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Marketing material

The Great OpportunityGreat Wealth Investment Report

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Contents

The upsides of unconstrained investing

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Private capital’s untapped potential

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Harvesting the value of peer networks

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Taking advantage of illiquidity

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Bank regulations create opportunity

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Harnessing behavioral biases

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Using liquidity to your advantage, capitalizing on dislocations created by increasing regulation and tapping into your unique information network.

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Foreword

Dear Reader,

We are pleased to present you with this inaugural investment report from the Ultra High Net Worth (UHNW) Chief Invest-ment Office team.

Different rules apply when investing great wealth. These investors have the resources and the autonomy to pursue an investment strategy that is free of the usual constraints on institutional investors.

That is why we wanted to create this report. Those with great wealth are often the very best in their field. They are deter-mined to succeed and have the courage to be bold along the journey. We believe that these qualities should be reflected in an investment strategy which is innovative and proud to be bold.

The backdrop of volatile world events demands such an approach. As we show in the following pages, UHNW individ- uals can be long-term and unconstrained in their approach, taking advantage of the risk aversion and behavioral biases of the broad mass of investors.

Yet as it stands, many great wealth investors are underper-forming. High allocation to cash and fixed income has been a drag on performance and a danger to real wealth preserva- tion.

Using liquidity to your advantage, capitalizing on dislocations created by increasing regulation and tapping into your own unique information network: these are just some of the invest-ment advantages great wealth investors can bring to bear.

With the right mindset and the right vision, the opportunities are there. We are passionate about creating great work, connecting great people and delivering great successes with our clients. We hope that this report works as a significant contribution to that effort.

Josef Stadler

Group Managing Director

Head Global Ultra High Net Worth

UBS Wealth Management

Simon Smiles

Group Managing Director

Chief Investment Officer UHNW

UBS Wealth Management

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Private investors have an advantage over institutional investors because they are not constrained by benchmarks.

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The upsides of unconstrained investing

Private investors have the freedom to invest in more complex and illiquid opportunities. Doing so can improve returns and make a lasting social impact.

• Private investors have an advantage over institu- tional investors because they are not constrained by benchmarks.

• This gives them the opportunity to seize investment opportunities that are more complex and less liquid.

• There is greater freedom to invest in non-traditional assets and to make longer-term investments in traditional equities and bonds.

• Finally, unconstrained investing offers the greatest opportunity to invest for social impact.

Most institutional investors are constrained in their ability to seek additional returns and cannot fully exploit the opportuni-ties arising from the way global wealth is structured. This is because they are tied to a benchmark defined by a combination of traditional indices. By contrast, private investors have the advantage of being able to adopt unconstrained investment strategies. They can invest with a flexible, adaptable approach across a wide set of asset classes and markets, without the limit-ations imposed by a broad market benchmark.

In other words, private investors are less constrained than other investors and can seize investment opportunities that are more complex and more illiquid.

Below, we look at the benefit of such an approach for: 1. Multi-asset class portfolios 2. Equity investors 3. Fixed income investors 4. Socially responsible investors

Advantages of multi-asset class portfolios

“For multi-asset class investors, the freedom to tap into non- traditional assets can enhance expected volatility-adjusted returns.” In essence, this means broadening the investment universe and taking positions across asset classes and geographies, including in more niche and less liquid markets. A large part of the wor-ld’s wealth is invested in private markets (non-public equity and debt), cash and money market instruments, real estate, other personal holdings such as art, and natural resources. Some estimates suggest that natural resources (e.g. oil), privately-held firms and owner-occupied housing are each worth in total tens of trillion of dollars, and thus comparable in size with public equity or debt markets.

Most institutional investors do not have a mandate to access these potential return streams but many private investors do have this liberty of choice.

By designing a portfolio strategy that generates the bulk of expected returns from non-traditional asset classes, private investors can gain a clear advantage over some institutional investors.

Flexibility in equities and bondsBut even for more traditional asset classes, there are opportuni-ties to enhance risk-adjusted returns. Benchmark indices typi-

Gregoire Rudolf – UBS Strategist, CIO Strategic Investment Solutions

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cally don‘t include the entire market and, consequently, being tied to a benchmark limits the potential investment universe. For equity investors, taking a view on long-term themes and trends can enhance the risk-return trade-off. Investing in the hope of moonshot innovations can be very risky and investors should feel more confident in the trends of urbanization, population growth and aging. We expect companies that can solve the world‘s food supply, healthcare and urban transportation prob-lems to benefit over time.

Take agricultural yield enhancement for example. A population which is growing and living in cities is highly likely to demand more calories. With a limited landmass and 200,000 more people worldwide to feed each day, we see companies that can help improve the efficiency of production – whether through soil sampling, localized weather forecasting or efficient use of fertilizer – as winners over time.

Private investors have the ability to express long-term investment themes in portfolios and deviate from traditional benchmark and can reap the benefit from doing so. As always, diversificati-on – whether within a single identified theme or across multiple themes – is key for success when investing through a cycle.

For fixed income investors, traditional portfolios benchmarked to the Barclays US Aggregate index are exposed to interest rate risk. Furthermore, the recent past has demonstrated the effect diverging central bank policies (e.g. those of the US Federal Reserve and the European Central Bank) can have on the performance of credit sub-asset classes. Several leading asset managers have responded to these circumstances by offering unconstrained strategies.

Broadly speaking, this means broadening the search for income yield into the full universe of credit classes. These include assets like mezzanine loans, asset-backed securities, corporate hybrid bonds and bank capital, alongside more ‘standard’ fixed income asset classes such as senior corporate bonds, emerging market credits and high yield credits.

Promoting sustainabilityFinally, some private investors seek both to generate financial returns and have an intentional positive social or environmental impact through ‘impact investing’. In other words, they use their wealth to promote sustainability, best defined by the UN Sustainable Development Goals (SDGs), while not compromi-sing financial returns. Believing that the world‘s current growth path is unsustainable, these investors have the greatest ability to help fund SDGs where there is clear market pricing. This is the case in areas such as zero hunger, good health, quality educa- tion and clean energy.

Private wealth has a unique role to play in helping to fund the SDGs, encouraging cross-capital investment and developing institutions to promote more equitable and tenable economic growth. By contrast, institutional capital faces more constraints or limitations. For example, high-risk weightings on long-term investments may preclude banks from investing in infrastructure to meet SDGs. And in the European insurance sector, regulation governing the maximum tenor and minimum credit rating of

United Nations Food and Agricultu-ral Organization (FAO) projects that food and feed production will need to increase by 70 percent by 2050 to meet the world‘s food needs.

Expected rise in food demand by 2050

70%

The expected long-term return for private equity is 12%, which is around 4% more than for public global equity markets.

Expected equilibrium return of private equity

12%Source: UBSFor illustrative purposes only.

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Private investors can broaden the search for income yield into the full universe of credit classes.

World population and calories consumed per day 1978 vs. 2015

1978 2015

CaloriesCalories

Population

Population

4.3bn

7.1bn

2.477

2.870

Source: Food and Agriculture Organization of the United Nations (FAO), numbers include food wasteFor illustrative purposes only

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debt instruments under EU Solvency ll legislation may prevent insurers from funding SDGs. If this were not the case, insurers, especially life insurers, would be natural investors as they typi-cally have long-term liabilities that would be a good match for SDG-funding assets.

Seizing opportunityPrivate investors willing to widen their investment opportunity set are uniquely positioned to be able to enhance their overall returns. Nevertheless, non-traditional funds or strategies lack true market benchmarks, which makes evaluating their perfor-mance difficult. These strategies can also carry risks of which many investors may not be aware. Underlying risk exposures can become difficult to identify in advance, which can raise the question of how they fit into a portfolio.

Even so, private investors can benefit from their investment freedom not only in portfolio construction but also when invest- ing in single asset classes such as equities and bonds. What’s more, they can deploy their wealth to make a lasting impact

on society. To make the most of unconstrained investing – to ac-cess, structure and evaluate this greater range of opportunities – it is important to get professional advice.

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Endowments make better use of their advantage of ownership of capital.

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Private capital’s untapped potential

• Leading university endowments show how UHNW investors and family offices could use the benefits of private capital ownership.

• Endowments take more risk and have a longer-term investment approach.

• Family offices hold more cash, which may pose a threat to the minimum goal of wealth preservation.

