Your Wealth & Life Personal strategies for wealth management

Your Wealth & Life Personal strategies for wealth management CIO Wealth Management Research Leverage your balance sheet a b

Contents 01 Editorial 02 Leverage your balance sheet 08 Interview: David McWilliams speaks with Clifford Asness 11 Disclaimer 12 Publication details This report has been prepared by UBS Financial Services Inc. ( UBS FS ). Please see important disclaimers and disclosures on page 11. This report was published on 1 June 2105.

Dear readers, Mike Ryan, CFA Our examination of a total wealth approach continues this quarter with a focus on the sometimes forgotten and often ignored side of the balance sheet: liabilities. Although there is general public anxiety around borrowing and debt, proactively managing the liability side of a balance sheet is an important part of holistic wealth management. Michael Crook, CAIA We offer an in-depth look at market factors driving current borrowing costs, behavioral reasons for debt aversion, and guidelines for managing liabilities effectively. We hope this work spurs you to take a look at your balance sheet and see if today s low-interest rate environment can enable you to create a more effective path to meeting your goals. Mike Ryan, CFA Chief Investment Strategist, WMA Regional CIO, Wealth Management US Michael Crook, CAIA Head of Portfolio & Planning Research CIO, Wealth Management US Your Wealth & Life June 2015 1

lev er age / lev( )rij, lēv( )rij/ e e verb 1. Use borrowed capital for (an investment), expecting the profits made to be greater than the interest payable. 2. Use (something) to maximum advantage. Leverage your balance sheet Michael Crook, CAIA; Brian Rose, PhD; Andrea Fisher, CFA; Matt Baredes Introduction If you turn on a financial news channel or read random investment commentary, chances are the topic will be assets. Typically, it will be favorite stock picks, the bond market, commodity prices, real estate or something about asset allocation. Rarely does the topic of liabilities come up. Over the last year, there have really been only two times that the media focused on this subject. One was when Warren Buffett 1 said it was a nobrainer to use a mortgage to short interest rates, and the other was when former Federal Reserve Chair Ben Bernanke 2 said he had trouble refinancing his mortgage. This lack of analysis and attention on liabilities is a shame. Why? Balance sheets have two sides: assets and liabilities (see Fig. 1). Both are vitally important for households, companies, endowments, and other institutions, and improper management of either can be detrimental to long-term wealth. However, thoughtful analysis around liabilities (i.e., debt) is difficult to come by, and many people are loath to discuss it. Whether for psychological reasons or due to perceived risks, ignoring debt isn t practical or prudent. Certain strategies can help investors improve their likelihood of accomplishing financial objectives. Also, the current interest rate environment presents a compelling opportunity to review existing liabilities in the context of asset allocation and investment goals. Before we proceed any further on this subject, it s probably helpful to explain what this edition of Your Wealth & Life is about and what it is not about. This is not a publication about using debt to purchase consumption that would otherwise 2 June 2015 Your Wealth & Life

not be affordable. It is not about using margin to leverage investment portfolios, and it is certainly not about imprudently adding excessive leverage to a household's balance sheet. It's also not about high-cost debt, like credit cards and car loans. All of the previously mentioned items are usually bad ideas. Instead, our focus is on applying sober, quantitative analysis to the construction of holistic balance sheets for high-networth and ultra high-net-worth households. It is about using liabilities for diversification rather than the amplification of risk and return. Mainly, it is about how liability strategies can help a wide range of investors reach their financial goals and objectives. Debt aversion and behavioral finance People tend to shy away from discussing liability management. Debt certainly has an emotional component to it, and most rules of thumb suggest removing it from a household's balance sheet as quickly as possible. Psychologically, this is because individuals are innately debt-averse. In a study at the Technical University of Berlin, experimenters tested individuals' saving and consumption decisions under two conditions: one where the optimal solution includes borrowing, and one where it includes saving. What did they find? The experimental findings imply that deviations from optimal behavior are higher when subjects have to borrow than when they have to save in order to consume optimally, suggesting debtaversion. 3 The study's results suggest that people are not good at determining how much they should borrow in order to smooth out consumption across their lifespan. It appears that our brains are not wired to think optimally when it comes to decisions involving debt. The natural aversion that most people have to debt is what psychologists call a heuristic. A heuristic is a mental shortcut we have developed to help make quick decisions. Now, to a certain degree, debt aversion is a good heuristic. However, it is clearly irrational to never use debt under any circumstances. Indeed, in a UBS survey, investors indicated the circumstances under which debt was bad or good (see Fig. 2). Many investors said that home purchases and education payments funded by debt are good decisions from a financial perspective. If a medical degree will lead to decades of high and stable earnings, taking out a loan to pay for the degree makes sense. This is representative of the typical lifecycle model of borrowing early in life in order to build human capital and savings for consumption later in life (see Fig. 3). Even in such prudent situations, it may not feel good to use debt. But we know debt aversion is not rational, which is why we should apply proven principles and logic to decisions around the right amount of debt to use. In other words, if our instincts are likely to lead us astray, then it is advisable to pull out the proverbial calculator and run the math. Fig 1: A typical household balance sheet Assets and liabilities should be managed proactively Assets 401k Investment assets Residential real estate Social security Pension Human capital Tangible assets Source: CIO WMR Liabilities Mortgage Securities-based loan Future retirement spending Future educational spending for children Your Wealth & Life June 2015 3

