment Management, Vol.1, No. 1, 2003. [10] Staub, Renato. "Integration of Alternative Investments into the Market Covariance Matrix." Working Paper, UBS Global Asset Management, 2001. [11] Terhaar, Kevin, Renato Staub and Brian Singer. "The Appropriate Policy Allocation for Alternative Investments." Journal of Portfolio Management, 2003, pp. 101-110. Previously published papers in the White Paper Series include: Renato Staub. Asset Allocation vs. Security SelectionBaseball with Pitchers Only? UBS Global Asset Management, November 2004. Edwin Denson. Dynamic Alpha Strategy. UBS Global Asset Management, September 2004. Tom Clarke. Market Behaviour Analysis. UBS Global Asset Management, August 2004. Tom Clarke and Jonathan Davies. Active Currency Management, Mean Reversion and Trading Rules. UBS Global Asset Management, June 2004. Brian Singer. Asset Allocation Revival. UBS Global Asset Management, March 2004. Brian Singer, Renato Staub and Kevin Terhaar. "An Appropriate Policy Allocation for Alternative Investments." Journal of Portfolio Management, Spring 2003. Renato Staub and Jeffrey Diermeier. "Segmentation, Illiquidity and Returns."Journal of Investment Management, First Quarter 2003. Author: Renato Staub, Ph.D Executive Director, Global Investment Solutions Tel. +312-525 7924 renato.staub@ubs.com To request any of our white papers, please contact: April Powell Tel. +1-312-525 7792 april.powell@ubs.com
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This publication is intended for limited distribution to clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. The information and opinions contained in this document have been compiled or arrived at based upon internal research. All such information and opinions are subject to change without notice and are for information purposes only. This document is not intended to be construed as a recommendation regarding the appropriateness of any investment or an offer to buy or sell any securities. Investors should also be aware that past performance of investments is not necessarily a guide to future performance.

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