• Endowments balance greater risk-taking with more diversification.

Owning their own capital is a major advantage that UHNW and family office investors have over institutional investors. As discussed elsewhere in this report, they can avoid succumbing to the behavioral biases of institutional investors, take more risk and a have longer-term view without fear of capital being taken away. However, when compared to investors with a similar advantage, endowment funds, we find that UHNW investors and family office investors could use their advantage to even greater effect.

Family offices will tell you: ”We’re not timing experts, we’re not traders, we’re not in and out of markets; we take a long-term view. Now, we may get the long-term view wrong, but that’s the way the family wants it.“

For the last few years, endowments of the top three US uni-versities (Yale, Princeton and Harvard), and to a lesser extent other US endowments, have outperformed the returns of the composite global portfolio of family offices, as calculated by the UBS/Campden Wealth Global Family Office Report 2016. This is in part due to endowments making better use of their

advantage of ownership of capital. That is, they take more risk and have a longer-term investment approach. Notably, UHNW and family offices should be aware of two aspects to taking risks.

The drawbacks of cashFirst, the UBS/Campden Wealth Global Family Office Report 2016 shows that, in aggregate, endowments are more fully invested than family offices. They have much lower allocations to cash and fixed income (see table on portfolio holdings be-low). Particularly with regard to cash, the comparison between endowments and UHNW Individuals is even more striking, with the Wealth-X World Ultra Wealth Report 2014 showing that UHNW individuals hold nearly 25% of their net worth in cash – compared to 0% held by the endowments of Yale, Princeton and Harvard.

“In the past, cash has chiefly been a drag on performance. In the future, it may pose a threat to achieving the minimum goal of real wealth preservation.” This is because after years of muted price increases, inflation in many parts of the developed world is likely to continue to pick up and policy rates are unlikely to catch up. The result would be real interest rates falling into deeper negative territory. In such an environment, cash‘s purchasing power will erode at a faster pace.

Ultra-high net worth (UHNW) investors and family offices have not been making the most of their natural advantages.

Maximilian Kunkel – UBS Chief Investment Officer Germany

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Further, nominal government bonds are unlikely to provide much remedy. In fact, they are likely to have dramatically different risk-return profiles than in the past. Take the example of Switzerland, which has one of the highest concentrations of UHNW individuals. At the time of writing, Swiss 10-year yields were around -0.10%. If annual inflation in Switzerland over the next 10 years was to return to its average rate of 3.0% between 1964 and 2007, holders would face losses of 27%. And even at current lower inflation rates, institutional investors that do not own their capital and are restricted in their invest- ment possibilities are feeling the brunt. For example, many pension funds have already had to start cutting their pension promises. UHNW and family office investors will have to use their competitive advantage of owning their own capital to avoid the same fate.

Why diversification mattersSecond, once UHNW and family office investors make use of their competitive advantage of owning their own capital and take more risk they should not forget about diversification. Here it is important to take a broader perspective of the net worth of UHNW individuals than just their investment portfo-lio. The UBS/PWC 2016 Billionaires Report and the UBS/Camp-den Wealth Global Family Office Report 2016 find that most of the world‘s billionaires and principals behind family offices are self-made and are still largely involved in founder-owned private businesses. As a result, they have a disproportionately large part of their wealth in their core businesses. This strongly exposes them to exogenous shocks. The macroeconomic environment, industry-specific issues such as technological change and competition, regulatory changes, and geopolitics can all detrimentally impact the prospects for a previously suc-cessful business. And having such a high share of one’s wealth exposed to just one asset goes against the most basic principle of portfolio construction – that diversification is essential to achieve optimal risk return outcomes.

How fleeting billionaire wealth can be due to this lack of diver-sification is particularly visible in Asia. For example, according to the UBS/PWC 2016 Billionaires Report, Asia’s entrepreneurs dominated the list of new billionaires in 2015. Some 113 Asian entrepreneurs, 80 of them from China, attained billionaire status during 2015, more than half (54%) of the global total. However, at the same time, far more billionaires in Asia lost their billionaire status than in Europe or the US. Eighty fell off the database in 2015, against 44 in Europe and 36 in the US, respectively.

In this context, diversification in the investment portfolio, particularly in private markets, is even more important. Here again, UHNW and family office investors can take their cue from endowments. Endowments have traditionally taken a more diversified approach than that of UHNW and family office investors with regard to venture capital and private equity. This approach has served them well during the last few volatile years and may well continue to do so going forward.

Improving risk-adjusted returnsThe other component of ownership of capital that UHNW and family office investors can use to their advantage is the poten-tial to have a longer-term investment approach.

“Changes to family control and investment objectives can nega- tively impact returns. Yet by en-suring stability in the investment approach and management over multiple phases in a similar way to endowments, UHNW and family office investors could improve their risk-adjusted returns.” In summary, not only has the relatively high allocation to cash and fixed income been a drag on performance for many UHNW and family office investors, it also can be a danger to real wealth preservation going forward. Owning their own capital allows UHNW and family office investors to better deal with this challenge than institutional investors. By following the example of endowments, they could make better use of this competitive advantage. What’s more, diversification in the investment portfolio as well as a longer-term investment approach remain critical to achieving the minimum objective of real wealth preservation over the generations.

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Portfolio holdings (%) Recent performance (%)

Source: The UBS/Campden Wealth Global Family Office Report 2016, Yale, Princeton and Harvard. Note: Due to rounding, totals may not add up to 100%

Developed market equity: adjusted for ETF allocation 2016Developing market equity: adjusted for ETF allocation 2016Real estate: adjusted for tangible assets, REITs and other allocations 2016For illustrative purposes only

Source: The UBS/Campden Wealth Global Family Office Report 2016, Yale, Princeton and Harvard. For illustrative purposes only

Endowments Family – top 3 US offices universities

Hedge funds: includes all strategies 8 21

Developed market equity 19 16

Developing market equity 7 10

Private equity / VC 22 24

Natural resources 3 8

Real estate 19 13

Fixed income 13 8

Cash 8 0

2013 2014 2015

Family offices 8.5 6.1 0.3

Endowments –

top 3 universities 11.8 18.4 10.0

Endowments – all US 11.7 15.5 2.4

Family‘s stake in the operating business

50%Majority

10

30

50

of family wealth stillinvested in operating

business

Source: The UBS/Campden Wealth Global Family Office Report 2016 For illustrative purposes only

Source: The UBS/Campden Wealth Global Family Office Report 2016For illustrative purposes only

52%23%Complete (100%)

16%Minority withoutcontrol rights

11%Minority withcontrol rights

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Harvesting the value of peer networks

• The democratization of information makes it harder for investors to beat the market.

• Markets respond to new information very quickly, compounding the difficulty.

• Professional investors are committing significant time to finding new information advantages.

• UBS’ Industry Leader Network has successfully synthesized the wisdom of business owners to give fresh perspectives on the global economy.

Echo Chamber: “A metaphorical description of a situation in which information, ideas, or beliefs are amplified or reinforced by communication and repetition inside a defined system.” (Wikipedia)

As professional investors we risk living and operating in an echo chamber. A typical day goes as follows: read Financial Times (or similar) and investment research on the way to work, arrive at desk, launch Bloomberg terminal, analyze economic and financial market data, watch keenly for data and news releases throughout the day. Investment decisions at most investment houses across the world are largely derived from an iteration of this process.

A potential drawback of this is that we all have access to the same information, which is bought from any number of market data providers. There are moral and regulatory reasons for this democratization of information and its simultaneous release across the world. Yet it means that financial markets absorb information extremely quickly, making it difficult for an investor to beat the market.

To address this issue, investors must gain an information ad-vantage. As a result, they are increasingly exploring innovative solutions, including: gaining faster access to information, identifying new information sources and finding their own proprietary data.

“Private business owners, within their professional and personal networks, have access to proprietary information that can be of huge value for both their business and investment decisions.”Markets respond fastAdvocates of the efficient market hypothesis believe that financial markets reflect all available information at any one time, and that when new information becomes available it is instantaneously incorporated by the market and reflected in the price. In reality this theory does not hold up. Though while not instantaneous, it is true that markets price new information very quickly. An example; On the first Friday of every month at 8.30 am US Eastern Time, professional investors eagerly await the release of some of the most important economic data – the monthly US employment report. This report, among other things, shows how many new jobs were created in the US in the prior month. People with jobs spend money, and so it gives a good indication of the health of US consumption – a crucial

Peer networks of business owners are yielding increasingly valuable insights as computer power democratizes information.