In theory Investors should always be very skeptical when they hear that something is a good idea in theory. In theory, Lehman Brothers was going to make a lot of money on its proprietary real estate positions right before it went bankrupt. In theory, many investors thought technology stocks were fairly priced in March 2000 right before they declined 81%. In theory, 2% is a fair yield on a 10-year Treasury bond in May 2015 (we ll have to wait and see how that last one pans out). Fig. 2: Good debt versus bad debt Survey question: Which of the following would you consider to be good debt versus bad debt? Credit card balance that is not paid off every month 2% 96% 2% Borrowing from family/friends 7% 86% 7% Mortgage on a second home/vacation home 29% 57% 14% Second mortgage on one home 18% 74% 9% Short-term borrowing to avoid realizing a large capital gain 46% 28% 26% Short-term borrowing to avoid selling assets you feel are going to appreciate in value 53% 28% 18% Student loan 58% 28% 14% Mortgage on primary home 92% 6% 2% 0 20 40 60 80 100 Good debt Bad debt Don t know Source: UBS Investor Watch, 2Q 2013 Fig. 3: The life-cycle theory of consumption and saving Fig. XX: The life cycle theory of consumption and saving Income, consumption Borrowing Saving Dissaving Saving accelerates during mid-life. Individuals generally borrow early in life for education and home purchases. College, buying a home Prime working years Retirement After retirement, individuals use their savings for living expenses. Income Consumption Source: St. Louis Federal Reserve 4 June 2015 Your Wealth & Life

The problem with traditional asset allocation theory is that it's derived from radical simplifications. Behavioral economist Richard Thaler points out in his new book, Misbehaving: The Making of Behavioral Finance, that in order to achieve the same mathematical precision of hard sciences, economists have to assume that people are rational optimizers whose behavior is as predictable as the speed of a physical body falling through space. Unfortunately, we know quite clearly that investors don't always behave as reliably as gravity. However, understanding theory can be instructive around broad concepts (such as diversification) as long as investor behavior is also taken into account. The efficient frontier, for instance, has been a powerful portfolio management tool despite its many failings 4. Once an investor s risk tolerance is determined and quantified in terms of variance or standard deviation, an optimal portfolio can be easily identified. But even in the overly simplified modern portfolio theory (MPT) framework, it is important to understand that investors have a choice. An aggressive investor can hold a portfolio concentrated in equity or hold a moderate portfolio that's been leveraged to the same risk as the riskier option. In this example, it's reasonable to think that the leveraged moderate portfolio is actually better diversified than an all-equity portfolio. While this refresher on MPT might seem overly technical, we feel it is instructive here, so we've included a visual of the efficient frontier to illustrate how this works. Portfolio A in Fig. 4 represents a leveraged moderate portfolio. It has a higher expected return yet a lower estimated risk than Portfolio B, which sits on the efficient frontier and does not use leverage. Essentially, it is possible to add leverage and increase return expectations without adding risk. We reach a similar conclusion regarding cash holdings when considering Portfolios C and D. It is theoretically possible (though perhaps this doesn't apply today in a world of zero interest rates) to hold a combination of cash and a moderate portfolio without giving up return compared to a bond-heavy conservative portfolio. We understand this evidence may not assuage the concerns of the most debtaverse investors. Frankly, as we said before, investors should be skeptical of basing decisions on theory. However, theory provides a simple but powerful guideline: leverage can be used for more than just amplifying risk. Why now? Fed liftoff in 5, 4, 3, 2, 1 The US economy has been gradually recovering from the global financial crisis, and the Federal Reserve is clearly signaling that it is getting closer to raising rates for the first time since June 2006. Why does this matter? Borrowing costs are tied to interest rates. Just as long-term interest rates remain near 50-year lows, borrowing costs are also lower than they ve been in many decades (see Fig. 5). Fig. 4: Efficient frontier and capital allocation line (CAL) In % 12 Annualized estimated return % 10 8 6 4 2 0 D 0 2 4 6 8 Annualized estimated risk % Note: Port. T = tangency portfolio Source: UBS CIO WMR, 21 May 2015 C Port. T Port. T + cash Port. T + lending A B 10 Your Wealth & Life June 2015 5

While we expect the Fed will achieve liftoff before the end of 2015, we expect this favorable lending environment to persist for some time. In fact, Fed Chair Janet Yellen has stated that, unlike past rate-hike cycles, most of my colleagues and I believe the return of the federal funds rate to a more normal level is likely to be gradual. According to the latest forecasts provided by members of the Federal Open Market Committee, the Fed is slated to raise rates to around 1.75 2.00% by the end of 2016. However, it is likely to take many years for interest rates to rise back to their (normal?) longer-run levels, typically between 3.5% and 4.0% (see Fig. 6). We therefore expect the fed funds rate to be only around 2.5% five years from now. Many investors find borrowing rates attractive for the same reasons they find bonds unattractive right now. A greater willingness to borrow is a logical counter-response to underweighting bonds in a portfolio since the investor is effectively taking advantage of low interest rates to issue debt from his or her own balance sheet. Similarly, if rates rise, the marginal benefit of various liability strategies will correspondingly decline. The overall value of debt will likely decline as the Fed normalizes interest rates. Guiding principles Individuals borrow for a number of different reasons. For example, young households use mortgages to purchase homes based on human capital 5 and future income. Parents use securities-based lending as a way to help their children and grandchildren without having to sell positions and incur tax consequences. Small business owners sell their company to their employees through a strategy known as an Employee Stock Ownership Plan, which typically requires borrowing. All of these borrowing strategies (and many more) make sense on a standalone basis, but they must be considered and managed appropriately. Here are our guidelines for doing so: 1) Compare the efficacy of various strategies through financial planning Before adding liabilities to a balance sheet, we find that the most useful analysis we can do is to re-run a financial plan to see whether or not doing so increases the overall probability of success for the plan. The multiple factors associated with determining the right way to structure liabilities (tax impact, balance sheet liquidity, cost of debt relative to investment returns, etc.) can be substantial and far-reaching. A financial plan is the only way to capture all of the various aspects in one analysis. 2) Maintain control by matching the duration of liabilities to the duration of assets History is full of devastating examples of investors and firms that borrowed short and invested long. Fig. 5: Interest rates remain near multi-decade lows Interest rates have declined since the early 1980s 14 12 10 8 6 4 2 0 1984 1989 1994 1999 2004 2009 2014 10-year US Treasury 3-month LIBOR Source: Bloomberg 6 June 2015 Your Wealth & Life