Chris Wright – UBS UHNW Cross-asset Strategist and Head of CIO Investment Networks & Media

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component of the US economy making up around 70% of GDP. But because there are so many eyes, and algorithms, watching the data the market responds to it fast. The chart above shows how US equities performed on 3rd June 2016, a day on which this data release showed fewer jobs were added than at any point in the prior six years. The data was released at 8.30 am, the market opened at 9.30 am and immediately crashed 1% in the first hour of trading. It took just an hour to absorb this new information.

This exemplifies the difficulty investors face when trying to out-perform their peers in a world of simultaneous and easy access to information. One either has to be fast (and ready to trade 24/7) or have access to information that others do not.

The hunt for information advantageProfessional investors now commit significant time and resour-ce to gain information advantage, as the following examples show. They do so in three ways: 1) getting faster access to in-formation, 2) identifying new information sources, 3) creating proprietary data.

1. Getting faster access to informationHigh frequency trading barely existed prior to 2005, but by 2010 represented around 40% of European equity trading volumes, and 60% in the US (according to data from TABB Group). This has led to a race for the fastest access to data possible, which can be seen in the rise of data masts paid for by traders – it can be up to 40% faster to send data through the air than through current fiber optic cables. Taking this race further, communications companies now plan to erect masts on the south-east coast of the UK to create a more direct line of sight between London and Frankfurt. By reducing the distance traveled by the data, they will reduce the 10 milliseconds it currently takes for a round-trip by valuable microseconds.

2. Identifying new data sourcesThe internet has opened up a new world of data, much of it real time, which can be harvested by anyone with the computing power, know-how and the motivation to derive information from it. And this is exactly what UBS Invest-ment Bank has done with its Evidence Lab. UBS Evidence Lab conducts surveys, mines the internet, systematically collects observable data and pulls information from inno- vative sources. It then applies a variety of advanced ana-lytic techniques to derive insights from the data collected. This valuable resource supplies UBS investment analysts with differentiated information to support their forecasts and recommendations. For example, Evidence Lab esti-mates the official US payroll data by triangulating among five different data sources – consumer surveys, business surveys, layoffs, online job postings and daily tax withhol-dings. This gives UBS analysts a good approximation of the official number one to three weeks ahead of its release.

3. Creating proprietary dataHedge funds have long been associated with innovative proprietary data collection techniques, and in recent years they have made increasing use of satellite imagery. Inves-tors use the imagery to monitor anything from the number of cars in a US shopping mall car park, to the movement of containers at a shipping dock in China. Until very recently, some hedge funds employed staff to do nothing else but count the cars and containers on satellite images from month-to-month or even week-to-week with the aim of gaining an insight into economic trends.

The efforts taken by professional investors suggest there is clear value in gaining information advantage. This suggests there is value in unlocking other information sources. UBS has identified clients’ peer groups as one such source.

S&P 500 price chart on 3 June 2016

2‘150

2‘100

2‘095

2‘090

2‘08508:30 09:30 10:30 11:30 12:30 13:30 14.30 CET

For illustrative purposes only

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Private business owners must unlock their information advantage Business confidence is another keenly watched economic indicator for professional investors, since it has historically warned of upcoming recessions. This indicator tends to be gauged by a monthly survey which is sent to the purchasing managers of companies. While the indicator has merit, it is criticized for being very subjective, relying on the person filling out the questionnaire to do so accurately. This person is never a C-Suite executive.

Many private investors, on the other hand, run their own businesses or are senior executives at large private companies. They also have large networks of peers in similar positions. When harvested in the right manner, these networks can cre-ate a fertile source of first-hand proprietary information, aiding both business and investment decisions. They have a number of advantages over publically available information.

First, this information comes directly from the decision makers within a business – the ones responsible for deciding on everything from expansion, to cost cutting, to wage increases. All these decisions provide useful information on the outlook for the company, and therefore the economies in which it operates. Furthermore, this information is available before it hits the newswires.

Second, private companies are not subject to the same regulatory oversight as public companies – they do not have a share price, so regulators are not concerned by the risk of price manipulation. This means that private company owners and executives are free to share more information that could be deemed ‘insider information’ for a public company, and therefore illegal to act upon.

An obstacle to using such information is simply its collection. For it to be useful, a large sample of decision-makers must be engaged regularly from all industries, operating in all stages of the supply chain, and in all relevant regions around the world. Critical to unlocking the potential of this information is the ability to systematically harvest the network. This is why UBS has partnered with its clients and created the Industry Leader Network. The Industry Leader Network

“Launched in 2015, UBS’ Industry Leader Network is a platform that facilitates the anonymous flow of information between decision-makers at private com-panies. This enables the collective wisdom of the network to provide

a real-time perspective on the global economy. ”Over the past two years, the network has unearthed valuable insight around periods of financial market volatility and unex-pected political events.

After the UK referendum in 2016, industry leaders noted that within their networks there was anxiety about how a non-EU UK would look and operate, and that many would be putting investment plans in the UK on hold until they had clarity on the outcome. This was valuable insight for business in the UK given that in the months after the referendum official economic data painted a far more positive outlook for the UK economy.

Also in 2016, after financial markets had their worst start to the year on record, industry leaders reported that the uncer-tainty unfolding was not being reflected in business activity and that they maintained a positive long-term outlook. This information was valuable from an investment perspective, as it suggested that there was no fundamental reason for the market crash and that markets should quickly recover.

Networks such as these will continue to grow in value as they disrupt increases in computer power in a world where we will see further democratization of information, with increasingly real-time delivery.

Financial markets crashed hard in 2016

Source: UBS Industry Leader Network For illustrative purposes only

During the crash we asked Industry Leaders whether it had changed their business strategy.

70% of Industry Leaders did not make adjustments to their business plans, remaining confident that the events were transitory and did not materially impact the the longer-term outlook for their com-pany.

70%No

30%Yes

This view ultimately proved to be correct, with markets regaining their losses and economic data remaining strong.

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When you surf Amazon, Netflix, or other consumer websites, you come into contact with statistical learning (also sometimes referred to as ’machine learning’). For example, after you purchase a book on Amazon, you may notice that Amazon suggests another book. To do this – to make a suggestion that has a better-than-average chance of being purchased by you – Amazon uses a profile it has developed of you as a consumer.

This profile includes books you have purchased in the past –the most direct way to understand your interests. But it may also consider other observations of your behavior, including other household items you have purchased, what you typically spend on Amazon per month, what day of the week (even time of day) you like to shop, and much more.

Amazon compares your profile against its vast database of profiles for millions of other consumers across billions of transactions. When it determines you have commonalities with a group of other consumers, it looks at what they have purchased and gently suggests an item or two for you.

Your profile will be updated to record whether you buy the book. The next time you search for a book, Amazon may make a new recommendation on the basis of your updated profile (and those of other consumers). In other words, the system learns from your evolving behavior as well as the ch-anging behaviors of other shoppers, sharpening its predictions over time.

Applications for investorsThe science behind this whole process – the idea of trying to find similarities between you and other consumers in order to make predictions – is statistical learning. But similar technolo-gy can be applied to improving predictions across many areas of our lives.

When investing, statistical learning can be employed to guide positioning. Through gathering decades of historical data on price movements, but also non-price data, it is possible to develop a ’profile’ of a traded market.

Statistical learning techniques are applied to this historical set of inputs (or ’features’ in statistical learning parlance) objecti-vely, without requiring a specific hypothesis concerning the im-pact a particular feature should have on price movements. This is why the process is often described as ’data-driven’ rather than ’hypothesis-driven.’ The result is a model, or a ’map,’ that describes a market in terms of these features, including how the market tended to move historically when features aligned in certain ways. These tendencies can include behaviors that

are not self-evident or easily uncovered by human researchers – patterns that may include complex interactions between features or data types.

With this map in hand, an investment manager’s systems can then take current, real-time readings of these same features and compare them against the tendencies in the historical data. Applying this process can guide future investment positioning. The belief is that this technique can produce small edges in predictability compared with traditional approaches, and spread across many markets and over time, these advan-tages can add up.

Models that learn, and adapt to new regimesAs illustrated in the Amazon example, these maps can learn. As new history is generated for each market, the models will regularly update themselves in consideration of changes in market structure, to deduce whether particular features are becoming more or less important. This built-in adaptability gives models the ability to detect (and adjust to) even subtle regime shifts or structural changes across scores of traded markets, all without requiring a researcher to notice that the regime change is happening.

The human element: the art of applicationWhile the use of historical data to predict future returns sounds logical and straightforward, financial data can be much noisier than consumer data. Consequently, finding robust tendencies in financial data, even using these advanced techniques, is not easy. Like any technology, the art lies in thoughtful, rigorous application, and a mindset of humility.

Millburn Ridgefield Corporation (’Millburn’) is a quantitative invest-

ment manager based in Greenwich, Connecticut. The firm has been

trading using systematic processes for more than 40 years, and for the

last 10 years has been employing a multi-factor approach intended to

extract more information out of an increasingly data-rich environment.

The firm has been researching and employing advanced statistical

learning (i.e. ’machine learning’ or ’artificial intelligence’) technologies in

a very deep way for more than six years – methods that have resulted in

strong, differentiated returns.

External viewThe rise of the (investor-friendly) machines

Barry Goodman – Co-CEO, Executive Director of Trading, Millburn Ridgefield Corporation

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Yale‘s David Swensen believes that many investors overpay for liquidity they don‘t really need.

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Taking advantage of illiquidity

• Academic studies show there is an ’illiquidity premi-um’ and have quantified it.

• Yet investors must be able to tolerate significant illiquidity, have a limited short-term need for capital, not need an income yield and have a sufficiently large amount of capital.

• There are risks because liquidating or exiting positions to raise cash can be difficult.

• UHNW and family office investors are well positioned to capitalize on illiquidity.

“ American investors, parti-cularly those with long-term horizons, pay far too much for liquidity.” David F. Swensen, Chief Investment Officer, Yale UniversityThe Economist, May 2000

Illiquidity: friend or foe?Most investors have a natural preference for liquidity, valuing their ability to sell investments at any time as a form of down- side protection. Yet the value of liquidity can only truly be rea-lized if an investor can time markets by selling ahead of correc-tions and reinvesting ahead of recoveries. Few if any investors do this consistently, which suggests that much of the benefit may be emotional or behavioral. Indeed, Yale‘s David Swensen

believes that many investors overpay for liquidity they don‘t re-ally need. This widespread irrational mindset offers opportunity for those investors who take a different view of illiquidity.

To be clear, this is not to advocate taking on illiquidity simply for the sake of illiquidity. However, the ability to lock up capital, whether indirectly with a fund manager or directly in an asset, can add incremental sources of return. Investors earn return premia in exchange for illiquidity, access potential manager skill and expand their investable universe. These potential excess returns are attractive in a lower-yield, lower-return environment, particularly as investors seek to diversify exposure beyond mar-ket beta (i.e. broad stock or bond market return). While many professional investors advocate incorporating illiquidity into their investment strategies, ultra-high net worth (UHNW) and family office investors are particularly well positioned to capitalize on illiquidity to improve their portfolios’ prospects.

Bar for admission is highYet investors must have distinct characteristics to tolerate significant illiquidity. Patience and a long-term orientation are especially important. The returns from illiquid investments – both active and passive – often take years to be realized and for capital to be returned, so investors must commit to building up and maintaining such exposure over the long term.

Investors must have a limited interim need for capital. By defini-tion, many illiquid investments cannot be traded in a market, so investors cannot expect them to be a source of ready liquidity, particularly not when they need it most. Similarly, investors must be able to place low importance on interim pricing or short-term ’marks’. Since there is no continuous market, or pricing, for unlisted assets and any reporting is infrequent, they are not suited to investors who need constant performance updates.

Family offices and ultra-high net worth (UHNW) investors should exploit their ability to make illiquid investments and earn a premium.

Andrew Lee – UBS Head of CIO Private Markets and Impact Investing

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Furthermore, most illiquid investments, whether companies or hard assets, tend to be more equity-oriented and do not necessarily provide current yield; so investors must typically forgo ongoing distributions.

Finally, investors must have sufficient capital. This is necessary – whether to meet top-quality fund managers’ minimum invest-ment requirements or to access deal flow.

Most UHNW and family office investors have these traits, whether they take full advantage of them or not.

A hallmark of certain institutional allocatorsCertain types of institutional allocators have long benefited from investing in illiquid assets, earning differentiated returns over long periods of time. Under the leadership of David Swensen, Yale University’s endowment established itself in the 1980s as the early leader in making illiquid investments, such as private equity and real estate, the cornerstone of its portfolio. Since then many other allocators including endowments, foundations, pension funds and sovereign wealth funds (SWFs) have copied the ’Yale model,’ with its preference for asset class diversifica-tion, strong equity orientation and heavy reliance on illiquid investments.

All these types of institutional investor have the characteristics to handle illiquidity. These include: a long-term perspective, less need for cash or distributions on an interim basis, and a man-date to preserve and grow capital for future generations. Like UHNW individuals, these investors – while they must answer to beneficiaries and meet distribution requirements – have man-dates to manage investments without the risk of capital being redeemed. They can lock up capital for long periods in illiquid investments, either with private fund managers or directly in unlisted companies and assets.

These large allocators – sovereign wealth funds, endowments and certain pension funds – generally have substantial long-term target portfolio weightings in unlisted assets and strategies. The International Forum of Sovereign Wealth Funds‘ annual survey showed an average allocation of 26.8% to unlisted investments as of July 2016. Meanwhile, the 2016 NACUBO-Commonfund Study of Endowments showed dollar-weighted allocations of 23% to private markets.

Historical returns show the benefits Allocators are not alone in recognizing the value of illiquidity. Alternative asset managers, including hedge funds and private market funds, use locked-up investor capital to pursue longer- term investment strategies. Quarterly or monthly lock-up periods provide hedge fund managers with short- to medium-term lati-tude to generate returns from primarily listed securities. Private equity and debt managers require longer lock-up periods of 7-10+ years. These give them the flexibility to invest in unlisted companies and assets, and the time to unlock their potential value over multiple years without the pressure of interim reporting or market demands. In return for these longer-term capital commitments, investors expect to earn additional returns

including liquidity premia, alternative investment premia and potential manager alpha. Historical private market fund manager returns show that illiquidity can indeed lead to excess returns, although high performance dispersion underscores the importance of manager selection.

Several academic studies have attempted to quantify this ’illiqui-dity premium’ or excess return compared to liquid benchmarks. One such study, for example, uses a ’public market equivalent’ approach to arrive at a median annual return premium estimate of ~3% based on historical private equity performance data. (’Private equity performance: what do we know?’, Robert Harris, Tim Jenkinson and Steven Kaplan).

Yet despite the potential benefits and excess returns, and despite high allocations to illiquid assets from a number of institutional investor types, the vast majority of the institutional investor universe remains focused on liquid rather than illiquid assets. No-tably, illiquid and alternative investments represent just a fraction of total assets managed by the world’s largest asset manager.

Advantage to UHNW and family office investorsUHNW and family office investors are especially well positioned to capitalize on the illiquidity premium. They share the key characteristics of the other professional allocators and investors described above. As such, they can benefit from the same well-documented advantages of illiquidity, including expansion of the investment universe, enhanced ability to capitalize on inefficiency and asymmetric information, expanded access to active manager expertise and potentially less correlated returns.

However, UHNW and family office investors have natural advan-tages in how they can turn illiquidity to their benefit. They can do so through both strategic shifts and a more opportunistic approach.

Truly long-term orientation and lack of need for interim capital gives them the flexibility to devote an even greater proportion of capital to illiquid investments than professional investors. In-vestors can decide to increase target illiquid allocations through exposure to either private market funds or direct investments.

Notably, this doesn‘t necessarily imply higher risk, as assets are often deployed in illiquid areas where investors have significant knowledge or comfort – for example, direct investments in sectors related to their sources of wealth, or landmark local real estate.

Smaller relative size and fewer mandate limitations than insti- tutional investors mean that they can make investments of differing sizes and terms. While their scale is sufficient to make meaningful investments, they still have the flexibility to take ad-vantage of opportunities not large enough to make a difference in an institutional portfolio. Furthermore, having no limit on how long capital is locked up means they can consider investments requiring extended illiquidity. This includes even evergreen investments with no specified exit. Other types of investor must return capital or make distributions within a set period.