Corporations that relied on the commercial paper market for daily financing prior to the financial crisis, and then overnight found themselves unable to fund operations, are just one example. We cannot stress enough how important it is to always maintain control of borrowing. Two best practices include having liquid assets available to pay off the liability if necessary, and locking in the terms of borrowing for at least as long as the investor expects to hold the associated asset if it is illiquid in nature. Many high-net-worth and ultra high net-worth-investors will be able to use short-term financing without running afoul of this principle due to the strength of their balance sheets and limited amount of borrowing done as a percentage of overall assets. Even so, the consequences of ending up on the wrong side of this trade are large enough to make it applicable for all investors. Consider this as a baseline: If investors do not have the contractual rights to the debt, then they should assume the lender can force them to pay it off at any time. 3) Manage liabilities proactively One of the best aspects of borrowing for households is that some structures, like mortgages, offer tremendous optionality. Because homeowners can refinance a mortgage without penalty but the lender cannot do the same, holding a mortgage is essentially like issuing callable bonds. If rates decline, the homeowner can simply refinance and take advantage of lower borrowing costs. If rates increase, the homeowner can hold the mortgage through the full term and take advantage of belowmarket rates of borrowing. It s only by managing liabilities proactively Fig. 6: This time may be different Federal funds effective rate, in % 7 6 5 4 3 2 1 0 that these opportunities can be fully exploited. 4) Use debt to diversify, not amplify Finally, perhaps the most important guiding principle we can offer is to not use debt to amplify investment returns. Leave that to the professionals, such as Cliff Asness, interviewed on the next page. Instead, use debt as a way to further diversify balance sheet risk and improve financial planning outcomes. Examples might be a small business owner who has 80% of his or her assets tied up in the business, or a 30-year-old (who likely has 80% of his or her assets tied up in human capital) purchasing a house for the first time. 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 Source: Bloomberg, as of 11 May 2015 Your Wealth & Life June 2015 7

Interview Clifford Asness David McWilliams: Why are debt and leverage typically considered dirty words for investors? David McWilliams, Head of Wealth Management Transformation at UBS, recently interviewed Cliff Asness, Co-Founder, Managing Principal and Chief Investment Officer at AQR Capital Management. Asness is an active researcher and has authored articles on a variety of financial topics for many publications, including The Journal of Portfolio Management, Financial Analysts Journal and The Journal of Finance. Cliff Asness: Well, they do add risk. Nobody is wrong about that. I ll note upfront that leverage and debt are not precisely the same thing, but they re highly related, so I ll just refer to leverage here. All else equal obviously all else is not always equal but all else equal, if you take the same investment and lever it, it adds risk. And going further, leverage has also been used irresponsibly. Even though this is the exception not the rule, many of our big headline problems in finance and investing are often related to leverage. When you give people a tool that can be used for good or evil you get a lot of headlines out of the people, even if they re few in number, who use it for evil. I think it s bad to form opinions by just looking at headlines, but it s very understandably human. I m sure I do it at times as well. But this means conventional wisdom often overlooks the many beneficial uses of leverage. Leverage is necessary to achieve not just investing objectives, which is what I focus on day-to-day, but also many corporate, personal, institutional, and governmental goals. Leverage is a form of smoothing out things over time, smoothing out consumption for individuals. As I ll talk about later, it s a form of building a better portfolio. Furthermore, investors should realize that a lot of the people who say they re uncomfortable with leverage often are skipping the fact that there is great implicit leverage in the world. Home mortgages of course are one example. Corporate borrowing is another. People will often think of equities as an unlevered investment even though a lot of equities are levered two or more to one. I don t think a modern economy could function without these things. Leverage is important and people should realize you can manage it you can understand it and you can take control of it yourself. But you really can t run from it. It s already there. What s really important is to separate the dangerous uses from the necessary ones and then to use it as prudently as you can. David McWilliams: So how do you think about leverage when it comes to building portfolios? 8 June 2015 Your Wealth & Life