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Also, flexibility of mandate means that they can participate in illiquid investments that professional investors cannot because they don‘t fall within specified guidelines. For example, many institutional investors can only invest with third-party managers that exceed certain minimum assets under management and prior track record. In contrast, UHNW and family office investors are free of such limitations and can even provide seed capital to help launch new fund managers. Such investments are especi-ally illiquid and hard to monetize, yet highly differentiated and not accessible by many other investors.

Finally, UHNW individuals or family offices have fewer res-trictions than entities managing capital on behalf of much larger, more diverse pools of beneficiaries with widely varying preferences. They can be opportunistic and responsive, rather than defensive or liquidity-focused, during market dislocations or periods of volatility. In this case, they can hold mis-priced assets for the long term, ignoring near-term headwinds or negative headline risk that prevents shorter-term investors from participating.

Indeed, the UBS/Campden Wealth Global Family Office Report 2016 found that the family offices surveyed currently allocate 37% to illiquid investments including private equity, direct invest- ments, co-investments, real estate investments and tangibles. This exceeds the 23-27% illiquid weightings cited above for endowments and SWF, and reflects UHNW and family offices‘ greater capacity to capitalize on illiquidity in both strategic and opportunistic ways.

What are the risks?But illiquid investments are not without potential risks, even for UHNW and family office investors. Without a continuous market for unlisted companies and assets it can be difficult to liquidate or exit positions to raise cash when needed. Disclosure can also be infrequent and limited. Investing through funds in-troduces additional potential risks, as investors cede control over investments and decisions on timing, strategy and operations, and other matters to third-party managers. They also face blind

pool risk with closed-end private market fund vehicles because they must generally commit capital without knowledge of the underlying investments.

Capitalizing on opportunityUHNW and family office investors have a particular advantage over many other market participants. Many individual and insti-tutional investors naturally shun illiquidity. For some, the driving factor is fear and lack of understanding. They cite ’black box’ approaches, lack of transparency, infrequent reporting and com-plexity of underlying strategies. For others, the rationale is more about insufficient resources and portfolio restrictions, given a potentially reduced ability to rebalance portfolios quickly, a need for interim liquidity, and lack of resources to properly evaluate, incorporate and monitor illiquid investments. Nevertheless, other institutional investors have specific mandates that restrict their ability to incorporate illiquid exposure.

“ UHNW and family office investors, however, are well positioned to utilize illiquidity to their advantage. ” They generally have very long-term perspectives, limited short-term need for capital or interim ’pricing,’ and typically few mandate restrictions. What’s more, many have deep knowledge of specific industries related to their source of wealth, which can provide comfort when making illiquid or contrarian invest-ments in the face of volatile markets. These investors have the flexibility to enhance investment portfolios by incorporating more structural illiquidity than most professional investors, and potentially to gain even more advantage by using this flexibility to be opportunistic.

Investors who enjoy such advantages but are not currently capi-talizing on them should consider whether they are overlooking opportunities. They can enhance and differentiate their portfo-lios using illiquidity.

37% 23-27%

Sources: The International Forum of Sovereign Wealth Funds‘ annual survey (as of July 2016) / 2016 NACUBO-Commonfund Study of Endowments / 2016 NACUBO-Commonfund Study of EndowmentsFor illustrative purposes only

Family Offices

Average allocation of unlisted (illiquid) investment portfolio weightings 2016

Endowments & SWF

Illiquid investments

Illiquid investments

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The „Yale model“ focuses on illiquid investments, such as private equity and real estate, making them the cornerstone of a portfolio.

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Mario Giannini – Chief Executive Officer, Hamilton Lane

One of the great benefits – or curses, depending on your vantage point - of investing in alternatives is that an inves-tor’s capital is locked in for an extended period of time. Private equity’s historical outperformance can be attributed to the information advantage gained from targeting private companies and from the tight control that private equity managers exhibit over companies once acquired. Moreover, this increased control and long-term focus gives general partners the opportunity for significant value-added and risk management. Private equity managers generally drive portfolio company value creation by employing some combi- nation of three core levers: implementing operational improvements, exiting a company at a multiple above the purchase price, and exercising the prudent use of leverage.

Private equity limited partners, by and large, measure the long-term success of their private market portfolios by achieving premium returns as measured against public equity indices. Because the private markets are inherently a long-term asset class, the return premium to more liquid in-vestments is expected to be achieved over periods measured in years rather than months. In fact, looking at the 10-year time-weighted return numbers, private equity outpaces the MSCI World by more than 500 basis points.1 Moreover, in a recent study conducted by Hamilton Lane, the majority of LP respondents stated that they expect PE investments to return anywhere from 300-500 bps (or higher) above their public equity benchmark over the next five years.

1 Hamilton Lane Fund Investment Database (data as of September 30, 2016)

Source: Hamilton Lane 2016/2017 Private Market Survey

It’s important to keep in mind that outperformance or underperformance of the benchmark over the near term does not necessarily predict the future performance of a portfolio of investments. Given the unique nature of the asset class – illiquidity, pacing, infrequent pricing, J-curve effect, etc. – benchmarking in private equity is not without its challenges. While imperfect, however, we have historically seen investors’ private equity portfolios outpace their public equity benchmarks by that 300-500 basis point range over the long term.

LPs – Over the next five years, my benchmark return for PE should be a public equity benchmark plus:

External viewTolerance for illiquidity en- ables value-added through private equity exposure

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More than 500 bps 19%

300 to 500 bps 62%

Less than 300 bps 19%

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Bank regulations create opportunity

• The US Volcker Rule banning proprietary trading creates dislocations in securities prices, and leads to investment opportunities.

• Basel III capital requirements offer ‘real money’ accounts such as family offices an edge in bond markets.

• Family offices could make collateralized loans to banks at attractive rates.

• Helping banks to meet contrasting regulatory capital requirements brings opportunities.

The combination of the US Volcker Rule (part of the Dodd-Frank Wall Street Reform and Consumer Protection Act) and Basel III accord bank capital regulations have increased both investment and trading constraints on banks relative to other investors. In turn, this has unlocked opportunities for investors to capitalize on these dislocations.

The Volcker Rule essentially prohibits proprietary trading by banks, except in Treasury securities, which means that they now operate more as brokers, especially for corporate bonds and equities. This offers family offices potentially attractive investment opportunities. If a dealer holds certain assets for too long, then it must divest them at a reasonable price to avoid the risk of being classified as a proprietary trader. While the current Republican administration may relax some of the Dodd-Frank regulations, perhaps even the Volcker Rule, this will be practi-cally immaterial to most banks in this area because of other regulations, namely Basel III.

Basel III requirementsWithout directly stating it, these regulations limit the ability of banks to engage in proprietary trading, even in Treasuries, due to balance sheet costs. While the capital requirements for Basel III are being phased in with a deadline of March 2019, almost all the major banks already comply.

Current capital and leverage requirements make it almost prohibitive for banks to actively deal in corporate bonds. For example, when a bank bids on a corporate bond, it will then need to hold more capital against the bond unless it can sell the bond immediately. The dealer would then finance the bond in the repo market, with a duration of less than 30 days to avoid any appearance of proprietary trading. In turn, the dealer would then have more debt on its books with a maturity of less than 30 days. The bank must then hold high-quality liquid assets, on a 1-for-1 basis, against that repo position to meet Basel III’s Liquidity Coverage Ratio (LCR) requirement. Then, to add insult to injury, the bank must hold additional capital against that high-quality liquid asset to meet a leverage ratio (see below). While these short-term assets the bank owns (e.g. T-bills) will generally be classified as zero-risk weighted assets (RWA), the Basel leverage requirements do NOT differentiate the risk weights for capital a bank must hold against these liquid assets. That is, a bank must hold the same amount of capital against a T-bill as it does for, say, a 30-year structured mortgage product to comply with the leverage ratio.

Since this leverage ratio is non-risk adjusted, banks would much prefer to hold riskier assets, as opposed to T-bills or other short-term liquid assets. This makes it much more expensive for banks to deal in corporate bonds, giving family offices the opportunity to step in and capitalize by buying corporate inventory. Basically, Basel III rules assume that bank balance sheets are fairly rigid, only adjusting slowly as new loans are made. The rules are not designed for active trading, which results in a dynamic balance sheet; in turn, this makes it more expensive to buy or sell corporate bonds, which generally do not turn over as quickly as Treasuries and must be held on the bank‘s balance sheet. Higher repo costs have also driven a capital wedge in leveraged trading, giving cash investors an advantage over leveraged ones. Likewise, Treasury liquidity is lower since leveraged funds find it harder to get the repo lines needed to execute large tra-des. While high frequency traders (HFTs) are becoming a larger share of the Treasury market, most HFTs do not have access to repo lines, limiting them to day trading since all positions must be unwound before end of day. Accordingly, HFTs mostly

Providing capital to help banks meet regulatory requirements offers an opportunity for profit.

Jerry Lucas – UBS Senior Trading Strategist, CIO Short Term Investment Opportunities

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deal in smaller sizes and trade Treasuries in a more limited way. Again, this can give an edge to ’real money‘ accounts since they also deal in smaller sizes and do not have the same liquidity constraints. Likewise, due to these liquidity constraints, Treasury prices can move violently when a big trade hits the markets. If real money is willing to step in and provide liquidity by purchasing cheap bonds, these trades should prove profitable. However, family offices must act quickly to take advantage of these opportunities.

New investment opportunitiesWhile many family offices may not have repo lines open – either because they do not trade in repo or do not have a credit rating – they could consider opening collateralized lending ar-rangements with banks. That is, a bank could reduce its balance sheet by lending out inventory to family offices, which would lend cash at attractive rates to the bank. This would provide hig-her returns to the cash portfolio of family offices for a low-risk collateralized loan. Likewise, the bank benefits by reducing its balance sheet and not being subject to the LCR. In short, this would provide a win-win scenario for both parties.

The LCR opens up another opportunity. As previously menti-oned, banks must own high-quality liquid assets against repo borrowing lines. But since these zero RWA still count against leverage limits, most banks would rather own higher risk assets. Yet these make banks more likely to fail their annual stress tests. So, bank dealers must find a balance between their average RWA and their liquidity needs. As a result, banks overweight sectors such as senior loans and certain commercial mortgage- backed securities.

The banks’ dilemma gives family offices a potentially profitable opportunity to help them meet their overall balance between capital requirements (measured against RWA), the aforementi-oned LCR (capital vs. total exposure where RWA do not apply) and stress test requirements. Helping banks to square the circle should present family offices with attractive investment oppor-tunities at reasonable prices.

Primary dealer net outright position in corporate securities*

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06 07 08 09 10 11 12 13 14 15 16 17

Source: Federal Reserve Bank of New York, UBS as of March 2017; *old definition (includes non-agency MBS) For illustrative purposes only

Paul Sharma – Alvarez & Marsal. Formerly Deputy Head of the UK‘s

Prudential Regulation Authority (PRA) and an Executive Director of

the Bank of England

First: Today regulation no longer primarily means rules. It never quite has done, but since the 2008 global financial crisis this is more than ever the case. Today’s regulators are first and foremost supervisors. That is they monitor banks and step in to prevent or remedy harm. The same applies to investment banks, insurance companies and other regulated financial firms.

In a rules-based approach ’harm’ occurs solely where a bank breaches a rule. Today ’harm’ embraces any conduct that threatens the achievement of the supervisor’s statutory objectives. Those objectives are broadly set as financial stability, consumer protection and prevention of the use of the financial system for money laundering. In consequence, banks face deep uncertainty as to what they are and are not allowed to do. Nor is this stable or consistent. Important supervisory decisions as to what is acceptable are often firm-specific, and not necessarily the same from one bank to another. Also, the supervisor may revise its view from one period to the next, sometimes even applying its new view retrospectively to past conduct. Banks may only find out years later the standard against which their conduct is to be judged. This uncertainty is not an accidental side-effect of regulators’ responses to the financial crisis. It is an intended consequence, and is their response to banks arbitraging rules, that is complying to the letter, but frustrating the purpose, of the rule.

Second: Paradoxically even as regulators make increasing use of this bespoke approach post the global financial crisis, they have also rewritten the rules to make them more one-rous and more detailed. Furthermore they have increased the penalties for non-compliance, not only on the banks but increasingly also personally on their directors and managers. Rule compliance has become ever more necessary, even as it has become far less able on its own to manage regulatory risk. This trend is set to continue at least in Europe. In the US we might see future Trump appointees to the banking regulators reduce rules but in my view they are very likely to continue with bespoke supervision.

Third: New technology will change everything. At present banks monopolize the private creation of money and do-minate the provision of credit. New technology will change how banks comply with regulation, e.g. through artificial intelligence. But more profoundly new technology creates opportunities for non-banks to provide credit (e.g. peer-to-peer lenders) and even create money (e.g. through virtual currencies). Regulators are striving to bring these non-banks within their scope. Critics say this the ’regulate first, under-stand later’ approach to innovation.

External viewThree trends to watch in bank regulation

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Human beings are rarely 100% rational. This is evident in the world of investments, most visibly in the formation, and subsequent bursting, of bubbles.

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Harnessing behavioral biases

• Irrational human behavior creates security pricebubbles and other distortions that can be exploited.

• UHNW investors are less likely to suffer frombehavioral biases than other types of investors.

• There are clear, systematic ways to turn these biasesinto profit opportunities.*

Despite neoclassical economists pleas to the contrary, human beings are rarely 100% rational. This is evident in the world of investments, most visibly in the formation, and subsequent bursting, of bubbles. Historical examples include the Tulip mania of the Dutch Golden Age, where a single tulip bulb changed hands for ten times the annual income of a skilled craftsman.1 More recently, in the dot-com bubble, 16 dot-com companies each paid more than USD 2 million for a 30-second Super Bowl commercial, with companies as obscure as OnMoney.com, e1040.com, E-Stamp.com and the infamous Pets.com all enjoying a brief moment in the sun.2

Empirical evidence suggests private investors are vulnerable to such behavioral biases. Papers presented in the Journal of Finance, academic evidence from the University of California3 and studies published in the Quantitative Analysis of Investor Behavior4 all reach broadly the same conclusion: that poor deci-sions by private investors, such as when to sell and buy, lead to inferior investment performance compared with a buy-and-hold or systematically rebalanced investment strategy. Indeed, our own UBS-Campden family office study echoes these findings, with the average family office returning 0.3% in 2016 despite US equity markets delivering 5% and the average of Yale, Prin-ceton and Harvard returning 10%.

The average family office re-turned 0.3% in 2016 despite US equity markets delivering 5% and the average of Yale, Princeton and Harvard returning 10%.* 5

However, although UHNW investors are vulnerable to many of the behavioral traps that dog smaller private and institutional investors, this need not be the case. In fact, UHNW investors have a behavioral advantage over their private and institutional investor counterparts. The lack of constraints on UHNW inves-tors – many of which are discussed in the other sections of this report – create investment advantages. For example, the lack of ’career risk’ when investing, or the desire to raise or protect third-party capital, frees UHNW investors from institutional behavioral biases such as ’herd mentality’ – the desire to ’keep with the pack’ – in order to avoid the possibility of an adverse outcome. While below is not an exhaustive list, it covers many of the key advantages.

AnchoringInstitutional investors, in aggregation, exhibit the behavioral bias known as ’anchoring’. Anchoring is the disposition to place undue weight on the prior state of nature and not to fully incorporate new information. This results in the ‘momentum’ abnormality, where stocks fail to follow a random walk and instead exhibit a degree of auto-correlation. In simple terms, stocks that have gone up on good news tend not to have fully incorporated all the good news and thus continue to do so. Similarly, stocks that fall in value tend to continue their unfor-

By taking advantage of behavioral biases, ultra-high net worth (UHNW) investors can make additional financial gains.

Human beings are rarely 100% rational. This is evident in the world of investments, most visibly in the formation, and subsequent bursting, of bubbles.

*Past performance is not a reliable indicator of future results.

James Purcell – UBS Head of CIO hedge funds and UHNW investments

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tunate trajectory. While UHNW investors can also be vulnerable to anchoring, savvy UHNW investors can exploit this behavioral bias by using momentum strategies to earn a long-term return exceeding the market.