Cliff Asness: That s the world I m most familiar with. And again, leverage can be used in fairly dangerous ways we don t recommend. The most famous use of leverage, the one in most people s mind, is probably just to make a big bet bigger. And it works for that. When I say it works, I don t mean it works out well all the time. I mean it will make a bet bigger and increase the upside and the downside. I think people are right to be scared of that. It s great, of course, if an investor or a manager gets it right, but it s terrible if they don t. But we think leverage has a very beneficial and often neglected use. If you re not taking enough risk to hit your goal and you ve analyzed your portfolio based on your assumptions but still end up saying this isn t going to get you there you really have two options, two things you can do. You can get more concentrated and try to be in the right things. Or, and this is where leverage comes in, you can lever a diversified portfolio. Leverage takes what s there and amplifies it, so if you re amplifying a good thing like a diversified portfolio, it can be helpful. An example of getting more concentrated is if I m 60/40 stocks/bonds but that s not hitting my goal, so I ll go to 80/20 or 100/0. Maybe that on average hits your goal, but it also makes your portfolio far more concentrated in equities and probably leads to a much wilder ride. On the other hand, we think applying modest leverage to a well-diversified portfolio is often a better choice. If you have the choice of taking a portfolio you really like, where you believe you have the appropriate asset allocation, and lever this, say, 1.3 to 1 (I made up the number of course, but something modest), well that s going to get your excess return 30% larger. And that s doing it without altering the fundamental characteristics and diversification of the portfolio. We like to say that leverage combined with diversification is a way to make all things matter but none too much. So getting back to your original question, how do we design a portfolio with leverage? We try to separate out the leverage decision from the portfolio allocation decision: we try to just create the best portfolio for the risk taken. Then if that s too conservative, check if adding a prudent amount of leverage can make it better. If not, if you come out and go, Well, you know, to make this reasonable I have to lever 32 to 1, go back to the drawing board. No one wants to see you do that. But if a prudent amount of leverage can make that diversified portfolio hit your goals, we think that is often a better plan than trying to pick and concentrate in the right asset class or the right assets. So there are two ways to get more return: concentration or leverage. We do not pretend leverage is riskless. You should run screaming from someone who says that. But concentration is risky too. And too often people don t think of the risk to concentration and over worry about the risk to leverage. We think they re both risky and we think leverage is often the better choice. David McWilliams: How do you determine how much leverage would be appropriate for a given situation? Cliff Asness: Well like anything else, you can use a more quantitative or qualitative approach. But, even a qualitative person has got to deal with numbers here. You have to ask, can this portfolio hit my goals without using leverage? And if not, how much leverage is necessary? If the answer is a reasonable number, then you re at least close to done. You ve come up with a portfolio that hits your goals with a reasonable amount of leverage. But if that amount is too aggressive, if the leverage number makes little intuitive or quantitative sense, then you have to adjust your portfolio. You have to say, well, leverage is a tool, but I can t go too crazy with it. Going back and forth coming up with a portfolio that is more diversified than a concentrated one and using leverage to get all or part of the additional expected return necessary is an iterative process. But I can t say it enough: you don t just follow a theory and say I m going to lever it to the moon because theory says to lever the best portfolio and Cliff said levering the best portfolio is a good idea. It has to eventually pass the common sense test. It has to come up with a level of leverage that, considering all the other factors, you think is reasonable. For example, at the beginning of building a portfolio we set a limit on dollar leverage, no matter what a model might tell you. So, you go back and forth to come up with the right level of leverage, but at the end of the day, you make sure quantitative and qualitative analyses are both built into the process by setting some limits for yourself beforehand and always surveying what you re doing with a basic common sense test. Survival is goal number 1. Prospering is goal number 2. It s a pretty important one too, but without survival, there is no prosperity. So setting that correct amount of leverage in a conservative, prudent way with some limits on it is about all I can tell people. Your Wealth & Life June 2015 9

Endnotes 1 Full quote: You would think that people would be lining up now to get mortgages to buy a home. It s a good way to go short the dollar, short interest rates. It is a nobrainer. Fortune Magazine conference, October 7, 2014. <http://www.bloomberg.com/news/articles/2014-10-07/ buffett-says-no-brainer-to-get-mortgage-to-short-rates>. 2 Full quote: Just between the two of us, I recently tried to refinance my mortgage and I was unsuccessful in doing so. National Investment Center for Seniors Housing and Care Conference, October 2, 2014. <http://www.bloomberg.com/ news/articles/2014-10-02/you-know-it-s-a-tough-market-whenben-bernanke-can-t-refinance>. 3 Meissner, Thomas. Intertemporal Consumption and Debt Aversion: An Experimental Study. Technical University of Berlin; Berlin, Germany (2013). 4 See Your Wealth & Life: Goals-based Wealth Management for an overview. 5 See Crook, Michael, Millennials: Age, Asset Allocation, and Human Capital. January 24, 2014. 10 June 2015 Your Wealth & Life

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Publication details Publisher UBS Financial Services Inc. Wealth Management Research 1285 Avenue of the Americas, 20th Floor New York, NY 10019 This report was published on 1 June 2015. Editor in chief Michael Crook Contributors (in alphabetical order) Matthew Baredes Michael Crook Andrea Fisher David McWilliams Brian Rose Mike Ryan Project Management Paul Leeming Drew Gilmore Desktop Publishing George Stilabower Cognizant Group Basavaraj Gudihal, Srinivas Addugula, Pavan Mekala and Virender Negi 12 June 2015 Your Wealth & Life

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