Loss aversionInstitutional investors, in aggregation, exhibit the behavioral bias known as ’loss aversion’ or ’prospect theory.’ Loss aversion crea-tes an asymmetric utility function where losses are more keenly felt than gains; this helps explain why distressed assets and so-called value stocks offer a long-term return exceeding that of the market. Institutional investors’ loss aversion may, again, be tied to the concept of career risk. In turn, this is a product of private investors’ own loss aversion – as they are more likely to withdraw their money from an underperforming fund than allocate more to an outperforming one. UHNW investors, who possess significant capital, should be less concerned about loss aversion than career-threatened institutional investors or solven-cy-threatened retail investors. They can exploit this behavioral bias by using value strategies to earn long-term returns that beat the market.

OverconfidenceInstitutional investors, in aggregation, exhibit overconfidence bias. Similarly, UHNW investors can also be guilty of this. A 2006 study entitled ’Behaving badly’6 found that 74% of surveyed fund managers believed they had delivered above-average job performance. Yet an average of 60% of mutual funds under-perform their benchmark in any given year – a figure that jumps north of 80% over five years.7 Various studies have shown, perhaps most publically (and unsurprisingly) trumpeted by passive behemoth Vanguard, fees are key to performance,8 and thus performance drag. In fact, they are more important than the manager’s ability to select stocks. This is not to dismiss the abilities of all institutional investors, but rather acknowledges that in aggregation the abilities of exceptional fund managers are diversified to the point of mediocrity. UHNW investors can exploit this behavioral bias by investing selectively in active managers (of course, it is possible that believing one can identify an outperforming fund manager might also be a form of beha-vioral bias) and using low-fee instruments for the rest of their investments. Indeed, recent research by Roubini suggests UHNW individuals are increasingly using low-cost passive instruments. Some 71% confirmed they were using or planned to use passive instruments in the next five years.9

Regulatory / investment guideline restrictionsMany of these UHNW advantages are compounded by regula-tory / investment guideline restrictions placed upon institutional investors. For example, benchmarking the performance of a

US large capitalization manager against the S&P 500 index can intensify herding behavior. Yet for UHNW investors it can create opportunities to earn long-term excess returns in overlooked small capitalization stocks. Similarly, mutual fund managers whose use of leverage is constrained might invest in higher- volatility stocks due to the over-confidence bias, so exposing themselves to larger losses. UHNW investors can exploit this possibility through low volatility or low risk-weighted investing.

How to benefitIn summary, private investors tend to exhibit greater behavioral biases than their institutional counterparts. Yet UHNW investors need not follow suit. Not only can they avoid these behavioral biases, but they can tailor investment strategies to exploit them. This is true across momentum, value, small capitalization and low volatility / low risk-weighted strategies. Furthermore, passive investing can lower an UHNW investor’s fee drag. Combining these biases, along with yield and quality factors to create a US multi-factor strategy would have outperformed the US stock market by 2.6% annualized in a back-test over the past 15 years.

By talking to their financial advisors, UHNW investors can avoid behavioral biases. They can also exploit those of others for financial gain.

The value of investments can go down as well as up. Your capi-tal and income is at risk.

Footnotes1 http://www.economist.com/blogs/freeexchange/2013/10/economic-history http://www.thebubblebubble.com/tulip-mania/ https://en.wikipedia.org/wiki/Tulip_mania2 https://en.wikipedia.org/wiki/Dot-com_commercials_during_Super_Bowl_

XXXIV3 https://www.umass.edu/preferen/You%20Must%20Read%20This/Bar-

ber-Odean%202011.pdf4 https://dalbar.com/Home/Index5 https://uhnw-gfo.ubs.com/en/gfo-report/6 www.kellogg.northwestern.edu/faculty/weber/decs-452/behaving_badly.pdf7 https://www.ft.com/content/e555d83a-ed28-11e5-888e-2eadd5fbc4a48 www.vanguard.com/pdf/s356.pdf9 http://www.roubinithoughtlab.com/wealth2021

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A Six Equity Factor* Equal Weight portfolio outperforms the market capitalization-weighted benchmark

Six Equity Factor* Equal Weight portfolio, rebalanced quar-terly and MSCI USA total return (net) performance, both rebased to 100 as of January 2001, with absolute difference marked

* Equal risk-weighted factors: momentum, value, small capitalization, low volatility / low risk, yield, and quality.

Source: BloombergFor illustrative purposes only

Equally weighted six factor portfolio Market capitalization-weighted

2001 2003 2005 2007 2009 2011 2013 2015 2017

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Bahamas: This publication is distributed to private clients of UBS (Bahamas) Ltd and is not intended for distribution to persons designated as a Bahamian citizen or resident under the Bahamas Exchange Control Regulations. Bahrain: UBS is a Swiss bank not licensed, supervised or regulated in Bahrain by the Central Bank of Bahrain and does not undertake banking or investment business activities in Bahrain. Therefore, Clients have no protection under local banking and investment services laws and regulations. Brazil: Prepared by UBS Brasil Administradora de Valores Mobiliários Ltda, entity regulated by Comissão de Valores Mobiliários (“CVM”). Canada: In Canada, this publication is distributed to clients of UBS Wealth Management Canada by UBS Investment Management Canada Inc.. Czech Republic: UBS is not a licensed bank in Czech Republic and thus is not allowed to provide regulated banking or investment services in Czech Republic. This material is distributed for marketing purposes. Denmark: This publication is not intended to constitute a public offer under Danish law, but might be distributed by UBS Europe SE, Denmark Branch, filial af UBS Europe SE, with place of business at Sankt Annae Plads 13, 1250 Copenhagen, Denmark, registered with the Danish Commerce and Companies Agency, under the No. 38 17 24 33. UBS Europe SE, Denmark Branch, filial af UBS Europe SE is a branch of UBS Europe SE, a credit institution constituted under German Law in the form of a Societas Europaea, duly authorized by the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin). UBS Europe SE, Denmark Branch, filial af UBS Europe SE is subject to the joint supervision of the BaFin, the central bank of Germany (Deutsche Bundesbank) and the Danish Financial Supervisory Authority (DFSA) (Finanstilsynet), to which this document has not been submitted for approval. France: This publication is distributed by UBS (France) S.A., French “société anonyme” with share capital of € 125.726.944, 69, boulevard Haussmann F-75008 Paris, R.C.S. Paris B 421 255 670, to its clients and prospects. UBS (France) S.A. is a provider of investment services duly authorized according to the terms of the “Code Monétaire et Financier”, regulated by French banking and financial authorities as the “Autorité de Contrôle Prudentiel et de Résolution”. Germany: The issuer under German Law is UBS Europe SE, Bockenheimer Landstrasse 2-4, 60306 Frankfurt am Main. UBS Europe SE is authorized and regulated by the “Bundesanstalt für Finanzdienstleistungsaufsicht”. Hong Kong: This publication is distributed to clients of UBS AG Hong Kong Branch by UBS AG Hong Kong Branch, a licensed bank under the Hong Kong Banking Ordinance and a registered institution under the Securities and Futures Ordinance. India: Distributed by UBS Securities India Private Ltd. 2/F, 2 North Avenue, Maker Maxity, Bandra Kurla Complex, Bandra (East), Mumbai (India) 400051. Phone: +912261556000. SEBI Registration Numbers: NSE (Capital Market Segment): INB230951431, NSE (F&O Segment) INF230951431, BSE (Capital Market Segment) INB010951437. Indonesia: This research or publication is not intended and not prepared for purposes of public offering of securities under the Indonesian Capital Market Law and its implementing regulations. Securities mentioned in this material have not been, and will not be, registered under the Indonesian Capital Market Law and Regulations. Israel: UBS Switzerland AG is registered as a Foreign Dealer in cooperation with UBS Wealth Management Israel Ltd, a wholly owned UBS subsidiary. UBS Wealth Management Israel Ltd is a licensed Portfolio Manager which engages also in Investment Marketing and is regulated by the Israel Securities Authority. This publication shall not replace any investment advice and/or investment marketing provided by a relevant licensee which is adjusted to your personal needs. Italy: This publication is distributed to the clients of UBS Europe SE, Succursale Italia, Via del Vecchio Politecnico, 3 - 20121 Milano, the branch of a German bank duly authorized by the “Bundesanstalt für Finanzdienstleis-tungsaufsicht” to the provision of financial services and supervised by “Consob”. Jersey: UBS AG, Jersey Branch, is regulated and authorized by the Jersey Financial Services Commission for the conduct of banking, funds and investment business. Where services are provided from outside Jersey, they will not be covered by the Jersey regulatory regime. UBS AG, Jersey Branch is a branch of UBS AG a public company limited by shares, incorporated in Switzerland whose registered offices are at Aeschenvorstadt 1, CH-4051 Basel and Bahnhofstrasse 45, CH 8001 Zurich. UBS AG, Jersey Branch’s principal place business is P.O. Box 350, 24 Union Street, St Helier, Jersey JE4 8UJ. Luxembourg: This publication is not intended to constitute a public offer under Luxembourg law, but might be made available for information purposes to clients of UBS Europe SE, Luxembourg Branch, with place of business at 33A, Avenue J. F. Kennedy, L-1855 Luxembourg. UBS Europe SE, Luxembourg Branch is a branch of UBS Europe SE, a credit institution constituted under German Law in the form of a Societas Europaea, duly authorized by the German Federal Financial Services Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin), and is subject to the joint supervision of BaFin, the central bank of Germany (Deutsche Bundesbank), as well as of the Luxembourg supervisory authority, the Commission de Surveillance du Secteur Financier (the “CSSF”), to which this publication has not been submitted for approval. Mexico: This document has been distributed by UBS Asesores México, S.A. de C.V. (hereinafter “UBS Asesores”). UBS Asesores is a subsidiary of UBS Switzerland AG (UBS), is an investment advisor incorporated under the Securities Market Law. UBS Asesores is a regulated entity and, it is subject to the supervision of the Mexican Banking and Securities Commission (Comisión Nacional Bancaria y de Valores, hereinafter “CNBV”), who exclusively regulates UBS Asesores regarding the rendering of portfolio management services when investment decisions are taken on behalf of the client, as well as on securities investment advisory services, analysis and issuance of individual investment recommendations, so that the CNBV has not surveillance faculties nor may over any other service provided by UBS Asesores. UBS Asesores does not guarantee any yield whatsoever. UBS Asesores will be prohibited from receiving cash, securities or any other assets as custodian, and also will be prohibited from receiving any compensation from any issuers for the promotion of its securities. UBS Asesores do not promote any bank service. UBS and its affiliates do not provide legal or tax advice and this presentation does not constitute such advice. Certain products and services are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis. UBS Asesores may only receive the expressly agreed fees from its clients for the effective rendered investment services; therefore UBS Asesores is not permitted to receive fees from local or foreign financial intermediaries, as well as issuers of securities that render services to its Clients. The total gross value referred to above comprises the sum of all your portfolios and is the most approximate value of your assets on the day. If the portfolios have different pricing

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dates, the total gross value may vary according to the selected date. Monaco: This publication is distributed by UBS (Monaco) S.A., (subsidiary of UBS AG), a stock corporation under Monegasque law, with fullypaid-up equity capital of EUR 49.197.000, 2, Ave. de Grande-Bretagne, B.P. 189, MC 98007, to its clients and prospects. UBS (Monaco) S.A is a provider of banking and investment services duly licensed by the French banking authority “Autorité de Contrôle Prudentiel et de Résolution” (“ACPR”) and the Monegasque financial authority “Commission de Contrôle des Activités Financières” (“CCAF”) by virtue of Law 1.338 of Septem-ber 7, 2007.” Netherlands: This publication is not intended to constitute a public offering or a comparable solicitation under Dutch law, but might be made available for information purposes to clients of UBS Europe SE, Netherlands branch, a branch of a German bank duly authorized by the “Bundesanstalt für Finanzdienstleistungsaufsicht” for the provision of financial services and supervised by “Autoriteit Financiële Markten” (AFM) in the Netherlands , to which this publication has not been submitted for approval. New Zealand: This notice is distributed to clients of UBS Wealth Management Australia Limited ABN 50 005 311 937 (Holder of Australian Financial Services Licence No. 231127), Chifley Tower, 2 Chifley Square, Sydney, New South Wales, NSW 2000, by UBS Wealth Management Australia Ltd. You are being provided with this UBS publication or material because you have indicated to UBS that you are a client certified as a wholesale investor and/or an eligible investor (“Certified Client”) located in New Zealand. This publication or material is not intended for clients who are not Certified Clients (“Non-Certified Clients”), and if you are a Non-Cer-tified Client you must not rely on this publication or material. If despite this warning you nevertheless rely on this publication or material, you hereby (i) acknowledge that you may not rely on the content of this publication or material and that any recommen-dations or opinions in this publication or material are not made or provided to you, and (ii) to the maximum extent permitted by law (a) indemnify UBS and its associates or related entities (and their respective directors, officers, agents and advisers (each a “Relevant Person”) for any loss, damage, liability or claim any of them may incur or suffer as a result of, or in connection with, your unauthorised reliance on this publication or material and (b) waive any rights or remedies you may have against any Relevant Person for (or in respect of) any loss, damage, liability or claim you may incur or suffer as a result of, or in connection with, your unauthor-ised reliance on this publication or material. Saudi Arabia: This publication has been approved by UBS Saudi Arabia (a subsidiary of UBS AG), a Saudi Arabian closed joint stock company incorporated in the Kingdom of Saudi Arabia under commercial register number 1010257812 having its registered office at Tatweer Towers, P.O. Box 75724, Riyadh 11588, Kingdom of Saudi Arabia. UBS Saudi Arabia is authorized and regulated by the Capital Market Authority of Saudi Arabia. Singapore: Please contact UBS AG Singapore branch, an exempt financial adviser under the Singapore Financial Advisers Act (Cap. 110) and a wholesale bank licensed under the Singapore Banking Act (Cap. 19) regulated by the Monetary Authority of Singapore, in respect of any matters arising from, or in connection with, the analysis or report. Spain: This publication is distributed to its clients by UBS Europe SE, Sucursal en España, with registered office at Calle María de Molina 4, C.P. 28006, Madrid, entity supervised by Banco de España and the Bundesanstalt für Finanzdienstleistungsaufsicht. UBS Europe SE, Sucursal en España is a branch of UBS Europe SE, a credit institu-tion constituted in the form of a Societas Europaea authorized and regulated by the Bundesanstalt für Finanzdienstleistungsaufsich. Sweden: This publication is not intended to constitute a public offer under Swedish law, but might be distributed by UBS Europe SE, Sweden Bankfilial with place of business at Regeringsgatan 38, 11153 Stockholm, Sweden, registered with the Swedish Companies Registration Office under the Reg. No 516406-1011. UBS Europe SE, Sweden Bankfilial is a branch of UBS Europe SE, a credit institution constituted under German Law in the form of a Societas Europaea, duly authorized by the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin). UBS Europe SE, Sweden Bankfilial is subject to the joint supervision of the BaFin, the central bank of Germany (Deutsche Bundesbank) and the Swedish financial supervisory authority (Finansinspektionen), to which this document has not been submitted for approval. Taiwan: This material is provided by UBS AG, Taipei Branch in accordance with laws of Taiwan, in agreement with or at the request of clients/prospects. UAE: This research report is not intended to constitute an offer, sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE). The contents of this report have not been and will not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities, the Emirates Securities and Commodities Authority, the Dubai Financial Market, the Abu Dhabi Securities market or any other UAE exchange. This material is intended for professional clients only. UBS AG Dubai Branch is regulated by the DFSA in the DIFC. UBS AG/UBS Switzerland AG is not licensed to provide banking services in the UAE by the Central Bank of the UAE nor is it licensed by the UAE Securities and Commodities Authority. The UBS AG Representative Office in Abu Dhabi is licensed by the Central Bank of the UAE to operate a representative office. UK: Approved by UBS AG, authorised and regulated by the Financial Market Supervisory Authority in Switzerland. In the United Kingdom, UBS AG is authorised by the Prudential Regulation Authority and subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. A member of the London Stock Exchange. This publication is distributed to private clients of UBS London in the UK. Where products or services are provided from outside the UK, they will not be covered by the UK regulatory regime or the Financial Services Compensation Scheme. USA: This document is not intended for distribution into the US, to US persons, or by US-based UBS personnel. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc., UBS Financial Services Inc. is a subsidiary of UBS AG. Version 11/2016.

© UBS 2017. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved

Published in July 2017

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UBS Switzerland AGGlobal Ultra High Net WorthP.O. Box8098 ZurichSwitzerland

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